America's Shadow Banking System, A Web of Financial Fraud

The Wall Street Journal reported on January 19 ^th that the Obama Administration was pushing heavily to get the 50 state attorneys general to agree to a settlement with five major banks in the "robo-signing" scandal.   The scandal involves employees signing names not their own, under titles they did not really have, attesting to the veracity of documents they had not really reviewed.   Investigation reveals that it did not just happen occasionally but was an industry-wide practice, dating back to the late 1990s; and that it may have clouded the titles of millions of homes.   If the settlement is agreed to, it will let Wall Street bankers off the hook for crimes that would land the rest of us in jail -- fraud, forgery, securities violations and tax evasion.   

To the President's credit, however, he seems to have shifted his position on the settlement in response to protests before his State of the Union address.  In his speech on January 24^th, President Obama did not mention the settlement but announced instead that he would be creating a mortgage crisis unit to investigate wrongdoing related to real estate lending.  "This new unit will hold accountable those who broke the law, speed assistance to homeowners, and help turn the page on an era of recklessness that hurt so many Americans,"  he said.

The Deeper Question Is Why

Whether massive robo-signing occurred is no longer in issue.  The question that needs to be investigated is why it was being done.  The alleged justification--that the bankers were so busy that they cut corners--hardly seems credible given the extent of the practice. 

The robo-signing largely involved assignments of mortgage notes to mortgage servicers or trusts representing the investors who put up the loan money.  Assignment was necessary to give the trusts legal title to the loans.  But assignment was delayed until it was necessary to foreclose on the homes, when it had to be done through the forgery and fraud of robo-signing.  Why had it been delayed?  Why did the banks not assign the mortgages to the trusts when and as required by law?

Here is a working hypothesis, suggested by Martin Andelman: securitized mortgages are the "pawns" used in the pawn shop known as the "repo market."  "Repos" are overnight sales and repurchases of collateral.  Yale economist Gary Gorton explains that repos are the "deposit insurance" for the shadow banking system, which is now larger than the conventional banking system and is necessary for the conventional system to operate.  The problem is that repos require "sales," which means the mortgage notes have to remain free to be bought and sold.  The mortgages are left unendorsed so they can be used in this repo market.  

The Evolution of the Shadow Banking System

Gorton observes that there is a massive and growing demand for banking by large institutional investors -- pension funds, mutual funds, hedge funds, sovereign wealth funds -- which have millions of dollars to park somewhere between investments.  But FDIC insurance covers only up to $250,000.  FDIC insurance was resisted in the 1930s by bankers and government officials and was pushed through as a populist movement: the people demanded it.  What they got was enough insurance to cover the deposits of individuals and no more.  Today, the large institutional investors want similar coverage.  They want an investment that is secure, that provides them with a little interest, and that is liquid like a traditional deposit account, allowing quick withdrawal.

The shadow banking system evolved in response to this need, operating largely through the repo market. "Repos" are sales and repurchases of highly liquid collateral, typically Treasury debt or mortgage-backed securities--the securitized units into which American real estate has been ground up and packaged, sausage-fashion. The collateral is bought by a "special purpose vehicle" (SPV), which acts as the shadow bank. The investors put their money in the SPV and keep the securities, which substitute for FDIC insurance in a traditional bank. (If the SPV fails to pay up, the investors can foreclose on the securities.) To satisfy the demand for liquidity, the repos are one-day or short-term deals, continually rolled over until the money is withdrawn. This money is used by the banks for other lending, investing or speculating. Gorton writes:

This banking system (the "shadow" or "parallel" banking system)--repo based on securitization--is a genuine banking system, as large as the traditional, regulated banking system.  It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit, which is essential for job creation, will not be created.

All Behind the Curtain of MERS

The housing shell game was made possible because it was all concealed behind an electronic smokescreen called MERS (an acronym for Mortgage Electronic Registration Systems, Inc.).  MERS allowed houses to be shuffled around among multiple, rapidly changing owners while circumventing local recording laws.  Title would be recorded in the name of MERS as a place holder for the investors, and MERS would foreclose on behalf of the investors.  Payments would be received by the mortgage servicer, which was typically the bank that signed the mortgage with the homeowner.  The homeowner usually thinks the servicer is the lender, but in fact it is an amorphous group of investors.         

This all worked until courts started questioning whether MERS, which admitted that it was a mere conduit without title, had standing to foreclose.  Courts have increasingly held that it does not. 

Making matters worse for the servicing banks, Fannie Mae sent out a memo telling servicers that in order to be reimbursed under HAMP--a government loan modification program designed to help at-risk homeowners meet their mortgage payments--the servicers would have to produce the paperwork showing the loan had been assigned to the trust.

The hasty solution was a rash of assignments signed by an army of "robosigners," to be filed in the public records.  But the documents are patent forgeries, making a shambles of county title records.   

Complicating all this are tax issues.  Since 1986, mortgage-backed securities have been issued to investors through SPVs called REMICs (Real Estate Mortgage Investment Conduits).  REMICs are designed as tax shelters; but to qualify for that status, they must be "static."  Mortgages can't be transferred in and out once the closing date has occurred.  The REMIC Pooling and Servicing Agreement typically states that any transfer significantly after the closing date is invalid.  Yet the newly robo-signed documents, which are required to begin foreclosure proceedings, are almost always executed long after the trust's closing date.  The whole business is quite   complicated , but the bottom line is that title has been clouded not only by MERS but because the trusts purporting to foreclose do not own the properties by the terms of their own documents.

John O'Brien, Register of Deeds for the Southern Essex District of Massachusetts, calls it a "criminal enterprise."  On January 18^th, he called for a full scale criminal investigation, including a grand jury to look into the evidence.  He sent to Massachusetts Attorney General Martha Coakley, U.S. Attorney General Eric Holder and U.S. Attorney Carmen Ortiz over 30,000 documents recorded in the Salem Registry that he says are fraudulent. 

From Lending Machines to Borrowing Machines

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