Sub-prime Debt, Dream Era Investments and Crime

It takes an extraordinary intelligence to contemplate the obvious.

- Alfred North Whitehead

It takes a lot of humility to look at a fact.

- Paul Brewer

Subprime loans were advertised as helping to fulfill the American Dream of homeownership by extending credit to people with poor or incomplete credit histories.

- Mark Gillispie

Historians are going to record the sub-prime mortgage episode as perhaps the greatest period of criminal excess in human history. The criminals where not the debtors who were the most part poor people who lacked the sophistication to conceive of the crimes that were committed. Indeed the debtors often discovered themselves to be the victims as much as investors whose savings were sucked into the too good to be true investment schemes. Both debtors and investors became marks in a monumental confidence scheme.

Consider the following press release from the United States Security and Exchange Commission:

Washington, D.C., Sept. 3, 2008 — The Securities and Exchange Commission today charged two Wall Street brokers with defrauding their customers when making more than $1 billion in unauthorized purchases of subprime-related auction rate securities. . . .

The SEC alleges that Julian Tzolov and Eric Butler misled customers into believing that auction rate securities being purchased in their accounts were backed by federally guaranteed student loans and were a safe and liquid alternative to bank deposits or money market funds. Instead, the securities that Tzolov and Butler purchased for their customers were backed by subprime mortgages, collateralized debt obligations (CDOs), and other non-student loan collateral.

"As alleged in our complaint, these two brokers foisted more than $1 billion in subprime-related securities upon unsuspecting customers to illegally obtain higher commissions from their sales," said Linda Chatman Thomsen, Director of the SEC's Division of Enforcement. . . .

The SEC's complaint, filed in federal court in Manhattan, alleges that Tzolov and Butler, while employed at Credit Suisse Securities (USA) LLC in New York, deceived foreign corporate customers in short-term cash management accounts by sending or directing their sales assistants to send e-mail confirmations in which the terms "St. Loan" or "Education" were added to the names of non-student loan securities purchased for the customers. Tzolov and Butler also routinely deleted references to "CDO" or "Mortgage" from the names of the securities in these e-mails. As a result, the complaint alleges that customers were stuck holding more than $800 million in illiquid securities after auctions for auction rate securities began to fail in August 2007. Those holdings have since significantly declined in value.

This billion dollar Credit Suisse swindle was just the tip of the iceberg. There were multiple levels of scam in the sub-prime mortgage business, and the total amount of money involved ran into the trillions. Last November Business Week carried a story titled: Sex, Lies and Subprime Mortgages. This story makes clear that the corruption reached from Wall Street boardrooms, to local banks. Mortgage wholesalers, whose ranks included high school dropouts, were assigned the task of acting as rainmakers for local banks. Their income was dependent on mortgage approval, because an approved mortgage could be sold to Wall Street, as backing for securities products. Wholesalers, many of whom were attractive women appear to have used bribery and sex to obtain mortgage approval from underwriters. If such inducements did not work, intimidation from bank higher ups often followed. There were incentives for banks to approve mortgage applications that had "bad credit risk" written all over them. The Business Week story describes,

A former Wells Fargo (WFC) wholesaler says he regularly used the copiers at a nearby Kinko's to alter borrowers' pay stubs and bank account statements. He would embellish job titles—turning a gardener, for instance, into the owner of a landscaping company—and inflate salaries. "I knew how to work the system," the former wholesaler says.

Bank underwriters who questioned loan applications were put under pressure to go along. Business Week tells one story:

Shortly after Rachel Steinmetz joined GreenPoint's Manhattan branch as a senior underwriter in September 2005, wholesalers at the bank started asking her to approve loans "under terms that the borrower did not qualify for," according to a wrongful termination suit filed in June by Steinmetz in New York federal court. She says she told her superiors that the applications contained suspect details and that the loan files didn't have enough paperwork to back up borrowers' claims. "Notwithstanding [her] concerns, management overrode her decisions" and approved the loans anyway, the complaint says.

In April 2006, Steinmetz claims, she rejected a loan application that inflated the borrower's income and the home's appraisal value. While Steinmetz was out of the office celebrating Passover, she says in the complaint, her superiors signed off on the loan. A month later, Steinmetz says, her boss asked her to compile the paperwork on the same loan in preparation for closing. "Although she protested," the complaint notes, "the loan was funded in her name."

Steinmetz says through her attorney that there was retribution for her reluctance to make bad loans. Even though her bosses knew she was devoutly religious, the complaint says, they often would inundate her with "additional work and unnecessary meetings" on the eve of the Sabbath and religious holidays. In May 2006, she says, her superiors nixed her bonus even though she made her loan quota.

Business Week is hardly the only source of such stories. A story "The subprime house of cards"
by Cleveland writer Mark Gillispie described the sub-prime bubble as

One of the biggest crime waves in the last decade . . .

One of Gillispie's sources did not mince words:

"This was actual fraud at the highest levels," said Anthony Accetta, a former federal prosecutor. "It wasn't an accident. It was not a failure of oversight. It was actual fraud, and we're not doing anything about it."

According to Gillespie, Accetta believes that

the subprime-lending business model worked like a Ponzi scheme. These lenders made loans that they sold to investment banks, which turned them into bonds sold to investors. Banks took their fees and commissions and lent money to mortgage originators so they could write more loans.

The scheme ground to a halt, Accetta said, when investment banks could no longer cover up the billions in losses that bad lending created. Too many people had stopped making their mortgage payments, which meant not enough money was coming in to pay investors.

"This is a national catastrophe, and the perpetrators [on Wall Street] are not being prosecuted," Accetta said. "It's one of the easiest cases to prove because there are plenty of witnesses and plenty of evidence out there."

Gillespie reports that Eric Forster, a Los Angeles-based consultant for mortgage fraud litigation claims

the entire subprime mortgage industry was "fraught with fraud."

"What makes this crime wave unique is that, in most cases, the banks cooperated with the perpetrators," Forster said. "Once they discovered they could securitize loans and transfer the risk to some investors in China or Europe, there was no reason to underwrite the loans any longer."

It appears then that for several years in the middle of this decade, American prosperity was propped up by a vast criminal scam, centered on Wall Street, but extending most likely to thousands of American banks and mortgage companies. On the local end thousands of loan wholesalers were expected to use a variety of corrupt means to qualify low income and poor credit risk investors for home loans. Some of the loans were for amounts of $500,000 and greater. Some loan applicants received approval for loans on multiple houses. Many of the loans fell into default because the debtor could not make even the first mortgage payment.

It appears than both local bank officials and bank corporation executives were very much a part of the fraud. The banking officials at all levels ignored and/or punished employees who questioned fraudulent practices. They directly and/or indirectly encouraged subordinates to engage in criminal behavior and actively sought to profit from the pervasive misconduct. Banking executives knowingly participated in massive loan and securities fraud. Wall Street executives were no better. They failed to perform checks on loan quality, and knowingly bought loans from banks known to authorize poor quality loans, and misrepresented the quality of underlying loans to securities customers.

The sub-prime scandal was not the only cause of the housing bubble. There had been a housing market in California the bubble emerged in other parts of the country. The bubble was driven by flipping, the practice of purchasing houses, and then reselling them for a profit. As long as the bubble was expanding, flipping was a viable money making practice, but the bubble could not and would not keep expanding forever, and at the heart of the bubble was speculative investment, gambling by investors that they would not be the ones left holding the bag after the market stopped expanding. The expanding sub-prime scam expanded the bubble. Low income buyers were convinced to take on high payment mortgage loans that they clearly lacked the where with all to pay.

The problem was that the housing bubble and the subprime racket was being driven by a return to economic conditions that were more characteristic of the 19th than the 20th centuries. The free trade policies of the United States and Western Europe had lead by the end of the 20th century to a vast expansion of international trade, and the bringing into existence of a huge amount of new production capacity, with more new production capacity constantly being brought onto line in China. China had adopted the Singapore economic model, which emphasized savings over consumption, thus the expansion of production in China did not correspond to a vast increase in consumption which could soak up all of that production capacity. Instead of consuming the Chinese saved, and by saving created a vast hoard of cash, much more than the Chinese knew what to do with. At the same time the huge oversupply in production capacity drove international prices down creating a deflationary economic situation. From the viewpoint of Macro-economic managers like Alan Greenspan the housing bubble was a God sent since it masked the consequences of production over capacity. At the same time the housing bubble allowed the United States to soak up the excess hoard of cash that was driven by the propensity of Europeans and the Chinese to save rather consume. Thus the burden of consuming the world's over supply of consumer production capacity was assigned disproportionately to the American consumer.

At the beginning of the 21th century, Greenspan was warned about the danger of the housing bubble, but he disregarded the warning, From his perspective there was good reason for him to do so. Without the housing bubble the deflationary consequences excessive international production capacity would begin to depress the American and eventually the world economies. The housing bubble was a means of postponing the evil day when the expansion of Chinese production capacity would slow down, and the sub-prime mortgage market was a means of postponing the evil day when the expansion of the housing bubble would stop.

Adam Smith teaches us that none of us are so wise that we can exercise management of an economy without unintended and undesirable consequences. The Chinese attempted to bring prosperity to their country, without sharing its fruits with the Chinese people. The result damaged the international economic order, upon which Chinese prosperity depended. A free Chinese labor movement with negotiated wages and benefits might well have increased the stability of the international economic order, and indeed Chinese society.

American society at the beginning of the 21st century was asleep and dreaming of a wealth, a prosperity and a power that was no longer possible. American economic policy was based on realities that if they ever existed, had long past. The dreams that that enthralled the American financial elite were dreams of great wealth produced by uncontrolled and unregulated economic activity. Unnoticed in the dream was the extent that the dreamers had turned to criminality in order to realize the dream. In the mean time the dreamers were unaware of the extent to the economic order of which they dreamed with such great confidence, was falling to peaces around them.

It is a foundational assumption of this blog, that wealth and prosperity in 21th century society is and will be based on abundant and low cost energy. Without energy human life becomes desperate and miserable. Today people are still dreaming about an energy order that no longer exists, or their dream has turned to to an ideal order that is both impractical and expensive. Few seem willing to measure their dreams by its cost. Few seem willing to ask how much will it cost to have the new dream realized and to ask how will that cost be paid. We are not being prepared for the struggle with waking reality. We are not yet prepared to acknowledge what that reality means. We need to look at the obvious, we need to look at facts, we need to acknowledge details before we begin to contemplate dreams.