Monthly Archives: November 2010

Support Representative Kaptur’s Bill: Time to Shut Down MERS and to Restore the Rule of Law

By L. Randall Wray
Every link of the home finance food chain was designed to promote fraud—from the mortgage brokers and appraisers who conspired to overvalue property to stick buyers with overpriced homes, to the mortgage lenders who preferred the riskiest mortgages to maximize interest and fees, on to the investment bankers that packaged them into securities that they bet would blow up, and to the credit rating agencies who conspired to certify the junk as triple A. We should not forget the hedge fund managers who worked closely with investment banks like Goldman to re-securitize the very worst stuff into CDOs, sold on to Goldman’s gullible customers, nor the mortgage servicers (who not coincidentally happen to be the same biggest banks that created the toxic mortgages) who now maximize late fees as they drag out foreclosures while preventing loan modifications.

But that is not the end of the story, by any means. The next shoe that dropped was the recognition that the foreclosures, themselves are fraudulent. Heck, it wasn’t enough that banks are foreclosing on the wrong debtors, sometimes with two banks competing to foreclose on the same owner–they are also foreclosing on homeowners with no mortgages, who own their homes outright! Banks were caught hiring professional fraudsters to manufacture documents, including the “wet ink” notes that are required to prove that one is actually a creditor. Mere document forgery is not bad enough as bank management lies in court—committing perjury: they claim to have misplaced documents, lost them, cannot find them, looking for them, dog ate them, accidentally sent them through the wash. You know the drill if you have ever taught a class of freshmen.

Yet, all is said to be in order—Bank of America claims to have reviewed its foreclosures and could not find a single improper action. After all, the homeowners are clearly deadbeats who are not making payments. A bunch of borrower fraud by clever high school dropouts that duped the nation’s most sophisticated “big boy” banks. Can the banks prove that? Uh, no, they have not kept adequate records to prove who owes what, who owns what, and who has paid what to whom. But they are sure the docs will show up, as soon as the banksters can forge them.

Ah, yes, ain’t the “ownership society” (as ex-President Bush proclaimed it) just grand? It was always the plan to indebt homeowners and then to transfer their homes to the true owners in our society—those on the northside of the top 3% of the kinked income and wealth distribution. As planned, the elite are quietly buying up blocks of improperly foreclosed homes for pennies on the dollar. If we could just speed up the foreclosures, dump more homes onto the market, and push the prices down some more, we could complete the transition to Bush’s ownership society—ownership at the top, indebted renters or homeless vagrancy everywhere else.

What has been truly shocking is the state of the paperwork. These are banks! One would think that they might have hired a few people to keep track of the documents, the payments, the delinquencies? But, no, they didn’t do that. Lost ‘em. Do you want to trust your life savings to these bozos—who have no idea where they might have misplaced something as important as the note that proves they are entitled to foreclose on a home when the debtor stops making payments on the mortgage? The same banks that misplace the payments, credit them to the wrong account, and send foreclosure notices to the wrong homeowners? Oh yes, I want them to handle my banking account with the automatic payments on auto loans for cars I never owned!

In their defense, the banksters say that they never saw a wave of delinquencies coming, so they never hired the staff required to take care of all the paperwork. Michael Heid, co-president of Wells Fargo Home Mortgage, claimed “In hindsight, we were all slow to jump on the issue. When you think about what it costs to add 10,000 people, that is a substantial investment in time and money along with the computers, training and system changes involved.” Yes with delinquencies spiking since 2007, the banksters have been a wee bit slow on the uptake—almost 4 years into the crisis they are now starting to ramp up, you betcha! Servicing a mortgage was never thought to be sufficiently profitable that one would actually want to devote resources to collecting the payments, crediting the accounts, documenting the delinquencies, and foreclosing when things go bad. So much paperwork, so little profits.

A critic might retort that they ought to hold off on the foreclosures until they actually do hire the staff and locate the necessary paperwork. But that would throw a monkey wrench into the plans for an ownership society. So many millions of homes to foreclose, so little time to throw those families out onto the streets.

So they’ve been busy hiring “Burger King kids” with no education or training or expertise, who couldn’t tell a mortgage note from a Freedom fry. They’ve created a whole new occupation, the RoboSigner. Not quite the RoboCop, the job description for the RoboSigner only requires a willingness to forge documents and to serve hard time behind bars with guys and gals pierced in places you don’t want to see. The banks make them executive Vice Presidents, hand them a notary stamp and a pen and tell them they need—oh—10,000 signed and notarized notes by end of business. Like, today, Buffy!

Sorry, that dog won’t hunt. The truth is that the banks purposely destroyed the documents and created a superficially sloppy system because that made it easier to perpetrate fraud– accounting fraud, tax fraud, and document fraud–in order to enrich top management. Fraud. Fraud. Fraud.

Let us just focus here on the role played by MERS—Mortgage Electronic Registry Systems Inc—which registers 66 million mortgages, or 60% of the total. This was created to defraud counties all across the country. In the old days, a mortgage got recorded and a fee was paid for the service, and each time the mortgage got resold another recording and fee was required. The purpose is to ensure clear claims on property—both to ensure that foreclosures are proper and to ensure that when foreclosed property is sold, the new owner can be ensured of clear title. The procedure dates back hundreds of years and is necessary if you want private property rights.

But the banksters hated those recording fees, particularly because the securitized mortgages might be resold a dozen times—and who wants to pay a fee for each transaction. That is so 1980s. (Of course, banksters love to charge fees for every transaction—for every breath you as customer take–they just hate to pay them!) So MERS claimed to offer an alternative, circumventing the county fees and tracking electronically the transfers of ownership of mortgages. It was also more modern—no more wet ink notes that might get lost in the wash or eaten by the neighbor’s dog. The records would be electronic, more efficient, and certainly more foolproof. Right!

No worries about errors of data entry, system crashes, hackers, or fabricated records. The whole thing would be idiot proof, and to prove that, MERS hired, well, idiots to run the thing. And the pudding’s proof is now featured in foreclosure cases at a court near you, with the idiots appearing before judges and trying to explain why the whole thing is an idiotic mess replete with errors of data entry, system crashes, hackers, and records fabricated by idiots squared and cubed, just like the securities based on the underlying sliced and diced mortgages put together by richly rewarded idiot savants now vacationing in the Caribbean.

Besides, banksters had learnt their lesson from Ollie North and needed plausible deniability. Those pesky little documents might come back to haunt them should someone later file a lawsuit. We know that brokers pushed inappropriate and unaffordable mortgages onto home buyers. We know that brokers and bankers forged documents—often after the fact to make mortgages appear to fit requirements investors placed on securities. We know that Goldman sold toxic CDOs to customers then bet on failure. In short, we know that everyone involved in the food chain was perpetrating fraud. Fraud, with a capital F. It was, and remains, the preferred business model of Wall Street.

MERS seemed to offer the perfect instrument for fraud, with its motto “process loans, not paperwork”. The Florida Mortgage Bankers Association admits that its members purposely destroyed the notes on the belief that electronic registry was sufficient, more modern, and carried no paper trail. Banks all over the country “misplaced” damaging documents, fed them to dogs and shredders, and then replaced them with conveniently more useful forgeries. Most notes were probably never transferred from the brokers—many of whom went bankrupt—putting mortgages and securities into a hellish limbo. Some reports indicate that fired workers took notes home as bargaining chips for back pay. They probably ended up lining bird cages and cat litter boxes. Can anyone say “clear chain of title”? In any event, who wants paperwork that might result in real jail time? Best to give it to the birds.

MERS also helped to perpetrate tax fraud. Mortgages were typically securitized and pooled in a Real Estate Mortgage Investment Conduit (REMIC) that would hold them in trust. Done properly this allowed them to take advantage of an IRS tax exemption. However, to avoid the county recording fees, MERS claimed to hold the mortgage loans so that it could allow them to be traded without paying the fees and filing the paperwork. But if MERS was holding them, how could they be in the REMIC trust? The IRS code is very strict—the paperwork must be conveyed to the REMIC. There must be a clear paper chain of title through the securitization and sales. Without the paperwork, the securitizations may not be legal, and could subject investors to back taxes and penalties. And in 45 states the notes are required for foreclosure.

MERS is busy helping to foreclose on its theory that it holds the mortgages—yet it does not have any notes. And if MERS really is the holder then the REMIC was a tax fraud from day one. So MERS wants it both ways at once: for the purposes of the REMIC tax advantage, MERS is only a database; but for the purpose of the securitizations and avoidance of county fees, MERS is the owner of the mortgages. Nice work if you can get it—tax evasion and fee avoidance.

In response to this mess, Representative Marcy Kaptur (Ohio) is going to introduce legislation to prohibit Fannie and Freddie from buying new mortgages that are registered in MERS. Since there is virtually no activity in mortgage markets save what Fannie and Freddie are doing, this would effectively take away all new business from MERS.

Further, her legislation would direct HUD to study the creation of a federal land title system to replace MERS while protecting rights of state and local governments. This is a sensible solution that would modernize the recording and tracking of property ownership. At the same time it would put out of business the hopelessly incompetent MERS, which has partnered with the banksters to perpetrate foreclosure fraud. Bye bye fraudsters.

Predictably, the industry has responded with an army of lobbyists who are spreading funds around Washington, hoping to buy the support that will be needed to protect MERS and the fraudsters. They want Congress to retroactively legalize everything MERS and the banksters did: legalize the avoidance of recording fees that cost counties billions of dollars; legalize the tax fraud that reduced Treasury revenue; legalize the illegal foreclosures; and legalize the securities fraud.

Oh, and they want Congress to reward MERS for its supreme incompetence by granting it the monopoly rights to run a national registry of mortgage fraud. Sort of like picking “heckuvajob Brownie” to run disaster relief. Wait, we tried that, with predictable results.

The truly scary thing is that MERS could win. Congress had already tried to legalize fraudulent forgery with its Interstate Recognition of Notarizations Act of 2009. President Obama used his pocket veto to decline to sign it. But we cannot be sure that he will block MERS’s latest attempt to ex post validate past illegal practices.

Congress is being told that nothing short of legalization of fraud will end the crisis of improper foreclosures as well as the lawsuits by investors in the fraudulent securities. It is claimed that we must let the banks continue to seize homes—even where they can provide no proof that they are creditors. We must stop the suits by investors like the NYFed and PIMCO, who claim that the mortgages put into securities did not correspond to the representations made by the investment bankers. And we have got to prevent the counties from collecting the fees they are owed. In short, we have to legalize robbery to save Wall Street’s robber barons.

Nothing could be farther from the truth. This crisis will not end until the fraud stops and the fraudsters are securely behind bars. The rule of law must be restored before faith in our institutions and our economy can be renewed. Both the right and the left can come together on this issue, to support Representative Kaptur’s legislation to stop government support for MERS. Prohibiting Freddie and Fannie use of MERS is the first step to restoring sanity in America.
Here is the beginning of my post. And here is the rest of it.

Yes, Deficit Spending Adds to Private Sector Assets Even With Bond Sales

By Stephanie Kelton

In a recent blog post, I explained that government deficits increase the private sector’s holding of net financial assets. And this led to the following question from one reader:

“How does a chartalist respond to the idea that gov’t spending does not actually add $ to the private economy because of debt issuance?”

And to the following command from another:

“stop insisting that gov’t deficits add wealth to the private sector (they don’t if the gov’t sells debt).”

Apparently, both readers believe that budget deficits could, in theory, increase the private sector’s holding of net financial assets, but that, in practice, they do not because, the sale of bonds “pulls dollars out of the private economy,” leaving the private sector with no net addition to their holding of financial assets.

Continue reading

The Celtic Chimera

By William Black

(fist published on

I’m writing from the scene of the first Kilkenomics Festival, which brings together finance experts and professional comics to try to answer the public’s questions about why the world is suffering recurrent, intensifying financial crises, why Ireland has gone to the heights and crashed spectacularly, and what options does it have that other nations in crisis have used successfully.

David McWilliams, an Irish economist, and Richard Cook the man that started the Kilkenny comedy festival (Cat Laughs) decided to create an economics festival with sessions run by professional comedians questioning the economists. This is an utterly bizarre idea, so I accepted immediately. It turns out that professional Irish comics are every bit as quick and well read as you would have guessed by extrapolating from what you see on Jon Stewart’s Daily Show. (Irish angst and Jewish angst bear a strong resemblance.) There’s a long European tradition of the “fool” being able to mock the pretentious and powerful and bring out the truth. Talking to the comics and answering their questions forces us to speak clearly and bluntly – or be skewered. The public love it (both parts – getting clear answers to their questions or watching the comics skewer us) and the roughly 20 events have been sold out.

Ireland was known as the “Celtic Tiger.” It shot to economic fame. From the poor man of Northern Europe, it was transformed into a nation with a reported per capita GDP equivalent to that of the United States. The old, true, and painful joke: “What’s Ireland leading export?” (Answer: “the Irish”) was reversed as people began to move to Ireland.

Unfortunately, the Celtic Tiger was ultimately revealed to be a Celtic Chimera. Irish bank supervision was so weak and Ireland’s banks so wild and crazy that the New York Times called Ireland the new “Wild West.” Ireland’s largest banks hyper-inflated twin bubbles in commercial and residential real estate. They grew massively. Fortunately, Lehman failed and the Irish banks’ ability to grow collapsed – which meant that the bubbles imploded in late 2008. Had it not done so, the Irish banks would have continued their staggering growth and caused almost incomprehensible losses (relative to the size of the Irish economy) when the (vastly larger) bubbles finally collapsed.

Anglo Irish Bank was merely the worst an awful collection of large Irish banks. The Irish entity disposing of the Irish banks’ bad assets is now estimating 70% losses on Anglo’s (copious) bad assets. That percentage loss estimate is, bizarrely, mandated to be as of a year ago even though property values have fallen significantly since that date and are expected to continue to decline next year. Non-linear increases in losses are common when a bubble hyper-inflates. Therefore, any estimate of the increased losses that would have resulted had the collapse of the Irish bubbles come two years later should assume percentage losses on the new assets of well above 75%. The size of Irish bank losses that the Irish government claims its taxpayers should bear is contested, but has a lower bound of roughly 60 billion Euros. Had Dick Fuld’s avaricious heart not led to Lehman’s collapse, or had Treasury bailed out Lehman and prevented (delayed) its failure, Ireland (and Iceland) would have collapsed as nations. If their banks had continued their growth for even two more years, Ireland and Iceland’s per capita debts would have been so staggering (in the range of $50,000) that they would have sparked massive emigration, which would have pushed the per capita debt even higher. Both nations would now be occupied almost entirely by pensioners and non-nationals.

The economists and finance practitioners that presented at the Kilkenomics Festival came from diverse streams of economic and political views. They, nevertheless, agreed on three points about the Irish crisis: (1) it was insane for the Irish government to provide and extend unlimited financial guarantees of virtually all debts of the failed Irish banks, (2) the Irish government had transformed a private banking crisis into a sovereign debt and budgetary crisis that imperiled Ireland’s recovery from the economic crisis and gravely stressed the EU and the Euro, and (3) that either the EU or IMF would bail out Ireland or Ireland would default.

I’m going to write a series of columns about what I’ve learned by examining the Irish and Icelandic crises. I urge readers to take these two small islands’ experience seriously for at least five reasons. First, one of the key analytical issues has long been which flashpoint would spark the next stage in the ongoing, global financial crises. The leading candidates have been the EU periphery and the collapse of the still-growing Chinese bubbles. (Of course, they may occur simultaneously or the first crisis may quickly trigger the second.) Europe now looks like it will win the “next crisis” race. (I believe that the European Union (EU) is rich enough to paper over the crisis for several years, but European politics could scuttle that effort.)

Second, the EU is set up in a fashion that creates strong, perverse incentives for future financial crises. Third, the EU is set up in a fashion that is periodically strongly criminogenic in particular nations. These criminogenic environments will feed future epidemics of “accounting control fraud” – the leading cause of severe financial crises. Massive amounts of European money will move to fund these frauds, which will cause financial bubbles to hyper-inflate and produce catastrophic banking losses and severe recessions.

Fourth, the EU is set up in a manner that makes it extremely difficult (and expensive) to attempt to respond to the severe recessions and debt crises that these perverse incentives generate. The EU “channels” IMF’s “let’s turn a financial crisis into a crisis of the real economy” strategy.

Fifth, the Irish government’s response to their epidemic of fraudulent lending has been so exquisitely awful that it (A) demonstrates the catastrophic costs of deregulation, desupervision, and deifying finance, and (B) allows one to illustrate why it is essential to combine good analytics, skepticism, courage, and integrity in responding to such epidemics.

One of the independent reports that the Irish government commissioned about the banking crisis was co-authored by Professor Karl Whelan of University College Dublin. That report has received moderate attention and I will discuss it in more detail in future posts. Professor Whelan, however, has provided a far more candid briefing paper for the European Parliament: “The Future for Eurozone Financial Stability Policy” (September 2010). His briefing paper makes clear why there will be an EU bailout of the Irish banks. One of his key conclusions is that sovereign defaults by EU nations are likely and that the EU must prepare now to deal with them. That fundamental candor is matched by his explanation for why the EU created a bailout fund earlier in 2010.

“While the public discussion of this decision has largely focused on the idea that the agreement was aimed at preserving the Euro as the common currency, the truth was more prosaic: The European banking system was already in a fragile state and would not have coped with a series of sovereign defaults. The need to maintain financial stability, specifically banking sector stability, was what prompted the unprecedented announcement of the bailout funds.”

“The health of the European banking system remains in question. The most likely trigger for sovereign defaults in the next few years is a prolonged period of slow growth or perhaps a double-dip recession.”

Whelan is trying to make clear the great underreported fact of the Irish banking crisis – the broader EU banking crisis. (And, while Whelan does not emphasize this point, his discussion inherently means that there was a horrific failure of EU banking regulation.) He explains that the European “stress tests” were farcical because they assumed no sovereign defaults could occur and ignored all market value losses on the banks’ “held for investment” exposures to sovereign risk. He cites the OECD study that discussed these massive loss exposures. The OECD emphasized that the losses were lumpy.

“Large cross-border exposures (defined as an exposure above 5% of Tier 1 capital) to Greece are present for Germany, France, Belgium (all with systemically important banks), Cyprus and Portugal. Large exposures to Portugal are present in Germany and Belgium; to Spain in Germany and Belgium; to Italy in Germany, France, Netherlands, Belgium, Luxembourg, Austria and Portugal; and to Ireland in Germany and Cyprus.”

The alert reader will have noted the nation whose banks have large, unrecognized losses on debt among each of the PIIGS – Germany. German banks acted like drunken “Girls Gone Wild” as soon as they were approached by a foreign borrower. Germany’s Banks Gone Wild were hooked on yield – for a trivial increase in yield, without any meaningful due diligence, they made massive unsecured loans to many of the most fraudulent borrowers throughout Europe. Borrowers engaged in control fraud have two great attractions for bankers gone wild – they typically report extreme profitability (which makes them appear to be creditworthy to the credulous) and they are willing to promise to pay higher interest rates). Their promises, of course, have all the reliability of the producers’ of “Girls Gone Wild” promises that the girls will be able to launch a film career if they shed their clothes.

Where were the German banking regulators? They seem to have believed that “What happens in Vegas (Dublin) stays in Vegas (Dublin).” Instead, their German banks came back from their riotous holidays in the PIIGS with BTDs (bank transmitted diseases). The German banks’ regulators continue to let them hide the embarrassing losses they picked up on holiday, but that cover up will collapse if any of the PIIGS default. The PIIGS will default if the EU does not bail them out, so there will be a bail out even though the German taxpayers hate to fund bailouts.

All of this should put a very different interpretation on Chancellor Merkel’s insistence on unsecured creditors suffering losses when they lend to banks that fail. She has argued that it is essential that they suffer losses so that they will have the proper incentives to provide effective “private market discipline” and that it is fair that they suffer losses given the premium yields they received and their lack of due diligence. German banks would be the primary losers under her proposal, so her position is remarkable. She is apparently disgusted with the German “banks gone wild” that were the largest funders of the accounting control frauds that drove several of the epicenters of the European financial crises and helped push Europe into the Great Recession.

Just What is Bernanke Up To?

By L. Randall Wray

(via New Deal 2.0)

On the eve of President Obama’s arrival to the G20 talks in South Korea, a growing chorus of voices is questioning the direction of U.S. monetary policy. Germany’s finance minister, Wolfgang Schaeuble, went so far as to scold Chairman Bernanke, saying “With all due respect, U.S. policy is clueless.” Some critics (with justification) have argued that America is guilty of the “currency manipulation” policy for which it castigates China. Others have argued that US policies are opening the door to a complete revision of the international monetary system based on the dollar. World Bank president Robert Zoellick appeared to even suggest a return to the gold standard when he talked of “employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”

I already argued that QE2 is more of a slogan than a policy, and will not repeat those criticisms here. Rather, I will deal with the two most important issues and misunderstandings surrounding quantitative easing. The first concerns the consequences of injecting another $600 billion of excess reserves into the banking system. The second is associated with the Fed’s attempts to lower long-term interest rates through purchasing treasuries. Both of these issues are in turn connected to the belief that QE2 will devalue the dollar and threaten its status as the international reserve currency. That, however, is a topic for another column.

All developed countries’ central banks now operate with an overnight interest rate target (the fed funds rate in the US). To hit this rate, they must supply reserves more or less on demand. We can think of the supply of reserves as “horizontal”, that is, as an infinitely elastic supply at the target interest rate. The simplest way to operate such a system is to offer “overdraft” facilities at the central bank, lending on demand at the target rate (this is done in Canada). Knowing that they can obtain reserves any time they want, banks would never hold substantial excess reserves, since they could borrow them as needed.

The Fed has never explicitly operated this way, preferring to supply most reserves through its open market operations (purchasing treasuries) while imposing “frown” costs on banks that come to the discount window. Most of the time, this does not really matter. However, when the financial tsunami hit, the fed funds market froze up as banks refused to lend to one another, even on the basis of good collateral. There was a general run to liquidity, and no bank felt it could get enough reserves to see it through the crisis. The Fed played around with an alphabet soup of auction facilities rather than simply announcing that it would supply reserves on an unlimited basis to all comers. That cost the economy dearly by dragging out the liquidity crisis. Fortunately, the Fed finally stumbled upon the obvious: supplying reserves in sufficient quantity. The liquidity phase of the crisis passed, and the Fed got the short-term interest rates down to its near-zero target.

So here is where Bernanke’s pet, quantitative easing, came in. Conventional wisdom is that the once the central bank takes the short-term rate to zero, it has shot its wad. Nayeth, sayeth Bernanke — the Fed can continue by flooding banks with excess reserves, which they do not want to hold. Some commentators have said that banks would eventually begin to lend out the excess reserves, seeking a higher interest rate than the Fed pays them. One hopes Bernanke never made that mistake — banks do not lend reserves (except to one another), since they exist only as entries on the Fed’s balance sheet. Only an institution with a “checking account” at the Fed can hold reserves, so there is no way a bank can lend these to households or firms (which do not have accounts at the Fed). So Bernanke presumably understood that if for some reason holding excess reserves caused banks to want to increase lending, this would simply shift the reserves around the banking system while leaving the outstanding quantity unchanged. But that means that offering Canadian-like overdraft facilities, promising banks they can have reserves anytime they want them, would have had the same impact as quantitative easing. Rather than actually holding excess reserves, the banks would have been just as happy knowing that they were safely “locked up” at the Fed and available anytime they were needed. In other words, pumping about $1.5 trillion into the banks would be no different than telling them the Fed would supply any amount at any time.

In sum, adding excess reserves to bank portfolios will not, by itself, do anything if the overnight interest rate has already been driven down to its near-zero target. QE2 proposes to add another $600 billion of excess reserves — but whether banks have $1 trillion or $10 trillion in excess reserves will have no impact.

So why would QE have any impact at all? Because to get those excess reserves into the banks, the Fed buys something from them. What did the Fed buy? Good, safe (mostly short-term) treasuries, and bad, toxic waste: mortgage backed securities. Now, treasuries are effectively reserves that pay a higher interest rate; they are like a saving account at the Fed, rather than a checking account. So when the Fed buys treasuries from a bank, it debits the bank’s saving account and credits its checking account. This will have no appreciable impact on the bank’s behavior and thus will have no discernible economic effect.

But if the Fed buys trashy assets, and at a nice price, the banks are able to shift junk they don’t want off their balance sheets and onto the Fed’s. And if the Fed were to do that in sufficient volume, it could turn insolvent banks into solvent ones. In truth, the Fed did buy a lot of junk, but banks were left with trillions of dollars of toxic waste assets — probably much worse than the trash they sold to the Fed — so they are still massively insolvent. Thus, while QE1 was useful, it did not come close to resolving the insolvency problem. It bought time for some of the trashiest banks, which they devoted to ramping up their dangerous and largely fraudulent activities, digging the hole ever deeper — but that, too, is a story for another day.

With QE2, the Fed proposes to buy longer-term treasuries. Since these are not toxic, it will not help the banks. It is like transferring funds from CDs they hold at the Fed to their checking accounts, thereby reducing their interest earnings. I suppose the idea is that the Fed is going to reduce bank income, impoverishing banks to the point that they will finally throw caution to the wind and begin to make loans to struggling firms and households. It is simultaneously a strange view of banking and also a scary remedy to a financial crisis that was created by excessive bank lending to those who could not afford the loans. It’s sort of like sending a covey of nymphomaniacs to the hospital bed of a nonagenarian suffering from myocardial infarction initiated by an age-inappropriate tryst.

The only plausible scenario in which this can prove useful is that QE2 pushes up prices of long maturity treasuries, lowering their yields. This could cause other longer-term interest rates to fall through competitive bidding by banks seeking better returns in alternative assets. Now, mortgage rates are already at historic lows, and what is needed to spur real estate markets is not lower interest rates (which will only generate big problems later when rates rise, crushing the holders of legacy mortgages that earn well below 4%) but rather the recovery of real estate markets. Only when it is clear that home prices have reached bottom and turned up will real homebuyers step forward — that is, buyers other than the vultures making speculative purchases of blocks of homes at pennies on the dollar. So far as business borrowing goes, the problem is the market for firms’ output, not excessively high interest rates. So the “bang for the buck” in terms of inducing domestic spending by lowering long-term rates cannot be very large and may not even be positive, since reducing interest rates also reduces the income of savers, which could depress spending.

This brings us back to the international sphere, and the fear that QE2 really means to succeed by “beggaring thy neighbor”. Bernanke has talked openly of his desire to raise inflation expectations, and that, in combination with lowering interest rates, could make America a less attractive investment option. If so, the dollar could depreciate, increasing US competitiveness in traded goods and services. This could boost exports.

At the same time, international managed money would be looking for more attractive investments in strong currencies with higher interest rates — say, the BRICs (Brazil, Russia, India, China) — fueling appreciation of their currencies. In other words, QE2 would do for the US what Geithner claims Chinese currency policy is doing for China: cheapen our exports. At the same time, many developing nations are also facing destabilizing capital inflows, and worry about a reprise of the Asian crisis of the late 1990s when the flows reversed and wrought havoc on their economies. That is why they are threatening to drop the dollar, reduce capital mobility, and move to some sort of fixed exchange rate based on gold or a new international currency.

I do not have the space to completely address all of these issues, but I will just say that while much confusion surrounds the complaints thrown at the US, there is at least an element of truth in the claim that QE2 puts the burden of adjustment on other nations. The critics are certainly right to argue that so far as domestic policy goes, QE2 does nothing to get the US out of its crisis. In fairness to the Fed, Bernanke has argued that relying solely on monetary policy for stimulus is less than ideal, so one could argue that the Fed is just doing the best it can in the absence of stimulative fiscal policy. That is correct, up to a point — only fiscal stimulus will get us out of the recession.

But Bernanke is not dealing with the one area for which the Fed does have primary responsibility, and in which a strong Fed policy initiative would do a lot of good: dealing with bankster fraud. Indeed, I believe that even with a huge fiscal stimulus (which is not going to happen) we would not escape another financial collapse and a long and deep economic depression unless the biggest banks are foreclosed. Right now the fraudsters are the biggest barrier to recovery.

At best, QE2 is a diversion from the task at hand.

Will QE2 Threaten the Dollar’s Status as Global Reserve Currency

By L. Randall Wray

(via Benzinga)

On the eve of President Obama’s arrival to the G20 talks in South Korea, a growing chorus of voices questions the direction of U.S. monetary policy. (Take a look here or here)

Germany’s finance minister, Wolfgang Schaeuble went so far as to scold Chairman Bernanke, saying “With all due respect, U.S. policy is clueless.” (As seen, here)

Some critics (with justification) have argued that America is guilty of the “currency manipulation” policy for which it castigates China. (You can see this, here)

Others have argued that US policies are opening the door to a complete revision of the international monetary system that is based on the dollar. (As seen, here)

World Bank president Robert Zoellick appeared to even suggest a return to some sort of gold standard when he talked of “employing gold as an international reference point of market expectations about inflation, deflation and future currency values”. (See this, here)

I already argued that QE2 is more of a slogan than a policy, and will not repeat those criticisms here. (To see this, click here)

In a new piece at New Deal 2.0, I deal with the two most important issues and misunderstandings surrounding quantitative easing. The first concerns the consequences of injecting another $600 billion of excess reserves into the banking system. The second is associated with Fed attempts to lower long term interest rates through purchases of treasuries. In sum, I argue that QE2 will do no more good than QE1 did because banks already have massive excess reserves and because lower long term rates is not a solution to a situation in which home prices and the markets for goods and services must first turn around before banks will want to lend and households and firms will want to borrow.

Both of these issues are in turn connected to the belief that QE2 will devalue the dollar and threaten its status as the international reserve currency. That is the topic for this column.

With QE2, the Fed will buy $600 billion worth of longer term treasuries (and will “reinvest” another $300 billion of revenues from the previous QE1). The only plausible scenario in which this can prove useful is by “beggaring thy neighbor”. Bernanke has talked openly of his desire to raise inflation expectations, and that in combination with lowering interest rates could make America a less attractive investment option. If so, the dollar could depreciate, increasing US competitiveness in traded goods and services. This could boost exports and depress imports.

At the same time, international managed money would be looking for more attractive investments in strong currencies with higher interest rates—say, the BRICs (Brazil, Russia, India, China)—fueling appreciation of their currencies. In other words, QE2 would do for the US what Geithner claims Chinese currency policy is doing for China—cheapen our exports through a weak currency. No wonder the Chinese are outraged at Secretary Geithner’s finger pointing and accusations of currency manipulation!

At the same time, many developing nations are also facing destabilizing capital inflows, and worry about a reprise of the Asian crisis of the late 1990s when the flows reversed and wrought havoc on their economies. That is why they are threatening to drop the dollar, reduce capital mobility, and move to some sort of fixed exchange rate based on gold or a new international currency.

China has long called for reformation of the international monetary system, preferring movement toward something like J.M. Keynes’s “bancor”—an international currency delinked from any particular country and used for clearing accounts among nations. Meantime, China has moved toward bilateral agreements, using currencies of trading partners rather than going through the dollar. Others have talked about the creation of three or four trading blocks, each using one of the world’s dominant currencies—a dollar area, a euro area, perhaps a pound sterling area, and a yen (or yuan; or won?) area. What I consider to be the nuttier proposals are those that would return to some sort of gold standard.

I do not have here the space to completely address all of these issues, but I will say that while much confusion surrounds the complaints thrown at the US, there is at least an element of truth in the claim that QE2 puts the burden of adjustment onto other nations. The critics are certainly right to argue that so far as domestic policy goes, QE2 does nothing to get the US out of its crisis, and it will work (for the US) only if it depresses the dollar and fuels US exports. But let us examine the arguments for international currency “reform”.

First, gold because that is the easiest. Some have argued that markets are already moving to gold as an alternative “monetary asset”. That is nonsense—gold is not a monetary asset, rather, it is a commodity (of some historical interest because of the two hundred or so year experience on-and-off the gold standard). Gold is currently enjoying a speculative boom (as are many other commodities—much as they did from 2004 to 2008, which was the biggest commodities price boom in human history). That is not too surprising—with the current depression it is hard to find any place to park managed money, and commodities markets are very small relative to the volume of money to invest (except oil and grain), so it does not take much movement into commodities to blow up their prices. Even on the gold standard, gold was never money. Rather, government pegged gold’s price in terms of the domestic currency. It was always a very bad idea. Successful pegging means government has accumulated enough gold to maintain the peg. From the other side, it means government has got enough gold to fend off any speculative attack of those shorting the currency—betting the peg cannot be maintained. Think George Soros. We do not even need to revisit all the economic depressions of the 1800s as well as the 1930s Great Depression to come up with a good argument against tying a nation’s fortunes to the value of gold. That is a subject for gold bugs, Austrians, and other (let us put it delicately) nut jobs.

So what about a “bancor” international currency? Fine. It requires an issuer. It requires international agreements on the conditions under which it is issued. It requires punishment of nations that violate agreements. That sounds like the euro. It is the euro. Who wants to be the next Greece? With no volunteers, let us move on.

The final possibility is division of the world into currency blocks. That is fine and indeed we are close to this already. The problem is that within a currency block, you have got the “regional” currency but between currency blocks you have got to choose the currency of denomination. For the near future, which will extend beyond a time that no one today can contemplate, it will be the dollar. For better or for worse, the dollar will remain the international reserve currency.

I do agree with critics that such a status implies responsibilities—responsibilities that the US has not been living up to. The rest of world needs dollars, especially in a crisis. It obtains those dollars by exporting to the US, and by attracting capital flows. But the US is mired in a deep recession, and it shows no signs of willingness to deal with the financial crisis that makes it impossible for the economy to recover. That is not the behavior that one must expect of the issuer of the international currency. Debasing the currency through policy designed to encourage capital flight or inflation is not appropriate to maintaining the dollar’s status. Critics are right to castigate Washington for short-sighted policy. (See this here)

The best thing that can be done, both for the US as issuer of the dollar and for the rest of the world users of the dollar, is to promote economic recovery in the US. This is not a matter of “affordability”. The US government can “afford” anything for sale in terms of dollars. It is a matter of political will. Can the US overthrow the silly pronouncements of deficit hawks, including today’s statements by the “Fiscal Responsibility” commission, ( to formulate a fiscal stimulus package that will put the US on the road to recovery? If so, the dollar’s problems will disappear. If not, run to gold.

Finally, maintaining the dollar’s international appeal also requires imposition of the rule of law in the US. Currently, the fraud perpetrated by the biggest banks is far worse than anything the Russian kleptocrats and mafia combined could possibly imagine. The US is in the grips of the worst scandals in world history, with the financial sector no longer constrained by anything that would be recognizable as lawful practice. And that is the biggest threat to the dollar as international reserve currency. Unless the top banks are closed, with their management jailed, there really is no hope for the US dollar or for its economy.

Keep the Deficit. Ditch the Doves.

By Stephanie Kelton

I just read another disappointing piece dealing with the preliminary recommendations from President Obama’s fiscal commission, this time from a contributor at The Huffington Post. Like any good deficit “dove,” he concedes the existence of the crisis, which he says any idiot with a third-grade education could recognize:

“The magnitude of the financial management of our government does not require algebra, calculus or knowledge of algorithms.”

Continue reading

If You Really Care About Social Security, Stop Capitulating to the Left

By Stephanie Kelton

I woke up this morning expecting to spend the better part of the day writing letters of recommendation for Ph.D. students. Then I came across an e-mail message that had been posted to a list serve that is read by many progressive (some might say “radical”) economists. The subject line read: DEFEND SOCIAL SECURITY so I took the time to read it.

Its author was outraged by the recommendations coming out of President Obama’s “bi-partisan” deficit reduction commission, which he characterized as “disgusting” and something that should “be fought as hard as possible.” Then, having urged “credentialed economists” to “take the fight” to the airwaves, newspapers, Internet, etc., he drew my ire and derailed my morning plans (sorry students) with the following tactical proposal:

“[I]t sometimes is necessary to defend incremental reforms when they’re under attack.”

Allow me to suggest an alternative approach, one that actually would be “radical” and therefore appealing to a self-proclaimed radical: Let’s start telling the truth about Social Security. We are not (or should not be) patsies for the Democrats (or any other political party or organization). We are educators. So let’s educate people on the basic facts.

Fact #1: Social Security is not “broken.” It is not “going broke.” It will, as Eisner told us more than a decade ago, “be there” as long as we protect it from its so-called saviors.

Eisner, Robert. “Save Social Security from its Saviors”, Journal of Post Keynesian Economics, Vol. 21, No. 1, Fall 1998). This is, in my view, the most honest and concise essay on the subject.

Bell and Wray. “Financial Aspects of the Social Security ‘Problem’”, Journal of Economic Issues, Vol. 34, No. 2, June 2000.

Fact #2: The balance in the Social Security Trust Fund is absolutely irrelevant when it comes to the government’s ability to make payments, in full and on time – today, tomorrow and forever.

Eisner (again) who said, “Accountants can just as well declare the bottom line of the funds’ accounts negative as positive – and the Treasury can go on making whatever outlays are prescribed by law”.

Bell and Wray again.

Greenspan: “A government cannot become insolvent with respect to obligations in its own currency.” (1997)

Greenspan: “I wouldn’t say that pay-as-you-go benefits are insecure, in the sense that there’s nothing to prevent the federal government from creating as much money as it wants and paying it to somebody. The question is, how do you set up a system which assures that the real assets are created which those benefits are employed to purchase” (2005)

Social Security isn’t broken. It doesn’t need to be “fixed”. Why on earth would we play along with this charade in order to give cover to the Democrats? Doesn’t anyone remember 1983? For anyone who doesn’t, that was the last time we saw “incremental reforms” of the kind many “progressive” economists support. As a result of those reforms, today’s workers are contributing more and retiring later. And for what? Those reforms were supposed to make the system solvent for 75 years. Now, here we are, less than three decades later and it’s still “broken”? And we’re supposed to defend further, incremental cuts?!

I guess it sounds like a small price to pay. An added year to two before retirement, a small hike in the payroll tax, a modest reduction in the cost-of-living adjustment. Whatever. Worth it to “DEFEND SOCIAL SECURITY” according to some. But just look at the impact of one of these so-called “incremental reforms”, taken from a paper I wrote in 2005:

Benefits promised to an average wage earner who retires in 2050 are a full 69% higher than the benefits that were paid to the average retiree in 2004. Republicans argue that these increases are too substantial and that the system promises a full $5,600 more than it can afford to pay to retirees in 2050. To deal with this problem, [they] call for a change in the way future benefits are calculated. If the President succeeds in redefining the formula, the “bend points” will be calculated using an inflation index instead of the current wage index.

At first glance, this might seem like a relatively innocuous adjustment. After all, the historical trajectory for prices is also upward, so benefits will still tend to increase over time. But prices tend to rise more slowly than nominal wages – over the long run – so benefits would increase less rapidly under inflation- indexing.

To see the full impact of switching to inflation indexing, consider the benefits that would be due to a hypothetical 20 year-old worker who enters the labor force in 2005, earns the average wage throughout her working life (roughly $36,500) and retires at age 65 in 2050. Using Congressional Budget Office (CBO) projections, she would be scheduled to receive benefits of roughly $22,000 (in today’s dollars). Thus, under the current system, she would receive $459,800 in guaranteed benefits over the course of her retired life (estimated at 20.9 years).

Now consider the impact of indexing to inflation rather than nominal wage growth over this same period. During the relevant period, the CBO projects that nominal wage growth will outpace inflation by 1.2 percent (i.e. real wages will grow at 1.2 percent). With the “bend points” indexed to inflation beginning in 2009, this worker will lose 1.2 percent of her scheduled benefit in each of the 39 years (2009 to 2047) included in her benefit calculation, leaving her with only 62.8 percent of her scheduled (2050) benefit. This amounts to a reduction of $8,184 in her annual benefit (0.628 x $22,000), which translates into a $170,000 reduction over the course of her lifetime!

So there you have it. Incremental reform? I doubt the twenty percent of retirees who rely on Social Security as their only source of income would agree. (Or the 60 percent who rely on it as their primary means of subsistence in retirement.)

Funding Social Security is always and everywhere a political choice. The strongest evidence of this comes directly from the 2009 Annual Report of the Trustees. In that report, they predict gloom and doom for Social Security because “there is no provision in current law that would enable full payment of benefits, once the Trust Funds are exhausted”.

In contrast, the Supplementary Medical Insurance (SMI) Trust Funds are “both projected to remain adequately financed into the indefinite future because current law automatically provides financing each year to meet next year’s expected costs.”

It is that simple. The former is in ‘trouble’ because the government isn’t committed to making the payments, and the latter gets a clean bill of health because the government will always make the payments.

It does not take courage to rally around the liberal mantra (Obama, Reich, Baker, Krugman, etc.) regarding ‘entitlements’ and ‘tough choices’. It takes courage to speak out against it.

Is there a zero bound? The “mysterious” world of negative nominal interest rates.

By Eric Tymoigne

Yesterday I attended a Federal Open Market Committee (FOMC) simulation at Reed College in Portland, OR. At the beginning of the simulation the President of the College jokingly asked participants to find a way to make the policy rate negative, so that we (the FOMC members) could pay banks who borrow reserves. Of course everybody in the audience laughed but let’s take a look at this more carefully: Could the Federal Reserve set the nominal federal funds rate and the nominal discount rate in negative territory?


The discount rate is the most straightforward to grasp: the Board of Governor has perfect control over the discount rate and can set it wherever it wants whenever it wants. There is no operational constraint that prevents the Board from setting a discount rate at -1%, -10% or even -100%, it just needs to announce tomorrow that this is what it is and that is it.

The federal funds rate is slightly more complicated but not that much. To set a negative fed fund rate, the Fed just has to do overnight repos on securities at a premium. If one applies this to zero-coupon securities like T-bills, the present value of a T-bill is:

P = F/(1 + d)t

P is the present value, F is the face value, d is the discount factor, and t is time to maturity (let’s set t = 1 to simplify). Usually, d is positive meaning that the Fed buys T-bills at $90 and bankers agree to buy back the next day at $95 (d = 5%). Currently, for practical purposes one can assume that d = 0%, i.e. if bankers want reserves from the Fed, they sell T-bills at $90 and promise to buy them back at $90 the next day. To set d negative, the only thing the Fed has to do is to buy at $95 and resell at $90; stated differently, the Fed just has to agree to accept T-bills as collateral at a value of $95 and bankers have to agree to buy them back at $90 the next day. In this case the federal funds rate target will be negative 5%: 90/95 – 1. If the Fed performs enough of these kinds of operations, the federal funds rate will reach the -5% target.

So there is no operational constraint on setting negative nominal interest rates.

Once one passes this first hurdle a second question that usually comes is: is it “moral,” or does it make sense, to get paid by the person who lent you money?

First, negative interest rates on borrowed money are not new. Take checking accounts, for decades you and I have been willing to deposit our funds at a bank while earning 0% and paying a fee to maintain our checking account. This still applies today if you do not maintain a certain amount of funds in your account. The same has been going on T-bills and T-bonds. For example, “from mid-1932 through mid-1942, the vast majority of coupon-bearing U.S. government securities bore negative nominal yields as they neared maturity” (Cechetti 1988: 1112). The bid price of newly issued short-term US Treasuries slightly exceeded par during some weeks in the 1930s and the 1940s (Board of Governors of the Federal Reserve System 1943: 460, 462; Clouse et al. 2000), which resulted in very small negative yields (averaging -0.05% (Cechetti 1988)). Similarly, Treasury bonds with less than a year to maturity reached a magnitude as low as -1.7%. More recently, Japanese short-term treasuries had a slightly negative yield in 1998. It also happened in 2001 and 2003 (repos) and again in 2008 (T-bills) in the US (e.g. Fleming and Garbade 2004). Those peculiar cases can all be explained relatively simply by technical aspects specific to those securities and/or the circumstances of the moment. And those rates would have gone more negative if the overnight inter-bank lending rate had been set negative.

Second, currently the Fed is advancing reserves at 0-0.25% and paying 0.25% on reserves, effectively having a negative carry on its reserve account. That’s negative interest rate by another name right there: banks can borrow reserves at a lower rate than what they get paid to hold them.

Third, does it make sense to set a negative interest rate? What makes sense is what satisfies the needs and financial considerations of borrowers and lenders. Does it make sense for you and I to pay a fee on our checking account even though the reward is negative (0% – fee) ? Yes it does because of the convenience of having a checking account. Did it make sense for financial market participants to agree on negative interest rates on T-bills and T-bonds? Yes it did given the considerations at the time. So IF the Federal Reserve thinks that it makes sense to set its policy rates in negative territory, it can do it. Not tomorrow, not with the help of others; now, and at its discretion. And it could do so not by injecting any excess reserves, but just by operating in a way it has been operating since 1914 as explained previously here.

Board of Governors of the Federal Reserve System (1943) Banking and Monetary Statistics: 1914-1941. Washington D. C.: Federal Reserve System.

Cecchetti, S.G. (1988) “The Case of the negative nominal interest Rates: New estimates of the term structure of interest rates during the Great Depression.” Journal of Political Economy, 96 (6): 1111-1141.

Clouse, J., Henderson, D., Orphanides, A., Small, D. and Tinsley, P. (2000) “Monetary policy when the nominal short-term interest rate is zero.” FEDS paper 2000-51.

Fleming, M.J. and Garbade, K.D. (2004) “Repurchase agreements with negative interest rates.” Federal Reserve Bank of New York Current Issues in Economics And Finance, 10 (5): 1-7.

Greenspan Finally Uses the F-Word. Will Holder and Obama be the Last Holdouts?

Let’s Set the Record Straight on Bank of America: Open the Books!

By William K. Black and L. Randall Wray

While we welcome Bank of America’s response to our two-part essay, “Foreclose on the Foreclosure Fraudsters,” it does not actually respond to any of the facts or analytical points we made. Indeed, it does not engage the issues we raised. Bank of America’s response contains some useful data on foreclosures that supports points we have made in prior articles, but overwhelmingly it is a plea for sympathy; Bank of America says it is beset by deadbeat borrowers and it is distressed that it is criticized when it forecloses on their homes. Bank of America portrays itself as the victim of an ungrateful public.
Bank of America Should be Placed in Receivership NOW

We argued that the FDIC should place Bank of America in receivership and the federal banking agencies should impose a moratorium on foreclosures until the mortgage servicers correct their systems, which currently often rely on massive fraud and perjury. There can be no assurance that foreclosures are lawful until the banks actually find the mortgage “wet ink” notes signed by debtors to prove they are the true beneficial owner of the mortgage debts, which is required to seize property. We also called on the banks to identify and compensate homeowners who were fraudulently induced to borrow by the lenders and their agents through a number of fraudulent practices variously marketed by lenders as “no doc”, liar, and NINJA loans (all subspecies of what the industry aptly called “liar’s” loans).

We showed that outside studies by a wide range of parties showed massive fraud by the bank.
The demands by investors that Bank of America repurchase loans and securities sold under false “reps and warranties” may cause exceptional losses if those making the demands document the broader fraud by the lenders. The article “Bank of America Resists Rebuying Bad Loans” shows that Bank of America’s potential loss exposure to Fannie and Freddie is staggering: “[Bank of America] said it sold $1.2 trillion in loans to the government-controlled housing giants from 2004 to 2008 and has thus far received $18 billion in repurchase claims on those loans.”

The company is fighting the groups that are demanding that it repurchase the toxic mortgages. Its CEO, Brian Moynihan counters their claims with the following analogy:

Such investors are like “people who come back and say, ‘I bought a Chevy Vega, but I want it to be a Mercedes with a 12-cylinder [engine],'” Mr. Moynihan said in October. “We’re not putting up with that.”
One-third of its subprime business is in default and Mr. Moynihan thinks Countrywide was selling Vegas? If one third of Vegas crashed and burned within three years of being purchased the metaphor might be apt and completely incriminating. We argued that putting Bank of America into receivership is the proper remedy for its substantial violations of the law and for its continuing reliance on unsafe and unsound practices. Outside reviews have documented the most extensive and financially harmful violations of law and unsafe banking practices and conditions in history.

As argued in a recent article by Jonathon Weil, the bank is nearing a “tipping point” as markets recognize it is “cooking the books,” vastly overstating the value of its assets as it refuses to recognize the true scale of losses on its purchase of Countrywide. Ironically, it still carries on its books $4.4 billion of fictional “goodwill” value created by overpaying for Countrywide (a notorious control fraud), as well as $142 billion of home equity loans that are worth far less. A more honest accounting of “good will” and of the value of home equity loans would take a big bite out of Bank of America’s market capitalization ($116 billion), which has lost 41 percent of its value since April 15. The markets are moving ever closer to shutting down the institution, but Moynihan is not “putting up with” the demand by investors for Bank of America to come clean on its fraudulent practices.

Ms. Mairone’s Response Verifies Our Claims

Rebecca Mairone replied on behalf of Bank of America to our two-part post. Step back for a moment and consider the context of Bank of America’s response. We cite evidence that the bank has committed massive fraud, explain that this provides a legal basis for placing it in receivership, and call on the FDIC to do so. Bank of America chooses to respond publicly, but its response never contests its massive fraud or our demonstration that there is a legal basis for placing it in receivership.

Instead, Bank of America complains that we “do nothing to illuminate the challenges [BofA’s home mortgagees] face.” This is not our task; nevertheless, the claim is incorrect. We illuminate the problems posed by the fact that nonprime borrowers were frequently victims of mortgage fraud perpetrated by lenders as well as many other operatives in the unprecedented criminal lending and securities fraud of the past decade. This problem is typically ignored — at least by the financial sector and the mainstream media — so we did “illuminate” the problem and the cause of action borrowers could bring for “fraud in the inducement.”

We showed that the fraudulent senior officers that controlled home mortgage lenders created “liars,” and NINJA loan programs designed to induce millions of Americans to take out loans they could not afford to repay. The endemic underlying fraud in the origination and sale of nonprime loans is critical to understanding why loan defaults are massive, why borrowers were typically the victims of the fraud and lost their meager savings due to the frauds, why loan modifications typically fail, and why foreclosure fraud has been so common. The endemic fraud also hyper-inflated the bubble and helped cause the economic crisis and severe loss of employment. Over a million Bank of America borrowers face these “challenges” that we “illuminated.”

Bank of America’s response is guilty of what it criticizes; it ignores the fraud by nonprime lenders and sellers, particularly Bank of America’s frauds in both capacities. It does not seek to “illuminate” the frauds or the problems that arise from endemic mortgage fraud. We did not invent the “epidemic” of mortgage fraud. The FBI began testifying about that in 2004. The FBI predicted that it would cause a “crisis” if it were not stopped — and no one claims it was stopped. The mortgage industry’s own fraud experts opined publicly in 2006 that the type of loans that Countrywide decided to elevate to its favored product was an “open invitation to fraudsters” and fully deserved the phrase that the lenders used to describe the product: “liars’ loans”. (Bank of America chose to purchase Countrywide at a time when it was notorious for the awful quality of its mortgage loans.) It is the lenders and their agents, the loan brokers, that directed the lies in these liar’s loans and appraisals and it was the lenders that made fraudulent “reps and warranties” in order to sell the fraudulent loans on to others in the form of securities. Economists and white-collar criminologists share a belief in “revealed preferences.” The senior officers that control lenders provide an “open invitation to fraudsters” in the midst of an “epidemic” of fraud because they intend to profit from those frauds.

Instead of contesting its issuance and sale of massive numbers of fraudulent loans, Bank of America writes to provide data on delinquencies and foreclosures in support of its claim that it is the victim of Countrywide’s deadbeat borrowers who it tries in vain to help. Bank of America’s data, however, add support for the evidence of widespread mortgage fraud, particularly by Countrywide. Accounting control frauds maximize their (fictional) reported income by lending routinely to those who cannot afford to repay their loans. It is this aspect of the fraud scheme that is most counter-intuitive to those that do not study fraud, but to criminologists it provides the most distinctive markers of fraud. The senior officers that control fraudulent lenders maximize the bank’s reported short-term income, in order to maximize their compensation, by growing extremely rapidly through making loans at a premium yield. This strategy creates a “sure thing” (Akerlof & Romer 1993). The lender is sure to report record (fictional) profits in the short term and suffer enormous (real) losses in the longer term.

The Evidence Supports Our Claims of Fraud

If we are correct that Countrywide operated as a fraud we would expect to find the following:

  1. disproportionately large rates of loan delinquencies and defaults
  2. huge losses upon default, and
  3. fraudulent representations and appraisals.
We would also predict widespread fraud in the “reps and warranties” that Countrywide and Bank of America provided to purchasers of nonprime loans originated by Countrywide. As we emphasized in our initial posts, a wide range of financial entities have confirmed the widespread fraud in the reps and warranties. This is why Bank of America is being sued. The data they provided in its response to our blogs supports the first three predictions.

First, Bank of America admits to a 14 percent delinquency rate on its mortgages. That percentage is roughly seven times greater than the normal delinquency rate for prime loans. It is roughly three times the traditional rule of thumb for a fatal delinquency rate (5 percent) for a home lender. Losses upon default during this crisis are dramatically greater than the historic percentages, and loss reserves were at historic lows, so the traditional rule of thumb for fatal losses is unduly optimistic in this crisis.

Second, Bank of America’s response states that Countrywide-originated loans have caused 85 percent of total delinquencies. Bank of America was a massive mortgage lender before it acquired Countrywide, so taken together these data suggest that the delinquency/foreclosure rate for Countrywide-originated mortgages must have been well over 20 percent — over ten times the normal delinquency rate and four times the traditional rule of thumb for fatal losses. These exceptionally large rates of horrible loans, defaulting so quickly after origination, are a powerful indicator that Countrywide was engaged in accounting control fraud. Unfortunately, lenders that specialized in making nonprime loans were typically fraudulent. The result was a massive bubble and economic crisis.

Our conclusions are well-supported by many other analyses, many of which were conducted long ago. For example, Reuters reported in January 2008 that one-third of Countrywide’s subprime mortgages were already delinquent:

(Reuters) – Countrywide Financial Corp CFC.N, the largest U.S. mortgage lender, on Tuesday said more than one in three subprime mortgages were delinquent at year-end in the $1.48 billion portfolio of home loans it services. Countrywide said borrowers were delinquent on 33.64 percent of subprime loans it serviced as of December 31, up from 29.08 percent in September.
Foreclosures are now vastly more common and the losses lenders suffer upon foreclosure, particularly for nonprime loans, are catastrophic. For example, Bloomberg reported at the end of 2009 that foreclosures result in losses amounting to nearly three-fourths of the value of the loan:
For subprime loans, losses averaged 73 percent for a foreclosure compared with 59 percent for a short sale, Amherst [Securities Group LP] reported.
Third, Bank of America’s data indicate another form of deceit that is a typical consequence of accounting control fraud. Bank of America has delayed foreclosing, sometimes for years, on large numbers of loans that have no realistic chance of being brought current, even with the loan modifications it offered. This behavior would be irrational for an honest lender, for it would increase ultimate losses, but is a typical strategy for a lender controlled by fraudulent senior officers because it greatly delays loss recognition and allows them to extend their looting of the bank for years through bonuses paid on the basis of fictional reported “profits” after the bank has (in economic substance) failed. Bank of America’s response to us admit that, of their 1.3 million customers who are more than 60-days delinquent, 195,000 have not made a payment in two years. Of those loans which have not received a payment in two years, 56,000 are already vacant.

For the foreclosure sales in the period from Jul-Sep, 2010:

  • 80 percent of borrowers had not made a mortgage payment for more than one year
  • Average of 560 days in delinquent status (approximately 18 months)
  • 33 percent of properties were vacant
The traditional rule of thumb is that a home loses 1.5 percent of its value each month it is delinquent but not foreclosed and sold. Those losses are far greater when the property is vacant. The loss of value is not limited to the particular home; all homes in the neighborhood are harmed when homes are left vacant for long periods. Bank of America does not address this issue, but the time from foreclosure to sale has also grown dramatically, which means that the length of time that foreclosed homes remain vacant prior to sale has grown substantially. The industry calls this huge number of homes, which are not producing income to the lenders because of the extraordinary growth in delinquencies and the delay in sales even after foreclosure, the “shadow inventory.” Note that none of the government foreclosure relief programs mandated that Bank of America sit on these delinquent assets for an average of 18 months and allow them to be wasting assets.

The bank’s response primarily criticizes its borrowers as deadbeats, yet the data it provides support points we have made in our prior posts, including Bill Black’s posts about the banks working with the Chamber of Commerce and Chairman Bernanke to extort the Financial Accounting Standards Board (FASB) in order to destroy the integrity of the accounting rules requiring banks to recognize losses on their bad loans. We have explained why the fraudulent officers controlling many lenders followed a strategy of making bad loans at premium yields in order to maximize (fictional) accounting income and their bonuses. This dynamic drove the current crisis. These frauds hyper-inflated the housing bubble and caused trillions of dollars of losses.

The extortion of FASB was successful; Bank of America was one of the leaders of that extortion. It changed the accounting rules so that banks could often avoid recognizing losses on these fraudulent loans, until they actually sold the home taken back through foreclosure. This dishonorable accounting fiction creates perverse incentives for banks to do exactly what Bank of America has done — let bad assets waste away and make already severe losses catastrophic.