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.

Mortgage Meltdown: Foreclosure Offense and Defense: Plan of Engagement


I am researching the possibility that there might be a securities violation that could inure to YOUR benefit (not just the buyers of CDOs). You see there are several breaches that occurred here all stemming from the fact that the market was artificially inflated. The scheme most closely resembles a Ponzi scheme and so it smacks of breach of fiduciary duty, lack of TILA disclosures, AND the sale of a security (which means failure to provide a prospectus, right of rescission, and other elements of registering or offering securities for sale of a security). remember that rescission rights, no matter what you may hear to the contrary, could extend to many years. Most people don’t know that. 

And in securities litigation, failure to provide a prospectus disclosing everything including your rescission rights, risk factors and how the deal is actually working, including use of proceeds, rights can extend far into the future with the statute of limitations running not from the date of the transaction, which sometimes happens, but more often from the date you discovered that you defrauded and how you were defrauded. 

The security in this case was the note and mortgage. You were encouraged by all the predatory participants to believe that the house was worth a certain amount of money (i.e., that fair market value was as stated), that you could sit back and watch it go up further without any action on your part, and without any knowledge on your part that the scheme would only work for YOU if they could continue to artificially inflate the apparent fair market values in the housing market. That way, you were told, you could either refinance and get money out of the deal or sell and get money out of the deal, all without any risk at all, or so it seemed. This then is a passive investment promising a return based upon the offering and the “work” of the offeror. 

All of these legal theories overlap, along with fraud in the inducement, fraud in the execution, failure to disclose under SEC rules, and violations of the various banking regulations which require a lender to do due diligence. In this case the lender did no due diligence (hence the proliferation of “no doc Loans) because they knew in advance that they were not assuming the risk of loss in the event of default. 

If you have a mind to do so I would encourage you to read the 10k and other filings of Countrywide Financial Corporation and you will see that they were selling the CDOs with a return of 8%, which of course is higher than any mortgage rate they were getting. The proceeds from the sale of the securities were allowed to be used for operational expenses INCLUDING service of the debt. Right there in black and white and signed by the executive of the company itself in full disclosure to avoid jail, is an admission of a Ponzi scheme —- which by definition is a scheme in which a greater fool down the line puts in money which is then used to profit the Ponzi operator and to pay prior “investors” until the money runs out.

So I would start with someone that can audit your closing documents from a TILA (Truth in Lending Act). Second I would look up some securities lawyers that really know their stuff, and who might be willing to take this on a contingency. And I would look up the class action lawyers in your neighborhood and have a talk with them. I am certain they will be very interested. Also go see and pester your local City Attorney and County Attorney and State Attorney would be very interested in this because they are ALL (1) under pressure to get relief for the government agency or unit and (2) understaffed and not very knowledgeable about the terms of relief that are available. They need help and you through your connection with me and others, can provide it. You can give them our blogsite so they can be brought up to speed. I can serve as adviser, expert or whatever. 

Here are some of the possible objectives that could be set without regard to any evaluation of the likelihood of success in your situation or any other:

1. Rescission and damages: tricky to get both, but the theory would be that you were deprived of the money you spent, you were deprived of the benefit of the bargain, and you lost money just by moving in and reasonably relying on what appeared to be the due diligence of the lender, appraiser, underwriter, etc., none of whom was doing the normal due diligence because there was no actual risk to them — including the fact that they they all could express plausible deniability. What they didn’t figure on, because they were too short-sighted, was the sudden implosion. So the plausible deniability defense is gone, a casualty of sheer volume. No lender, appraiser, or underwriter can expect to pass the giggle test when they go out and value a house at $250,000 one week and then $275,000 the following week, and then $335,000 the next month without wondering whether these prices are a real. 

2. Reduction of mortgage balance to reflect inflated values. So if your mortgage is $225,000 and the house is now showing a fair market value of $185,000, you should get a $40,000 reduction in the principal due on your mortgage.

3. Reduction in the interest rate, and getting fixed rate.

4. Reduction of payments without negative amortization.

5. Refund of loan origination costs or reduction of mortgage further for those amounts.

6. Refund the down payment you made or reduction of the balance further for that amount.

7. Payment of compensatory damages

8. Payment of Attorney Fees

9. Payment of treble damages under applicable RICO and similar acts.

10. Payment of punitive damages for bad behavior.

11. Payment of exemplary damages to serve as an example to others who might engage in the same wrongful behavior.

12. Settlement (where both parties release each other from claims made in litigation) MIGHT include a provision for reduction of your mortgage balance and reduction of your payments; this could be tied to an agreement wherein over the years if you are able to refinance or sell the house for more than the amount of the reduced mortgage, the lender can participate as an equity partner in the house. If worded properly, this would enable the lender, the investment banking operations and the owners of CDOs to restore the value (all or some) to their balance sheets, thus getting them out of trouble with regulatory authorities in terms of the viability as a continuing business. If such settlements occur on a widespread basis, the housing market will stabilize more quickly and after it stabilizes, the prospects for an earlier recovery are correspondingly enhanced. If real estate values recover, then tax revenues to government will stabilize proportionately and also recover. If people are kept in their homes, the prospect of ghost villages virtually vanishes.

13. With the causes of action for SEC violations, fraud and breach of fiduciary duties involved, there is nothing to stop people who have already been evicted from their homes from bringing these suits and settling with the added factor of taking that vacant house, putting them back in it, with a little money in their pocket so they can right themselves and go on with their lives. 

We are not being so presumptuous to say that we have the key to put ALL the toothpaste back in the tube. However, this approach takes into account the needs of the economy as a whole as well as individual victims and the perpetrators whose downfall might simply hurt more people.

I know this is a nasty business. But it is business. Don’t get mad, get even. And don’t get even, get ahead. When you discuss this with others leave out the the moralizing, and present the “conspiracy” in a calm, deliberate and organized way. Remember that lawyers are busy and some are lazy. You need to get to the meat of the situation quickly to interest them and what you want is someone to take this on a contingency. 

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