Why I Advocate Prosecution by Karl Denninger

If you've wondered why I advocate prosecuting homeowners who have lied on their mortgage applications along with the banksters who fraudulently "packaged and sold" non-underwritten loans as "AAA" securities, implying actual underwriting and defined risks, here's the reason:

Sillman says he's seeing “a ton of fraud,” especially as it applies to fake “short sales,” which is the industry term used to describe the sale of a property for less than what is owed on it.

And how are they cheating? Take your pick:

Fortace also has uncovered many instances where solvent owners are imploring employers to tell lenders they no longer work there or are temporarily signing over assets to friends or distant relatives. “Everyone's trying to hide assets,” Sillman says.
Others have uncovered similar shenanigans. Jeffrey Taylor at Digital Risk, an Orlando, Fla., firm that analyzes loan portfolios on behalf of potential investors, has found numerous cases where co-workers are supposedly verifying income rather than the boss, or where people are claiming they have been told they will be laid off in 30 or 60 days so they qualify as “imminent defaults.”
Many owners whom Taylor says “are trying to get their share of the free money, one way or another” are also failing to disclose bank and stock accounts, neither of which are listed on credit reports. “It's easy to hide assets if you don't want to disclose them,” says Taylor, whose firm scours numerous databases to root out liars.

That is, the fraud and games are still going on.

The problem arises when the FBI ignores "fraud for housing", as it has been said to do for years. This, of course, allows people to lie with impunity, provided they intend to live in or otherwise occupy (or rent) the home in question, smug in the knowledge that while this is a felony it will not be prosecuted.

Think about how many banks would be robbed if it became known that the FBI would not investigate or prosecute anyone who openly brought a gun into a bank - so long as they didn't rob it.

Of course once the gun is inside the bank...

Yeah.

The problem with "Fraud for Housing" is that it is still fraud, and it still generates losses. The argument that "this wasn't done for money" is not material; a loss is a loss is a loss, and the reason the person who committed the fraud did so - whether they did it to live in the place or to flip it and pocket $50,000 - doesn't matter to the lender or person to whom the loan was sold when it goes bad. The loss is the same to the lending side of the transaction and thus the damage done to the financial system and broader economy is identical.

Until we see an announced and executed intent to prosecute everyone who commits fraud anywhere and everywhere in the lending chain, from borrowers to mortgage companies to banks that package up securities without doing any sort of real diligence on the loans to ratings agencies who "simply assume" values in their models that are not provided the fraud will continue.

Trust in our financial system must be restored for our economy to heal.

Trust cannot be restored so long as fraud is allowed to continue unpunished.

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Where's My Pitchfork?

President Obama was said to have recently had a meeting in which he said:

But President Barack Obama wasn’t in a mood to hear them out. He stopped the conversation, and offered a blunt reminder of the public’s reaction to such explanations. “Be careful how you make those statements, gentlemen. The public isn’t buying that.”

“My administration,” the president added, “is the only thing between you and the pitchforks.”

Yes, Mr. President, you are. But let's be blunt - should your administration be exempt from the pitchforks?

Let's set the wayback machine to December 29th, 2007. On that date I wrote:

If the CDS writer has charged you an amount of money necessary to actually cover the risk of a default, plus their profit, the total amount of money available off that 200 basis points decreases. That is, the total profit available in the deal must decrease for each component that is added to the complexity of the transaction and for each person who has some “finger in the pie.”
The common law of business balance prohibits it from being otherwise in fact, no matter what you are told.
....
Because the person who writes that swap at a lower-than-actual-risk premium has effectively "created" money. They have made a promise to pay they cannot keep at the actual price of risk; in effect, they have "grown" the monetary base via cheating!

Go back and read that entire article again. It has now "aged" by more than a year.

Then read the Ticker from yesterday again:

The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams - with no correlation between “fees” paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world.

President Obama, it is one thing to be "surprised" that someone ran some sort of game in the markets and conned people, such as Bernie Madoff. One can excuse the fact that until the checks stop coming, it's somewhat difficult to "see inside" these deals and know what's going on, although in this case the government ignored multiple people blowing whistles on the fraud for - quite literally - years.

It is another thing entirely to have a regulated industry - the banking and mortgage industry - operate for more than a decade with the very people in your administration (e.g. Tim Geithner) staring in the face the clear violation of the common law of business balance that one cannot get something for nothing, and yet do nothing to those people who illicitly profited from such a scam at the expense of, quite literally, the entire American Population even after the collapse that such misbehavior causes occurs and damages the public.

It is even more outrageous for you and your administration to claim to present the government as a "shield" from the "pitchforks" of rightfully-pissed-off Americans who have discovered the scam, are being decimated by it, and are demanding justice.

Simply put Mr. President there is absolutely no defense of any sort for the "CDS" and "securitization" marketplace as it developed.

Let's go back and do the basic math again.

Let us presume the "risk free" (Treasury) rate for money at 30 years is 6%. That is, you can loan your money to the US Treasury by buying a 30 year bond, and that bond has a 6% coupon.

It should be clear that nobody in their right mind will loan money to anyone for less than 6% for 30 years in this environment, because they can get a risk-free return of that amount over that duration.

Now I have two batches of mortgages. One is a bunch of very high income, very low debt people. They buy homes, put down 20% of the purchase price, have a history of income going back a decade, take a 30 year fixed mortgage and that mortgage is only 20% of their pretax monthly income.

These mortgages are extremely safe.

The price to the home buyer is 7% - about 100 basis points over Treasuries of comparable duration. Why? Because the loan is nearly as safe as a Treasury - it is very unlikely that the lender will lose anything, even if the borrower loses his or her income. The 20% down payment is a fairly good cushion against that, even in a situation where home prices are declining or flat.

Now let's take a second set of assumptions - a group of mortgages made to people with no verification of income or assets and no down payment requirement.

These mortgages are fairly risky. The rate to the borrower might be 9%, or 300 basis points over Treasuries, because if there is a loss of income or the borrower simply lied, there will probably be a considerable loss that accrues to the lender. There's no cushion against a flat or declining market and worse, we have no evidence of capacity to pay.

We will further "norm" this to the 30 year Treasury rate by eliminating the ability to prepay (in the real world there is prepayment risk in mortgages as people move or refinance, but that complicates the analysis, so we'll keep it simple for the purpose of illustrating the point.)

So we go make a bunch of both of these loans and have two pools of mortgages, one of each group, with 1,000 loans in each. We roll them up and create two bond issues, taking 50 basis points for our trouble as the "securitizer", and peddle them to buyers such as pension funds, sovereign wealth funds and individual investors.

We now have two bonds, one that pays a 6.5% coupon, and one that pays an 8.5% coupon.

This is as it should be - the securitizer must be paid, remember, and the risk of default is higher in the second group, therefore, it should carry a higher coupon.

Now let's assume I want to "reach for yield" and thus I want to buy the second bond issue, yielding 8.5%, but I'm unhappy with the possible risk of not being getting paid.

Is it possible for me to hedge that risk and still wind up better than if I had bought the less-risky bond, without someone, somewhere either (1) being criminally stupid or (2) committing fraud?

NO.

Here's why.

The actual risk spread between these two issues is 200 basis points.

If you come to me as an insurer and ask me to write you a CDS against that more risky bond defaulting, I must charge you more than 200 basis points because I have to make a profit and pay my staff!

But if you buy a CDS that costs 250 basis points, that is, the risk of default plus the CDS writer's operating expense and a profit you would be a total idiot to buy the second mortgage pool in the first place, because you could buy the first one at a higher total return - by 50 basis points! Therefore you have no reason whatsoever to buy a CDS against such an instrument because you would be better off buying the lower-yielding but safer bond instead if you are uncomfortable with the default risk.

This is the basics of the math behind this entire mess and why those who claim that this is all some sort of "accident" are LYING!

I have been screaming about this for nearly two years, since I first discovered what was going on. It is simply impossible for these "default policies" to be written at the actual risk of default and yet for the underlying security + the CDS to yield more than the risk-free return rate; ergo, either (1) someone isn't going to be able to pay because they are/were stupid or (2) someone isn't going to be able to pay because they never intended to pay in the first place.

In either event the outcome is the same for the buyer of this so-called "protection": they're hosed, unless someone (the government) makes an uneconomic (and possibly criminal!) bet "good".

Stupidity must not be rewarded, and criminality must be severely punished; a cop who instead of prosecuting lawbreaking enables it is a criminal, not a cop, and a government comprised of criminals with badges is not a government, it is a fascist dictatorship.

If someone can show me how the math can possibly work otherwise - that is, how you can create a financial perpetual motion machine - I'm all ears.

All the fancy math in the world cannot make 2 + 2 = 5.

Absent demonstrating the impossible my original position from nearly two years ago on this issue stands - this entire mess is nothing more or less than a scheme born out of either stupidity or criminal malice, and either way, the taxpayer cannot and must not bail it out.

Further, government must, if we are to restore confidence in the markets, discern between stupidity (and expose it) and criminal malice (and prosecute it), no matter where in the financial system it may be.

Again I repeat - if the people come to the conclusion that the government is the felon instead of the cop, social and political order are at risk of being lost.

President Obama, you not only have no right to stand between the public with pitchforks and the bankers, you have a duty under The Constitution to wield one of the pitchforks.

I have only one question left: Are you (the government) a cop or a felon?

(Vote for "Felon Or Cop" at this link)