Tinker, Tailor, Soldier, Spy? Banker, Trader, Lender, Mortgage Broker? Or, How I Learned to Love the Fraud.

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.”
—Thomas Jefferson (1743 - 1826)

The money arrived from investment banks via “warehouse lines” which didn’t care about anything except getting back paperwork for closed loans. Dead or alive. The borrowers were irrelevant.

As we have now learned, as written in Huffington Post about the MF Global collapse, “The swift implosion of MF Global highlights a common practice used by aggressive speculators, one that experts say makes the broader financial system vulnerable to another crisis. It's called re-hypothecation, and it allows a firm to essentially pledge the same limited collateral to arrange fresh loans.

MF Global is believed to have used client funds as collateral to borrow money to make bets on the risky sovereign debt of Portugal, Spain and Italy, leading to a daisy chain of securitization, Thomson Reuters Business Law Currents reported. It's akin to using a single home as collateral for several loans and then investing that money to earn dividends before payments are due on the loans.”

Both hypothecation and re-hypothecation have been used by Wall Street and the banks for decades, using commercial paper, securities and mortgage loans as collateral. It increases leverage and functions as a tool to increase their liquidity, despite the risk.

During the S & L crisis, there were 1400 arrests and prosecutions. As a result of this current conspiracy, there have been none. Only borrowers and small investors across America have been targeted by local law enforcement and the Feds for accepting the fraudulently produced loans -- because it is easy and cheap to obtain convictions. But the perpetrators of this historic scheme are walking away with billions from their Trillion-dollar conspiracy.

Much has been written about the partnership between the Investment banks, commercial banks and Wall Street when it came to the mortgage bonds that fueled the housing bubble. In fact, it was not a bubble. It was more like a neutron bomb. It destroyed everything it came in contact with, except the physical representations of people and the properties themselves.

Originally, conceived by Lou Ranieri who was a bond trader at Solomon Brothers in the 1980’s, Wall Street lost interest in the CMO’s (collateralized mortgage obligations) during the 1990’s. That turbulent period was confused by the S & L crisis, the collapse of Long Term Capital Management, and the Russian default in 1998. While this is an oversimplification of that turbulent financial period, the essentials still hold true. And, it was also a period during which the Investment banks became public companies, able to trade for themselves in a highly leveraged fashion. The focus of their efforts became the trading for their own accounts rather than making money for clients. Partners now could make huge fortunes by using client money, leveraging that capital up to 40 times what they held in collateral for trading in bonds and securities.

The action was in the repo market, the commercial lending market where firms borrowed the money to operate on a daily basis. Many firms, in other words, could not function for even one day without loans collateralized sometimes by client assets pledged for that capital. The level of risk was both dangerous and unsupervised by the Feds. Most companies had U.K. offices to allow for looser standards.

The crash of Lehman Brothers occurred because they could no longer borrow money to operate in the repo market for even one day – and they ran through billions in a matter of days. By hypothecating their assets, pledging assets owned by clients for loans, the giant Ponzi scheme stumbled forward – until it couldn’t. Those who took the gamble by originating the loans based upon pledged assets would often then re-hypothecate these same assets to others to recoup their loaned cash. MF Global, did exactly this by operating out of subsidiaries in the U.K., where the controls on such transactions were looser and fully legal and, once again, unsupervised.

The Glass-Steagal Act, which created a firewall between banking and investing – between commercial banks and their depositors and Wall Street firms as well as investment banks and their investors – was neutered in the 1990’s due in a large part by the efforts of Robert Rubin, former Treasury Secretary. It didn’t take long for the effects of that action to trickle down to the colluding corporations.

But, the end result of these colliding occurrences became the streamlined operation for the funding of the housing market. The products which were the result of comingling of financial entities, banks, insurance companies and investment banks – and loan products -- were called S.I.V.’s, or intentionally abstruse nomenclature of Structured Investment Vehicles, the most famous of which became the CDO, or Collaterized Debt Obligation.

Ranieri’s “invention” had been a mortgage bond known as a CMO, or Collateralized Mortgage Obligation. The new version, introduced to bond traders with great gusto, was the CDO, or Collateralized Debt Obligation. Now, the recreated bond included commercial paper, mortgages and auto loans. It became a potpourri of debt that could be sold all over the world and balanced the bond risk with debt graded from BBB- to AAA. Theoretically, based upon the mathematical genius of employees known as “quants” for those engaged in quantitative analysis, the balance of different types of debts in one bond made the likelihood of default practically impossible. Or, so they thought. This same mistake was made by the “intellectuals” at Long Term Capital Management.

A few details about this new security eventually blew everything up. While the quants calculations may have been sound, the implementation of their results was less than perfect. Their view, of course, was skewed in favor of their Wall Street employers and the calculations and terminology included in these bonds were very difficult to understand. Once the Investments banks got their hands on the concept of a bond that could be sold all over the world and that the fees generated by these securities would net them hundreds of billions of dollars in fees and profits, the most important element became the valuation of the security. But, in order to guarantee that pension funds and governments, as well as hedge funds and investors would gobble them up like candy, they needed a triple-A rating. Initially, that was not a problem since they were too new to question. But, as the defaults began to occur, something had to be done quickly to salvage the billions in loans that were temporarily shelved.

The major rating agencies, which were responsible for grading the bonds, were Fitch, Standard & Poor, and Moody’s. They were captive entities. All three, in essence, worked for the major Investment banks and Commercial banks, which, by now, were all selling CDO’s out of their bond trading departments – since the Glass-Steagal Act had been removed as an impediment to the mixing of securities sales and banking. Rubin, a Citicorp executive had seen nicely to that. The ratings agencies were held hostage to Wall Street and the banks since the fees generated by the bond trades, paid the salaries of the ever-increasing number of high paying bond-grading jobs. Plus, few people outside of the quants even understood them. As Alan Greenspan later said of these bonds, “We had 150 Ph.D.’s on our staff at the Fed, and even they did not understand what was in them.” You can imagine how much comprehension there was from bond traders to mortgage brokers – let alone borrowers who understood little about the loan products – in light of this statement.

So, to solve the default problem which was threatening to lower the rating on the CDO’s (and sticking the firm with unsalable bonds), the logical answer would have been to increase the value of the bonds or, lower the rating of the bonds, or, failing that, strip the bonds of the offending mortgage loans. But, since the mortgage loans were the essence of the bonds, only one solution was palatable to Investment banks, Wall Street, and, especially, to the bond traders – some of whom were walking away with salaries of half a million a year, and bonuses of up to $5 million. CEO’s like Fuld were pulling down 20 and 30 million per year. Hank Paulson, later Treasury Secretary, but CEO of Goldman Sachs bought his own island off the coast of North Carolina with his bonuses and salaries due in a large part from the CDO trades.

The solution was to re-grade the debt and get rid of it. Get it off the books.

Dutifully, all of the rating agencies complied with a slight of hand by virtue of rearranging the “tranches” in the CDO’s. If you think of the bonds as pyramids, with the highest rated debt in tranches at the top of the pyramid – which paid the lowest interest rate but was arguably the safest debt – and the lowest tranche is the highest paying interest rate but with the greatest risk – it becomes easier to understand how this particular shell game worked.
The highest risk debts, in other words the subprime mortgage loans with the highest, almost guaranteed default probabilities, were the lowest tranche in the pyramid. These were the BBB- rated mortgage loans that people defaulted on within a month of closing on a home loan.

These were also the loans that came to be known as “liar loans.” Almost nothing about their quality was true, except to say that lenders like Countrywide and hundreds of thousands of mortgage brokers doctored and manipulated the paperwork so that almost anyone breathing would qualify for a mortgage. Washington Mutual, or WaMu, later purchased by JPMorgan Chase, in fact, had in-house mortgage brokers who fabricated paperwork, created job descriptions and invented incomes for borrowers in order to push through loans. Documented evidence shows that many of these WaMu employees were doing Meth while creating loan files. They were not alone. Most mortgage brokers, looking for that YSP and seeking to assuage their masters, the investment banks, stood in line begging for warehouse lines to complete closings. Any way they could do it.

It was the only way that the loans could keep the CDO freight train moving and to fill the securities with product. Without that, the million-dollar bond trading bonuses would evaporate.

These lowest rated loans, then, the subprime tranches or strips of defaulting, or soon to default mortgage loans, were removed from the existing, unmarketable bonds. A new CDO was created with these rapidly defaulting loans; loans which lacked any meaningful underwriting. These new CDO’s were re-graded by the rating agencies and was known as a CDO-squared by the bond traders. The new rating of the old BBB- debt was now, are you ready for this, AAA? This eliminated all of the previous problems. The new bonds could now be sold to institutions as AAA securities, whereas the old bonds which were being degraded by the very loans that were now included in the new bond, were graded and rated as junk.

This sleight of hand was the original fraud perpetrated upon the entire banking system. It went on for years.

And, consequently, this rating trick brought down the economy and numerous institutions with it. The bond traders knew about it, the ratings agencies knew about it, the CEO’s knew about it, the GSE’s knew about it and the Treasury Department knew about it. Few in the housing market knew about since they only understood liquidity, or, whether the money still flowed for deals. Mortgage brokers only knew about the flow of the money and what they had to do to keep the spigot turned on.

In fact, beginning in 2005, the intensity of getting deals done became extremely tense. From the bond traders, middle management and upper management -- through to the bank closing attorneys, title closers and ultimately to the mortgage brokers and wholly owned lenders – the heat was turned up. Now, the game was to close and unload greater and greater quantities of these CDO’s before it all collapsed. They all knew that the game was ending as the default rate on the bonds increased geometrically. All of these securities had to be dumped as quickly as possible before the music stopped. By the time lenders started to fail at the end of 2006 and through the early part of 2007, hundreds of billions in loans had been written and sold off as high-grade securities.

And, the derivatives, insurance against default, which was written by A.I.G., MBIA and a few other companies were also threatening to blow up all at once. This insurance, known as a Credit Default Swaps, was insurance against default of the CDO’s. Wall Street had purchased them in increasing quantities starting in 2004 and they were now being called. This was the most telling aspect of what the bond sellers knew and when they knew it. What no one knew, since A.I.G. had sold off their insurance obligation to other investors, was whom the responsible parties were – to pay off on the defaulting bonds. The derivatives market was unregulated and no one knew who was obligated to pay.
This derivatives market, which included the CDS’s, is estimated to exceed $1 Quadrillion dollars.

Unfortunately, the mathematical basis for the CDS’s was not geared to an entire class of liabilities defaulting at the same time. Like the House in a casino, A.I.G. was being called upon to pay off on bets that all came due at once, and which, in many cases, it no longer owned.

The mathematical probability of that occurring was close to zero – as long as fraud was not part of the equation.

While the derivatives market – leveraged bets – is close to $1 Quadrillion, paying off on several hundred billion in debts coming due at once is impossible. At this point in time, about the time of the Lehman collapse in 2008, that is what was happening. Wall Street, the investment banks and the commercial banks -- through the CDO’s that were defaulting en masse -- created a cataclysmic event as a result of their fraud.

By creating products that were guaranteed to default; by pushing loans that were doctored and misunderstood so that they could quickly be securitized and sold off; by re-grading the lowest quality loans as highest quality in order to sell them off; by abandoning any semblance of underwriting on loans -- they created a disaster of epic proportions. Borrowers and small investors were clueless as to what was happening. And, the more desperate the bond sales department became, the more pressure was exerted upon mortgage brokers to lower lending qualifications, fabricate loan standards, fill out the applications for loans as needed, and eliminate underwriting.

It was the greatest RICO conspiracy ever perpetrated upon the American public.

Mortgage brokers received a kickback on every loan for which they hid the details and qualifications. It was called a Yield Spread Premium (YSP). It was paid by the bank for putting borrowers into loans that either had higher interest rates or lower qualifications. These loans were guaranteed to default. And, brokers filled out applications in any way that would guarantee a closing would occur. Many borrowers never saw the applications filled out for them and at closings, done in two hours, not one borrower ever had time to read through what was stated to obtain the loan. Papers were shuffled back and forth across closing tables. Attorneys, title closers, mortgage brokers and bank representatives created an elaborate, time-tested and completely fraudulent method – to return completed loan files to Wall Street for inclusion in their insatiable black hole of securities – the CDO’s. And, they were sold off before the ink was dry on the loan documents.

Then the investment bank salesmen got huge fees for packaging the loans into bonds and selling them off.

And, the banks made huge multi-billion dollar profits for selling off packages of securities to pension funds, hedge funds, private investors and sovereign countries. Profits amounted to Trillions over the years.

It is estimated that the Fed had to make $29 Trillion dollars available to protect our economic system from collapse.