Shadow Banking...Time To Shine A Light On Fraud

On January 17, the Obama Administration announced that it was pushing to get the 50 state attorneys general to agree to a mortgage fraud settlement with America’s largest banking institutions. However, a key fraudulent practice will not be part of that proposed settlement--the “robo-signing” scandal. This ongoing scandal involves bank employees signing names not their own, under titles they did not have, attesting to the veracity of documents they had not seen or reviewed. Much evidence exists that it was an industry-wide practice, dating back to 1998 at the earliest, and that it has, in fact, clouded the titles of millions of homes. If the settlement is agreed to, it will let bankers off the hook for crimes that would land you and me behind bars--fraud, forgery, securities violations and tax evasion.

This is most unfortunate, as state-level robo-signing prosecutions are the simplest form of fraud to prove and thereby punish the offenders for. But the Obama Administration has sided with the banks on this one and handed them a “get out of jail free” card. As part of the proposed mortgage fraud settlement, the banks will not face any more investigations into this crime. To the President’s credit, however, he seems to have felt the wrath of the 99% of us in regard to his position on the settlement, in response to protests before his State of the Union address. During his speech on January 24, he did not mention the settlement itself, but announced instead that he would be creating a mortgage crisis unit to investigate wrongdoing related to real estate lending. Only the future will tell if this investigative unit will be given the authority needed when it comes to criminal prosecutions.

The robo-signing largely involved assignments of mortgage notes to mortgage servicers or trusts representing the investors who put up the loan money. Assignment was necessary to give the trusts legal title to the loans. But in millions of cases the assignment was delayed until it was necessary to foreclose on the homes, when it had to be done through the forgery, fraud and back dating of robo-signing. Why did the banks not assign the mortgages to the trusts earlier, when it’s required by law in all 50 states?

I think it speaks to the evolution of what Nobel Prize Economist Paul Krugman has aptly monikered “the shadow banking system.” I witnessed this evolution during my time spent as a title insurance underwriter from 1995 to 2005. My co-workers and I once took pride in the title industry as its 3rd-party neutrality worked as an effective regulatory mechanism in ensuring the legality of documents and offered protection to borrowers against fraud, deceitful mortgage lenders and unscrupulous real estate agents. It was our job to make sure borrowers knew what they were signing and entering into. I took full advantage of the three-day right of rescission law and corresponding legal document that many lenders never submitted to me for the borrower’s signature and protection. I continually had to demand it from banks--I would refuse to allow the borrower to sign any loan documents without it. I reviewed everything, in particular the terms of the mortgage note. I alerted countless borrowers to what I thought were undesirable terms, made them read any language related to rate increases, excessive closing costs, balloon payments, severe penalties triggered if they were to re-finance or pay off the loan within a certain timeline, etc, etc. In signing the three-day right of rescission form, this allowed me to have a conversation with borrowers about what they may be getting themselves into and allowed the borrowers time to think it over for a couple of days with the option of backing out. Some did, many did not.

However, as early as 2000, I would often confide with my wife at the growing level of deception unfolding within the mortgage industry and the erosion of what the title insurance industry once was. Banks became hostile to the title insurance industry--did not care for the checks and balances of people looking out for borrowers’ best interests. Then it came, a wave of corporate acquisitions and forced mergers by banking subsidiaries of thousands of title agencies, thereby severing the web of neutrality and oversight. Thousands of well-intentioned and knowledgeable people lost their jobs as a result. The title industry now serves at the whim of the banking industry. I could no longer participate in the charade and resigned in disgust at the rampant fraud being perpetrated by banks and by the growing collusion of the title insurance industry (what little is left of it) working in the shadows with the banking industry.

There is a working explanation that cuts through some of the haze in regard to the shadow banking industry that has been set forth by Yale economist Gary Gorton as follows: securitized mortgages are the “pawns” used in the pawn shop known as the “repo market.” The “repos” are overnight sales and repurchases of collateral. Repos are the “deposit insurance” for the shadow banking system, which is now larger than the conventional banking system and is necessary for the conventional system to operate and stay alive. The problem is that repos require “sales”--lots of them--which means the mortgage notes have to remain free to be bought and sold at a moment’s notice. The mortgages are left unendorsed so they can be used again and again in this hyper-active repo market.

As Gorton observes, there is a massive and growing demand for banking by large institutional investors--pension funds, mutual funds, hedge funds, etc.--which have millions of dollars to park somewhere between investments. FDIC insurance is designed to protect individual investors--not institutions. The large institutional investors want an investment that is secure, that provides them with interest, and that is liquid like a traditional checking account, allowing for a quick withdrawal.

The shadow banking system evolved in response to this need, operating largely through the unregulated repo market. “Repos” are sales and repurchases of mortgage-backed securities—the securitized units into which American real estate has been ground up like a sausage. The collateral is bought by a “special purpose vehicle” (SPV), which acts as the shadow bank. The investors put their money in the SPV and keep the securities, and if the SPV fails to pay up, the investors can foreclose on the securities. To satisfy the demand for hyper-liquidity, the repos are one-day or very short-term deals, continually rolled over until the money is withdrawn. This money is used by the banks for other investing and lots of market speculating, including betting against the SPVs sold to a different group of investors.

MERS is the banking industry’s nasty four-letter word. This mortgage shell game was made possible because it was all concealed behind an electronic smokescreen called MERS (an acronym for Mortgage Electronic Registration Systems, Inc.). MERS allowed houses to be shuffled around like poker chips among multiple, rapidly changing owners while circumventing local recording laws. Title would be recorded in the name of MERS as a place holder for the investors, and MERS would foreclose on behalf of the investors. The homeowner usually thinks the servicer is the lender, but in fact it is a group of shadow investors.

Ten years ago, I channeled my inner Nostradamus, and told my wife that MERS would eventually cause the implosion of the housing market. Starting in 2009, courts across the country began questioning if MERS, which has admitted that it was a mere conduit without title, had legal standing to foreclose. Courts have increasingly held that it does not. In 2009 and throughout most of 2010, I worked as a foreclosure prevention specialist for a regional nonprofit, assisting homeowners to have banks modify their mortgages and avoid foreclosure. MERS and the shadow banking industry presented immense challenges to those of us trying to broker mortgage modifications. For example, in 2009 Fannie Mae sent out a memo telling servicers that in order to be reimbursed under HAMP—a government loan modification program designed to help at-risk homeowners meet their mortgage payments—the servicers would have to produce the paperwork showing the loan had been assigned to the trust. That paperwork did not exist. The banks’ solution was a rash of assignments signed by an army of robo-signers. But ALL the documents are forgeries, making a shambles of county title records. There are homes here in Lakewood and throughout the nation in which the legal ownership can’t be determined. These homes just sit and rot--bringing down the value of other homes that surround them.

Not only has the system destroyed county title records, but it is highly vulnerable to bank runs and collapse. That is what happened in September 2008 following the bankruptcy of investment bank Lehman Brothers. The top 1%, highly distrustful of one another, rushed to pull their money out overnight. Lending came to a screeching halt and our nation’s largest banks did not have their clients’ money on hand to pay it back.

Understanding what happened in the shadows is crucial to understanding the last crisis and stopping the next one. The shadow banking market is where big banks, institutional investors, and CEOs who have a lot of money do their banking--particularly their short-term banking. So let’s say I was Mitt Romney back in 2007. I had $10 million that I did not want to pay taxes on and needed to invest pronto. I needed to put it somewhere and, being Mitt and a disciple of free-market fundamentalism, I head to the “repo market,” and I ask my good friend John Kasich over at Lehman Brothers to hold my money and pay me interest. John agrees. But how do I know that John and Lehman Brothers won’t just keep my money and not make me more money?

You and I--simple little individual depositors in the normal banking market, never have that fear. Through the FDIC, the government insures our deposits up to $250,000. But they don’t insure massive deposits from people like Mitt Romney. So Mitt asks John for “collateral”--something valuable he could hold in order to make sure Lehman Brothers returned Mitt’s money plus interest. Something like, say, mortgage-backed securities. This manner of banking created a colossal hunger for collateral. See, Mitt and John, being high-finance vultures, did not really trust one another (would you?). So they, together with some of their friends, needed to create something, anything, to make a profit. It was this greed-driven hunger that drove the wild demand for mortgage-backed securities.

But think about the difference between the shadow banking market and you. The FDIC’s deposit insurance exists to prevent bank runs like those that took place in the early 1930s (which happen when creditors become scared that their bank is insolvent and rush to get their money back, which in turn makes their bank insolvent). The shadow banking market doesn’t have deposit insurance. So how does it deal with the problem of bank runs? It doesn’t, and John Kasich cut himself a nice fat check as he ran from his bank in 2008 just before the collapse--sorry Mitt--so long Lehman Brothers, hello Ohio. What we had in 2008 was a bank run. No one knew which banks were exposed to the crisis, so everyone froze. Then in October of 2008, the CEOs of our largest banks ran to then- President George Bush, who cut them a check for $700 billion, interest-free and no strings attached--problem solved as far as the 1% is concerned. We paid their debts.

The longer we continue to ignore the problem, the more it leaves the system vulnerable to future shocks. Fraud-induced bank shocks will continue to come in waves, penetrating ever deeper until the country does something to prevent them. If history teaches us anything, as far as the banking industry is concerned, criminal charges and jail time are the only effective deterrents. The only thing I want to hear is that there will be indictments and lawsuits. Little or no immunity is the only tolerable deal in creating a Federal mortgage fraud investigative unit. It is no longer acceptable to perpetuate the atmosphere where doing deals, paying tiny fines, and admitting no wrongdoing is the way it’s always been done in the banking industry.