The mortgage fraud that lead to the sub-prime meltdown: Kohler

the “American dream” that “anyone can make it” has been exposed as a debt-laden illusion.

The recession train has left the station in the US, even as stationmaster Henry Paulson is standing on the track with a lantern trying to wave it down. But he and his boss George W Bush and the rest of this administration will jump clear in a few months and head to various ranches to watch the action from afar.

But however long and deep this economic downturn proves to be, there are going to be very long and deep cultural effects in America flowing from the 2007-08 sub-prime crash.

American friends tell me there is a deep sense of embarrassment in the northeast of the country, where the financial elites who have been riding the boom live in their nice houses.

And there is a deep and growing anger in the rest of the country among those who are now being asked to bailout the fraudulent structures created by people who have made their fortunes already – and made off with them.

One American I know talks about a new era of class struggle in the US because the long-standing inequality of wealth has now widened and become both obvious and entrenched, and the “American dream” that “anyone can make it” has been exposed as a debt-laden illusion.

One outlet for all this anger and shame will be regulation – free-market capitalism in the US is likely be a lot less free in future; Wall Street is going to find itself in chains for decades to come, doing penance with paperwork, chafing under another “new deal”.

In general, political America could see a swing to the left, while the right, reeling under a storm of litigation and embarrassment, will be unable to resist. That’s especially true if Barack Obama wins the presidential election next month, and it is difficult to see how that won’t happen now.

The litigation and bankruptcy workouts will go for years and years. The man in charge of the Lehman Brothers administration, Tony Lomas of PricewaterhouseCoopers, says the Lehman work is likely to take 10 years or more. He has 150 people working on Lehman at Canary Wharf in London.

Meanwhile two states – California and Illinois – are suing Countrywide Financial, which was acquired by Bank of America very early on in the crisis, alleging misleading and corrupt behaviour. Bond insurer MBIA launched a lawsuit of its own last week against Countrywide. There are also dozens of criminal cases involving mortgage fraud across the country.

It’s clear that widespread and systematic fraud has characterised the mortgage industry in the United States for years, and that Wall Street investment banks have, at best, turned a blind eye to what was going on and, at worst, were complicit in it. For the next few years this is going to be mercilessly exposed in courts across the land.

The lawsuit by the “people of the state of California” against Countrywide details page after page of high-pressure, deceptive mortgage sales practices and loan products that were specifically designed to look good upfront and cause appalling financial shocks later.

“In 2004,” the complaint says, “in an effort to maximise Countrywide’s profits, defendants (the top executives of Countrywide) set out to double Countrywide’s market share to 30% through a deceptive scheme to mass produce loans for sale on the secondary mortgage market.

“Defendants… employed various lending policies to further their deceptive scheme and to sell ever-increasing loans, including (a) the dramatic easing Countrywide’s lending standards, (b) the increased use of low or no-documentation loans which allowed for no verification of stated income or stated assets or both, or no request for income or asset information at all, (c) urging borrowers to encumber their homes up to 100% (or more) of assessed value; and (d) placing borrowers in ‘piggyback’ second mortgages… while obscuring their total monthly repayments.”

The Californian lawsuit goes on to detail the high pressure sales environment in the company and the way the loans were then securitised and sold to Wall Street firms, often at a premium, and often sold “forward” – that is, they were sold before the borrowers were even signed up.

From 2003 on, Countrywide aggressively marketed its “pay option adjustable rate mortgage”, which is the type of loan that is now causing the most problems in the American financial system. These loans have the greatest defaults and are losing the ultimate holders of these loans the greatest amount of money.

Essentially, the pay option ARM has an extremely low “teaser” rate, usually 1% for an introductory period of a few months, and then the rate increases dramatically.

But the borrower can keep the repayments low, with the unpaid interest being added to the principal, producing negative amortisation.

After a few years, the contract requires the borrower to start paying full repayments based on a much higher loan balance. Many of these time bombs have been going off this year, resulting in foreclosures.

Countrywide’s loans were generally insured by MBIA, which provided high credit ratings for the mortgage securities sold by the company.

On Friday MBIA also sued Countrywide, alleging fraud, misrepresentation and breach of contract.

The insurers, MBIA and Ambac, call this “remediation” and both are now pursuing mortgage originators for money under these clauses.

Many of them, including Countrywide, have been acquired by banks, so the insurers and various state governments will be suing the banks for years over mortgage fraud.

One thing that has not yet emerged in the Paulson bailout plan, but soon will, is whether the US Treasury will also pursue remediation over the mortgages it buys from banks and others in the proposed $US700 billion fund.

Obviously banks will be seeking to unload their most troublesome “toxic” mortgage securities – that is, the ones that were sold to the least creditworthy borrowers.

The question is, will the Obama administration be engaged in years of litigation against the nation’s banks for fraud, having bailed out those same banks by buying the results of that fraud?

This article first appeared on Business Spectator