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Global bankers seek to raid taxpayers over subprime fiasco

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By Patrick Wood

Banking used to be simple. When you bor­rowed money from a bank, the bank owned your mort­gage and you paid the interest and prin­cipal directly. This is easily under­stood by this graphic representation:


Things got com­pli­cated when bankers got greedy, fig­uring the could make a whole lot more than just simple interest. The scheme is called secu­ri­ti­za­tion, as depicted by the fol­lowing flow-chart.

In its sim­plest terms, secu­ri­ti­za­tion is a process whereby illiquid finan­cial instru­ments (e.g., mort­gages) are pur­chased and com­bined into pools. The pool is then struc­tured where shares can be sold to 3rd party investors like banks, pen­sion funds and even gov­ern­ments. Any type of asset can be secu­ri­tized as long as it has a steady flow of cash asso­ci­ated with it. The cash flow is the incen­tive for pur­chasers to make their investment.

There are many fees that are paid along the road to suc­cessful secu­ri­ti­za­tion. The orig­inal bor­rower pays “points” to the ini­tial broker and/or banker. The pool oper­ator receives the rights to income at a dis­counted price. The invest­ment banker who syn­di­cates the sale charges hefty fees plus com­mis­sions paid to the selling broker/dealer or invest­ment representative.

The invest­ment bankers are the pri­mary enablers and dri­vers of the secu­ri­ti­za­tion process. Right behind them is the Fed­eral Reserve, who is sup­posed to be a watchdog on shaky banking practices.

Invest­ment bankers have many tricks that help to make secu­ri­tized invest­ments more attrac­tive. Appraisers are employed to give favor­able val­u­a­tions (and often greatly inflated) to the under­lying prop­er­ties. Credit agen­cies are employed to give favor­able rat­ings (again, often greatly over-rated) to the invest­ments, thus pro­moting con­fi­dence. The credit risk is often mit­i­gated by adding insur­ance poli­cies, dif­ferent classes of investors, hedging against failure by pur­chasing or selling deriv­a­tives. It gets more com­pli­cated than we want to dis­cuss here.

Cur­rently, Attor­neys Gen­eral in New York, Ohio, and Col­orado are inves­ti­gating illegal appraiser activity with respect to banks and other lenders pres­suring appraisers to fudge their appraisals. The Secu­ri­ties and Exchange Com­mis­sion is cur­rently inves­ti­gating illegal activity at credit rating com­pa­nies who might have been pres­sured into issuing arti­fi­cially high credit ratings.

For the invest­ment bankers, most of their profit is taken out of the “enhance­ment” value at the expense of the under­lying invest­ment that is being pur­chased by unsus­pecting investors. In other words, the ulti­mate investor is get­ting  hosed from the start but the house of cards doesn’t fall until the cash flow starts to dry up — as in, John Doe can’t make his house pay­ment and goes into default on his mortgage.

Secu­ri­ti­za­tions made against the sub-prime lending mar­kets were simply the weakest links in the finan­cial chain.

This is exactly where greed starts to really show up: when bankers decided to relax bor­rowing stan­dards, they began to allow loans that never, ever should have been made. In other words, bor­rowers had defi­cient or delin­quent credit his­to­ries, little doc­u­men­ta­tion on income and over-appraised prop­er­ties. Adjustable rate mort­gages (ARM’s) were tai­lored to fit the income of the bor­rower, which was already too small for a normal loan. Thus, when the ARM adjusted upward, up went the pay­ment amount and the bor­rower finds him­self delin­quent and facing bankruptcy.

Those holding the secu­ri­tized invest­ments all of a sudden receive less income and are forced to “revalue” their invest­ment down to the reality of income actu­ally received plus the prospect of addi­tional declines in income in the future. Remember that these assets were over-inflated in the first place, so investors are forced into taking huge hits on their bal­ance sheets.

Since secu­ri­tized assets are quite illiquid, it is very hard to find another buyer. If you are lucky enough to find one, the buyer will be inter­ested in offering you a “pennies-on-the-dollar” type of price.

It is insuf­fi­cient to blame the credit col­lapse on the sub­prime market. Because it was the weakest ele­ment of an overall flawed invest­ment market, It was simply the first seg­ment to blow up. The rest the market (non-subprime) is fol­lowing right behind it.

Now that people are looking for someone to blame for this debacle, the banking com­mu­nity, including even the Fed­eral Reserve, is shifting the blame to the con­sumer for having made poor bor­rowing deci­sions in the first place. After all, nobody forced them to submit an appli­ca­tion for a loan that they couldn’t afford. They should have known better.

Yet, it was the banking com­mu­nity that struc­tured the loan offers that lured unsus­pecting bor­rowers into their lair. For years, TV ads for mort­gages and credit cards dom­i­nated the air­waves. Many con­sumers received dozens of credit card offers by mail each week. Is it right for the bankers to say that they were merely responding to market con­di­tions, to give the foolish con­sumers what they demanded? In fact, the average person looks to his banker as an “expert adviser”, expecting knowl­edge­able answers that will be in the bor­rowers best interest.

I think not. Their mar­kets were arti­fi­cially cre­ated by the very adver­tising they flooded us with. Adver­tising cre­ates expec­ta­tions that can only be filled by pur­chasing the advertiser’s products.

According to a recent state­ment by Trea­sury Sec­re­tary Henry Paulson, former chairman and CEO of Goldman, Sachs, the Trea­sury will now step in with a plan that “helps investors and lenders avoid unnec­es­sary and costly fore­clo­sures that are not in their interest.” He has also talked of a rate freeze on Adjustable Rate Mort­gages that are soon to reset to a higher interest rate.

You can imagine how the owners of secu­ri­tized invest­ments feel about that. Having been guar­an­teed a cer­tain rate of interest, they will meet any gov­ern­ment inter­ven­tion or price-fixing with a flood of lawsuits.

Of course, a tsunami of law­suits, mort­gage fore­clo­sures and bank­rupt­cies would be fatal to at least a few U.S. banks. Yet appar­ently, to assume respon­si­bility for their own mis­takes (or even crim­inal actions) is too much to ask of them.

If the banking crowd suc­ceeds in taking another full drink from the public trea­sury, it will cost the Amer­ican tax­payers bil­lions in the end.

Mean­while, don’t expect that  the banking crisis is lim­ited to just the sub­prime lending market: It’s merely the tip of the iceberg!

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