THE FINANCIAL TSUNAMI Part 1: Deutsche Bank's Painful Lesson

Financial Sense University ^ | November 24, 2007 | F. William Engdahl

[Travis McGee]

Even experienced banker friends tell me that they think the worst of the US banking troubles are over and that things are slowly getting back to normal. What is lacking in their rosy optimism is the realization of the scale of the ongoing deterioration in credit markets globally, centered in the American asset-backed securities market, and especially in the market for CDOs—Collateralized Debt Obligations and CMOs—Collateralized Mortgage Obligations. By now every serious reader has heard the term “It’s a crisis in Sub-Prime US home mortgage debt.” What almost no one I know understands is that the Sub-Prime problem is but the tip of a colossal iceberg that is in a slow meltdown. I offer one recent example to illustrate my point that the “Financial Tsunami” is only beginning.

Deutsche Bank got a hard shock a few days ago when a judge in the state of Ohio in the USA made a ruling that the bank had no legal right to foreclose on 14 homes whose owners had failed to keep current in their monthly mortgage payments. Now this might sound like small beer for Deutsche Bank, one of the world’s largest banks with over €1.1 trillion (Billionen) in assets worldwide. As Hilmar Kopper used to say, “peanuts.” It’s not at all peanuts, however, for the Anglo-Saxon banking world and its European allies like Deutsche Bank, BNP Paribas, Barclays Bank, HSBC or others. Why?

A US Federal Judge, C.A. Boyko in Federal District Court in Cleveland, Ohio ruled to dismiss a claim by Deutsche Bank National Trust Company. DB’s US subsidiary was seeking to take possession of 14 homes from Cleveland residents living in them, in order to claim the assets.

Here comes the hair in the soup. The Judge asked DB to show documents proving legal title to the 14 homes. DB could not. All DB attorneys could show was a document showing only an “intent to convey the rights in the mortgages.” They could not produce the actual mortgage, the heart of Western property rights since the Magna Charta if not longer.

Again why could Deutsche Bank not show the 14 mortgages on the 14 homes? Because they live in the exotic new world of “global securitization”, where banks like DB or Citigroup buy tens of thousands of mortgages from small local lending banks, “bundle” them into Jumbo new securities which then are rated by Moody’s or Standard & Poors or Fitch, and sell them as bonds to pension funds or other banks or private investors who naively believed they were buying bonds rated AAA, the highest, and never realized that their “bundle” of say 1,000 different home mortgages, contained maybe 20% or 200 mortgages rated “sub-prime,” i.e. of dubious credit quality.

Indeed the profits being earned in the past seven years by the world’s largest financial players from Goldman Sachs to Morgan Stanley to HSBC, Chase, and yes, Deutsche Bank, were so staggering, few bothered to open the risk models used by the professionals who bundled the mortgages. Certainly not the Big Three rating companies who had a criminal conflict of interest in giving top debt ratings. That changed abruptly last August and since then the major banks have issued one after another report of disastrous “sub-prime” losses.

A new unexpected factor

The Ohio ruling that dismissed DB’s claim to foreclose and take back the 14 homes for non-payment, is far more than bad luck for the bank of Josef Ackermann. It is an earth-shaking precedent for all banks holding what they had thought were collateral in form of real estate property.

How this? Because of the complex structure of asset-backed securities and the widely dispersed ownership of mortgage securities (not actual mortgages but the securities based on same) no one is yet able to identify who precisely holds the physical mortgage document. Oops! A tiny legal detail our Wall Street Rocket Scientist derivatives experts ignored when they were bundling and issuing hundreds of billions of dollars worth of CMO’s in the past six or seven years. As of January 2007 some $6.5 trillion of securitized mortgage debt was outstanding in the United States. That’s a lot by any measure!

In the Ohio case Deutsche Bank is acting as “Trustee” for “securitization pools” or groups of disparate investors who may reside anywhere. But the Trustee never got the legal document known as the mortgage. Judge Boyko ordered DB to prove they were the owners of the mortgages or notes and they could not. DB could only argue that the banks had foreclosed on such cases for years without challenge. The Judge then declared that the banks “seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance. Finally put to the test,” the Judge concluded, “their weak legal arguments compel the court to stop them at the gate.” Deutsche Bank has refused comment.

What next?

As news of this legal precedent spreads across the USA like a California brushfire, hundreds of thousands of struggling homeowners who took the bait in times of historically low interest rates to buy a home with often, no money paid down, and the first 2 years with extremely low interest rate in what are known as “interest only” Adjustable Rate Mortgages (ARMs), now face exploding mortgage monthly payments at just the point the US economy is sinking into severe recession. (I regret the plethora of abbreviations used here but it is the fault of Wall Street bankers not this author).

The peak period of the US real estate bubble which began in about 2002 when Alan Greenspan began the most aggressive series of rate cuts in Federal Reserve history was 2005-2006. Greenspan’s intent, as he admitted at the time, was to replace the Dot.com internet stock bubble with a real estate home investment and lending bubble. He argued that was the only way to keep the US economy from deep recession. In retrospect a recession in 2002 would have been far milder and less damaging than what we now face.

Of course, Greenspan has since safely retired, written his memoirs and handed the control (and blame) of the mess over to a young ex-Princeton professor, Ben Bernanke. As a Princeton graduate, I can say I would never trust monetary policy for the world’s most powerful central bank in the hands of a Princeton economics professor. Keep them in their ivy-covered towers.

Now the last phase of every speculative bubble is the one where the animal juices get the most excited. This has been the case with every major speculative bubble since the Holland Tulip speculation of the 1630’s to the South Sea Bubble of 1720 to the 1929 Wall Street crash. It was true as well with the US 2002-2007 Real Estate bubble. In the last two years of the boom in selling real estate loans, banks were convinced they could resell the mortgage loans to a Wall Street financial house who would bundle it with thousands of good better and worse quality mortgage loans and resell them as Collateralized Mortgage Obligation bonds. In the flush of greed, banks became increasingly reckless of the credit worthiness of the prospective home owners. In many cases they did not even bother to check if the person was employed. Who cares? It will be resold and securitized and the risk of mortgage default was historically low.

That was in 2005. The most Sub-prime mortgages written with Adjustable Rate Mortgage contracts were written between 2005-2006, the last and most furious phase of the US bubble. Now a whole new wave of mortgage defaults is about to explode onto the scene beginning January 2008. Between December 2007 and July 1, 2008 more than $690 Billion in mortgages will face an interest rate jump according to the contract terms of the ARMs written two years before. That means market interest rates for those mortgages will explode monthly payments just as recession drives incomes down. Hundreds of thousands of homeowners will be forced to do the last resort of any homeowner: stop monthly mortgage payments.

Here is where the Ohio court decision guarantees that the next phase of the US mortgage crisis will assume Tsunami dimension. If the Ohio Deutsche Bank precedent holds in the appeal to the Supreme Court, millions of homes will be in default but the banks prevented from seizing them as collateral assets to resell. Robert Shiller of Yale, the controversial and often correct author of the book, Irrational Exuberance, predicting the 2001-2 Dot.com stock crash, estimates US housing prices could fall as much as 50% in some areas given how home prices have diverged relative to rents.

The $690 billion worth of “interest only” ARMs due for interest rate hike between now and July 2008 are by and large not Sub-prime but a little higher quality, but only just. There are a total of $1.4 trillion in “interest only” ARMs according to the US research firm, First American Loan Performance. A recent study calculates that, as these ARMs face staggering higher interest costs in the next 9 months, more than $325 billion of the loans will default leaving 1 million property owners in technical mortgage default. But if banks are unable to reclaim the homes as assets to offset the non-performing mortgages, the US banking system and a chunk of the global banking system faces a financial gridlock that will make events to date truly “peanuts” by comparison. We will discuss the global geo-political implications of this in our next report, The Financial Tsunami: Part 2.

© 2007 F. William Engdahl

[thinking]

I have everyday knowledge of economics...however, it seems to me that, a bank makes a series of marginal loans, then sells off the loans, knowing the loans would default, to some other bank/institute, this enables the original bank to wash their hands of the matter...."no longer our problem"

[dennisw]

If this financial meltdown really comes don’t look for hyperinflation. Because these days our instantaneous markets render harsh judgment on nations that do this. Instead look for debt repudiation. Full repudiation or partial. Where various levels of gov’t and large corporations refuse to pay off a bond when they find themselves unable to issue new debt (no one’s buying) to retire old debt

You already see a partial debt repudiation as mortgage CDOs are found to be worth a lot less than everybody said

[AndyJackson]

don’t look for hyperinflation. Because these days our instantaneous markets render harsh judgment on nations that do this. Instead look for debt repudiation. Full repudiation or partial.

This is where we are stuck. When the $ was the world's resere currency, the markets could not render harsh judgment. As central banks repudiate the dollar as the reserve currency, we will look more like Argentina in the 80's than the US in under Carter, which was bad enough.

[Travis McGee]

In 1971, Nixon began this slow-motion debt repudiation when he slammed the gold window on Degaulle's fingers. This was a clear repudiation of the 1944 Bretton Woods Agreement, and since 1971, the dollar has essentially been a "faith backed currency," essentially no different than the old Soviet Ruble. It carried on as the world's reserve currency on sheer momentum, until very recently.

The next stage is anybody's guess, there are inflationists and deflationists. Myself, I think we'll go through both stages, in spasms, as govts are urged to "do something!" to fix the problem pronto. But the entire structure is rotten, and banging on new vinyl siding won't hold it up.

Still, they will try, and I think we will go through both hyperinflation and deflation. The "fixes" the govt tries will only deepen and lengthen the crisis, because Americans can no longer stomach the truth or strong medicine.

[Travis McGee]

“Argentina with nukes.”

[DeaconBenjamin]

And even when you get the pig put back together it is still a rotten worthless carcass, although that would probably not stop you from selling futures on it.

There will always be someone willing to put lipstick on that pig.

[Travis McGee]

It may not be the mortgage originator’s problem, but the problem hardly ends there. It only begins there.

[Gritty]

This entire subject is giving me a king-sized migraine. I think I'll follow the government's sage advice, do my part, and just go shopping - while my Dollars can still fit in my pocket instead of my wheelbarrow.

As usual (and illustrated once again by this massive Ponzi scheme), the smartest guys in the room really aren't. But rest assured, we taxpayers will pick up their tab.

[Travis McGee]

Great essay linked there at #8!

http://www.oftwominds.com/blognov07/empire-debt1.html

[LurkingSince'98]

Travis,

I have also wrestled with the inflation/deflation scenarios and keep coming back to the same point on which I am stuck - If $1 Trillion is mortgages reset and seize in the next year or so and the CDOs and MBSs based on them crater in an amount of $500-750 Billion - How could the Fed or gov every inject enough liquidity to compensate for that deflation? How would they get the $1.5 Trillion or so into the system?

Either Inflation or Deflation we are screwed and not in a nice way.

Regards,
Lurking’

[ex-Texan]

How Mortgage Companies Steal Your House . . .

With bogus accounting records. Some companies intentionally create false records your payment as 'received late.' Some companies destroy all incoming mail periodically. Sound far fetched to you? If so, you are living in a dream world.

The mortgage lenders are following the identical scenario adopted by major credit card companies.

Credit card companies make more money by shredding mail than by opening it. Why? Bogus late fees, over limit charges and surcharges add up very quickly. If the account is sent into the collection department, then companies add on "collection charges" and even bogus attorneys fees. Everyones who participates in this operation is engaged in a national scam.

The scam is called "theft by deception," a felony in virtually every state. It is also called mail fraud which is federal felony. The scam is very well organized. The practice was aimed primarily a people who already have glitches on their credit. Recently, with the subprime crisis expaning, even people with perfect credit have become targets.

In short, this is organized criminal activity. Run by large banks, credit card companies and Wall Street firms. Also involved are the so-called credit reporting companies.

Rent the DVD "In Debt We Trust." Another good DVD is "Maxed Out" -- that deals primarily with credit card companies. See employees tell horror stories about payments being held (or destroyed) in order to pile on late fees.

Want to Learn More? . . . Click the link and scroll down.

[stephenjohnbanker]

“With bogus accounting records. Some companies intentionally create false records your payment as ‘received late.’ Some companies destroy all incoming mail periodically. Sound far fetched to you? If so, you are living in a dream world.

The mortgage lenders are following the identical scenario adopted by major credit card companies.

Credit card companies make more money by shredding mail than by opening it. Why? Bogus late fees, over limit charges and surcharges add up very quickly. If the account is sent into the collection department, then companies add on “collection charges” and even bogus attorneys fees. Everyones who participates in this operation is engaged in a national scam.

The scam is called “theft by deception,” a felony in virtually every state. It is also called mail fraud which is federal felony. The scam is very well organized. The practice was aimed primarily a people who already have glitches on their credit. Recently, with the subprime crisis expaning, even people with perfect credit have become targets.

In short, this is organized criminal activity. Run by large banks, credit card companies and Wall Street firms. Also involved are the so-called credit reporting companies.
“

For those of you who doubt the veracity of ex-texan....I have been in high finance all of my life, and ex-texan is telling the gospel truth. Believe what you want, but he and I predicted this mtg downfall almost 2 years ago. We were flamed! Not anymore!

[stephenjohnbanker]

SEE post 112.

[Travis McGee]

Inflation and deflation are not opposites so much as the two sides of the same coin, being an economy finally run to ruin via infinite credit creation. Once the game is up, there is no "out" other than to start over again, but govt's usually try to print their way out of the disaster (hyperinflation) and when that fails it goes the other way.

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

~~Ludwig von Mises

[Travis McGee]

DAMN!!! Man, that would be a pisser, for someone with perfect credit who has never missed a payment on anything, and always has a zero credit card balance every month.

[Travis McGee]

A professional friend who knows the business inside and out sent me this in response to the replies on this thread. By coincidence, he sent me a link to this very article today, not knowing I had already read it and posted it here last night.

The "they" he is referring to are the respondents to this thread.

"They argue over the trivial issues of procedure, law etc. and I agree that the court ruling may just be an administrative snag, that will take some time to sort out, but the BOTTOM line is that the debt is only as good as the creditor's ability to pay, or the price that the property will fetch in an all cash foreclosure sale. In the interim, the debt cannot be priced at "market" so the capital markets "lock up" The velocity of money is as important as the money itself in a debt based fiat system, and since all money, (including debt/ money created outside the FR system) is then debt based the asset value is derived entirely upon the market value of the corresponding debt. If the debt value is in question, then so is the asset value, thus the velocity of "money" becomes hamstrung as a result. This is the kiss of death in a fractional reserve system that lends 10:1, as greater levels of debt/ money need to be created (and accepted) for the system to function. Absent hyperinflation there exists no remedy , and history is VERY clear on where all this ends up. (by the way, gold is virtually the only liquid asset that is "MONEY" and has no debt attached to it!!)

[AndyJackson]

The velocity of money is as important as the money itself in a debt based fiat system

It is clear that the financial system has been under a lot of stress for a couple of years when it was profitable for a large number of folks to be employed to make telephone calls to accelerate payments, from the electric company to mortgage servicing companies.

I used to get calls once a month from my mortgage company that would say, your mortgage is due in two weeks and you have not paid it yet. Can we do this now over the phone.

I suppose if they can get 1-2 weeks float on everyone's mortgage payment they can make a nice chunk. But of course, this requires a lot of leverage on the float.

[Revel]

Great article Travis. Things could get bad.

[Travis McGee]

Everything is just peachy!

U.S. Consumers Spent 3.5% Less on Holiday Shopping - Bloomberg (11/25/2007 05:33 PM)

California homes deal to avert defaults - FT (11/25/2007 01:32 PM)

Wake up to the dangers of a deepening crisis - FT (11/25/2007 02:50 PM)

Don’t look now: Here comes the recession - Fortune (11/25/2007 05:31 PM)

Fannie and Freddie pullback would devastate economy - Reuters (11/24/2007 08:24 AM)

Housing woes have domino effect - USA Today (11/25/2007 01:02 PM)

Eating out is getting lonelier - LA Times (11/24/2007 08:35 AM)

Mortgage Failures Could Create Nightmare - AP (11/24/2007 06:41 AM)

Crunch May Hit Insurers Of Bonds - Washington Post (11/24/2007 08:23 AM)

Oil Closes at Record in New York as Fuel Inventories May Drop - Bloomberg (11/24/2007 08:26 AM)

Euro is becoming the it currency - USA Today (11/24/2007 08:28 AM)

Turning the screw back to 1973 - or perhaps further - FT (11/25/2007 01:33 PM)

Subprime Mess to Worsen - WSJ ($) (11/25/2007 03:22 PM)
Refinancing May Be Harder to Enjoy - WSJ ($) (11/25/2007 03:28 PM)

Hedge Funds:Leveraging The Numbers - WSJ ($) (11/25/2007 03:29 PM)

CDOs explained: Eavis - Fortune (11/25/2007 05:30 PM)
Dollar Displaces Yen, Franc as Favorite for Funding Carry Trade - Bloomberg (11/25/2007 05:38 PM)

Derivative liquidity crisis ‘to continue’ - FT (11/25/2007 03:04 PM)

Carmakers face more pain to get back on right road - FT (11/25/2007 03:00 PM)

Freddie to raise $5 bln in preferred stock sale: report - Reuters (11/24/2007 08:27 AM)

Countrywide Woes Mount - New York Post (11/24/2007 08:38 AM)

Freddie and Fannie’s Achilles’ heel - Fortune (11/25/2007 05:49 PM)

In Europe, Weathering Credit Storm From U.S. - NY Times (11/24/2007 06:41 AM)

Yen Gains Versus 16 Major Currencies as Investors Reduce Risks - Bloomberg (11/24/2007 08:25 AM)

French bank Natixis says it took €407 million hit from subprime credit crisis - IHT (11/25/2007 01:33 PM)

Sub-prime ‘time bomb’ is set to explode in Britain - UK Times (11/24/2007 08:36 AM)

The dwindling dollar takes toll on Europe - UK Times (11/25/2007 06:41 AM)

UK manufacturing productivity outstrips global rivals - FT (11/25/2007 02:56 PM)

Krugman: Banks gone wild - IHT (11/25/2007 08:03 AM)
Wake up to the dangers of a deepening crisis: Summers - FT (11/25/2007 01:05 PM)

The next credit scandal: Eavis - Fortune (11/25/2007 05:32 PM)

Fortunes shift as oil prices soar - LA Times (11/24/2007 08:30 AM)

Blame the Borrowers? Not So Fast: Morgenson - NY Times (11/24/2007 07:17 PM)

A Time for Bold Thinking on Housing: Shiller - NY Times (11/24/2007 07:18 PM)

[Travis McGee]

Thanks. Getta load of 119.