Goldman Sachs And The Big Hedge Funds Are Pushing Leverage To Ridiculous Extremes

As stocks have risen in recent years, the big hedge funds and the "too big to fail" banks have used borrowed money to make absolutely enormous profits.  But when you use debt to potentially multiply your profits, you also create the possibility that your losses will be multiplied if the markets turn against you.  When the next stock market crash happens, and the gigantic pyramid of risk, debt and leverage on Wall Street comes tumbling down, will highly leveraged banks such as Goldman Sachs ask the federal government to bail them out?  The use of leverage is one of the greatest threats to our financial system, and yet most Americans do not even really understand what it is.  The following is a basic definition of leverage from Investopedia: "The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment."  Leverage allows firms to make much larger bets in the financial markets than they otherwise would be able to, and at this point Goldman Sachs and the big hedge funds are pushing leverage to ridiculous extremes.  When the financial markets go up and they win on those bets, they can win very big.  For example, revenues at Goldman Sachs increased by about 30 percent in 2012 and Goldman stock has soared by more than 40 percent over the past 12 months.  Those are eye-popping numbers.  But leverage is a double-edged sword.  When the markets turn, Goldman Sachs and many of these large hedge funds could be facing astronomical losses.

Sadly, it appears that Wall Street did not learn any lessons from the financial crisis of 2008.  Hedge funds have ramped up leverage to levels not seen since before the last stock market crash.  The following comes from a recent Bloomberg article entitled "Hedge-Fund Leverage Rises to Most Since 2004 in New Year"...

Hedge funds are borrowing more to buy equities just as loans by New York Stock Exchange brokers reach the highest in four years, signs of increasing confidence after professional investors trailed the market since 2008.

Leverage among managers who speculate on rising and falling shares climbed to the highest level to start any year since at least 2004, according to data compiled by Morgan Stanley. Margin debt at NYSE firms rose in November to the most since February 2008, data from NYSE Euronext show.

So why is this so important?

Well, as a recent Zero Hedge article explained, even a relatively small drop in stock prices could potentially absolutely devastate many hedge funds...

What near record leverage means is that hedge funds have absolutely zero tolerance for even the smallest drop in prices, which are priced to absolute and endless central bank-intervention perfection - sorry, fundamentals in a time when global GDP growth is declining, when Europe and Japan are in a double dip recession, when the US is expected to report its first sub 1% GDP quarter in years, when corporate revenues and EPS are declining just don't lead to soaring stock prices.

It also means that with virtually all hedge funds in such hedge fund hotel names as AAPL (the stock held by more hedge funds - over 230 - than any other), any major drop in the price would likely lead to a wipe out of the equity tranche at the bulk of AAPL "investors", sending them scrambling to beg for either more LP generosity, or to have their prime broker repo desk offer them even more debt. And while the former is a non-starter, the latter has so far worked, which means that most hedge funds have been masking losses with more debt, which then suffers even more losses, and so on.

By the way, Apple (AAPL) just fell to an 11-month low.  Apple stock has now declined by 26 percent since it hit a record high back in September.  That is a very bad sign for hedge funds.

But hedge funds are not the only ones flirting with disaster.  In a previous article about the derivatives bubble, I pointed out the ridiculous amount of derivatives exposure that some of these "too big to fail" banks have relative to their total assets...

According to the Comptroller of the Currency, four of the largest U.S. banks are walking a tightrope of risk, leverage and debt when it comes to derivatives.  Just check out how exposed they are...
JPMorgan Chase
Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)
Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)
Citibank
Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)
Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)
Bank Of America
Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)
Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)
Goldman Sachs
Total Assets: $114,693,000,000 (a bit more than 114 billion dollars - yes, you read that correctly)
Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)

Take another look at those figures for Goldman Sachs.  If you do the math, Goldman Sachs has total exposure to derivatives contracts that is more than 362 times greater than their total assets.
That is utter insanity, but we haven't had a derivatives crash yet so everyone just keeps pretending that the emperor actually has clothes on.

When the derivatives crisis happens, things in the financial markets are going to fall apart at lightning speed.  A recent article posted on goldsilverworlds.com explained what a derivatives crash may look like...

When one big bank faces some kind of trouble and fails, the banks with the largest exposure to derivates (think JP Morgan, Citygroup, Goldman Sachs) will realize that the bank on the other side of the derivatives trade (the counterparty) is no longer good for their obligation. All of a sudden the hedged position becomes a naked position. The net position becomes a gross position. The risk explodes instantaneously. Markets realize that their hedged positions are in reality not hedged anymore, and all market participants start bailing almost simultaneously. The whole banking and financial system freezes up. It might start in Asia or Europe, in which case Americans will wake up in the morning to find out that their markets are  not functioning anymore; stock markets remain closed, money at the banks become inaccessible, etc.

But for now, the party continues.  Goldman Sachs and many of the big hedge funds are making enormous piles of money.

In fact, according to the Wall Street Journal, Goldman Sachs recently gave some of their top executives 65 million dollars worth of restricted stock...

Goldman Sachs Group Inc. GS -0.76% handed insiders including Chief Executive Lloyd Blankfein and his top lieutenants a total of $65 million in restricted stock just hours before this year's higher tax rates took effect.
The New York securities firm gave 10 of its directors and executives early vesting on 508,104 shares previously awarded as part of prior years' compensation, according to a series of filings with the Securities and Exchange Commission late Monday.

And the bonuses that employees at Goldman receive are absolutely obscene.  A recent Daily Mail article explained that Goldman employees in the UK are expected to receive record-setting bonuses this year...

Britain’s army of bankers will re-ignite public fury over lavish pay rewards as staff at Goldman Sachs are expected to reward themselves £8.3 billion in bonuses on Wednesday.
The American investment bank, which employs 5,500 staff in the UK, will be the first to unveil its telephone number-sized rewards – an average of £250,000 a person – as part of the latest round of bonus updates.The increase, up from £230,000 last year, comes as British families are still struggling to make ends meet five years after banks brought the economy to the brink of meltdown.

Wouldn't you like to get a "bonus" like that?
Life is good at these firms while the markets are going up.
But what happens when the party ends?
What happens if the markets crash in 2013?
When you bet big, you either win big or you lose big.

For now, the gigantic bets that Wall Street firms are making with borrowed money are paying off very nicely.

But a day of reckoning is coming.  The next stock market crash is going to rip through Wall Street like a chainsaw and the carnage is going to be unprecedented.

Are you sure that the people holding your money will be able to make it through what is ahead?  You might want to look into it while you still can.

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The Real Interest Rate Risk: Annual US Debt Creation Now Amounts To 25% Of GDP Compared To 8.7% Pre-Crisis

By now most are aware of the various metrics exposing the unsustainability of US debt (which at 103% of GDP, it is well above the Reinhart-Rogoff "viability" threshold of 80%; and where a return to just 5% in blended interest means total debt/GDP would double in under a decade all else equal simply thanks to the "magic" of compounding), although there is one that captures perhaps best of all the sad predicament the US self-funding state (where debt is used to fund nearly half of total US spending) finds itself in. It comes from Zhang Monan, researcher at the China Macroeconomic Research Platform: "The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP."

This is a key statistic most forget when they discuss the stock and flow of US debt: because whereas the total US deficit, and thus net debt issuance, is about $1 trillion per year, one has to factor that there is between $3 and $4 trillion in maturities each year, which have to be offset by a matched amount of gross issuance just to keep the stock of debt flat (pre deficit funding). The assumption is that demand for this gross issuance will always exist as old maturities are rolled into new debt, however, this assumption is contingent on one very key variable: interest rates not rising.

It is the question of what happens to this ~$4 trillion in annual debt creation by the US, as well as other key ones, that Monan attempts to answer in the following paper on what happens to the world if and when the moment when rates truly start rising, instead of just undergo another theatrical 2-4 week push higher only to plunge over fears the Fed may soon pull the punchbowl.

By Zhang Monan, published first in Project Syndicate

The Real Interest-Rate Risk

Since 2007, the financial crisis has pushed the world into an era of low, if not near-zero, interest rates and quantitative easing, as most developed countries seek to reduce debt pressure and perpetuate fragile payment cycles. But, despite talk of easy money as the “new normal,” there is a strong risk that real (inflation-adjusted) interest rates will rise in the next decade.

Total capital assets of central banks worldwide amount to $18 trillion, or 19% of global GDP – twice the level of ten years ago. This gives them plenty of ammunition to guide market interest rates lower as they combat the weakest recovery since the Great Depression. In the United States, the Federal Reserve has lowered its benchmark interest rate ten times since August 2007, from 5.25% to a zone between zero and 0.25%, and has reduced the discount rate 12 times (by a total of 550 basis points since June 2006), to 0.75%. The European Central Bank has lowered its main refinancing rate eight times, by a total of 325 basis points, to 0.75%. The Bank of Japan has twice lowered its interest rate, which now stands at 0.1%. And the Bank of England has cut its benchmark rate nine times, by 525 points, to an all-time low of 0.5%.

But this vigorous attempt to reduce interest rates is distorting capital allocation. The US, with the world’s largest deficits and debt, is the biggest beneficiary of cheap financing. With the persistence of Europe’s sovereign-debt crisis, safe-haven effects have driven the yield of ten-year US Treasury bonds to their lowest level in 60 years, while the ten-year swap spread – the gap between a fixed-rate and a floating-rate payment stream – is negative, implying a real loss for investors.

The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP. As this figure continues to rise, investors will demand a higher risk premium, causing debt-service costs to rise. And, once the US economy shows signs of recovery and the Fed’s targets of 6.5% unemployment and 2.5% annual inflation are reached, the authorities will abandon quantitative easing and force real interest rates higher.

Japan, too, is now facing emerging interest-rate risks, as the proportion of public debt held by foreigners reaches a new high. While the yield on Japan’s ten-year bond has dropped to an all-time low in the last nine years, the biggest risk, as in the US, is a large increase in borrowing costs as investors demand higher risk premia.

Once Japan’s sovereign-debt market becomes unstable, refinancing difficulties will hit domestic financial institutions, which hold a massive volume of public debt on their balance sheets. The result will be chain reactions similar to those seen in Europe’s sovereign-debt crisis, with a vicious circle of sovereign and bank debt leading to credit-rating downgrades and a sharp increase in bond yields. Japan’s own debt crisis will then erupt with full force.

Viewed from creditors’ perspective, the age of cheap finance for the indebted countries is over. To some extent, the over-accumulation of US debt reflects the global perception of zero risk. As a result, the external-surplus countries (including China) essentially contribute to the suppression of long-term US interest rates, with the average US Treasury bond yield dropping 40% between 2000 and 2008. Thus, the more US debt that these countries buy, the more money they lose.

That is especially true of China, the world’s second-largest creditor country (and America’s largest creditor). But this arrangement is quickly becoming unsustainable. China’s far-reaching shift to a new growth model implies major structural and macroeconomic changes in the medium and long term. The renminbi’s unilateral revaluation will end, accompanied by the gradual easing of external liquidity pressure. With risk assets’ long-term valuation falling and pressure to prick price bubbles rising, China’s capital reserves will be insufficient to refinance the developed countries’ debts cheaply.

China is not alone. As a recent report by the international consultancy McKinsey & Company argues, the next decade will witness rising interest rates worldwide amid global economic rebalancing. For the time being, the developed economies remain weak, with central banks attempting to stimulate anemic demand. But the tendency in recent decades – and especially since 2007 – to suppress interest rates will be reversed within the next few years, owing mainly to rising investment from the developing countries.

Moreover, China’s aging population, and its strategy of boosting domestic consumption, will negatively affect global savings. The world may enter a new era in which investment demand exceeds desired savings – which means that real interest rates must rise.

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Inflation Propaganda Exposed

Economists who hold the popular view that expanding the money supply will provide the best medicine for our ailing economy dismiss the inflationary concerns of monetary hawks, like me, by pointing to the supposedly low inflation that has occurred during the current period of rampant Fed activism. In a recent blog post aimed specifically at me, Paul Krugman noted that the sub 2.5% increases in the Consumer Price Index (CPI) over the past few years are all that is needed to prove me wrong. In fact, Krugman and others have even suggested that the CPI itself overstates inflation and that the Fed would be better able to help the economy if less strict methodologies were used. However, there is plenty of evidence to suggest that the CPI is essentially meaningless as it woefully under reports rising prices.

Magazines and newspapers provide a good case in point. The truth has not been exposed through the economic reporting that these outlets provide, but in the prices that are permanently fixed to their covers. For instance, from 1999 to 2002 the Bureau of Labor Statistic's (BLS) "Newspaper and Magazine Index" (a component of the CPI) increased by 37.1%. But a perusal of the cover prices of the 10 most popular newspapers and magazines (WSJ, Washington Post, Time, Sports Illustrated, U.S. News & World Report, Newsweek, People, NY Times, USA Today, and the LA Times) over the same time frame showed an average cover price increase of 131.5% (3.5 times faster than the BLS' stats). This is not even in the same ballpark.

Some defenders of the BLS may conclude that prices were held down by the availability of free online news content or the convenience of digital delivery. But that is beside the point. Prior to the digital age, the BLS could have claimed that newspaper costs were held down by public libraries that provided free access. It's also true that online publications deliver less value on some fronts. Not only do many people enjoy the tactile process of reading physical newspapers or magazines, but they offer the secondary value in helping to kindle fires, housebreak puppies, pack dishes, and line birdcages.

Another stunning example is found in health insurance costs, which is a major line item for most families. According to the BLS we can all breathe easy on that front because their "Health Insurance Index" increased a mere 4.3% (total) in the four years between 2008 and 2012. Interestingly, over the same time, the Kaiser Survey of Employer Sponsored Health Insurance showed that the cost of family health insurance rose 24.2% (5.5 times faster). But even if the BLS had reported higher costs, it wouldn't have made much of a difference in the CPI itself. Believe it or not, health insurance costs are assigned a weighting of less than one percent of the overall CPI. In contrast, the Kaiser Survey revealed that in 2012 the average total cost for family health insurance coverage was $15,745, or almost one third of the median family income.

If the BLS could be so blatantly wrong in reporting the prices of newspapers and health insurance, should we believe that they are more accurate on all other sectors? If the inaccuracy of these two components were consistent with the rest of the CPI's components, inflation could now be reported in double-digits!

Even more egregious than the manner in which prices are currently reported is the way that CPI methods have been changed over the years to insure that most increases are factored out. Since the 1970's, the CPI formula has changed so thoroughly that it bears scant resemblance to the one used during the "malaise days" of the Carter years. Main stream economists dismiss criticism of the changes as tin hat conspiracy theories. But given the huge stakes involved, it's hard to believe that institutional bias plays no role. Government statisticians are responsible for coming up with the formulas, and their bosses catch huge breaks if the inflation numbers come in low. Human behavior is always influenced by such incentives.

The newer CPI methodologies are designed to report not just on price movements, but on spending patterns, consumer choices, substitution bias, and product changes. In other words, the metrics have been altered to track not so much the cost of things, but the cost of living (or more accurately, the cost of surviving). But if you simply focus on price, especially on those staple commodity goods and services that haven't radically changed in quality over the years, the under reporting of inflation becomes more apparent.

As reported in our Global Investor Newsletter, we selected BLS price changes for twenty everyday goods and services over two separate ten-year periods, and then compared those changes to the reported changes in the Consumer Price Index (CPI) over the same period. (The twenty items we selected are: eggs, new cars, milk, gasoline, bread, rent of primary residence, coffee, dental services, potatoes, electricity, sugar, airline tickets, butter, store bought beer, apples, public transportation, cereal, tires, beef, and prescription drugs.)

We know that people do not spend equal amounts on the above items, and we know their share of income devoted to them has changed over the decades. But as we are only interested in how these prices have changed relative to the CPI, those issues don't really matter. We chose to look at the period between 1970 and 1980 and then again between 2002 and 2012, because these time frames both had big deficits and loose monetary policy, and they straddle the time in which the most significant changes to the CPI methodology took effect. And while the CPI rose much faster in the 1970's, the degree to which the prices of our 20 items outpaced the CPI was much higher more recently.

Between 1970 and 1980 the officially reported CPI rose a whopping 112%, and prices of our basket of goods and services rose by 117%, just 5% faster. In contrast between 2002 and 2012 the CPI rose just 27.5%, but our basket increased by 44.3%, a rate that was 61% faster. And remember, this is using the BLS' own price data, which we have already shown can grossly under-estimate the true rate of increase. The difference can be explained by how CPI is weighted and mixed. The formula used in the 1970's effectively captured the price movements of our twenty everyday products. But in the last ten years it has been quite a different story.

If these price changes in our experiments had been fully captured, CPI could currently be high enough to severely restrict Fed action to stimulate the economy. Instead, the Fed is operating as if inflation is extremely low. As a result, they are making a huge policy mistake that will come back to haunt us. During the last decade the Fed spent many years denying the existence of a housing bubble, even as a mountain of evidence piled up to the contrary. That error caused the Fed to hold interest rates too low for too long, blowing more air into the bubble and imposing enormous negative consequences on the economy. The Fed, now similarly blind to the inflation threat, is repeating its mistake, only this time the negative consequences will be even more dire.

Apart from the statistical problems that hide inflation, there are also macroeconomic factors that have helped keep prices down despite the quantitative easing. Massive U.S. trade deficits and foreign central bank dollar accumulation mean that much of the printed money winds up in foreign bank vaults, not U.S. shopping centers. As foreign consumer goods flow in, and dollars flow out, a lid is kept on domestic prices. In effect, our inflation is exported as foreign central banks monetize our deficits and recycle their surpluses into U.S. Treasuries. The demand has pushed down bond yields which has allowed the U.S. government to borrow inexpensively. Of course, when the flows reverse, bond prices will fall, yields will climb, and a tidal wave of dollars will wash up on American shores, drowning consumers in a sea of inflation.

Unlike Krugman and the Keynesians, I would argue that it is impossible to create something from nothing. I believe that printing a dollar diminishes the value of all existing dollars by an aggregate amount equal to the purchasing power of the new dollar. The other side takes the position that the new money creates tangible economic growth and that real economic value can therefore be created by putting zeroes onto a piece of paper. I think that those making such absurd claims should bear the burden of proof. For more on the interesting topic of hidden inflation, see my video that I just posted.

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Former Deutsche Bank Employee Claims Bank Took Big Libor Bets During Crisis Because It Could Influence Rates

The Wall Street Journal has an exclusive story based on a whistleblower leak, apparently with supporting transaction records.
In 2008, Deutsche Bank made very large bets instruments linked to one, three, and six month dollar, euro, and sterling Libor, that differential between one month rates versus the three and six month tenors would widen as the crisis became more severe. The German bank reportedly made over €500 million on these trades.
What is significant is that these were very large wagers, particularly at a time when most banks were desperate to shed risk. This is the guts of the story:

The documents from the former Deutsche Bank employee set out how traders in London and New York working for the German bank’s global-finance unit successfully bet that borrowing costs in euros, U.S. dollars and British pounds over three- and six-month periods would rise faster than one-month interest rates because of deepening stress throughout the global financial system.
The interest-rate bets included an estimated potential profit of €24 million for each hundredth of a percentage point that the three-month U.S. dollar Libor increased compared with the one-month U.S. dollar Libor, according to the documents.

The former employee has told regulators that some employees expressed concerns about the risks of the interest-rate bets, according to documents. He also said that Deutsche Bank officials dismissed those concerns because the bank could influence the rates they were betting on.

Naturally, Deutsche Bank officials deny the allegations. So as damaging and plausible as the charges seem (who would take such a big bet then if they weren’t confident they had some sort of advantage?), unless the source can provide some sort of supporting evidence, this is “he said, she said,” and the matter will shake out in the German bank’s favor.

One has to wonder why the bank is going to extreme lengths to disprove a conspiracy to manipulate rates. Again from the Journal:

Deutsche Bank hopes to persuade regulators to delay talks on a potential settlement until the bank completes its internal probe later this year, according to the people close to the bank.

Regulators have ordered banks to trawl through emails, chat messages and phone records dating back at least several years. The internal probe by Deutsche Bank began in May 2011, about three years after U.S. regulators began probing Libor.

The internal probe has been arduous because Deutsche Bank is inspecting thousands of trades between 2005 and 2011, including the big interest-rate bets detailed in the documents from the former employee.

The internal inquiry goes beyond looking for “smoking gun” emails or messages such as those exposed by regulators in their settlements with UBS and Barclays. Deutsche Bank is trying to match traders’ emails and chats with messages from clients and outside brokers, aiming to detect any subtle conspiracy to fix rates, said the people close to the bank.

The hunt to essentially prove the negative—that a specific person wasn’t trying to rig rates—explains why the bank-led internal probes are taking so long, said one of those people.

Deutsche seems unusually concerned about liability, which gives the impression they have something to hide. Firms also vary a fair bit in terms of how openly staffers express themselves; one of the reasons that Congressional investigations of particularly toxic Goldman CDOs turned up comparatively little dirt is that Goldman has a very buttoned-down culture. The same deals at other firms would have had a lot more in the way of sniggers and trash talk about the deals and the clients dumb enough to buy them in the records. Libor diddling seemed to be sufficiently widespread in 2005 to 2007 that it seems unlikely that any Deutsche trader would have been careful about covering his footprints….but if one had wanted to be, I can imagine it would not have been hard (limiting discussions to face to face meetings, not using the firm phones, etc And that’s the easy stuff. I had a probably deservedly paranoid buddy who did business in Russia go on about how to leave messages on Usenet groups in ways that no one could figure out the hidden communication).

So as much as the pattern of Deutsche’s activity looks sus, the whistleblower’s claims are likely to be stared down by the banks unless others come forward reporting that they heard the same thing from managers in a position to know . Then, of course, the German bank would simply change course and try to depict them as simply being wrong, or if that failed, painting them as rogue actors. In other words, I don’t see the odds as high that the source will be deemed to have the goods, even if what he is saying is completely accurate. I’m expecting these times to generate a new cliche, along the lines of “you can’t beat City Hall” to describe the futility of trying to prove that a major bank really did engage in bad behavior.

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Bank Outlook 2013: Lower Mortgage Volumes, Higher Interest Rates

As 2013 begins, the US economy is facing higher taxes and an uncertain outlook in terms of jobs and growth. As one senior GOP staffer told The IRA over drinks in Washington last week, we took a European approach to the crisis - namely bailing out the largest banks, etc. This is why there is no traditional recovery in terms of jobs and capital formation.


"We used to shake out all of the losers and start again," notes the veteran Washington financial services operative. "This time we bailed out everyone and there is no job growth. We may already have seen the 'recovery' in 2012."


The other aspect of the refusal by Washington to impose pain on the stock and bond holders of the TBTF banks, for example, is that the Fed is still entirely focused on fighting deflation. Since the US refused to get the process of restructuring done quickly and painfully, the adjustment is ongoing - now six years since the subprime crisis began -- and the US central bank is still trying to avoid a reset in asset prices.


Thus when we look at the US banking system, the outlook seems to be flat to down earnings and revenue for 2013. Mortgage refinancing volumes are likely to be down significantly, creating a significant negative bias in bank revenue and earnings this year.


The Mortgage Bankers Association is expecting new loan origination volumes to fall from $1.7 trillion in 2012 to $1.3 trillion this year, but few Sell Side analysts on Wall Street have taken notice of this fact as yet. The culprit is a drop in mortgage refinancing volumes. As we have noted in previous missives, the US banking sector is going through a serious structural change in terms of sources of new revenue.

"Reduced expenses for loan losses and rising noninterest income helped lift insured institutions' earnings to $37.6 billion in third quarter 2012," reports the FDIC in the most recent Quarterly Banking Profile. "Net interest income was $746 million (0.7 percent) higher than a year ago, even though the average net interest margin (NIM) fell from 3.56 percent to 3.43 percent. The increase in net interest income was made possible by a 4.6 percent increase in interest-earning assets. Two out of every three insured institutions (67.8 percent) reported year-over-year NIM declines, as average asset yields declined faster than average funding costs."


So the good news from the perspective of the FOMC is that banks are putting on more assets. The bad news for banks is that the earnings per dollar of asset are falling with NIM. This trend is due to the other negative factor for US banks in 2013 besides lower mortgage origination volumes, namely the Fed and its zero rate policy.


As we noted in our last comment, net, net the impact of the Fed's purchases of RMBS and zero rates more generally is decidedly negative for banks. Many observers are focused on the continuing fiscal disarray in Washington as the explanation for economic troubles in the year ahead, but we see the FOMC as perhaps the biggest single negative for both banks and consumers.


The impact of financial repression c/o the Fed has been widely noticed for years now, but the members of the FOMC refuse to change their policies. In 2013, however, we see the negative impact of ZIRP on banks and consumer activity becoming even more pronounced. And we also look for some unexpected surprises from the TBTF banks in terms of legacy mortgage exposures.


Once the FOMC finally relents and allows short-term interest rates to rise, we expect to see asset returns at banks improve. Consumers and savers will also start to see their cash flow rise after years of financial repression. But the adjustment process will take years, so for 2013 we think it is safe to assume that margins at US banks will continue to compress under the pressure of ZIRP and constrained consumer activity. So long as the Fed penalizes savers and subsidizes debtors via zero rate policy, there will be no meaningful recovery in the US economy.


But once the Fed does let US interest rates rise -- perhaps as early as the middle of 2013 -- the pressure on Washington in terms of fiscal reform will start to escalate dramatically. For the past six years, the FOMC has given Congress and President Barack Obama a free ride in terms of fiscal issues. As the Treasury starts to see the cost of borrowing rise and Fed purchases of collateral subside, the true dimensions of the fiscal crisis in Washington will become the central concern for global markets and financial institutions. That's when the fun really begins.

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$8.5 Billion Foreclosure Fraud Settlement: Yet Another Loss for Homeowners Touted as a Victory

It’s bad enough to see long suffering homeowners take it once again in the chin, thanks to the way the bank regulators prostrate themselves before their supposed charges. It adds insult to injury to see this type of ritualized sellout yet again presented as a boon for consumers.

The latest case study is the $8.5 billion foreclosure fraud settlement announced today. This agreement came out of a consent decrees among 14 servicers, the OCC, and the Fed entered into in April 2011. This was never a good faith effort to change bank behavior; the OCC was using this ruse to try to undermine the (then) 50 state AG-Federal regulator negotiations (which looked like they might be serious because Elizabeth Warren was informally advising the government side).

There were two major elements of the consent decrees, also known as cease & desist orders. One was a list of servicing standards, which were a partial recitation of what they were supposed to be doing already under current law. The second was a Potemkin review of foreclosures. The cover story was that this process was to identify wrongful foreclosures and compensate harmed borrowers. The real purpose was to whitewash servicer behavior.

And I can’t stress enough that the outcome was not only predictable, it was predicted as soon as the consent orders were published: that the OCC had deliberately devised a process that the servicers could exploit to claim that nothing bad had taken place. For instance, Georgetown professor Adam Levitin wrote:

By far the most interesting bit in the draft C&D order is the bit requiring the banks to engage independent foreclosure review consultants to review “certain” foreclosures that took place in 2009-2010. There is no specification as to which foreclosures are to be reviewed or precisely what the standards for review are. But that’s all kind of irrelevant. Who do you think the banks are going to engage to do these reviews? Someone like me? Not a chance. They’re going to find firms that signal loud and clear that if they get the job, they won’t find anything wrong. It’s just recreating the auditor selection problem, but without even the possibility of liability for a crony audit.

Frankly, this sort of regulatory outsourcing is pretty astounding–the OCC has resident examiner teams at the major servicer banks. Shouldn’t they be the ones auditing the internal controls and performance, not a third-party compensated by the bank? (Oh wait, I forgot that the OCC is paid by the banks–it’s budget comes from chartering fees and assessments on the banks is regulates. Indeed, I was struck in some places by the linguistic similarities between the proposed C&D order and the banks’ counterproposal to the AGs. It’s impossible to know who was cribbing from whom, but the similar language is revealing.)

So here’s what’s going down. The bank regulators are going to provide cover for the banks by pretending to discipline them very hard, but not really doing anything. The public will see a stern C&D order, but there won’t be any action beyond that. It’s as if the regulators are saying so all the neighbors can hear, “Banky, you’ve been a bad boy! Come inside the house right now because I’m going to give you a spanking!” And then once the door to the house closes, the instead of a spanking, there’s a snuggle. But the neighbors are none the wiser. The result will be to make it look like the real cops (the AGs and CFPB) are engaged in an overzealous vendetta if they pursue further action.

It turns out we were not cynical enough. We recounted in a post last week in gory detail that the information that leaked out as the reviews were underway showed not only that the review process was every bit as corrupt as we expected. It was also, peculiarly, turning out to be (per the banks) very costly. We couldn’t fathom the latter (we discussed how implausible the hours claimed to have been spent per borrower file were). The only explanations we can fathom are 1. that the banks were doing a lot more than OCC file review (as in they were bundling in “file remediation” as in cleanup/document fabrication) and 2. people were being paid to do nothing (we’ve gotten reports from insiders that some high-skill temps were kept “on the beach” at the start of the process).
Fast forward, and what happens? The banks bitch about the costs and use that to persuade the OCC and the Fed to shut the process down (they may also have become concerned that with so many people involved in file reviews, many of them temps and hence with no loyalty to the banks, that if they let the process continue to completion, they would have been exposed to enough leaks to get Congresscritters interested). Plus the banks were going to such lengths to suppress any unfavorable findings that the result, that pretty much no one was hurt, would be so ludicrous as to open the process up to unwanted scrutiny.

The excuse was that the money spend on performing the reviews would be at the expense of payouts to wronged homeowners. Huh? We are not talking about parties with strained budgets. The homeowners were supposed to be recompensed. That has squat to do with the expense of figuring out who was wronged.

Nevertheless, the banks and the Feds started negotiating in secret (homeowner advocates and Congressmen were not appraised), with the settlement total rumored at $10 billion for 14 servicers. It turned out to be $8.5 billion for 10. We get the party line and some commentary from Ben Hallman at Huffington Post:

Under the deal, announced by the Office of the Comptroller of the Currency and the Federal Reserve, the mortgage companies will make $3.3 billion in direct payments to “eligible borrowers” whose foreclosures were handled improperly, and will make $5.2 billion available in other assistance to struggling borrowers, such as loan modifications.
“The OCC and Federal Reserve accepted this agreement because it provides the greatest benefit to consumers subject to unsafe and unsound mortgage servicing and foreclosure practices during the relevant period in a more timely manner than would have occurred under the review process,” the regulators said in a joint statement….

The new settlement Monday replaces a deal struck in April 2011 that established the Independent Foreclosure Review, a program that was supposed supposed to give homeowners an opportunity to have an unbiased third-party review their foreclosure and determine whether they might qualify for a cash payout of up to $125,000. Scrapping a previously agreed-to legal deal, especially one as high-profile and complex as the Independent Foreclosure Review, is highly unusual, and a tacit acknowledgement of the program’s failure.

“[It] has become clear that carrying the process through to its conclusion would divert money away from the impacted homeowners and also needlessly delay the dispensation of compensation to affected borrowers. Our new course of action will get more money to more people more quickly, and it will speed recovery in the nation’s housing markets,” said Comptroller of the Currency Thomas Curry in a statement.

If you think this deal was about helping borrowers, I have a bridge I’d like to sell you. The New York Times reported that servicers were eager to wrap the deal up so they could say in their soon-to-be-published 2012 financial reports that the matter was behind them. The Federal Reserve held up the deal briefly, wanting the banks to pony up an additional $300 million. The sense of urgency on behalf of the banks gave the regulators negotiating leverage. But the Fed inexplicably caved.

Now remember, we don’t know how the money will be divvied up, and the bank record on modifications in the deal struck in February of last year shows that they consistently gone for the cheapest route, which is modifying big ticket mortgages (bigger mortgages gets you to a dollar total with the minimum number of mortgages, and the costs are pretty much the same no matter how large the mortgage is). So the odds are high that mortgage mods will go to a comparatively small number of high income (but overleveraged) borrowers.

As for the part of the funds that goes to people who suffered wrongful foreclosures, how the hell are the servicers gonna do that now that the reviews have been aborted? Divide the funds among those that requested a review? Pro-rate it among them, adjusting for mortgage amount? Or divvy it among everyone they can find who was foreclosed on in 2009 and 2010 that they can locate (note they’ve had trouble finding the addresses of former customers who lost their homes) whether they think they were wronged or not? Gretchen Morgenson went through the math using the somewhat bigger numbers (starting with the rumored $10 billion) over the weekend:

Some back-of-the-envelope arithmetic on this deal is your first clue that it is another gift to the banks. It’s not clear which borrowers will receive what money, but divvying up $3.75 billion among millions of people doesn’t amount to much per person. If, say, half of the 4.4 million borrowers were subject to foreclosure abuses, they would each receive less than $2,000, on average. If 10 percent of the 4.4 million were harmed, each would get roughly $8,500.

This is a far cry from the possible penalties outlined last year by the federal regulators requiring these reviews. For instance, regulators said that if a bank had foreclosed while a borrower was making payments under a loan modification, it might have to pay $15,000 and rescind the foreclosure. And if it couldn’t be rescinded because the house had been sold, the bank could have had to pay the borrower $125,000 and any accrued equity.

Let’s look at the the paltry less than $2,000 to perhaps $8,500 compared to the harm some borrowers have suffered. Consider this example from a report posted here from one of the file reviewers:

For example, in one case I reviewed the borrower paid approximately 25K to reinstate his mortgage. Then he began to make his mortgage payments as agreed. Each time he made a payment the payment was sent back stating he had to be current for the bank to accept a payment. He made three payments and each time the response was the same. Each time he wrote and called stating he had sent in the $25K to reinstate the loan and had the canceled check to prove it. After several months the bank realized that they had put the 25K in the wrong account. At that time that notified him that they were crediting his account, but because of the delay in receiving the reinstatement funds into the proper account he owed them more interest on the monies, late fees for the payments that had been returned and not credited and he was again in default for failing to continue making his payment. The bank foreclosed when he refused to pay additional interest and late fees for the banks error. I was told that I shouldn’t show that as harm because he did quit making his payments. I refused to do that.

So the bank basically scammed the borrower out of an additional $25,000 before foreclosing as originally planned. Under the old formula, he’d be owed $15,000 plus his house back or $125,000 plus accrued equity. Instead, he’ll get an insultingly small amount. Oh, and he’ll almost certainly also be asked to release the bank from any liability as a condition of getting the dough.
This is what passes for justice in America: the authorities are all too happy to paper over what any sensible person would consider to be criminal conduct.

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"The Magic Of Compounding" - The Impact Of 1% Change In Rates On Total 2022 US Debt

They say "be careful what you wish for", and they are right. Because, in the neverending story of the American "recovery" which, sadly, never comes (although in its place we keep getting now semiannual iterations of Quantitative Easing), the one recurring theme we hear over and over and over is to wait for the great rotation out of bonds and into stocks. Well, fine. Let it come. The question is what then and what happens to the US economy when rates do, finally and so overdue (for all those sellside analysts and media who have been a broken record on the topic for the past 3 years), go up. To answer just that question, which in a country that is currently at 103% debt/GDP and which will be at 109% by the end of 2013, we have decided to ignore the CBO's farcical models and come up with our own. Our model is painfully simple, and just to give our readers a hands on feel, we have opened up the excel file for everyone to tinker with (however, unlike the CBO, we do realize that when calculating average interest, one needs to have circular references enabled so please do that before you open the model).

Our assumptions are also painfully simple:

i) grow 2012 year end GDP of ~$16 trillion at what is now widely accepted as the 'New Normal' 1.5% growth rate (this can be easily adjusted in the model);

ii) assume the primary deficit is a conservative and generous 6% of GDP because America will never, repeat never, address the true cause of soaring deficits: i.e., spending, which will only grow in direct proportion with demographics but as we said, we are being generous (also adjustable), and

iii) sensitize for 3 interest rate scenarios: 2% blended cash interest; 3% blended cash interest and 5% blended cash interest.

And it is here that we get a reminder of a very key lesson, one that even the CBO admitted on Friday they had forgotten about, in what compounding truly looks like in a country that is far beyond the Reinhart-Rogoff critical threshold of 80% sovereign debt/GDP.

The bottom line: going from just 2% to 3% interest, will result in total 2022 debt rising from $31.4 trillion to $34.1 trillion; while "jumping" from 2% to just the long term historical average of 5%, would push total 2022 debt to increase by a whopping $9 trillion over the 2% interest rate base case to over $40 trillion in total debt!

Sadly, this is no "magic" - this is the reality that awaits the US.

And for those more curious about that other critical economic indicator, debt/GDP, the three scenarios result in the following 2022 debt/GDP ratios:

• 2% interest - 169%;
• 3% interest - 183.5%; and 
• 5% interest - 217%, or just shy of where Japan is now.

Which reminds us: in the next few days we will recreate the same exercise for Japan's ¥1 quadrillion in total sovereign debt, which will show why any more "exuberance" arising from Abe's latest economic lunacy, will promptly send the country spiraling into that twilight zone where every dollar in tax revenue is used only to fund interest expense.

Once again, it is not our intention to predict what US GDP or debt/GDP will be in 2022: only the IMF can do that with decimal level precision, apparently, and not just with anyone, but Greece. The whole point is to show that when dealing with a debt trap lasting a decade, even the tiniest change in input conditions has profound implications on the final outcome. We invite readers to come up with their own wacky and wonderful projections of what the futures of the US may look like.

And that one should, indeed, be careful what one wishes for.

The results summarized for the three scenarios:

Total debt: 2013-2022.

The Zero Hedge open source model, for everyone to play around with, can be found here. Remember: don't be a CBO, enable circs!

P.S. don't even think of modelling a recession: everything Refs up then.

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Pimco's El-Erian: Divided US Government No Longer Good for Economy

A divided government no longer benefits the U.S. economy as it did in the past, said Mohamed El-Erian, CEO of fund giant Pimco. In the past, indecisiveness and political stalemates in Washington prevented policymakers from passing laws that got in the way of the private businesses, which were otherwise free to go to work with Washington out of their hair. "It was once fashionable to argue that a divided government was good for the economy," El-Erian wrote in an OpEd appearing in The Huffington Post. "The view then was that politicians would be too busy with political brinkmanship to get in the way of a dynamic private sector. As a result, unfettered by government interference, the private sector was more likely to invest, hire and prosper ... It is hard — very hard — to make this argument today." – MoneyNews

Dominant Social Theme: Government needs to get back to work.

Free-Market Analysis: Presumably, this is an emergent dominant social theme that Mohamed El-Erian is giving voice to. Perhaps it is a subdominant social theme, as well.

The dominant social theme is, of course, that government is good and among humankind's most necessary inventions. The subdominant social theme could be that government has never been more necessary than NOW.

Why? Well, as El-Erian suggests, the world in general, and the US specifically, has a need for a steady hand on the tiller. What he doesn't indicate, of course, is that it is government and central bank monetary policy that has placed Western economies in jeopardy in the first place.

To some degree, of course, El-Erian is "talking his book." He manages US Treasuries and it is not in his interest if the US as an entity and its fixed income instruments are downgraded. He wants the US – and government in general – to be responsive and make necessary changes.

For this reason, he's made this statement – which certainly goes against what has often been repeated in the business community. The idea that a divided government is good for the economy and the private sector has been a favorite truism of political analysis as well.

For the powerful El-Erian to reverse this perspective is a fairly significant event in mainstream financial circles. Here's some more from the article:

"Our self-inflicted fiscal cliff drama may be the most visible illustration of Congressional political dysfunction, but it is unlikely to be the last one or the most challenging," El-Erian wrote.
"It would also undermine the country's longer-term growth potential and, with that, the ability of many citizens to realize the American dream."

Lawmakers themselves say they understand anger on the part of voters when it comes to the fiscal cliff, a potentially recessionary combination of tax hikes and spending cuts due to take effect at year end.

"I don't blame people at home for wondering what in the heck is going on in the nation's capital," said Sen. Mary Landrieu, a Louisiana Democrat who is up for reelection in 2014, according to Politico. "It's hard to explain. ... I don't think it looks good for either party."

Now Mary Landrieu may believe people are wondering what in heck is "going on" in DC (like El-Erian) but we would tend to believe such statements are disingenuous. Did Ms. Landrieu not notice what has become known as the Tea Party? This constituency is not "wondering" about the US government. In aggregate it wishes to dismantle much of it.

It is perhaps unfair to suggest that El-Erian, too, is ignoring what has taken place, but his solution – to utilize current sociopolitical tools more energetically than ever – is perhaps not feasible long term. The system, we would argue, is dysfunctional on purpose.

This is, in fact, the preferred method of the top elites, for whom El-Erian works. Business as usual is the order of the day. In fact, the just resolved (for the moment) Fiscal Cliff is a good example of how these things occur.

Nothing changed for the US as a result of the agreement to avert for the moment the Fiscal Cliff. The debt remained the same, the regulatory structure, the endless fiat money printing of the central bank.
El-Arian may want focused government officials to make necessary changes in the US and throughout the West. But one has to ask, what is it that modern government is to do?

Certainly, El-Erian wants a return to a previous status quo in which government debt was seen as properly apportioned and not overwhelming and in which US consumers – buoyed by easy money – pursued a virtually endless buying spree.

But the trouble is that the current economic system is set up to gradually fail. Central banking creates booms and then gigantic busts and economies both centralize and subside as a result. Eventually, the plan seems to be for world government to gradually emerge. Those who have created the current system have built an environment that like a shark only moves in one direction, forward.

For a number of reasons, then, what El-Erian is asking for may not be realizable. Government officials shall continue to overspend. The culture of corruption will grow. Sooner or later (and probably sooner) El-Erian's US bond market will experience a precipitating event that will burst what some have called the biggest fixed-income bubble ever.

This is no doubt what El-Erian really fears, a destabilizing element that crashes bond prices and causes rates to rise hard and fast. But he is looking at these issues narrowly and obviously does not sense how much the larger sociopolitical conversation has changed in the US.

The dissatisfaction that created the Tea Party has not gone away. While many are proclaiming a US recovery, any real economic advance will generate considerable price inflation. That's because the tens of trillions printed by central banks will surely start to circulate, causing rates to rise and choking off "green shoots" once again.

When it becomes clear to people that this greatest recession since the depression of the 1930s is not really over at all but is destined to go into yet another phase, as it did in the 1970s, whatever patience remains is likely to be exhausted.

El-Erian and others may wish to turn to renewed government activism to "solve" the 21st century problems that government has caused. But those who have set up the current system did not apparently intend for it to remain stable. And what we call the Internet Reformation is likely to continue to undermine people's willingness to put up with the status quo.

For more about what people are learning about the economy thanks to the Internet, see this Daily Bell Special Report: " The Best Free-Market Economics and Pro-Liberty Educational Resource on the 'Net and Why I Use It Religiously."

Conclusion: We are not at all sure that El-Erian's plea for a renewal of activist big government is line with what realistically can – and will – occur. He and others in his position may wish for such an event but we would guess that the opposite may be in the offing, more divisiveness rather than harmony. The 21st century will be nothing like the 20th, in our view.

 

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Pending Foreclosure Fraud Settlement Achieves New Level of Abject Regulatory Failure

After too many years to count of regulatory failure and limp-wristed reforms, it’s hard to be surprised. Nevertheless, I hope to convince you that a yet another mortgage settlement, leaked on New Year’s Eve when hopefully no one would notice, achieves the difficult task of reaching a new level of dereliction of duty.

This latest bank gimmie comes in the retrading of consent orders that were entered into in April 2011. Readers who followed the mortgage beat closely may recall that the OCC broke with other banking regulators, the DoJ, and HUD in entering into its own consent decrees in the hope of undermining the mortgage negotiations. But this OCC settlement (which the Fed joined) was in some ways broader that the one entered into by 49 state attorneys general and various Federal agencies in early 2012, in that it involved the 14 major servicers, while the later state/Federal deal was limited to the biggest five. The banks piously promised to shape up, and were required to conduct reviews of foreclosures performed in a specified time frame if consumers asked for them, plus conduct a review of a sample of other foreclosures.
 
Now a number of observers, including yours truly, called out these settlements as patently ridiculous and rife for abuse Why? Rather than act like a proper regulator, and oversee the review process itself, the OCC outsourced it to consultants hired by the banks! Yes, the OCC would get to review them for conflicts of interest, but who are we kidding? And it was even worse than you can imagine, since the OCC accepted that conflicts would be the norm. As we wrote in July 2011:

If you’ve been following this sorry saga, you may recall that in April of this year, major servicers entered into servicing consent orders with the OCC and Fed. They were clearly all for show. Rather than observer the normal procedure, and have a regulator conduct the exams, the consent orders instead provide for the banks to hire soi-disant independent parties to conduct the reviews. As we and more recently Francine McKenna pointed out, there is pretty much no one with a brand name that is worth renting that doesn’t either have a relationship with the big banks or is keen to develop one. Since the reviews won’t be made public, there is every reason to expect that any problems reported will be strictly cosmetic.

And as we noted in May 2011:

One component of the OCC program was “independent” foreclosure reviews that would be offered to borrowers to determine if they had been harmed by a foreclosure and provide restitution. You have to understand that this was never a good faith effort, even though HUD secretary Donovan trumpeted these assessments as an important part of “social justice.” The purpose of every new bank review process implemented since the Obama administration took office has been to go through the motions of being thorough (typically not convincingly, as with the first stress test and the Foreclosure Task Force demonstrate ) and give a clean bill of health. Having the OCC look at a whole passel of foreclosures and say, “See, the overwhelming majority were OK” would be an important step in turning the clock back to before the robosigning scandal broke.

And as this farce went on, what little information that did come to light was even worse than our low expectations. For instance:

Sheila Bair deemed the consent orders to be inadequate, argued the millions of mortgages were likely “infected”

Obviously conflicted parties hired as consultants (here, here, and here)

Low level, minimally skilled parties hired to do file reviews (advertised pay $23 an hour; a robosigner or call center employee with one year of experience would fit the job description)

Borrowers were shunning the reviews, perhaps because they recognized they could prejudice any case against the banks/servicers

And it indeed turned out the banks were doing all they could to stack the deck against homeowners seeking reviews. First, the GAO determined that the materials were drafted over the heads of most borrowers, at the second year college reading level, in clear violation of Federal “plain language” guidelines. And whistleblowers reported that Wells Fargo was designing the questionnaires to assure it would never find anything wrong. From a post by Abigail Field:

The full revelations of the temp hired, trained and supervised by Promontory Compliance Solutions, working on the Wells Fargo’s OCC independent foreclosure reviews project, are available as a Mandelman blog post and a Mandelman Podcast. But here’s a few highlights to show how rigged the process is:

“I have found errors that should be moved up through the ranks, but am told “quit digging so deep”…”put your shovel away”…Focus on the questions “in scope”… The review forms are set up so no harm could ever be found. It’s equivalent of an attorney presenting his case to a judge with just 20% of the evidence.”

 

and

“The foreclosed victims don’t realize if they do not provide specific dates on the intake forms… their complaints are considered “general comments” out of scope.

 

The kicker? The forms don’t tell people their information will be ignored if the complaints are not dated.

Mandelman reports that the insider

“also says that the questions on Promontory’s form are worded in such a way that it makes it very difficult to ever find fault. For example, by using compound questions, he is often told to answer “no,” when the first part of the question would be a “yes.””

 

A last, flashing neon sign announcing the reviews will protect banks and do no justice is who has been hired to do the reviews. See, here’s the insider that’s willing to talk, and it’s probably why he’s willing to talk:

I have 15 years industry experience in all facets of the mortgage & title industry, and just needed a job at the moment.

 

But this is who he’s working with and for:

some of the people brought in with me do not know the difference between a truth in lending statement, and a note. It’s a shame, these are your reviewers!!! The supervisors don’t want any trouble…they are mostly temps too, just trying to get a promotion to full time.

 

Sounds like no bailed-out bank will be held accountable and no homeowner compensated. Nice product you’re selling there “U.S.” Housing Secretary Donovan.
Indeed, Wells Fargo’s Promontory process apparently found no wrong doing in 9,996 cases out of 10,000 examined. The other four were sent to Wells Fargo for further review but came back as no problem. At least, 0 problems out of 10,000 files is what the insider’s supervisors announced to everybody. I don’t know if the supervisors were telling the truth or just trying to message everyone to not find any problems in any files. Either way it tells you the same thing: the reviewers won’t find anything wrong with the files.

Now what would a competent regulator do when word of this egregious gaming of the process was taking place? Come down on the miscreant’s head like a ton of bricks. But nothing of the sort took place. And this was no surprise. Before the whistleblower report, Georgetown law professor Adam Levitin had concluded:

I think it demolishes even the thin fiction that the OCC/Fed servicing consent orders are anything more than Potemkin villages. Instead, what we have here is nothing less than a federally-blessed Robosigning 2.0.

Now fast forward to the “settlement” revelation of New Year’s Eve, courtesy the New York Times. The first nasty bit is that this deal has been under discussion with the 14 servicers in the consent decree for a month or so, with no inclusion of representatives of borrowers, which is already a big warning sign. Here are the key bits:

Banking regulators are close to a $10 billion settlement with 14 banks that would end the government’s efforts to hold lenders responsible for foreclosure abuses like faulty paperwork and excessive fees that may have led to evictions, according to people with knowledge of the discussions….

In recent weeks within the upper echelons of the comptroller’s office, pressure was mounting to negotiate a banner settlement with the banks, according to people with knowledge of the matter. The reason was that some within the agency had started to realize that a mandatory review of millions of bank loans was not yielding meaningful examples of the banks’ wrongfully evicting homeowners who were current on their payments or making partial payments, according to the people…

Under the terms of the order, the 14 banks had to hire independent consultants to pore through the loan records to determine whether the banks illegally charged fees, forced homeowners to take out costly insurance or miscalculated loan payment amounts. Consultants initially estimated that each loan would take about eight hours, at a cost of up to $250 an hour, to go through.

The costs of the reviews have ballooned, though, according to people with knowledge of the reviews, in part because each loan file is taking up to 20 hours to review. Since its inception, the reviews have cost the banks about $1.5 billion, according to those people.

Before we get any further, we need to stress how patently ridiculous these cost claims are. Notice that one of the things that this review process claims to be doing is reviewing whether borrowers were charged incorrectly. Reviewing the loan files is not going to get you there. You could either check a random sample of consumer records (which would be time consuming but give you insights you could not get any other way) or audit servicer software to see how payments were applied and processed. We’ve discussed for a long time that servicer-driven foreclosures (due to illegal application of charges to borrowers) are a big part of the problem; foreclosure defense lawyers say they represent 50% to 70% of the cases they handle. But this process was never set up properly to diagnose that.

Second is the absurdity of the “up to $250 an hour” and “up to 20 hours a loan file” claims. We’ve spoken at length to mortgage experts; it should take someone competent no more than an hour on average to review a file because there aren’t than many items to review if you are looking for frauds on borrowers as opposed to going on a treasure hunt for file errors, the overwhelming majority of which don’t have any implications as far as borrower harm is concerned.

We interviewed a partner at SolomonEdwards, a firm that has mortgage file reviews and remediation as a line of business and had 600 people deployed on OCC reviews. We deemed the process to be overkil. Even so, they were spending 3 hours on average, vastly less than the level the Times implied:

I called SolomonEdwards to discuss its press release about “scrubbing” loan files and had two conversations totaling over 50 minutes with a partner in this business. What was disconcerting about this discussion what that despite his emphasis on how thorough SolomonEdwards is in inspecting loan files (its software allows it to flag hundreds of items on a file review) and how strict it is in managing conflicts….he seemed remarkably unaware of the differences between how you can handle a loan that a bank owns versus one that was supposed to be transferred to a trust pursuant to a PSA. When I asked specifically about whether their process was different for securitized loans versus bank owned loans, he said that there was not a great deal of differences…

In fact, these reviews sound like documentation theater. The partner stressed how through SolomonEdwards was and how they had software that allowed them to record up data items and capture whether a item was material or not material and then risk rate an entire loan file. They can look at up to 12000 variants (no typo) for the OCC reviews (how many they actually look at depends on the scope of the client engagement; the difference between the number of steps, as he called them, in the OCC reviews versus the typical bank engagement is because the OCC reviews include state law requirements. Needless to say, it’s a bit curious that routine forensic investigations do not include state law matters). He also stressed that they have senior teams working on these projects, 5 years average experience for the OCC work, more than that on bank work, and that on a normal engagement, they would typically spend 3 hours per file, but if a bank had serious documentation problems, it might take as long as 12 hours.

He said that a typical bank engagement would require looking at 100 to 150 items. For a 3 hour process, that’s less than two minutes an item (and remember, that includes the time to log their findings). But the reality is that there are really only 5-10 things you need to look at: Do you have an original note? Does it have all the endorsements that the PSA says it should have? Do the mortgage assignments correspond to the endorsements? Were they all completed on time?

These multi-hour investigations are fee-padding form over substance. But this sort of thing is perfect for the bank-defending OCC, since it would take someone pretty expert to penetrate the fiction that this exercise in counting trees was designed to miss the forest.

I suggest you read the entire post to get a clearer picture of how bad this is. First, it makes clear that this firm, which prides itself on its expertise, really did not get many basic legal issues. It seemed to be working back from what servicers considered to be important in foreclosures, when the problem has been servicers have been running roughshod over the law (I’ve spoken at conferences with servicer employees among the participants, and I get reactions ranging from stunned to outraged when I tell them what the chain of title issues are). Second, this firm, and I suspect its competitors, offers not just “review” services, but “remediation” services as well, which include such dubious practices as document fabrication (creating allonges) and making back-dated mortgage assignments. Thus it isn’t hare to imagine that the reason that the costs have ballooned is not that the reviews are costing this much, but that the reviews are being used as cover to tidy up bad mortgage files.
Look, it is simply not plausible that these reviews have found nothing. The US Trustee found widespread abuses in bankruptcy courts, particularly improper default servicing fees (inflated harges for legal work, property inspections, insurance and appraisals).

From the New York Times account:

But after sifting through the data produced by this investigation, Mr.[Clifford] White [director of the Trustee's executive office] disagreed that problems are rare. “In Senate testimony, an executive from Countrywide said its error rate was 1 percent,” Mr. White recalled. “The mortgage servicer industry error rate might be 10 times higher, based on the number of cases we are looking at.”

“There are continued flaws in the process, and they are not merely technical,” Mr. White continued. “Those flaws undermine the integrity of the bankruptcy system. Many homeowners have been harmed, including where the lender has come in and said ‘we want to lift the stay and go back into foreclosure proceedings,’ even though they lacked a sufficient basis to do it.”

He went on: “There are enough examples of this to know that we are not dealing with small numbers.”

Or consider this case:

In an April 2008 ruling, Elizabeth Magner, a U.S. bankruptcy judge in New Orleans, rejected the two charges [for broker price opinions charged when the parish in which the home was located was evacuated thanks to Hurricane Katrina] as invalid. She also disallowed 43 home inspections, 39 late charges, and thousands of dollars in legal fees charged to the Stewarts’ account.

Almost every disallowed fee was imposed while the Stewarts were making regular monthly payments on their home…

Magner determined that Wells Fargo had been “duplicitous and misleading” and ordered the bank to pay $27,000 in damages and attorneys’ fees. She also took the unusual step of requiring the servicer to audit about 400 home loan files in cases in the Eastern District of Louisiana.

Wells fought successfully to keep the results of the audit under seal, and last summer a federal appeals court overturned the part of Magner’s ruling that required the audit. But two people familiar with the results told iWatch News that Wells Fargo’s audit had turned up accounting errors in nearly every loan file it reviewed.

Or how about the fact that the Michigan Supreme Court just ruled that $3.75 billion of JP Morgan mortgages in that state are voidable? Or how about the guilty plea of Lorraine Brown of the DocX unit of Lender Processing Services, who admitted to preparing and filing over 1 million fraudulently signed and notarized documents? Any foreclosure that relied on them would be subject to question.
Let’s be clear on what happened here. The OCC created a process that was giving the banks a license to cheat. Not only di they cheat, but it’s almost certain they did so on aggressively, on every possible axis, then had the temerity to complain to the authorities that they were running up big consultant bills, when it’s certain these bills were massively inflated (whether due to letting the consultants rape them, or the more likely that they loaded every possible servicer-related bit of activity is moot, the bottom line is the charges bear no relationship to the work that actually needed to get done). This is a variant of a common bank scam, tantamount to killing their parents and then asking for sympathy for being an orphan. And the regulators are too craven, corrupt, or just plain incompetent to bring the banks to heel. They don’t examine the twattle they are served; at best, they are too deeply invested in the fiction of the settlement to admit that this colossal screw-up was completely predictable and undeniably their fault. There is no way to excuse this sort of gross misconduct.

Reader Hugh wrote this about the fiscal cliff yesterday, and it applies here as well:

The two parties, our whole political class, are not stupid or incompetent. They are not good people making mistakes. Nor are they psychopaths making bad decisions. Each of these rationales in some way contains the idea that they are not wholly and completely responsible for their acts. While each of these explanations holds a certain attraction, none of them are true. The truth is a lot simpler. They are criminals acting as criminals. It doesn’t matter what they think. It doesn’t matter what they believe.

Who cares if they equate their good with the general good, and believe the more they take for themselves, the more the general good is served? Would we accept this argument from a car thief, a burglar, or a bank robber? No. So why should we accept it from our political class?

We need to be as serious and hard assed about this as they are. Everytime you see Obama, Boehner, Reid, McConnell, or Blankfein and Dimon, everytime you see any of our political classes remember that they murder more Americans in a year than a dozen bin Ladens did in a lifetime. They steal more in a year than a million Dillingers. They create more destruction than a hundred natural disasters. More pain and suffering than a major epidemic. They are the banality of evil made manifest. We must stop being distracted by that banality and look at them up close and in the face in all their evil and ugliness.
They mean with every atom of their being to loot us to the last drop and beyond if they can. To resist them, we must be as clear eyed and steadfast as they are to destroy us. We must put aside comforting but false stereotypes. We should keep ever present in our mind the evil that they are and the evil that they do. We can not afford to let that image slip an instant from our view, because when we do, they win. They succeed in making their evil appear less, or even no evil at all, and so easier to sell and continue.

We do need to keep this sort of thought foremost in our minds. The feckless conduct of what passes for leadership in America is too well established to pretend that the results are the result of good intentions stymied or gone awry. You can see the gory details above, that the outcome here was no mistake. It was not merely predictable, it was predicted as soon as the settlements were announced.
The political classes have a vested interest in giving “cost of doing business” punishments because no punishment at all undermines their role and what little confidence there is left in the system. But the sooner we understand that their interests are not merely divorced from those of ordinary citizens, but actually opposed to them, the closer we are to coming up with realistic courses of action.

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50 Predictions For 2013

Are you ready for a wild 2013?  It should be a very interesting year.  When the calendar flips over each January, lots of people make lots of lists.  They make lists of "resolutions", but most people never follow through on them.  They make lists of "predictions", but most of those predictions always seem to end up failing.  Well, I have decided to put out my own list of predictions for 2013.  I openly admit that I won't get all of these predictions right, and that is okay.  Hopefully I will at least be more accurate than most of the other armchair prognosticators out there.  It is important to look ahead and try to get a handle on what is coming, because I believe that the rest of this decade is going to be extraordinarily chaotic for the U.S. economy.  The false bubble of debt-fueled prosperity that we are enjoying right now is not going to last much longer.  When it comes to an end, the "adjustment" is going to be extremely painful.  Those that understand what is happening and have prepared for it will have the best chance of surviving what is about to hit us.  I honestly don't know what everybody else is going to do.  Many of the people that don't see the coming collapse approaching will be totally blindsided by it and will totally give in to despair when they realize what has happened.  But there is no excuse for not seeing what is coming - the signs are everywhere.
So with that being said, the following are 50 bold predictions for 2013...

#1 There will be a major fight between the Republicans and the Democrats over raising the debt ceiling.  This will be one of the stories that dominates news headlines in the months of February and March.

#2 Most of the new "revenue" that will be raised by tax increases in 2013 will come out of the pockets of the middle class.

#3 No matter what "fiscal deals" the Democrats and the Republicans make in 2013, the federal budget deficit will still end up being greater than a trillion dollars for the fifth consecutive year.

#4 The credit rating of the U.S. government will be downgraded again in 2013.

#5 The Federal Reserve, along with major central banks all over the globe, will continue to wildly print money.

#6 There will be more criticism of the Federal Reserve in 2013 than at any other time since it was created back in 1913.

#7 The term "currency war" will be used by the media more in 2013 than it was in 2012.

#8 The movement away from the U.S. dollar as the primary reserve currency of the world will pick up momentum.  This will especially be true in Asia.

#9 The economic depressions in Greece and Spain will get even worse and unemployment in the eurozone will go even higher in 2013.

#10 A financial crisis in Europe will cause officials to grasp for "radical solutions" that will surprise many analysts.
#11 The unemployment rate in the United States will be higher by the end of 2013 than it is now.

#12 The percentage of working age Americans with a job will fall below 58 percent by the end of the year.
#13 At least one "too big to fail" bank will fail in the United States by the end of 2013.

#14 By the end of the year, more people than ever will understand what "derivatives" are, and that will be because they have caused major problems in the financial world.

#15 We will see the beginnings of another major housing crisis before the end of 2013 and foreclosure activity will start rising once again.

#16 We will see another new wave of "tent cities" start to go up in communities around the nation before the end of the year.

#17 There will be another major drought in the United States this upcoming summer and there will be widespread crop failures once again.

#18 The massive dust storms that we have seen roll through cities like Phoenix in recent years will become even larger and even more intense.

#19 Traffic along the Mississippi River will be significantly interrupted at some point during 2013.  This will be a very negative thing for the economy.

#20 Food prices will soar in 2013.  This will especially be true for meat products.

#21 In some of the poorer areas of the globe, major food riots will break out.  Governments will have trouble containing the civil unrest.

#22 There will be more genetically-modified foods in our supermarkets than ever before, and more Americans than ever will reject them and will seek out alternatives.

#23 The average price of a gallon of gasoline in 2012 was about $3.60.  The average price of a gallon of gasoline in 2013 will be lower than that.  Yes, you read that correctly.

#24 The number of vehicle miles driven in the United States will continue to decline in 2013.

#25 The Dow will end 2013 significantly lower than it is right now.

#26 When the final statistics for 2013 are compiled, U.S. share of global GDP will be less than 20 percent for the first time in modern history.  Back in the year 2001, our share of global GDP was 31.8 percent.

#27 The U.S. Postal Service will continue to experience massive financial difficulties and will lay off personnel.

#28 As violence in our public schools becomes increasingly worse, more Americans families than ever will decide to home school their children.

#29 The Obama administration and Democrats in Congress will make an all-out attempt to pass gun control measures in 2013.  When their efforts on the legislative front are stalled somewhat by Republicans in the House, Obama will use his executive powers to further his gun control agenda.

#30 One of the cities with the strongest gun laws in the nation, Chicago, had 532 murders in 2012 and it is now considered to be one of the most dangerous cities on the planet.  By the end of 2013, the murder total in Chicago will be above 600.

#31 There will be an increasing amount of tension between state governments and the federal government.  The issue of "states rights" will move front and center at various points in 2013.

#32 CNN will continue to sink to horrifying new lows.  Piers Morgan will end up leaving the network before the end of the year.

#33 The number of Americans on food stamps will surpass 50 million for the first time ever at some point during 2013.

#34 The U.S. trade deficit with China in 2013 will be well over 300 billion dollars.

#35 The phrase "made in China" will increasingly be viewed as a reason not to buy a product as Americans become more educated about the millions of good jobs that we have lost to China over the past decade.

#36 We will see increasing cooperation between the governments of the United States, Canada and Mexico and border restrictions will be loosened.

#37 There will continue to be a mass exodus of families and businesses out of the state of California.  The favorite destination will continue to be Texas, but Texas residents will become increasingly resentful of all of these new transplants.

#38 There will be some truly jaw-dropping examples of violence by parents against their own children in 2013.  Many of these stories will make headlines all over the nation.

#39 The percentage of Americans that are obese will continue to rise and will set another new all-time record in 2013.

#40 There will be more war in the Middle East in 2013.  But it will only set the stage for even more war in the Middle East in 2014 and 2015.

#41 U.S. troops will be deployed in more countries than ever before in 2013.

#42 Volcanic eruptions and major earthquakes along the Ring of Fire will make headlines all over the globe in 2013.

#43 Giant sinkholes will continue to appear all over the United States and all over the globe, and scientists will continue to struggle to find an explanation for why it is happening.

#44 The peak of the solar cycle in 2013 will cause significant problems for satellite communications.

#45 The U.S. government will put more resources into the surveillance of the American people than ever before, but most Americans won't mind all of this surveillance because they have become convinced that it is important to give up some of our liberties for more "security".

#46 Our infrastructure (roads, bridges, tunnels, airports, sewers, electrical grids, etc.) will be in worse shape by the end of 2013 than it is now.

#47 The percentage of "two parent households" in the United States will continue to decline.

#48 "Political correctness" will reach ridiculous new heights during 2013, and more Americans than ever will start to rebel against it.

#49 There will be more anger at the wealthy in 2013 than at any other time in modern history.

#50 There will be some shocking political scandals in Washington D.C. in 2013.  We will see some high profile resignations by the end of the year.

Once again, please keep in mind that I do not expect to be 100% correct about all of these things.  I am just trying to put all of the pieces of the puzzle together just like everyone else is.

But I do hope to have a better track record than most of the other people putting out lists of predictions at the beginning of this year.  So save this list and let's revisit it at the end of the year.

Do you have any bold predictions of your own for 2013?  Please feel free to share them by posting a comment below...

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Goldman Sachs Contributes to the Military/Corporate/Financial Complex

Oliver Stone recently appeared on CBC describing his new ten-hour series called Oliver Stone's Untold History of the United States. It will be an interesting series to watch. In the interview, he described the US as three "countries" each vying for its own space:--the first, is the USA population of the country within its continental borders; the second, is the huge military component of the economy and, third, the financial system. Each has its own objective but the military and financial objectives include power that does not recognize the public purpose for which the government was originally created.

Eisenhower warned the people of the United States about power being aggregated in any one sector including the military and the industrial components.

"In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military/industrial complex. The potential for the disastrous rise of misplaced power exists and will persist." (Eisenhower's speech, 1961)

However, he did not foresee that the industrial part of the economy would be decimated by outsourcing in the search for cheap labor and he may not have envisaged the power of the banks in the 21st Century. So the thing to beware of is the "military, corporate and financial complex" which we now suffer within.

Through what means does the financial system, for example, achieve such power and political influence? See the following article which shows how those creating the rules and regulations for a better financial system easily move from making laws to working for those for whom the laws are being created! What a full-blown conflict of interest is brought about which will in no way resolve any of the financial problems brought to us by the banks.

Goldman Sachs is a leader in these revolving door relationships between government rule-making and banking fraud.

The CFTC is chaired by a former Goldman Sachs guy, Gary Gensler, who is attempting to make new rules under Dodd-Frank.

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