Banking System

The Parade Of Mendacity continues in The Capitol today, with a committee hearing on the reform of the OTC Derivatives market.

The witness list reads as a who's who of the den of wolves, of course.  We have the obligatory commercial interests who use derivatives (Cargill and John Deere) along with SIFMA via Morgan Stanley, the Managed Funds Association, the insurance companies (Prudential) and the mandatory academics.

Many of the witnesses make the obvious point that derivatives are useful to hedge off risks of various types, some of which are "custom" in their implications - that is, there is no currently-corresponding exchange-traded instrument that duplicates what they are trying to accomplish.  In this they are correct.

But two pieces of testimony are deeply troubling; those of James Hill and Dave Hall of SIFMA and Chatham Financial, respectively.

James asserts as his opening volley:

We believe that a guiding principle for congressional action should be not to impose new regulations that will limit the availability or usefulness of derivatives or increase their cost unless there is a compelling reason to do so.

In other words, James asserts that there should be no regulation that provides for actual safety improvements to the system, because such improvements will of course increase their cost.

He goes on to say:

It was the lack of meaningful regulation of AIG’s derivatives affiliate that allowed poor business practices to lead to a situation in which the federal government had to invest tens of billions of dollars in that enterprise in order to avert what could possibly have been a systemically significant business failure. The Act would address this regulatory shortcoming by creating a legislative and regulatory framework that ensures such a lapse should not occur again.

That's a nice sentiment, but it does not take Mr. Hill long to gut his own prescription.  See, AIG's problems revolved around a simple reality: It was operating while insolvent, and allowed to become not only insolvent but ridiculously insolvent, to the point that it literally threatened to be unable to cover ANY of its outstanding derivative positions.

SIFMA's position becomes clear almost immediately thereafter:

For example, the Act would authorize regulators to impose margin requirements on swaps in which one of the counterparties is an end user. It is difficult to understand why counterparty credit exposure created through a swap transaction should be required to be collateralized when lending arrangements between the parties can be made on an unsecured basis. The Act would direct regulators to allow parties to post non-cash collateral, but even that carries a cost, including reducing the end user’s borrowing capacity and potentially causing an end user to violate negative pledge covenants.

There's the problem with the banking system right there - in your face!  We had multiple failures last year because banks lent money unsecured beyond their excess capital; when that money was not paid back by the supposedly-credit worthy customers in a sufficient number the bank failed, forcing the intervention of the Federal Government.

Worse, we have hard proof that this conduct is still going on in the form of nearly 100 bank failures thus far in the crisis.  In virtually every case it is discovered that these banks are not just insolvent, they are ridiculously beyond insolvent, having burned through their so-called 6% Tier One regulatory capital three, four, five or even six or seven times over before being "caught" and closed.

These deficiencies did not happen overnight.  Indeed this sort of insolvency takes weeks, months or years to develop, during which there has been willful blindness both in Washington DC and the several States to the pending implosion of these firms.  In many states, such as Virginia, Michigan, Maryland, Nevada, North Carolina, Indiana, Missouri this is defined as an offense, and some states define it as a criminal felony for which one can be imprisoned for a term of years.  All of the above named states define such an offense as one that subjects all officers, directors, and branch managers to personal liability for loss of such deposits, and demands personal knowledge of the books of account of such institutions by all these individuals.  While some states apply this only to "state banks", others are far more broad, applying these strictures simply to "banks", strongly implying that these standards apply to any firm that operates a bank in their state by virtue of corporate charter (as a foreign corporation or not!)

Now SIFMA has the gumption to come to The House of Representatives and put forth the position that institutions are "free" to do this sort of thing, exposing themselves to insolvency via lending, they should be able to expose themselves to even greater insolvency via derivatives contracts, and that no margin supervision should be required as a matter of law in order to prevent insolvency from occurring.

This is tantamount to asking for official federal sanction to commit a felonious act under the laws of several states.

Another provision concerns dealer segregation of funds or other property posted as margin. We believe it is important for end users to have that option in connection with over-the-counter swaps, but both the decision to require margin and the details of how it is handled should be left to negotiation between the dealer and the end user in the ordinary course of their lending and risk management processes.

Both Lehman and AIG's failures were systemically significant as a direct consequence of the failure to demand margin segregation.

Lehman is particularly troubling.  As I have previously documented there were tens of billions of dollars in NY Fed money that Lehman had outstanding at the time of its bankruptcy filing.  What appears to have transpired, however, is that The NY Fed was repaid in apparent violation of bankruptcy preference laws after the petition was filed, even though such actions are per-se improper once an insolvency is declared by the firm (indeed, any payment made that appears to be in "preference" looking back prior to the filing for a reasonable time, usually 90 days, can be reversed in bankruptcy.)

The larger issue is simply this: SIFMA is arguing that collateral posted with a bank or other financial institution to secure a current liability under a derivative contract should be available to the institution for general corporate purposes.  This runs contrary to every principle of fiduciary responsibility, agency status for a broker/dealer and common sense.

Indeed, these funds are not, under any circumstances, the broker/dealer's to use.   They are posted as security for performance, just as is an earnest money deposit on a home purchase or margin posted for a short stock position.  These funds are collected for the express purpose of securing performance, nothing more or less, and they need to be held and kept separate under formal escrow protection.

The legislation under consideration does not go far enough to guarantee this protection for customers.  Under no circumstances should the assets of a customer that are posted for margin purposes be able to be co-mingled with the general operating funds of the corporation holding them, nor should they be subject to seizure and conflation with the firm's assets in the event of insolvency.  The money or other collateral in these instances is posted for the specific purpose of securing performance; nothing more or less, and does not belong to the institution holding these funds!

SIFMA's objection is both self-serving and outrageous.  By permitting the corporate use of these funds not only are the banks able to "double dip", that is, earn interest lending out money that is not theirs, effecting theft (even if temporary) by conversion, they also expose customers to the risk of loss in the event of a firm's insolvency - a risk that is not disclosed clearly and conspicuously to them when they enter into these derivatives contracts.  Indeed with that disclosure it is likely that no customer in his or her right mind would agree to such a contract, as the very time when a loss occasioned by this would be realized would be when that firm would be making maximal use of its hedging activity via these derivatives.

I will note for the record that other institutions have been caught using customer segregated funds generally for their own corporate purposes in recent years, and subjected to fines for doing so.  This is insufficient; such a violation should be punishable by criminal sanction as well as revocation of a firm's operating charter, as this is nothing more or less than theft by conversion.

Dave Hall echoes the sort of ridiculous statement of SIFMA with regards to margin:

Margin – Any requirement for business end users to cash collateralize hedging transactions would create an extraordinary and unnecessary drain on working capital.

Huh?  The exposure on a short transaction that has gone "against" the customer is real!  The requirement to post margin comes out of the fact that performance, assuming the position remains where it is or continues to move adversely, will require the payment of those funds.  Posting of margin may "drain working capital" but so does performance!  What will be next?  Repudiation of swaps that go the wrong way for the customer?

Mr. Hall goes on to say:

To illustrate this point, a bank may choose to make a loan without collateral if the business is creditworthy, therefore it is reasonable that a derivative should be allowed to be offered to a business end user without margin if the business end user is creditworthy.

And again I note that we have nearly 100 proved cases thus far in the form of bank seizures where so-called "credit-worthy" customers in fact were not and the refusal of those institutions to maintain the sound banking practice of never lending unsecured beyond the bank's own collateral has resulted in insolvency from three to nine times over (vis-a-vis the Tier 1 Regulatory Capital) prior to seizure.

In short OTC derivatives, over the previous ten years, have become a mechanism for avoidance of sound financial regulations and gross abuse of regulatory arbitrage.  These abuses have led to billions of dollars of losses in the case of Lehman and taxpayer expense of over $100 billion dollars that was passed through AIG to counterparties that, on their face, had a claim to exactly nothing following AIG's recognition of inability to pay as agreed.

These failures were not accidents, they were systemic and intentional abuses that, under the laws of several states, should have been charged and prosecuted as felonies.  That there is no corresponding federal law prohibiting a financial institution from accepting funds and/or operating while it is in a negative equity position and criminalizing this conduct - that is, operating while insolvent - is an outrage. 

SIFMA and The Chatham Financial Corporation wish to not only continue this charade but, it appears, to be given formal permission from The Federal Government to expand it.

Their requests not only must be denied but Congress must also write into law criminal penalties mirroring that of states such as Nevada, which formally define the operation of a "bank" (but extending it to all financial institutions) while insolvent as a felonious act, exposing all officers and directors not only to prison time but also to personal liability for all losses suffered by customers and counterparties as a consequence thereof.

It is time to "clear the decks" and talk about exactly what a sound banking system is - and is not.

It is time to identify that which is an exercise in capitalism, and that which is an exercise in fraud.

It is time to strip back the mask of the so-called "moneychangers" and lay bare for all to see exactly what has been going on for the last two decades, and more importantly, to identify whether or not there is a kernel of respectability contained therein.

And finally, it is time to dispense with many of the calls from all corners for "hard money" and the demise of fractional lending as nothing more than an interesting philosophical exercise masquerading as an intentional (or horribly-misguided) misdirection.

Let's first define a few terms; these should be familiar:

• Principal: The amount of money you borrow for a given term of time.
  
  
• Interest: The amount of money you pay, usually expressed as a percentage, to cover three risks and costs - the risk you will not be able to pay the principal, the risk of currency devaluation and the demanded profit on the loan by the lender.
  
  
• Collateral: The item or items you post with the lender to secure your indebtedness.  While "collateral" in the broadest sense includes anything that could be seized after a judgment should you fail to pay (including your labor at subsequent points in time), for the purpose of this discussion we will limit the term "collateral" only to that specific physical, tangible property you post to secure a specific loan, explicitly excluding anything of a speculative nature (such as your ability to earn money in the future.)
  
  
• Monetary Base: The monetary base of all credit-based monetary systems is the sum total of all unencumbered assets against which one is both able and willing to borrow.  (No, it is not "M1", "M'" or any such nonsense.)  If you run into a so-called "Economist" who claims to have letters after his name yet makes the argument that "base money" (or any such thing) is the monetary base in a debt-based system find out where he got those letters from and petition them to revoke his degree; he fails at the fundamental skill of logic and deduction, yet it is a near-certainty that he carries proof that his claimed position is wrong in his wallet (a credit card, which spends identically to the dead president it resides next to.)

Ok, having settled on definitions, we will now turn to the fundamental reality of fractional reserve banking.  Many people claim that banks "create money" or "print money."  This is not true; a bank recycles money, that is, it increases the velocity of a given amount of money in circulation, but an ordinary bank (not a Central Bank) never creates new money.

We'll start with our hypothetical bank that has no assets and no deposits, and a 10% fractional reserve requirement.  Joe walks in and deposits $10,000 and leaves.  The bank now has $10,000 in assets (cash) and $10,000 in liabilities (a book entry that says it owes Joe that $10,000 on his demand.)

Jane now walks in and wants to borrow money to buy a car.  She borrows $9,000 from the bank and posts as security the title for the car she purchased.  The bank now has exchanged $9,000 of the cash asset that it had for a piece of paper (the title to a car and a promissory note.)   Let's, for the sake of argument, agree that Jane paid half cash for the car and that it is worth far more than the $9,000 she borrowed (this becomes important in a minute.)

Now the car dealer comes in and deposits the $9,000 that Jane spent.  The books look like this:

This is where the complaint that the bank is "printing money" comes from; notice that there was only $10,000 in the beginning, but there is now suddenly $19,000 worth of both assets and liabilities. 

The "purists" will argue that both the car dealer and Joe can't come in and demand their money - its not there (only $10,000 is, not $19,000.)

This is false: The bank holds a piece of paper worth at least $9,000 and can sell it immediately into the market if necessary.  As such it CAN pay both the car dealer and Joe should they both demand their money by disposing of the asset it holds in lieu of the other $9,000 - Jane's loan.

This also looks ok from an accounting perspective - both sides of the ledger balance.  Let's keep going.

Steve now comes into the bank and opens a credit card account with a $8,100 credit line.  He immediately blows the entire line on an exotic cruise vacation.  The cruise line deposits the funds.  This is what we've got now (note that the $8,100 he borrowed was 90% of the deposit from the car dealer; I have grouped the transactions to make it simpler to follow.)

Now we have a problem.  See, the "Credit Card" loan that Steve took out is unsecured.  That is, it is nothing more than a raw promise to pay in the future, backed by nothing other than Steve's word, and what's worse, Steve immediately consumed the entire $8,100 - it's gone.

So now if the cruise line, car dealer and Joe all come into the bank and demand their money the bank has a very high probability of not being able to pay.  It may be able to sell Steve's paper (the card account) for $8,100, but that line, being unsecured, is likely going to be subject to some sort of haircut in the market - maybe a big one.  The particular "haircut" is entirely dependent on the exact state of the economy at any given point in time, along with Steve's personal financial situation.

The important point is that the asset that the bank holds from Steve is nothing more than a signature and promise.

This is unacceptable and in fact is the cause of every economic Depression featuring a deflationary credit collapse over time, as defaults begat more defaults and those defaults, uncovered with capital, cascade through the system instead of being isolated to the failed institution.  All of them.  1873, 1929 and the present mess were all caused by systemic and pernicious violation of the most fundamental rule of sound banking: One must never lend out more unsecured than one has in excess capital. 

So how could the bank have avoided this?  Simple.  Let's say that the bank had taken in capital in the form of stock issued to the public; it thus might have a balance sheet that looks like this:

Now everything is fine.  Why?  Because the shareholder equity can get whacked as required.  Let's assume Steve defaults; we now have:

Notice that the books balance, but the loss was taken out of the shareholder's hide.

"Paid in Capital" is one of several types of "excess capital" that a bank can hold.  A bank could also issue bonds and it can retain earnings; all three are actual hard cash.

Therefore, the fundamental rule is this:

No bank may be permitted, under any circumstances, to have outstanding more in unsecured lending than it has in actual excess capital.

So long as this rule is adhered to there is never a risk of depositor loss and "deposit insurance" such as the FDIC is irrelevant.  Indeed, the FDIC should exist only to cover the malfeasance of government officials who have failed in their essential task - that is, guaranteeing that the banks under its supervision never exceed their excess capital in unsecured lending.

The counter-argument - that one cannot quantify asset prices accurately and thus incursion of this rule will occur "accidentally" - is often raised.  This is a chimera - the standard is that it may never happen, and it is the responsibility of bank management to decide how close they want to fly to the Sun!  That is, the more leverage they take on, the lower the down payments they permit for their asset-based lending and the closer they run in today's market prices for the assets they hold to their excess capital the greater the risk that an economic dislocation of some sort will render them instantly insolvent and closed, wiping out the entirety of their unsecured bond and stockholders.

In point of fact any bank which has outstanding more in unsecured lending than it has in excess capital is at that moment insolvent, in that it has no security against the amount outstanding in loans that exceed excess capital.

Note that this has exactly nothing to do with whether you are on a Gold Standard nor does it have anything to do with fractional reserve lending.  In fact the Depressions of both 1873 and the 1929/1930s occurred while on "hard money".  A gold standard (or any other "hard" currency) will do nothing to stop this, because the problem has never been the fiat nature of currency - it is the fact that credit is being extended without collateral beyond the actual cash reserves of the institution in question.

Now here's the nasty: It is illegal in many states for a bank to accept a deposit while in this condition.  As just one of many examples (Nevada):

 1.  It is unlawful for a president, director, manager, cashier or other officer or employee of any bank to permit the bank to remain open for business, or to assent to the reception of deposits or the creation of debts by the banking institution, after he has knowledge of the fact that it is insolvent or in failing circumstances. An officer, director, manager or agent of a bank shall examine the affairs of the bank and shall know its condition. Upon the failure of any such person to discharge his duty of examination, he must be held, for the purpose of this title, to have had knowledge of the insolvency of the bank, or that it was in failing circumstances, and shall be deemed to have assented to the receipt of deposits while the bank was insolvent or in failing circumstances. A person who violates the provisions of this subsection is individually responsible for deposits so received, and all such debts so contracted, but any director who has paid more than his share of such liabilities has a remedy at law against other persons who have not paid their full share of such liabilities for contribution.

....

3.  A person who violates the provisions of this section, or who is an accessory to, or permits or connives at, the receiving or accepting of any such deposits, or the giving of such preferences, is guilty of a category D felony and shall be punished as provided in NRS 193.130.

Each and every bank officer and manager is not only civilly liable for any loss suffered (e.g. balances beyond insured limits) but is also CRIMINALLY liable for the acceptance of deposits while the bank they work for is factually insolvent in many of these states, including Nevada.

If The Federal Government will not close these institutions and will not act in this fashion then we must insist that the STATES do so in accordance with their legal code.

These laws exist for a simple reason: When you walk into a bank and deposit money you have a contractual understanding that it will be returned to you either immediately on demand or in a relatively short period of time (effectively on demand.)  This is even true for so-called "time deposits"; you will forfeit some amount of interest (sometimes all of it!) but if you cash a CD early they are still required to hand over your money.

If the bank does not have it nor can they raise it immediately as a consequence of lending out money unsecured in amounts that exceed their excess capital then they have committed the common-law crime of fraud; they have induced you to lend them money with a promise to repay that they know is entirely speculative in terms of their capacity to perform. Unless that is disclosed to you before you tender your funds to them they have committed fraud by concealing the speculative nature of their ability to return your funds on demand.  It is that simple and a number of states recognize this as a formal section of their legal code.

IF THE FEDERAL GOVERNMENT WILL NOT DO ITS  JOB THEN IT IS TIME FOR WE THE PEOPLE TO DEMAND THAT THE STATE GOVERNMENTS DO SO FOR THEM!

Look at how Bloomberg is treating BAC's resignation:

Oct. 1 (Bloomberg) -- Kenneth D. Lewis bet Bank of America Corp.’s future on America at a time when America went bust.

Lewis, 62, said yesterday he will resign as chief executive officer at the end of the year, leaving his successor to capitalize on, or salvage, the acquisitions that led to his downfall. The bank didn’t name a replacement.

Yeah, such a bet.  "We'll play 'give me bailout or the puppy dies!'" games along with Bernanke, raiding not one but two companies (don't forget Countrywide!), was a huge part of people getting tossed out of their homes on their ear, was a major funding and "partner" with ACORN (just-recently "suspended") and more.

Bank of America is one of the "bad guys" in transaction re-ordering too:

A few weeks ago, Bank of America hit the Chicago marketing man with a $35 overdraft fee when he had more than $130 in his account. The bank was apparently “holding” his money for charges that hadn’t cleared — only they appear to have been holding three times more than he actually spent. Then, if that wasn’t enough, they “reordered” his subsequent purchases in a way that tripled his overdraft charges. Within a couple days, he had racked up $140 in fees.

Let's not even talk about "authorization holds" - that's yet another sneaky trick (this is where a gas station will place a hold for $50 on your account when you swipe your card; if you buy $20 in gas, the other $30 can remain "held" for as much as five days!)  Or shall we talk about ATMs and online balance systems showing uncleared funds as part of your "balance", thereby encouraging you to overdraw your account - and allowing it at an ATM without a warning that it will incur an overdraft fee too!

Now to be fair Bank of America says they're changing some of these policies with implementation dates out into the middle of next year. 

But to also be fair I must point out that until there was a threat of legislation banks refused to stop this blatant robbery - tactics that hit consumers at the lowest end of the economic strata the hardest.

Was Ken Lewis forced out?  Nobody's admitting it if so, which brings up another question - why not?

The better question from my perspective is why any of us in America tolerate this garbage.  There are alternatives, and when it comes to blatantly unfair practices boycotts, moving business to credit unions and bringing pressure on your state attorneys general to file criminal complaints and suits for blatantly unfair practices are three of those alternatives that in my opinion every American should be considering.

Finally, as I have written about dozens of times, we are starting to see more notice in the mainstream press on the hiding of losses on bank balance sheets:

Georgian’s clean-up will be unusually costly. The book value of Georgian’s assets was $2 billion as of July 24, about the same as the bank’s deposit liabilities, according to a Federal Deposit Insurance Corp. press release. The FDIC estimates the collapse will cost its insurance fund $892 million, or 45 percent of the bank’s assets. That percentage was almost double the average for this year’s 95 U.S. bank failures, and it was the highest among the 10 largest ones.

Right.  Colonial anyone?  But look at what Jonathan says:

The cost of Georgian’s failure confirms that the bank’s asset values were too optimistic.

OPTIMISTIC?

"Estimating" the value of a bucket of "assets" at nearly double what their realistic market value happens to be is "optimistic"?  I can see being off by 5% or maybe 10% as "optimistic", but nearly half is a matter of "optimism"?

I can think of a handful of other adjectives that better describe this situation, which we have seen repeated over and over during this fiasco.  How about "Scam"?  "Ripoff"?  "Charade"?  "Myth"?

Or perhaps we should use the word that would be used were I try to pull something like this in essentially any other line of work (and which, by the way, was used repeatedly when this sort of "optimistic" valuations were exposed after the .COM blowup):

FELONY

That's right folks.

One can argue that people are being "optimistic" in a vacuum with single instances, but when you keep seeing bank failure after bank failure - nearly 100 of them now - where balance sheets are universally overvaluing claimed "assets" .vs. their disposition value at some point you have to call this what it is: a pattern of intentional conduct designed to deceive regulators and the public as to the condition of these institutions.

And that folks, is not a mistake.

It is, in my opinion, a criminal offense, and one that every member of the board of these banks, along with their auditors, should be answering for.

We are far beyond where we should have been demanding full forensic audits of every bank in the nation to determine the extent to which "loss hiding" through "optimistic" valuations have infested those institutions we call "too big to fail", along with the community and mid-sized banks.

Why? 

Because it is a criminal offense to intentionally overstate asset valuations in a publicly-traded company, and especially post-SARBOX, doing so is a not just a civil matter of screwing shareholders for which one can be sued, it is a crime (18 USC Sec 1519, up to 20 years in prison.) 

While not all of these firms have been public companies, a good number of them were and are.

How blatant and outrageous does the "optimism" need to be before criminal indictments are handed up in these cases?

We can pass all the laws we want but if they remain unenforced then their value in protecting the public and deterring the blatant looting that has gone on over the last decade is in fact zero.

STOP THE LOOTING AND START PROSECUTING

It was just a matter of time....

A global regulator would ensure that U.S. banks aren’t subject to tighter regulations than the rest of the world, Mack said. A push for regulation during the financial crisis has weakened as the administration of President Barack Obama pursues other tasks, he said.

Got it? 

The way this game works is that you find a significantly-large nation that is willing to allow all sort of accounting games and extreme leverage (cough-Germany-cough!) and then you whine and bitch because you can't get the same rules over here.

Heh, it worked for Paulson, right?  Remember that investment banks were limited to 14:1 leverage - until 2004 when Paulson went to the SEC and got them to lift the cap.

What was Lehman and Bear's leverage when they blew up?

Oh, and what is the actual leverage at Deutche Bank?  Does anyone know?  What are they holding on their balance sheet (and off), and does anyone know what their actual risk on those alleged "assets" are?

Nope.

The ECB-space banks are in many ways worse than ours in terms of disclosure. 

But what Mack wants, having been bailed out after running his organization at an untenable level of risk and leverage, is to be able to take on even more leverage and risk!

This sort of perversion must be stopped; if Mack doesn't like reasonable leverage limits (like 12:1, with no off-balance sheet exposures and everything marked to the market) then he should move to Germany.

I'll buy him a one-way first-class ticket - provided he renounces his US Citizenship and agrees to a permanent bar on ever entering this nation again on the jetway.

Janet Tavakoli has launched another salvo related to the massive Fraud Street machine:

Wall Street gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private-label residential mortgage backed securities (RMBS).  Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre-agreed amount of loan losses.  But many RMBSs were backed by portfolios comprising risky fraud-riddled loans.  Most of the “AAA” investment was imperiled, and subordinated “investment grade” components were worthless.  Wall Street disguised these toxic “investments” with new value-destroying securitizations and derivatives.¹

As I have repeatedly pointed out it is not possible for the value in a transaction to ever be higher than at the point of origination of a loan.  It is mathematically impossible for it to be otherwise as the cash flow from the debtors is a fixed quantity; you can divide it up and siphon part of it off, but you can't manufacture that which does not exist.  Any claim that you can do so is fraud on its face.

Meanwhile, collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in doomed securities.  New money allowed Wall Street to temporarily hide losses and pay enormous bonuses.  This is a classic Ponzi scheme.

Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities.  Underwriters are responsible for appropriate due diligence, an investigation into the risks.²   If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed.  If you fail to disclose material information, expect to be investigated for fraud. If you have a mortgage subsidiary, expect it to be investigated, too.

One question: When?

An IMF official asserted: “You can’t prove fraud” and insisted it was in the interest of risk managers not to let their institutions collapse.  (He was unable to attend my exposition based on Chs. 5-12 of Dear Mr. Buffett).   This IMF officer isn’t just soft on crime; he’s in denial.  Failure to recognize fraud led to statements like the one that opened Chapter 2 of the IMF’s April 2006 Global Financial Stability Report:

Actually, proving fraud is simple: All you need to do is prove that a financial institution marketed securities from some batch of debt that had as its total claimed return a number greater than the original deals that went into the package. 

This requires nothing more than a calculator.  The claimed returns are known from the marketing and the coupon on each asset that went into the package is also known.  2 + 2 still equals 4 and if the institution claimed to have "manufactured" wealth it committed fraud.

Likewise, the risk-adjusted return of each loan in the package is known (interest .vs. growth at the time of origination.)  If, at the time of origination, the risk-adjusted return of the "securities" was greater or equal (remember, nobody works for free!) than the components, once again, fraud was committed.

Yes, there were thousands (or tens of thousands) of loans in a package.  So what?  We have a thing called a "computer" nowdays that makes summing and dividing large quantities of numbers a trivial, sub-second enterprise. 

To demonstrate that fraud was the essence of these securities we need only show that a financial institution represented that it had invented perpetual motion in the financial sense.  As that is mathematically impossible any such claim is ipso facto fraudulent.

Troubled financial entities should be put into receivership and restructured.  Old shareholders will be wiped out.  Debt-holders will take a haircut (discount) along with a debt for new equity swap to recapitalize the entity.  But the job won’t be complete until we separate high risk activities from traditional banking in a return to a Glass-Steagall like structure with regulators that indict fraudsters, snuff out systemic fraud, and allow honest bankers to prosper. 

The laws already exist; it is illegal to promote perpetual-motion machines and take money from people for their promised delivery, irrespective of where and how you claim to have "invented them", because such a machine, whether in the form of a physical engine or a financial product, cannot possibly exist.

Janet does a great job in this piece of exposing the web of interconnections between parties, including the fact that Tim Geithner headed the NY Fed when the "big burst" of this fraudulent activity took place and that as the NY Fed's head at the time he was directly and personally responsible for the willful regulatory blindness to what was an obvious and "in your face" scam.

As Janet says, we have the tools to take care of these problems - we simply need to will to use them.