Home and Away

Consider a country in another time and space. It is big and sprawling. It is too big and and too sprawling to be governed by a cadre, ruling class or oligarchy. It is a veritable nation-state of quasi-continental dimensions. In form it is a representative government, somewhere between a people's republic and a constitutional monarchy. But its political processes are as captured and as ossified as one might expect of an ancient, honored and imperial republic. Not a single party state by any means, but two parties jointly rule in a comfortable though occasionally unruly duopoly. This country still imagines itself as a Beacon on a Hill.

As might be expected, it has a political class and a financial elite. They are not exactly open, and not exactly closed. Porous is perhaps the best way to think of them. And much of the rest of the place is not particularly interested in joining either. There is also a cultural elite (several, in fact), various underclasses of varying hue and diverse origins, and all the complications and ramifications of several centuries of development as a civilization (all the while trying to imagine itself as a source of innovation and progress). For whatever reason, that bit is critical to its identity.

A few years ago, an economic crisis developed, mostly as a result of internal contradictions in organization, but in the aftermath of a some fairly miserable foreign adventures. And the situation had enough external aspects that it is possible, as most peoples are want to do, to blame the rest of the world for the current difficulties. As a result these people find themselves is a slow and tedious recovery without the instant return to happy prosperity that they believe is their due as the world's Beacon on a Hill and source of innovation and progress. That has soured the politics and the economy, and made them a bit more unruly, but so far had no greater ramifications.

In the throes of the economic crisis, that financial elite successfully held the political class hostage with a threat that boiled down, according to a domestic humorist, to 'save our banks or we'll kill your economy.' A reasonable number of the banks were saved, and since then the government has papered over (literally, printing gobs of the stuff) the inability of the banking systems to meet broad swaths of the mandate its social contract implies. In the process, interestingly, various agencies of the government have developed a set of procedures, capacities and competencies that significantly reduce the necessity for a financial services sector as presently constructed. But that has occurred almost by stealth, with virtually no public comment.

In the aftermath of the crisis, the political class was collectively enraged by the failure of the financial elite that it had just saved to 'stay bought.' This is entirely understandable. As a group the political class is premised on relationships rather than transactions. Relationships come in all varieties and strengths, but they are generally characterized by concepts of power, obligation, and nuanced flexibility through time. As a group, the financial elite is oriented towards transactions. Transactions come in equal variety, but they are generally one-off, creating no long term obligations, and the terms are set at the outset, lived up to, then renegotiated (or confirmed) before the next piece of business is done.

From the point of view of the financial elite, the political class were suckers. They didn't extract enough advantage at the outset of the transaction and so they sold their assistance too cheaply. To come back afterwards and expect to recut the deal is naive beyond words. Once past the crisis, the sensible thing to do, for the financial elite, was address the urgent rebuilding of their wealth--both at the institutional and the personal level. The public optics of that exercise would be manageable.

Fairness compels a distant observer to note that the first match of this series was fought in the home court of the financial elite. The political class was operating on the turf of the financial elite, for high stakes. The early innings moved at a fast moving pace, without time or space for reflection, compromise or error. When in its latter stages the political class attempted to collect for its assistance, it got stiffed (so did the public interest, but only a fool would expect optimal policy outcomes in a game played by these rules).

And there will be a rematch. It may come fairly soon. But it will not play out quickly. It will not play out on the home turf of the financial barons. It may not play out in public. And the result is not foreordained.

I have the sense that the opening volleys are being fired in this whole mortgage fiasco. The early efforts to quantify the impact are fairly amusing. We haven't even figured out how to characterize what's been going on. Is it a paperwork snafu caused by antiquated real estate filing requirements under state law? Is it the commission on an almost heroic scale of routine criminal acts of forgery and perjury for which bank charters should be surrendered and senior executives imprisoned. Is it a systems breakdown that with the commitment of organizational resources on a massive scale can be remediated. Is it the sort of back office failure of epic proportions that delivered the final blow to so many Wall Street brokerages of the Go-Go Years and required a regulatory reshaping of that landscape?

So damage assessment is way premature. How this plays not only will depend on what needs to happen to fix the problem that first brought it to light. It will depend on a variety of other agendas: internal agendas, public agendas, regulatory agendas, private agendas. And the battle lines aren't drawn yet, the roles haven't been defined. Look at the New York Fed--it is a regulator, customer, agent, plaintiff, etc., etc.

And just because the financiers won their home game, that doesn't give them any advantage when they play away. If the way they've run their operations in the past is any sign, Big D has never been a strong point on their side. And that's what will be needed. Nor have cohesion, class solidarity or anything else along the lines of cooperative, collective, united front activities been strong points. Their leadership are the alpha fish of a shark tank--cold, slimy, powerful, dangerous and stupid.

Furthermore, on the basis of their behavior since the crash, I think it is more likely that they will be hooked, netted and filleted. But time--lots of it--will tell.

Throwing in the Towel

Is this the beginning of the end,
for our old friend,
extend and pretend?

At least as far as the commercial and residential real estate markets and the continued viability of the financial services sector as presently constituted are concerned?

Consider the following seven data points/factoids/developments:

1. Over the summer the first time home buyer incentive program came to an end. There is no political appetite for resuming it.

2. All of the housing indexes are indicating a resumption in house price declines. Good news for home buyers, bad news for home owners and lenders.

3. Residential and commercial construction is dead. Still dead. Not yet undead. Making no contribution to the 'recovery,' such as the recovery is.

4. HAMP was a failure. And servicer footdragging/non-cooperation that contributed to that preceded the inevitable homeowner redefaults to come.

5. There is the nasty little problem of a huge slug of not-yet-written down second mortgage loans on the books of various TBTF financial institutions (arguably a reason for the footdragging mentioned in point 4?).

6. The commercial real estate market, which hasn't been supported with the kind of governmental effort that has distorted the residential market, has resumed its decline and continues to set new lows. A contributor to continuing weakness of bank balance sheets and a harbinger of the residential real estate market?

7. The foreclosure gate scandal is leading all kinds of revelations about how the originate-to-distribute business model has actually been functioning (perhaps since inception?).

And a bonus, freebie, consideration--18 months ago the feds required the major banks to prepare stress tests predicated on a pair of assumptions concerning the path of residential real estate prices and unemployment levels. House prices could drop slightly more than 15% from where they are today without dropping to the the price levels projected in that exercise for the base case. House prices would have to drop almost 25% before reaching the levels projected in the more adverse case for the stress tests.

All of this suggests that a strategy of 'let's just hold things together 'til things get better' may have exhausted its utility and that the the time may have come to actually address the problems.

G20 Meeting and the Lessons of Japan

The truth that was illuminated at the G20 meeting.

If you assess currency manipulation by the impact of policy on exchange rates rather than the announced intentions of policymakers, we are all manipulating our exchange rates.

Er, so let's change the paradigm?

The Lesson of Japanese Lost Decade.

In a world of globalized trade and free international capital flows, the effects of a Keynesian approach to economic stimulus at the nation state level will dissipate across the globe and cannot be effectively targeted within the geographical boundaries of a national economy actively participating in the international trade (probably either as an exporter or an importer). You simply turn your currency into a funding vehicle for the carry trade.

Anyone care to speculate in the emerging markets using the dollar as a funding currency?

Blood on the Knife

We need some blood on the knife.

That's my takeaway on the progress of the financial crisis so far. There is a public appetite for blood on the knife, and it hasn't been satiated. To put a finer point on it, the retributive aspect of justice has been sacrificed to the pragmatic interest in keeping the wheels on the system. It's time to shift gears.

There is an inchoate sense of rage that the people who made this mess, and profited handsomely from it, are getting off scot-free, leaving the rest of us to clean it up and pay for it. I think that's a big part of the Tea Party rage and will be the explanation for the midterm success of the Republicans (one of whom in Texas, my God, is calling for armed insurrection, claiming it is constitutionally permissible. Not since Edmund Ruffin of South Carolina in 1861 has such nonsense, oh, wait a minute, I forget Rick Perry of Texas about 18 months ago . . . )

I wish I could say that those in authority above us are too principled and committed to the rule of law to indulge such a taste. But I don't think so. The perp walks following Enron and the other scandals of a decade back suggest not. I think they are simply gutless, spineless and clueless.

It's time to throw some resources into criminal task forces. Now, there's a shovel ready project everybody can agree on.

Appalling Wall Street Journal Attack on Lawyers

The Wall Street Journal published one of those stupid 'shoot the messenger' articles about the consumer lawyers who by doing their jobs brought to light the robosigning and document fabrication that has become endemic in the foreclosure process. The article reeked of implicit class bigotry, which will play well with the WSJ's intended demographic. And properly reflects the complete capture by paradigm of the formerly ink-stained wretches who currently inhabit the gilded cage of the higher reaches of salaried journalism.

The denizens of Wall Street whom the WSJ serves elected to jettison the safeguards, procedures and formalities of the credit culture they had inherited. That credit culture had developed over generations. Remember the three C's? Probably not. For the last decade, those pillars of financial innovation shoved money out the door with utter abandon and cut a lot of corners doing that. They lent a lot of money to customers they shouldn't have.

Now, surprise, they're taking the same cavalier approach to getting the money back.

The great public was willing to take the money pushed its way. But when it comes to cowboy recklessness in getting the money back, not so fast, hombre. The legal and judicial safeguards and procedures developed over generations in real property matters exist to protect legal rights. They evolved and reflect a prudent and painfully developed set of accomodations and balances. Just because the financial services sector lost its collective sanity and jettisoned the credit culture is no reason for the judicial system to follow its example.

And the news of the last couple of months suggest that those legal safeguards and procedures need to be strengthened, not diminished. Which, of course, is what the New York courts took a step towards yesterday by rule imposing additional duties on counsel for foreclosing financial institutions.

Wells Fargo and the New York Fed: Three Fronts and A Big Issue

Yesterday was big for the New York Fed on the MBS problem. Bill Dudley implicitly questioned the adequacy of the current back office operations in a speech and in a demand letter the New York Fed joined a group of other potential plaintiffs in starting the clock ticking on BofA in a situation involving bad loan putbacks.

Meanwhile, out on the left coast Wells Fargo today vigorously defended its own mortgage servicing operation. Admittedly, the defense could be interpreted, depending on one's perspective, as either 'our operations meet and exceed industry standards' or 'we're not as lame as the rest of the business.' But it was vigorous.

All of this has been freighted with much meaning. But I'm not so sure that the people either dismissing or heralding these developments have enough to go on to be very persuasive. The old joke about litigators--frequently wrong but never in doubt--comes to mind.

So I'm not going to say anything about the viability of the litigation implicitly threatened by a demand letter. I'm not going to speculate on the course of regulatory response to the possibility that material operations of some too big to fail financial institutions suffer from inadequate systems, procedures and controls, or management failures that have resulted in a pattern of routine violations of law. And I don't know how to sort out what Wells Fargo senior management says on the quarterly earnings call versus what Wells Fargo operating managers say under oath in deposition (beyond observing that maybe neither bank officers nor sworn testimony enjoy the confidence they'd once earned).

Instead, I'll offer something organizational--three fronts and a big issue. There are three fronts on which the mortgage backed securities business is being challenged.

Front No. 1. The originate to distribute part of the model. This where the put back issue comes from. There appear to be some problems with the disclosures made in offering documents. This will all be the grist of expensive and lengthy litigation. Both the plaintiffs and the defendants will be drawn from the financial services sector. There may be tax issues, though I'd be stunned if the IRS challenged the conduit status of the REMICs. The separation of record and beneficial ownership of the notes and security interests occurred at this point, but the problems it is now presenting lead directly to Front No. 2.

Front No. 2. The ongoing mortgage servicing operations of trustees and servicing organizations. In a kinder and gentler time (the boom of five years ago), these operations were seen as essentially custodial (the trustee holding the property for the benefit of the trust that issued the MBS) and ministerial--the accounting, recording keeping, reporting, disbursing of cash flows, etc.--of the mortgage servicer. These systems are now being stressed past the breaking point. In the first instance, that stress showed up in the foreclosure scandal, but it's rapidly spreading to other issues (viz., the demand letter). That first stress takes us to Front No. 3.

Front. No. 3. The legal issues coming out of the foreclosure disclosures. This is rough stuff. Without prejudging the question of whether the actual conduct was an endemic and indefensible as it appears to have been, the policy question of what to do about it is just beginning to surface. Do you settle for a patch and a local fix? Or do you conclude that the too big to fail financial institutions require rethinking? One relevant observation--those institutions seems to have many, many problems in a wide variety of different arenas. Foreclosure gate is part of a pattern, not a one-off. Consider the pay to play scandals in state and municipal finance. Consider the pay practices. And, don't forget the meltdown in the financial markets two years ago (a situation salvaged by bureaucrats and the taxpayer, though the leadership of those institutions and their publicists have conveniently forgotten that).

And, finally, the big issue. It's less global than pondering what to do about too big to fail financial institutions, but it's an aspect of their size. Conflicts of interest are a huge problem in the mortgage servicing business. The extent to which the different roles are intertwined in different operations of the same ultimate parent organization are going to be an enormous obstacle to resolving this mess. (It also may be a fatal weakness in legal attempts to contain it). One of the institutions joining in the demand on Bank of America is 34% owned by BofA. Wells Fargo is famous for making both first and second mortgages on the same property. One reason HAMP is believed to have had such dismal results is that the servicers were in a blatant conflict of interest situation.

All in all, interesting times. A lovely mess of policy issues, legal complications, operational challenges, all in a stew of tangled jurisdictional questions, potential criminal liabilities, and so on. A recipe for . . .

Back Office Collapses in History

Of course it's still way too early to tell just how systemically important the back office failings of the mortgage servicers will turn out to be. But NY Fed President Dudley referenced the importance of robust back office operations underpinning a functioning mortgage securities markets in his speech this morning. And that is important.

Indeed, the financial markets were wrecked by a back office meltdown the living of memory man, indeed in the memory (just barely) of non-retirement age living man--and woman, for that matter, though back then the women weren't the, ah, players they've since become. Actually, the back office meltdown just finished the job. It came after a market boom followed by a meltdown had stressed the whole system, against the backdrop of prolonged and unsatisfying military entanglements on the Asian landmass and a rickety economy.

Maybe that all sounds familiar. And in the last three years we've had a debate about whether we were headed for a reprise of the 1930s or the 1970s. What I'm talking about here happened early in the 1970s, and was really the final inning of a game started in the 1960s.

The 1960s were the Go-Go years. You had mutual funds instead of program trading and conglomerates rather than hedge funds, but you had the same psychology of boom. Which was followed by bust. And throughout it all, elevated levels of transactional activities.

All of which settled on paper. And all that paper swamped the back offices. Now these were the back offices of the member firms of New York Stock Exchange firms. Those firms were partnerships and the partners were frequently more interested in playing golf at Winged Foot, racing sailboats on Long Island City or drinking at the Brook Club.

By the time anybody started paying any attention, the systems had broken down. As in, knee deep in trade slips, lost stock certificates, daily ledgers weeks behind in recording transactions, blown settlements, broken trades, etc. A number of firms failed.

Unlike the current situation, all of these failures were internal, pretty much confined to Manhattan, maybe bleeding over to Jersey City. An effort today is being made to portray the problem as one of antiquated state property laws and filing requirements. As far as I can tell, those antiquated state systems and procedures work just fine, and 'time-tested' might be a more polite adjective.

The problem is a systemic back office failure to comply with state legal requirements, leaving the beneficial owners of the notes in a position where they are unable to efficiently and quickly assert their rights under state law. At worst, they lose the benefit of their security interest and become general creditors in a bankruptcy. At best, at considerable expense to the trusts, servicers and perhaps even the deal sponsors, the remedial work necessary to comply with well-established state law requirements.

But it's difficult to challenge the notion that, if a litigant wants to assert rights in a state court under the laws of that state, it should be compelled to comply with the procedural requirements of that forum. And it that litigant is a federally regulated financial institution, it's about time that federal regulators look into the situation. If those institutions have by their own strategic decisions, operating procedures, and resource allocation, put themselves in a position where they can't obtain state legal remedies, then there need to be some changes--in the financial institutions, not in the state laws.