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On Our Rotten Financial System

Posted by Karl Denninger

So today Goldman will come before the Senate Permanent Committee on Investigations – with Lloyd himself, along with “Fabulous Fab” on the witness panel.

Blankfein’s prepared testimony makes some interesting claims:

“We didn’t have a massive short against the housing market, and we certainly did not bet against our clients,” Blankfein says in prepared remarks released by the company. “Rather, we believe that we managed our risk as our shareholders and our regulators would expect.”

Uh, Lloyd, are you sure?

Carl Levin, a Michigan Democrat who leads the Senate’s Permanent Subcommittee on Investigations, released documents that he said showed the company “put its own interest and profit ahead of the interests of its clients,” a conflict he called on Congress to end. Lloyd Blankfein, Goldman Sachs’s chairman and chief executive officer, will dispute that assertion and argue the firm was merely managing its own risk.

Yep. 

It’s amusing how Goldman claims it “lost money” on some of these deals.

So what?

The question is not whether there were residual pieces of trash that Goldman wound up (unwillingly) eating when they couldn’t sell them.  The question is whether or not Goldman (and everyone else) should have had the ability to put these deals together in the first place, and how it came to be that trillions of dollars of alleged “AAA” paper was better suited for use in the men’s bathroom stalls!

Levin said:

“This market is not free until it is free of self-dealing and until it is free of conflict of interest,” Levin, 75, said at a press briefing yesterday. “It is not free until it ends the gambling operation that results in gambling debts that the public ends up paying.”

That can’t happen until we see handcuffs Senator. 

“The SEC and the courts will resolve the legal question of whether Goldman’s actions broke the law,” Levin said. “The question for us is whether Goldman’s actions in 2007 were appropriate and whether we should act, legislatively, to bar similar actions in the future.”

17 pages Senator.  They’re called “Glass Steagall”, and that law absolutely barred the conduct that led to and caused this crisis.

Let’s be frank: Creating these sorts of toxic deals is, for these institutions, simply a reach for fees.  They don’t care if they perform so long as they don’t get stuck with the trash.  A particular transaction was even referenced as “one shi&&y deal” by Goldman employees, according to some internal emails:

“Boy that timberwo[l]f was one shi**y deal,” Montag, who is now Bank of America Corp.’s president of global banking and markets, said in a June 22, 2007, e-mail to Daniel Sparks, who ran Goldman Sachs’s mortgage business at the time, according to the panel’s statement. Within five months of Timberwolf’s debut, the CDO had lost 80 percent of its value, and it was liquidated in 2008, according to the panel.

The CDO was among securities that Goldman Sachs sold to clients after deciding the New York-based firm needed to reduce its mortgage holdings, Carl Levin, a Michigan Democrat who leads the panel, said in the statement. Chief Executive Officer Lloyd Blankfein and six other current and former executives will testify tomorrow in front of the panel about practices in mortgage securities markets before they collapsed.

And of course such conduct, and the people who commit it, aren’t fired.  Mr. Montag is now Bank of America’s president of Global Banking and Markets.  “Market discipline” doesn’t, it appears, extend to forcing people to eat their own cooking and when they sell things they know smell like dead fish to clients, it’s all ok.

Perhaps it is under the law, but whether it should be is another matter.

It is often argued that if we don’t permit this sort of “innovation” that our economy and businesses will suffer.  Really?  Who suffers?  Wall Street?  Can we reasonably have an economy where 1/3rd of all profits made in the nation are “earned” by asset-stripping other people?  That’s what even the good deals do – they turn over a part of the transactional flow of some business to the wall street banks, which then keep it for themselves. 

The bad deals, like this one referenced, are even worse in that they siphon off fees from someone who later loses all their money!

This is not restricted to Goldman, by the way.  Indeed, let’s examine another deal that the government was intimately involved in, this first reported by Zerohedge in the form of the Fannie Mae Preferred offering that was foisted on the market just weeks before the firm blew up.

The underwriters, who coincidentally received 3.15% of $2 billion, or $63 million bucks, include Merrill Lynch (now absorbed), Citibank (rescued), Morgan Stanley, UBS (who has a running spat with the IRS about assisting Americans in illegally evading taxes) and Wachovia (which collapsed in a ball of fire that was contained only by forced marriage to Wells Fargo.) 

Why was this deal so insanely toxic?  It was issued on May 19th of 2008, and paid exactly one coupon before Fannie was absorbed into conservatorship. 

And unlike the “sophisticated investors” who bought CDOs and other similar trash from the big banks, this deal was bought by literal widows and orphans, along with community banks.

I would argue that it should have never been brought to the market in the first place, as before it was offered I had opined (in public in fact) that Fannie and Freddie were both insolvent.

Indeed, on March 8th of 2008 I called out the games in a letter written to President Bush and others in which I said (among other things):

Mr. Bernanke and The Fed have lowered the Fed Funds Target from 5.25% to 3% over the last few months and the “slosh”, or free funds available in the Fed Banking System, has nearly doubled over that time. Yet this additional liquidity has done nothing to address the problem and won’t because the issue is not one of inadequate liquidity; rather it is a desperate move to hide the fact that a significant number of financial institutions in our nation are, if forced to mark all their paper to the market and recognize their exposure to off balance sheet vehicles, insolvent.

At the root of the matter, Mr. President, is a lack of trust caused by the intentional acts of these institutions, and lack of regulatory enforcement by both the Federal Reserve and other agencies such as the OTS and OCC.

We have fixed exactly nothing since then.  We have only papered over the insolvencies with government fiat currency, claiming they’re “loans” – and they are in a sense – they’re forced purchases of bankrupt companies by the taxpayer which we are now liable for.

Wall Street created this monster with the full knowledge and permission of the government. 

Despite laws prohibiting executives from signing off on fraudulent financial statements – that is, any financial statement that does not make a full and fair exposition of the firm’s financial position (Sarbanes-Oxley) these executives have not been prosecuted.  “I didn’t know” is not a defense under Sarbox – if you’re in the executive suite of a public firm you have an affirmative duty to know. 

So why have not the former CEOs of Bear Stearns and Lehman been indicted?  Why have not the CEOs of the other big banks that failed, all of whom proclaimed that everything was fine right up until they blew sky high? 

As for all these hinky deals that the big banks did, if this crisis has taught us one thing it is that if there’s a way to game a rule or regulation it will be gamed.  So long as these firms can find a way to play “heads we win, tails taxpayers lose” they will do so.  So long as they can effectively force companies to forfeit 30% of every dollar of GDP produced in this nation to them, they will do so.

So long as firms with access to federal assistance of any sort, whether it be The Fed window, overnight repo loans from or by firms with Fed Clearing access, or the privilege of deposit-taking and fractional loan-making exists, these firms will leverage government-provided backstops to their own benefit for the purpose of fee extraction. 

These fees do not benefit society as a whole.  They are in fact a tax on top of all other taxes that firms and thus individuals pay.  This burden is, today, roughly 30% of GDP, and our nation and its economy simply cannot afford to redirect this vast amount of wealth to a handful of rich and powerful people on Wall Street, whether their acts are founded in illegal conduct or not.

17 pages Senator.  That’s all it takes.

Reinstate Glass-Steagall and force all these banks to spin off the parts of their organizations that are in conflict.  All institutions that want access to any sort of public safety net, whether it be Fed Discount loans or FDIC insurance may not trade in or on the securities and insurance markets – OTC or otherwise – period.

Force all instruments onto a public exchange, including all CDS, without exception.  This immediately forces nightly margin supervision which prevents the sort of detonations that happened with AIG and others, and absolutely bars contagion, as no firm can maintain a position that it cannot back with capital.

It is often said that if we do this firms will “flee” to other nations that don’t have such restrictions.  No they won’t – not if we refuse to grant them access to our securities markets and the firms in them unless they comport with these rules worldwide no matter where they are headquartered. 

America is a vast economy.  Yes, China is growing, but we’re still a plurality of world GDP. 

Firms will threaten Senator, but if the law is crafted such that if they want access to our markets in any form or fashion they must comply worldwide with separation of function and exchange clearing, they will comply.

Yes, they’ll make “less money”, and that’s their argument against such changes. 

But let’s be frank – every dollar Wall Street “makes” it in fact extracts.  That is, Wall Street creates nothing.  It siphons off capital from other production – that’s all it can do, since it creates not one car, television, or cellular phone.  Indeed, every dollar of fees extracted by Wall Street and every dollar of interest paid to those firms is one dollar that cannot be returned to the economy in the form of innovation for the production of goods and services.

The essential functions of clearing payments and matching those who wish to loan capital with those who wish to borrow it is ministerial.  All the hinky deals alleged to “spread risk” have now been proved to do no such thing, but instead are complex simply so as to be difficult to understand and thus easy to intentionally misprice. 

That mispricing is fraud Senator, whether it can be legally labeled as such or not, and until we put a stop to it we will continue to have these bouts of crisis, each worse than the last.

Our government and society cannot withstand another banking system attack run, and it is imperative that The Senate, along with prosecutors, put a stop to it both through legislation and prosecution.

We have one last chance to stop it.  If we do not at this time do so, and another ”market failure” occurs, our economy and even our political system – that is, our society and republican form of government – will fall.

Those are the stakes, and the question before you now is whether the bribery that is rampant in Washington (although we call it “lobbying”) will win, or whether you will rise to the occasion and uphold the oath of office that you, along with every other member of Congress, took before being seated.

Secret AIG Document Shows Goldman Sachs Minted Most Toxic CDOs

Feb. 23 (Bloomberg) — When a congressional panel convened a hearing on the government rescue of American International Group Inc. in January, the public scolding of Treasury Secretary Timothy F. Geithner got the most attention.

Lawmakers said the former head of the New York Federal Reserve Bank had presided over a backdoor bailout of Wall Street firms and a coverup. Geithner countered that he had acted properly to avert the collapse of the financial system.

A potentially more important development slipped by with less notice, Bloomberg Markets reports in its April issue. Representative Darrell Issa, the ranking Republican on the House Committee on Oversight and Government Reform, placed into the hearing record a five-page document itemizing the mortgage securities on which banks such as Goldman Sachs Group Inc. and Societe Generale SA had bought $62.1 billion in credit-default swaps from AIG.

These were the deals that pushed the insurer to the brink of insolvency — and were eventually paid in full at taxpayer expense. The New York Fed, which secretly engineered the bailout, prevented the full publication of the document for more than a year, even when AIG wanted it released.

That lack of disclosure shows how the government has obstructed a proper accounting of what went wrong in the financial crisis, author and former investment banker William Cohan says. “This secrecy is one more example of how the whole bailout has been done in such a slithering manner,” says Cohan, who wrote “House of Cards” (Doubleday, 2009), about the unraveling of Bear Stearns Cos. “There’s been no accountability.”

CDOs Identified

The document Issa made public cuts to the heart of the controversy over the September 2008 AIG rescue by identifying specific securities, known as collateralized-debt obligations, that had been insured with the company. The banks holding the credit-default swaps, a type of derivative, collected collateral as the insurer was downgraded and the CDOs tumbled in value.

The public can now see for the first time how poorly the securities performed, with losses exceeding 75 percent of their notional value in some cases. Compounding this, the document and Bloomberg data demonstrate that the banks that bought the swaps from AIG are mostly the same firms that underwrote the CDOs in the first place.

The banks should have to explain how they managed to buy protection from AIG primarily on securities that fell so sharply in value, says Daniel Calacci, a former swaps trader and marketer who’s now a structured-finance consultant in Warren, New Jersey. In some cases, banks also owned mortgage lenders, and they should be challenged to explain whether they gained any insider knowledge about the quality of the loans bundled into the CDOs, he says.

‘Too Uncanny’

“It’s almost too uncanny,” Calacci says. “If these banks had insight into the underlying loans because they had relationships with banks, originators or servicers, that’s at the least unethical.”

The identification of securities in the document, known as Schedule A, and data compiled by Bloomberg show that Goldman Sachs underwrote $17.2 billion of the $62.1 billion in CDOs that AIG insured — more than any other investment bank. Merrill Lynch & Co., now part of Bank of America Corp., created $13.2 billion of the CDOs, and Deutsche Bank AG underwrote $9.5 billion.

These tallies suggest a possible reason why the New York Fed kept so much under wraps, Professor James Cox of Duke University School of Law says: “They may have been trying to shield Goldman — for Goldman’s sake or out of macro concerns that another investment bank would be at risk.”

Poor Performers

Goldman Sachs spokesman Michael DuVally declined to comment.

Schedule A also makes possible a more complete examination of why AIG collapsed. Joseph Cassano, the former president of the AIG Financial Products unit that sold the swaps, said on a December 2007 conference call that his firm pulled back from selling swaps on U.S. subprime residential CDOs in late 2005. The list shows that the $21.2 billion in CDOs minted after 2005, mostly based on prime and commercial mortgages, performed as badly as or worse than the earlier subprime vintages.

A lawyer for Cassano declined to comment.

As details of the coverup emerge, so does anger at the perceived conflicts. Philip Angelides, chairman of the Financial Crisis Inquiry Commission, at a hearing held by his panel on Jan. 13, questioned how banks could underwrite poisonous securities and then bet against them. “It sounds to me a little bit like selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars,” he said.

‘Part of the Coverup’

Janet Tavakoli, founder of Tavakoli Structured Finance Inc., a Chicago-based consulting firm, says the New York Fed’s secrecy has helped hide who’s responsible for the worst of the disaster. “The suppression of the details in the list of counterparties was part of the coverup,” she says.

E-mails between Fed and AIG officials that Issa released in January show that the efforts to keep Schedule A under wraps came from the New York Fed. Revelation of the messages contributed to the heated atmosphere at the House hearing.

“What date did you know there was a coverup?” Republican Congressman Brian Bilbray of California demanded of Geithner. Lawmakers used the word coverup more than a dozen times as they peppered Geithner with questions.

Geithner said that he wasn’t involved in matters of disclosure and that his former colleagues did the best they could. In a Jan. 19 statement, the New York Fed said, “AIG at all times remained responsible for complying with its disclosure requirements under the securities laws.”

The government has committed more than $182 billion to AIG and owns almost 80 percent of the company.

Document Withheld

In late November 2008, the insurer was planning to include Schedule A in a regulatory filing — until a lawyer for the Fed said it wasn’t necessary, according to the e-mails. The document was an attachment to the agreement between AIG and Maiden Lane III, the fund that the Fed established in November 2008 to hold the CDOs after the swap contracts were settled.

AIG paid its counter­parties — the banks — the full value of the contracts, after accounting for any collateral that had been posted, and took the devalued CDOs in exchange. As requested by the New York Fed, AIG kept the bank names out of the Dec. 24 filing and edited out a sentence that said they got full payment.

The New York Fed’s January 2010 statement said the sentence was deleted because AIG technically paid slightly less than 100 cents on the dollar.

Paid in Full

Before the New York Fed ordered AIG to pay the banks in full, the company was trying to negotiate to pay off the credit- default swaps at a discount or “haircut.”

By March 2009, responding to a request from Christopher Dodd, chairman of the Senate Committee on Banking, Housing and Urban Affairs, AIG released the names of the counterparty banks. In a filing later that month, AIG included Schedule A, showing bank names while withholding all identification of the underlying CDOs and the amounts of collateral each bank had collected. The document had more than 800 redactions.

In May 2009, AIG again filed Schedule A, this time with about 400 redactions. It revealed that Paris-based Societe Generale got the biggest payout from AIG, or $16.5 billion, followed by Goldman Sachs, which got $14 billion, and then Deutsche Bank and Merrill Lynch. It still kept secret the CDOs’ identification and information that would show performance.

‘Right to Know’

“This is something that belongs in the public domain because it was done with public money,” Issa says. “The public has the right to know what was done with their money and who benefited from it.” Now, thanks to Issa, the list is out, and specific information about AIG’s unraveling can be learned from it.

At the Jan. 27 hearing, the New York Fed was still arguing that the contents of Schedule A shouldn’t be fully disclosed. Thomas Baxter, the New York Fed’s general counsel, testified that divulging the names of the CDOs could erode their value: “We will be hurt because traders in the market will know what we’re holding.”

Tavakoli calls that wrong. With many CDOs, providing more information to the market will give the manager a greater chance of fetching a realistic price, she says.

Jack Gutt, a spokesman for the New York Fed, declined to comment, as did AIG’s Mark Herr.

Bad to Worse

Tavakoli also says that the poor performance of the underlying securities (which are actually specific slices or tranches of CDOs) shows they were toxic in the first place and were probably replenished with bundles of mortgages that were particularly troubled. Managers who oversee CDOs after they are created have discretion in choosing the mortgage bonds used to replenish them.

“The original CDO deals were bad enough,” Tavakoli says. “For some that allow reinvesting or substitution, any reasonable professional would ask why these assets were being traded into the portfolio. The Schedule A shows that we should be investigating these deals.”

Among the CDOs on Schedule A with notional values of more than $1 billion, the worst performer was a tranche identified as Davis Square Funding Ltd.’s DVSQ 2006-6A CP. It was held by Societe Generale, underwritten by Goldman Sachs and managed by TCW Group Inc., a Los Angeles-based unit of SocGen, according to Bloomberg data. It lost 77.7 percent of its value — though it isn’t in default and continues to pay.

SocGen spokesman James Galvin and TCW spokeswoman Erin Freeman declined to comment.

Documentation Needed

Ed Grebeck, CEO of Tempus Advisors, a global debt market strategy firm in Stamford, Connecticut, agrees that more digging is necessary. “You need all the documentation and more than that, all the e-mails,” he says. “That would allow us to understand what went wrong and how to fix it going forward.”

Neil Barofsky, the special inspector general for the Troubled Asset Relief Program, who delivered a report on the AIG bailout in November, says he’s not finished. He has begun a probe of why his office wasn’t provided all of the 250,000 pages of documents, including e-mails and phone logs, that Issa’s committee received from the New York Fed.

Schedule A provides some answers — and raises questions that need to be tackled to avoid the next expensive bailout.

To contact the reporter on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net

What Took You So Long? (Put-Backs and Blow-Ups)

Posted by Karl Denninger

IRA put forward a nasty report on the “putback and blowup” risk issue related to the banks and fraudulent mortgages:

The wave of loan repurchase demands on securitization sponsors is the next area of fun in the zombie dance party, namely the part where different zombies start to eat one another. The GSE’s are going to tear 50-100bp easy out of the flesh of the banking industry in the form of loan returns on trillions of dollars in exposure, this as charge-offs on the several trillion in residential exposure covered by the GSEs heads north of 5%. The damage here is in the hundreds of billions and lands in particular on the larger zombie banks, especially Bank of America (BAC) and Wells Fargo (WFC).

….

The action “arises out of the alleged fraudulent acts and breaches of contract of Countrywide in connection with fifteen securitizations of pools of residential second-lien mortgages” Take particular care to savor the fact that these are second lien pools and that, where defaults have occurred on the primary mortgage, loss severities on the seconds will tend to be 100%. Or the cost could be more than par if you count the cost of remediation and recovery efforts.

Sigh…. how long does it take folks?

On April 20th, 2007 I wrote the following:

Why? Because every last one of the stated income loans that has been made can be PUT BACK ON THE LENDERS IF IT DEFAULTS.

And by the way, this is not limited to Countrywide (CFC). It applies to IndyMac, Downey, AHM, Washington Mutual and every other lender in the ALT-A space.

Let me restate that again so that everyone gets it – every single ALT-A lender is at risk of having every defaulted loan – no matter how long it has been since it was securitized and sold off – PUT back on them if there is any material misstatement in the paperwork!

To those of you who are claiming that this is a “Subprime” problem, that it is “contained”, that it is limited to “poor people who can’t pay their bills” or anything like that, let me point out that you are one hundred percent full of crap.

Emphasis in the original.

And on April 17th:

So while mortgage companies may maintain that they have “little” exposure to defaults because they sold these loans off to the bond market without recourse, if in fact 60 percent of the ALT-A stated income products have incomes fraudulently inflated by 50% or more those mortgage companies can probably be forced to take back each and every one of those loans.

HALF of all stated-income loans?

This will BANKRUPT every single one of these companies if it happens.

Now go look at the big bank’s balance sheets for second line (HELOC, silent seconds, etc) exposure.  70% of the outstanding dollar volume was written in California, Florida, Nevada and Arizona – on bubble houses.  The clear majority of those have a first that is underwater and thus the recovery value on those HELOCs, if they default or are “put back” due to fraud, IS ZERO.

When you look at these large banks balance sheets and then take out of their capital the likely losses under this sort of analysis you find that every single one of them will be driven into regulatory capital trouble at best.

This is just one of the issues we have ducked instead of facing.  The other big one is commercial real estate securitizations – S&P put out a report the other day in which it essentially said “if the banks have to eat the reduced value now they’re all insolvent.”

We in fact have fixed none of the underlying issues that brought down Fannie, Freddie, AIG, Bear and Lehman.  The only reason we have seen supposed “improvement” in the markets is that the government has given permission to lie to financial institutions in the exact same form and fashion (that is, hiding actual liabilities and probable losses) that brought down ENRON.

But the underlying loss is still real, still present, and still out there.  Refusing to recognize it doesn’t make it go away.  It just sweeps it under the carpet with the hope (wish really) that the institution will be able to screw you, the consumer, out of enough money to cover the shortfalls before they’re forced to recognize the already-occurred losses and thus declare bankruptcy.

If this was all “the government” that was stuck with these bad loans that were unmarketable (since they have a zero recovery value under legal collection methods they truly can’t be sold for more than a few pennies to one of those “shark” companies that cheats on the law when it comes to those rules) we might have a situation where the government could try to shift it onto the taxpayer through opaque bailouts of Fannie, Freddie and The Fed.

But a good part of this debt was in fact securitized and distributed.  Those holders, such as the FHLB that recently filed suit, aren’t the government and have no reason to sit there and absorb a loss that occurred as a consequence of allegedly-fraudulent underwriting.  For that matter neither does Fannie and Freddie, as despite their “conservatorship” they remain a publicly traded corporation and intentionally absorbing losses caused by other party’s frauds could open their directors and officers up to a derivative action (read: lawsuits a-plenty.)

No folks, these losses won’t be “buried and monetized.”  They will travel back up the chain to the last remaining standing organization that touched them, which just happens to be the zombie banks, since all the “independent brokers” that fed the bilge into these securitization factories are long gone, dead and buried.  Thus the ticking bomb will wind up exploding on the balance sheets of those “too big to fix” institutions we refused to resolve last year because we lacked the political will to go in a close one or more of these banks, and when it happens….. it will rock our world.

You’ve had nearly three years warning Washington – and investors.

When – not if – this goes off I don’t want to hear “nobody saw it coming” from The Halls of Congress and elsewhere in DC because I will be happy to run a campaign advertisement against anyone who so bleats with a copy of my TICKERS from 2007 documenting that in fact some people did see it coming – and were intentionally ignored.

(The Supreme Court recently made such speech legal…. and for that I must extend my heartfelt thanks!)

Origins of an American Kleptocracy

Submitted by Marla Singer

Some days ago we wondered aloud at the blank check extended to Fannie and Freddie along with the suspiciously convenient timing of those announcements on Christmas Day.  Back then we wondered if we had been told the entire story.  To wit:

So.  Let us summarize:

We do not expect the GSEs to grow their portfolios at all, so we are fixing the bloated portfolio problem by easing the portfolio caps to permit a quarter trillion dollar expansion thereof.

We do not expect either of the GSEs to need more help from the Treasury, so we are responding to the underutilized $400 billion “lifeline” the GSEs have with the Treasury ($111 of which is currently used) by expanding it to… infinity.

Oh, and though they have collectively lost nearly $200 billion, we are paying the CEOs around $6 million each.

Great work team!  It’s already almost 11:00.  Let’s go to lunch.

The other shoe having now dropped, Bloomberg has joined in our skepticism:

Taxpayer losses from supporting Fannie Mae and Freddie Mac will top $400 billion, according to Peter Wallison, a former general counsel at the Treasury who is now a fellow at the American Enterprise Institute.

“The situation is they are losing gobs of money, up to $400 billion in mortgages,” Wallison said in a Bloomberg Television interview. The Treasury Department recognized last week that losses will be more than $400 billion when it raised its limit on federal support for the two government-sponsored enterprises, he said.

Wallison continues:

“It was always safe to buy these notes,” he said. The U.S. government was always going to stand behind them. They’re as good as Treasury notes.”

We are no longer sure this is the most inspiring comparison. Wallison also chimes in via the Wall Street Journal and points to a darker vein shot through the GSE story:

New research by Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, has found that from the time Fannie and Freddie began buying risky loans as early as 1993, they routinely misrepresented the mortgages they were acquiring, reporting them as prime when they had characteristics that made them clearly subprime or Alt-A.

In general, a subprime mortgage refers to the credit of the borrower. A FICO score of less than 660 is the dividing line between prime and subprime, but Fannie and Freddie were reporting these mortgages as prime, according to Mr. Pinto. Fannie has admitted this in a third-quarter 10-Q report in 2008.

But because of Fannie and Freddie’s mislabeling, there were millions more high-risk loans outstanding. That meant default rates as well as the actual losses after foreclosure were going to be outside all prior experience. When these rates began to show up early in 2007, it was apparent something was seriously wrong with assumptions on which AAA ratings had been based.

Losses, it was now certain, would invade the AAA tranches of the mortgage-backed securities outstanding. Investors, having lost confidence in the ratings, fled the MBS market and ultimately the market for all asset-backed securities. They have not yet returned.

It has become conventional wisdom, perhaps even cliche, to pin the origins of the credit crisis on the big banks or, AIG or even the practice of financial modeling.  Certainly, these actors have received the most play in the media, and have now endured the focus of populist ire for more than a year.  We now think that the analysis leading commentators to focus blame on these entities is fatally flawed.

We have seen no credible data that any of the large banks or other underwriters of mortgage backed securities (“MBSs”) or collaterized debt obligations (“CDOs”) or firms like AIG selling protection on same actually misrepresented the character of underlying collateral.  This is in direct contrast to the allegations of Edward Pinto as printed by the Wall Street Journal.  If Pinto is correct such that the mis-marking of mortgages by the GSEs and the discovery thereof destroyed confidence in the accuracy of ratings in mortgage backed securities and their derivatives (and it seems probable to suspect that he is) then it seems almost beyond question that the policies (or policy malfeasance) of Fannie and Freddie, and not the actions of large banks or firms like AIG are the proximate cause of not just the credit crisis, but also the continuing multi-act, multi-bailout farce that continues to be passed off to the public as necessary “stimulus.”

It takes only a cursory examination to suspect that misdirection plays a key part in the latest act of the ongoing crisis theater of the absurd.  Misdirection to distract attention from the key complicity of GSEs in the crisis.  Misdirection to deflect scrutiny away from the political personalities from both sides of the aisle responsible.  Misdirection to conceal what could only be described as the most damaging acts of accounting and securities fraud in the history of accounting, securities or fraud.

Precious few assumptions are required to come to conclusions laying responsibility for the largest economic disaster in recent memory at the feet of the GSEs.

First, that the GSEs had substantial influence over the mortgage market.

This is a no-brainer with the GSEs either holding or guaranteeing 51% of outstanding home mortgage debt in 2003.  To put this in perspective, that figure was around 33% of the GDP of the entire United States in 2003.  Read that last line again.  Anyone wishing to play in the market had to compete with the rates set by Fannie and Freddie.

Second, that the GSEs artificially depressed rates (read: underpriced risk).

This is equally trivial to find given that this precise mandate has been the express purpose of the GSEs since at least 1993.  The GSEs were not tasked with increasing the capacity for mortgage lending.  They were tasked with making loans “affordable.”  They used a number of tools to do so, but the key elements were acting as a proxy for quasi-government guarantees and bundling mortgages into risk tiers to act as a sort of clearing house for securitization pools.  It is often said that providing a guarantee (particularly governmental) reduces risk.  This is, of course, a fantasy.  All that explicitly or implicitly tax dollar backed guarantees do is socialize risk.  However, they manage to do so without requiring consolidation of the resulting liabilities on the government’s balance sheet.  Convenient that, yes?  A guarantee is a subsidy.  Period.  Failing to understand this is what permitted the political class to mislead the American public into thinking that cheap loans for everything from housing to small businesses to education (the next fiscal disaster on the horizon) come with no cost.  (Or that cheap debt wouldn’t pump up the price of everything from education to housing).  Today’s pundits seem to enjoy blaming “moral hazard” (by which they mean “corporate moral hazard”) for the crisis.  Oddly, government guarantees, particularly those that everyone assumes will be costless, are not typically part of this definition.

These assumptions, on their own should be sufficient to indict the GSEs, the totally unqualified and unaccountable recipients of political payoffs who occupied the executive offices of these fiscal singularities1 and their other supporters (including the voters who continued year after year to return these jokers to public office) on charges of gross negligence.

If, as Pinto suggests, we add purposeful misrepresentation of underlying collateral to the mix three things become apparent:

First, absent some intervening criminal act by actors farther downstream (and we may yet find some), we have isolated absolutely the cause of all that followed.

Second, it becomes quite easy to construct a criminal case for literally millions of counts of accounting, securities, wire and mail fraud against the GSEs.  To the extent executives at Fannie and Freddie signed off on financial statements disclosing the portion of their balance sheets that held “AAA” securities and these had been purposefully misidentified we should be exploring prosecution for violations under e.g., Sarbanes-Oxley.  (Given, however, Rham Emanuel’s involvement in Freddie and Fannie, we aren’t holding our breath).

Third, given the presence of blatant government price fixing in more than a third of the entire economy, the United States hasn’t been anything like a “free market” since before 2003.

It should shock you that literally a third of the U.S. economy should become a playground for the social experiments of any political group of any party affiliation.

It probably will not shock you (since you are reading Zero Hedge) to find what may be the largest example of securities fraud ever directly connected to elected officials of the United States and their cronies.

Taking a step back, it should shock you that power over literally a third of the U.S. economy should ever have been allowed to become concentrated in two entities with blatantly socialist aims and under the control of executives with no relevant qualifications of any note other than loose purse strings on their political contribution satchels.

What should grip readers with even more substantial alarm is the combination of blank checking for Fannie and Freddie backstops, and the shifty manner in which these disclosures were made.  Is it possible anymore to doubt that the administration simply lied through its teeth while promising us it expects no need of increased credit lines for the GSEs while simultaneously expanding same literally to infinity?

Given that Fannie, Freddie and the FHA have now taken up the mandate of supporting housing prices at any cost (to the taxpayer via endless bailouts and unlimited credit) is it possible in any way to credit the current “upturn” to fundamentals?  When we factor in similar capture of the FDIC and the like, where does this leave us, exactly?

Permit us to ask a few questions:

1.  Why are Fannie and Freddie still operating in any way whatsoever?

2.  Given that their credibility for reliable (or even remotely non-fiction) financial disclosure nears complete obliteration, who is likely to buy anything from these entities in the future?  (If you said “The Fed” you may advance to the bonus round).  Surely the conflict of interest implicit in government ownership does nothing to improve the situation.  Perhaps the news that the Fed plans to issue securities to shrink its balance sheet and reverse “quantitative easing” describes an attempt to securitize the tattered reputation of the GSEs?  Will the Fed simply aggregate its balance sheet and issue tranches?  Does that make the Fed simple the collateralized debt obligation (“CDO”) of last resort?  Who will do the rating?  Who will be writing protection on CDO Fed Tranch A-1 (AAA)?

3.  Given that neither entity is currently monitored by an Inspector General (despite what used to be statutory language so mandating) and both entities are completely captured by the current administration, how can it be anything other than insanity to expect any result from these entities other than the formation (or expansion) of a ravenous fiscal black hole?

4.  Given increasing government control beyond Fannie and Freddie that now extends far beyond 33% of GDP, what can we expect if we continue to permit political parties of any stripe to exercise command and control influence over what is now probably a simple majority of our economy?

There was a time when we hoped that the United States would learn its lesson with respect to permitting political control over large swaths of private markets.  Today that time seems very long ago, and somewhat naive.

Perhaps we are being too harsh on the likes of Barney Frank and other GSE proponents.  Adopting a slighty more relativistic economic morality, we might count Frank as one of the greatest legislators of all time.  Consider:

To the extent Mr. Frank and his ilk self-identify as advocates for low-cost housing for those ill-able to afford it, or beset by poor credit, the last 20 years have represented the largest single wealth transfer (composed primarily of real estate and flat screen TVs) to that sector known to us.  Not only that, but given the de facto nationalization of MBS portfolios (we’ll give you three guesses who have been the largest MBS buyers over the last several quarters) the GSEs and their supporters have managed to get taxpayers to pay for it all.  Of course, had they simply proposed such a measure in Congress it would have been laughed from the chamber.  And yet, it almost seems as if these individuals simply wrote a multi-trillion dollar check to their constituents that happened to be drawn on the United States Treasury.

It almost seems this way because it was this way.

1. 1. Just consider Fannie Mae’s torrid leadership history: James A. Johnson (Fannie CEO 1991-1998, Democratic luminary, Obama fundraiser, John Kerry vice presidential selection committee chair, $21 million in Fannie compensation). Franklin Raines (Fannie CEO 1999-2004, Clinton’s Director Office of Management and Budget, $90 million+ in Fannie compensation later the subject of a civil suit) Daniel Mudd (Fannie CEO 2005-2008, $80 million in Fannie compensation) Herbert M. Allison (Fannie CEO 2008-2009, National Finance Chair, John McCain Campaign).  Freddie’s record is no better.

Responding to Goldman Sachs