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Big Banks as The Producers? Not Likely

October 18, 2010

Uh, The Producers.

Here’s Krugman on the “mortgage morass” now enveloping the foreclosure machine like a blob. He’s got this relatively well pegged (dig his dig on the WSJ plutocrats). But one of his commenters has a theory I think deserves some consideration.

What if, as Mike O. of Oakland, Calif., suggests (actually, asserts), the banks and securitizers deliberately obscured all the lines of mortgage ownership in order to resell the same asset multiple times?

It’s a variation of the classic scam in “The Producers,” in which a theatrical producer and his accountant sell 50% of a play’s proceeds to dozens of investors, knowing that the play will fail and so nobody will ask for their money.

This brings to mind a very wealthy fellow I profiled more than a decade ago. Beginning in the 1970s, he’d buy 1,200- and 1,000-acre tracts of undevelopable land, subdivide it into lots of 1.25 and 2.5 acres each, and sell them, one at a time, to gullible pensioners in the Midwest and overseas through his boiler room operation. Each buyer would pay maybe $120 per month for 10 years to purchase their $10,000 piece of paradise (actual value: $2,000).

It was a compelling enough scam on its face, but an allegation I heard from one of the lawyers who’d sued him—an allegation I was never able to corroborate—was that the swamp seller was reselling the same lots to multiple investors.

Since the lots were not platted—not registered with the county as individual lots—no one really knew what land they had bought. And since the mortgage contract and deed was held by the seller, unrecorded in the public record, there was no way to independently check the ownership. Those few buyers who completed their purchases and asked for deeds were given the runaround. Meets and bounds were variable, at best. To me it seemed possible that the swamp seller was pulling a Producers-style operation on top of the raw scam of selling swamp at inflated prices.

Is it possible that Lehman Brothers or other packagers of mortgage-backed securities did something similar? Mike O.:

You can’t take an individual mortgage and sell it to 50 different investors because people would notice. But if you cut 1,000 mortgages into 100 pieces each, shuffle them together and then sell chunks of the resulting amalgam over and over again, it’s almost impossible to drill down to the individual mortgage level to find out what happened. It’s fraud on an unprecedented level and could bring down the economy.

The only problem with Mike O.’s theory is this: It’s already perfectly legal to do something very much like this, through the magic of credit default swaps and “synthetic CDOs.”

To recap: CDOs, or “collateralized debt obligations,” are those bundles of mortgages or other debt to which Mike O. refers. For more than a decade the numbers of mortgages, subprime and other, barely kept up with the desire of investors to buy the right to collect the income stream from all those homeowners. At the peak of the frenzy, all those mortgage brokers and boiler room operations could not keep up with the demand for dicey, high-interest mortgages on overpriced property. So the banks fashioned “synthetic” CDOs from the indexes of the real CDOs, which were further sliced and diced into new bonds—just betting slips, really—with new credit default swaps placed against them.

A credit default swap, remember, is an insurance policy on someone’s payment stream. For a few thousand bucks you could buy from an allegedly solvent company (AIG, for example) a guaranty that bond X would pay off in full. If you thought bond X was poo, you could buy two or more policies, potentially getting paid double if the bond fails. You did not need to own any part of the bond to buy this protection. It was just a bet too. So a credit default swap on a synthetic CDO was a bet against the bet on the original (non-synthetic) bond.

This is what the Magnetar deal was, and the ABACUS arrangement that helped John Paulson clear a reported $3.7 billion profit in 2007.

So if the big banks could already resell shadows of the same crappy loans over and over to impressionable, dumb money “investors” (and clean up by betting against those same bets), then they’d have no reason to further screw things up with faulty paperwork and fraudulent affidavits on the real mortgages come foreclosure time. So what’s the “mortgage morass” really all about?

Occam’s razor can guide us. Or, at least, Calculated Risk.

Bill at Calculated Risk reread a 3-year-old “uber-nerd” post by the late Tanta and posted the best explanation I’ve seen so far.

Turns out mortgage servicing companies are just like any other business. They have overhead, and they have expenses, and these expenses shift in interesting and sometimes unpredictable ways. Lately, expenses for mortgage servicers have been way up. Income has been down. So they’ve been trying to save money by cutting corners. Robo-signers are but one manifestation of this phenomenon.

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