Wednesday, October 24, 2012 - Do the Hustle

Do the Hustle

by Sinclair Noe

DOW – 25 = 13,077

SPX – 4 = 1408

NAS – 8 = 2981
10 YR YLD +.01 = 1.77%
OIL - .43 = 88.30
GOLD – 6.20 = 1702.50
SILV + .06 = 31.83
PLAT – 12.00 = 1566.00

Someday, we'll get through a whole week without having to report on the never-ending string of bad behavior by the big banks. I thought this might be the week. There were other things in the news; the Presidential debate on Monday; the Federal Reserve FOMC meeting today. We even had a proxy for the bad banks; the giant insurance company AIG reached a settlement with 39 states for creating a death list, where they would stop paying on annuities when someone died but they wouldn't look for beneficiaries of a life insurance policy. Then to top it off the CEO, Robert Benmosche, said he was indignant that nobody in the government had thanked him for paying back the bailout money that kept the company from total collapse 4 years ago. And over the past couple of weeks, Chase and Wells Fargo were sued for shoddy and virtually non-existent underwriting of mortgages that failed. Who was left?

You might think the big bad banks would take the week off from the news cycle. Yes, someday, we'll break the bonds of this gruesome litany of dirty deeds; someday this war will end. But not today.

The latest federal lawsuit over alleged mortgage fraud paints an unflattering picture of a doomed lender: Executives at Countrywide Financial urged workers to churn out loans, accepted fudged applications and tried to hide ballooning defaults. The prosecutor described Countrywide's reckless lending practices as “spectacularly brazen in scope.”

The suit claims Countrywide introduced a program called the “Hustle” or “High Speed Swim Lane” (lousy acronym)to churn out mortgage loans. No income, no problem. If the computer program raised a red flag, just change the numbers. Bonuses were based on quantity not quality; and later, bonuses were paid on the ability to hide the high number of defaults. We've seen this story before:everyone was incompetent, nobody verified income in the no-income-verification loans, when they found defects they hid them, and there were sleazy changes in procedures and compensation practices whereby Countrywide went from “try to originate lots of good mortgages” to “try to originate even more lots of mortgages with no quality standards whatsoever and also there’s a bonus for steamrolling quality-control checks.” Also it’s got a terrible name – the “Hustle”; one of these days there’s going to be a lawsuit about a mortgage lender called the Fast Underwriting Basis Alternate Rate program. Figure out the acronym for yourself, or make up your own; it's fun.

And after Countrywide wrote the loans and lied about the quality of the loans, they sold the loans to Fannie Mae and Freddie Mac; that's where we all get involved. Taxpayers have spent $170 billion to keep Fannie and Freddie afloat, and it could cost $260 billion more to support the companies through 2014. The lawsuit says that Fannie and Freddie suffered $1 billion in losses because they had to pay for Countrywide's defaulted loans. The lawsuit also complains that Bank of America is refusing to buy back mortgages "even where the loans admittedly contained material defects or even fraudulent misrepresentations."

Bank of America bought Countrywide Financial in 2008 and it’s fair to say it hasn't been a happy marriage; the Murdoch Street Journal totaled up the Countrywide losses at approximately $40 billion, as of last summer. If you held stock in BofA, be sure to thank Hank Paulson and Angelo Mozilo. If you were trying to figure out the maximum past and future losses you might start with the fact that Countrywide Financial originated about $2.25 trillion of mortgages between 2003 and 2007.

The fun fact about today's lawsuit is that it is originating from the Department of Justice; meanwhile, Fannie and Freddie are independently trying to get back money from BofA. Now I don't know if these are overlapping bad mortgages, or a different batch of bad mortgages.

Another day another bad bank story. The Royal Bank of Scotland agreed to pay $42.5 million late Tuesday in a settlement with the Nevada attorney general that ends an 18-month investigation into the deep ties between the bank and two mortgage lenders during the housing boom. Most of the money paid by R.B.S. — $36 million — will be used to help distressed borrowers throughout Nevada. In addition, R.B.S. agreed to finance or purchase subprime loans in the future only if they comply with state laws and are not deceptive. The settlement between the bank and Catherine Cortez Masto, Nevada’s attorney general, relates to conduct at Greenwich Capital, the R.B.S. unit that bundled mortgages into securities and sold them to investors. Nevada found that R.B.S. worked closely with Countrywide Financial and Option One.

International Paper has agreed to pay the FDIC to settle a year-old lawsuit stemming from the 2009 collapse of Guaranty Financial Group, an Austin, Texas, company that ranks as the fifth-biggest U.S. bank failure. As part of the agreement, the failed bank’s creditors will get an added $38 million, bringing the total settlement to $80 million. Although International Paper didn’t have any direct connection until this year to the banking industry or to the failed Texas bank, its involvement in the case demonstrates the long tentacles of the financial crisis. International Paper was pulled into the case in February when it bought packaging firm Temple-Inland, which had owned Guaranty for nearly two decades before spinning it off into an independent company in 2007. Guaranty failed less than two years later, weighed down by toxic securities that were backed by adjustable-rate mortgages. It had 162 branches and $13.5 billion in assets. The failure cost the FDIC’s deposit-insurance fund $1.29 billion

Meanwhile, with a splash of irony that would make even Socrates cringe, the Federal Reserve concluded its FOMC meeting today and announced they will keep interest rates at zero and they will stimulate the economy by purchasing $40 billion a month in mortgage backed securities until the economy improves or the cows come home. The Fed went on to say that inflation is not a problem, consumer spending isn't strong but it isn't weak and the economy continues to expand as it is stumbling along and they really didn't say much with two weeks to go before an election. The FOMC meets again in December, just in time to preview the fiscal cliff. For now, job growth has been slow and the unemployment rate remains elevated, so pass the MBS.

Fed Chairman Bernanke is seeking to spur the economy with a third round of quantitative easing, and he says his stimulus works by lowering borrowing costs and encouraging investors to seek higher-yielding assets. Boosting home and equity prices through bond buying will encourage consumers and businesses to spend more. Since these are the same assets that plummeted during the financial crisis after reaching record highs, “is there some risk you could start a new bubble and repeat the whole cycle?

While Federal Reserve Bank of New York President William Dudley acknowledged that current policy “could distort asset allocations and lead to renewed financial-asset bubbles,” this isn’t a risk now, he said in an Oct. 15 speech. Dudley says: “There is little evidence of problems or excesses, but this could change.” Dudley said the Fed’s policies are affecting yields in the bond market though “to say that’s a bubble, I don’t think that’s quite right.” He added that the debt market is a “lever of policy” for the central bank. And we should pay no attention to the man behind the curtain, pulling the levers.

The Standard & Poor’s 500 Index reached 1,465.77, the highest since 2007, on Sept. 14, the day after the FOMC said it would buy $40 billion of mortgage-backed bonds a month without limiting the total or duration of purchases. QE1, QE2, Operation Twist, and the ECB-led Long-term Refinancing Operation which a year ago was a really big deal in unleashing a massive global risk-on trade. But this time around the laws of diminishing returns are setting in. Six weeks after the unveiling of QE3, the market is down 2%. This hasn't happened before. Every economic-sensitive sector is in the red, and even Financials, the one sector that should benefit, have made no money for anybody.

Home prices also have begun to rise, jumping in the second quarter by the most in more than six years. The real question is how does the Fed know whether or not these prices will prove to be justified in the long run? The Fed doesn’t have perfect knowledge about what constitutes a sound long-term price for equities or housing, but this is a risk the Fed is willing to take. I know you don't want to fight the Fed, just be careful when they send you out to hunt high yield.