Yesterday I opined that Countrywide's Samuels all but admitted fraud while in the hearings on the Subprime mess on Capitol Hill.

It appears that I wasn't the only one to get that idea.

This morning a lawsuit was announced against Countrywide (CFC) and Indymac (NDE), alleging the same thing.

But I'd like to explore this a bit further.

Consider this - if you qualify someone on a "Teaser Rate" for their mortgage, or on the basis of an "Option ARM" minimum payment, this doesn't just have suitability problems.

It also has "churning" problems, and arguably, was undertaken just for your benefit as a lender and all in the food chain for lenders, and has nothing to do with the suitability or even the benefit for a borrower! In fact, it can be argued that such a practice is almost never suitable or appropriate for a borrower!

How's that?

Well, most people when they take a mortgage, intend that eventually they will own their home free and clear, yes?

Ok, so you're a lender, and you get Joe to come in for a mortgage. You qualify him for a "Teaser Rate" and under that Teaser Rate his DTI (Debt-to-income) is a reasonable 36%.

He goes out and buys the house.

But under the fully-indexed rate, which he will be required to pay in a year or so, his DTI is 60%! You know in advance that he cannot make that payment because you qualified him originally, and you knew his DTI at the time. What are the odds that he will earn TWICE as much money in a year? For 99% of the borrowers - ZERO.

You'd say "Heh, that's fraud right up front!" But that's not really the worst of it, nor is it why I believe that perhaps - just perhaps - these guys might have breached the RICO (yes, Racketeering) laws.

Here might be why you made that loan - You know that Joe, in a year, now owning that house, will be forced to come back and get a NEW mortgage in another year! This will generate fees for you, for the mortgage broker, for the appraiser and for the title insurance company.

While the appraiser doesn't work for you all these of these either do or might, and for you and the broker, this is an income stream that would be FIVE TIMES OR MORE the expected income stream.

See, if someone has a conventional 5/1 ARM with no teaser, they have no reason to come back (other than market conditions) for five years. If they have a 30/fixed, they have no reason to come back at all! But if they are qualified on a teaser rate mortgage which you know they cannot repay once it indexes off the teaser rate, then they are forced to return for a new loan when that teaser expires.

What's worse, this is never in the best interest of the homeowner, because he pays all those costs every time, and so long as you maintain this scheme he also never gets any closer to owning his home outright!

Guys, this is where the real fraud is.

Isn't this a whole lot like how crack dealers get their customers? "The first hit is free!" is the siren song, and indeed, the first hit is free. But the second, well, that'll cost you - a bit. The third costs more. And by the time you're good and hooked, well, those hits get really expensive.

So let's see, we take Mr. Homeowner-To-Be who wants to buy a $600,000 home. Problem is, he only makes $100,000 a year, or $8,333 a month. With a "Teaser" rate of 2%, his P&I is $2,214.03 - 27% DTI on the mortgage - very workable.

Ok, now the teaser expires, and the indexed rate is LIBOR + 1, or 6.2% (today). Now his payment is $3655.92, which is 44% DTI for his mortgage alone! If he's also got a $500 a month car payment and $300 a month in credit card bills, his total "nut" now approaches 67% DTI! And guess what - he's got 35% of his money being withheld for income tax!

He is now screwed, blued and tattooed. Seeing this coming, he runs back to the mortgage office and hollers and yells! And, they sell him a new mortgage - carrying back the difference between the 2% and 6.2% negative amortization into the balance!

Now his DTI is 29% and he goes home again.... for another year... and does it again........

Until the housing market stops appreciating, at which point he's got more debt than equity in the house! What's worse, he hasn't paid down any of the home's principle balance - to the contrary, the principle has actually gone UP!

And now our homeowner is hooked. He can't refinance out to a 30/fixed, because he couldn't afford the house in the first place, and still can't on a DTI basis. He can't sell it without taking a $50,000 loss. He can refi until he hits the 100% LTV cap on the refinance, but as he gets closer and closer the risk premium goes up and so does his "indexed" interest rate, making the negative amortization worse and worse with each go-around!

This cycle ultimately ends in foreclosure. The homebuyer was fed his first hit of mortgage crack, he smoked it, and now, having smoked it, he gets more and more hooked with each successive puff - until he smokes himself quite literally to death.

How's this become racketeering? Simple - all racketeering requires is that two or more people conspire to commit a fraud. And oh, by the way, racketeering is one of the "triple damage" deals - that is, if you can prove that there was a conspiracy to commit it, you can sue not just for your harm but for three times the amount you were screwed out of.

Now there will be those who will argue that "but the borrower was the one who came in and asked for the loan to buy that house!" And you'd be right - Joe indeed did do so.

But Mr. Mortgage Broker is the expert in mortgages, not the starry-eyed buyer. We have in place a requirement that investments be suitable for a person's investment goals and appetite for risk when recommended by others in the securities industry. It is illegal for a securities broker or investment manager to recommend that you buy, for example, AGIX stock (a VERY high-risk biotech) unless your investment goals include speculation. Certainly, such an "investment" is not suitable for someone who is on a fixed income and cannot afford capital losses!

Yet we heard, yesterday, that Mr. Samuels from Countrywide EXPLICITLY DISCLAIMED any responsibility whatsoever for suitability screening in how his mortgage products are offered to homebuyers!

Simply put:
These loans should have never been made. If you can't qualify on the fully-indexed rate rather than the teaser, meaning your DTI is over 36% at that rate, you cannot afford the house!

Are there exceptions? Sure. An Option ARM might make sense for someone who is buying a replacement home and can't quality for two "full-load" mortgages. He'll be out of the first house (and thus have his capital back) within six months to a year, before the "Option Bomb" blows up, will refi to a conventional loan and use some or all of his net proceeds to pay down the principle.

But for the owner or investment property buyer? Show me one scenario where qualifying someone on a teaser rate, when they cannot quality on the indexed rate, is a good idea for them. And, by the way, if you cite a "rapidly rising home market" what you've just told me is that you think people ought to be able to buy homes on 100% margin.

We tried that (actually 90%) with stocks in 1929, and we know how it ended.

Disclosure: I'm short a bunch of these companies.... I knew I smelled dead fish.