Qualified Mortgages, Loan Credit Standards and Safe Harbors for Securities Fraud

“Default, dear Brutus, is in our stars, not in ourselves……”   

Paraphrase from Julius Caesar Cassius (pronounced “Cash Us”)  

The announcement last week of the new “qualified mortgage” regulations by the Consumer Financial Protection Bureau has generated a largely muted reaction from the industry, banks and non-banks alike.  The smaller specialized lenders and servicers in the world of distressed residential mortgage finance can easily live with the new normative standard. 

Meanwhile, the large banks are exiting the capital intensive portions of the mortgage business stage right under pressure from Basel III and other regulations.  Under B III, mortgage servicing rights above 15% of tangible common equity will require 100% capital weighting.  And yet, when it comes to lending standards and risk, one could argue, that the new QM rule is more permissive than the bad old days of the subprime boom. And some people do. 

“The Qualified Residential Mortgage rule is meant to discourage “risky” mortgages,” opines our friend and risk manager Nom de Plumber.  “However, if risk is defined as value or cash flow volatility, please note how both real estate and personal incomes are far riskier than their associated mortgages—-whose payments are typically static rather than volatile.”   

He continues:  “During this crisis, borrowers generally defaulted not because their mortgage payments skyrocketed unexpectedly, but because their home prices and employment income collapsed. The best solution for risky home prices and incomes is less mortgage leverage.  Yet, a 43% DTI is the official, post-crash threshold for “safe, affordable” mortgage payments, oddly far above the 30% to 35% DTI underwriting range of pre-bubble days.”  

Once again, notes Nom de Plumber, the regulators are obfuscating.  “The QRM rule is barking up the wrong tree, sidestepping the core, persistent problem of excessive debt to purchase unaffordable homes.”

Ed Pinto at AEI also is critical of the new rule for being too permissive, “CFPB’s new ‘qualified mortgage’ rule: The devil is in the details,”:

“The rule is made pursuant to the Dodd-Frank Act’s provision calling for minimum mortgage standards. It is being touted as making sure “prime” loans will be made responsibly. Yet true to the government’s long history of promoting excessive leverage, it sets no minimum down payment, no minimum standard for credit worthiness, and no maximum debt-to-income ratio. Under its tortured definition of “prime”, a borrower can have no down payment, a credit score of 580, and a debt ratio over 50% as long as they are approved by a government-sanctioned underwriting system.”

Pinto is critical of the fact that the CFPB has grandfathered the FHA and GSEs such as Fannie and Freddie for seven years.  He also echoes the criticism of Nom de Plumber by noting that “the CFPB has codified HUD’s view that the way to distinguish a prime loan from a subprime one is by the interest rate charged, not risk.”

Of course one area where regulators, Congress, the White House and others are entirely silent is securities fraud.  With Attorney General Eric Holder busily destroying what remains of the Department of Justice, there is no agency in the US governance apparatus  to address fraud.  The degree of securities fraud seen in the Subprime boom was so large that it did threaten the US economy in a systemic way, thus leading to the bailout.  But the bailout also hid the bad deeds of a number of prominent officials in Washington and on Wall Street.  Just read the first 100 pages of Sheila Bair’s book, “Bull by the Horns.”

“In a nutshell, the “real” point is shockingly simple,” notes one veteran bank attorney.  “We forgot a basic lesson of banking.  There is no such thing as an ‘off balance sheet liability’ of any financial intermediary on which the financial system depends.”

As the crisis hit, he argues, we faced an inevitable need to “recognize as much as $67 trillion of ‘shadow banking’ unreported ‘off balance sheet’ liabilities.  Like a manufacturer that suddenly discovers that it’s only product produces cancer and that the damages exceed its net worth, the banking system was flat broke and on course to destroy all the wealth ever accumulated within a year or so.”  

“Absent the outstanding crisis management of Chm. Bernanke and others,” says the long serving securities counsel, “the ‘unreported’ $67 trillion liability represented a 67% ‘hit’ to the world’s $100 trillion of ‘market value’ for equities,” thus explaining the stock market crash of 2008-9.  “If we had not taken steps to prevent deflation and drastically reduce the ‘carry’ cost of all debt, we were a mere 33% away from total worldwide bankruptcy and the inevitable WW III that would have followed,” he argues.

“Sheila Bair got the FDIC to end ‘off  balance sheet liabilities’ of US insured banks on Sept. 27, 2011 (assuming bankers are unwilling to stoop to outright thefts that insiders are obligated to report under 18 USC Sec. 4).  If her position holds up, we should be past this problem and on a path to ultimate recovery in another year or so.”

Maybe, but the battle in Washington over restraints on securities fraud rages on.  From the moment America’s leaders decided to dismantle depression era control of banking (the “level playing field commission” correctly made that a bi-partisan goal in 1969) we began experimenting with “how” and discovering problems that needed solution for the economy to function.  From then on, the power of unanticipated consequences led us to the doom we faced in 2008 and the economic gloom we now suffer.

For example, it soon became clear to the likes of Bill Isaac (GOP) and Paul Volcker (Dem) that de-regulated banks needed capital requirements or the FDIC’s insurance fund would be decimated.  They discovered, however, that one area of finance, funding trade receivables for manufacturing, was both essential and functioning very well without capital backing, because the depression era lenders created a system based on the Scottish reserve model that was self-correcting.  

That observation led Isaac, Volcker and his successor ( Alan Greenspan) to “bless” the notion that a “few very strong banks” should be allowed to do this “risk-free” form of lending in “conduits” that would not be included for capital purposes.  That, of course, soon blossomed into the entire $67 trillion “shadow banking” industry.

When those “shadow” liabilities came due in 2006-8, recognition of the hidden liability (backed by assets which had no discernible value at the time) destroyed the net worth of just about everyone.  As one of the largest hedge fund managers in the world said to me in 2008, “for a few months we were all broke.”

The illusion that conduits would only be used for low risk lending only lasted through for a few years in the 1980s.  The expansion of “off balance sheet liabilities” beyond funding of “risk free” trade receivables a few “trusted banks,” along with the emergence of the private RMBS market, forced FASB to consider when receivables were “sold.”  In 1982 it decided that the issue was whether the seller “purported” to sell the receivables (reliance on legal “form,” ignoring such obvious issues as “recourse” that converts a “sale” into an “equitable mortgage”).  

FDIC, thinking that standard was phony, “opted out” of FASB’s rule and relied on “regulatory accounting” to allow only the “big safe bank conduits” and other “safe” off balance sheet deals it “liked.”  The S&L crisis proved “regulatory accounting” was a calamity.  FSLIC’s blessing of special rules to hide losses led, in the Winstar case, to the US having to cover the phony capital FSLIC created using regulatory accounting.

FASB in the early 1990s studied its “purport to be a sale” test and correctly decided it was phony.  It adopted “legal isolation” (which recognizes that US law converts fraudulent transfers into secured debts–whereby money paid in exchange for assets a bank wants to hide from capital requirements must be repaid when the “seller’s” receiver recovers assets fraudulently transferred).  Effective January 1, 1997, FDIC accepted FASB’s legal isolation rule, dumping “regulatory accounting” on this issue.

The next “OOPS” soon emerged.  ABS/MBS lawyers for banks had lobbied FASB for a looser “isolation” standard for banks by absurdly telling FASB that “trustees” in Bankruptcy (Article 1 “administrative” officers) have more power than FDIC as a bank “receiver” (appointed with Article III “judicial” power–giving receivers truly awesome authority).  FASB fell for the lie.  As a result, FASB’s first “legal isolation” test was believed to be easier on banks than on others. 

In this instance the permissive tendency of Washington in the FASB rule making combined with the bank lawyers’ mistaken reading of receivership law to create an impossible situation.  FASB falsely assumed receivers have less power, but it turned out that FDIC could overturn literally ALL pre-receivership deals.  The banks’ lawyers had, in fact, negotiated a standard which allowed for NO financial asset “sales” by banks.  

An accounting profession committee posed that very problem to FASB and FDIC and asked if “no sales” was what FDIC wanted.  That’s resulted in FDIC’s adoption of a “safe harbor” rule for bank asset “sales” that ignored fraudulent transfer laws (which convert transfers for the purpose of leaving a selling bank with inadequate capital into secured borrowings).

It is that rule which Sheila Bair dumped in September 2011, in favor of a rule that finally “levels the playing field,” giving banks the exact power of non-banks–an ability to “sell” assets when the transaction is not done as a fraudulent transfer.

Lawyers that built careers writing the fraudulent transfer arrangements by which banks stripped themselves of assets and generated a large part of the $67 trillion “shadow banking” empire that imploded in 2007-8 are understandably “shocked.”  Unless they can find a new loophole, they will be required to opine on fraudulent transfer law in the same manner as has applied to non-bank lawyers since 1997.  Absent conformance with those laws, future transfers designed to retain “tail” risk while reducing the capital needed to protect FDIC against “tail” loss will be accounted for as secured borrowings–eliminating a major cause of the crisis.

Like the “tax shelter” salesmen of the early 1980s (who found their business depleted when Congress decided to stop that trade), lawyers whose business it was to generate the $67 trillion “shadow banking” empire undoubtedly feel deprived of valuable “rights.”  Their problem, however, is shockingly simple.  It is a “fraudulent transfer” to transfer assets with intent to leave the transferor with inadequate capital. This has been Anglo-American law since at least the 14th Century.  It is the foundation on which free-enterprise capitalism builds the leverage that permits accelerated growth for new value-added concepts. 

All state laws reflect this standard.  Thus every bank “sale” done for the purpose of reducing regulatory capital is, by definition, fraud — a form of bank theft. 

Only government can waive theft, as long as FDIC affirmatively “waived” the right to challenge these frauds, attorneys could not be required to opine that the transactions complied.  When FDIC stopped waiving this type of fraud in September of 2011, “misprision of felonies” (18 USC Sec. 4) mandates that attorneys disclose these matters to authorities.  Conversely, this may also mean that banks can’t be prosecuted for transfers before made FDIC changed course in September 2011. 

Will bank lawyers win a debate by saying “since we clearly cannot be caught having to reveal our clients’ thefts, the accountants need to change their rules so we don’t need to tell them when theft is occurring”?  Stay tuned. 


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