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 DeepCapture.com, 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.