America's banks are shafting customers and investors again.

The foreclosure crisis is getting heavier. America's banks are foreclosing on homes they cannot prove they own, but they are filing so many foreclosures that the judges (if honest) don't have time to look at them. If they did, almost 97% of the foreclosures are based on fraudulent paperwork.

I had a few things to say about this over the last month or two, but I think people had a hard time believing that fraud and perjury on this scale was actually possible; that people were being thrown out onto the street on the basis of affidavits that were forgeries and perjury through and through. Forged, back-dated documents purporting to be contemporaneous records of the transfer of mortgage notes from one party to another. Complete circumvention of the existing legal system for recording real estate ownership - and its associated taxes and fees - and its illegal replacement with an unreliable, understaffed private system. The employees of the corporation running that system passing themselves off as vice-presidents of dozens of banks and servicers so they could foreclose on mortgages. Banks even claiming both that they were and were not the actual owner of the mortage in the very same filings. Failures to convey the actual mortgages to the real estate trusts that backed the securities that were sold to investors. Attempts to convey mortages to those trusts only at the moment of foreclosure. Servicers with a vested interest in the mortages they service going into foreclosure so they can collect fees, and associated failures to collect payments. People given mortgage modifications by the bank, then foreclosed on for failing to pay the original amounts. People without mortgages being foreclosed on. Multiple banks claiming to own the same mortgage foreclosing on the same property.

And at the sharp end of all this, an automated process of perjury and fraud. Notarized affidavits claiming that the signer has personal knowledge of the facts of the case described that were signed by someone else with no knowledge of the facts and not notarized at all. And a court system overloaded with foreclosures unable to and uninterested in examining the facts of the cases in front of it. Families thrown out on the street in the tens or hundreds of thousands on the basis of minute-long hearings in courts where judges refused to consider questions of fraud.

It's hard to comprehend just how pervasive and serious this problem is. Trillions of dollars have already been lost in the bursting of the real estate bubble, but trillions of dollars more of the remaining mortgage-backed securities may be entirely worthless. Not to mention the massive destruction of households and neighborhoods wrought by a mindless, mechanical legal process.

If you don't have time to read the whole thing at RS, I'm excerpting the key parts after the fold. But I recommend taking the time to read it.[ from Rolling Stone.]

There is a great deal more to read all worth it. But if you want to know why the mega banks are working so hard to commit this massive fraud on the courts and on the homeowners, look that this final statement from the Obsidian Wings article. I have bold-faced the key paragraphs below:

It's undeniable that many of the people facing foreclosure bear some responsibility for the crisis. Some borrowed beyond their means. Some even borrowed knowing they would never be able to pay off their debt, either hoping to flip their houses right away or taking on mortgages with low initial teaser rates without bothering to think of the future. The culture of take-for-yourself-now, let-someone-else-pay-later wasn't completely restricted to Wall Street. It penetrated all the way down to the individual consumer, who in some cases was a knowing accomplice in the bubble mess.

But many of these homeowners are just ordinary Joes who had no idea what they were getting into. Some were pushed into dangerous loans when they qualified for safe ones. Others were told not to worry about future jumps in interest rates because they could just refinance down the road, or discovered that the value of their homes had been overinflated by brokers looking to pad their commissions. And that's not even accounting for the fact that most of this credit wouldn't have been available in the first place without the Ponzi-like bubble scheme cooked up by Wall Street, about which the average home­owner knew nothing — hell, even the average U.S. senator didn't know about it.

At worst, these ordinary homeowners were stupid or uninformed — while the banks that lent them the money are guilty of committing a baldfaced crime on a grand scale. These banks robbed investors and conned homeowners, blew themselves up chasing the fraud, then begged the taxpayers to bail them out. And bail them out we did: We ponied up billions to help Wells Fargo buy Wachovia, paid Bank of America to buy Merrill Lynch, and watched as the Fed opened up special facilities to buy up the assets in defective mortgage trusts at inflated prices. And after all that effort by the state to buy back these phony assets so the thieves could all stay in business and keep their bonuses, what did the banks do? They put their foot on the foreclosure gas pedal and stepped up the effort to kick people out of their homes as fast as possible, before the world caught on to how these loans were made in the first place.

Why don't the banks want us to see the paperwork on all these mortgages? Because the documents represent a death sentence for them. According to the rules of the mortgage trusts, a lender like Bank of America, which controls all the Countrywide loans, is required by law to buy back from investors every faulty loan the crooks at Countrywide ever issued. Think about what that would do to Bank of America's bottom line the next time you wonder why they're trying so hard to rush these loans into someone else's hands.

---

Addendum 6:22 PM CST
Here is another recent article on the mortgage disaster. It lays out some of the problems and the likely fall out.

Employees or contractors of several major banks have testified in court cases that they signed, and in some cases backdated, thousands of certifying documents for home seizures. Financial firms that service a total $6.4 trillion in mortgages are involved, according to the new report. Big banks including Bank of America Corp., JPMorgan Chase & Co. and Ally Financial Inc.'s GMAC Mortgage have suspended foreclosures at some point because of flawed documents.

Federal and state regulators, including the Federal Reserve and attorneys general in all 50 states, are investigating whether mortgage companies cut corners on their own procedures when they moved to foreclose on people's homes.

"Clear and uncontested property rights are the foundation of the housing market," the report says. "If these rights fall into question, that foundation could collapse."

Here are some ramifications:

• Borrowers may not be able to ascertain if they're sending their mortgage payments to the right party.
• Judges may block all foreclosures.
• Prospective buyers and sellers could be in left in limbo.
• For major banks, if they discovered that they still owned millions of bad mortgage loans they assumed had been sold, the losses could reach billions.

It's that last one that really frightens the banks.

In theory the banks sold those mortgages on to investors who should take the losses. But if there is no proof that the mortgages were transferred to the investors, then those mortgages still belong to the banks when they go into default. The banks will have to make restitution to the investors because they investors have no court standing to foreclose from the (alleged) defaulters. Only the legal owner can do that.

If you notice in the earlier article (above) that may apply to as many as 97% of the mortgages that are (allegedly) in default. This is not a simple problem that the homeowners failed to pay and should be foreclosed on. This is major. It is a question of who takes the loss when the mortgage goes bad. If the investors legally own the homes, they are out the loss. But if the bank never transferred ownership then it is the banks who are on the hook for the massive and now inevitable losses in those homes.

If you think that the banks took a big hit to their reserves two years ago when the economy went bad, this would very probably dwarf those losses. Think the feds will step in and bail them out a second time in two years??

This is exactly the scenario that Alan Greenspan thought that the self-interest and professionalism of the banks would prevent when he allowed to housing bubble to grow uncontrolled. Greenspan was responsible for regulating the bank's behavior and he did not do so, depending on the invisible hand of the market.

Greenspan is a libertarian. He had been informed that everyone from the original mortgage brokers through the original lending banks to the firms that bundled the mortgages into mortgage-backed securities and sold them on to investors was cutting corners and holding down administrative costs by not doing the due diligence and the required legal document transfers. But the market factors were supposed to handle that. Guess what? The market failed - again!

I'd hate to own stock in a major bank right now.

Why are businesses allowed to retructure loans in bankruptcy and homeowners are not?

Any business going into Chapter 11 bankruptcy reorganization can restructure and reamortize loans whose conditions they find onerous or can no longer meet. But an individual homeowner going through Chapter 13 bankruptcy cannot restructure his mortgage loan. Why not?

As the bankruptcy Judge wrote in the Washington Post

Homeowners are the only ones who cannot modify the terms of their secured debts in bankruptcy. Corporate America flocks to bankruptcy courts to do precisely this -- to restructure and reamortize loans whose conditions they find onerous or can no longer meet. Airlines are still flying and auto parts makers still operating because they have used this powerful tool of the bankruptcy process. Lehman Brothers will surely invoke it. But when the bankruptcy code was adopted in 1979, the mortgage industry persuaded Congress that its market was so tightly regulated and conservatively run that it should be exempted from the general bankruptcy rules permitting modification. [Snip]

For more than a year, a number of legislators, academics and judges have advocated removing this ban on home mortgage modification to help stem the increasing number of foreclosures. I have twice participated in briefing sessions organized by the House Judiciary Committee, where I was lectured by lobbyists for the mortgage industry about the sanctity of contracts. I have listened to their high-priced lawyers make fallacious constitutional arguments based on discredited cases from the 1930s. (This is, incidentally, an industry that is not particularly concerned about its own contractual obligations as it tries, through various Treasury-aided programs, to stay afloat.)

The current prohibition on bankruptcy judges in Chapter 13 reorganization cases for individuals might make sense if the homes could be resold at market values that were as high as the mortgage values, or if the mortgage itself were not a subprime mortgage designed to automatically increase to levels the mortgage buyer was never going to be able to afford. But the current market in many parts of America has to drop 40% to 50% so that the average home can be afforded by the average homebuyer. And a great many home buyers and individuals who refinanced to pay for home repairs were shifted into adjustable Rate Mortgages (ARMs) they were never going to be able to afford, but which provide the mortgage seller a much larger commission.

Personal note: My next door neighbor was sold an ARM which reset a year and a half ago. Her mortgage payment jumped from $650 a month to over $1100 a month. The out-of-state mortgage owner refused to work with her on the payments. She lost the house to foreclosure. She had purchased it for $58,000 and it sold in foreclosure for $38,000. Who won? The mortgage broker who was long gone.

The average cost of foreclosure is 25% of the total value of the home. This goes to pay for the foreclosure process. The mortgage holder loses this just as the homeowner does. Foreclosure is a very expensive process.

The mortgage-holder has a mortgage on their books at a price that is much higher than the home can be sold for. But if it goes through foreclosure, an additional 25% of the current value is taken away from the mortgage holder. A bankruptcy judge could save this cost by restructuring the mortgage. The homeowner would get a mortgage at a price that reflects realistic current market values and the mortgage holder would avoid the additional 25% cost imposed by the foreclosure process.

Unfortunately, the mortgage broker still gets off scot free with his ill-gotten commissions.

It simply is not reasonable any more to think that mortgage industry's market is so tightly regulated and conservatively run that it should be exempted from the general bankruptcy rules permitting modification. Too many homeowners - AND their mortgage holders are being forced into foreclosure and bankruptcy in the current economy to continue this stupid provision of the bankruptcy code. "Tightly regulated and conservatively run?" That's a fiction left over from the days before financial deregulation with its subprime and ARM mortgages along with liar loans are bundled into massive Mortgage-backed Securities in which the investor does not have the time or money to deal with reconstructing an individual mortgage contract.

The banks are fighting against the change in the bankruptcy law because it will force them to write down mortgages that are part of their assets. This is especially threatening to them because the large banks are already having to write down so may losses from their assets. But when those mortgage assets go through foreclosure, the same write-down will be required - except that the foreclosure process will cost an additional 25% of the value of the home.

The only reasonable and cost-efficient solution is to give bankruptcy judges the power to restructure mortgages. Judge Leonard is correct. The proposed change in the bankruptcy law is a win-win solution to a problem that should not be allowed to continue.

Wall Street's failure and Credit Default Swaps explained - and the future guessed at

Calculated Risk offers a video from "60 Minutes" in which Steve Kroft explains the mortgage crisis, credit crisis, and now the financial melt down on Wall Street and overseas. The key to it is Credit Default Swaps.

There is a short advertisement before the video starts. The video is worth sitting through the advertisement.


Watch CBS Videos Online

This is background information. It does not explain what the bail out legislation is supposed to do to solve the problem. Nor does it explain what the problem is with banks now refusing to lend money to borrowers and especially to other banks. For an explanation of the current problem in which banks are now refusing to lend to anyone, Robert Reich offers as good an explanation as I have seen recently in his recent blog entitled "The Meltdown (Part I)".

Global capital markets have seized up. Confidence is evaporating. Put simply, no lender trusts any borrower to repay, fearing that that borrower won't be able to rely on anyone else to honor obligations. Even banks are hoarding cash, unwilling to lend to other banks. Everyone with any savings is heading for the hills -- for gold, for under the mattress, for wherever savings can be watched. We're witnessing a huge international bank run. We have not seen a global financial crisis on this scale since the 1930s.

What's happened? Put simply, the Bailout of All Bailouts has been a dud, at least so far. Most obviously, it hasn't done what it was intended to do -- reassure financial markets that the Treasury and the Fed would have enough money to handle any financial crisis.

So it's everyone and every institution -- and every country -- for itself. Several nations (Ireland, Greece, Germany) have basically guaranteed all deposits. As a result, global capital is moving their way. They're also thereby creating a new form of socialized capitalism. At the rate they're going, these nations will soon own and run their financial markets, and maybe a big chunk of the world's.

I fault Hank Paulson, first and foremost. He never succeeded in explaining to anyone what exactly he'll do with the bailout money -- how, for example, an auction to acquire mortgage-backed bad debt would work, and whether and to what extent he's planning to recapitalize the banking system. Even now, the American public has no idea what he's up to. Nor, for that matter, do many insiders.

Leadership isn't just about passing a big piece of legislation. It's about explaining and thereby gaining trust and confidence from a public -- including a global public -- that's otherwise afraid and confused. A credible and powerful explanation is necessary right now -- about where we've been, how we got into this mess, and how a particular plan (in this case, the bailout), will get us out of it. Yet Paulson has proven himself uniquely unable to explain anything to anyone. George W. Bush, for his part, is hopeless and hapless. Worse than a lame duck, he's a seriously disabled parakeet, with no remaining store of public trust. Ben Bernanke seems like an able fellow but his capacity to communicate is almost as bad as his predecessor's. Congressional leaders are too busy pointing fingers of blame to be capable of explaining much of anything and summoning confidence. And fewer than three weeks before a national election, both candidates are inevitably caught up in partisan wrangling. Obama does understand what's happening, and could calm global capital markets if he were already president. But he is not president as yet, nor even president-elect.

The leadership vacuum could not happen at a worse time. If credit markets remain frozen, we'll soon witness a huge round of business bankruptcies. We're in completely uncharted terrain.

So what happens next?

That's what "completely uncharted terrain" means. No one knows. But a good guess would start with assuming that economic conditions are going to rapidly get worse between now and the Presidential election on November 4th.

After that?

The problem right now is that no one knows what will happen next, and the current political and financial leadership are all fighting each other for individual advantage. There is no established leader who anyone trusts. Bush, for example, refused to even recognize the housing bubble until recently and when the Paulson Proposal was developed overnight and handed to Congress like the hot potato it was, Bush's name couldn't even be placed on it. The generally unknown Paulson was a much better name to apply to the sales job. And Paulson has also demonstrated no political leadership.

Without leadership, the trust the bankers need to start lending again will not be recreated. The House conservative Republicans who killed the first effort to pass the Paulson Proposal (as directed by Newt Gingrich, in the name of saving the "Free Market" on Wall Street) similarly have no clue. They are fighting to retain the power they have had since Gingrich led the conservative Republican takeover of the House in 1994.

But they are fighting to retain their power and the ability to enforce their ideology, with no regard to what happens to America. That's what happens when a corrupt leadership faces a new threat to the nation. The scrap over power instead of working to solve the problems.

Brad DeLong said last week or so that the problems America face will not be solved until the Republican party is gone. The conservative Republican party needs to be buried, the ground they are buried in needs to be plowed under, and the ground needs to be salted so that they cannot grow back.

I agree with him. The conservative ideology is totally incapable of dealing with the current economic crisis, and the conservatives will continue to obstruct effective actions as long as they are allowed to remain in the government.

After that? Let's hope that the new President can provide some effective leadership quickly - and McCain does not have that capability as the current disastrous condition of his Presidential campaign clearly shows.

We'll have a decent idea what's going to happen by New Year's, I think. But the Recession will last at least the next two years. Beyond that? No telling.

Government siezes WaMu; Sells assets to JP Morgan Chase

The long expected takeover of Washington Mutual Bank occurred today. This is the largest bank failure ever in the U.S. JP Morgan Chase will take over the assets of WaMu. WaMus branches will reopen Friday as branches of JP Morgan Chase bank.

The deal will cost JPMorgan Chase $1.9 billion, and the bank said in a statement it planned to write down WaMu's loan portfolio by approximately $31 billion. JPMorgan Chase, which acquired Bear Stearns Cos. last March, also said it would sell $8 billion in common stock to raise its capital position. [Snip]

The government measures bank failures by an institutions's assets; Seattle-based WaMu has roughly $310 billion in assets. The previous record was the failure of Continental Illinois National Bank in 1984, with $40 billion in assets when it closed. IndyMac, seized in July, had $32 billion.

WaMu was searching for a lifeline after piling up billions of dollars in losses due to failed mortgages; it has seen its stock price plummet 95 percent from a 52-week high of $36.47 to its close of $1.69 Thursday. On Wednesday, it suffered a ratings downgrade by Standard & Poor's that put it in danger of collapse. [Snip]

In a statement, JPMorgan Chase said it was not acquiring any senior unsecured debt, subordinated debt, and preferred stock of Washington Mutual's banks, or any assets or liabilities of the holding company, Washington Mutual Inc.

JPMorgan Chase said the acquisition will give it 5,400 branches in 23 states. JPMorgan Chase said it plans to close less than 10 percent of the two companies' branches; the bank has not yet decided which to close.

In March, the bank acquired the failing Bear Stearns in a deal brokered by the government. It paid $2.3 billion for the company and its stock, bringing its expenditure on both Bear Stearns and WaMu to a total of $4.2 billion.

According to the FDIC list of failed banks, this is the 20th bank to fail in 2008.

Feds to put $85 billion into a bridge loan for AIG

From the Wall Street Journal"

The U.S. government was moving toward an emergency rescue of American International Group Inc. -- one of the world's biggest insurers -- signaling the intensity of its concerns about the danger a collapse could pose to the financial system.

It's a dramatic turnabout for the federal government, which has strongly resisted overtures from AIG for an emergency loan or some intervention that would prevent the insurer from falling into bankruptcy. Just last weekend, the government effectively pulled the plug on Lehman Brothers Holdings Inc., allowing the big investment bank to fail instead of giving it financial support.

The precise details of the government's plans were still being formulated late Tuesday. The primary option being hammered out involved the Fed providing AIG with a short-term "bridge" loan of $85 billion, according to people familiar with the situation. In exchange, the government would receive warrants in AIG representing the right to buy its stock, under certain conditions. That could put the government in a position to potentially control a private insurer, a historic move, particularly considering that AIG isn't directly regulated by the federal government.

The moves capped a day of high drama in Washington. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke convened in the early evening an unexpected meeting of top congressional leaders, including Sen. Harry Reid of Nevada, the majority leader, top members of the Senate Banking Committee and leaders, too, from the House.

Sen. Richard Shelby of Alabama said he didn't receive a "satisfactory" answer from Mr. Paulson in an early conversation about the ultimate scope of government intervention. "I laid out -- where do you stop? Where do you draw the line?"

Well, it is in process. AIG was the most likely next domino to fall. It is the largest insurance company in the world after all, and it has a lot of non insurance financial business that connects into the shadow banking system.

Now, how about Washington Mutual (WaMu)? FDIC normally closes banks down on Friday.

Are Goldman Sachs and Morgan Stanley going to be able to survive at independent organizations without being taken over or bought out?

Two extremely shaky banks WAMU and Lehman Bros.

Reuters reports that Lehman Brothers is looking to be purchased, with Bank of America a possible buyer.

investors remained gloomy as the steady stream of grim tidings and the dearth of information from the company stoked fears that some of Lehman's clients and trading partners might take their business to more stable firms.

"Although many investors thought it would be avoided, customers of Lehman Brothers are becoming more and more skittish in their dealings with them," said William Lefkowitz, options strategist at vFinance Investments, a brokerage firm in New York. "If this fear continues to grow, that could lead to the demise of Lehman Brothers,"

Six months since the collapse and eventual fire-sale purchase of investment bank Bear Stearns, confidence in the Wall Street business model has faded.

The stock closed down $3.03 to $4.22 Thursday after falling as low as $3.80 earlier in the day. They have lost more than three-quarters of their value since Monday and more than 90 percent from their 52-week high of $67.73 last November. [Snip]

With Thursday's stock fall, its market capitalization fell to $2.93 billion, behind once much-smaller companies like Huntington Bancshares Inc at $3.04 billion and Raymond James Financial Inc at $3.8 billion. Goldman Sachs Group Inc has a market cap of $61.8 billion.

"As much as they try to ... calm investors down, investors don't have yet the answers they need," said Rose Grant, managing director of Eastern Investment Advisors. "There's a complete lack of faith, lack of confidence and lack of trust."

The company reported a record quarterly loss of $3.9 billion on Wednesday, and said it would spin off distressed assets and sell a stake in its asset management business. But details about the size, scope and timing of the potential sales were few -- leading to fresh fears about its plans. [Snip]

The company has written down billions of dollars in assets in the last year -- largely holdings of complex mortgage-backed securities. And over the last several months, the bank has been battling rumors of defecting clients and talk of a takeover at a low price.

Atrios points to a funny piece of Schadenfreude from this. The original report is from Bloomberg:

Sept. 11 (Bloomberg) -- Argentine President Cristina Fernandez de Kirchner told Lehman Brothers Holdings Inc. to worry about its own finances, three weeks after the firm said the South American country could default within two years.

``Today the news in the papers, in all the papers, is the collapse of another bank far away in the United States -- that bank that predicted the collapse of Argentina,'' Fernandez, 55, said during a speech last night. ``They should spend more time looking at their own accounts rather than looking at other countries.''

Oh, and the other bank to watch tomorrow? Washington Mutual (WaMu).

NEW YORK, Sept 11 (Reuters) - Washington Mutual Inc (WM.N: Quote, Profile, Research, Stock Buzz) shares sank below $2 for the first time since 1990 as anxiety grew about its capital needs and survival prospects, before staging a powerful late rally.

The thrift's shares closed up 51 cents, or 22 percent, at $2.83 on the New York Stock Exchange, after earlier trading as low as $1.75. Despite the late jump, they were down 34 percent since Monday, when Washington Mutual named Alan Fishman its new chief executive. [Snip]

Washington Mutual shares are down 92 percent in the last year. Its "distressed" 5.25 percent notes maturing in 2017 fell 2 cents on the dollar to 44 cents, pushing its yield up to 18.08 percent from 15.87 percent, according to MarketAxess.

REGULATOR MONITORING SITUATION

Earlier this week, Washington Mutual said its main regulator, the Office of Thrift Supervision, has stepped up its oversight into how the thrift manages risk.

"We're fully aware of the situation, and we're monitoring it," said William Ruberry, an OTS spokesman.

Fishman is a former chief executive of Brooklyn, New York's Independence Community Bank Corp, which was bought by Sovereign Bancorp Inc (SOV.N: Quote, Profile, Research, Stock Buzz) in 2006.

He became Washington Mutual's chief executive Monday, replacing Kerry Killinger, who was ousted by the board after 18 years at the helm.

Richard Bove, a Ladenburg Thalmann & Co analyst, suspended his "neutral" rating on Washington Mutual Thursday, citing uncertainty about what the OTS ordered the thrift to do.

DEPOSITS

Analysts have said the thrift may be starved for buyers because of an accounting rule that takes effect in December. The rule will force buyers to write down assets of targets to market prices, perhaps requiring them to raise costly capital.

JPMorgan Chase & Co (JPM.N: Quote, Profile, Research, Stock Buzz) is said to have approached Washington Mutual early this year about a merger, but Killinger rejected the overture, according to published reports. Washington Mutual ended June with $309.7 billion in assets, while JPMorgan had $1.78 trillion.

Moreover, a clause in the TPG investment agreement complicates any capital raising. Washington Mutual must cover any dilution in TPG's investment if the thrift is sold, or if it raises more than $500 million of equity, for less than $8.75 per share -- within 18 months of the infusion.

So WaMu, who just replaced their long-term CEO, is looking for a buyer but has skeletons hiding in their financial reports. The stock market does not rate their chances of success highly as they just hit their 52-week low of $1.75 per share today before bouncing up a bit.

America's financial problems are not getting better. If anything, they are getting worse, but because much of the credit crisis is at its base real estate and mortgage problems, the problems do not effect the market instantly as is the case when the problems are in stocks and bonds. That's because mortgage default and foreclosure is such a long drawn out process that it can take up to a year or so from the time the owner gets into financial problems to the time of final default and foreclosure.

"Debt Deflation?" Krugman points to a problem of the overall economy

The government has nationalized Fannie Mae and Freddie Mac! The economy is Saved!!

The first statement is true. The second? We wish. Krugman applauds the government takeover of the two mortgage institutions that currently handle about 70% of all American mortgage loans. It had to be done, and Bernanke and Paulson did it rather well.

Why did it have to be done? Krugman explains "Debt Deflation."

...when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money. As Paul McCulley of Pimco, the bond investor, put it in a recent essay titled “The Paradox of Deleveraging,” lately just about every financial institution has been trying to reduce its leverage — but the plunge in asset values has nonetheless left these institutions with more debt relative to their assets than before.

What's happening now is that highly leveraged financial players are trying to eliminate debt by selling assets to pay it off. But the collapse in asset values is forcing them to sell at lower prices.

Leverage is the amount of debt held compared to the value of assets held. If a financial player owned assets worth one million dollars, they might borrow another million and get the profit from controlling two million dollars, paying in exchange the interest on the borrowed one million dollars. That is, they would have two million dollars in assets working for them and owe one million dollars. That's 50% debt.

Keep in mind that Bear Stearns had a debt ration of 33:1. For every dollar of their own, they had borrowed $33 more and had $34 in assets. Those assets were in - among other things - high-paying sub-prime real estate mortgages. When enough real estate mortgages went bad so that the lost, say $2 of that $34, they had only $32 for every $33 they owed lenders. No lender was going to lend them more money for fear of not getting it back.

So the highly leveraged financial players couldn't sell assets fast enough to pay off debt to bring their leverage down. In fact, their efforts to sell assets all at the same time caused the value of all of their assets to drop.

Banks and financial institutions which do not have any capital cannot loan money to others. When Bear Stearns had lost all of their own money and were losing borrowed money, they could no longer buy mortgages. Plus, no lender was going to lend them more money to buy mortgages. They were literally losing money on every transaction they made. So they went out of business - to be bought by J.P. Morgan. The U.S. treasury sold Bear Stearn's good loans (assets) to J. P. Morgan and kept the bad ones essentially for the taxpayers to pay for.

Unfortunately, the entire banking industry is highly leveraged. They thought they could get away with it because everyone knew that mortgages were the safest kind of loans. Now they know better and they are all scrambling to sell off loans and get to a more sustainable level of leverage . As they try to sell off assets (loans) to lower their leverage, the value of all such assets is dropping rapidly. Since they are trying to sell loans, they can't make new ones, which is why the credit crunch that has been happening this year has happened.

The absence of credit is causing business of all kinds to contract, including credit cards, leading the the layoffs and lack of hiring that has been happening all year. The layoffs and the shortage of consumer credit are hitting retailers. Steak and Ale and Bennigan's are gone now.

Silver State Bank reportedly failed because of bad construction and real estate loans. I don't know for sure, but Nevada has been one of the areas, like California and Florida, where real estate values were highest. The builders were building to take advantage of those high prices, but since the mortgage lenders have largely shut off mortgage lending this years, they haven't been able to sell what they have already built. Back in Texas in the early 80's (the Reagan Era) a similar thing happen because of the S&L crisis.

Builders couldn't sell what they had built, so Banks loaned them more money to keep them building and stay in business until the economy turned around - only it took to long for the economy to turn around. Then the builders did finally go bankrupt and took the banks with them. Every town in Texas had new retail stores sitting empty for several years because there were no businesses that could make enough money to fill them.

So we come to Krugman's conclusion:

...the effort to contain the financial crisis seems to be failing. Asset prices are still falling, losses are still mounting, and the unemployment rate has just hit a five-year high. With each passing month, America is looking more and more Japanese.

So yes, the Fannie-Freddie rescue was a good thing. But it takes place in the context of a broader economic struggle — a struggle we seem to be losing.

So how long will it be until the economy turns around again? That depends on how long the current debt deflation continues, and THAT depends largely on how soon and how effective action it taken by the U.S. Congress to stimulate the economy. Tax cuts to the wealthy are useless since this is a recession caused by inadequate consumption. Effective action has to get more money to the consumer to spend, and that will mean more and better paying jobs for the consumer. Tax cuts will not restart the economy. Tax cuts, even for consumers, will be like a gas-powered mower that gets just enough gas to pop once or twice, but won't start running. This economy isn't going to be restarted by handing out checks. It has to have jobs, which will mean government and government-created jobs.

Only after consumers can start increasing purchases will the private market be able to start a comeback. And that will be ... who knows? It's against conservative ideology.

Government to take over Fannie Mae and Freddy Mac; Credit crisis continues

Friday the officials from the Bush Treasury and the Federal Reserve informed the top executives of Fannie Mae and Freddie Mac that the government was taking them over. It a move that will wipe out the shareholders and replace the top executives and Boards of Directors of the two struggling institutions, the Federal government will place both into conservatorship. Both companies will continue to function, with the government guaranteeing their debt.

The declining housing and real estate markets have continued to erode the balance sheets of Fannie Mae and Freddie Mac with the loan losses no longer limited to subprime mortgages. This action by the government is required because the losses suffered in the Mortgage market continue and the Fannie Maw and Freddie Mac are no longer able to deal with those losses without government guarantees. More loan losses are expected in the future so that the weakened balance sheets threaten the continued existence of the two firms. The erosion of the balance sheets have so weakened the firms that foreign governments have become extremely antsy about holding debt issued by the two institutions.

Since together Fannie Mae and Freddie Mac guarantee 70% of American mortgages, the two institutions must continue to function or the American housing market will cease to function. Since the two firms are finding that they can no longer raise the capital needed to continue to operate, the only solution is for the government to take them over and guarantee their loans. This action will permit the mortgage markets in the US to continue functioning, at the cost of making formal previously stated guarantees by government officials that the taxpayers will guarantee the securities issued to the two firms. This makes official the implied exposure of taxpayers to the large potential future losses.

The two companies will continue to operate as they have previously, buying up mortgages, packaging them into securities and selling the securities to obtain new funds to allow the purchase of more mortgages. Since the government has been telling foreign governments that the US government already stands behind the securities sold by Fannie Mae and Freddie Mac, this move essentially makes the guarantees made by the US government official.

It is expected that ultimately the two companies will be broken up into smaller institutions which are not “too large to fail” and sold off to private investors.

From the New York Times.

Protect the rich and make them richer; Repub solution to the credit crisis and economic problems

Now that we know that the Bush administration is going to bail out Fanny Mae and Freddy Mac, something that as late as last Friday they were saying they would not do, let's look at how they are going about it. Dean Baker has a lot to say:

Bush and Congress Want to Raise Your Taxes to Help out Fannie and Freddie's Management and Shareholders
By Dean Baker - July 13, 2008, 11:27PM

That's the word from the press reports. Apparently the government is going to hand Fannie and Freddie bucket loads of taxpayer dollars, no questions asked. The NYT reports that they will be given access to $300 billion of government loans at below market interest. [Snip]

Some people say that we had to hand tens of billions of dollars to the country's richest people to prevent a financial collapse. This is simply not true.

We had to keep Fannie and Freddie in business, but we could have done this by putting conditions on the bailout. The government uses conditions all the time when it offers help to low and moderate income people. Unemployment insurance, TANF, food stamps, and even student loans come with all sorts of conditions.

It is only when it comes to giving money to extremely rich people that we find it impossible to impose conditions. Again, we could have told Fannie and Freddie that no executives will get more than $2 million a year in total compensation. We could have told their shareholders that they are out of luck, because that is what is supposed to happen when you invest in a bankrupt company.

Instead, we told the people who work as truck drivers, school teachers, and fire fighters that they will have to pay more in taxes to help some of the richest people in the country escape the consequences of their own stupidity. While kicking the poor is always fun for politicians, neither the Bush administration nor Congress are prepared to tell the very rich that they are on their own.

Congress and the administration have no interest in protecting the people who are losing their homes to foreclosure, often because they were put into mortgages they could not pay. This had the effect of forcing real estate prices up while allowing mortgage brokers and lenders to reap huge commissions before the mortgages were sold to investors as parts of collateralized debt obligations or similar arcane and not understood financial instruments.

The result was Alan Greenspan's housing bubble and a lot of very wealthy mortgage brokers knocking down commissions of as much as a million dollars a year, all at the cost of a lot of people spending a lot of money on homes that would inevitably be in foreclosure as soon as the bubble broke and investors who found that the "secure" investments they were sold a AAA instruments suddenly were worth much less than they paid for them.

IndyMac Bancorp, which failed and was taken over by the federal government last Friday existed to accept deposits from people who wanted to save their money and to make loans to people who wanted to buy homes. According to Mish's Global Economic Trend Analysis:

The Pasadena, California-based bank specialized in so-called Alt-A mortgages, which didn't require borrowers to provide documentation on their incomes. Its home state has been among the hardest hit by foreclosures.

"Given their focus on Alt-A and a heavy concentration in California, they would have suffered meaningful losses in almost any scenario...

Alt-A loans are often called "Liar Loans.")

IndyMac's big profits came from making more loans, so they did the logical thing - they stopped verifying income. Whatever the customer said his income was they accepted without question.

Of course, the mortgage broker trying to get the loan accepted by IndyMac Bankcorp would not get a commission unless the loan was accepted, and they got a bigger commission if the loan was bigger, so the mortgage brokers encouraged the home buyers to inflate their income. This was almost required in area where home prices were highly inflated, but when the loan was accepted, it added to the inflation of home prices. That was a major contributor to the housing bubble.

IndyMac is often described as a bank closely associated with CountryWide Mortgage Company, previously the nation's largest mortgage broker. So CountryWide was making the mortgage loans and making its money from the commissions, while IndyMac was lending the money that was used to buy the homes, and taking its commissions. IndyMac was then bundling the mortgages into CDO's and selling them to investors.

The investors, like Freddy Mac and Fannie Mae, would buy the CDO's, which would give IndyMac more money to loan. The investors would look at the CDO's and see investments that were backed by mortgages. Homeowners generally pay their mortgage first before they pay other bills, and if they stop paying, the home can be sold in foreclosure to recover the investment.

As long as home prices were rising, this seemed like a safe investment, so the bond rating agencies would quickly stamp them AAA quality, which meant that more investors could bid to buy them. (Many large investors are limited to buying only certified very safe investments by the people who give them money to invest.) We now know that the bond rating agencies were competing with each other by promising security sellers (like IndyMac) higher ratings as long as they got the job of issuing the rating. Since the bond rating agencies did not get paid unless they got the rating job, they were bidding the ratings up higher.

All of this was exaggerated by the Ayn Rand acolyte and Libertarian Alan Greemspan's Federal Reserve. He lowered interest rates to pump more money into the economy and avoid Recession prior to Bush's reelection in 2004, and then encouraged the use of exotic mortgages like Adjustable Rate Mortgages (ARM) so that more people could qualify for home mortgages. In addition, he refused to use the power the Federal Reserve has to set lending standards for lenders or to require mortgage brokers to provide comprehensible information to the borrowers on the risks to the loans they were issuing.

Finally, there was no regulator that any of the participants had to provide honest information about their loans or their own financial stability to. Investment banks (like Bear Stearns) have never been regulated and Congress, led by the Austro-Libertarian Senator Phil Gramm, repealed the Glass Steagall Act, removing most regulation from banks like IndyMac.

It is now clear in hindsight that this (lack of) system could not survive long. The question was not if it would collapse, but when.

So why did the credit crisis occur when it did? The answer is "Alan Greenspan." As noted in my previous post Politics of the federal Fund Rate, Greenspan lowered the interest rate to keep the economy out of recession prior to the 2004 Presidential election. The rate reached 1.75$, a rate so low that there was literally no incentive to save or invest in fixed rate securities. A major reason why large investors were investing in Collateralized Debt Obligations was that bank savings rates and federal bonds were so low that after inflation there was no effective return, and the rating agencies were saying that the higher paying CDO's were safe (see the rating agency discussion above.)

Even Alan Greenspan knew that the interest rate he had established was too low, so starting in November 2004 (immediately after it would effect the Presidential election) he started raising the interest rate 1/4% per month. This went on until the Summer of 2006. The first publicly announced warning of the impending mortgage market collapse was when CountryWide Mortgage Company warned in early 2007 that foreclosures were sharply increased. The rest has been a long, slow collapse of the credit markets, now to be followed by the collapse of more banks. Here's Jim Cramer:

We all know that Citigroup (NYSE: C) (Cramer's Take), Wachovia (NYSE: WB) (Cramer's Take), Washington Mutual (NYSE: WM) (Cramer's Take) and National City (NYSE: NCC) (Cramer's Take) are in trouble. Bank of America (NYSE: BAC) (Cramer's Take) says it isn't in trouble, but obviously the market doesn't believe management because the stock failed to rally when it said its dividend was safe.

The current economic problems are going to continue until the inflated prices of homes bought during the housing bubble are cleaned out of the system, and as they do get cleaned out, the banks that have those old over-priced mortgages on their books as assets are going to be losing money. That's what just killed IndyMac, and It's what the Federal Reserve is trying to head off by lending money to Freddy Mac and Fanny Mae. The fear is that as the losses mount, the investors/lenders/Depositors may decided that they have to remove their money first, because those who wait will find no money there to pay them. The race to be first to try to get your money back is called a run on the bank. The fed is promising that they will pump in taxpayer money to Freddy and Fannie to prevent that.

The financial managers who have been running this mess have the knowledge to recognize the ponzi scheme that our American investment and commercial banks had become, but they were staying in long enough to get their millions and move them to safer investments. They've lobbied Congress and the administration to head off the regulation that would have stopped their personal wealth-generating activities before they got out. Now the fed is bailing them out using taxpayer money, while letting the individuals who bought homes take the hit.

Note also that nothing in the bail-out adds any regulation to the system, so that the same thing is going to happen again as soon as this economic collapse finishes. And they guys who caused it have their wealth in safe places so that they can wait out the economic time of troubles and start a new boom as soon as it's over.

This is the logical working out of the Reagan Revolution and the conservative movement with its free market banking policies. It will always work this way, every time you allow bankers to operate without regulation and close, effective oversight.