In this issue of The Institutional Risk Analyst, we return to a subject which we have awaited for nearly three decades and which many of the inhabitants of Wall Street have only recently discovered, namely the imperfection of collateral liens on mortgages underlying asset backed securities or ABS. The failure on the part of the largest banks to perfect the liens on the home, office building or other real property that underlies a securitization is turning out to be not merely a legal headache — and it is — but also the operational catalyst for the next crisis in financials. But the foreclosure mess is not — repeat not — the crux of the biscuit, to paraphrase the late great composer Frank Zappa.

We also feature a comment by our contributor Dick Alford on the recent speech by NY Fed President William Dudley regarding the resumption of quantitative easing or “QE.” Suffice to say that Dudley has adopted the happy face messaging seen in use by Fed Chairman Ben Bernanke and other members of the compliant Federal Open Market Committee in Washington. Yet as we shall be telling an audience later today at American Enterprise Institute, the best part of the financial crisis lies ahead.  Click here to download the slide deck, “Pictures of Deflation.”

We noted in previous comments that the Fed’s zero interest rate policy or “ZIRP,” in conjunction with QE, is draining something on the order of $1 trillion annually in income from individual and corporate savers to subsidize the banking sector. The key thing to understand about the continuing crisis in the mortgage sector is that the process of foreclosing on homes is reducing assets of commercial banks by an amount that is far larger than the $1 trillion in total tangible capital of the U.S. banking industry.  Read that last sentence again.

While the Fed has been attempting to refloat these same banks — and their bond holders — on a sea of cheap money, the central bank is ignoring the larger, structural problems in the real estate sector. Forget mere valuations losses on ABS and derivatives on same. The real surprise heading for Washington and Wall Street is when everyone realizes that the big risk facing the U.S. economy is not from the foreclosure crisis, but from the actions of the “Big Five” financial monopolies — Fannie Mae, Freddie Mac, Bank of America (BAC) (Q2 2010 Stress Rating “C”), Wells Fargo (WFC) (Q2 2010 Stress Rating “B”) and JP MorganChase (JPM) (Q2 2010 Stress Rating “C”) to prevent tens of millions of American homeowners from refinancing their performing mortgages.

But first, let’s take a stroll down memory lane.

A few years back, a young analyst from the FRBNY named Chris Whalen went to work at the London branch of Bear, Stearns & Co. During the morning we sold German bunds and the other debt issued by what are now the EU member nations.  In the afternoon we sold mortgage-backed securities. Terms like CMO and convexity were soon heard on the trading floor as we vigorously stuffed large quantities of these very early private label RMBS into every open orifice on the European continent, including a number of large Japanese banks and insurance companies. Thus was coined the term “yield to commission.”

During this period, we stayed in touch with our colleagues at the Fed, particularly a courageous attorney named Walker Todd , who was then working at the FRBNY. We described in previous comments how members of the Fed’s Washington staff persecuted Todd and other Reserve Bank officials for having the temerity to object to some of the more ridiculous policy positions pursued during the tenure of Fed Chairmen Paul Volcker and Alan Greenspan (See “IndyMac, FDICIA and the Mirrors of Wall Street’, January 6, 2009”). There is an entire chapter devoted to the good works of Chairman Volcker and his protege, Gerald Corrigan, in the upcoming book, Inflated: How Money and Debt Built the American Dream.”  And we answer the question: Is Paul Volcker the father of “Too Big To Fail?”  Click here to see the new target page for inflated.

The Fed’s Washington staff was particularly infuriated by Todd’s writings regarding the amendments to the Federal Reserve Act contained in the FDICIA legislation in 1991. The amendment pushed by then-Fed staff director Donald Kohn was adopted without vote during a late-night Senate conference committee session chaired by none other than Christopher Dodd (D-CT). In a very real sense, Dodd, Kohn and armies of Wall Street attorneys from the large banks who drafted the amendment are the authors of the great bank bailout of 2008.

One of the topics we discussed at length with Todd in the mid-1980s was the way in which Wall Street firms underwriting of residential mortgage backed securities or “RMBS” failed to perfect the collateral lien of the securities against the home or other real estate. This was a serious legal problem, especially if you believe in property rights and due process of law. Yet because the value of the real estate that served as collateral was rising pretty much continuously during the past several decades (Hello — What’s wrong with this picture?), the issue of imperfect collateral liens in ABS received little attention from the Fed or other regulators. See our comment: “No True Sale: Interview with Joseph Mason’, March 3, 2008”

Now let’s walk through the process of creating an RMBS to illustrate the problem facing many home owners, lenders and investors. We’ll use the actual example of IRA cofounder Christopher Whalen. Back in 1998, Chris and his wife bought a home in Westchester County NY. The primary mortgage was originated by and independent broker and placred with Roslyn Savings Bank, which retained the paper for its own portfolio. In 2001, Chris refinanced with the Bank of New York Mellon (BK) (Q2 2010 Sress Rating: “A”), which immediately sold the “Alt-A” loan to the firm formerly known as Lehman Brothers. But that was only the start of this mortgage’s journey.

The loan was then resold by Lehman Brothers to a special purpose vehicle (SPV) and then sold again to a Delaware trust created to securitize the mortgage into an ABS. Lehman controlled the trust, but the vehicle was administered as though it were in fact separate. Servicing was provided by Aurora Loan Servicing, a wholly owned subsidiary of Lehman, which is now being liquidated. When the time came to sell bonds to investors, the trustee for the Delaware vehicle issuing the securities repeated the process performed thousands of times before and merely took the documentation describing the mortgages into a file folder and went on to the next deal.

Here’s the problem. If you go down to the Courthouse in White Plains, New York, and pull up the title record for the property purchased a decade ago by the Whalens, the only indication of any encumbrance over the collateral that is supposed to back up the securitization sold to investors by Lehman Brothers is the original assignment to Roslyn Savings and later to the Bank of New York. There is no change in recordation of the collateral lien on the property to Lehman Brothers much less the SPV or the Delaware trust that acted as the securitization vehicle in the ABS.

In the event of a default, it could be argued that Lehman Brothers never owned the loan and thus never had the power to assign ownership to the SPV or the Delaware trust. Indeed, in plain legal terms, Bank of New York (and now JPMorgan, the successor to the Bank of New York retail business), is the only party with legal standing to enforce the lien on the property. But as far as Bank of New York is concerned, the loan was sold to Lehman Brothers more than a decade ago.

Now you are probably wondering why the good people at Lehman Brothers never bothered to send a paralegal to the New York State Courthouse in White Plains to record a change in the collateral lien — at least regarding the sale to Lehman Brothers. The cost of perfecting the lien on the hundreds or even thousands of loans in a typical ABS costs money, but in aggregate would have added less than half a point to the cost of the deal. But the investment bankers at Lehman Brothers took that half point as profit instead of doing their jobs. No doubt claims for fraud, RICO and other misdemeanors are possible against Lehman and other RMBS underwriters, as with the civil RICO lawsuit againstCitigroup (C) (Q2 2010 Stress Rating “C”) and Ally Financial (Q2 2010 Stress Rating “A+”).

You can argue that the banks were greedy and stupid for failing to perform their legally required duties as securities dealers and fiduciaries. You can also argue rightly that many banks are doing stupid things in foreclosures as they are being overwhelmed by mortgage defaults. But these very real concerns miss the larger issue. The bigger point that members of the media and the other happy campers who are following the foreclosure mess need to understand is that a poorly managed documentation trail does not change the fact that the loans are bad.  Focusing on the foreclosure mess at the expense of paying attention to the larger, secular threat from the deflation of the mortgage sector could be a fatal choice for American consumers, banks and the nation as a whole.

House Speaker Nancy “Red” Pelosi (D-CA) and all of the other politicians clamouring for inquiries of bad home foreclosures are simply playing to their ill-informed audience. Neither Pelosi, most members of Congress nor the vast majority of Americans understand that the real crime by the Big Five banks is not the failure to perfect the loan documents on a mortgage a decade ago, but the active steps being taken today to prevent millions of American households from exercising their contractual right to refinance their mortgages when interest rates fall.

The focus by Washington on the very real mortgage foreclosure mishaps committed by many lenders is the functional equivalent of putting Al Capone away for tax evasion. The real, continuing act of racketeering and criminality being committed by the Big Five banks is the cartel behavior which prevents home refinancing for performing borrowers and also renders Fed monetary policy largely ineffective. Instead of suing American Express (AXP), the Department of Justice should be suing the Big Five for anti-trust violations, price fixing and criminal RICO. Until the blockade erected by Fannie Mae and Freddie Mac to prevent refinancing of performing mortgages is removed, Fed monetary policy will be stymied and no amount of QE will be effective in stabilizing much less re-inflating the U.S. economy.

Why Does Bill Dudley Want More QE?
By Richard Alford

New York Federal Reserve Bank President William Dudley gave a very well received speech last week. It is easy to see why Wall Street applauded the speech. It promised further steps by the Fed to support asset prices. It is less clear why anyone outside Wall Street would applaud the speech, as it contained arguments that were disingenuous, logically inconsistent and possibly dangerous.

Dudley addressed a number of questions, including: “How much would the Fed have to purchase to have a given impact on the level of long-term interest rates and economic activity? Dudley asserts that recent experience suggests: “that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point.” This was the take-away money passage and was quoted frequently in the press.

However, the full answer is neither as precise nor as certain. A little later in that discussion Dudley went on to say: “Suppose the Fed was indeed successful in reducing long-term interest rates further-what then? Some claim that lower rates would have no effect on economic activity-that the Fed would be ‘pushing on a string.’ This is too dark a view. Although the responsiveness of demand to reductions in interest rates is probably lower in a world in which balance sheet constraints are important, the responsiveness is not zero. I believe that it remains significant.”

Dudley asked: “How much would the Fed have to purchase to have a given impact on the level of long-term interest rates and economic activity? And asserting without qualification that QE is stimulative (and stimulative is generally understood to imply increase economic activity) in the first statement, Dudley backtracks in the second statement even as he dismisses the opposing view with an unsupported assertion: “This is too dark a view.”

After presenting a precise quantitative link between QE and long-term rates, the best Dudley can offer in regard to the link between changes in long-term rates and economic activity is: “I believe that it is significant”. In fairness to Dudley, it is the best any supporter of QE can do. Given the failure of QE to stimulate the Japanese economy, there is no evidence that QE will stimulate economic activity in the US today.

We need to recognize that assertions regarding the effectiveness QE are just part of a belief system unsupported by data — the definition of most modern religions.  This is troubling enough, but Dudley goes on to sketch the mechanism by which he believes that QE would support economic activity:

“Even in today’s challenging circumstances; lower long-term rates would support the economy through a number of channels. Lower long-term rates would support the value of assets, including houses and equities and household net worth. Lower long-term rates would make housing more affordable and support consumption by enabling households to refinance their mortgages at lower rates. This would increase the amount of income left over for other spending.”

In short, Dudley supports QE partly because he believes that it would lead to a policy-based, higher asset-price, easier credit, consumption-driven boom much like but more widely based than either the NASDAQ technology stock or more recent real estate bubbles. This ought to be very troubling as it suggests that the Fed has not learned from past mistakes.  The Fed believed that the financial markets without serious oversight were efficient and robust enough to weather a prolonged period of a near zero real and then unusually low Fed funds rates, as well as a tidal wave of financial innovation. The Fed’s fundamentalist faith in efficient markets was misplaced, as shown when risks they had dismissed were realized. Currently, the markets is pricing-in the Fed ushering in QE2 with “shock and awe” after the next FOMC meeting. It appears that the Fed will expose the economy to risks it has cavalierly dismissed as “too dark” in pursuit of returns that it “believes” exist. The public deserves better. It deserves a good faith analysis and honest presentation of both the upside and downside risks attached to QE.

Early in the speech, Dudley applauded the rise in the personal savings rate and deleveraging as necessary steps to restore sustainable growth. However, late in the speech he argues that QE will work because it will depress savings and encourage the re-leveraging of the economy. But how can we re-leverage the economy when, as discussed above, banks are shrinking because neither the Treasury or the Fed have the courage to immediately restructure these institutions?  Logical consistency ought to be a necessary component of policy and explanations of policy, but apparently not at the Fed.

Dudley remains mute on a number of ancillary issues. For example, he does not mention the transference of more than three-quarters of a trillion dollars annually from savers to the banks due to low rates even though this decreases the amount of income available for consumption spending. He also remains mute on the blurring of the distinction between the Fed and Treasury. From the Fed financing the public ownership of AIG to the apparent willingness to commit to monetizing (though QE) of the fiscal deficit, the Fed has moved in the direction of allowing both the Executive and Legislative branches of government to avoid their responsibilities.

It is October in an election year. One expects speeches such as this from candidates running for public office, but not from Fed officials.

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