Part III BIG BANKING
By Nossen Yoffe
This section includes explanations of how the banking system works and descriptions of three pharaohs: their wealth, power, and influence.
The most important thing to understand about derivatives (and credit default swaps in particular) is that they are an unregulated market that allows people to bet that a person, a corporation, or an institution will default on financial obligations. In traditional finance, before anyone loaned money or bought debt belonging to another person or organization, there would be a thorough examination of that person’s or organization’s credit history, income security, and other pertinent information.
Now, creditors who are exposed to a default often buy a credit default swap against it. This causes two problems. First, with less checking on the creditworthiness of borrowers at all levels of the financial system, it becomes much more vulnerable to fraud. Second, the vast majority of the financial system becomes exposed to the risk that once large numbers of borrowers start to default (like during a financial crisis), these insurers will be unable to cover their losses and the delinquent borrower’s creditors will remain exposed to the defaults.
Derivatives also allow financial players to take relatively small amounts of money and make huge bets against the creditworthiness of other institutions, even when they have no direct exposure to their default. There is a reason it’s illegal for one person to buy fire insurance on another person’s house. It is because the purchaser then has a direct financial interest in seeing the house burn down. The only difference between the two is fire insurance has “insurance” in the name and is thus regulated as insurance while “Credit Default Swap” sounds complicated and doesn’t have insurance in its name.
The most important thing to know about the current loan securitization process—which took off more than two decades ago—is there are now financial institutions servicing people’s loans for investors (as in process the payments, provide costumer service, etc.) that have no direct financial interest in the borrowers’ paying back their loans. The only income these service institutions receive is the fees they charge. As a result, servicers have discovered that foreclosing on a family is more profitable than doing loan modifications for borrowers who are behind on their payments. Worse, they’ve also discovered that forcing borrowers into delinquency even when they have made all of their payments is more profitable than simply servicing a loan until it is paid off. How can they do that? Yves Smith explains:
“It’s actually very simple. It’s called servicing errors and fraud. And whether by mistake or design, when a borrower gets caught in the servicer hall of mirrors of compounding fees and charges, there is no way to appeal and pretty much no way out. Let’s look at how this begins. A payment is credited as being late. It might actually legitimately be late, the borrower might have neglected to send it in on time or the bank might have been slow to process it. That might be simple queuing meets bad controls, or it might be deliberate. Servicers have been found to delay posting checks to incur late fees. Unless the borrower incurs the cost of sending mail via a service that provides proof of time of delivery, the bank can always claim the payment arrived late.
“Let’s say the late fee is $75. It will be charged against the next month’s payment, but the borrower doesn’t know that he owes more that month. He gets a mortgage coupon and sends his regular payment in. Now the servicer starts playing the sort of tricks practiced elsewhere in retail banking. Under the terms of the loan and Federal law, monthly payments are to be applied to principal and interest first, fees second. But the bank applies it to fees first. This makes his second month come up short. He gets charged a fee for insufficiency, and perhaps a late fee too. Once the borrower has had two late fees, the servicer is often required by the pooling and servicing agreement to get a broker price opinion (BPO). This is a typically $250 exercise in form in which a broker drives by, takes a couple of pictures of the house, and offers a guesstimate of what it might be worth. Many servicers double dip and also charge the BPO to the borrower as well. So the fees and average charges and interest charges are compounding at a faster rate now.
“It takes a remarkably short amount of time for pyramiding fees to add up to a few thousand dollars, unbeknownst to the borrower, until he gets a call from the servicer, or worse, a foreclosure notice.
“This is where it gets even better. Even when the borrower hires an attorney, it is remarkably difficult to get the servicer to disgorge its records showing the borrower payment history and its fees and charges. I’ve also been told by attorneys that the reports are difficult to decipher and reconcile with the borrower’s records of payments that have cleared his account. So unless the attorney is tenacious, or has been down this path before, he may not realize that the borrower isn’t nuts when he says he was late only once, maybe twice at most, and doesn’t understand how the bank is now foreclosing.”.
In this way, the servicers are defrauding not only the homeowners but the investors for their personal profits.
Accounting Control Fraud
At this point the reader might be asking how this is allowed to happen. First, the regulators (the cops of financial crime) have to be prevented from regulating. This can happen a number of ways. The regulators could be underfunded relative to their workload; rules that used to prevent certain activities or markets can be reduced or removed; the rules can stay in place but the regulators can simply stop enforcing them; or crimes committed in the industry can simply not be enforced or enforced rarely.
With the regulators out of the way, the industry becomes incredibly vulnerable to unscrupulous CEOs who are willing to do anything to walk away wealthy. First, the CEO makes the bank he [bank CEOs are historically men] manages lend out as much money as it can to anyone with a pulse while setting aside very little money relative to the large amount of future losses. The only way the company can grow massively in such a way is to lend to borrowers who are unable to pay them back. In order to minimize the paper trail of the fraud the CEO is in the process of committing, he uses what are called “liar loans,” that is, loans where the only information the lender gathers is the borrower’s stated income (sometimes simply made up by the broker in charge of the loan). In this way, the CEO can report record profits in the short turn and will be compensated tremendously for his “superb management skills.” By the time the fraud is revealed and the company collapses (or gets bailed out) the CEO will leave incredibly wealthy.
Perversely, once one banker makes record profits in this illegal or quasi-illegal manner, other banks become under pressure to replicate their results. Those who are unwilling to follow the path of the unethical or fraudulent bankers get pushed out of the industry until the entire industry is run by the most unethical among us. This type of fraud is not new and occurred before, notably during the 1980s and early 1990s in what has been named the S&L crisis. The difference between that crisis and this one is thousands were prosecuted as result of the S&L crisis. To date, not one banker has been put into prison.
For further reading:
Black, William. The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. 1st ed. University of Texas Press, 2005. 351. Print.
Das, Satyajit. Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. 1st ed. FT Press, 2006. Print.
Smith, Yves. ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. 1st ed. Palgrave Macmillan, 2010. 368. Print.
“The Goldman Sachs Group, Inc. (Goldman Sachs) is a bank holding and a global investment banking, securities and investment management company. The Company provides a range of financial services to customers, including corporations, financial institutions, governments, and high-net-worth individuals. Its depository institution subsidiary, Goldman Sachs Bank USA (GS Bank USA), is a New York State–chartered bank. It operates in three segments: Investment Banking, Trading and Principal Investments, and Asset Management and Securities Services. In March 2010, the Company’s subsidiaries sold the La Francia mine and related infrastructure assets, including Concession 5160, and Adromi Capital Corp., the holder of the La Francia II concession, to a subsidiary of The Goldman Sachs Group, Inc. In May 2010, Nexen Inc. sold its natural gas trading operations to a unit of The Goldman Sachs Group, Inc.”
“Goldman was one of many Wall Street firms that created complex mortgage securities—known as synthetic collateralized debt obligations—as the housing wave was cresting. The firm created the security Abacus 2007-AC1 in 2007. At the time, traders like the prominent hedge fund manager John A. Paulson, as well as those within Goldman, were looking for ways to short the overheated market.
“And in April 2010, the bank was accused of securities fraud in a civil suit filed by the Securities and Exchange Commission that claimed the bank created and sold a mortgage investment that was secretly devised to fail. The move marked the first time that regulators have taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market. The firm later paid $550 million to settle the charges.”
“The role of banks like Goldman became the focus of criticism in February 2010 as Greece, Spain, and other southern European countries found themselves facing a debt crisis. Over the last decade, Goldman and others helped the Greek government legally mask its debts so the nation appeared to comply with budget rules governing its membership in the euro, Europe’s common currency. In that role, Goldman advised Greece and, in return, collected hundreds of millions of dollars in fees from Athens.”
Information taken from the New York Times
Goldman Sachs Group Inc.
200 West St., 29th Floor
New York, NY 10282
Phone: +1 (212) 902-0300
Fax: +1 (212) 902-3000
Net Sales/Revenues for 2010: $46 Billion
Total Assets as of 2010: $911 Billion
Power and Influence of Goldman Sachs
2010 Lobbying Expenditures: $4,610,000
Senate Majority Leader Harry Reid (D-NV) was the largest Senate recipient of Goldman Sachs campaign contributions in the 2010 election cycle. The law that led Goldman Sachs and other big Wall Street firms to set up commercial banking businesses while avoiding the regulation this normally entails has been preserved in the bill remaking financial regulations and closing loopholes. Reid was listed as an influential senator who allowed this loophole to remain.
Michael McMahon (D-NY) was the largest House recipient of Goldman Sachs campaign contributions in the 2010 election cycle. In an Op Ed piece for The Hill (the newspaper published daily when Congress is in session), he wrote that the source of the financial meltdown was caused not by derivatives but by the bad apples that sometimes trafficked in them. With the House considering expansive financial reform legislation, McMahon warned his colleagues against an “overreaction” to the financial crisis.
“Goldman Sachs launched a new public relations campaign in September with a full page advertisement in the Wall Street Journal touting the company’s role in raising capital for a clean energy project. The clean energy advertisement was the first of many that will tout the role of Goldman as a good citizen. Other advertisements may emphasize Goldman’s role in providing business education to women and small business owners.”
Rolling Stone magazine’s Matt Taibbi describes Goldman Sachs as follows: “The bank’s unprecedented reach and power have enabled it to turn all of America into a giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere—high gas prices, rising consumer credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you’re losing, it’s going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it’s going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth—pure profit for rich individuals.’’
Bank of America
“Over the last decade, Bank of America transformed itself from a regional institution into the nation’s largest brokerage house and consumer banking franchise. But during the financial crisis, it was sapped by huge losses and the controversial acquisition of Merrill Lynch. It lost its position of pre-eminence and its longtime chief executive, Kenneth D. Lewis, lost his job amid questions of whether the bank failed to disclose the brokerage firm’s worsening condition to his shareholders before they approved the purchase.
In short, just about everybody regarded the Merrill deal as a dud. But in April 2010, Mr. Lewis’s successor, Brian T. Moynihan, reported a first-quarter profit of $3.2 billion, and gave much of the credit to surging profits from trading at Merrill Lynch. The results were a stark turnaround from the deep hole the bank had dug itself in 2008.
"However, in January 2011, the bank reported a steep loss for 2010 and warned that the lingering effects of the mortgage mess could cost it billions more. It lost $2.24 billion for the year as gradual improvements in its core banking business were offset by charges linked to its disastrous 2008 acquisition of Countrywide Financial, the subprime mortgage specialist whose lending practices have come to typify how the housing boom turned to bust.
“In February 2011, the bank said it would create a unit to handle 1.3 million soured mortgages as Mr. Moynihan tried to distance the company from the fallout of the mortgage crisis.”
“Bank of America and other mortgage-servicing giants remain at the center of an investigation into foreclosure practices by all 50 state attorneys general. One particular focus is the role of what became known as robo-signers, bank officials who signed thousands of documents a month with barely a review, as well as whether foreclosures and evictions were pursued despite the absence of crucial documents.”
Brian T. Moynihan, CEO
Bank of America
100 N. Tryon St.
Charlotte, NC 28255
Phone: +1 (704) 386-5681
Fax: +1 (704) 386-6699
Net Sales/Revenues for 2010: $129.9 Billion
Total Assets as of 2010: $2.26 Trillion
Power and Influence of Bank of America
2010 Lobbying Expenditures: $3,980,000
2008 Lobbying Expenditures: $4,886,000
Richard Burr (R-NC) was the major Senate recipient of campaign contributions from Bank of America. Senator Burr voted against giving bankruptcy judges more authority to modify existing home mortgages, voting with the industry.
Barney Frank (D-MA) was a major House recipient of campaign contributions from Bank of America. Barney Frank has developed a web of relationships, alliances, and attachments to financial elites as chairman of the House Financial Services Committee that have repeatedly undermined his independence on everything from bailout negotiations to the financial reform legislation.
The Securities and Exchange Commission (SEC) sued Bank of America for not disclosing the extent of Merrill Lynch’s losses and the $3.6 billion accelerated payment of bonuses to its shareholders before they voted to approve the acquisition. District court Judge Jed Rakoff refused to approve the original $33 million settlement agreed to by the SEC and Bank of America, and he reluctantly approved it only after the penalty was increased to $150 million.
In reviewing the settlement, Rakoff harshly criticized the SEC for being too lenient, saying Bank of America’s punishment was “half-baked justice at best.”
Bank tellers at Bank of America receive a median wage of $10.73/hour, or $22,328 annually. In contrast, former CEO Ken Lewis’s pay for 2007–2008 was $34.8 million, or 779 times the median teller wage.
“Morgan Stanley is a financial holding company. Through its subsidiaries and affiliates, the Company operates as a global financial services company that provides its products and services to a diversified group of clients and customers, including corporations, governments, financial institutions and individuals. It operates through three business segments: Institutional Securities, Global Wealth Management Group and Asset Management. In May 2010, Invesco Ltd. acquired the Company’s retail asset management business. During the year ended December 31, 2009, it disposed its former real estate subsidiary, Crescent Real Estate Equities Limited Partnership. On May 31, 2009, the Company and Citigroup Inc. (Citi) consummated the combination of the Company’s Global Wealth Management Group and the businesses of Citi’s Smith Barney in the United States, Quilter in the United Kingdom and Smith Barney Australia. The combined businesses operate as Morgan Stanley Smith Barney Holdings LLC.”
Information taken from the New York Times
New York, NY 10036
Phone: +1 (212) 761-4000
Net Sales/Revenues for 2010: $38.16 Billion
Total Assets as of 2010: $807.7 Billion
Power and Influence of Morgan Stanley
“Morgan Stanley is one of the world’s top investment banks, offering its clients everything from stock portfolio management to credit services. Like others in the securities industry, however, it lobbied for money from the federal government in 2008 and 2009 when the industry—along with the economy—was floundering. The investment bank received billions in taxpayer money from the bailout bill. Morgan Stanley invests in and advises virtually every industry affected by federal legislation. The company, which splits its contributions evenly between Democrats and Republicans, has been a major proponent of privatizing Social Security. Morgan Stanley also has lobbied in favor of proposals to deregulate the securities industry, so that investment firms can further extend their reach into financial services.”
2010 Lobbying Expenditures: $2,750,000
2009 Lobbying Expenditures: $2,880,000
Information taken from opensecrets.org
Senator Richard C. Shelby (R-AL), Chairman, Committee on Banking, Housing and Urban Affairs was one of the top recipients of campaign contributions from Morgan Stanley during the 2010 election cycle. Shelby fought an amendment to the financial services reform bill that would ban commercial banks from trading for their own benefit with taxpayer-backed money. Shelby also objected to an amendment from Senator Kay Hagan (D-NC) that would rein in predatory practices of payday lenders and one from Senator Byron Dorgan (D-ND) that would have banned naked credit default swaps, which were at the heart of the financial crisis.
Former Congressman Scott Murphy (D-NY) was one of the top recipients of campaign contributions from Morgan Stanley during the 2010 election cycle. A former venture capitalist who won a special election to replace Kirsten Gillibrand when she took over Hillary Clinton’s Senate seat, he nonetheless lost his bid for a full term of office. However, he had already sponsored an amendment that weakened the derivatives portion of the financial reform bill exempting all sorts of swaps-trading from regulation and effectively undermining the legislation. Trillions of dollars of derivatives, which Warren Buffett has called “financial weapons of mass destruction,” are traded in “dark pools” that nearly brought down the global financial system in 2008. Many of these pools remain unregulated in the House reform bill.
Morgan Stanley created financial derivatives based on subprime mortgages that it bet would decline in value. The Wall Street Journal reported in May 2010 that federal prosecutors were looking into whether Morgan Stanley had misled investors about mortgage-related investments it designed and bet against.
Gary Aguirre, an SEC investigator, was fired after he questioned the agency’s failure to pursue an insider-trading case against John Mack, the chairman of Morgan Stanley and one of America’s most powerful bankers. The investment banker had been a fundraising “Ranger” for George W. Bush’s presidential race in 2004, and would go on to be a key backer of Hillary Clinton in 2008.