naked capitalism

Readers may recall that this site broke the story of litigation against Lender Processing Services, the biggest player in foreclosure management on behalf of mortgage servicers. These cases, launched earlier in the fall, accused the company of taking impermissible legal fees. These class action lawsuits were joined by the US bankruptcy trustee for the Northern District of Mississippi, both for herself and on behalf of all US bankruptcy fees, which meant she felt the issues set forth in the case had merit and were serious. In November, an additional class action case was filed against LPS, this time securities litigation, charging the company with making false and misleading statements to investors from July 29, 2009 to October 4, 2010, including “deceptive and improper document execution and preparation related to foreclosure proceedings.”

Subsequently, as our Richard Smith detailed earlier today, Housing Wire’s Paul Jackson attacked critics of LPS, including this blogger, of going off half baked in accusing the company of engaging in document fabrication. A Reuters investigation published today supports the critics’s case, revealing that document creation was far more extensive that the company has suggested.

From Reuters (hat tip April Charney):

Public records reveal that the company’s LPS Default Solutions unit produced documents of dubious authenticity in far larger quantities than it has disclosed, and over a much longer timespan.

Questionable signing and notarization practices weren’t limited to its subsidiary, called DocX, but occurred in at least one of LPS’s own offices, mortgage assignments filed in county recorders’ offices show. And rather than halt such practices after the federal investigation got underway, the company shifted the signing to firms with which it has close business ties. LPS provided personnel to work in the new signing operations, according to information from an LPS spokeswoman and court records including an October 21 ruling by a judge in Brooklyn, New York. Records in county recorders’ offices, and in the judge’s opinion, show that “robosigning” and preparation of apparently false documents went on at these sites on a large scale…

The criminal investigation in Jacksonville by federal prosecutors and the Federal Bureau of Investigation is intensifying. The same goes for a separate inquiry by the Florida attorney general’s office. Individuals with direct knowledge of the federal inquiry said that prosecutors have impaneled a grand jury, begun calling witnesses and subpoenaed records from LPS…

The U.S. Comptroller of the Currency’s office, which is responsible for supervising national banks, also announced in November that it had teamed up with the Federal Reserve to conduct an on-site examination of LPS…

Meanwhile, the threats from four class action lawsuits filed in federal courts appear to be greater than the company has indicated, especially one filed in Mississippi. In a highly unusual move, a unit of the U.S. Justice Department has joined that suit as a plaintiff. The lawsuit alleges that LPS extracted many millions of dollars in kickbacks from law firms through an illegal fee-sharing arrangement, in exchange for doling out lucrative foreclosure work to them.

Note the Reuters story confirms, with almost all of the details reported here, the practices we discussed in a post more than two months ago: how LPS pushed the foreclosure mills in its network to foreclose on a very strict timetable, by threatening to terminate the large flow of foreclosure litigation it directed to them if they did not perform as specified.

The story also indicates that DocX, the LPS subsidiary that not only engaged in robo signing (one perp is the now notorious Linda Greene) and filing of other questionable documents continued to operate far longer than LPS had earlier claimed (LPS maintains that the bad practices had ceased, but given its continued strained relationship with the truth, I’m not certain I’d take these denials at face value).

The article suggests that the some of questionable activities extended beyond DocX, which raises the possibility that, just as robo signing was moved into network foreclosure mill firms, other improper practices may simply have been shifted elsewhere in LPS or to its law firm arms and legs:

Hundreds of public records examined by Reuters show that production of suspect mortgage assignments was not limited to DocX.

The records indicate that employees in one of LPS’s own offices, in Mendota Heights, Minnesota, signed and notarized large numbers of documents which for multiple reasons appear invalid. Records filed with county recorders’ offices show that the Minnesota office continued to turn out these documents at least through the end of January 2010.

Dozens of assignments were signed by LPS Minnesota office employees who listed themselves as corporate officers of banks and other loan servicers, a sampling of public records from counties in five states shows. As at DocX, the assignments were signed years after the mortgages should have been transferred to the investment trusts…

Equally difficult to explain are mortgage assignments signed by LPS Minnesota employees purporting to be officers of lenders that no longer existed. For example, in January 2010, two Minnesota employees jointly signed one as officers of Encore Credit Corp., defunct since 2008.

It’s good to see the mainstream media start to take charges against foreclosure miscreants seriously, even if against a solo, if important actor. We’ll know a see change has taken place when we see similar detailed reporting on the “improprieties” of a TBTF bank.

→ Washington’s Blog

There is a lot to say about Bernanke’s comments on 60 Minutes today.

Bernanke’s statement that unemployment is the biggest impediment to economic recovery is ironic, given that Bernanke’s policies have increased unemployment. See this and this.

Harry Blodget notes that Bernanke implied that inequality is destroying America. Tyler Durden hones in on Bernanke’s statements that the economic recovery may not be self-sustaining, and that the Fed may buy even more bonds. Daily Bail picks on Bernanke’s claim that the Fed is not printing money.

There are certainly a lot of interesting things to say about Bernanke’s words.

But I think the real story is how nervous Bernanke appears.

Listen to his voice, and watch his lips quaver.

Ignore his words … does this look like a man who is confident about the state of the economy and the prospects for recovery?

Does this sound like a man who is sure that history will judge his actions kindly?

Events during this financial crisis have repeatedly displayed a degree of disrespect for various pundits’ authority; every so often another pulpit is toppled. So spare a thought for the pundits, the most unmourned of crisis casualties. One skips through the roll of slight miscues (”Lehman repo looks solid”, April ‘08), shame (”believe Fuld, Lehman bears are liars”, July ‘08), survivable embarrassment (”this is the bottom in banks’ equity!” July ‘08), and more shame (”Ireland is a great example of free markets in action, wait, no, a terrible example of government interference”, 2006-2010) in bemusement.  At least Tom Brown’s stock tip is a wee bit higher than it was when he tipped it.

Why do they set themselves up for a fall like that, I wonder? Volunteering to be part of the collateral damage seems to be compulsive. The latest to stick his neck out is the respected Housing Wire commentator, Paul Jackson.

Hang it, don’t spare a thought for him at all. He should know better than to combine a shoddy defense of document forgers with a drive by shooting of servicer critics.

The starting point of the piece is the celebrated DocX document fabrication price sheet, which, having debuted in the blogosphere in early October, made it onto TV the week before last, brandished in the mitt of Rep. Maxine Walters. This is why it matters (from the class action against LPS):

Docx is a wholly owned subsidiary of LPS. Docx is the largest lien release and assignment processing firm in the U.S., with more than 100 employees. Docx software is used by banks to track U.S. residential mortgages from the time they are originated until either the debt is satisfied or the borrower defaults. When the borrower defaults and the bank decides to foreclose, LPS assists the bank in preparing the paperwork that is filed with the court.

But the price sheet is old news, says Paul Jackson, very old news. So old, in fact, that it means nothing:

Here’s the real bombshell about the now-infamous DocX pricing sheet: It is very much real, but it was in use more than a decade ago, and last seen years before LPS actually acquired Docx in late 2005. No wonder my sources couldn’t remember seeing it. Who would recall a 10-year-old pricing sheet from a then-much-smaller company in an obscure corner of the mortgage services world?

It mattered then; and, if DocX got big, and was still doing the same things, then it does matter now, too, Mr Jackson. Just asking a rhetorical question isn’t enough to rebut that point. Try harder.

It’s not just the grandstanding Maxine Walters, and other “congressional leaders” who are in Jackson’s sights, but also state attorneys general, “consumer groups”, “Carol Asbury, the Florida-based foreclosure defense attorney that first posted the DocX pricing sheet on her blog”, “consumer websites, including the Naked Capitalism blog” (I bet Yves likes that characterization), and, last but by no means least those dreadful “foreclosure defense attorneys” with their shoestring budgets and not-rich clients. A platoon of tiny assailants picking on the poor old multibillion dollar servicing industry. So unfair to the servicers! Be still, my beating heart, fer chrissake.

In short, Jackson’s shooting at pretty much anyone who thinks LPS, the not-too-happy owner of DocX, is full of it; but Jackson’s stance, devoid of evidence as it is, amounts to nothing more than a smear:

But the same level of scrutiny now applied to servicers ought to apply to both sides of this very heated debate, including those making the accusations. That those so aggressively accusing mortgage servicers of lying and fraud may themselves also be guilty of the same is a troubling trend.

Whoa, where did that come from? How did the ten-year-old DocX price sheet mutate into evidence of lying and fraud by the accusers of mortgage servicers? Well, you can catch Jackson’s weaselling in full view here: “may themselves also be guilty of the same is a troubling trend”. That’s all he’s got. A little semantic shift turns a baseless, indeed counterfactual speculation into “a troubling trend”, in the space of half a sentence. On he limps, immediately and artlessly exposing his own modus operandi:

Because it begs important questions: What other fact patterns have been twisted around? Who can we really trust to tell the truth here?

Another semantic shift: now the “fact patterns” have definitely been “twisted around”. Two sentences of low grade rhetoric, and you have a case! If only it were that easy. My tip to Mr Jackson: don’t mistake rhetoric and conviction, nor your own obliviousness to recent court cases,  for evidence; your readers certainly won’t; and on the Internet, everyone can see what you’ve been up to, for ever.

But yes, the question is indeed begged. Let’s see if we can get an idea of who might be twisting what facts.

First, Jackson’s bombshell is a dud. The very age of the price sheet, centrepiece of his argument is, um, old news. LPS pointed that out in its October 6 conference call.. The helpful Skeptic99 makes Jackson’s point six weeks earlier than Jackson, in a comment to Yves’s first post in this subject. We should note that Skeptic99 comment is dated October the 18th, rather a long time after the post itself (5th October). That, of course, is not the typical NC commenter pattern: they put their stuff up within a day or two at the most of the initial post. Not that I’m certain, but if you are a dopey corporation getting a news management campaign together, it might indeed take a couple of weeks to realize what a disaster the initial news (and accompanying bear raid) represents, get lawyered up and sort a line out, hold an investor conference, plan the PR campaign, and trot through the hostile links you have assembled, making challenging comments, anonymously. But as we will see, if Skeptic99 is a sockpuppet aligned with LPS, his comments verge on counterproductive (again not implausible; one investor told Yves that LPS’ crisis response was the worst he had even seen).

Note the similarity between Jackson’s main claim and Skeptic99’s talking points, which are in turn pasted from a transcript of the LPS conference call:

So when we see information coming out of these blogs that are not fact based we’re not going to be able to respond to every nonfactual blog item that comes out. When you look at this particular blog that introduced this price sheet under DOCX, this is the price sheet that relates back to early 2000, we think 2001, 4 years before we owned the entity.

Now it appears that Jackson simply made his own investigation, well after the fact, came across the LPS conference call discussion, and took it at face value. Not insanely great beat journalism, that, but there’s nothing unethical about it. I am impugning Mr Jackson’s journalistic competence, not his ethics, for the moment. Tip to Mr Jackson: do try to keep up with the stories.

Second, the age of the price sheet is perfectly irrelevant. From the conference call transcript:

What the service was and again this is not underneath us, what the service was, was basically you are talking about a very manual environment and throughout the mortgage process documents are required not just in foreclosure. And so what we did, because it was a very manual process to get records from counties and because there were a lot of records needed in the various transactions that occur in servicing a mortgage, we established a network or DOCX established a network of what we call runners. Employees or contractors in each significant locale that if a customer had a loan that was missing information they could call us, we would call our runner in that area, take a run down to the courthouse, then find this piece of documentation related to this loan that this lender doesn’t have in their files.

So, under the spotlight of a falling stock and unfavorable press, note that there is no denial by LPS. Nowhere do they say that the price sheet listed services that the company ceased offering long ago. Yet that is precisely the conclusion Jackson tries to make us jump to, despite the absence of any evidence to support his assertion.

You’d expect a flat denial if the truth was on the company’s side. Instead, the conference call features an  unilluminating discussion of how its services were to contend with a heavily “manual” environment, and seeks to imply that what DocX did was always based on getting information from public records, and therefore valid and not at all suspect. There is not a hint of suggestion that the service offerings changed, irrespective of whether it’s 2000, when the price sheet was knocked up, or 2005, when LPS took over DocX, with the securitization bonanza in full swing, or April 2010, when they shut DocX down. Well, LPS say they shut it down, but then, so does the Florida AG; so someone’s lying about that, too. Whatever the year, it’s the same legal framework, the same paper-heavy process, the same need for the same document set priced up in 2000. DocX either had the 2000 pricing model and prices, or they changed the pricing model and the prices between then and now.

It makes no difference. DocX were getting paid for doing something, and LPS, even when under the interrogation lights, offers no reason to think it wasn’t the same sorts of things all along. Tip to Mr Jackson: when constructing your story, try to keep the big picture in mind, and monitor your assumptions for plausibility.

While I’m at it, I’d better answer Sceptic99’s concluding question:

There are few possibilities as I see it: 1)the CEO of LPS doesn’t understand his own business and is simply clueless, 2) he is lying about committing fraud and is therefore committing fraud again by misleading analysts and shareholders on a public call, or 3) DOCX was actually performing a legitimate and legal service and you have misinterpreted the terms on this pricing sheet.

I would appreciate your thoughts on this matter. Thanks.

Well, you can rule out 3), I should think. Eventually, we might get an adjudication on whether 1) or 2) applies, and how much of each. For what it’s worth, LPS’s shareholders’ lawyers may agree with me: a class action against LPS kicked off at pretty much the same time as this stuff went public (and I doubt if that’s a big coincidence). So those are my thoughts, Sceptic99; I hope you like them. Back to Jackson.

Third, there is evidence supporting the notion that DocX continued offering document fabrication services into more recent times. Nick Wooten, an Alabama lawyer who has been heavily involved in foreclosure defense, recognized the service codes on the DocX price list, as did other attorneys in his circle (Wooten is involved both in the group of foreclosure defense attorneys around Max Gardner, as well as in contact with colleagues in the Southeast). Per Nick:

We’ve been seeing these codes on the documents produced by the foreclosure mills in court for years, and wondered what they meant. The light bulb went off when I saw the DocX list. It’s their codes.

So the supposedly dated price list turns out to be very much current. The service codes were in use well after 2001; attorneys like Wooten are involved almost entirely with loans originated in the 2004-2007 time frame.

Similarly, a Florida attorney general’s investigation, was also on the trail of DocX abuses in 2010, again indicating that the questionable practices were of recent vintage. It might behoove Jackson to check his own archives, since this report comes from HousingWire in June of this year:

The Florida Attorney General’s office is investigating Fidelity National Financial (FNF: 13.88 +0.73%), its former subsidiary Lender Processing Services (LPS: 31.12 -0.03%) and LPS subsidiary Docx, alleging the companies used false documents to foreclose on Florida homeowners….

The civil investigation revolves around allegations that FNF and LPS may have engaged in creating and manufacturing “bogus assignments” of mortgage ownership in order to perform foreclosures quicker, the Florida AG’s office said on its website.

The documents in question appear to be forged, incorrectly and illegally executed, false and misleading, the AG’s office claims, adding the documents were used in court cases as “real” documents of assignment, used to expedite foreclosure proceedings in the state.

Tip to Jackson: get better sources; do background research.

Fourth, I said “document fabrication “, and I meant it. Says Jackson, rather pompously:

I wouldn’t claim to truly know what “recreate entire collateral file” ultimately means, for example, although consumer attorneys suggest it means forging documents from whole cloth. (I’ve of course been told otherwise by title industry experts.)

Aww Paul, those sources. If they don’t have a clue, and you don’t have a clue, and then they tell you something, you still won’t have a clue. That is how it works. Tip: cultivate a critical attitude to your sources: are their claims consistent with the other info that you have?

That’s assuming you have any other info, of course. Robosigning, for instance, is the sort of other evidence one might take into account. Or multiple attempts by different banks to foreclose on the same property. Or affidavits that the signer later repudiates in court. That type of thing. You might wish to consult www.nakedcapitalism.com (try the real estate tag), or www.4closurefraud.com, or www.rortybomb.com, or www.ritholtz.com/blog, to get an idea of what’s been going wrong, squarely in the middle of Housing Wire’s patch, possibly for up to a decade.

The notion that “recreate entire collateral file” has some sort of innocuous explanation is bogus. Tom Adams, an attorney and mortgage industry lifer, explains the role it serves:

The collateral file is the collection of documents which represent the ownership interest in the mortgage loans.

The collateral file is intended to be the documents which give the trust rights of enforcement or potential rights of collection. It is distinguished from origination documents – such as the mortgage application and documents required in the origination process, such as appraisal, letters from employer, bank statements, tax returns, etc. It is also distinguished from the “servicing file” which includes documents that are created, electronically or otherwise, during the life of the loan, such as letters to the borrower or notes from collectors. All of these may be kept by the servicer.

The collateral file is defined in each PSA (often identified as the “mortgage file”). These documents are clearly required to be held by the trustee to announce and require that the trust holds the things which create the “collateral” for the trust.

Now why is the idea of recreating a collateral file suspect? The most important document in the collateral file is the note, the borrower IOU. This is a negotiable instrument, and it is exempt from laws permitting electronic signatures. In judicial states, the party foreclosing must present the note, and evidentiary rules require it to be an original, with so-called wet ink signatures. Recreating an entire collateral file thus inevitably entails recreating the note, which in turn means forging the borrower’s signature on a commitment usually worth hundreds of thousands of dollars. We don’t tolerate even minor forgeries of checks, another type of negotiable instrument, but Jackson would have us believe, based on the assurances of his apparently know-nothing title insurance industry source, that creating bogus negotiable instruments and forging signatures is completely acceptable behavior.

Another service on the DocX price sheet, and just as dubious, is “create note allonge”. This should be an impossibility, at least for a party concerned with observing the law. Under the Uniform Commercial Code, an allonge is to be so firmly attached to the note as to not be able to travel separately. It is used to allow parties to provide additional endorsements. Those endorsement again need to be wet ink signatures, by authorized parties. Thus the only legitimate allonge that DocX could create is a blank sheet of paper; the parts that have any legal meaning are a signature, name, and title of an authorized individual of the entity that owns the note. And since allonges are generally used (and abused) as a way of appearing to convey notes through specified parties, “create allonge” is almost certain to mean “create one with multiple signatures”: which means electronic forgeries. And this sort of document appears with impressive frequency in court cases, with pixellated signatures (that is, they are electronic, not actual signatures), and often visibly Photoshopped to fit the signature line.

This snapshot from a 2003 DocX archived webpage (hat tip Lisa Epstein of ForeclosureHamlet.org) supports our interpretation (click to enlarge; DocX web pages became much less forthcoming over time):

Note the “preparation of note allonges in lieu of note endorsements”. That’s an admission of fabrication of signatures.

For my part, I think the consumer attorneys have it right. The rubric “recreate entire collateral file” most probably means “recreate entire collateral file”. Tip to Mr Jackson: if you’ve got a source who offers an alternative theory, make sure you understand what it is, and why he might be offering it, before you treat it as authoritative; and if (if) you actually think there’s something in it, you might consider disclosing that theory to your readers’ scrutiny, too.

Fifth, I should point out that not everything Jackson writes on this subject is utter garbage. Though he has no clue about how things got so screwed up, he is properly outraged about the back-office mess that spawned the riot of fraud that we now see. Yet, puzzlingly, he doesn’t join the dots: once you have a big paperwork mess, the only way to keep the slowly disintegrating show on the road is to forge documents. Denying this is futile, but he tries, anyway. Why?

Finally, there is a last piece of  Jacksonian windbaggery:

…in the dispute over foreclosures, as with nearly every other dispute in life, reality ultimately lies somewhere in between two extremes.

…and then a piece of his sky falls in. In an unfortunate piece of timing, for Mr Jackson anyway, some other dodgy document chains surfaced on Friday, along with a bunch of non-lawyers pretending to be lawyers. Check out the attorney signatures here (the second Scribd panel down), or the gloss from Yves. Even Jackson can tell this is a no-no; an agonized tweet from @pjackson may capture his response to this news:

I just read something tonight that has utterly blown my mind. If true, the corruption involved is beyond pale. All I’ll say for now.

Voila. Indeed, best to pause for thought, right there, Mr Jackson. Wouldn’t want to risk your reputation defending that one, too, would you? You’re in quite deep as it is; time to rummage around for that reverse gear, if you have one, on your pulpit.

In the end, Jackson’s piss-poor journalism, and his imperilled credibility as a pundit, do turn out to have a great big ethical implication. The people he is speaking up for, and the stand he is taking, are profoundly antisocial. Denying, and thus, tolerating, this fraud involves even more collateral damage than a blogger’s standing, more even than abused mortgage holders, clouded title and a stalled housing market. The ultimate destination would be capitalist society without contract law: impossible. Says Tom Adams:

To date, courts have consistently sided with servicers and trustees because of the power dynamics (big banks vs. borrowers in default).  With all of the recent news, I suspect many judges are reconsidering this, especially in light of the significant case law history which would be unsympathetic to the position of the servicers/trustees.  To consistently hold for the servicer/trustee with poorly documented or protected collateral rights would create a very problematic set of precedents for other types of notes and contracts.  This is why attorney generals and judges should be very considered about the current state of mortgage industry.  It is a disaster for the rest of the legal world and no judge wants a collection of precedents set in their state where they have to ignore the UCC, prior precedents and common sense, in order to find for the servicer/trustee.  It is truly a terrifying issue.

Australia Floods Damage Crops, Disrupt Coal Output Bloomberg. When I was in Sydney, one week had the most astonishing rain I can recall. It was extremely heavy the entire time, interrupted by 4-5 absolutely torrential downpours per day. I recall it being reported on TV as 230 centimeters for the week, which I must have heard incorrectly but trust me, it was pretty impressive regardless.

Japan’s Robot Picks Only the Ripest Strawberries Singularity Hub

Saudi Arabia is ‘biggest funder of terrorists’ Independent (hat tip reader May S)

The Impact of Public Guarantees on Bank Risk Taking: Evidence from a Natural Experiment Alea

Hungarian Forint Slips on Moody’s Downgrade WSJ MarketBeat

Rescue-package debt seniority and the vicious cycle of rescues and emergencies Daniel Gros, VoxEU

A hopeless Europe, unable to cope Wolfgang Munchau, Financial Times

European Officials Split Over Fund Increase, New Eurobond Bloomberg

Juncker and Tremonti: “E-bonds would end the crisis” Eurointelligence

Global Imbalances and the War of Attrition Chevelle. This is a cogent analysis, but I doubt this is what is driving the Fed’s policy (or it is at most a secondary consideration).

Let’s Not Make a Deal Paul Krugman, New York Times

Dem: We could have let economy fall and been in majority for 40 years The Hill. So the bailouts and having the banksters loot on a massive scale is better? This sort of discussion reinforces the ongoingfalse dichotomy, the choices weren’t TARP v. do nothing, there were other possible courses of action.

Pay Freeze Could Cripple Dodd-Frank Dave Dayen, FireDogLake. Is this a bug or a feature?

Foreclosure paperwork miscues piling up Denver Post (hat tip Max Gardner). Another case of someone being foreclosed upon who is current, in this case, they paid off their mortgage!

Paxman Meets Hitchens Paul Kedrosky. Even when Hitchens is off base, he’s sufficiently articulate about it to force opponents to sharpen their rebuttals.

Amex chief calls for jobs taskforce Financial Times. This is interesting. Is it mere window-dressing, or a sign that some senior businessmen are wiling to break ranks with plutocrat-favoring policies? Recall that Simon Johnson, in his Atlantic article The Quiet Coup, stressed that the only way third world countries implemented reform programs was when some of the oligarchs decided to break ranks.

Global Health and Wealth over Two Centuries Rajiv Sethi

The NYT loves Jamie Dimon Felix Salmon. I promised a shred of this piece, but I could barely stomach reading it. I would have been snarkier than Felix, but he points out many of the problems with this example of hagiography masquerading as reporting.

Antidote du jour (credit http://www.zveryshki.ru/:

By Marshall Auerback, a portfolio strategist, hedge fund manager, and Roosevelt Institute Senior Fellow.

Like marriage, membership in the euro zone is supposed to be a lifetime commitment, “for better or for worse”. But as we know, divorces do occur, even if the marriage was entered into with the best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself might also be reversible, and that one or more countries might revert to national currencies.

As far as European Monetary Union goes, the prevailing thought has been that one of the weak periphery countries would be the first to call it a day (in Ireland’s situation, one could make a good case for it on the grounds of persistent spousal abuse). It may not, however, work out that way: All of a sudden, the biggest euro-skeptics in Europe are not the perfidious English, but the Germans themselves. Take a look at these headlines (kindly drawn to my attention by James Aitken of Aitken Advisors, LLP):

Germany and the euro: We don’t want no transfer union | The Economist

Jenkins: Where Are the Business Europhiles Now? – WSJ.com

And even a book by Hans-Olaf Henkel, formerly of IBM (Germany), and hitherto one of Germany’s great euro-enthusiasts: English translation: “Return our Money”

So let’s consider what happens if Germany decides to follow Herr Henkel’s advice. On the plus side, given Germany’s historic reputation for sound finances, the country will likely emerge with a strong Deutschmark, a global safe haven currency for currency speculators keen to find a true store of value.
But this will likely come with a huge cost: Germany will probably save its banking system at the expense of destroying its export base. The newly reconfigured DM will soar against the euro and become the ultimate safe haven currency. This will mitigate the write-down impact of the inevitable haircuts on euro-denominated debt, because the euro (assuming it is retained by the remaining euro zone countries) will fall dramatically. Even if the euro itself vaporises, the Germans simply will pay back debt in the old currencies, likely fractions of their previous value.

But Germany’s external sector will be wiped out. The resultant appreciation of the new Deutschmark, along with the inevitable banking crises in the periphery (which will exert significant deflationary domestic pressures in those countries and therefore reduce consumer demand in the euro zone ex Germany) will engender a huge trade shock: Germany’s growth will slow dramatically, as exports comprise such a large proportion of GDP.

Another interesting byproduct: By accounting identity, a fall in Germany’s external surplus means a large increase in the budget deficit (unless the private sector begins to expand rapidly, which is doubtful under the scenario described above), so Germany will find itself experiencing much larger budget deficits.

Let’s elaborate a bit further: We start with the standard macro observation that in any accounting period, total income in an economy must equal total outlays, and total saving out of income flows must equal total investment expenditures on tangible assets at the aggregate level. The financial balance of any sector in the economy is simply income minus outlays, or its equivalent, saving minus investment. A sector may net save or run a financial surplus by spending less than it earns, or it may net deficit spend as it runs a financing deficit by earning less than it spends, but at the aggregate level the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income.

At the end of any accounting period, then, the sum of the sectoral financial balances must net to zero. Sectors in the economy that are net issuing new financial liabilities are matched by sectors willingly owning new financial assets. One sector can run a surplus (spend less than its income) so long as another deficit spends. In macro, fortunately, it all has to add up. This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis.

We can next divide the economy into three major sectors: the domestic private sector (including households and businesses), the government sector, and the foreign sector (imports and exports), and ask a simple question relevant to current developments. What happens if one of those three variables experiences a dramatic shift from surplus to deficit (as we envisage occurring here under Germany’s external accounts)?

The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.
From the sources perspective, we get this equation:

GDP = C + I + G + (X – M)

This formula simply indicates that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

From the uses perspective, national income (GDP) can in the following ways:

GDP = C + S + T

This equation indicates that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

In aggregate, we can express the formula in the following manner:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the three sectoral balances view of the national accounts, which we discussed above:

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero (see here for more)

• The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
• The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

This is also a basic rule derived from the national accounts it always applies. This is not high Keynesianism, but simple double entry bookkeeping, developed some 6 centuries ago. Call it the tyranny of Accounting 101.

You can then manipulate these balances to tell stories about what is going on in a country, as we are seeking to do here with Germany. For example, when an external deficit (X – M < 0) and a public surplus (G – T < 0) coincide, there must be a private deficit. So if X = 10 and M = 20, X - M = -10 (a current account deficit). Also if G = 20 and T = 30, G - T = -10 (a budget surplus). So the right-hand side of the sectoral balances equation will equal (20 - 30) + (10 - 20) = -20.

As a matter of accounting then (S - I) = -20 which means that the domestic private sector is spending more than they are earning because I > S by 20 (whatever $ units we like). So the fiscal drag from the public sector is coinciding with an influx of net savings from the external sector. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process. It is an unsustainable growth path.

This situation describes the recent history of the United States, notably under the Clinton years when the country was running budget surpluses. By the same token, using the sectoral balance approach, we can say that a current account surplus (X – M > 0), if large enough, allows the government to run a budget surplus (G – T < 0) which applies in the case of many Asian countries or a European country, such as Norway (where the world does its spending for it).

What about Germany today? In the current German situation, although the country runs a large current account surplus, it is insufficient to offset a high private sector predisposition to save (which means there is some deficit). But the current account surplus does allow for a smaller budget deficit than its so-called "profligate" Mediterranean neighbors, whilst still facilitating the private domestic sector’s desire to net save. As we have argued before, it is the “profligacy” of Germany’s Mediterranean trading partners, which has allowed it to rack up huge current account surpluses, and therefore run smaller budget deficits than the likes of the PIIGS countries.

Once divorce from the euro is complete, Germany will regain its fiscal freedom. This is itself is something the Germans should celebrate, providing their government takes advantage of their newfound fiscal freedom. Remember, once it returns to the DM, Germany becomes the issuer, as opposed to the user of a currency, as is the case under the euro, and is fully sovereign in respect of its fiscal and monetary policy.
Consequently, the German government can offset the external shock by running large government budget deficits, which will add new net financial assets to the system (adding to non government savings) available to the private sector.

It will become almost impossible to run budget surpluses under this scenario, but this is no bad thing for any country which issues debt in its own free-floating non-convertible currency. As unpalatable as this conclusion might be for many, it is entirely consistent with national income accounting. As Bill Mitchell has pointed out on many occasions, “the systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.”

A budget deficit per se, then, will not cause any problems per se for Germany, as it will no longer have any external constraint, having restored the DM as its currency of choice. But historically, Germany has embraced an export based model at the expense of curbing domestic consumption.

So its policy makers face a choice: will the country offset the decline in its current account surplus via a more aggressive fiscal policy by choice (i.e. proactively, in search of a full employment policy), or reactively via the growth in the automatic stabilizers? If the Germany economy slumps (as I expect it will), the deficits via the automatic stabilisers will rise as a matter of course. Germany can easily counter that if it chooses to do so.

It’s never a laughing matter to see any economy slump, but anybody with a sense of irony will naturally be wondering whether the German government and its voters will get themselves in a frenzy about being so “profligate” as the inevitable trade shock develops. I suspect there will also be a touch of “schadenfreude” on the part of its recently divorced euro zone “ex-spouses” (how does one say “schadenfreude” in Greek or Spanish?). Personally, I’ve never seen the merits in eliminating government debt just so that the private sector is forced to go into greater deficit, and perhaps the Germans will eventually figure that out as well, In any case, one suspects that we are about to get a nice “teachable moment” for Frau Merkel, if Germany does embrace the course of action now so enthusiastically endorsed by the likes of Herr Henkel.

But the country might well find truth in the adage, “Be careful what you wish for”.

By Daniel Gros, Director of the Centre for European Policy Studies, Brussels. Cross posted from VoxEU.

Muddling through isn’t working. This column argues that troubled Eurozone nations should simultaneously open restructuring talks while continuing to service their debts normally. Germany, France, and other core Eurozone nations would have to stand ready to recapitalise the banks most exposed to the restructured debt. The ECB would then stabilise the banking system and the EFSF would stabilise sovereign debt. This big bang could be prepared in a weekend; the market already seems to be pricing it in.

I hope that everything I write in this column turns out to be irrelevant; I very much hope that it will not be necessary to resort to such drastic actions. Economic logic, however, suggests that it might soon represent the least bad solution to a crisis which keeps getting worse. That said…

The horses have left the stable. Europe’s leaders have announced officially that there might be sovereign defaults in the Eurozone. Now they have no good options left. Governments want markets to believe that defaults will happen only after 2013, but what investor is going to wait patiently to be fleeced in a couple of years? The buyer’s strike of peripheral Eurozone debt is thus likely to continue, thus raising the cost of the further rescue operations which are clearly on the horizon. The cost of muddling through is increasing by the day.

It would, of course, also be a mistake to let policy be dictated by short-term gyrations in the bond markets. But one recent development has increased the urgency of acting soon. This is the recent announcement of the Eurogroup of November 28th that the loans of the future “European Stability Mechanism” (ESM) would be senior to private creditors.[1]

As I argue at length in a companion column (Gros 2010), this implies that large bailout programs might actually lead to higher risk premiums because large official bailout programmes would imply that little any eventual restructuring loses will be shifted to long-term creditors; short-term creditors will have already been paid off in full.

Moreover, the punitive interest rate (5.8%) imposed on Ireland now by the EFSF implies that a large official loan makes actually default more likely because an interest rate that is clearly above the growth rate one can now expect for the next years (1-2% only). When the numerator (debt service) rises faster than the denominator (GDP, i.e. ability to pay), a snowball effect occurs whereby it is ever more difficult for the country to service its debt (which in the case of Ireland would amount to 75% of GNP; see Eichengreen 2010).

The problem: Vicious circles

This creates the risk of a vicious circle under which a country that has only a manageable problem might be forced into an EFSF (ESM) programme, which would then make debt service more onerous because of the punitive interest rates. This is likely to induce investors to sell the longer-term debt of the country, which would in turn increase the pressure on the country to accept an EFSF programme. The larger the program, the less would be available in the end for bondholders should the programme not work. This is likely to lead to a further increase in the risk premium. The present strategy of “muddling through” on a case by case basis, but insisting that the future mechanism will be senior to private creditors (and that the latter must expect losses), thus carries a strong risk that more and more countries will be forced into a deadly spiral of increasing risk premiums and ever-increasing financing needs.

The solution

The only way out seems to be a big bang; to deal with all the problem cases in one go. The argument against a restructuring of, say, Greek public debt has always been that this would lead to contagion. But contagion is already a fact of life, and it focuses on countries with real problems. Portugal with its combination of high external debt and poor growth prospects looks like Greece. Spain has the “Irish disease”; a real estate bust that leads to huge losses in the banking system. Every country is different, and some countries (Spain, for example) would under normal circumstances not need a bail out. But these are not normal circumstance, and it is not possible to deal with each country in sequence because each bailout lead the markets to expect the next one. Only a big bang can resolve the impasse.

How should this “big bang” look like? A sudden collective default would of course constitute a “mega Lehman” and would have catastrophic consequences. However, it is entirely possible for the countries in question to make investors an exchange offer while continuing to service their payment obligations. There should thus be no technical default, but simply an offer to bondholders to engage in discussions about debt restructuring accompanied by a concrete exchange offer.

Everybody is different

All countries should thus move at the same time, but every country has different problems, and would make a different offer to creditors. Greece and Spain illustrate the two polar cases:

In the Greek case, the problem is clearly the sovereign. Holders of Greek public debt could be offered a par bond (100% of the nominal, but with a low interest rate and a long maturity). This would ensure that banks (and the ECB) would not have to book immediately huge losses on their accounts.

In addition to the par bond, creditors would be offered GDP warrants under which the government of Greece would offer to allocate a certain percentage of any increment in nominal GDP (after the through expected for 2010/11) to additional payments to foreign creditors, pro rata their present holdings.[2] If Greece were to pay to foreign creditors about 4-5% of any increment in nominal GDP substantial payments could built up over time, with full (even if late) payment possible if Greece returns to a decent growth path. The annex provides some crude model calculations to this effect. For Portugal, a simple rescheduling might be sufficient.

In the Spanish case, the problem stems from the banks. Nobody can know with certainty how large their losses will be in the end. But this uncertainty drags down the entire country. The banks must thus be sacrificed if the sovereign wants to stay afloat. Holders of bonds of the banks most exposed to the real estate bust would thus be offered a debt for equity swap. The Spanish government would then be free of further large contingent liabilities, and should have no problems servicing its present debt of around 60% of GDP.

The accounting losses for the holders of Spanish bank bonds might again be limited if the bonds are transformed into subordinated debt with the same face value of the bonds. For holders of the bonds which do not mark to market the accounting losses could then be taken over a longer period. Spanish banks would not be forced into fire sales, and patient investors might limit their losses if the Spanish real-estate sector does recover.

The same should have been done in Ireland. But at this point it would require first the (new) Irish government to renege on the guarantee given by the old one. This will lead to legal problems and would formally be equivalent to a default, but it would restore the solvency of the Irish government, so that no haircut would be needed on Irish government debt. The debt-for-equity swap (as with GDP warrants) allows investors to participate in the upside that would materialise if the assets of the Irish banks and Spanish cajas are really worth as much as the banks and their regulators maintain.

Core governments would of course have to stand ready to recapitalise those of their banks with the highest exposure to the peripheral debt to be restructured.

Quick preparation

All this could be prepared during a special weekend meeting of the European Council (followed by a Eurogroup and probably also an EcoFin meeting).

What about the day after? Although this package should restore the solvency of those governments currently under market pressure there might still be initially turmoil in the markets. However, at this point the ECB would be justified in providing abundant liquidity to the interbank market which should then be free of “zombies”. Governments and the ECB would thus agree on a division of a labour:

The ECB stabilises the banking system, and
The EFSF/ESM (the fiscal authorities) take care of the financing needs of governments.

The funding of the EFSF should then be sufficient to cover the (reduced) financing needs of all four GIPS (Greece, Ireland, Portugal and Spain) countries for quite some time.

Patient execution

The big-bang approach is not without risks. It could be prepared in a weekend, but it would require months of patient negotiations to get bondholders to agree.

This is actually very likely to happen because the offer would be close to current market prices and because a large part – maybe even a majority – of the bonds are in the hands of institutions that should respond to political pressures to accept the deal.

Could a “hold out” by a minority of bondholders who refuse to accept a deal created endless legal problems? There is a solution to this problem suggested by Buchheit and Gulati (2010). Greece and other countries could just pass a “mopping up” law which stipulates that any agreement by a super-majority of bondholders (say two-thirds) is binding on the remainder. This would create immediately a statuary “collective-action clause”. The absence of “collective-action clauses” thus does not constitute an insurmountable obstacle to reaching an agreement with creditors, as argued recently also in Nouriel Roubini in the Financial Times.

Conclusions
Muddling through is more attractive in the short run, but it does not lead anywhere when doubts about debt sustainability persist and the market has been destabilised by the announcement that the loans of the new permanent crisis mechanism would be senior to private creditors.

Restructuring will become virtually impossible once the Greek and Irish programs have run their course. At the end of these programmes the major part of the debt of these countries will be owed towards creditors which regard themselves a senior (IMF and ESM), but still impose interest rates far above growth rates.

At that point the haircut for the remaining private creditors would have to be enormous should the debt sustainability assessment announced by the Eurogroup come to a negative result. Even a low probability of such a result can destabilise markets today making procrastination expensive.

Please see VoxEU for references and a technical appendix on how to value GDP warrants

Reader Swedish Lex, who was involved in the famed and generally well regarded Swedish banking industry cleanup of the early 1990s, read an innocuous-sounding Financial Times story the same way I did. Not only are the banks who lent recklessly to Ireland’s overheated property sector being shielded from most of the consequences of their stupidity and greed, but other financiers are likely to make out like bandits on what looks certain to be an unduly rapid sale of bad bank assets.

For readers new to how banks get euthanized, an approach generally regarded as sound when dealing with banks that are seriously insolvent (as in their assets are worth less than their debts) is the “good bank-bad bank” approach. The bank is taken over, the board and senior management is fired. The good parts of the bank are usually spun back out as quickly as possible with new management in place. The bad parts, typically the bad loans, are put in a separate entity and disposed of.

Now there are a lot of variants on that theme. For instance, a bank might be taken over, given a government guarantee, and have its bad assets spun out gradually (as opposed to setting up a separate bad bank entity). Some Texas banks that went bust in the late 1980s had their own bad bank entities. By contrast, the S&L crisis featured one big bad bank entity, the Resolution Trust Corporation, whose mission it was to sell the asset of failed thifts. Most of these banks had gotten into trouble with speculative real estate lending (sound familiar?) and as a result, a lot of the assets that had to be sold were real property.

The problem is that the US RTC example has been treated, in revisionist history fashion, as an unadulterated success, when its record was seen as more mixed at the time. That isn’t a reflection of the performance of the RTC staff, as much as how its charter was defined. First, the RTC was authorized only to liquidate assets. That meant it could not restructure loans. By contrast, the Swedish treated their bad bank company as a asset manager and gave it more latitude. It could restructure bad loans (which would make them more appetizing to buyers). It was even allowed to extend more credit to borrowers (Sweden was going through a bad recession, due to the impact of the end of the Soviet Union on its economy, and some companies with otherwise sound businesses were experiencing cash crunches that looked to be short term in nature. It often made good business sense to cut a borrower like that some slack).

Second, the liquidate bad assets mandate meant the RTC was in the auction business. One of the key tricks of that trade is never, never put too much product on the market if it can at all be avoided; all you do is depress prices. But Congress, which was decidedly not happy to have to make special budget authorizations to clean up the savings and loan crisis mess, wanted the RTC wound up relatively quickly. Even though the RTC did better than anticipated, recovering 85 cents on the dollar, even the staff of the RTC thought that extending the process another year or so would have yielded even better returns.

By contrast, the article tonight at the Financial Times has all the indicators that the time pressure will be considerable. And that not only means greater odds of low prices, which equates to a steal for buyers, but even worse, the potential for collusion. As Swedish Lex noted, “It increases the risk for corruption since it is impossible to say that assets were disposed of too cheaply when the market is a 100% buyers’ market.”

From the Financial Times:

Ireland will accelerate the pace of shrinking the country’s banks, as a quid pro quo for continued access to emergency European funding.

The banks will have to sell tens of billions of euros worth of legacy loans in a matter of months, say people briefed on the details of Ireland’s €85bn ($114bn) bail-out by the European Union and the International Monetary Fund.

“The deleveraging has to go fast. That was part of the deal to keep European Central Bank funding,” said a person involved in the discussions.

It’s one thing for the assets to be removed from the banks quickly, quite another for them to be sold quickly. But it looks like the ECB is taking an even more short-sighted view than Congress did in the early 1990s, which is just peculiar. Congress resented funding the working capital of the RTC; the ECB similarly appears not too happy to fund the crappy bank assets. But the ECB is a central bank, comparatively insulated from short term budgetary pressures. The only reason for haste might be that it envisions a great deal more bank asset liquidations in the pipeline, and assumes prices will be low no matter what process in put in place.

We are on Harry Shearer’s Le Show, a full hour interview on the mortgage mess. Harry really did his homework, so I think readers will enjoy the conversation. It’s “live” at 1 PM EST, then runs throughout the day at various times on public radio stations around the country, including 7 PM on WNYC-AM in New York. Streams from other stations available through publicradiofan.com.

Hope you enjoy it!

Down Pompeii? The ruin of Italy’s cultural heritage Independent (hat tip reader May S). Pompeii may not be the best example. Most of the artwork and artifacts have been stripped and are at a museum in Naples. The site is pretty barren and not as interesting as one might hope, although it is instructive to see the scale and layout of a Roman city and the various establishments (houses, various merchants, even the brothels).

Giant panda breeding breakthrough BBC

People with a university degree fear death less than those at a lower literacy level Medical Daily. Hhm, strikes me as sus. Study methods not clear, but surveys and even interviews are not exactly a great way to get an accurate reading on primal emotions like fear (and how do you keep out researcher bias if you are interviewing?). Probably has to do with illusions of greater control in life generally extending to sentiments about death. Or it could also be that people of lower literacy levels are more willing to cop to negative feelings than more educated people.

Government agencies restrict employee access to WikiLeaks Raw Story. This is surreal.

Shutting Down the Internet, One Seizure at a Time danps, FireDogLake

All the President’s Captors Frank Rich, New York Times. Directionally correct, but still far too kind to Obama. I met a law school classmate of Obama’s last week, and heard the long form version of reports on his conduct then: he’d get up and consistently make completely pedestrian, middle of the road comments (his classmate put them on the order of “rain is wet”).

United Nations Silent as NATO Destroys Potentially Thousands of Afghan Homes Kabul Press (hat tip reader May S)

The roof falls in on Ireland’s Millionaires Row Guardian (hat tip reader Swedish Lex)

Shane Ross: Bankers who peddled the poison Independent (Ireland, hat tip Swedish Lex). Wow, a long form rant, and well done at that.

Record levels of poverty among families with wages Independent (hat tip reader May S)

Running Backwards in the US Economy Gregor Macdonald (hat tip reader Crocodile Chuck)

FRBSF: Disinflation – It’s Not Just Housing Mark Thoma

Today’s Jobs Numbers: Proof Against Structural Unemployment MIke Konczal

Uncertainty Over Bush Tax Cuts is Not Hindering Economy Christine Romer, New York Times.

‘It’s Ugly Out There’ Michael Panzner

Mounting State Debts Stoke Fears of a Looming Crisis New York Times. Note this is at odds with the optimistic take, that the fact that state tax receipts and spending are up 5% means things are getting better.

Taking Sides in a Divorce, Chasing Profit New York Times. A symptom of growing income disparity. This sort of thing makes sense only if the amount at issue is large.

Wells Fargo to submit affidavits: Reviewing 55,000 pending foreclosures seems to be taking longer than planned Charlotte Observer (hat tip April Charney)

What Jamie Dimon Won’t Tell You: His Big Bank Would Be Dangerously Leveraged Anat Admati, Baseline Scenario

Antidote du jour:

It isn’t clear why the American Securitization Forum decided to walk into a buzzsaw, but the carnage is proving to be an amusing spectacle.

For readers who have not followed this wee saga, mortgage securitization abuses are increasingly looking to be a mess of Titanic proportions. The securitization industry created complex and specific procedures for getting the loans into the securitization legal vehicle, a trust. (The loan, meaning the borrower IOU, is called the note; confusingly, the lien is separate and called a mortgage or in some states, a deed of trust).

These procedures were complex for very good legal reasons. These securitizations had to pick their way very carefully through a thicket of issues: state-based real estate law; the Uniform Commercial Code; the desire to create bankruptcy remoteness (so if the originator went bust, the investors would not be exposed to the risk of lenders to the originator trying to get the notes back out of the trust); securities regulations; tax law; trust law.

These provisions were adhered to for nearly two decades. But sometime in the early 2000s, it appears that the industry simply quit observing the requirements of its own contracts, called pooling and servicing agreements. And the worst is that there are no simple fixes for the resulting mess.

If the breakdown was as widespread as it appears to be, at a minimum, in the overwhelming majority of states, it will become more and more difficult to foreclose as consumer lawyers and judges wise up to these issues. And in a worst case scenario, it is entirely possible in some, perhaps many cases, no assets got the the trusts by closing, which would make them void under New York law, which governs virtually all mortgage securitization trusts (even if true, investors may choose not to pursue that theory in a lawsuit, but more evidence of pervasive problems may lead investors use related theories to press to have the deal unwound, which is still a pretty dire outcome).

The American Securitization Forum which represents originators (it also has investors as members, but investors and independent observers see the ASF as very much originator-oriented) has decided to come out guns-a-blazing against critics. The problem is, however, that it has neither the law or facts on its side. Its strident attacks are looking a wee bit desperate.

In recent Congressional hearings, the ASF executive director Tom Deutsch provided testimony that was truly astonishing (see here and here). It asserted, in effect, that extremely clear and easy to interpret language in the PSA about how the notes were to be conveyed to the securitization meant the opposite of what they said. The contracts call for a “complete” or “unbroken” chain of endorsements. The ASF testimony argued that that very same language meant the very opposite, that no such thing needed to happen. And the testimony peculiarly personalized the attack, fixating on Georgetown law professor Adam Levitin. Even though he has almost become a fixture on Congressional panels on this topic, he is far from the only expert to have argued for this interpretation.

Levitin deigned to address the ASF argument, and his post, “Fisking the American Securitization Forum’s Congressional Testimony,” is engaging. I suggest you read it in its entirely. Here are some of the key bits:

My first thought was “gosh, ASF’s awfully defensive. They sure seem spooked.” And on looking at the details of the ASF’s rebuttal, my sense is they’re on very shaky ground if these are the best arguments they have….

ASF takes me to task because the argument I make about PSAs is not supported by caselaw. Duh. Of course it isn’t. These issues have never been litigated. The whole point I’ve been making is that there are a bunch of unresolved legal issues. I’m not the one who decides what the outcome is. I can only offer my semi-learned opinion. But just as my argument lacks caselaw support, so too does that of the ASF. At least I’m not the one who built a $1.2 trillion dollar private label residential mortgage securitization industry hinging on uncertain law…..

ASF argues that the language in many PSAs requiring a “complete” or “unbroken” chain of endorsements only means that there must be a chain of endorsements legally sufficient to effectuate the transfer of the note to the trust…

There are a few problems with this argument. First, if the ASF is correct in its claim that the loans are transferred by sale under Article 9 of the UCC, the legal sufficiency of the endorsements should simply be irrelevant. In making this claim, ASF seems to be conceding that PSAs are the governing law for RMBS transactions.

Second, it’s worth looking at the entire language used in PSAs, not the selectively quoted language referred to by the ASF. For example, consider the PSA for Securities Asset Backed Receivables LLC Trust 2005-FR3, dated July 1, 2005, § 2.01(b), July 1, 2005. It provides that the depositor will deliver to the trust:

“the original Mortgage Note bearing all intervening endorsements showing a complete chain of endorsement from the originator to the last endorsee, endorsed ‘Pay to the order of _____________, without recourse’ and signed (which may be by facsimile signature) in the name of the last endorsee by an authorized officer.”

Note the bold language (my emphasis; the italics are original). There can be no question that this language is calling for every endorsement from the originator to the trust, and cannot be satisfied with a single endorsement in blank. For deals with this language, at least, ASF’s testimony is demonstrably wrong.

Now, it is important to note that not every PSA has such language…The incidence of various PSA language is unknown, but certainly there are a good number of PSAs where there has to be a complete chain of endorsements.

Another inconvenient fact is, contrary to the ASF assertions, that judges are also looking for the chain of endorsements to make sense, without reference to the PSA. By happenstance, April Charney sent a Florida decision today which illustrates how the lack of proper endorsements derailed a foreclosure (April has graciously included me in her frequent updates to various groups of lawyers involved in foreclosure defense).

Order for BAC Home Loans Servicing v. Stentz

This order is short and make for instructive reading. The note in question was indorsed (bankruptcy courts use “indorse” for “endorse”) in blank, something the ASF says is perfectly kosher. The Florida judge is not entirely comfortable with that, noting that Florida law requires that the party prosecuting a foreclosure both own and be the holder of the note. He dismissed the case without prejudice, but notice the requirements he stipulates for any amended complaint (boldface mine):

1. Allege additional facts, not conclusions of law, that specifically set forth the and identify the present owner of the note and mortgage and the present holder of the note and mortgage and in so doing deraign the chain of ownership/holdership since the loan’s inception.

2. Allege additional facts why the note is indorsed in blank and specifically deny, if that be the case, that it or an interest has been pledged to another….

5. Allege and identify all documents, by attachment, upon which Plaintiff relies to establish ownership of the note and mortgage.

Now look at the mess we have here. How, pray tell, are the plaintiffs going to prove how the note traveled from originator to its purported current owner in the absence of having the note endorsed with a full and unbroken chain of assignments? How are they going to prove a negative (as in 2, that it wasn’t pledged to another party? How will the plaintiffs prove the transfers? A basic feature of negotiable instruments like mortgage notes is that they are transferred by delivery, not by contract or assignment, AND that the party making the transfer must endorse the instrument so that it is payable to the recipient (or it can be endorsed in blank).

Oh, and if the borrower’s attorney is at all savvy, he will find the PSA for this loan. If the plaintiffs try to claim the conveyance chain was different than that stipulated in the PSA (something the ASF also tried to argue was fine), and the borrower’s counsel points out the discrepancy. This judge looks to be the sort that would find it troubling.

Here, again by virtue of synchronicity via April Charney yesterday, is another example of a judge, this time in Ohio, refusing to foreclose. One of the reasons is the chain of assignments is broken (see the part I boldfaced):

Case: CV-09-706959
Case Caption: PROVIDENT FUNDING ASSOCIATES, L.P. vs. TAMARA TURNER, ET AL
Judge: TIMOTHY MCCORMICK
Room: 20C JUSTICE CENTER
Docket Date: 11/09/2010
Notice Type: (JEPC) JOURNAL ENTRY NOTICE
Notice ID/Batch: 16552802 – 875214

To: JAMES R DOUGLASS

MOTION OF THE DEFENDANTS PHILLIP TURNER AND TAMARA TURNER TO DISMISS FOR PLAINTIFF’S LACK OF STANDING TO FILE THE FORECLOSURE IS GRANTED. PLAINTIFF DID NOT PRESENT EVIDENCE TO THE COURT THAT IT OWNED THE SUBJECT PROMISSORY NOTE AS OF THE DATE OF THE FILING OF ITS COMPLAINT IN THIS CASE AND COULD NOT, THEREFORE, PROVE THAT IT HAD STANDING TO FILE THIS CASE. SEE WELLS FARGO BANK V. JORDAN, 2009 OHIO 1092 (8TH DIST. CT. APP., MAR. 12, 2009). MERS COULD NOT ASSIGN THE NOTE AS IT NEVER HELD THE PROMISSORY NOTE. THERE IS NO EVIDENCE THAT THE ALLONGE WAS EVER AFFIXED TO THE NOTE. VIRTUAL BANK PURPORTS TO INDORSE THE NOTE TO THE PLAINTIFF, BUT THERE IS NO EVIDENCE THAT VIRTUAL BANK HELD THE NOTE AT THE TIME OF THE INDORSEMENT. VIRTUAL BANK IS ALSO NOT THE PAYEE ON THE NOTE. COMPLAINT DISMISSED WITHOUT PREJUDICE. AS PLAINTIFF DID NOT HAVE STANDING TO FILE THIS CASE, THE COUNTERCLAIM IS ALSO DISMISSED WITHOUT PREJUDICE. (FINAL)
COURT COST ASSESSED TO THE PLAINTIFF(S).

CLDLJ 11/09/2010
NOTICE ISSUED

Ohio and Florida require that the party foreclosing be the owner of the note. But even in states like California, which appear merely to require that the foreclosing party be a holder, “holder” signifies more than mere possession. In IndyMac Federal v. Hwang, the judge cites the California Commercial Code (3301 (a) and 1201 (20)) and UCC (3-301 (a) and 1-201 (20)):

For an instrument payable to an identified person (such as a note in this case), there are two requirements for a person to qualify as a holder: (a), the person must be in possession of the instrument and (b) the instrument must be payable to that person.

These examples prove a basic point. There is good reason why the PSAs stipulated a complete, unbroken chain of endorsements. The absence of them creates huge problems, independent of the requirements of the PSA, in enforcing the note.

As we said in our New York Times op-ed,

The people who so carefully designed the mortgage securitization process unwittingly devised a costly trap for people who ran roughshod over their handiwork. The trap has closed — and unless the mortgage finance industry agrees to a sensible way out of it, the entire economy will be the victim.

The ASF, perversely or perhaps predictably, is persisting in being part of the problem rather than part of the solution.