This is the biggest fraud in the history of the capital markets. And it’s not something that happened last week. It happened when these loans were originated, in some cases years ago. Loans have representations and warranties that have to be met. In the past, you had a certain period of time, 60 to 90 days, where you sort through these loans and, if they’re bad, you kick them back. If the documentation wasn’t correct, you’d kick it back. If you found the incomes of the buyers had been overstated, or the houses had been appraised at twice their worth, you’d kick it back. But that didn’t happen here. And it turned out there were loan files that were missing required documentation. Part of putting the deal together is that the securitization professional, and in this case that’s banks like Goldman Sachs and JP Morgan, has to watch for this stuff. It’s called perfecting the security, and it’s not optional.
What people forget about this issue is not that the banks just lost the paperwork over the last two years to cut corners and signed out these foreclosure titles en masse. It's the much bigger fact that these mortgage mill banks have been defrauding the American taxpayer and their own investors for years. These banks did everything they possibly could to get one thing and one thing only: close the sale.
The entire point of turning these mortgages into financial cole slaw was volume and quantity, not quality, of the mortgage loan. The banks just needed the raw financial biomass of mortgages to chop up and throw into the pot and say "it's all AAA ingredients here!" like putting formaldehyde into bathtub rotgut or sawdust into dog food. It just has to look like a mortgage to work.
As long as nobody questioned the millions of individual mortgages, everything would have been fine. The problem is those individual mortgages, especially the subprime adjustable ones, went into default. A lot of them. Enough of them in fact for people to notice "Hey, these securitized mortgages are all total filler and no steak." So people started taking a closer look, especially people like state Attorneys General who had Governors asking them "Hey, why are our state property tax revenues going to hell?"
The thing to remember is that the banks have been doing since since well before the crisis hit. Institutionalized fraud, the excuse of "well everyone in the industry is looking the other way" was the entire point. If everyone was guilty of fraud, there's no way to single out one bank or one loan officer or one mortgage broker for it. Besides, the entire industry was getting rich, and had the money to donate to Washington to keep the gravy train rolling.
No different than an episode of Boardwalk Empire, only writ large across the entire country.
So here we are, everyone suddenly realizing that the entire last seven years of economic activity was in fact faked. it wasn't just foreclosure paperwork. It wasn't just securitization. It wasn't just the housing bubble. it was the entire economy, predicated on pretend money. So yes, it's all come crashing down right now. The pain we refused to take by going after Wall Street two years ago is now threatening to wipe out the American dream for pretty much all of us.
EK: Given that our financial system is still fragile, isn’t that a disaster for the economy? Will credit freeze again?
JT: I disagree. In order to make the financial system healthy, we need to recognize the extent of our losses and begin facing the fraud. Then the market will be trustworthy again and people will start to participate.
EK: It sounds almost like you’re saying we still need to go through the end of our financial crisis.
JT: Yes, but I wouldn’t say crisis. This can be done with a resolution trust corporation, the way we cleaned up the S&Ls. The system got back on its feet faster because we grappled with the problems. The shareholders would be wiped out and the debt holders would have to take a discount on their debt and they’d get a debt-for-equity swap. Instead we poured TARP money into a pit and meanwhile the banks are paying huge bonuses to some people who should be made accountable for fraud. The financial crisis was a product of our irrational reaction, which protected crony capitalism rather than capitalism. In capitalism, the shareholders who took the risk would be wiped out and the debt holders would take a discount but banking would go on.
There's a way out if we have the courage to take it. Another TARP bailout here won't cut it. The monster is just too big.
[UPDATE] And now Sen. Harry Reid has called for a foreclosure halt by all the major mortgage lenders in all 50 states. I expect we will see compliance on this within the next few days.