Category | Unsettled Trades & Systemic Risk

The End of the World as We Know It

I will begin this preamble to the subject systemic risk with two quotes from Warren Buffett (by quoting him I do not mean to imply his support in these efforts of mine):

  • Of excess leverage in the system, Mr. Buffett has said, “No one knows who’s been swimming naked until the tide goes out.”
  • Mr. Buffett calls derivatives, “financial weapons of mass destruction.”

I would like to explore the meaning of this in the context of unsettled trades in our nation’s settlement system.

Mark Twain said, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”

Consider this scenario:

  • I loan you an umbrella.
  • You use that umbrella as collateral to borrow 5 more from someone else.
  • You take the 6 umbrellas and loan them out to your 6 brothers.
  • Each of your six brothers now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more. Each brother now has 6 umbrellas, and loans them out to 6 of his friends.
  • Each of those (6 brothers) X (6 friends each) = 36 friends now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more.
  • There are now 6 X 6 X 6 = 216 umbrellas in all.

It starts to rain.

  • I go to you and say, “I need back that umbrella I loaned you.”
  • You say, “But that was collateral for the 5 I borrowed! If I have to return your umbrella, I’ll also have to return the other 5 I borrowed using your umbrella as collateral.”
  • So you go to your six brothers and say, “I need those six umbrellas back!”
  • Each brother says, “But I used that umbrella as collateral for 5 more!” So they go out to get each of their six umbrellas back by going to their 36 friends and saying, “We need our umbrellas back!”

And so on and so forth. It is easy to see how this situation, where balancing upon one umbrella were 216 borrowed and reborrowed umbrellas, could unravel in a chain reaction of “unborrowing” and returning of umbrellas.

Remove “umbrellas” in the above example and replace it with “dollars,” and you get a good image of excess leverage in our financial markets, and one of systemic failure as well.

How could the government stop this collapse? In the umbrella example, the government would take truckloads of umbrellas and inject them into the umbrella market (perhaps by loaning them out at low rates) so as to slow down and even stall that chain reaction. In the example of our financial system, the government would do it by taking truckloads of dollars and injecting them into the capital market.

This is exactly what the government has been doing for over a year. The broadest measure of the money supply is called, “M3.” The government reported the rate of change in M3 since 1959. After reporting M3 for 47 years, in March 2006 the government stopped disclosing M3. From other numbers that are disclosed by the Federal Reserve, however, it is possible to back into M3. An economist named John Williams does just that on the Shadow Government Statistics website. According to Mr. Williams’ calculations, the rate of expansion in M3 has reached 16.7% – higher than at any time since they started reporting it (the last time it reached 16%, Nixon reacted by instituting wage and price controls).

That is problematic because (very roughly speaking) the growth in money supply will equal inflation plus growth in US productivity (along with other factors like velocity and number of transactions: that is why I say “roughly). According to the Fed, productivity is growing at just under 3%. If money supply growth stays gunned at 16%, underlying inflation will heat up over 10%, at which point the dollar will crack some more, at which point interest rates will be hiked into the high teens in order to tempt foreigners to continue loaning us money to subsidize our fiscal and current account deficits, at which point we will be thrust into an inflationary recession that makes the early 1970’s look like a Sunday picnic.

That is to say, massive amounts of liquidity are being injected into the US financial markets to keep it from imploding. This will lead to inflation (“Inflation is always and everywhere a monetary phenomenon,” wrote Milton Friedman and Anna Schwartz) then a recession.

Or not, if, as some believe, M3 is too volatile to worry about.

The “rain cloud” which was the proximate cause of this situation was the home mortgage crisis that began to be exposed in the summer of 2007. People bought homes with borrowed money for which they signed IOU’s (“mortgages”). Those IOUs were aggregated and resold, chopped up, packaged and resold again to firms which borrowed even more on top of them. Unfortunately, since everyone in the chain made money from fees charged for that aggregation, chopping and packaging, they had incentives not to notice that many of the folks underneath it all were signing IOU’s they would not be able to repay. Once they stopped paying their mortgages (i.e., once those “umbrellas” started to be recalled), the system started to collapse on itself. A coordinated effort by the largest central banks in the world injected money into the financial markets to stop a runaway implosion such as that described in the umbrellas example above.

There are numerous articles out there explaining the mortgage crisis in far greater detail than the above. I present this explanation for three reasons only.

  • The first is to provide the lay reader with the mental imagery by which to conceive of a systemic collapse.
  • The second is so that I could point out that the mortgage crisis was the rain cloud that triggered the current crisis, but it may not be the only rain cloud. Lots of storms have more than one rain cloud.
  • Third, the rain cloud is not the same thing as the underlying situation. It is merely the trigger which has caused an unhealthy underlying situation to manifest. It is important to understand not just the trigger but also that underlying situation: tremendous amounts of systemic leverage are, in the end, a giant confidence game (in the most literal sense), and if that confidence is disrupted the system can implode. What disrupts that confidence may be nothing more than a sudden, broad realization that more leverage has accumulated than has been generally understood, perhaps by accumulating in such a way that no one recognized it for what it is. I will argue in future posts that this is precisely what unsettled trades in our stock settlement system create.

Again, that third point is key: recognize that the mortgage crisis, while real, is a trigger but not the underlying situation. The dancer is different than the dance.

I would like to switch metaphors now, to discuss derivatives.

I ask you to imagine a special casino. On the ground floor, it looks like a normal casino. There are 100 people standing around playing craps, roulette, and blackjack. They each brought $10,000 so there is $1 million of betting on the first floor.

On the second floor, however, there is another casino. In that casino, people are watching television screens showing people gambling on the first floor. In the second floor casino, people bet each other on who they think is going to win and lose on the first floor. All the really big players are in that second floor casino, and they are betting hundreds of millions of dollars of action on various people in that first floor casino. Their outcomes are “derivative” of the outcomes on the first floor. A roll of the dice on the first floor that loses someone $100 may create tens of thousands of dollars of losses on the second floor (and if there is a third floor where people are placing even bigger bets on the outcomes on the second floor….)

I will argue that unsettled trades in the financial system bear the characteristics of such derivatives. However, they present a special kind of derivative. If you and I walk into the first floor casino and bet on whether the next roll of the dice is a 7 or not, no amount of betting on our part can affect the underlying event. Similarly, the underlying event will not be affect by any amount of betting by the people above us on the second floor (or by betting on them by people on the third floor).

Unsettled stock trades, however, can affect the underlying events upon which they are a bet. In fact, unsettled trades resulting from “the option market maker exception” are often the by-product of deliberate efforts to affect those underlying events. When an underlying event that someone deliberately affects is a stock price movement, it used to be called, “manipulation” (and was also called “illegal” until Wall Street captured the SEC, at which time it became known as, “a hedge fund business model”).

Because unsettled trades have this property of affecting the underlying events upon which they are a bet, they are derivative contracts with an especially nasty twist.

I tell you, that guy Buffett will go places.

PS Again, because I do not wish to imply endorsement of my views, I am going to give one additional quote, without comment. In May, 2007 Messieurs Buffett and Munger were asked to comment on the issues I am raising here in Deep Capture. Mr. Munger’s response was as follows (page 6): “Those delays in delivering sometimes reflect tremendous slop in the clearance process. It is not good for a civilization to have huge slop. Sort of like how it isn’t good to have a lot of slop in nuclear power plants.”

Posted in Unsettled Trades & Systemic RiskComments (3)

A Peace Sign for Wall Street

groovey1 A Peace Sign for Wall Street

Greetings, and peace. As we Irish say, “I’m sorry for your troubles.”

In today’s Salt Lake Tribune there is a story that is 100% correct: two years ago an elder statesman of the hedge fund industry sat me down to tell me that I had become the most hated man in living memory in New York, that you folks despise me utterly, and so on. All true, I’m sure. So it goes.

However, from examining the logs I also know that thousands of people from major Wall Street institutions have visited this site and are passing these pieces around. I was planning on writing an open message to you in the 2007 holiday season, or the 2008, yet while I have learned that I have but little influence over this course of events, I have even less over its pace. Now it is August, and the time to write has arrived.

I have said harsh things about Wall Street. Harsh words have been said about me as well. Let’s get past that for a moment. Instead, I have a story to share before we return to our battle.

Richard Feynman, one of the greatest physicists of the 20th century, sat in a drum circle telling stories that were compiled into the book Surely You’re Joking, My. Feynman (which can be conveniently purchased at a discount site I know). Some stories came from his days as a 24 year-old quant working on the Manhattan Project. One concerns the time he was sent to review plans for the factory in Oak Ridge, Tennessee, where the uranium for the atomic bomb would be purified. I will quote from it at length, both for its charm and, also, because it says something about the battle into which you folks and I seem to be locked.


Some of the special problems I had at Los Alamos were rather interesting. One thing had to do with the safety of the plant at Oak Ridge, Tennessee. Los Alamos was going to make the bomb, but at Oak Ridge they were trying to separate the isotopes of uranium — uranium 238 and uranium 235, the explosive one. They were just beginning to get infinitesimal amounts from an experimental thing of 235, and at the same time they were practicing the chemistry. There was going to be a big plant, they were going to have vats of the stuff, and then they were going to take the purified stuff and repurify and get it ready for the next stage. (You have to purify it in several stages.) So they were practicing on the one hand, and they were just getting a little bit of U235 from one of the pieces of apparatus experimentally on the other hand. And they were trying to learn how to assay it, to determine how much uranium 235 there is in it. Though we would send them instructions, they never got it right.

So finally Emil Segre said that the only possible way to get it right was for him to go down there and see what they were doing. The army people said, “No, it is our policy to keep all the information of Los Alamos at one place.”

The people in Oak Ridge didn’t know anything about what it was to be used for; they just knew what they were trying to do. I mean the higher people knew they were separating uranium, but they didn’t know how powerful the bomb was, or exactly how it worked or anything. The people underneath didn’t know at all what they were doing. And the army wanted to keep it that way. There was no information going back and forth. But Segre insisted they’d never get the assays right, and the whole thing would go up in smoke. So he finally went down to see what they were doing, and as he was walking through he saw them wheeling a tank carboy of water, green water — which is uranium nitrate solution.

He said, “Uh, you’re going to handle it like that when it’s purified too? Is that what you’re going to do?”

They said, “Sure — why not?”

“Won’t it explode?” he said.

Huh! Explode?

Then the army said, “You see! We shouldn’t have let any information get to them! Now they are all upset.”

It turned out that the army had realized how much stuff we needed to make a bomb — twenty kilograms or whatever it was — and they realized that this much material, purified, would never be in the plant, so there was no danger. But they did not know that the neutrons were enormously more effective when they are slowed down in water. In water it takes less than a tenth — no, a hundredth — as much material to make a reaction that makes radioactivity. It kills people around and so on. It was very dangerous, and they had not paid any attention to the safety at all.

So a telegram goes from Oppenheimer to Segre: “Go through the entire plant. Notice where all the concentrations are supposed to be, with the process as they designed it. We will calculate in the meantime how much material can come together before there’s an explosion.”

Two groups started working on it. Christy’s group worked on water solutions and my group worked on dry powder in boxes. We calculated about how much material they could accumulate safely. And Christy was going to go down and tell them all at Oak Ridge what the situation was, because this whole thing is broken down and we have to go down and tell them now. So I happily gave all my numbers to Christy and said, you have all the stuff, so go. Christy got pneumonia; I had to go….

At any rate, I arrived at Oak Ridge. The first thing I did was have them take me to the plant, and I said nothing. I just looked at everything. I found out that the situation was even worse than Segre reported, because he noticed certain boxes in big lots in a room, but he didn’t notice a lot of boxes in another room on the other side of the same wall — and things like that. Now, if you have too much stuff together, it goes up, you see.

So I went through the entire plant. I have a very bad memory, but when I work intensively I have a good short-term memory, and so I could remember all kinds of crazy things like building 90-207, vat number so-and-so, and so forth.

I went to my room that night, and went through the whole thing, explained where all the dangers were, and what you would have to do to fix this. It’s rather easy. You put cadmium in solutions to absorb the neutrons in the water, and you separate the boxes so they are not too dense, according to certain rules.

The next day there was going to be a big meeting. I forgot to say that before I left Los Alamos Oppenheimer said to me, “Now, the following people are technically able down there at Oak Ridge: Mr. Julian Webb, Mr. So-and-so, and so on. I want you to make sure that these people are at the meeting, that you tell them how the thing can be made safe, so that they really understand.”

I said, “What if they’re not at the meeting? What am I supposed to do?”

He said, “Then you should say: Los Alamos cannot accept the responsibility for the safety of the Oak Ridge plant unless…!”

I said, “You mean me, little Richard, is going to go in there and say –?”

He said, “Yes, little Richard, you go and do that.”

I really grew up fast!

When I arrived, sure enough, the big shots in the company and the technical people that I wanted were there, and the generals and everyone who was interested in this very serious problem. That was good because the plant would have blown up if nobody had paid attention to this problem.

There was a Lieutenant Zumwalt who took care of me. He told me that the colonel said I shouldn’t tell them how the neutrons work and all the details because we want to keep things separate, so just tell them what to do to keep it safe.

I said, “In my opinion it is impossible for them to obey a bunch of rules unless they understand how it works. It’s my opinion that it’s only going to work if I tell them, and Los Alamos cannot accept the responsibility for the safety of the Oak Ridge plant unless they are fully informed as to how it works!”

It was great. The lieutenant takes me to the colonel and repeats my remark. The colonel says, “Just five minutes,” and then he goes to the window and he stops and thinks. That’s what they’re very good at — making decisions. I thought it was very remarkable how a problem of whether or not information as to how the bomb works should be in the Oak Ridge plant had to be decided and could be decided in five minutes. So I have a great deal of respect for these military guys, because I never can decide anything very important in any length of time at all.

In five minutes he said, “All right, Mr. Feynman, go ahead.”

I sat down and I told them all about neutrons, how they worked, da da, ta ta ta, there are too many neutrons together, you’ve got to keep the material apart, cadmium absorbs, and slow neutrons are more effective than fast neutrons, and yak yak — all of which was elementary stuff at Los Alamos, but they had never heard of any of it….


Richard Feynman was not only one of the greatest scientific minds of the 20th century, he was also hilarious, and I encourage you to read his book. I include this Las Alamos story here for the resemblance it bears to our battle over “naked short selling”. I am not claiming to be smarter or more moral than any of you folks. I do believe, however, that you have a problem in your “factory” (the nation’s stock settlement system) of which you are unaware. That problem is the systemic risk created by unsettled trades. Like the U-235 in Feynman’s story, this is dangerous, and from my point of view, it looks like you folks have not paid much attention to the safety question. We of the Market Reform Movement worry about “how much material can come together before there’s an explosion.”

I will assume that all Wall Street readers understand why an unsettled trade is a derivative, and specifically, a Contract For Difference (“CFD”). You know also that the value of a derivative is a function of some underlying event (that’s what makes it “a derivative”). Unsettled equity trades seem to me unusual in their ability to affect the underlying events of which their values are derivative. Florida orange farmers wanting to hedge their risk can buy all the derivative contracts on sunshine in Florida that they want, but it will not affect the amount of sunshine in Florida. Similarly, Credit Default Swaps do not affect the rates of third party defaults (in any immediate sense, anyway). But from the SEC’s recent Emergency Order it would appear that the SEC, the 19 financial institutions now enjoying special protection, and 8,500 banks clamoring for the same treatment, have come to recognize naked short selling can affect share prices.

This is not to say that naked short selling always affects the underlying event (one could naked short Berkshire Hathaway all day long and it would not affect its share price), nor is it to say that unsettled equity trades are the only derivatives with this ability (various debt-related derivatives may be another, in the long run). However, if one considers naked shorting in small and mid-size stocks, one sees that it is a derivative that affects the underlying events immediately and directly.

So if the underlying event drives the value of the derivative, and this derivative can drive the underlying event, there exists a self-reinforcing dynamic. That’s a “short squeeze”, and it is what makes unsettled trades particularly dangerous. A market participant may believe she has simply written CFD’s on (by failing to deliver) 10 million shares of a small software firm that is currently trading at 20 cents and trades 50,000 shares per day. She carries that as a $2 million liability. But she cannot settle this CFD with cash. To settle her position she must buy stock, and if the stock in question trades 50,000 shares/day it is going to take her a long time to buy those 10 million shares, and (because the price squeezes) it will cost her a lot more than $2 million to buy them.

Thus, when it comes to the potential liabilities associated with unsettled equity trades, the nominal liability is a fraction, and perhaps a quite tiny fraction, of the money it is going to take to clean up that liability. In the Feynman story, “…they did not know that the neutrons were enormously more effective when they are slowed down in water. In water it takes less than a tenth — no, a hundredth — as much material to make a reaction that makes radioactivity. It kills people around and so on. It was very dangerous, and they had not paid any attention to the safety at all.” Similarly, unsettled equity trades in our capital market could well be “enormously more effective” than their current nominal value would indicate.

How many times more effective? 2? 10? 20? I have no idea. However, for ease of reference, I will refer to this as “The Feynman Principle”, and the ratio of true-cost-to-cover versus nominal liability as “F”.

Let us look at where these unsettled trades can reside within the piping of the “factory” that is our nation’s stock settlement system, The Depository Trust & Clearing Company (“DTCC”). I will use Goldman and Morgan as hypothetical examples only.

• “Desked trades” – Imagine Goldman takes your order for 1,000 shares of stock, but stashes your order in a desk and sends you statements saying that you have those 1,000 shares in your account (and use your money towards the $10 billion they pay themselves at the end of the year for being so clever). They have written a CDF to you without your knowledge: there is a 1,000 share failure-to-deliver to you at Goldman (which no one else knows about, incidentally).

• “Pre-netting” – Goldman has one client sell 5,000 shares and another buys 3,000. The seller never delivers. Goldman “pre-nets” the trades before submitting them to the DTCC. Hence, the DTCC sees only 2,000 shares of the failure.

• “CNS netting” – Goldman submits to the DTCC’s Continuous Net Settlement system that it sold 2,000 shares that it does not deliver. Imagine Morgan Stanley was on the other side of that particular trade. But maybe Morgan has a client who sold 1,000 to a Goldman client, and which that Morgan client failed-to-deliver. The DTCC nets the two trades, and therefore sees just 1,000 shares of failure (Goldman to Morgan).

• “Stock Borrow Program” (“SBP”) – The DTCC looks at that 1,000 share failure, and says, “We have 400 shares we can loan Goldman from our Stock Borrow Program”, i.e., from the accounts of other BD’s within the DTCC. That reduces the failures it sees to 600.

• “Ex-clearing” – Suppose Goldman and Morgan apply to the DTCC to move 500 of those fails ex-clearing, and the DTCC approves. Those 500 FTD’s are turned into a derivative contract between Goldman and Morgan. As a private contract, it is not regulated by the SEC, and the DTCC does not even know when that contract gets cleaned up, if ever.

• “Offshore Failures” – Suppose someone sells 1,000 shares into this market from a foreign offshore exchange? There is a different terminology to describe such failures, and therefore the data is hard to get to. What is clear, however, is that there is little pressure to clean up failures among exchanges.

In this example, there are 100 failures at the CNS level. Yet there were 7,000 failures throughout the system. Therefore, we should remember that, however many unsettled equity trades there are at the CNS level, it is likely to be a fraction, and maybe a quite tiny fraction, of the total unsettled trades in the system.

What is the ratio of total fails in the system to those trapped in the CNS system? No one seems to know (and in fact, while the individual pieces of data are known individually, I strongly suspect that no one party has the bird’s eye view of how many of these there are at all levels). The estimates I am told range from 3 to 15. For ease I will refer to this as, “The Iceberg Principle” and the ratio of total failures to CNS failures as “I”.

So how big a problem is this?

•The last reported size of the failures-to-deliver at the CNS level are $8.7 billion.

•By Iceberg Principle, total failures = I X $8.7 billion ≈ $30 to $120 billion.

•By Feynman Principle, total cost to cover = F X I X $8.7b = F X ($30 to $120 billion).

So respectfully, Wall Street, I believe you are Oak Ridge, Tennessee, blithely going about your jobs at the factory, taking for granted “the piping” that is our settlement system. I believe you have manufactured, and are sitting squarely on top of, a financial atomic bomb. That’s not good for you, of course, and if it goes critical, America is downwind.

Since I have learned that these columns are getting passed around Wall Street, I thought it would be a good idea to explain to you why I took on this Crusade (or “Mitzvah” or “Jihad”, depending on where you stand). I truly wish that this could be solved without anyone getting hurt, and in fact, that is what I am trying to see happens. You folks may “despise” me, but I’m not vindictive, and I do not despise anyone in return. I believe that many of you know that mine is a necessary and righteous battle. (Of course, feel free to lend a hand if you get a chance!)

And in any case, I am sorry for your troubles.


Sincerely and respectfully,

Patrick M. Byrne

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The DTCC’s CNS naked short selling residue

In a previous post I named various places where unsettled trades can accumulate: in the desks of brokers, in pre-netting among brokers, in the Continuous Net Settlement (CNS) system, in the Stock Borrow Program (SBP), through ex-clearing, and in delivery mechanisms from offshore exchanges. For all I know, these represent just a subset of the cracks in the system. The great unanswered question is, How much financial toxic waste has naked short selling and its various equivalents left scattered throughout these cracks?

The answer is: I don’t know, and I think no one knows. I suspect no one agent has the full picture of what is going on across all of these cracks. In fact, I suspect some of these cracks are so obscure no one has a clear picture of what is going on in them individually, let alone collectively.

To some degree this is knowable a priori. We have a system that is shielded from scrutiny of every type. State regulators cannot successfully subpoena it (as various state regulators have told me) because the DTCC argues it is shielded by federal regulation. Yet when Feds try to look inside it they are simply rebuffed, and are helpless to assert themselves (as a high-level SEC official told some colleagues of mine). The Feds do not understand it (as a former DTCC employee and various Feds have told me). On those occasions that the Feds do get to look inside the system,  they get shined-on (as a former DTCC official tells me and a former SEC official confirms).  In fact, four years ago when I began this quest, the first thing I tried to do was to find out who regulated the DTCC, and quickly discovered that, other than a brief mention in an obscure GAO report, even the Feds are not sure if they regulate it.  And yet, through this opaque system the treasure of the ages passes every week. Such system-design is a recipe for disaster.

To a lesser degree this is knowable a posteriori, though getting data about the system from the system is an exercise in Kafkaesque futility. There are endless anecdotes of trades that won’t settle, of course. There is also the partial information expressed by the Reg SHO list.  There are various FOIA responses which have been pried from the SEC. And for the true aficionados, there are, lately, data files that the SEC periodically releases to the public regarding failures in one of the cracks mentioned, the CNS. Making use of these files is impractical for any members of the general public who do not employ an economist, statistician, and database expert to work the data.

Fortunately, DeepCapture employs an economist, a statistician, and a database expert to work the data. In the following series of posts I am going to reveal their output, stressing again that the failures I will be disclosing are not the totality of failures, but simply a fraction of the total, residing in just one of the cracks (the CNS) into which our federal regulator is permitted to peer.

Here is a chart showing the CNS failures from 2004, the year Reg SHO was adopted, through Q1, 2008:

Here is the same data with some key Reg SHO dates noted:

If this article concerns you, and you wish to help, then:

1) email it to a dozen friends;

2) go here for additional suggestions: “So You Say You Want a Revolution?

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Regulators Spring Into Action Against Naked Short Sellers. Or not.

As is explained in numerous pieces in DeepCapture, there are many cracks in the settlement system, one of them being the DTCC’s Continuous Net Settlement system, or CNS. I am highly confident that the federales (at least, the SEC) are not permitted to explore the other cracks, that the failures to deliver that they see within the CNS are thus but a small fraction of all that exist, and that, therefore, trying to gauge the depth of the naked short selling problem from the level of FTD’s in the CNS is like trying to guess the condition of an automobile from the level of water in its radiator.

But it’s a start. Given that the CNS system is the one place the SEC can look, and might be able to do something about, it is instructive to see how well they are cleaning up unsettled trades there.  Towards that end, DeepCapture has analyzed the data that the SEC released last week. These graphs show their fine progress in that regard.

Any questions?

If this article concerns you, and you wish to help, then:

1) email it to a dozen friends;

2) go here for additional suggestions: “So You Say You Want a Revolution?

Posted in Deep Capture the Data, Our Captured Federal Regulator the SEC, Unsettled Trades & Systemic RiskComments (37)

The Foreclosure Crisis: Punchline to a Michael Lewis Joke from 2008?

The foreclosure crisis is being written and spoken of as though it were exclusively a paperwork crisis. For example, an October 18, 2010 Associated Press  wire described the scandal as one concerning “questions on the accuracy of documents used in the foreclosure process” and “faulty paperwork”. The narrative is that banks got behind in their processing, hired robo-signers, bluffed folk out of homes, etc.

That all sounds true and unsurprising. However, there may be another element that is being missed.

In late 2008 Michael Lewis wrote a Portfolio article (“The End“) weaving together a story line concerning a then-recent  lunch  between himself and John Guttfreund of Salomon Brothers and Liar’s Poker fame (thus, arguably, nemeses), and another concerning Steve Eisman, a money manager who bet heavily against the MBS market.   The climax of the Eisman story runs as follows:

“That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. ‘They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,’ Eisman says. ‘They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?'”

Investors who bought mortgage-backed securities believed that if interest payments stopped coming through the piping they would be able to recapture some value via the foreclosure process.  If Michael Lewis was right, sometimes there were actually no underlying homes on which to foreclose.

Note that mortgage-backed securities backed by phantom mortgages are actually “mortgage”-backed securities. Such instruments are in reality derivatives that in calm markets would track the  performance of securities that are really mortgage-backed. In calm markets one security may track another security (or basket thereof), but when a market reaches its shear strength nothing tracks anything. In fact, “shear strength” actually means “the point at which parallel internal surfaces in a material slide past one another” (a strangely beautiful discussion of which can be found on this engineering site). That’s a good way to think about what happens in markets under sufficient stress: surfaces which had previously stayed parallel begin sliding past each other.

If Michael Lewis was right, banks packaging up mortgages did not just do sloppy packaging. They were also selling the packages several times over. Buyers of the “fake” packages were kept unaware of the situation because they continuously received the “interest payments” they were due, those payments being funded out of the money Goldman charged investors like Eisman to keep their bearish positions in place.

Which, to readers of, may sound familiar.

If this is really what happened down below, how would things appear on the surface? Like this: A bunch of lawyers representing the interests of owners of these “mortgage”-backed securities would be going into court trying to foreclose on homes, but not be able to establish clear chain of title. Which is precisely what is happening. That’s not the same as saying it is why it is happening. However, if Lewis’ story about Steve Eisman is correct, then eventually this would have to happen.

Whatever the cause (or amalgam of causes) of this foreclosure crisis, its effects could ripple into our financial system in a way that some say will become catastrophic (e.g., “The Real Danger from the Foreclosure Crisis“, George Washington, Zerohedge).  Banks which believe that millions of people owe them money suddenly realize that no specific people owe them money while millions of borrowers suddenly realize they don’t owe money to any specific bank; banks suspend foreclosures, but people thrown out of their homes by banks who lacked chain of title form classes to recover what is rightfully theirs; title insurance becomes impossible on a non-negligible fraction of homes. Etc.

Yet the foreclosure crisis may become an opportunity for the United States.  DeepCapture has, I think, adequately documented that one of the great problems within American society is that Wall Street’s megabanks have Washington, D.C. under their thumb. Two years ago this country drew a firebreak around those Wall Street megabanks and said, “We won’t let them burn.” The better answer would have been to draw the firebreak around them and say, “Let them burn first.”

Next time around, let’s do it.

At least it will take care of the thumb.

Posted in Unsettled Trades & Systemic RiskComments (53)

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