Here Comes Da Judge
The innovations of the boom years are having their day in court
by Bill Bonner
“Structured investment vehicles are being put on trial. Some will get the gallows. Many more probably deserve it”
Mr CA Boyko recently fired a shot that was heard around the world. At least around the world of structured finance. Or, at least, around the world of Deutsche Bank, which got a bullet in the head. Poor Deutsche Bank is the victim of its own avarice, its own stupidity – and the cycles of nature. Nothing to be ashamed of. In war, even the best soldiers get their brains blown out. In finance, they blow them out themselves. Before pulling the trigger, the judge was curious. A curiosity shared by millions, no doubt. He wanted to crack open a sophisticated derivative product – a mortgage-backed security – and find out what was in it. In the event, he found that something was missing; structured finance was not structured quite as well as it pretended to be.
At issue in his courtroom was…
…whether Deutsche Bank National Trust Company could repossess 14 houses in the Cleveland area. The first part of courtroom proceedings always begins with a preposition. Whereas the homeowners were living in houses with mortgages, said the lawyers. And whereas said homeowners hadn’t made their payments. And whereas Deutsche Bank was the de facto mortgage holder, the pleadings went on – said bank wished to foreclose on the 14 properties.
Here, we add some whereases of our own. Whereas there is about $6.5trn worth of securitised mortgage debt in the US alone. And whereas the value of the collateral – the houses themselves – is going down. And whereas the hotshots who securitised this debt operated so fast and loose they might have been undertakers in a plague year. And whereas standards of creditworthiness, and details of the mortgages themselves, were permitted to slip. And whereas the whole idea was to earn high fees for loading people down with debt, while pushing the risk of loss onto the naïve, the slow-witted and the unborn. And whereas the losses are now expected to tot up to somewhere between $150bn and $400bn – and as much as $2trn, according to Goldman Sachs, in lost credit. And whereas every half-wit knew there would be hell to pay when the credit cycle turned down…this case might be a bigger deal than people realised.
Judge Boyko showed little interest in the macro-economic whereases. What he wanted to know was: where are the mortgage documents? It may be true that these people owe you money, but we don’t take a man’s house away from him without a valid mortgage contract. Not in the sovereign state of Ohio, anyway.
Deutsche Bank’s legal team looked at each other. Then looked in their briefcases. The lawyers had plenty of documents, including some clearly showing an “intent to convey the rights in the mortgages”. But as for the mortgages themselves, they had none. Deutsche Bank is hardly exceptional. When a law professor studied foreclosure proceedings recently, she found that in 40% of cases, the creditors either didn’t or couldn’t produce the vital documents, giving them the right to retake the houses. Apparently, the financial intermediaries who had bundled these 14 mortgages together with thousands of others to create the Structured Investment Vehicle
(SIV) bought by Deutsche Bank, had neglected to bundle in the actual mortgage documents.
A year ago, it scarcely would have mattered. For the first six years of this century credit was expanding. Mortgage firms earned fees by lending money to those who couldn’t pay it back. The lenders sold the mortgages to Wall Street firms who bundled them up and turned them into tradable securities, backed by complex mathematical models that showed what they were supposed to be worth. These were rated by firms such as Fitch and Moody’s, again for fees, and sold to people who didn’t know what was in them, generating more rich bonuses for the financiers. That was the beauty of securitised debt; the money was made in the middle, while the trouble was pushed out to both ends. Despite what the mathematicians said, the borrower would surely come up short sooner or later. So would the lender. The intermediaries would come out ahead. In effect, the stick was short on both ends, but long in the middle. In this case, one of the short ends was held by Deutsche Bank, which had bought the SIV and expected to enjoy the usufructs of said mortgages, such as they were. That is when Judge Boyko broke the spell:
“The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance. Finally put to the test, their weak legal arguments compel the court to stop them at the gate.” Of course, that’s what corrections are for, to put the pretentious innovations of the bull market to the test. Trillions of dollars worth of SIVs were laid off on investors, based on dubious maths and dopey logic. Now, they’re being put on trial – in courtrooms and in markets. Some will get the gallows. Many more probably deserve it.
On another note…
“As Jim Stack of Investech recently noted, a market drop of even the recent -7.1% following a third discount rate cut has happened only 3 times in the past 80 years: February 1930, July 1982, and March 2001. In each case, the economy was already in recession (or worse). Those are not the kind of odds that make one feel comfortable in today’s uncharted waters…. The level of my concern should strike long-time readers of these comments as unusually high… There are occasionally situations where the set of conditions becomes so extreme that we observe them only before significant shocks…. In short, the financial markets are at a critical point. It’s possible that investors will somehow adopt a fresh willingness to speculate, but my impression is that in the weeks ahead, investors will be forced to recognize that recession risk has tipped…. The return/risk profile on both stocks and the economy as a whole appear increasingly lopsided towards bad outcomes.”
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