Where Is the Collateral?

Any government official asked to come up with a workout plan for troubled financial institutions, large portfolios of financial assets and liabilities and/or places that are financially challenged first must consider all the constituencies involved. No matter what his or her goals, an official must choose from among the options available. Before we judge them harshly, we must consider what we would do if we stood in the same shoes.

The challenge that US Treasury Secretary Hank Paulson faces when working out the problems with Fannie Mae or Freddie Mac is that a significant number of mortgages that serve as collateral for US mortgage backed securities markets are not real. They do not exist.

The problem is not that the people who bought the house and borrowed the money can not afford to pay it back or the house that they bought has dropped in value. If these were the problems, we would not be watching the debt the US government is responsible for increase by $5 trillion dollars. We would not be watching the National Bank of Australia announce a 50% loss rate on their mortgage backed securities.

When my company served as lead financial adviser to the Federal Housing Administration (FHA) we surveyed industry loss rates to compare them to FHA’s high rate of 35%. The highest we found in the industry was 25% and this was at the end of the last housing bubble bust, when loss rates would be expected to be high. As we due diligenced the FHA non performing and foreclosed portfolios, trying to understand a 35% lost rate, we started to find symptoms of fraudulent collateral practices. Indeed, we found portfolios with 50% loss rates and the losses had nothing to do with income levels or housing prices.

Here is a story that I have told many times before:

“Indeed, in 1994 after the first FHA/HUD financial audit was published, a mortgage banker came to see me. He was a serious engineering type who clearly worked hard and mastered the details of his business. He was distressed, he said. For decades he had been keeping a tally of total outstanding FHA/HUD mortgage insurance credit. He had brought printouts of his database for me. It turned out that the government’s published financial statements showed the amount outstanding was substantially less than the actual amount outstanding. He was sure. I assumed that the guy was crazy. If what he said were true, then the US Treasury and the Federal Reserve would have to be complicit in significant fraud, including securities fraud.”

After I began researching HUD fraud in the last 1990s, I would be contacted by people with experience with HUD fraud. They insisted the same home was being used to create ten or more mortgages that were placed into different pools. They alleged that Chase as the lead HUD servicer and the other big banks were implementing such systems. This was why we would see the same house default two, three or four times in a year, they claimed. You needed to churn the FHA mortgages through multiple defaults to generate the cash to keep all these fraudulent pools afloat. This, they insisted, was all going to finance various secret government operations and private agendas.

This issue of collateral fraud was repeated in other markets. As I started to learn more about precious metals and the commodities markets I would hear story after story about precious metals arrangements in which investors really had a bank credit — there was no real bullion behind the arrangement.

I have come to believe that the allegations of mortgage collateral fraud are true – not just for FHA and Ginnie Mae at HUD, but across the board throughout the mortgage markets.

What this means is that Freddie and Fannie Mae must be converted to essentially government debt. Such conversion means that investors simply don’t care if the mortgages have a real lien on anything real or not (at least for the meanwhile). Otherwise there would need to be a process by which all the defaulted mortgages can be sorted through to determine which of the mortgages are legitimate and which are not.

Creating and managing such a process would indeed crash the global financial system. It is hard for a multi- trillion dollar financial system to maintain liquidity when contracts and laws are meaningless.

The challenge for Hank Paulson is that by increasing the national debt by $5 trillion — whether collateralized by real estate or phony paper — he can delay the day of reckoning, but he can not cancel it.

There is only one thing that can cancel the day of reckoning and that is a return to productivity – a reengineering of resources in households and communities, a revitalization of culture, education and markets, a rebuilding of infrastructure, an integration of new technology and new process and a shift away from warfare, centralization, financial fraud and organized crime and those who lead and promote it.

Hank Paulson’s hands may be tied, but ours are not. Ultimately, you and I have the power to change this. So…who is your banker? Who is your farmer? Where is your money?

Read Parts I, II, III, IV, VI, VII, VIII, IX of this commentary >>>

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