Was Abacus the Business Model for the Entire Mortgage Industry?

Washington’s Blog

As I've repeatedly pointed out, the big banks intentionally signed up as many borrowers as possible, even if there was no way they could repay their loans.

For example, I recently wrote:

[Professor William] Black explained that fraud by a financial company usually involves the company:

1) Growing like crazy
2) Making loans to people who are uncreditworthy, because they’ll agree to pay you more, and that’s how you grow rapidly. You can grow really fast if you loan to people who can’t you pay you back
3) Using extreme leverage.
This combination guarantees stratospheric initial profits during the expansion phase of the bubble.

But it guarantees a catastrophic subsequent failure when the bubble loses steam.

And collectively - if a lot of companies are playing this game - it produces extraordinary losses (more than all other forms of property crime combined), and a crash.

In other words, the companies intentionally make loans to people who will not be able to repay them, because - during an expanding bubble phase - they'll make huge sums of money. The top executives of these companies will make massive salaries and bonuses during the bubble (enough to live like kings even even if the companies go belly up after the bubble phase).

[Simon] Johnson confirmed that a high housing default rate was part of the banks' models. The financial giants knew they would make huge sums during the boom, and then transfer their losses to the American people during the bust.

But there might have been another reason that loaning to borrower who couldn't repay was the prevalent business model.

As foreclosure expert Neil Garfield notes, mortgages are worth a lot more if they default than if they perform.

Specifically, a mortgage worth $300,000 if the homeowner repays in full might be worth $9 million to the various owners of synthetic cdos and credit default swaps if the owner defaults.

We know - as alleged by the SEC:

Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure.

Paulson also advised Los Angeles apartment mogul Jeff Greene to do something similar. Greene was heavily involved in the subprime market, and he bought the worst of the mortgage backed securities, and then bet against the bonds using CDS.

But Garfield says that it is broader than just a couple of investors like Paulson and Greene. He believes that was basically the business model for the entire mortgage industry.

He said that the big banks that packaged mortgage backed securities had an incentive to suck in really bad mortgages. If a certain percentage of the mortgages default, the cdo and cds side bets pay many times more than the actual mortgage could possibly pay.

The state attorneys general, Sigtarp, and other federal and state authorities investigating foreclosure fraud should determine the extent to which these incentives motivated the mbs packagers to include mortgages which did not meet underwriting standards and then hide the bad loans.

They should also investigate the extent to which these incentives motivated mortgage originators to create "liar's loans", "ninja loans", "neutron loans", and "toxic waste".

See this on how credit default swaps can be used like buying fire insurance on someone else's house and then burning down the house, and this explanation by Ellen Brown (starting about half way into video).