The Market Ticker

Unbelievable.

As those who read this column regularly know I have commented before that I believe Fannie and Freddie are woefully under reserved and potential "short to zero" candidates, simply because of the depth of their capital (or more specifically, the lack thereof) behind their credit book.

Now we get something far more ugly - proof that what I have been told was in fact happening - that Fannie and Freddie were buying "Liar Loans" - is in fact true.

"A federal probe of Countrywide, the nation's largest mortgage lender, is turning up evidence that sales executives at the company deliberately overlooked inflated income figures for many borrowers, people with knowledge of the investigation say.
.....
Both Countrywide and Fannie Mae, the government-sponsored company that bought many of the loans, classify the loans as "prime," meaning low-risk.
....
John Sipes, a former loan officer at Countrywide in Los Angeles, said sales agents loved the loan. "In the good old days, that was the best loan we had at Countrywide," he says. Borrowers were required to sign a form allowing Countrywide to verify their incomes with the Internal Revenue Service, but "they never really checked," he says."

Yeah, right.

Remember now, we were told last spring and summer this was a "Subprime" problem.

Then that there were some "liar loans" but they were not considered "prime" paper, and that the "prime" mortgages that were written over the years were in fact safe - even from "bubble" vintages.

Now, as the FBI digs into the matter, we get down to what appears to be the truth.

Let's lay it out here, assuming that the FBI investigation proves out:

• Countrywide (and presumably other lenders) wrote mortgages to people on "stated" income, allegedly with the right to verify income against tax returns, but in fact they never did.
• These loans were then packaged up and sold to various channels, including the GSEs Fannie and Freddie, contaminating their "prime" credit book with garbage paper that is at high risk of default. These loans were bought by Fannie and Freddie despite both of those firms representing to its investors that they buy only "safe, prime" mortgage paper.
• This was allegedly hidden from investors (In the stock? In the paper? From Fannie?), thereby inducing those investors to purchase things (stock, bonds, mortgages) they would not have otherwise bought.
• Either Countrywide's folks in the corner office were incompetent (unaware) or complicit (worse) - so how is it that Sambol has been given a job by BAC?

Oh, and now that the firm has been gutted Countrywide lacks the ability to "buy back" the defaulted paper, so the buyers - including Fannie and Freddie - are going to wind up eating it.

Is this the only instance of this sort of outrageous behavior and misrepresentation in the system, which now appears to have been promoted and enabled by the very same GSEs that are supposed to "help" Americans buy and own homes?

Care to take a bet on it?

I wouldn't.

Let's leave aside for a moment whether the FBI can dig up enough evidence to bring criminal charges against a wide range of players, including perhaps indicting the firm itself (there has been one broker who apparently drew a 2-year sentence already and triggered the broader look) and focus on what this means generally for the mortgage marketplace.

This is, perhaps, the most damning piece of information we have seen so far, when one takes time to think about it and add it up. Some will refuse to recognize this, but that would be a huge mistake.

See, if Countrywide pulled this sort of thing it has to be assumed that this bad paper was not only originated by them, the "nation's largest lender" but also by many other mortgage lenders, both large and small. It also has to be assumed that this risk was sold off to virtually everyone in the chain, and that huge parts of it remain hidden all over the banking and lending system.

The magnitude of this problem cannot be understated, and there is literally nothing that can be done about it at the present time. These loans will go bad, and when they do, there will be little or no recourse back to the originators, especially if Bank America retains Countrywide as a separate subsidiary and/or "bankrupts" them intentionally once absorbing the pieces it wants to keep.

The losses embedded in the GSEs are impossible to determine up front but the capital reserves these firms hold is minuscule compared to their credit book. Very small amounts of real change in exposure to risk make a big difference to the outcome, and it is essentially impossible for any investor in this paper to know what they're buying, given that it appears Fannie was "clueless" about the deception, whether through carelessness, willful blindness or active deceit by others.

If these investors have a hint of brainpower this article will immediately cause spreads on that paper to blow out, which means conforming loans are going to get more expensive.

Perhaps a LOT more expensive.

If you are an investor in Fannie and Freddie paper, you have to ask yourself today - why would you hold those bonds when you have absolutely no idea what is actually in them? If you are a stockholder, do you want to find out the hard way that these firms have a fraction of the capital base necessary to absorb these credit losses and remain afloat?

I suspect the ultimate answer is that both GSEs wind up being nationalized, bondholders will take significant losses on bonds purchased in the last few years and common stockholders will get zero.

The accounting scandal of a few years ago at both Fannie and Freddie was bad.

This is hundreds of times worse because it threatens not just how the books are added up but what underlies those books! In short, what everyone has assumed was "money good" is increasingly looking like used toilet paper with a very high risk of stinking up the joint before you can dispose of it in the commode.

It is now clear that there is no such thing as a "safe" mortgage bond, even those issued by Fannie and Freddie, because the entire system has been contaminated by channel-stuffing with barrels full of liar loans!

What may be at least equally bad is that Countrywide, when it lost access to the commercial paper market in the middle of last year, tapped the FHLB system hard.

In November Senator Schumer sent a letter to the FHLB expressing "concern" about the volume and concentration of risk that FHLB Atlanta was engaging in with extensions of credit to Countrywide.

Is it possible that this could bring ruinous losses to the FHLB system too? Yes, although again, without much more information we simply will not and do not know. But the risk is certainly there, especially if these loans were bought at very low spreads as is common for "prime" paper - when in fact the loans were anything but prime, stuffed chock full of fraudulent misrepresentations.

Hopefully as this all unwinds the fraudsters will get themselves 20 years in the Greybar Motel.

Fannie and Freddie are chartered under Congressional "oversight" to promote "affordable" housing and maintain liquidity in the marketplace.

They have done an amazing job of maintaining "liquidity" but on affordable housing they have in fact done their damndest to screw Americans instead of helping them. They were in fact the chief enablers of the bubble and attempted to profit from it, levering up their "special" position due to Congressional blessing and in fact buying the same sort of trash paper that sunk AHM!

On the "liquidity" front their "efforts" looked good but in fact they were a chief source of the "free money" that led to the bubble in the first place, and thus were a chief driver of the fraudulent, Ponzi-like home-price "appreciation" that took hold in this nation.

These institutions need to be shut down or nationalized as it is clear that they are unable to operate within their charter and will take every opportunity to game the system while screwing Americans wholesale.

Their stockholders should get zero and their executives should be indicted for abusing the public trust. It is clear that these firms promoted and in fact helped create the bubble that now threatens to take millions of Americans' homes.

OFHEO needs to be disbanded for failing in its essential purpose of oversight and regulation.

Why we as a nation continue to tolerate this sort of nonsense and outright theft by organizations that are supposed to be there to "help us" - especially when they operate under explicit Congressional charter with "privileged position" - is beyond me.

There is a serious problem with the "hide the salami" game that these institutions are playing.

You can hide it all you want but eventually it stops cash flowing according to requirements and defaults. At that point you can try to sucker your way through by propping it up, but that only works until your cash runs out. The obvious defensive move is to increase spreads so you have more cash coming in to make up the flow requirements, but that just hammers housing harder, as real rates rise, as rising real rates effectively devalue every home in America.

This can quickly deteriorate into a self-reinforcing spiral, dragging not only housing but ultimately essentially all lending goes down the drain.

There is no way out of this mess other than for those who did the evil things to be forced into the light, prosecuted when necessary, the firms involved put out of business or (in the case of the GSEs) nationalized and punishments levied.

The garbage paper has to be forced into the open and those who have losses are going to have to eat them, no matter how painful.

I realize this is politically unpopular but the alternative is that we will reach a tipping point where confidence in the quality of this debt will be lost, and then the market will do for us what we don't want to happen - that is, a generalized "buyer's strike" will ensue, and that will be the end of that.

Instead, we must take our medicine - now - no matter how bad it tastes.

We are simply out of time and ability to absorb more fraud and destruction of trust in our credit market and banking system.

Congress needs to hear from each and every one of us on a daily basis in some form - whether it be by email, phone, or fax - until these problems are addressed. It is not enough to sit back and wait for the FBI to finish their investigation - there needs to be an all-on assault on the fraudsters and it needs to be made clear that irrespective of who they are, where they work, or how bad it is, the truth must be laid bare on the table now.

Our economy literally hangs in the balance.