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Exclusive: Democratic Senators Dump on Mortgage Review

By    |   Friday, 12 April 2013 12:54 PM

First, the disclaimer. I will never offer investment advice in these articles. The overriding reason is that this is the arrangement with the publisher. However, readers know they can turn to abundant media and get sell-side investment advice, and occasionally they can get advice from leading investors that is actually valuable.

As I write this, a couple “too big to fail” banks are about to report their so-called earnings, which might better be labeled “yearnings.” An important but generally neglected component of these so-called earnings is litigation expense, and regardless of what the banks report today, the truth, and you may be hearing it here first, is that nobody knows the true amounts. At an FDIC forum a couple years ago, a bank analyst complained that she can’t estimate litigation expense within a factor of 20.

I must also disclaim practicing law. But as one who has studied the subject, the law of torts evolves, and one can never tell when the courts are going to decide that what had been accepted practice by a given industry will be subjected to a standard of strict liability. From the standpoint of an investor, one can never tell when the market will recognize that such a change is taking place.

Lawyers are trained to reason by analogy, and they are required to demonstrate some ability to do this before they can even be admitted to study law. (Try to think back to when the law was considered to be a learned profession invested with great prestige.)

It wasn’t so long ago that the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, stood astride the world of a mortgage finance system that was “the envy of the world.” How do we know that?

The industry and its so-called regulators told us so. Sell-side analysts touted the industry, and its leader, Franklin Raines, former head of the federal Office of Management and Budget, proclaimed that his company, Fannie, was the best governed, most transparent financial company in the world and set a standard that the largest banks would do well to copy.

Of course, we know how that turned out, and even former employees were distressed to see much of their savings wiped out when Fannie and Freddie were finally placed into conservatorship at a cost of several hundred billion dollars, which was considered a lot of money before the advent of the Federal Reserve’s open-handed policy known by the Orwellian term “quantitative easing.”

For some unknown reason, sell-side analysts and so-called banking regulators, or “irregulators,” seem unable to appreciate the parallels between the too big to fail money center banks of today and the defunct GSEs of only a few years ago and, if the housing finance industry has its way, perhaps of tomorrow as well.

This phenomenon may be due to the fact that analysts and regulators see their mission as one of “restoring confidence” in the government-backed institutions. One would be well-advised, however, to recall the warning of American Enterprise Institute’s Alex Pollock that, “A confident investor is a stupid investor.”

Now to the developing story. The Senate Banking Committee’s Subcommittee on Financial Institutions and Consumer Protection, chaired by Sherrod Brown, D-Ohio, held a brief hearing Thursday to try to find out what was going on with a program called the “Independent Foreclosure Review,” which was supposed to be conducted by the so-called banking regulators as part of the settlement reached after protracted negotiations between the nation’s politically ambitious attorneys general and the mortgage servicing arms of the too big to fail banks.

Brown was joined by Elizabeth Warren, D-Mass., and for a time by Jack Reed, D-R.I. Apparently the ranking Republican, Patrick Toomey, R-Penn., was busy elsewhere, but in fact, no Republican senators attended the hearing.

Brown stated that he decided to hold the hearing because the banking regulators had not responded to several letters he and Warren had written asking questions about how the regulators were conducting the project and, in particular, about the “foggy” relationship with expensive consultants.

The Democratic senators questioned two panels of witnesses: the first consisting of lawyers from the two agencies in charge of the project, the Comptroller of the Currency (OCC) and the Federal Reserve Board; and the second consisting of representatives of leading consulting firms engaged to work on the project. It turns out that the agencies have no written procedures for how to manage the use of consultants in a project like this one, although Brown suggested that work on a set of written standards would probably begin that very afternoon.

More astounding is that under questioning by Warren, the consultants confirmed that they had no role in the preparation of a one-page document that listed the violations committed by the respected too big to fail banks and the amount each would have to pay to customer victims of the mortgage servicers.

The regulators had testified that the review project had become so complex that they decided to halt it without determining the actual extent of improper practices by the banks, so that they could hasten the distribution of checks for several hundred dollars to identified customer victims.

I spoke Thursday with a prominent commentator and asked whether he might like to speak to the erudite traders about this development lest it affect the quality of the reported numbers, and he replied, “The numbers are good.”

So now that Warren has established that the reported error rates and monetary exposures are the product of the banks themselves, with no input by the consultants and no review of the regulators, she is on a mission, on the warpath.

Warren wondered aloud whether error rates by the banks, reported as 6.5 percent, might instead be as high as 90 percent, and she demanded that the regulators compile firm-specific data for ultimate release to the customer victims so that they can sue the too big to fail banks.

Perhaps the sell-side is right to assume that the regulators will succeed in keeping the lid on this case, but an alternative scenario is that now that the senators have exposed this caper to public view, a drip of data potentially toxic to the industry has started. The answer will be known, as a famous New York senator used to say, “in the fullness of time.” Watch this space for further developments.

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The Senate Banking Committee’s Subcommittee on Financial Institutions and Consumer Protection, chaired by Sherrod Brown, D-Ohio, held a brief hearing Thursday to try to find out what was going on with a program called the “Independent Foreclosure Review.”
Friday, 12 April 2013 12:54 PM
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