Credit Crisis or the Exploitation of Financial Engineering??????
The current credit crisis which you most probably are suffering from to some extent or another is basically hinged upon two concepts, most have never heard of, and if you have, don’t understand them fully or how they have been twisted and exploited to create the avalanche of problems in both the housing and banking industries, what many are calling the Credit Crisis or the Sub-Prime Contagion.
One might wonder and correctly so, how the “Sub-Prime crisis” has become such a big issue, as it has hammered almost every sector of our economy? Sub-Prime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market. Large, but it is not statistically significant to ravage the entire banking industry thus there must be another culprit. It is not Sub-Prime but Wall Street and its compatriots that has gotten us in this mess, one could call it the “Prime-Slime” crisis, as every major and minor banking institution seems to be involved and / or affected by their own virus…a fraud of such gargantuan proportion we may never know its true size or extent but it is safe to say it makes Enron and World Com look like choir boys.
The only way a diseased patient is “healed” is to find the correct problem and then aggressively attack that cause point. The financial system seems endemic at this point along with the housing system, not to mention our government and their reactionary and ignorant meddling. It is all of course connected, but we are to examine only one piece of the equation in this article and that is the financial institutions and their continued role in financial disasters.
We could blame the price of oil, which many are doing, but I am here to tell you, being a student of that Industry that oil is the least of our problems. For the record, I am not an advocate for any Oil Company or Industry. Oil is one of the cheapest commodities on the planet relative to other commodities or services we consume, all of which offer far less in value than power to our buildings, our cars and our civilization. This too is a subject so vast and entertaining it deserves its own space, in fact a book, as I believe the best thing that could happen to our country is $8/gallon gasoline.
Now that I have your attention and it was not meant to do that, but one must address the correct area before it can be corrected, you must agree. And until the correct area is addressed nothing changes and that is what we have here, nothing changing. All we have to do is look back to the S&L Crisis or even closer to 2001 at the Dot Com crisis to see that nothing has changed expect the size of the fraud and the players (in fact, some have stayed the same as they are the same major players from Wall Street who helped create many of the problems of that Era) and reaps massive benefits from the Enron and World Com era all based on a financial term known as Mark to Model), this term shall be fully explained later.
I am going to explore a couple of areas in this writing to help you truly understand what has happened in part to get our economy in this situation and hopefully offer some ways out, albeit they may be painful and hard to swallow. One area we will cover is the lending process, too often called the sub prime crisis, but which I have renamed the Prime-Slime crisis and the terms Mark to Market and Mark to Model (financial tools that were very systemic in the Enron Era and the collective collapse of an entire industry, the Telecom Crisis and the Dot Com Bubble, and are terms you should know as we go forward.)
Let’s first examine the host of players and their roles: there is the Buyer of a home or condo, the Developer or Builder of the home or condo, the Bank or Mortgage company who loans the money, the group who acquires these loans from the banks, usually Freddie Mac and Fannie Mae (both public company’s) and a host of others, and then there is Wall Street, the wizards of finance, who acquires large amounts of portfolios of loans from Freddie and Fannie, and the Rating Agencies appointed by the SEC, to ensure that each company has a rating relative to its risk to repay its debt and to protect investors by rating company’s and their ability to repay their obligations, and then of course the Buyers that Wall Street convinces to buy all these packaged loans, who are expecting dividends paid out monthly or quarterly backed by these “highly secure assets”.
Step One:
-article by Gary Cardone
The Developer, the Builder:
This is a major piece of the crisis not being told by anyone and it has contributed to a massive amount of built up supply of homes and condos that has exasperated the housing problem and will do for some time to come. In the height of the market, some home builders and developers and many “Johnny come Lately Developers” lied and were fraudulent to their Banks and, some public traded home builders who continued to build in the face of an overbuilt situation probably violated their corporate governance and violated “full disclosure laws”.
Allow me to explain; the Developer would locate an apartment building or raw piece of land and convince a bank that if he could buy it with their money and secondary loans (mezzanine) and with little or no money down and do some slight improvements his team could then market those as condos and sell them for 150k per door. And some did very successfully for a long time and made a lot of money and some even built some nice Condos and Homes. They would go to the banks with their financial models and estimations of the future and sign loan and rehab documents, 100 pages long these documents, quite extensive and comprehensive, making all types of promises and statements about the lendees abilities, their balance sheet and capitalization. These guys suggested they already had firm sales, (I know of one company that would make presales to their employees and friends, talk about sub prime, and state those as sales to the banks as if they were real and valid sales). Additionally, they could estimate values in the future so creatively it was amazing and got the bank to buy off to their view of the world. It wasn’t difficult since the Bank makes money loaning money and competes with other Banks for this business.
But the hidden secret behind the developer is that many of them didn’t even need to sell the houses or condos as they had already collected a fee to manage the deal. I am talking large management fees incenting any Johnny come Lately to be a builder. A “developer” could take a loan out for $20 million then take out upwards of 5% of that gross value of the project before any sales are made. Then he could take that “future capital, the 5%, that’s right, and have it reflected as an asset on his books ” and do another deal, this time a 30 million dollar project or larger, and so on and so on. Just go to San Diego, Miami, Las Vegas, and you will see their footprint. These guys were prolific and they were very fraudulent and it is sitting in the loan docs for all to see. The fees in and of themselves is not the issue but the lying and fraud to collect these fees is the main issue and had that integrity been maintained in this market the overbuild situation would not have gotten to such a frothy point but in and of itself does not get us a Financial Crisis that has shook the world.
Step Two:
-article by Gary Cardone
Jose buys a house or condo from Developer above, with the help of a Bank or Mortgage Company (Jose commits NO fraud since he essentially stated in his one page loan doc that he did not have enough money to buy the house, but was happy to “own” a home). These loans known as NO DOC loans are the only non fraudulent loan in the process of buying a home….since, they required no docs or proof of viability so by definition have no fraud. Jose is the weakest player in the system and suffers the most as his credit is spoiled for a long time and he now has to go find a new home, probably an apartment, and his dream was ruined. “Jose, if its too good to believe its probably too good to be true” as my mom always use to tell me. Of course the guys pushing these No Doc loans are clearly part of the problem collecting a fee for a loan that one knew would never get fully repaid. I met a Banker today who admitted to me that he saw hundreds of people taking out loans to buy a home or condo and he knew they could never repay these loans.
Step 3:
-article by Gary Cardone
A Mortgage company pushes to get Jose approved for a loan or if the Bank itself loans the money to Jose under a fixed or floating interest rate…most likely floating, an adjustable rate mortgage (ARM), since it was cheaper for Jose. The bank or mortgage company knows fully well that Jose cannot afford this loan over the long term unless everything goes perfect for Jose but are paid per transaction. By the time the problem shows up the Mortgage company / broker has been paid their margin and / or commission and its no longer their problem as they have off loaded the mortgage to someone else. See Country Wide Financial, New Century Financial and others in this field for further explanation and verification of this.
Step 4:
-article by Gary Cardone
Bank or Mortgage XYZ then goes to Freddie Mac, Fannie Mae, (both formed by the Government to help Joe Public be able to acquire homes), or other such players, and sells the loan to them at a profit. Bank XYZ is most likely no longer in the process and has pocketed a profit for that quarter on that loan, aiding its stock price and bonus pool. Unless of course they did some of these “development” loans (above) and decided to keep them on their books as they are not so easy to offload to others. This will explain why Regional Banks are in trouble as they did a lot of business with unscrupulous, fraudulent builders with little or no management experience in running a business. You cannot convince me the banks did not know that these very builders were not over-levered. They are required to have massive loan docs ensuring this is not the case and a tremendous amount of due diligence on each loan. So either the banker was stupid or violated Federal lending laws and internal banking requirements or the Developer lied in the loan docs or a little of all of the above. Frightening isn’t it, but quite easy to discover if one just examines the loan docs of all these failed or struggling deals, there we will find much wrong doing and bending of reality.
Step 5:
-article by Gary Cardone
Then Freddie or Fannie package up all these Jose loans, Joan loans, Bob and Mary loans and sells them to Wall Street. Freddie has to continue buying loans and reselling them as this is their business and thus drives its stock price (yes they are Public company’s, amazing uh?).
Now the interesting issue is as follows; in a market that is not commoditized or liquid with clearly traded prices by which one can sell or buy (like housing) how is the value really established in these large pools of loans, which establishes the value of these company’s assets and thus their stock price or bonuses?
This is the basis of this writing; as I will suggest these assets were “financially modeled” to indicate or fantasize a valuation that was never real but that was valued in their share price through manipulation of a very “grey” or “opaque” market controlled by them, the major banking institutions and the Rating Agencies to distort reality and generate wealth for the select few until the entire cycle came crashing down as it always does as these guys always go too far with a good scam. Greed drives the day!
Step 6:
-article by Gary Cardone
Then of course no story would be complete without Wall Street, the well schooled, elite; some highly incentivised wiz kids and their “handlers” on Wall Street create profits, real or imagined so as to warrant their bonuses decides that the Company should take these loans, let’s call them Jose’ loans, and “repackage” them. Since these loans are going through the well-established business of Bear Stearns or Goldman Sachs or Lehman Brothers, or any of the others that did this, it now deserves a higher credit rating, right? Just for passing through the gilted doors of these esteemed company’s the value of this less than ideal loan portfolios are upgraded. This was called a CDO, collateralized debt obligations and it is defined as; s a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors.
A little history and Statistical data for you;
The first CDO was issued in 1987 by Bankers at now-defunct Drexel Burnham Lambert for Imperial Savings Association. Wasn’t that a big bust up also???? Oh yes, the Savings and Loans Crisis.
L. William Seidman, former chairman of both the FDIC and the Resolution Trust Corporation, stated, "The banking problems of the '80s and '90s came primarily, but not exclusively, from unsound real estate lending."
According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion in 2007. Research firm Celent estimates the size of the CDO global market to close to $2 trillion by the end of 2006.
Is this sounding familiar to anyone or is it just me?
Back to the present drama; one should ask, how can a product worth 10 dollars be held by another person then be worth more than 10 dollars, if no value was added? These are not purses or shoes made in Malaysia then branded by Gucci or Louis Vuitton that the wealthy pay extra for just because of a name. These are a portfolio of homes and condo’s, packaged up and then giving new credit values just because it was going through a fancy bank and given new status by the Ratings Agencies who were either coerced (or worst) to upgrade the package, and resold at higher values to others incapable of monitoring their value.
Our “Slick Willies” on Wall Street, by the way, this is not one guy but a team of people, groups, several dozens of individuals at each company who perpetrates these crimes; they convince the Ratings Agencies to upgrade a sub prime mortgage which by definition; in U.S. mortgage lending specifically, the term "sub prime" simply refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. It may or may not reflect credit status of the borrower as being less than ideal and may not even reflect the interest rate on the loan itself. The phrase also refers to bank loans taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and to certain types of self-employed persons.
So lets understand this: the Nationally Recognized Statistical Rating Organizations designated by the U.S. Securities and Exchange Commission in 1975, such as Moody’s Corporation, Standard and Poor and / or Fitch, upgrade a portfolio of loans which Goldman’s or Lehman’s hold which by definition do not meet guidelines of Fannie or Freddie and known as “B” paper. Hmmmm?????
What are these Ratings agencies and what is their role or what is it supposed to be? The Ratings Agencies performs financial research and analysis on commercial and government entities. The companies’ are suppose to rank the credit-worthiness of borrowers using a standardized ratings scale so as to allow investors to understand the risk and credibility of each firms balance sheets allowing the U.S. markets to be the safest most transparent and competitive market in the world.
Wall Street of course has strong incentives for profit to ensure that this pool of Loans has an enhanced rating just because it has been packaged or shall we say, “repackaged” by our MBA friends on Wall Street. Incredible! Ever seen the guy on the street with the three shells, “the shell game”, sounds familiar doesn’t it? Well, any good New York cop will run them off the street as it is clearly a scam, but not on Wall Street.
So what happens? Moody’s agrees, gives its stamp of approval, upgrades the portfolio, then Wall Street begin selling these vast portfolios at astronomical margins to others, usual oversees buyers, Germany, London, Spain, US pension funds and others who invest in conservative portfolios, etc. Buyers look at the ratings that Moody’s and Fitch has put on them and they think, well that is a safe investment one made by Goldman’s and blessed by Moody’s, given a Golden Seal of Approval….wouldn’t you?
Wall Street does a combination of repackaging sales and keeping some of these on their books since now they are worth more now that they sit with a new approval rating, why bother getting rid of them when they can “book” earnings from them for this quarter and the next and the next one….Ohhhh, Ken Lay is rolling in his grave….”I should have been a banker or better yet the Head of a Ban
Now this is where Mark to Market and Mark to Model come in;
Definition:
- article by Grant Cardone
Mark to Market; the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would fetch in the open market currently, even though the position is not yet closed or realized.
Mark to Model: As the practice of “marking to market” caught on in corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be objectively determined (because there was no real day-to-day market available), so assets were being 'marked to model' using estimated valuations derived from financial modeling, and sometimes marked to fantasies.
Since homes and condos aren’t a commodity, they have no liquid price, meaning a price upon which one can sell tomorrow. The banks and lending institutions can easily persuade that one must “model” the value of a portfolio of “assets”. That in it self is not the problem as not everything can be “marked to market” as that requires a very liquid and transparent market like Oil or Currencies or a publicly traded stock, but the fraudulent hiding of losses and manipulation of this “modeling” in the face of widespread data to the contrary is fraudulent and illegal.
What is modeling or a model? Defined: it is the task of building a financial model, a tool designed to forecast the performance of a business, project, or any other form of financial investment. A financial model uses relationships among macro-economic, operating, investing, tax, accounting, and financing variables to predict performance. The central aim of financial modeling is to forecast under uncertainty, and a financial model must allow multiple scenarios to be run efficiently, known as deterministic modeling.
I have rarely in 25 years in markets seen any of these models correct and not biased by the purchase price of the asset itself. I have seen them more often than not, however, come up with sophisticated “modeling” for their bosses expectations and future view of the world, usually justified by the last deal he did or the one he wanted to do to book earnings. This is modeling. Some of you will say I am being very cynical, I will say you are somewhat naïve, bordering on ignorant and that this is indeed the truth and “the why” of where we are with the current Credit Crisis and that it all boils down to very aggressive and unscrupulous accounting strategies/financial engineering to bolster earnings and bonuses.
That is where we are right now in the real estate market, stock values and with the value of the Banking community. No one has a clue what any of these “assets” are worth and thus cannot value risks. Thus we have a credit crisis, but really it is a Crisis of Credibility as there is still an enormous amount of money in the world…in fact, there has been no real loss but probably in reality a gain across the world and a massive shift of wealth. Wall Street and investors are trying to figure out what the price in the future for these assets are…what is a portfolio of 10,000 Jose loans worth? And therein lies our confusion and crisis.
Wall Street loves Mark to Model even though all they talk about is Mark to Market and transparency. A friend of mine just went to work at a large investment house in a very senior position that I knew for years from the Energy business. He told me he was stunned by the amount of Risk being taken by this firm, who he stated was one of the more conservative of the Investment Banking community and the amount of leverage and risks being exercised was thousands of times greater than anything we had seen in the Enron Era. This again could make up another story as I predict the earnings from all U.S. Investment Banks will be stymied for many years to come as we learn that the risk they have been taking even in their Mark-to-Market books, their trading books, far exceed anything we have ever anticipated would be allowed for world class corporations. If their activities were truly transparent I think the major investment banks would look more like Hedge Funds than what one considers when they think of an Investment Bank. Furthermore, if they or other Banks cannot loan money out to solid deals with good economics their earnings will continue to contract. This will of course include Private Equity whose earnings shall contract along with most of the hedge funds who no longer have the use of free and liberal capital allowing them to invest in companies and make monster returns for their investors. The days of 32% rates of return for the Ultra Wealthy in these Funds are over. These groups will be forced to look again at excellent management teams versus just chasing deals.
Back to our story; almost everyone in the system was treating there shareholders, their company, their stock price, their bonuses based on Mark to Model, manipulated to approve the deal….or in other terms; “make it up as you go to justify your stock price and your bonus.”
And you thought corporate governance had changed and Wall Street, had learned its lessons after Ken Lay and Jeff Skillings at Enron and Bernie Ebbers at World Com and a host of others…….Not one bit! And that really is the crux of this writing; hundreds and hundreds of people should have gone to jail for the crimes that were committed in the 2001 dot.com bust, the Enron Era…but only a very few actually did and some of them are the wrong people. I say this because of first hand experience of watching these crimes perpetrated and knowing that in order for crimes of this magnitude to be effected there are dozens and dozens of people involved, all focused on distortion for the purpose of their bonus or earnings for their company, their options program or to appease their boss and be a part of the “team”.
In order for crimes and fraud of this magnitude, and make no mistake about it this debacle; this raping of individual wealth is massive in comparison to the Enron and World Com crimes, there must be wide spread fraud and distortion, not just isolated pockets of crime. So wide spread there will be very little responsibility taken for it. No responsibility of any real level was enforced last time this happened and thus we are here again.
So what needs to be done? There is no panacea here but what needs to take place is aggressive action by the enforcement bodies who are being paid by you and I in the form of taxation to ensure that we live in a society where there are rules and guidelines and an ethos by which people operate so that competition and skill can be properly measured and rewarded and to ensure the Capitalist model prevails.
Let’s first off understand who was not at fault.
Jose was not at fault or most anyone who signed a sub prime loan as his documents are one or two pages stating his name, address, etc., and basically he can just afford to pay the note, if that. HE DID NOT LIE. He took the leaf that was offered him and now his credit is crushed, along with his dream. Can you blame him for wanting a home, the American Dream? Very few of these people upon review will be found to have lied any more than anyone has perhaps overstated their position on a loan document.
I cannot think of anyone else in the process that cannot be found and held accountable.
The “Speculators,” everyone knows someone who became a Real Estate professional, who were flipping condos and homes like they were commodities; these people have not created this wide spread contagion of credit crisis and in fact these people for the most part are suffering either financially or through credit deterioration, or both.
Developers: wide spread fraudulent misrepresentation and falsifying of banking documents. All that one needs to do is to review the loan docs, especially of failed or near failed groups or projects to find fraud perpetrated and take these unethical persons down and get them out of the system. We will find a massive amount of fraud in this sector of the market who have been responsible for exploiting not only lax lending standards but went further and were fraudulent with millions of dollars of other people’s money. These guys have created a large amount of overhang in supply that has further exasperated this problem and will take years to work out of the system.
Public builders; many have stretched the whole concept of mark to model and I suspect many public builders were misleading in their transparency and their operations. Review their documentation. Did they do full disclosure, did they manipulate the mark to model too much, in the face of other data? Were their loan documentation done by the letter of the law and within their corporate governances? Were public companies in earnings reports providing full disclosure?
These two previous sectors of the market will be easy to assess where there was foul play.
The Banks, Lenders, Mortgage company: the all retain all their loan documents? Review them. Find the fraud and prosecute it to the letter of the law, if and where it is found. Determine where, if any areas, banks violated their Federal lending laws and prosecute bank management and Boards to the letter and any individuals that were committing these frauds. How could regional or national banks end up with a crisis of such size? There was either a tremendous amount of “doctoring” of the books, which is illegal and fraudulent, or they were downright stupid. It has to be one or the other and I shudder to believe what the greatest nation in the world and the largest economy on Earth has to say if we claim it was all stupidity.
Global Banking, syndicators, packagers of the loans: what did they know? How much manipulation occurred to change all those poor credit loans to get them upgraded in credit? Did they violate their risk parameters? Did they misrepresent? Was there coercion or complicity with the Ratings Agencies?
What did Freddie and Fannie and all the others know regarding the repackaging of loans? Did they violate their corporate governances? Did they exceed their risk guidelines?
The Rating Agencies: are they stupid, if so, extinguish their existence. Remember these are the same guys that missed Enron and World Com. Why are they public company’s and can one ever separate their duty to inform the public of risk issues when they are inclined by profit? Investigate aggressively and find the smoking gun(s).
Until the FBI and the SEC (Securities and Exchange Commission) do their job which is to police fraud and crimes and to hold at task responsibility for public entities, private groups who perpetuate fraud, only then will our society in the U.S. be the greatest economy in the world. Until then we will rank with the wild, wild, West of Russia and other Eastern countries and Developing countries who manipulate earnings, deal in opacity and lack of transparency and feed off of those not a part of the club.
I lived in Europe for ten years and I remember hearing many people there talk about our financial system with disgust suggesting it was rampant with fraud and non transparency. I was stunned and offended. I was naïve, as one can no longer close an eye to this apparency.
The hard medicine that must be taken:
The only way our system gets back in shape and fast is to go back to where we started; Mark to Market or Mark to Model? Where available push mark to market very aggressively so that all companies have to write down values now. This will indeed rock the financial world, but prices will come down to liquidation values and then you will see a massive move of investments into this market, mostly from overseas. Then there will be credibility reestablished, after the initial shock wears off from what everyone knows anyway. And money will flow to where value is, it always does.
Where products are very difficult to determine its value we will have to continue to do some modeling however, once liquidation occurs in the above scenario groups will be forced to remark these models to levels that do not over inflate valuations and thus incent groups to take what they can or to consolidate positions.
It reminds me of a story; I used to call Enron in Europe, because I knew they had a large Electric position in their books that was being “modeled”. These were massive transactions they were claiming were worth hundreds of millions of dollars. I would offer to buy or sell Electricity to them, (called a bid / offer spread), for a ten-cent spread. I think I offered to buy at 17 and sell at 17.1 for five years the entire output of an electric power station to the head of the division of the “greatest traders in the world” as they claimed, the “smartest guys in the room.” The guy went dead quiet on the taped line, then muffled something and hung up. They would not execute that trade with me because they knew the moment they traded with me they would have to move their transactions that they valued in a model at hundreds of millions of dollars into a mark to market book and that would unravel one of their many and largest scams. It was quite interesting. He is now the head of a major investment bank division.
Markets always work. Always! Capitalism is built on the fundamental of supply and demand and very basic economic principles of competition. But when there is a skew of reality created by the unscrupulous and distorted machinations, markets capitulate and heave and stall, and that is where we are right now.
The sooner we are honest with valuations the sooner we can get on with rebuilding a great Nation. The sooner we flush the system of whole-sale fraudulent practices, of breeching corporate governances and the trust of shareholders, the sooner we get back onto the road of true Capitalism and away from distorted form of Socialism or worst.
If one studies history, every great nation on this planet has lost its position of dominance through out-ethics and this one too will lose its greatness, if it is not already to late, if its global credibility continues to languish and erode.
All rights resevered by Gary Cardone
One might wonder and correctly so, how the “Sub-Prime crisis” has become such a big issue, as it has hammered almost every sector of our economy? Sub-Prime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market. Large, but it is not statistically significant to ravage the entire banking industry thus there must be another culprit. It is not Sub-Prime but Wall Street and its compatriots that has gotten us in this mess, one could call it the “Prime-Slime” crisis, as every major and minor banking institution seems to be involved and / or affected by their own virus…a fraud of such gargantuan proportion we may never know its true size or extent but it is safe to say it makes Enron and World Com look like choir boys.
The only way a diseased patient is “healed” is to find the correct problem and then aggressively attack that cause point. The financial system seems endemic at this point along with the housing system, not to mention our government and their reactionary and ignorant meddling. It is all of course connected, but we are to examine only one piece of the equation in this article and that is the financial institutions and their continued role in financial disasters.
We could blame the price of oil, which many are doing, but I am here to tell you, being a student of that Industry that oil is the least of our problems. For the record, I am not an advocate for any Oil Company or Industry. Oil is one of the cheapest commodities on the planet relative to other commodities or services we consume, all of which offer far less in value than power to our buildings, our cars and our civilization. This too is a subject so vast and entertaining it deserves its own space, in fact a book, as I believe the best thing that could happen to our country is $8/gallon gasoline.
Now that I have your attention and it was not meant to do that, but one must address the correct area before it can be corrected, you must agree. And until the correct area is addressed nothing changes and that is what we have here, nothing changing. All we have to do is look back to the S&L Crisis or even closer to 2001 at the Dot Com crisis to see that nothing has changed expect the size of the fraud and the players (in fact, some have stayed the same as they are the same major players from Wall Street who helped create many of the problems of that Era) and reaps massive benefits from the Enron and World Com era all based on a financial term known as Mark to Model), this term shall be fully explained later.
I am going to explore a couple of areas in this writing to help you truly understand what has happened in part to get our economy in this situation and hopefully offer some ways out, albeit they may be painful and hard to swallow. One area we will cover is the lending process, too often called the sub prime crisis, but which I have renamed the Prime-Slime crisis and the terms Mark to Market and Mark to Model (financial tools that were very systemic in the Enron Era and the collective collapse of an entire industry, the Telecom Crisis and the Dot Com Bubble, and are terms you should know as we go forward.)
Let’s first examine the host of players and their roles: there is the Buyer of a home or condo, the Developer or Builder of the home or condo, the Bank or Mortgage company who loans the money, the group who acquires these loans from the banks, usually Freddie Mac and Fannie Mae (both public company’s) and a host of others, and then there is Wall Street, the wizards of finance, who acquires large amounts of portfolios of loans from Freddie and Fannie, and the Rating Agencies appointed by the SEC, to ensure that each company has a rating relative to its risk to repay its debt and to protect investors by rating company’s and their ability to repay their obligations, and then of course the Buyers that Wall Street convinces to buy all these packaged loans, who are expecting dividends paid out monthly or quarterly backed by these “highly secure assets”.
Step One:
-article by Gary Cardone
The Developer, the Builder:
This is a major piece of the crisis not being told by anyone and it has contributed to a massive amount of built up supply of homes and condos that has exasperated the housing problem and will do for some time to come. In the height of the market, some home builders and developers and many “Johnny come Lately Developers” lied and were fraudulent to their Banks and, some public traded home builders who continued to build in the face of an overbuilt situation probably violated their corporate governance and violated “full disclosure laws”.
Allow me to explain; the Developer would locate an apartment building or raw piece of land and convince a bank that if he could buy it with their money and secondary loans (mezzanine) and with little or no money down and do some slight improvements his team could then market those as condos and sell them for 150k per door. And some did very successfully for a long time and made a lot of money and some even built some nice Condos and Homes. They would go to the banks with their financial models and estimations of the future and sign loan and rehab documents, 100 pages long these documents, quite extensive and comprehensive, making all types of promises and statements about the lendees abilities, their balance sheet and capitalization. These guys suggested they already had firm sales, (I know of one company that would make presales to their employees and friends, talk about sub prime, and state those as sales to the banks as if they were real and valid sales). Additionally, they could estimate values in the future so creatively it was amazing and got the bank to buy off to their view of the world. It wasn’t difficult since the Bank makes money loaning money and competes with other Banks for this business.
But the hidden secret behind the developer is that many of them didn’t even need to sell the houses or condos as they had already collected a fee to manage the deal. I am talking large management fees incenting any Johnny come Lately to be a builder. A “developer” could take a loan out for $20 million then take out upwards of 5% of that gross value of the project before any sales are made. Then he could take that “future capital, the 5%, that’s right, and have it reflected as an asset on his books ” and do another deal, this time a 30 million dollar project or larger, and so on and so on. Just go to San Diego, Miami, Las Vegas, and you will see their footprint. These guys were prolific and they were very fraudulent and it is sitting in the loan docs for all to see. The fees in and of themselves is not the issue but the lying and fraud to collect these fees is the main issue and had that integrity been maintained in this market the overbuild situation would not have gotten to such a frothy point but in and of itself does not get us a Financial Crisis that has shook the world.
Step Two:
-article by Gary Cardone
Jose buys a house or condo from Developer above, with the help of a Bank or Mortgage Company (Jose commits NO fraud since he essentially stated in his one page loan doc that he did not have enough money to buy the house, but was happy to “own” a home). These loans known as NO DOC loans are the only non fraudulent loan in the process of buying a home….since, they required no docs or proof of viability so by definition have no fraud. Jose is the weakest player in the system and suffers the most as his credit is spoiled for a long time and he now has to go find a new home, probably an apartment, and his dream was ruined. “Jose, if its too good to believe its probably too good to be true” as my mom always use to tell me. Of course the guys pushing these No Doc loans are clearly part of the problem collecting a fee for a loan that one knew would never get fully repaid. I met a Banker today who admitted to me that he saw hundreds of people taking out loans to buy a home or condo and he knew they could never repay these loans.
Step 3:
-article by Gary Cardone
A Mortgage company pushes to get Jose approved for a loan or if the Bank itself loans the money to Jose under a fixed or floating interest rate…most likely floating, an adjustable rate mortgage (ARM), since it was cheaper for Jose. The bank or mortgage company knows fully well that Jose cannot afford this loan over the long term unless everything goes perfect for Jose but are paid per transaction. By the time the problem shows up the Mortgage company / broker has been paid their margin and / or commission and its no longer their problem as they have off loaded the mortgage to someone else. See Country Wide Financial, New Century Financial and others in this field for further explanation and verification of this.
Step 4:
-article by Gary Cardone
Bank or Mortgage XYZ then goes to Freddie Mac, Fannie Mae, (both formed by the Government to help Joe Public be able to acquire homes), or other such players, and sells the loan to them at a profit. Bank XYZ is most likely no longer in the process and has pocketed a profit for that quarter on that loan, aiding its stock price and bonus pool. Unless of course they did some of these “development” loans (above) and decided to keep them on their books as they are not so easy to offload to others. This will explain why Regional Banks are in trouble as they did a lot of business with unscrupulous, fraudulent builders with little or no management experience in running a business. You cannot convince me the banks did not know that these very builders were not over-levered. They are required to have massive loan docs ensuring this is not the case and a tremendous amount of due diligence on each loan. So either the banker was stupid or violated Federal lending laws and internal banking requirements or the Developer lied in the loan docs or a little of all of the above. Frightening isn’t it, but quite easy to discover if one just examines the loan docs of all these failed or struggling deals, there we will find much wrong doing and bending of reality.
Step 5:
-article by Gary Cardone
Then Freddie or Fannie package up all these Jose loans, Joan loans, Bob and Mary loans and sells them to Wall Street. Freddie has to continue buying loans and reselling them as this is their business and thus drives its stock price (yes they are Public company’s, amazing uh?).
Now the interesting issue is as follows; in a market that is not commoditized or liquid with clearly traded prices by which one can sell or buy (like housing) how is the value really established in these large pools of loans, which establishes the value of these company’s assets and thus their stock price or bonuses?
This is the basis of this writing; as I will suggest these assets were “financially modeled” to indicate or fantasize a valuation that was never real but that was valued in their share price through manipulation of a very “grey” or “opaque” market controlled by them, the major banking institutions and the Rating Agencies to distort reality and generate wealth for the select few until the entire cycle came crashing down as it always does as these guys always go too far with a good scam. Greed drives the day!
Step 6:
-article by Gary Cardone
Then of course no story would be complete without Wall Street, the well schooled, elite; some highly incentivised wiz kids and their “handlers” on Wall Street create profits, real or imagined so as to warrant their bonuses decides that the Company should take these loans, let’s call them Jose’ loans, and “repackage” them. Since these loans are going through the well-established business of Bear Stearns or Goldman Sachs or Lehman Brothers, or any of the others that did this, it now deserves a higher credit rating, right? Just for passing through the gilted doors of these esteemed company’s the value of this less than ideal loan portfolios are upgraded. This was called a CDO, collateralized debt obligations and it is defined as; s a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors.
A little history and Statistical data for you;
The first CDO was issued in 1987 by Bankers at now-defunct Drexel Burnham Lambert for Imperial Savings Association. Wasn’t that a big bust up also???? Oh yes, the Savings and Loans Crisis.
L. William Seidman, former chairman of both the FDIC and the Resolution Trust Corporation, stated, "The banking problems of the '80s and '90s came primarily, but not exclusively, from unsound real estate lending."
According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion in 2007. Research firm Celent estimates the size of the CDO global market to close to $2 trillion by the end of 2006.
Is this sounding familiar to anyone or is it just me?
Back to the present drama; one should ask, how can a product worth 10 dollars be held by another person then be worth more than 10 dollars, if no value was added? These are not purses or shoes made in Malaysia then branded by Gucci or Louis Vuitton that the wealthy pay extra for just because of a name. These are a portfolio of homes and condo’s, packaged up and then giving new credit values just because it was going through a fancy bank and given new status by the Ratings Agencies who were either coerced (or worst) to upgrade the package, and resold at higher values to others incapable of monitoring their value.
Our “Slick Willies” on Wall Street, by the way, this is not one guy but a team of people, groups, several dozens of individuals at each company who perpetrates these crimes; they convince the Ratings Agencies to upgrade a sub prime mortgage which by definition; in U.S. mortgage lending specifically, the term "sub prime" simply refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. It may or may not reflect credit status of the borrower as being less than ideal and may not even reflect the interest rate on the loan itself. The phrase also refers to bank loans taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and to certain types of self-employed persons.
So lets understand this: the Nationally Recognized Statistical Rating Organizations designated by the U.S. Securities and Exchange Commission in 1975, such as Moody’s Corporation, Standard and Poor and / or Fitch, upgrade a portfolio of loans which Goldman’s or Lehman’s hold which by definition do not meet guidelines of Fannie or Freddie and known as “B” paper. Hmmmm?????
What are these Ratings agencies and what is their role or what is it supposed to be? The Ratings Agencies performs financial research and analysis on commercial and government entities. The companies’ are suppose to rank the credit-worthiness of borrowers using a standardized ratings scale so as to allow investors to understand the risk and credibility of each firms balance sheets allowing the U.S. markets to be the safest most transparent and competitive market in the world.
Wall Street of course has strong incentives for profit to ensure that this pool of Loans has an enhanced rating just because it has been packaged or shall we say, “repackaged” by our MBA friends on Wall Street. Incredible! Ever seen the guy on the street with the three shells, “the shell game”, sounds familiar doesn’t it? Well, any good New York cop will run them off the street as it is clearly a scam, but not on Wall Street.
So what happens? Moody’s agrees, gives its stamp of approval, upgrades the portfolio, then Wall Street begin selling these vast portfolios at astronomical margins to others, usual oversees buyers, Germany, London, Spain, US pension funds and others who invest in conservative portfolios, etc. Buyers look at the ratings that Moody’s and Fitch has put on them and they think, well that is a safe investment one made by Goldman’s and blessed by Moody’s, given a Golden Seal of Approval….wouldn’t you?
Wall Street does a combination of repackaging sales and keeping some of these on their books since now they are worth more now that they sit with a new approval rating, why bother getting rid of them when they can “book” earnings from them for this quarter and the next and the next one….Ohhhh, Ken Lay is rolling in his grave….”I should have been a banker or better yet the Head of a Ban
Now this is where Mark to Market and Mark to Model come in;
Definition:
- article by Grant Cardone
Mark to Market; the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would fetch in the open market currently, even though the position is not yet closed or realized.
Mark to Model: As the practice of “marking to market” caught on in corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be objectively determined (because there was no real day-to-day market available), so assets were being 'marked to model' using estimated valuations derived from financial modeling, and sometimes marked to fantasies.
Since homes and condos aren’t a commodity, they have no liquid price, meaning a price upon which one can sell tomorrow. The banks and lending institutions can easily persuade that one must “model” the value of a portfolio of “assets”. That in it self is not the problem as not everything can be “marked to market” as that requires a very liquid and transparent market like Oil or Currencies or a publicly traded stock, but the fraudulent hiding of losses and manipulation of this “modeling” in the face of widespread data to the contrary is fraudulent and illegal.
What is modeling or a model? Defined: it is the task of building a financial model, a tool designed to forecast the performance of a business, project, or any other form of financial investment. A financial model uses relationships among macro-economic, operating, investing, tax, accounting, and financing variables to predict performance. The central aim of financial modeling is to forecast under uncertainty, and a financial model must allow multiple scenarios to be run efficiently, known as deterministic modeling.
I have rarely in 25 years in markets seen any of these models correct and not biased by the purchase price of the asset itself. I have seen them more often than not, however, come up with sophisticated “modeling” for their bosses expectations and future view of the world, usually justified by the last deal he did or the one he wanted to do to book earnings. This is modeling. Some of you will say I am being very cynical, I will say you are somewhat naïve, bordering on ignorant and that this is indeed the truth and “the why” of where we are with the current Credit Crisis and that it all boils down to very aggressive and unscrupulous accounting strategies/financial engineering to bolster earnings and bonuses.
That is where we are right now in the real estate market, stock values and with the value of the Banking community. No one has a clue what any of these “assets” are worth and thus cannot value risks. Thus we have a credit crisis, but really it is a Crisis of Credibility as there is still an enormous amount of money in the world…in fact, there has been no real loss but probably in reality a gain across the world and a massive shift of wealth. Wall Street and investors are trying to figure out what the price in the future for these assets are…what is a portfolio of 10,000 Jose loans worth? And therein lies our confusion and crisis.
Wall Street loves Mark to Model even though all they talk about is Mark to Market and transparency. A friend of mine just went to work at a large investment house in a very senior position that I knew for years from the Energy business. He told me he was stunned by the amount of Risk being taken by this firm, who he stated was one of the more conservative of the Investment Banking community and the amount of leverage and risks being exercised was thousands of times greater than anything we had seen in the Enron Era. This again could make up another story as I predict the earnings from all U.S. Investment Banks will be stymied for many years to come as we learn that the risk they have been taking even in their Mark-to-Market books, their trading books, far exceed anything we have ever anticipated would be allowed for world class corporations. If their activities were truly transparent I think the major investment banks would look more like Hedge Funds than what one considers when they think of an Investment Bank. Furthermore, if they or other Banks cannot loan money out to solid deals with good economics their earnings will continue to contract. This will of course include Private Equity whose earnings shall contract along with most of the hedge funds who no longer have the use of free and liberal capital allowing them to invest in companies and make monster returns for their investors. The days of 32% rates of return for the Ultra Wealthy in these Funds are over. These groups will be forced to look again at excellent management teams versus just chasing deals.
Back to our story; almost everyone in the system was treating there shareholders, their company, their stock price, their bonuses based on Mark to Model, manipulated to approve the deal….or in other terms; “make it up as you go to justify your stock price and your bonus.”
And you thought corporate governance had changed and Wall Street, had learned its lessons after Ken Lay and Jeff Skillings at Enron and Bernie Ebbers at World Com and a host of others…….Not one bit! And that really is the crux of this writing; hundreds and hundreds of people should have gone to jail for the crimes that were committed in the 2001 dot.com bust, the Enron Era…but only a very few actually did and some of them are the wrong people. I say this because of first hand experience of watching these crimes perpetrated and knowing that in order for crimes of this magnitude to be effected there are dozens and dozens of people involved, all focused on distortion for the purpose of their bonus or earnings for their company, their options program or to appease their boss and be a part of the “team”.
In order for crimes and fraud of this magnitude, and make no mistake about it this debacle; this raping of individual wealth is massive in comparison to the Enron and World Com crimes, there must be wide spread fraud and distortion, not just isolated pockets of crime. So wide spread there will be very little responsibility taken for it. No responsibility of any real level was enforced last time this happened and thus we are here again.
So what needs to be done? There is no panacea here but what needs to take place is aggressive action by the enforcement bodies who are being paid by you and I in the form of taxation to ensure that we live in a society where there are rules and guidelines and an ethos by which people operate so that competition and skill can be properly measured and rewarded and to ensure the Capitalist model prevails.
Let’s first off understand who was not at fault.
Jose was not at fault or most anyone who signed a sub prime loan as his documents are one or two pages stating his name, address, etc., and basically he can just afford to pay the note, if that. HE DID NOT LIE. He took the leaf that was offered him and now his credit is crushed, along with his dream. Can you blame him for wanting a home, the American Dream? Very few of these people upon review will be found to have lied any more than anyone has perhaps overstated their position on a loan document.
I cannot think of anyone else in the process that cannot be found and held accountable.
The “Speculators,” everyone knows someone who became a Real Estate professional, who were flipping condos and homes like they were commodities; these people have not created this wide spread contagion of credit crisis and in fact these people for the most part are suffering either financially or through credit deterioration, or both.
Developers: wide spread fraudulent misrepresentation and falsifying of banking documents. All that one needs to do is to review the loan docs, especially of failed or near failed groups or projects to find fraud perpetrated and take these unethical persons down and get them out of the system. We will find a massive amount of fraud in this sector of the market who have been responsible for exploiting not only lax lending standards but went further and were fraudulent with millions of dollars of other people’s money. These guys have created a large amount of overhang in supply that has further exasperated this problem and will take years to work out of the system.
Public builders; many have stretched the whole concept of mark to model and I suspect many public builders were misleading in their transparency and their operations. Review their documentation. Did they do full disclosure, did they manipulate the mark to model too much, in the face of other data? Were their loan documentation done by the letter of the law and within their corporate governances? Were public companies in earnings reports providing full disclosure?
These two previous sectors of the market will be easy to assess where there was foul play.
The Banks, Lenders, Mortgage company: the all retain all their loan documents? Review them. Find the fraud and prosecute it to the letter of the law, if and where it is found. Determine where, if any areas, banks violated their Federal lending laws and prosecute bank management and Boards to the letter and any individuals that were committing these frauds. How could regional or national banks end up with a crisis of such size? There was either a tremendous amount of “doctoring” of the books, which is illegal and fraudulent, or they were downright stupid. It has to be one or the other and I shudder to believe what the greatest nation in the world and the largest economy on Earth has to say if we claim it was all stupidity.
Global Banking, syndicators, packagers of the loans: what did they know? How much manipulation occurred to change all those poor credit loans to get them upgraded in credit? Did they violate their risk parameters? Did they misrepresent? Was there coercion or complicity with the Ratings Agencies?
What did Freddie and Fannie and all the others know regarding the repackaging of loans? Did they violate their corporate governances? Did they exceed their risk guidelines?
The Rating Agencies: are they stupid, if so, extinguish their existence. Remember these are the same guys that missed Enron and World Com. Why are they public company’s and can one ever separate their duty to inform the public of risk issues when they are inclined by profit? Investigate aggressively and find the smoking gun(s).
Until the FBI and the SEC (Securities and Exchange Commission) do their job which is to police fraud and crimes and to hold at task responsibility for public entities, private groups who perpetuate fraud, only then will our society in the U.S. be the greatest economy in the world. Until then we will rank with the wild, wild, West of Russia and other Eastern countries and Developing countries who manipulate earnings, deal in opacity and lack of transparency and feed off of those not a part of the club.
I lived in Europe for ten years and I remember hearing many people there talk about our financial system with disgust suggesting it was rampant with fraud and non transparency. I was stunned and offended. I was naïve, as one can no longer close an eye to this apparency.
The hard medicine that must be taken:
The only way our system gets back in shape and fast is to go back to where we started; Mark to Market or Mark to Model? Where available push mark to market very aggressively so that all companies have to write down values now. This will indeed rock the financial world, but prices will come down to liquidation values and then you will see a massive move of investments into this market, mostly from overseas. Then there will be credibility reestablished, after the initial shock wears off from what everyone knows anyway. And money will flow to where value is, it always does.
Where products are very difficult to determine its value we will have to continue to do some modeling however, once liquidation occurs in the above scenario groups will be forced to remark these models to levels that do not over inflate valuations and thus incent groups to take what they can or to consolidate positions.
It reminds me of a story; I used to call Enron in Europe, because I knew they had a large Electric position in their books that was being “modeled”. These were massive transactions they were claiming were worth hundreds of millions of dollars. I would offer to buy or sell Electricity to them, (called a bid / offer spread), for a ten-cent spread. I think I offered to buy at 17 and sell at 17.1 for five years the entire output of an electric power station to the head of the division of the “greatest traders in the world” as they claimed, the “smartest guys in the room.” The guy went dead quiet on the taped line, then muffled something and hung up. They would not execute that trade with me because they knew the moment they traded with me they would have to move their transactions that they valued in a model at hundreds of millions of dollars into a mark to market book and that would unravel one of their many and largest scams. It was quite interesting. He is now the head of a major investment bank division.
Markets always work. Always! Capitalism is built on the fundamental of supply and demand and very basic economic principles of competition. But when there is a skew of reality created by the unscrupulous and distorted machinations, markets capitulate and heave and stall, and that is where we are right now.
The sooner we are honest with valuations the sooner we can get on with rebuilding a great Nation. The sooner we flush the system of whole-sale fraudulent practices, of breeching corporate governances and the trust of shareholders, the sooner we get back onto the road of true Capitalism and away from distorted form of Socialism or worst.
If one studies history, every great nation on this planet has lost its position of dominance through out-ethics and this one too will lose its greatness, if it is not already to late, if its global credibility continues to languish and erode.
All rights resevered by Gary Cardone
