How Wall Street Perverted the 4 Cs of Mortgage Underwriting


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Editor’s Comment: 

For thousands of years since the dawn of money credit has been an integral part of the equation.  Anytime a person, company or institution takes your money or valuables in exchange for a promise that it will return your money or property or pay it to someone else (like in a check) credit is involved.  Most bank customers do not realize that they are creditors of the bank in which they deposit their money.  But all of them recognize that on some level they need to know or believe that the bank will be able to make good on its promise to honor the check or pay the money as instructed. 

Most people who use banks to hold their money do so in the belief that the bank has a history of being financially stable and always honoring withdrawals.  Some depositors may look a little further to see what the balance sheet of the bank looks like.   Of course the first thing they look at is the amount of cash shown on the balance sheet so that a perspective depositor can make an intelligent decision about the liquidity or availability of the funds they deposit. 

So the depositor is in essence lending money to the bank upon the assumption of repayment based upon the operating history of the bank, the cash in the bank and any other collateral (like FDIC guarantees).

As it turns out these are the 4 Cs of loan underwriting which has been followed since the first person was given money to hold and issued a paper certificate in exchange. The paper certificate was intended to be used as either a negotiable instrument for payment in a far away land or for withdrawal when directly presented to the person who took the money and issued the promise on paper to return it.

Eventually some people developed good reputations for safe keeping the money.  Those that developed good reputations were allowed by the depositors to keep the money for longer and longer periods.  After a while, the persons holding the money (now called banks) realized that in addition to charging a fee to the depositor they could use the depositor’s money to lend out to other people.  The good banks correctly calculated the probable amount of time for the original depositor to ask for his money back and adjusted loan terms to third parties that would be due before the depositor demanded his money.

The banks adopted the exact same strategy as the depositors.  The 4 Cs of underwriting a loan—Capacity, Credit, Cash and Collateral—are the keystones of conventional loan underwriting. 

The capacity of a borrower is determined by their ability to repay the debt without reference to any other source or collateral.  For the most part, banks successfully followed this model until the late 1990s when they discovered that losing money could be more profitable than making money.  In order to lose money they obviously had to invert the ratios they used to determine the capacity of the borrower to repay the money.  To accomplish this, they needed to trick or deceive the borrower into believing that he was getting a loan that he could repay, when in fact the bank knew that he could not repay it.  To create maximum confusion for borrowers the number of home loan products grew from a total of 5 different types of loans in 1974 to a total of 456 types of loans in 2006.  Thus the bank was assured that a loss could be claimed on the loan and that the borrower would be too confused to understand how the loss had occurred.  As it turned out the regulators had the same problem as the borrowers and completely missed the obscure way in which the banks sought to declare losses on residential loans.

Like the depositor who is trusting the bank based upon its operating history, the bank normally places its trust in the borrower to repay the loan based upon the borrowers operating history which is commonly referred to as their credit worthiness, credit score or credit history.  Like the capacity of the borrower this model was used effectively until the late 1990s when it too was inverted.  The banks discovered that a higher risk of non-payment was directly related to the “reasonableness” of charging a much higher interest rate than prevailing rates.  This created profits, fees and premiums of previously unimaginable proportions.  The bank’s depositors were expecting a very low rate of interest in exchange for what appeared as a very low risk of nonpayment from the bank.  By lending the depositor’s money to high risk borrowers whose interest rate was often expressed in multiples of the rate paid to depositors, the banks realized they could loan much less in principal than the amount given to them by the depositor leaving an enormous profit for the bank.  The only way the bank could lose money under this scenario would be if the loan was actually repaid.  Since some loans would be repaid, the banks instituted a power in the master servicer to declare a pool of loans to be in default even if many of the individual loans were not in default.  This declaration of default was passed along to investors (depositors) and borrowers alike where eventually both would in many, if not most cases, perceive the investment as a total loss without any knowledge that the banks had succeeded in grabbing “profits” that were illegal and improper regardless if one referred to common law or statutory law.

Capacity and credit are usually intertwined with the actual or stated income of the borrower.  Most borrowers and unfortunately most attorneys are under the mistaken belief that an inflated income shown on the application for the loan, subjects the borrower to potential liability for fraud.  In fact, the reverse is true.  Because of the complexity of real estate transactions, a history of common law dating back hundreds of years together with modern statutory law, requires the lender to perform due diligence in verifying the ability of the borrower to repay the loan and in assessing the viability of the loan.  Some loans had a teaser rate of a few hundred dollars per month.  The bank had full knowledge that the amount of the monthly payment would change to an amount exceeding the gross income of the borrower.   In actuality the loan had a lifespan that could only be computed by reference to the date of closing and the date that payments reset.  The illusion of a 30-year loan along with empty promises of refinancing in a market that would always increase in value, led borrowers to accept prices that were at times a multiple of the value of the property or the value of the loan.  Banks have at their fingertips numerous websites in which they can confirm the likelihood of a perspective borrower to repay the loan simply by knowing the borrower’s occupation and geographical location.  Instead, they allowed mortgage brokers to insert absurd income amounts in occupations which never generate those levels of income.  In fact, we have seen acceptance and funding of loans based upon projected income from investments that had not yet occurred where the perspective investment was part of a scam in which the mortgage broker was intimately involved.  See Merendon Mining scandal.

The Cash component of the 4 Cs.  Either you have cash or you don’t have cash.  If you don’t have cash, it’s highly unlikely that anyone would consider a substantial loan much less a deposit into a bank that was obviously about to go out of business.   This rule again was followed for centuries until the 1990s when the banks replaced the requirement of cash from the borrower with a second loan or even a third loan in order to “seal the deal”.  In short, the cash requirement was similarily inverted from past practices.  The parties involved at the closing table were all strawmen performing fees for service.  The borrower believed that a loan underwriting was taking place wherein a party was named on the note as the lender and also named in the security instrument as the secured party. The borrower believed that the closing could never have occurred but for the finding by the “underwriting lender” that the loan was proper and viable.  The people at the closing table other than the borrower, all knew that the loan was neither proper nor viable.  In many cases the borrower had just enough cash to move into a new house and perhaps purchase some window treatments.  Since the same credit game was being played at furniture stores and on credit cards, more money was given to the borrower to create fictitious transactions in which furniture, appliances, and home improvements were made at the encouragement of retailers and loan brokers.  Hence the cash requirement was also inverted from a positive to a negative with full knowledge by the alleged bank who didn’t bother to pass this knowledge on to its “depositors” (actually, investors in bogus mortgage bonds). 

Collateral is the last of the 4 Cs in conventional loan underwriting.  Collateral is used in the event that the party responsible for repayment fails to make the repayment and is unable to cure it or work out the difference with the bank.  In the case of depositors, the collateral is often viewed as the full faith and credit of the United States government as expressed by the bank’s membership in the Federal Deposit Insurance Corporation (FDIC).  For borrowers collateral refers to property which they pledge can be used or sold to satisfy obligation to repay the loan.  Normally banks send one or even two or three appraisers to visit real estate which is intended to be used as collateral.  The standard practice lenders used was to apply the lower appraisals as the basis for the maximum amount that they would lend.  The banks understood that the higher appraisals represented a higher risk that they would lose money in the event that the borrower failed to repay the loan and property values declined.  This principal was also used for hundreds of years until the 1990s when the banks, operating under the new business model described above, started to run out of people who could serve as borrowers.  Since the deposits (purchases of mortgage bonds) were pouring in, the banks either had to return the deposits or use a portion of the deposits to fund mortgages regardless of the quality of the mortgage, the cash, the collateral, the capacity or any other indicator that a normal reasonable business person would use.  The solution was to inflate the appraisals of the real estate by presenting appraisers with “an offer they couldn’t refuse”.  Either the appraiser came in with an appraisal of the real property at least $20,000 above the price being used in the contract or the appraiser would never work again.  By inflating the appraisals the banks were able to move more money and of course “earn” more fees and profits. 

The appraisals were the weakest link in the false scheme of securitization launched by the banks and still barely understood by regulators.  As the number of potential borrowers dwindled and even with the help of developers raising their prices by as much as 20% per month the appearance of a rising market collapsed in the absence of any more buyers.

Since all the banks involved were holding an Ace High Straight Flush, they were able to place bets using insurance, credit default swaps and other credit enhancements wherein a movement of as little as 8% in the value of a pool would result in the collapse of the entire pool.  This created the appearance of losses to the banks which they falsely presented to the U.S. government as a threat to the financial system and the financial security of the United States.  Having succeeded in terrorizing the executive and legislative branches and the Federal Reserve system, the banks realized that they still had a new revenue generator.  By manufacturing additional losses the government or the Federal Reserve would fund those losses under the mistaken belief that the losses were real and that the country’s future was at stake.  In fact, the country’s future is now at stake because of the perversion of the basic rules of commerce and lending stated above.  The assumption that the economy or the housing market can recover without undoing the fraud perpetrated by the banks is dangerous and false.  It is dangerous because more than 17 trillion dollars in “relief” to the banks has been provided to cover mortgage defaults which are at most estimated at 2.6 trillion.  The advantage given to the megabanks who accepted this surplus “aid” has made it difficult for community banks and credit unions to operate or compete.   The assumption is false because there is literally not enough money in the world to accomplish the dual objectives of allowing the banks to keep their ill gotten gains and providing the necessary stimulus and rebuilding of our physical and educational infrastructure.  

The simple solution that is growing more and more complex is the only way that the U.S. can recover.  With the same effort that it took in 1941 to convert an isolationist largely unarmed United States to the most formidable military power on the planet, the banks who perpetrated this fraud should be treated as terrorists with nothing less than unconditional surrender as the outcome.  The remaining 7,000 community banks and credit unions together with the existing infrastructure for electronic funds transfer will easily allow the rest of the banking community to resume normal activity and provide the capital needed for a starving economy. 

See article:

Garfield Continuum White Paper Explains Economics of Securitization of Residential Mortgages

SEE The Economics and Incentives of Yield Spread Premiums and Credit Default Swaps

March 23, 2010: Editor’s Note: The YSP/CDS paper is intentionally oversimplified in order to demonstrate the underlying economics of securitization as it was employed in the last decade.

To be clear, there are several things I was required to do in order to simplify the financial structure for presentation that would be understandable. Even so, it takes careful study and putting pencil to paper in order to “get it.”

In any reasonable analysis the securitization scheme was designed to cheat investors and borrowers in their respective positions as creditors and debtors. The method used was deceit, producing (a) an asymmetry of information and (b) a trust relationship wherein the trust was abused by the sellers of the financial instruments being promoted.

So before I get any more comments about it, here are some clarifying comments about my method.

1. The effects of amortization. The future values of the interest paid are overstated in the example and the premiums or commissions are over-stated in real dollars, but correct as they are expressed in percentages.

2. The effects of present values: As stated in the report, the future value of interest paid and the future value of principal received are both over-statements as they would be expressed in dollars today. Accordingly, the premium, commission or profit is correspondingly higher in the example than it would be in real life.

3. The effects of isolating a single loan versus the reality of a pool of loans. The examples used are not meant to convey the impression that any single loan was securitized by itself. Thus the example of the investment and the loan are hypothetical wherein an average jumbo loan is isolated from the pool from one of the lower tranches and an average bond is isolated from a pool of investors, and the isolated the loan is allocated to in part to only one of the many investors who in real life, would actually own it.

The following is the conclusion extracted directly from the white paper:

Based upon the foregoing facts and circumstances, it is apparent that the securitization of mortgages over the last decade has been conducted on false premises, false representations, resulting in intentional and inevitable negative outcomes for the debtors and creditors in virtually every transaction. The clear provisions for damages and other remedies provided under the Truth in Lending Act and Real Estate Settlement Procedures Act are sufficient to make most homeowners whole if they are applied. Since the level 2 yield spread premium (resulting from the difference in money advanced by the creditor (investor) and the money funded for mortgages) also give rise to claim from investors, it will be up to the courts how to apportion the the actual money damages. Examination of most loans that were securitized indicates that they are more than offset by undisclosed profits, kickbacks, fees, premiums, and rebates. The balance of “damages” due under applicable federal lending and securities laws will require judicial intervention to determine apportionment between debtors and creditors.



  • any imaginary person or thing spoken of as though existing
  • any fictitious story, or unscientific account, theory, belief, etc.
  • Kudos to investigative journalist Kevin Hall with McClatchy Newspapers for inserting himself into the so called “loan modification” process and exposing the farce that is being perpetrated on the American public in the article below. Why is this happening? Pretty simple, two reasons, first the fact is that in almost all cases where you have a mortgage that has been securitized, you the homeowner or you the lawyer representing the homeowner are not dealing with a party that has authority to modify the loan and second they NEED a default. One of the many missions of this site is exposing the truth, hence the name “Livinglies.” The reality is that they, the “pretender lender,” know the debt is unenforceable, the real party in interest is unidentifiable in most cases, and the title to the property has a cloud on it. So what do they REALLY need:

    1. They need new paperwork and they need new signatures on something they can represent as your affirmation of the debt….to THEM… not the party that actually funded your loan who may be damaged by a default or even the party still on the deed or mortgage at the county recorders office. 
    2. They need you to waive any rights and claims you could assert because the “real lender”  or “real party in interest” and/or various parties in the chain of securitization assumed liablity for those claims you could assert as the notes flowed up the chain.
    3. Here’s the biggie, they have insurance in the event of default, they can’t collect on the insurance, credit default swaps, PMI, etc.  in the event of modification.

    Insurers have a habit of including exclusions into policies of all types and credit default insurance policies are not different. Here is a little sample of a PMI exclusion:

    “Notwithstanding any other provision of this Policy, the coverage extended to any Loan by a Certificate of Insurance may be terminated at the Company’s sole discretion, immediately andwithout notice, if, with respect to such Loan, the Insured shall permit or agree to any of thefollowing without prior written consent of the Company: (1) Any material change or modification of the terms of the Loan including, but not limited to, the borrowed amount, interest rate, term or amortization schedule, excepting such modifications as may be specifically provided for in theLoan documents, and permitted without further approval or consent of the Insured.“*

    *Radian Guaranty Master Policy, Condition 4.C, at Master_Policy

    So who is the “insured”? Well, the bondholders who put up the money that was actually used to fund your loan, reality is they are the only other party other than you that has been damaged in this whole mortage meltdown. Every other party between you and them was an intermediary, who made a killing, and had no capital at risk. The truth, there is no incentive or reason to modify your loan. In order to collect on the insurance they need a default, not a modification.

    Why do you think they want you to use the “fax” to resend them your “modification” paperwork for the umpteenth time? So they can “lose” it again. If they allowed you to scan and email it to them or send it Certified Mail Return Receipt Requested you would have evidence that a) they received it b) who received it and c) when they received it. Then all of a sudden you have a timeline, then all of a sudden someone has to be accountable and explain why they received your information 3 months ago and you haven’t heard “boo” since…

    They know that 60% of these “modifications” are back in default within a year so they need to clear the deck to foreclose when that happens. Meantime, with regard to these “trial” modifications, the paperwork I have seen explictly says that the payments will NOT be credited to your loan account but will be placed in a “suspense” account until after the trial modification period is done. Now, if you fail to complete the trial period or when the “trial” period is completed and you did comply, but they tell you they cannot approve your for a modification…who do you spose keeps that money sitting in the suspense account?

    Bottomline folks, even if you are “working with your servicer on a loan modification” you need to consult a competent attorney, don’t wait until the wolf is at the door to start looking for one.

    If you are a competent attorney, practicing in this area and not on our list of “Lawyers that Get It” we want to hear from you.

    Homeowners Often Rejected Under Obama Plan

    By Kevin G. Hall G. Hall | McClatchy Newspapers

    WASHINGTON — Ten months after the Obama administration began pressing lenders to do more to prevent foreclosures, many struggling homeowners are holding up their end of the bargain but still find themselves rejected, and some are even having their homes sold out from under them without notice.

    These borrowers, rich and poor, completed trial modifications of their distressed mortgage, and made all the payments, only to learn, often indirectly, that they won’t get help after all.

    How many is hard to tell. Lenders participating in the administration’s Home Affordable Modification Program, or HAMP, still don’t provide the government with information about who’s rejected and why.

    To date, more than 759,000 trial loan modifications have been started, but just 31,382 have been converted to permanent new loans. That’s averages out to 4 percent, far below the 75 percent conversion rate President Barack Obama has said he seeks.

    In the fine print of the form homeowners fill out to apply for Obama’s program, which lowers monthly payments for three months while the lender decides whether to provide permanent relief, borrowers must waive important notification rights.

    This clause allows banks to reject borrowers without any written notification and move straight to auctioning off their homes without any warning.

    That’s what happened to Evangelina Flores, the owner of a modest 902 square-foot home in Fontana, Calif. She completed a three-month trial modification, and made the last of the agreed upon monthly payments of $1,134.60 on Nov. 1. Her lawyer said that in late November, Central Mortgage Company told her that it would void her adjustable-rate mortgage, which had risen to a monthly sum above $2,000, and replace it with a fixed-rate mortgage.

    “The information they had given us is that she had qualified and that she would be getting her notice of modification in the first week of December,” said George Bosch, the legal administrator for the Law Firm of Edward Lopez  and Rick Gaxiola, which is handling Flores’ case for free.

    Flores, 58, a self-employed child care worker, wired her December payment to Central Mortgage Company on Nov. 30, thinking that her prayers had been answered. A day later, there was a loud, aggressive knock on her door.

    Thinking a relative was playing a prank, she opened her front door to find two strangers handing her an eviction notice.

    “They arrived real demanding, saying that they were the owners,” recalled Flores. “I have high blood pressure, and I felt awful.”

    Court documents show that her house had been sold that very morning to a recently created company, Shark Investments. The men told Flores she had to be out within three days. The eviction notice had a scribbled signature, and under the signature was the name of attorney John Bouzane.

    A representative in his office denied that Bouzane’s law firm was involved in Flores’ eviction, and said the eviction notice was obtained from Bouzane’s Web site,

    Why would a lawyer provide for free a document that gives the impression that his law firm is behind an eviction?

    “We hope to get the eviction business,” said the woman, who didn’t identify herself.

    Flores bought her home in 2006 for $352,000. Records show that it has a current fair-market value of $99,000. The new owner bought it for $78,000 at an auction Flores didn’t even know about.

    “I had my dream, but now I feel awful,” said Flores, who remains in the house while her lawyers fight her eviction. “I still can’t believe it.”

    How could Flores go so quickly from getting government help to having her home owned by Shark Investment? The answer is in the fine print of standard HAMP documents.

    The Aug. 25 cover letter from Central Mortgage Company, the servicer that collects Flores’ mortgage payments, offered Flores a trial modification with this comforting language:

    “If you do not qualify for a loan modification, we will work with you to explore other options available to help you keep your home or ease your transition into a new home.”

    CMC is owned by Arkansas regional Arvest Bank, itself controlled by Jim Walton, the youngest son of Wal-Mart founder Sam Walton.

    A glance past CMC’s hopeful promise finds a different story in the fine print of HAMP document, which contains standardized language drafted by the Obama Treasury Department and is used uniformly by lenders.

    The document warns that foreclosure “may be immediately resumed from the point at which it was suspended if this plan terminates, and no new notice of default, notice of intent to accelerate, notice of acceleration, or similar notice will be necessary to continue the foreclosure action, all rights to such notices being hereby waived to the extent permitted by applicable law.”

    This means that even when a borrower makes all the trial payments, a lender can put the house up for auction if it decides that the homeowner doesn’t qualify — assuming that foreclosure proceedings had been started before the trial period — without telling the homeowner.

    Until now, lenders haven’t even had to notify borrowers in writing that they’d been rejected for permanent modifications.

    In January, 11 months after Obama’s plan was announced, homeowners will begin receiving written rejection notices, and the Treasury Department finally will begin receiving data on rejection rates and reasons for rejections.

    The controversial clause notwithstanding, the handling of Flores’ loan raises questions.

    “Foreclosure actions may not be initiated or restarted until the borrower has failed the trial period and the borrower has been considered and found ineligible for other available foreclosure prevention options,” said Meg Reilly, a Treasury spokeswoman. “Servicers who continue with foreclosure sales are considered non-compliant.”

    CMC officials declined to comment and hung up when they learned that a reporter was listening in with permission from Flores’ legal team. Arvest officials also declined comment.

    McClatchy did hear from Freddie Mac, the mortgage finance agency seized by the Bush administration in September 2008. Freddie owns Flores’ loan, and spokesman Brad German insisted that Flores was reviewed three times for loan modification.

    “In each instance, there was a lack of documentation verifying that she had the income required for a permanent modification,” German said.

    That response is ironic, said Michael Calhoun, the president of the Center for Responsible Lending, a nonpartisan group in Durham, N.C., that works on behalf of borrowers.

    “These lenders gave loans with no documentation and charged them a penalty interest rate for doing so. And now when the people ask for help, they are using extravagant demands for documentation to give them the back of their hand and continue to foreclosure,” Calhoun said.

    German said that Flores was sent a letter on Nov. 24, which would have arrived several days later, given the Thanksgiving holiday, informing her that she’d been rejected for a permanent modification. Flores and her attorney said she never got a letter, and neither Freddie Mac nor CMC provided proof of that letter.

    Exactly one week after the letter supposedly was sent, Flores’ home was sold to Shark Investments. That company was formed on Aug. 19, according to records on the California Secretary of State’s Web site. Shark Investments, apparently an unsuspecting beneficiary of Flores’ woes, has no phone listing. The Riverside, Calif., address on the company’s filing as a limited liability company traces to a five-bedroom, four-bath house with a swimming pool.

    German didn’t comment on whether Flores received sufficient notice under Freddie Mac rules, or how the home could move to sale so quickly.

    Flores’ legal team, which specializes in foreclosure prevention, thinks that lenders and servicers are gaming Obama’s housing effort.

    “It seems servicers are giving people false hopes by sending them a plan, and they are using the program as a collection method, getting people to pay them with no intention of modifying the loan,” said Bosch. “I believe they are using this as a tool to suck people dry.”

    Dashed hopes aren’t exclusive to the working poor such as Flores.

    David Smith owns a beautiful home in San Clemente, Calif., the location of the Richard Nixon Presidential Library. Smith purchased his five bedroom home four years ago for $1.3 million. Today, the real estate Web site estimates the value of Smith’s home at $981,000, slightly below the $1 million he still owes on it.

    Smith said he went from “making a lot of money to making hardly any” as the national and California economies plunged into deep recession. He’s a salesman serving the hard-hit residential and commercial construction sector. On top of his hardship, Smith’s mortgage exceeds the limits for the HAMP plan.

    In late August, Smith signed and returned paperwork in a prepaid FedEx envelope to Bank of America that said it had received the contract needed to modify the adjustable-rate mortgage he originally took out with the disgraced lender Countrywide Financial, which Bank of America bought last year.

    The modification agreement shows that Bank of America agreed to give Smith a 3.375 percent mortgage rate through September 2014, and everything Smith paid between now and through 2019 would count as paying off interest. He’d begin paying principal and interest in October 2019, with the loan maturing in 2037.

    The deal favors the lender, but Smith, 55, jumped on it because it kept him in the home.

    Armed with what he thought was “a permanent modification,” Smith returned a notarized copy of the agreement and made subsequent payments on time.

    In return, he got a surprising notice from Bank of America saying that his house would be auctioned off on Dec. 18.

    “It looks like they’re trying to sell this out from underneath me,” Smith said. “My wife cries all the time.”

    After a Dec. 16 call from McClatchy asking why Bank of America wasn’t honoring its own modification, the lender backed off.

    “The case has been returned to a workout status and a Home Retention Division associate will be contacting Mr. Smith for further discussions,” said Rick Simon, a Bank of America spokesman. “The scheduled foreclosure sale will be postponed for at least 30 days to allow for review of the account in hope of completing a home retention solution for Mr. Smith.”

    The Center for Responsible Lending says such problems are common.

    “Everyone acknowledges that the system is not working well,” Calhoun said.


    As the following article demonstrates, the model currently used in this country and dozens of other countries  is “pay to play” — and if there is a crash it is the fees the banks paid over the years that bails them out instead of the taxpayers.
    For reasons that I don’t think are very good, the economic team is marginalizing Volcker and headed down the same brainless path we were on when Bush was in office, which was only an expansion of what happened when Clinton was in office, which was a “me too” based upon Bush #1 and Reagan. The end result is no longer subject to conjecture — endless crashes, each worse than the one before.
    The intransigence of Wall Street and the economic team toward any meaningful financial reform adds salt to the wound we created in the first palce. We were fortunate that the rest of the world did not view the economic meltdown as an act of war by the United States. They are inviting us to be part of the solution and we insist on being part of the problem.
    Sooner or later, the world’s patience is going to wear thin. Has anyone actually digested the fact that there is buyer’s run on gold now? Does anyone care that the value of the dollar is going down which means that those countries, companies and individuals who keep their wealth in dollars are dumping those dollars in favor of diversifying into other units of storage?
    The short-term “advantage” will be more than offset by the continuing joblessness and homelessness unless we take these things seriously. Culturally, we are looking increasingly barbaric to dozens of countries that take their role of protecting the common welfare seriously.

    Bottom Line on these pages is that it shouldn’t be so hard to get a judge to realize that just because the would-be forecloser has a big expensive brand name doesn’t mean they are anything better than common thieves. But like all theft in this country, the bigger you are the more wiggle room you get when you rob the homeless or a bank or the government or the taxpayers. Marcy Kaptur is right. She calls for a change of “generals”  (likening Obama’s situation to Lincoln),  since their skills were perhaps valuable when Obama first tackled the economic crisis — but now are counterproductive. We need new generals on the economic team that will steer us clear from the NEXT crisis not the LAST crisis.

    November 8, 2009

    Britain and U.S. Clash at G-20 on Tax to Insure Against Crises

    ST. ANDREWS, Scotland — The United States and Britain voiced disagreement Saturday over a proposal that would impose a new tax on financial transactions to support future bank rescues.

    Prime Minister Gordon Brown of Britain, leading a meeting here of finance ministers from the Group of 20 rich and developing countries, said such a tax on banks should be considered as a way to take the burden off taxpayers during periods of financial crisis. His comments pre-empted the International Monetary Fund, which is set to present a range of options next spring to ensure financial stability.

    But the proposal was met with little enthusiasm by the United States Treasury secretary, Timothy F. Geithner, who told Sky News in an interview that he would not support a tax on everyday financial transactions. Later he seemed to soften his position, saying it would be up to the I.M.F. to present a range of possible measures.

    “We want to make sure that we don’t put the taxpayer in a position of having to absorb the costs of a crisis in the future,” Mr. Geithner said after the Sky News interview. “I’m sure the I.M.F. will come up with some proposals.”

    The Russian finance minister, Alexei Kudrin, also said he was skeptical of such a tax. Similar fees had been proposed by Germany and France but rejected by Mr. Brown’s government in the past as too difficult to manage. But Mr. Brown is now suggesting “an insurance fee to reflect systemic risk or a resolution fund or contingent capital arrangements or a global financial transaction levy.”

    Supporters of a tax had argued that it would reduce the volatility of markets; opponents said it would be too complex to enact across borders and could create huge imbalances. Mr. Brown said any such tax would have to be applied universally.

    “It cannot be acceptable that the benefits of success in this sector are reaped by the few but the costs of its failure are borne by all of us,” Mr. Brown said at the summit. “There must be a better economic and social contract between financial institutions and the public based on trust and a just distribution of risks and rewards.”

    At the meeting at the Scottish golf resort, the last to be hosted by Britain during its turn leading the group, the ministers agreed on a detailed timetable to achieve balanced economic growth and reiterated a pledge not to withdraw any economic stimulus until a recovery was certain.

    They also committed to enact limits on bonuses and force banks to hold more cash reserves. But they failed to reach an agreement on how to finance a new climate change deal ahead of a crucial meeting in Copenhagen next month.

    The finance ministers agreed that economic and financial conditions had improved but that the recovery was “uneven and remains dependent on policy support,” according to a statement released by the group. The weak condition of the economy was illustrated Friday by new data showing the unemployment rate in the United States rising to 10.2 percent in October, the highest level in 26 years.

    The finance ministers also acknowledged that withdrawing stimulus packages required a balancing act to avoid stifling the economic recovery that has just begun.

    “If we put the brakes on too quickly, we will weaken the economy and the financial system, unemployment will rise, more businesses will fail, budget deficits will rise, and the ultimate cost of the crisis will be greater,” Mr. Geithner said. “It is too early to start to lean against recovery.”

    As part of the group’s global recovery plan, the United States would aim to increase its savings rate and reduce its trade deficit while countries like China and Germany would reduce their dependence on exports. Economic imbalances were widely faulted as helping to bring about the global economic downturn.

    Mr. Geithner acknowledged on Saturday that the changes would take time but that “what we are seeing so far has been encouraging.”

    Banks Ready to File Suit Against Short-Sellers

    editor’s note: This is part of what we have been talking about. years down the road these bankers are looking to sue borrowers for deficiencies after people recover from the disaster the bankers caused. Also set to explode in a few years are title defects that are incurable resulting from the securitization of loans and incorrect parties bringing foreclosure actions and taking title while the Lender sits blithely unaware that his rights are being twittered away.

    Banks Threaten Lawsuits Against Short Sales

    Updated: Oct 05, 2009 4:25 PM

    Banks Threaten Lawsuits Against Short Sales

    There’s a new warning out for struggling homeowners who think a short sale is their way out of a foreclosure. Big name banks like Bank of America, Citibank, and Wells Fargo are threatening to come after those who sell their homes through short sales years later once their credit is restored.

    Realtors say banks threatening to do this are causing some fear, but homeowners have no other options but to turn to short sales over foreclosure. Remember that bail out money these banks were given? Realtors say if banks do go after people, that bail out money should be given back to the government.

    Realtor Tammy Truong started in the short sale market two years ago when she noticed home owners were desperate and didn’t consider foreclosure as an option. “They’re confused and don’t know what to do. They want to do the right thing and they don’t want to walk away and foreclose,” she said.

    But short sales are now being threatened by banks. “They are pushing out the short sale process for as long as possible and looking for new avenues to try and sue people after a short sale is completed,” said Realtor Justin Chang.

    Chang says at a recent realtors meeting, big name banks were on hand and made it clear they had no problem with going after homeowners who short sell years from now as they attempt to improve their credit. “In a meeting with a lot of bank officials who came out here, they came out here and said we are able to track for up to six years peoples credit, so if they do get back on track and are able to purchase again and employment comes back, that’s when they’ll try to tag them and sue them for the difference,” he said.

    Both Truong and Chang say banks were given millions in bailout money to help them survive and help the crippling housing market. Going after owners who complete short sales was not part of the plan. “If they go back after all these people, I feel they should give back all the bailout money,” said Truong.

    Realtors are turning to Nevada’s Congressional Delegations, hoping to get them involved in this and stop these banks before anyone is sued years from now.

    Ex Freddie Mac Exec Says “Securitize No More”

    In order to revive securitization, taxpayers would have to absorb large risk. The social gains would be small, or perhaps even nonexistent. The best thing to do with the shattered Humpty-Dumpty of mortgage securitization would be to toss the broken pieces into the garbage.

    See Also Securitized Mortgages Are Illegal: Securitization Is ILLEGAL

    Should Mortgages be Securitized?

    Arnold Kling
    28 September, 2009
    arnold kling 77x77.jpg

    Like Humpty-Dumpty, mortgage securitization has taken a big fall. There is a widespread presumption that government policy, if not all the king’s horses and all the king’s men, should be aimed at putting securitization together again. The purpose of this essay is to question that presumption.

    The first section of this paper will describe how securitization worked at Freddie Mac in the late 1980s, when I worked there. This will allow me to introduce and explain the concepts of interest rate risk and credit risk in mortgage finance.

    The second section of this paper will describe developments in the mortgage industry from the mid-1980s through the 1990s, when Freddie Mac and Fannie Mae took on more interest rate risk. The third section looks at what evolved over the past ten years, when the process for allocating and managing credit risk changed, with “private-label” securitization and the growth of subprime mortgages.

    The fourth section of this paper describes various options for reviving mortgage securitization. The final section steps back and looks at interest rate risk and credit risk from a public policy standpoint. Government policy influences the allocation of credit risk and interest rate risk in capital markets. What are the social costs and benefits of various allocations? I suggest that policymakers might consider reverting to the housing finance system that preceded the emergence of securitization, in which depository institutions were responsible for managing both credit risk and interest rate risk for mortgages.

    Freddie Mac around 1989

    I joined Freddie Mac as an economist in December 1986. About eighteen months later, I was promoted to Director of Pricing/Cost Analysis, under the Vice-President for Financial Research. My job was to oversee the models used to manage interest rate risk and credit risk.

    At the time, my primary focus was credit risk. Freddie Mac bundled loans into securities, and then it sold the securities. If a mortgage loan defaulted, Freddie Mac would pay the entire unpaid balance on that loan to the security holder and then try to recover as much as it could from foreclosure proceedings on the property. Thus, Freddie Mac insulated security holders from the credit risk. This was known as the guarantee business, because Freddie Mac would guarantee that investors in its mortgage securities would not have to worry about individual mortgage defaults.

    A change in market interest rates could affect the value of the cash flows due to the investor in a mortgage. Because Freddie Mac packed nearly all of the mortgages it guaranteed into pass-through securities, Freddie Mac in the late 1980s had very little interest-rate risk. The interest-rate risk was borne by the investors who bought Freddie-Mac securities and relied on the cash flows that were passed through. Note that at that time there was a difference between Freddie Mac and Fannie Mae. Fannie Mae had traditionally financed most of its mortgage purchases with its own debt, rather than with pass-through securities. Thus, Fannie Mae had taken on interest-rate risk.

    Interest-rate risk arises because the typical mortgage in the United States is a thirty-year fixed-rate mortgage with a prepayment option. This means that the firm receiving the cash flows of the mortgage (call this the mortgage holder) faces a difficult problem in matching funding with the cash flows from the mortgage.

    Suppose that the interest rate on the mortgage is 8%, and suppose that the mortgage holder finances its position by issuing a five-year bond at 7%. If interest rates remain unchanged, then after five years the holder can issue another five-year bond at 7%. If this environment persists for thirty years, then the holder clearly makes a profit.

    However, suppose that after two years, market interest rates drop by two percentage points. The borrower takes advantage of this to obtain a new mortgage at 6%, using the proceeds from this refinance to pay off the original mortgage. The holder is still stuck with having to pay interest on the five-year bond for three more years at 7%. However, the holder cannot find investments that yield more than 6 percent, so the holder takes a loss. This is known as prepayment risk, or the cost of the prepayment option.

    On the other hand, suppose that after two years market interest rates rise by two percentage points and that this rise is permanent. Now, the mortgage borrower will try to retain the loan as long as possible, while the mortgage holder’s financing will run out after five years. At the end of the fifth year, the holder is going to have to obtain new funding, which will cost 9%, so that the holder is going to be suffering a loss. This might be called duration risk, because the cash flows from the mortgage have a longer duration (the last payment will not be received until thirty years from the date of origination) than the holder’s liability (a five-year bond in our example).

    When I joined Freddie Mac, its major competitors had recently been stung by duration risk. In the late 1960s and early 1970s, mortgage interest rates were around 6%. By the early 1980s, market interest rates had more than doubled. Fannie Mae, which at that time relied on medium-term debt to finance its mortgage holdings, was losing $1 million a day in 1982. More importantly the savings and loan industry, which financed its mortgage holdings with short-term deposits, was bankrupt.

    Thus, by the early 1980s, the approach of funding mortgages with short-term deposits was discredited. Securitization, which allowed the interest-rate risk to be transferred to institutions such as pension funds and insurance companies, seemed to be a superior financing method.

    The big challenge with securitization was managing credit risk. This required pricing policies, capital policies, and risk management policies.

    For pricing, we wanted to price mortgages according to risk. We specified a probability distribution for house prices, and we assumed that losses from mortgage defaults would take place when individual house prices fell below the outstanding mortgage balance. Because of this, the guarantee fee charged on a loan that was for 80% of the purchase price would be higher than the fee charged on a loan that was for 60% of the purchase price.

    Our capital policy was tied to something that we called “the Moody’s scenario,” since it was suggested to us by that credit rating agency, based on what happened in the Great Depression. Under this scenario, the average house price would fall by 10% per year for four years, and then remain flat thereafter. Although this was the average price path under the Moody’s scenario, we simulated a distribution of house prices, in which some fell by more and some fell by less. We then measured the total losses under this scenario, and we assumed that we would need enough capital to cover those losses. The cost of this capital was then priced into the guarantee fee. This capital charge did even more to penalize the relatively high-risk loans, such as loans backed by rental properties or loans with a high loan-to-value ratio.

    Pricing for risk is fine, assuming that the loan origination process is standardized. However, because loan origination was not under the control of Freddie Mac, we faced principal-agent problems. The incentive of the originators was to aim for volume, regardless of quality. To appreciate the challenge that we faced, consider that we might encounter a shady mortgage originator, whose intent is to create fraudulent mortgages and then abscond with the origination fees—or even the entire proceeds of the loan. Freddie Mac might revoke the eligibility of the shady operator, only to find that the operator moves to another location and does business under a different name.

    To manage this principal-agent problem, Freddie Mac had a number of devices (and Fannie Mae had very similar measures):

    –a qualification system for sellers. To sell loans to Freddie Mac, you had to prove that your staff had experience and you had to show sufficient capital that you could buy back loans that had been improperly originated.

    –a seller-servicer guide. This spelled out exactly the procedures and rules that we wanted originators to follow when approving or rejecting loan applications.

    –contractual obligations. Sellers were providing contractual representations and warranties to us that they were following our guide.

    –quality control. We inspected the loan files of a sample of loans from each originator. Loans that were found to violate the “reps and warrants” were put back to the seller to be repurchased.

    All of these risk management processes were costly, and all were imperfect. The principal-agent problems in securitization were difficult, and we were constantly tinkering with our systems to try to improve them.

    Freddie Mac and Fannie Mae Achieve Domination

    In the mid-1980s, inflation and interest rates began trending down. This made it profitable to finance mortgages with medium-term debt. Indeed, the downward movements in interest rates served to highlight prepayment risk. Mortgage holders had difficulty protecting themselves against sharp declines in interest rates, which caused borrowers to refinance while the holders were still paying interest on medium-term debt.

    Fannie Mae found a solution to the prepayment problem by issuing callable debt. For example, it might issue a ten-year bond that it could extinguish at par after five years, if interest rates had fallen. This effectively transferred prepayment risk from Fannie Mae to its debt investors, in return for which Fannie paid a slightly higher interest rate.

    The innovation of callable debt ultimately produced a dramatic change in the mortgage market. It undermined the Freddie Mac model of issuing pass-through securities. Investors were more comfortable with the relative simplicity and transparency of callable debt. In the 1990s, Freddie Mac jointed Fannie Mae as a “portfolio lender,” meaning that it held its own mortgage securities and funded them with callable debt.

    Funding mortgages with callable debt was so efficient that by 2003 Freddie Mac and Fannie Mae together held half of the mortgage debt outstanding in the United States. This dominant position was undermined by other innovations, discussed below.

    Securitization Goes Private-Label

    The benefits of securitization come from the fact that investors do not have to go to the trouble and expense of examining the underlying mortgages. Investors know the types of mortgages and the interest rates on the mortgages in the pool, which is the information that they need to manage interest-rate risk. However, investors assume that they are entirely insulated from credit risk, because of the guarantee provided by Freddie Mac or Fannie Mae.

    The guarantees from Freddie Mac and Fannie Mae were credible because of the capital and historical record of those firms. Most of all, however, the guarantees were credible because of the perception that it would be politically unacceptable to allow those firms to fail.

    There are mortgages that Freddie and Fannie could not guarantee, because of legislated limits on the size of loan eligible for those agencies. Moreover, ten years ago there were loans that the agencies would not guarantee, because low downpayments or weak borrower credit history made the loans high risk for default.

    About ten years ago, a number of innovations emerged that substituted for an agency guarantee, allowing “private-label” securities to compete with those of the agencies. Borrower credit scores provided a simple, quantitative measure of the borrower’s credit. Structured securities allowed credit risk to be reallocated, with subordinated holders taking most of the risk and senior holders only taking what was left over. The various tranches were evaluated by credit rating agencies, so that investors could treat AAA private-label securities as equivalent to agency securities (a practice which was formally ratified by bank regulators in a policy that took effect on January 1, 2002). For extra comfort, the holder of a security could purchase a credit default swap, which would pay off in the event that the security’s principal repayment was jeopardized.

    With all of these layers or protection, holders did not have to examine the underlying mortgages. In fact, it is not clear where that responsibility lay. With agency securitization, it was clearly the responsibility of Freddie Mac and Fannie Mae for managing, measuring, and bearing credit risk. However, with private-label securitization, those functions were diffused. The Wall Street firms that packaged securities had no experience with the risk management functions needed to ensure quality standards in mortgage origination. The credit rating agencies had most of the responsibility for credit risk measurement, but they bore none of the risk. In retrospect, the incentive to be overly generous in rating securities was far too high.

    Toward the latter part of the housing boom, the risk management process also broke down at Freddie Mac and Fannie Mae. Private-label securitization and the growth of subprime mortgages were leading to a sharp fall in the market share at the two agencies. In retrospect, the agencies should simply have held on to their capital standards and risk-management controls. However, at the time, they suffered from doubts about whether their traditional approach was still valid. They began to loosen standards for mortgage quality, to maintain insufficient capital relative to credit risk, and to purchase subprime mortgage securities based on agency ratings rather than on an assessment of the risks of the underlying loans. As a result, when the crisis hit, the agencies were not in a position to survive the losses that they incurred.

    Fix Securitization?

    On April 30, 2009, Gillian Tett lectured at the London School of Economics.[1] Tett, the author of perhaps the best book published so far on the origins of the financial crisis,[2] was asked a question about the impact of the failure of Lehman Brothers. In her response, she said that having the securities market break down was the equivalent of waking up one morning and finding that the Internet and cell phones had broken down.

    The consensus in the financial community is that securitization simply must be fixed. The question is how this can be done.

    Securitization worked because the holders of securities assumed that they were not bearing any credit risk. Securitization broke down when mortgage defaults reached a level where holders of securities were no longer confident that they were insulated from credit risk. For mortgage securitization to work again, the credit risk will have to be absorbed in a credible way by someone other than the holder of the securities.

    Mortgage credit risk includes both systemic risk and idiosyncratic risk. Systemic risk is the risk that conditions in the overall housing market will take a sharp turn for the worse. Idiosyncratic risk is the risk that mortgage originators will deliver faulty or fraudulent loans into the securitization process.

    The private-label securities operations did not seem to have strong mechanisms for dealing with idiosyncratic risk. Recently, the U.S. Treasury published recommendations for financial reform that included requiring mortgage originators to retain a 5% interest in the mortgage loans that they deliver for securitization. This strikes me as a crude approach. Five percent is too high for an honest but capital-strapped mortgage broker. At the same time, it is too low to deter serious fraud: retaining a 5% interest is no penalty at all if your intent all along is to abscond with 100% of the funds.

    A basic problem in private-label securitization is that the functions for managing idiosyncratic risk (procedures for qualifying sellers, establishing and enforcing guidelines, and so forth) are no one’s responsibility. Some party must take on those functions in order to address idiosyncratic risk.

    Another problem with all forms of mortgage securitization is that of systemic risk. At this point, there is no private-sector firm that can credibly insulate security holders from systemic risk. If Freddie Mac, Fannie Mae, and AIG all are unable to proceed without government backing, then there is no way that securitization can come back without the government acting as a guarantor of last resort.

    One suggestion that I have heard is that government should provide support along the lines of “the GNMA model.” This strikes me as nonsense. GNMA packages loans that are guaranteed by FHA and VA. GNMA is not taking any credit risk. Instead, losses are absorbed by the agencies from which it obtains the loans.

    The only way that the “GNMA model” could be used for the entire mortgage market would be if the FHA were to guarantee every mortgage. However, the FHA is not even capable of properly pricing the credit risk within its own niche. The FHA currently is suffering significant losses, creating large liabilities for taxpayers.

    Another proposal is what I refer to as “Wall Street’s Wet Dream.”[3] The idea is that a government agency would behave like a late-1980s Freddie Mac. This agency would take all of the credit risk in the securitization process, but it would not hold any securities in portfolio. This would be ideal from Wall Street’s point of view, because it would maximize the circulation of mortgage securities, rather than keep them stuck inside Freddie Mac or Fannie Mae in their own portfolios. The result would be an agency that bears no interest rate risk (which Freddie and Fannie were able to manage successfully), but which bears all of the credit risk (which brought them down).

    The “Wall Street Wet Dream” model would ensure that mortgage securities can be traded safely and profitably. The government agency would be responsible for managing the idiosyncratic risk of dealing with mortgage originators. It also would have to price for the systemic risk that arises from fluctuations in regional and national housing markets. Ultimately, this systematic risk would be borne by the taxpayers. Thus, the profits of the securities business would be fully privatized, and the credit risk would be fully socialized. Given the way Washington and Wall Street relate to one another in our society, it is a good bet that this is the model that will gain the most political support.

    Returning to the Savings and Loan Model

    Policymakers should consider returning to the mortgage finance system that we had forty years ago. Mortgages were originated and held by firms that financed their mortgage holdings with deposits. These were the savings and loans.

    The savings and loans did not suffer from the principal-agent problems that plague securitization. The loan originator is controlled by the institution that is going to hold the mortgage. The management of idiosyncratic risk is internalized.

    To manage systemic risk, regulators could subject depository institutions to capital regulations and stress tests. Mortgage holders that benefit from deposit insurance would have to hold enough capital to withstand a severe drop in house prices.

    The biggest flaw with the savings and loan model was that the savings and loans could not manage interest rate risk. When inflation and interest rates leaped higher in the 1970s, the savings and loans were stuck holding mortgages with interest rates that were well below the new prevailing market rates.

    There are various ways to make the S&L model work better than it did in the past. One is to conduct monetary policy in a way that stabilizes the inflation rate. In fact, since the early 1980s the Fed has been able to do that.

    Another approach would be to encourage variable-rate mortgages. These do not have to be the sort of high-risk, “teaser” loans that became notorious in recent years. Instead, they could work more like Canadian rollover mortgages, in which the interest rate is renegotiated every five years. The loans would be on a thirty-year amortization schedule, and they would start out at a market interest rate, rather than an artificially low rate. If interest rates were to rise sharply over any given five-year period, we would expect that the borrower’s income would have risen as well, so that the burden of the loan would not be significantly larger.

    Defenders of securitization will argue that it is more efficient to fund mortgages in the capital market. I would make two counter-arguments. The first counter-argument I would make[AN1] is that the alleged efficiency of securitization has not been demonstrated in the market. Mortgage securities are the artificial creation of government, starting with GNMA and Freddie Mac. The second-counter-argument is that adding efficiency to mortgage securitization serves to divert capital from other uses, and it is not necessarily the case that this capital diversion is best for society. More recently, bank capital regulations severely distorted the cost of holding mortgages relative to holding securities, strongly favoring the latter. In a completely free market, it is doubtful that securitization would emerge, particularly in light of recent experience.

    At its best, securitization appeared to lower mortgage rates about about one quarter of one percentage point relative to loans that could not be placed into securities. Suppose that government-backed securitization could be put in place to achieve a comparable reduction in mortgage interest rates. Is that an outcome for which we should aim?

    Compared with the risks that the government must assume in order to make securitization work, it seems to me that lowering mortgage interest rates by one quarter of one percent is not a commensurate benefit. This is particularly so given the alternative uses of capital. If mortgage rates are a bit higher than they could be under the most efficient system, then some capital will go toward other uses—interest rates charged to businesses or to consumers for other loans will be slightly lower. It is not clear that mortgage loans are better for society than other uses of capital. If it turns out that the “originate and hold” model is not as efficient as securitization for delivering low mortgage interest rates, that would not be a tragedy.

    In order to revive securitization, taxpayers would have to absorb large risk. The social gains would be small, or perhaps even nonexistent. The best thing to do with the shattered Humpty-Dumpty of mortgage securitization would be to toss the broken pieces into the garbage.


    Arnold Kling is an economist and member of the Financial Markets Working Group of the Mercatus Center at George Mason University. In the 1980’s and 1990’s he was an economist with the Federal Reserve Board and then with Freddie Mac. He blogs at

    [1] A recording of the lecture is available at or…

    [2] Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (Free Press, 2009).

    [3] For an example of the type of proposal I am describing, see Harley S. Bassman, “GSE’s: The Denouement,” available at….

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