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10/18/2010
THE ONLY VICTIMS IN THE FORECLOSURE MESS WILL BE TAXPAYERS

I took a stab at analyzing the latest economic meltdown for PJ Media; the foreclosure scandal and its many moving parts.

A sample:

In this respect, the two competing narratives involving the foreclosure mess may both be successful in demonizing pet targets like big banks or ACORN. But as far as reflecting the reality of the problem, both narratives come up considerably short.

On the left, it’s heartless, greedy banks foreclosing illegally on tearful, innocent homeowners, throwing children and grammas out in the street for no reason hardly at all. On the right, it’s sinister forces manipulating the system in order to allow deadbeat homeowners to remain in houses as a result of nothing more serious than a paperwork snafu, despite the fact that they should long ago have been foreclosed upon and evicted.

Compassion versus personal responsibility. Class warfare versus the politics of resentment. As political narratives, both succeed in playing to the emotions and preconceived notions of their respective partisans. But as commentaries on what is actually happening, they are wildly off base.

By any measure, we are facing an extremely serious crisis that not only affects foreclosures, but mortgage securities, the financial viability of banks that are still “too big to fail,” and, most importantly, the rule of law in America. Silly, pretentious attempts to gain political points in this crisis will only make it more difficult to act when the crunch comes.

Is a crunch coming? The uncertainty alone is already affecting the housing market, bank stocks, the credit markets, and the economy in general. And until a way can be found out of this mortgage quicksand, it is likely that those trends will continue, threatening to throw the economy back into recession and perhaps even initiating another financial meltdown similar to the one we experienced in September of 2008.

I have come to the conclusion - or let’s say I agree with a notion advanced by other conservatives - that the real path to the economic collapse we’ve been experiencing began when the financial services industry moved outside it’s traditional role of funding start ups and supplying a haven for money, and into a Las Vegas style, wild west format where nothing is out of bounds and “caveat emptor” are words to live by.

We can trace this curve back to the day that Wall Street’s big banks were granted permission to operate as consumer banks. Glass-Steagall may have been cumbersome, but it acted as a firewall against the manipulation of the financial system so many of these huge banks participated in.

Mortgage bonds, for instance:

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of Clayton’s test. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

I talked to one underwriting bank — not Citi — which claimed that investors were told that the due diligence had been done: on page 48 of the prospectus, there’s language about how the underwriter had done an “underwriting guideline review”, although there’s nothing specifically about hiring a company to re-underwrite a large chunk of the loans in the pool, and report back on whether they met the originator’s standards.

In any case, it’s clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool.

Note that this potential financial Armageddon is mostly unrelated to the foreclosure crisis but the exposure of the big banks and mortgage bond holders to massive lawsuits by investors is very real and could precipitate another meltdown - if the foreclosure crisis doesn’t cause one first.

I would say to my conservative brethren who pooh-pooh the idea of financial reform that the thought of many dozens of Bernie Madoffs out there getting away with fraud while having the potential to cause another crisis should alter your perception. This isn’t capitalism. It is an abuse of the system and cries out for regulation to fix it.

By: Rick Moran at 8:15 am

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