How the Scam Works- Hudson

[don]

How the Scam Works

By MICHAEL HUDSON
Newspaper reports seem surprised at how high banks are bidding for the junk mortgages that Treasury Secretary Geithner is now bidding for, having mobilized the FDIC and Fed to transfer yet more public funds to the banks.

Bank stocks are soaring – thereby bidding up the Dow Jones Industrial Average, as if the “financial industry” really were part of the industrial economy.

Why are the very worst offenders – Bank of America (now owner of the Countrywide crooks) and Citibank the largest buyers? As the worst abusers and packagers of CDOs, shouldn’t they be in the best position to see how worthless their junk mortgages are?

That turns out to be the key! Obviously, the government has failed to protect itself – deliberately, intentionally failed to do so – in order to let the banks pull off the following scam.

Suppose a bank is sitting on a $10 million package of collateralized debt obligations (CDOs) that was put together by, say, Countrywide out of junk mortgages. Given the high proportion of fraud (and a recent Fitch study found that every package it examined was rife with financial fraud), this package may be worth at most only $2 million as defaults loom on Alt-A “liars’ loan” mortgages and subprime mortgages where the mortgage brokers also have lied in filling out the forms for hapless borrowers or witting operators taking out mortgages at far more than properties were worth and pocketing the excess. The bank now offers $3 million to buy back this mortgage. What the hell, the more they bid, the more they get from the government. So why not bid $5 million. (In practice, friendly banks may bid for each other’s junk CDOs.) The government – that is, the hapless FDIC – puts up 85 per cent of $5 million to buy this – namely, $4,250,000. The bank only needs to put up 15 per cent – namely, $750,000.

Here’s the rip-off as I see it. For an outlay of $750,000, the bank rids its books of a mortgage worth $2 million, for which it receives $4,250,000. It gets twice as much as the junk is worth.

The more the banks holding junk mortgages pay for this toxic waste, the more the government will pay as part of its 85 per cent. So the strategy is to overpay, overpay, and overpay. Paying 15 per cent is a small price to pay for getting the government to put in 85 per cent to take the most toxic waste off your books.

The free market at work, financial style.

Michael Hudson is a former Wall Street economist.

[Rajiv]

Re: How the Scam Works- Hudson

The link to the article - Michael Hudson: How the Scam Works

[stanley2008]

Re: How the Scam Works- Hudson

Are you overweight on bank stocks?

[marvenger]

Re: How the Scam Works- Hudson

love his simplicity, no bullshit telling the big picture like it is.

[Mango]

Re: How the Scam Works- Hudson

I'm surprised there are so few responses to this post. I read the original on Counterpunch and was happy to see it put up here. Hudson seems to nail the financial world as it really works, not as bland bureaucratic nerds opine. But I'm still very much at sea over it all, so I wrote Hudson the following.

Perhaps iTulipers will explain or critique some of the questions or thoughts I posed:

Dr. Hudson,

[...]

It looks to me like the whole thing is akin to writing the banks a retroactive insurance policy, and doing so for a premium locked in as a small percentage of the overall loss. If I've suffered a loss, then I want the insurance company to cover as much of it as possible, so I would expect the banks to do the same, especially since the premium cost is a fixed percentage. ...

I've read Krugman's critique of the Geithner plan, and I've struggled through Brad DeLong's first defense of the plan, along with some 160 comments made in response to him. http://delong.typepad.com/sdj/2009/03/the-geithner-plan-faq.html The vast majority of the comments (perhaps 145 to 15) doubted DeLong and leaned toward Krugman.

Yet I only found 5 comments in those 160 or 145 who seemed aware of the problem you pointed to, and I'm not sure that even all of those five comments really were grasping the same idea. ...

(BTW, one other comment on DeLong was from a Ph.D. in economics who felt confused by it all.) ...

Lots of numbers are thrown around by all parties. I'm trying to reconcile numbers I see in your column with figures I see bandied around DeLong's and other places. I want to explain this deal to a number of my friends, several with various sorts of Ph.D.s, but who are less willing than I to struggle through the details.


You say that the FDIC puts up 85% and the banks put up 15% of the purchase price. But it seems that the government is putting up even more than that.


According to a set of helpful figures that DeLong does provide, the one trillion dollar deal will be financed with $820 billion from the FDIC, $150 billion from TARP, and only $30 billion from the banks. Thus in a trillion dollar deal only 3% is coming from the banks and 97% is government financed. Perhaps the $150 billion (15%) from TARP has payback requirements or other conditions attached to it. I seem to remember that the government was to get some preferred stock in the banks in return for TARP funds, but I'm unsure of that or how it would figure here. In any case, the comments to DeLong's blog presume that the government is putting up 97% of the money. (One comment claims the terms have been revised to require 7.5% from the banks instead of 3%.)


I would appreciate it if the difference between your estimate of 85% and others I've seen ranging from 93% to 97% government funding could be clarified

BTW, other comments on DeLong raise the possibility that the "investors" will not only use it to wipe out their losses for a small percentage of what they are already losing, but will turn around and hedge the investment somehow so that they even end up making money. But I don't even want to get into trying to understand that.

Thank you,

[Slimprofits]

Re: How the Scam Works- Hudson

Anyone (don, rajiv?) know anything else about the Fitch study that Hudson refers too? I would love to get my hands on that.

[Sharky]

Re: How the Scam Works- Hudson

Here's what people don't seem to understand about the government's recent bailout packages:

1. The credit crisis has destroyed all bank capital in the US. All of it. If banks were forced to mark their loans to market they would all fail. The FDIC would be called in, many depositors would lose their shirts, etc, etc.
2. The Fed cannot create bank capital. They can only lend to the banks, in exchange for "AAA"-rated assets.
3. The Treasury doesn't have the authority to directly create bank capital either (except through special programs like TARP). However, they have weaseled a way to create loan "guarantees."
4. Problem solved: issue guarantees against the known-bad debt, in a way that will get it off of the bank's balance sheets, so that their capital will be replenished.

In other words, the "scam" that Hudson points out is exactly what they're trying to accomplish: to recapitalize the banks using taxpayer dollars, without explicit Congressional authorization to do so -- presumably because if Congress had any idea what the price tag would be, they would likely say no.

[tree]

Re: How the Scam Works- Hudson

While Prof. Hudson is getting better and better at explaining these things to "average" readers, I thought, when I read this at CounterPunch, that this article was not particularly accessible to such folks (of whom I am one).

I read it over and over and still didn't get it. It was, for Hudson on CP, a very short piece, and could have been made much clearer, I thought.

Nothing will change until "average" (bright but not particularly financially-savvy) readers get what's going on.

[we_are_toast]

Re: How the Scam Works- Hudson

I'm sorry, I didn't quite catch that. You know the finalists for American Idol are being chosen, and it is March Madness after all.

Nothing will change until "average" (bright but not particularly financially-savvy) readers get what's going on.

You don't think things will change until the "average" j6p get's what's going on?

Riiiight, let me know how that works out. ;)

[tree]

Re: How the Scam Works- Hudson

we_are_toast: I find your sarcasm not in line with general tone at iTulip, but that's your business....

I thought I did a fairly good job of trying to explain what I meant by "average," but I guess not so I'll try again--I'm talking about folks like our president, who probably knows a whole lot about everything except economics, business and money except in a very mainstream, New York Times kind of way.

(Watch a clip of PBS's Tavis Smiley interviewing finance columnist Kathy Kristoff--he says very plainly he can't think about this stuff, and laughs at himself for it.)

That's why the president chose Geithner, Summers, etc., because he doesn't want to think about contrarian economics and is probably scared by it. Whole lotta folks out there now with big portfolio losses, and I have a strong feeling that if things are clearly explained to them, they'll cross over and understand the value of folks like Michael Hudson and understand why Dennis Kucinich wasn't allowed on podiums during the campaign and shut out of press coverage that failed to mention Hudson was his economic adviser.

And I do enjoy American Idol! Try it, you might like it!

[we_are_toast]

Re: How the Scam Works- Hudson

we_are_toast: I find your sarcasm not in line with general tone at iTulip, but that's your business....

I thought I did a fairly good job of trying to explain what I meant by "average," but I guess not so I'll try again--I'm talking about folks like our president, who probably knows a whole lot about everything except economics, business and money except in a very mainstream, New York Times kind of way.

(Watch a clip of PBS's Tavis Smiley interviewing finance columnist Kathy Kristoff--he says very plainly he can't think about this stuff, and laughs at himself for it.)

That's why the president chose Geithner, Summers, etc., because he doesn't want to think about contrarian economics and is probably scared by it. Whole lotta folks out there now with big portfolio losses, and I have a strong feeling that if things are clearly explained to them, they'll cross over and understand the value of folks like Michael Hudson and understand why Dennis Kucinich wasn't allowed on podiums during the campaign and shut out of press coverage that failed to mention Hudson was his economic adviser.

And I do enjoy American Idol! Try it, you might like it!

My apologies. I meant no offense to you. I tried to expand your reference of average readers, to average americans, apparently without success. Sarcasm can be a powerful tool of persuasion, but it can also be easily misinterpreted if used improperly, which I just did.

If you are reading iTulip you are by no means an average reader, you are far more informed than the average person in the public.

Again, accept my apologies for my poor attempt at humor, but I won't be accepting your suggestion about American Idol.

[flintlock]

Re: How the Scam Works- Hudson

The fact is these scams are going on and they will continue to go on. They are just complex enough to turn off the "average reader" who's eyes will glaze over after two paragraphs. Most Americans don't have a clue what is going on and this will continue I'm afraid. They'll get sucked into petty arguments about executive bonuses, partisan politics, and other smokescreens thrown out by the politicians. So the fact is this stuff will continue and won't be stopped until it's too late( already is imo). The real question is how do we invest in this environment? Buy bank stocks?:eek:

[K Carlson]

Re: How the Scam Works- Hudson

How the Scam Works

By MICHAEL HUDSON
Newspaper reports seem surprised at how high banks are bidding for the junk mortgages that Treasury Secretary Geithner is now bidding for, having mobilized the FDIC and Fed to transfer yet more public funds to the banks.

Bank stocks are soaring – thereby bidding up the Dow Jones Industrial Average, as if the “financial industry” really were part of the industrial economy.

Why are the very worst offenders – Bank of America (now owner of the Countrywide crooks) and Citibank the largest buyers? As the worst abusers and packagers of CDOs, shouldn’t they be in the best position to see how worthless their junk mortgages are?

That turns out to be the key! Obviously, the government has failed to protect itself – deliberately, intentionally failed to do so – in order to let the banks pull off the following scam.

Suppose a bank is sitting on a $10 million package of collateralized debt obligations (CDOs) that was put together by, say, Countrywide out of junk mortgages. Given the high proportion of fraud (and a recent Fitch study found that every package it examined was rife with financial fraud), this package may be worth at most only $2 million as defaults loom on Alt-A “liars’ loan” mortgages and subprime mortgages where the mortgage brokers also have lied in filling out the forms for hapless borrowers or witting operators taking out mortgages at far more than properties were worth and pocketing the excess. The bank now offers $3 million to buy back this mortgage. What the hell, the more they bid, the more they get from the government. So why not bid $5 million. (In practice, friendly banks may bid for each other’s junk CDOs.) The government – that is, the hapless FDIC – puts up 85 per cent of $5 million to buy this – namely, $4,250,000. The bank only needs to put up 15 per cent – namely, $750,000.

Here’s the rip-off as I see it. For an outlay of $750,000, the bank rids its books of a mortgage worth $2 million, for which it receives $4,250,000. It gets twice as much as the junk is worth.

The more the banks holding junk mortgages pay for this toxic waste, the more the government will pay as part of its 85 per cent. So the strategy is to overpay, overpay, and overpay. Paying 15 per cent is a small price to pay for getting the government to put in 85 per cent to take the most toxic waste off your books.

The free market at work, financial style.

Michael Hudson is a former Wall Street economist.

One author has suggested that Pimco and GS are enthusiastically endorsing the plan as a part of a government deal to avoid the bondholder haircuts that would come with nationalization. Sorry, I don't remember the source.

[godraz]

Re: How the Scam Works- Hudson

Anyone (don, rajiv?) know anything else about the Fitch study that Hudson refers too? I would love to get my hands on that.

Don't know about the Fitch report itself, but this NYT article from Jan 2008 (see 2nd to last paragraph) mentions one such study. http://www.nytimes.com/2008/01/27/bu...pagewanted=all

I think I've seen this mentioned elsewhere recently too, but then again it could of just been when I read this in Hudson's original CounterPunch post. :confused:

[WildspitzE]

Re: How the Scam Works- Hudson

Here's what people don't seem to understand about the government's recent bailout packages:

1. The credit crisis has destroyed all bank capital in the US. All of it. If banks were forced to mark their loans to market they would all fail. The FDIC would be called in, many depositors would lose their shirts, etc, etc.
2. The Fed cannot create bank capital. They can only lend to the banks, in exchange for "AAA"-rated assets.
3. The Treasury doesn't have the authority to directly create bank capital either (except through special programs like TARP). However, they have weaseled a way to create loan "guarantees."
4. Problem solved: issue guarantees against the known-bad debt, in a way that will get it off of the bank's balance sheets, so that their capital will be replenished.

In other words, the "scam" that Hudson points out is exactly what they're trying to accomplish: to recapitalize the banks using taxpayer dollars, without explicit Congressional authorization to do so -- presumably because if Congress had any idea what the price tag would be, they would likely say no.

This is exactly spot on. Don't forget the benefits of reversing all that loss provisioning too.