In a December 2007 article in The San Francisco Chronicle, attorney Sean Olender stated that the actual purpose for the Treasury Department’s planned subprime bailout schemes was to avoid a flood of litigation against the banks. The goal at the time was to freeze interest rates on a small number of subprime loans. Olender penned:
“The entire purpose of the freeze is to prevent mortgage-backed securities owners, many of whom are foreigners, from suing US banks and forcing them to pay back worthless mortgage securities at face value, which is currently nearly 10 times their market value.” The financial system’s ticking time bomb isn’t resetting subprime mortgage rates. The main issue is that investors in mortgage bonds have the contractual right to force banks to buy back loans at face value if there was fraud during the origination process.
“The disastrous effects of bond investors forcing originators to buy back loans at face value are beyond the scope of the current media debate.” The loans at issue outweigh the total capital available at the largest U.S. banks, and investor lawsuits would expose them to staggering liability, causing even the largest U.S. banks to fail, culminating in major taxpayer-funded bailouts of Fannie and Freddie, as well as the FDIC. …………………………
“It would be prudent and logical for the banks that sold this toxic garbage to purchase it back, and a large number of people to go to prison.” They should have to purchase back the bonds if they were aware of the deception.” 1
Even the most powerful investment bankers, notably Treasury Secretary Henry Paulson, who led Goldman Sachs during the peak of hazardous subprime paper-writing from 2004 to 2006, would get a shiver at the prospect. Mortgage fraud is found in the architecture of banks’ “financial products,” not just in the promises made to borrowers or on loan documentation. Securitized mortgage debt has become so complex that ownership of the underlying security is sometimes lost in the jumble; and without a legal owner, there is no one with the authority to foreclose. Because of this procedural flaw, Federal District Judge Christopher Boyko ruled in October 2007 that Deutsche Bank lacked standing to foreclose on 14 mortgage loans held in trust for a group of mortgage-backed securities investors. 2 Trillions of dollars in mortgage-backed securities (MBS) could be jeopardized if a large number of delinquent homeowners challenge their foreclosures on the grounds that the plaintiffs lack standing to suit. Irate security holders may then file lawsuits, putting the financial Goliaths’ existence in jeopardy.
STATES AT THE FOREFRONT OF THE CHARGE
State and municipal governments, which hold considerable sections of their assets in MBS and comparable investments, are among the MBS investors with the power to file major cases. A complaint filed by the State of Massachusetts against investment bank Merrill Lynch on February 1, 2008, for fraud and misrepresentation relating around $14 million worth of subprime securities offered to the city of Springfield, was a foreshadowing of things to come. The lawsuit focused on the sale of “certain complex financial instruments known as collateralized debt obligations (CDOs)” that were “unsuitable for the city” and “become illiquid and lost nearly all of its market value within months of the sale.” 3
The city of Baltimore had sued Wells Fargo Bank for damages related to the subprime mortgage crisis earlier this month, alleging that the bank had willfully discriminated by offering high-interest mortgages to blacks more frequently than whites, in violation of federal law.
Cleveland Mayor Frank Jackson filed a complaint against 21 major investment banks in January 2008, accusing them of fueling the subprime lending and foreclosure crises in his city. The claim was filed against investment banks that profited from the subprime mortgage industry by purchasing them from lenders, “securitizing” them, and then selling them to investors. Officials from the city said they planned to recoup hundreds of millions of dollars in damages from the banks, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned homes. Deutsche Bank, Goldman Sachs, Merrill Lynch, Wells Fargo, Bank of America, and Citigroup were among the defendants. They were accused of establishing a “public nuisance” by buying and selling high-interest home loans in an irresponsible manner, resulting in massive defaults that decimated the city’s tax base and left neighborhoods in shambles.
“This is no different to me than organized crime or drugs,” Jackson told The Plain Dealer in Cleveland. “It has the same effect as neighborhood drug activity.” It’s a type of organized crime that happens to be lawful in a lot of ways.” “This lawsuit stated, ‘You’re not going to do this to us anymore,'” he said in a videotaped interview. 5
The Plain Dealer also spoke with Ohio Attorney General Marc Dann, who was considering suing some of the same investment institutions on behalf of the state. “Clearly, something went wrong,” he continued, “and the source is Wall Street.” I’m delighted I’m not alone in my search.”
On the way to the courthouse, however, something amusing occurred. Attorney General Dann, like New York Governor Eliot Spitzer, resigned in May 2008 amid a sexual harassment probe in his office. 6 Both prosecutors were hard on the trail of the banks before they were forced to quit, aiming to hold them accountable for the disastrous wave of house foreclosures in their districts.
The hits, on the other hand, keep coming. California Attorney General Jerry Brown sued Countrywide Financial Corporation, the nation’s largest mortgage lender, in June 2008, for illegally promoting hazardous loans to consumers, resulting in thousands of foreclosures. The 46-page complaint claimed, among other things:
“‘Defendants considered borrowers as nothing more than a conduit to generate more loans, originating loans with little or no concern for borrowers’ long-term ability to finance them and to maintain homeownership’…
“Despite ‘many complaints from borrowers claiming that they did not comprehend their loan terms,’ the corporation habitually ‘turned a blind eye’ to misleading actions by brokers and its own loan representatives.”
“…underwriters who confirmed information on mortgage applications were ‘under enormous pressure… to complete 60 to 70 loans every day,’ which made careful evaluation of applicants’ financial situation and the suitability of the loan product for them practically impossible.’
“The high-pressure sales environment and compensation system at Countrywide encouraged serial refinancing of Countrywide loans.”
Illinois and Florida have both brought similar lawsuits against Countrywide and its CEO. These lawsuits seek not just monetary damages, but also the cancellation of the loans, posing a potential nightmare for banks.
AN ONSEIGNMENT OF CLASS ACTIONS?
Defrauded borrowers may also file large-scale class action lawsuits. U.S. District Judge Lynn Adelman ruled in 2007 in Wisconsin that Chevy Chase Bank had violated the Truth in Lending Act by concealing the terms of an adjustable rate loan, and that tens of thousands of other Chevy Chase borrowers might join the plaintiffs in a class action on that basis. According to a Reuters story from June 30, 2008:
“By determining that the borrowers might force the bank to cancel, or rescind, their loans, the judge changed the case from a routine class action to a potential nightmare for the US banking industry.” The ruling was put on hold pending the outcome of an appeal to the 7th United States Circuit Court of Appeals, which is likely to rule soon.
“The idea of canceling tainted loans to stop the flood of foreclosures has gained traction in other quarters; an Illinois attorney general lawsuit filed last week asks a court to withdraw or alter Countrywide Financial mortgages obtained through ‘unfair or misleading tactics.’
“…the mortgage banking industry is already under fire from state and federal authorities, who accuse banks of lowering underwriting standards and forcing some borrowers into pricey adjustable loans through fraud, which the banks then packaged and sold as high-interest investment vehicles.”
The Truth in Lending Act (TILA) was enacted in 1968 to protect customers from bank loan fraud by demanding full disclosure of loan conditions and fees. When a lender is determined to be in breach, it allows consumers to seek rescission or termination of a loan, as well as the refund of any interest and fees. According to California bankruptcy expert Cathy Moran, the statute’s beauty is that it allows for strict responsibility, which means that disgruntled borrowers don’t have to prove they were personally tricked or misled, or that they suffered substantial damages. They have the authority to revoke and deprive the lenders of interest simply because the disclosures were inadequate. In Moran’s limited sample, TILA violations were found in at least half of the loans. 8 If class actions are deemed to be eligible for rescinding loans due to fraud in the disclosure process, expect a flood of class lawsuits against banks across the country. 9
RETURNING THE LOSS TO THE BANKS
Rescission may be a viable option for both borrowers and MBS investors. Many loan sale agreements stipulate that lenders must take back loans that default exceptionally soon, contain errors, or are fraudulent. For the banks, an avalanche of rescissions may be disastrous. Banks were offloading loans from their books and selling them to investors, allowing them to make many more loans than would otherwise be permitted by banking restrictions. The banking rules are complicated, but a bank’s loan portfolio is supposed to be limited to around $10 for every dollar of shareholder capital on its balance sheet. The challenge for banks is that when the process is reversed, the 10 to 1 rule can work in the opposite direction: reclaiming a dollar of bad debt can lower a bank’s lending potential by a factor of ten. According to Prof. Nouriel Roubini, as quoted in a BBC News story:
“[S]ecuritization was critical in assisting banks in avoiding the 10:1 rule imposed by regulators. To make their dangerous loans appear more appealing to buyers, banks utilized sophisticated financial engineering to repackage them as super-safe investments that earned far higher returns than comparable super-safe products. Banks have even discovered ways to remove loans from their balance sheets without selling them. They developed odd new financial organizations known as Special Investment Vehicles, or SIVs, in which loans could be held off balance sheet, out of sight, and outside the reach of regulators’ laws. SIVs, once again, freed up balance sheet space for banks to lend.
“Banks had gotten around regulators’ requirements by selling off their problematic loans, but the losses were remained inside the financial system because so many of the securitised loans were bought by other banks.” SIV loans were nominally off banks’ balance sheets, but when the value of the loans inside SIVs began to fall, the banks who put them up discovered that they were still liable. As a result, losses from investments that looked to be outside the scope of the regulators’ 10:1 rule began to show up on bank balance sheets. The challenge that many of the largest lenders are currently experiencing is that when losses show on their balance sheets, the regulator’s 10:1 rule kicks in since losses lower a bank’s shareholder capital. ‘If you have a $200 billion loss that reduces your capital by $200 billion, you must limit your lending by ten times that amount,’ adds [Prof. Roubini]. ‘So you may have a two-trillion-dollar drop in total credit to the economy.’ 10
It’s also possible that some banks will go insolvent. At the conclusion of the third quarter of 2007, the top 100 US banks had $800 billion in total equity. Banking losses are likely to increase by up to $450 billion, wiping out more than half of the banks’ capital bases and rendering many of them bankrupt. 11 The outcome could be even worse if debtors flood the courts with legitimate defenses to their obligations and mortgage-backed securities holders contest their securities.
RETURNING THE GENIE TO THE BOTTLE
So, what if the mega-banks who are involved in these dangerous tactics went bankrupt? These banks are widely considered to be at fault, but because they are “too big to fail,” they expect to be bailed out by the Federal Reserve or taxpayers. The idea is that if they are allowed to fail, they will bring down the entire economy with them. That is the fear, but it is not based on reality. We do require a fast supply of credit, thus banks are required; but, private banks are not required. Banks do not lend their own money or even their depositors’ money, which is a little-known, well-kept secret. They make the money they lend, and making money is a public rather than a private activity. The Constitution gives Congress, and only Congress, the right to create money. 12 Banks are just extending credit when they make loans, and the right entity for extending “the full faith and credit of the United States” is the United States.
More than only the fair treatment of harmed homeowners and investors in mortgage-backed securities is at issue. Banks and financial firms are squeezing the last drops of blood from the US government’s credit rating by “borrowing” money and offloading worthless paper on the government and taxpayers. The banks, stock brokerages, and hedge funds for wealthy investors will be saved after the dust settles. The repossessed will become the dispossessed, and unless your pension fund has invested in politically connected hedge funds, you can probably say goodbye to it, as Florida teachers have already done.
The banking genie, on the other hand, is a creature of the law, and the law has the power to put it back in its bottle. The impending demise of a few large banks could provide the government a chance to reclaim control of its finances. More importantly, it might give the finances needed to address previously unsolvable challenges that are now threatening to ruin our level of living and global stature. The only long-term solution is to remove the power of money creation away from private bankers and give it back to the people collectively. That should have been the case all along, and it was in our early history; yet, we have become so accustomed to banks being private enterprises that we have forgotten about our forefathers’ public banks. In Benjamin Franklin’s province of Pennsylvania, a government-owned bank produced money and lent it to farmers at 5% interest. The government received the interest, which was used to replace taxes. During the decades when that system was in place, Pennsylvania was tax-free, inflation-free, and debt-free.
Instead of bailing out bankrupt banks and sending them on their way, the Federal Deposit Insurance Corporation (FDIC) should examine their records and place any that are found to be insolvent into receivership. Unlike the Federal Reserve, the FDIC is a federal organization with the power to take a bank’s stock in exchange for bailing it out, thus nationalizing it. This is how failed banks in Europe are handled, and it’s how Continental Illinois, the country’s fourth largest bank, was handled when it went bankrupt in the 1990s.
A system of really “national” banks might issue “the full faith and credit of the United States” for public objectives such as infrastructure finance, renewable energy development, and health care.
13 Credit supplied by the government could also help to alleviate the subprime crisis. Local governments might use it to purchase defaulted mortgages, compensating MBS investors and releasing the property for public sale. The residences may then be rented back to the residents at fair rates, allowing individuals to stay in their homes without the financial benefit of owning a home without having to pay for it. A lease-to-own program could likewise be implemented. The proceeds would be used to repay the credit used to purchase the mortgages, bringing the money supply back into balance and preventing inflation.