Financial Crisis Inquiry Commission: A Comment on Three Members' Dissenting Statement

The Financial Crisis Inquiry Commission released its final report this morning. I have briefly looked at it but have not had a chance to read all of it. I have, however, read the Dissenting Statement of Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas. The fourth Republican on the Commission, Peter Wallison, did not join in this statement, but rather appended a 96-page dissenting statement of his own, which I have not yet read. (Apparently, the full dissenting statements will not be reproduced in the commercially published version of the report. Each statement there will be limited to nine pages. That would seem to be an avoidable mistake of the majority. The full dissenting statements are included in the more expensive version published by the Government Printing Office and for free on the web.)

I am pleased that the Dissenting Statement of the three Commissioners is much better than the "Financial Crisis Primer" the four Republican Commissioners issued last month. (My negative review of that release can be found here.)

The dissenters are right to make the point that the U.S. was not the only country to experience a credit and housing bubble nor to experience problems with financial firms. They consequently conclude that it cannot just be domestic U.S. failures that need to be looked at in evaluating the causes of the crisis.

With respect to monetary policy, the Dissenting Statement is weaker. They appear to be correct in saying that "the Commission should have focused more time and energy on exploring ... questions about global capital flows, risk repricing, and monetary policy." The dissenters, though, conclude that "global capital flows and risk repricing caused the credit bubble ..." and that "U.S. monetary policy may have been an amplifying factor, but it did not by itself cause the credit bubble, nor was it essential to causing the crisis." This is an interesting assertion; unfortunately, the dissenters do not provide much in the way of analysis to support it.

There is more to the dissent, and it is all interesting. They do not go easy on Wall Street firms and do not lay all the blame, just some of it, on Fannie Mae and Freddie Mac. Unlike the primer, the dissent does not read like a partisan or ideological tract, and I give the authors credit for furthering the debate on the issues in an intelligent way.

The State of the Union Proposal to Reorganize the Government: Implications for the Treasury Department?

When hearing President Obama yesterday evening in his State of the Union address propose reorganizing the federal government in a more sensible fashion, I wondered what the effect might be on my former employer, the U.S. Treasury Department. The last major reorganization of the government occurred when the Department of Homeland Security was created. In terms of turf, the Treasury was a big loser then. It lost Customs and the Secret Service to Homeland Security and much of the Bureau of Alcohol, Tobacco, and Firearms to the Justice Department.

The Treasury did retain the Office of Foreign Assets Control (OFAC) and the Financial Crimes Enforcement Network (FinCen). OFAC in particular could plausibly be placed in other agencies, such as the State Department, Homeland Security, the Justice Department, or even the Commerce Department. The argument for keeping it in Treasury is that a large part of what it does involves banks, but certainly many of its activities are much broader in scope than banking transactions. Moreover, OFAC carries out both an enforcement and foreign policy function. It is not a neat fit anywhere. In Treasury, there is tension between OFAC, whose activities by necessity make financial transactions more difficult to carry out, and the Treasury's institutional predisposition to the free flow of capital and belief in the efficacy of financial markets. One hopes this tension leads to a good balance between competing objectives.

The Treasury also retains authority on wine labeling, as this function of ATF did not go to Justice. That could plausibly be housed elsewhere. For example, there was a controversy during the Clinton Administration over whether the wine industry could refer on wine labels to the potential health benefits of drinking wine in moderation. Senator Strom Thurmond strongly objected to this and prevailed. I suspect that most senior Departmental officials, including most Secretaries, would rather not have to get involved in this type of issue.

The Treasury has over the years lost many functions, including drug enforcement, formulating budget policy, and managing the Coast Guard. In recent years, it has gained regulatory authority by getting the Office of Thrift Supervision as one of the pieces of the Federal Home Loan Bank Board that was abolished and split up due to the S&L crisis. The OTS is to be merged with the OCC, but both bureaus have a great deal of independence from the Secretary. Dodd-Frank gives the Treasury more authority in the financial regulatory sphere, but the organizational structure of financial regulation continues to be overly complex and fragmented. The Administration will probably not want to tackle this right now, having recently made its policy and political judgments in the process leading to the enactment of the Dodd-Frank legislation.

One of the criticisms that could be levied against former Treasury Secretary Paul O'Neill is that he did not fight the loss of Treasury functions when the Department of Homeland Security was created or insist on something in return. He undoubtedly thought that the functions Treasury was losing were not central to Treasury's primary responsibilities. On the other hand, others would argue that the more responsibilities an agency has, the more respect private sector actors will accord that agency. Moreover, some think that losing the Secret Service was a big loss; in addition to protecting the President, the Secret Service has the responsibility to battle counterfeiting, which arguably is related to Treasury's core functions.

In any case, it is not clear what President Obama intends by proposing government reorganization nor whether there are any plans to add responsibilities or to subtract them from Treasury.

Too Big to Fail: The Wall Street Journal, Simon Johnson, and Neil Barofsky (SIGTARP)

Neil M. Barofsky, the Special Inspector General for the Troubled Asset Relief Program ("SIGTARP") released an "audit report" earlier this month entitled "Extraordinary Financial Assistance Provided to Citigroup, Inc." The report provides useful and interesting information about the use of TARP funds to help out Citigroup, but there are no surprising revelations. Policymakers were responding as best they could to a difficult situation under enormous time pressure.

I was, though, struck that both the Wall Street Journal editorial page and Simon Johnson, who offers frequent comments on the blog "The Baseline Scenario," used the report to comment on the issue of "too big to fail." The two come to this from different perspectives—Simon Johnson is a former chief economist of the IMF who favors making the largest banks smaller and the WSJ editorial perspectives on a myriad of subjects are well-known enough that it is unnecessary for me to characterize them.

Both the WSJ editorial, "The Ruling Ad-Hocracy" (subscription required), and Simon Johnson's Bloomberg article, "'Citi Weekend' Shows Too-Big-to-Fail Endures," mention Treasury Secretary Geithner's admission in the SIGTARP report that he could not rule out taking similar actions again if there were a comparable shock to the financial system. The WSJ editorial page and Simon Johnson are also both skeptical concerning the Dodd-Frank legislation's efficacy for making improvised bailouts in the future less likely.

Johnson has the more developed argument of the two. He focuses on the "big" in "too big to fail," advocating that a problem that should be addressed is the vast size of the biggest banks. He also believes, with some justification, that the resolution authority granted to the FDIC by the Dodd-Frank legislation will not work for these huge international financial institutions because of the global operations of these entities.

The point that the WSJ editorial page is trying to make beyond carping that the regulators have not done away with "too big to fail" and that they have not produced objective criteria as to what constitutes a systemically important institution is harder to discern. On the one hand, the editorial argues that "the time to tighten the rules on too-big-to-fail firms is when the market is calm, not amid a panic," which is a somewhat surprising statement from the editorial page editors given their usual anti-regulatory stance. They return to form at the end of the editorial in saying: "Any Republicans tempted to accept Dodd-Frank as settled law should dig into the details and work to restore the freedom to fail in American finance."

If it were possible to minimize the collateral damage from the failure of a financial institution, I would agree with that last sentiment. But that's the problem. Who can doubt that a sudden failure of Citigroup to meet its obligations would not have adversely impacted all of us? The failure experiment was run with the much smaller Lehman Brothers, and no one liked the results.

It is this issue that Johnson is trying to address by his tireless advocacy on his blog and in the book he coauthored with James Kwak, Thirteen Bankers, of limiting the size of financial institutions. While I think Johnson's ideas should be considered more seriously by policymakers than they have been, I would also point out that it does not solve all problems. Limiting the size of financial institutions does not necessarily get the government off the hook; for example, consider the savings and loan crisis of the 1980s and 1990s. To put it somewhat simply, the S&Ls ran into trouble because their business model of borrowing short and lending long could not survive a large increase in interest rates. Their regulator, the Federal Home Loan Bank Board, tried to paper over the problem by allowing S&Ls to pretend they were solvent by substituting "regulatory accepted accounting principles" for GAAP. The S&Ls could not grow out of their problem, and the George H.W. Bush Administration decided that, once and for all, they had to resolve this problem which had developed during the previous Reagan Administration.

(As an aside, Fannie Mae ran into the same problem as the S&Ls in the 1980s. Fannie was able, though, to grow out of its financial difficulties. A new management decided to embrace mortgage-backed securities, for which Fannie retained the credit risk but not the interest rate risk. This strategy, along with a better matching of the duration of liabilities with the duration of assets, worked. Also, of course, Fannie's strategy relied on its continuing access to capital markets due to the implicit federal government guarantee of its securities. After Fannie got a new regulator, the not very effective Office of Federal Housing Enterprise Oversight, its interest rate risk increased, but that is not what did it in. Fannie had no way of shedding the credit risk on mortgages it either had securitized or held in its portfolio. Freddie Mac ran into the same problem in the recent crisis, but in the 1980s it had a very small portfolio and minimal interest rate risk.)

As readers of this blog know, I have been concerned about the regulatory capture problem. Whatever structure we have for our financial institutions and markets and however the government is organized to regulate and supervise these institutions and markets, there will be heavy reliance on the quality of government regulation. There were regulatory failures that exacerbated the financial crisis; we need further thought on how to avoid such failures in the future. It is not an easy problem.

There will be a next time. One thing I learned from following these issues for over 30 years is that problems and crises in financial markets happen with a disturbing frequency. I don't think that can be prevented. The goal should be to minimize the severity of crises and particularly to limit the fallout. I am skeptical, as are the WSJ editorial page and Simon Johnson, about the efficacy of Dodd-Frank. It makes some improvements, but one does get the sense that what is happening now is a political process where the Treasury and the regulators are trying to address some issues while not offending financial institutions too much.

As far as when the next time will be, I have no idea. But if one wants something to worry about, one need only think about the continuing decrease in housing prices, the foreclosure mess, the high unemployment rate, the economic problems in Europe, the potential for Middle East conflicts, the increase in food and energy prices, the financial condition of state and local governments, etc. That is not an inclusive list. One can only hope that the optimism expressed by the stock market and the improved GDP growth rate are more important.

More Bank Foreclosure Woes – The Ibanez Case

There is more news concerning banks and foreclosures. First, though it is not clear what this signifies, R.K. Arnold, the former CEO of MERS, has retired. Also, and the subject of this post, is an important Massachusetts court case which definitely has implications in that state for the foreclosure process going forward. It also appears to provide grounds in Massachusetts for anyone who has lost a house because of a foreclosure action to bring suit if there is reason to believe that the financial institution involved did not clearly hold the mortgage at the time of the foreclosure. It may also have implications for foreclosures in other states as other state courts consider the opinion of the Massachusetts Supreme Judicial Court.

U.S. Bank and Wells Fargo lost in their appeals to the Massachusetts Supreme Court of a lower court's ruling that the foreclosure sales of houses were invalid. The banks were the only bidders for the foreclosed properties; the two cases had been combined since they raised similar legal issues. The lower court ruled, and the Massachusetts Supreme Court agreed, that the foreclosures were improper because the banks could not show that they held the mortgages at the time of the foreclosures. These two cases, which do not appear to involve MERS, indicate that the paperwork problems of the banks will have real effects.

It is impossible to read the various filings in this case and not be appalled at the extraordinary sloppiness of the two banks with respect to these two home mortgage loans. The details of these cases and the arguments surrounding the issue are to be found in these filings. A list of them with links can be found at this blog post of "foreclosuresblues."

With respect to the sloppy paperwork, the brief filed for Ibanez quotes a lawyer for U.S. Bank telling the lower court in reply to a question concerning the legality of holding a foreclosure sale in the absence of an assignment of the mortgage as saying: "It was really never identified as a problem…admittedly, it's their own fault, the securitized industry, you know, has been caught with their 'pants down' so to speak…" Further, the lawyer for U.S. Bank is quoted as saying: "I tell you for our law firm we do just what you say, we have changed our practice…and we don't start the Notice of Sale process until we do the assignment and get it on record." (p.3 of Ibanez brief.)

The Attorney General of Massachusetts filed an amicus brief opposed to the banks. At the end of the brief, there is this observation: "As the Land Court points out, the banks were the only bidders at the foreclosure sales and they purchased these properties for less than the market values stated in their own appraisals, an advantage they may have gained because of the defects in their notices…This was particularly damaging to Mr. Ibanez, as U.S Bank bid for and purchased the Ibanez property for some $16,000 less than the amount of the outstanding loan, leaving a significant deficiency…Thus, the plaintiffs profited from the risks they took, at the expense of each of the borrowers. Having reaped the benefits of their casual attitude toward ensuring they possessed valid assignments of the mortgages, it is not unjust that plaintiffs should now bear the costs of their errors." (Martha Coakley is the Attorney General of Massachusetts. She lost an election to the U.S. Senate to Scott Brown for the seat held for years by Ted Kennedy.)

Felix Salmon of Reuters is wringing his hands over this decision in a January 7 post. He notes that the decision is retroactive, which may well prompt litigation in Massachusetts, and, while the decision only applies to that state, it will be looked at by the courts of other states. Salmon writes: "If a similar decision comes down in California, which is a non-recourse state, the resulting chaos could be massive. People who are current on their mortgage and perfectly capable of paying it could simply make the strategic decision to default, if and when they find out or suspect that the chain of title is broken somewhere. They would take a ding to their credit rating, but millions of people will happily accept a lower credit rating if they get a free house as part of the bargain."

It is not clear whether that is true. Presumably, even if the note and the mortgage have been separated, some entity does own the note, which may now be an unsecured loan. The ability of a creditor to compel payment on this note outside of bankruptcy probably differs from state to state; and, in bankruptcy, I would guess that the bankruptcy judge would have some latitude about how to deal with this.

But it is true that this poses a big problem for the banks. While the federal regulators are no doubt trying to figure out what they can do about this, they are faced with an important constraint – it is state law, not federal, which is relevant in these cases.

Salmon concludes – "Maybe we'll muddle through this somehow – that's still probably the base-case scenario. But maybe we won't. And if we don't, the downside here, to the banking system and to the economy as a whole, could hardly be larger." I suspect that Salmon's worst case scenario of wholesale defaults on mortgages by perfectly solvent homeowners who nevertheless are able to retain title and remain in their homes will be avoided, but there is plenty to worry about. That is not to say that the court was wrong in its decision; banks cannot be above the law. One result of this decision if other state courts with laws similar to those in Massachusetts come to similar conclusions is that it may encourage banks to pursue loan modifications more actively.

Meanwhile, in another case, the Massachusetts Supreme Court is considering whether people who bought houses which have been sold by financial institutions which did not have the right to foreclose on the properties are in fact owners of the houses they thought they had purchased.

MERS In the Spotlight Again

The Washington Post published a long article on the Mortgage Electronic Registration Systems ("MERS") this Sunday – "First the electronic mortgage superhighway. Then, the pileup." (Previous online version here.) The spotlight on MERS must be increasingly uncomfortable for the parent firm's (MERSCORP) 45 employees (MERS itself has no employees) who work in Reston, Virginia (a suburb of Washington, DC). The article states that "MERS is facing lawsuits from across the country seeking unpaid county recording fees. Several state courts have rejected attempts by MERS to act on behalf of banks seeking to foreclose on delinquent mortgages. And Congress is weighing legislation that would bar home loan giant Fannie Mae from buying any mortgage listed in MERS, potentially a death knell for the registry."

I have written on this subject in two previous posts (here and here). The new Washington Post article will no doubt increase the attention played to the MERS controversy. Court decisions currently are mixed on MERS, but if a major court decision does not go MERS' way, financial institutions and markets could be in for some real trouble.

MERS seems to be modeled after the Depository Trust Company ("DTC"), which serves to "immobilize" securities held in street name and operate a book-entry system to transfer securities among member firms. The firms in turn mark their books and the last tier in this book-entry system indicates the beneficial owners of the securities. However, MERS was constructed on the cheap, and does not have anything similar to the large underground vault that DTC has in Manhattan filled with paper securities.

Also, the legal regime for real property differs from securities. One of the purposes of MERS is to avoid the fees and the work involved in filing with local authorities the transfers of mortgages. There is some question whether listing MERS with local authorities is sufficient. There are also questions concerning whether MERS serves to separate the notes, which set out the terms and conditions of the loans, and the mortgages, which give the right to the lenders to foreclose on property should the borrowers default. Case law dating from the 19^th Century indicates that a mortgage separated from the note is worthless. This also implies that a note without the mortgage is unsecured, which has important implications in a bankruptcy proceeding. Moreover, some claim that MERS serves to disrupt a clear record of the chain of ownership of the mortgage and the note.

Obviously, to the extent that fraud is involved, as it would seem to be in the case of "robo-signers," shredded and/or forged documents, improper notarizations, and so on, there is no argument that this does not pose a serious problem. The more troubling question is whether the MERS system itself works as a legal matter even without such clearly improper action. One can easily find some extremely heated discussion of MERS as itself a fraud. For example, see L. Randall Wray's three part series for The Huffington Post on MERS ("Anatomy of Mortgage Fraud") which begins here. At the end of the series, he writes: "Some might think I have used the 'F' word excessively and cavalierly throughout these three pieces. To be sure, fraud is something that must be proven in court and since it involves intent that is not easy. I am using the term in the common everyday sense of the term and I think it accurately describes the behaviors I have outlined--and I am not alone. Christopher Peterson, Associate Dean and Professor of Law at the University of Utah calls MERS "a deceptive and anti-democratic institution", a "shell company" with a structure that could 'arguably be considered fraudulent'."

Also, Yves Smith has written very critically of MERS on her blog naked capitalism. For example, see "Will MERS Exam Be a Whitewash?" and "Why MERS Needs to be Taken Out and Shot." (Incidentally, "Yves Smith" is a pseudonym. It is a clever pun based on the Book of Genesis and a famous Scottish economist.) A more dispassionate look at the legal challenges MERS faces can be found in this Reuters article. On the other side, for an argument that MERS will likely in the end fend off the legal challenges, see "MERS Prevails In The Show-Me State." The author, a lawyer who works for a "creditors' rights law firm," concludes her article with advice to those on her side of the issue: "In order to stay on the winning side, lenders need to continue to adapt their procedures and policies to timely provide foreclosure counsel with documents and information. Likewise, foreclosure counsel must continue to update their archive of case law with favorable decisions, such as the ones cited in this article. With a united front in defending these challenges, MERS will knock out claims left and right, eventually finding itself in a permanent place of victory."

While some of the rhetoric is over the top, there is a serious problem. Not only are the legality of many foreclosures in question, but so are the validity of the securities backed by mortgages, which face both security and tax law questions. In addition, local governments are realizing that they may have lost significant fee income because of MERS. For example, one lawsuit claims that California local governments are owed at least $60 billion (not a typo) in recording fees. Apparently, the state has not joined in the lawsuit, and it is not clear it will, but $60 billion might seem to be a tempting amount of money for a state with serious budget problems. Other state and local governments are looking into this.

It will take some time for the legal issues to be settled in the states. While The Washington Post article speaks of legislation that would effectively mean the end of MERS by prohibiting the GSEs from purchasing or securitizing mortgages which are in MERS, one can be sure that there are lobbyists who are fighting to preserve MERS and, if necessary, get legislation passed that blesses what has been done in the past. The constitutionality of any such legislation, if enacted, could well end up being decided by the Supreme Court.

The creation of MERS in the 90s in such a way that these legal challenges are gaining traction is a failure of both the government and the private sector. Government regulators did not analyze MERS as much as they should have when it was created. They had plenty of authority under banking, security, and tax laws to demand changes if they thought it necessary. For its part, the private sector (major banks and Fannie and Freddie) did not listen to warnings about the legal risks. These failures now pose risks to all of us.

Acting Comptroller John Walsh indicated that the OCC and other bank regulators are looking into MERS. While his statement to this effect seems more focused on operational issues, the OCC and other government agencies must be worried about the legal issues. I suspect that they do not know what to do. The risks the government must see if court decisions go against MERS are that financial institutions and financial markets could again be in serious trouble and that Fannie Mae and Freddie Mac could face even more losses, which it seems would need to be covered by the federal government (meaning all of us). On the other hand, the Executive Branch will find it difficult to influence what state and federal courts will do, and the legal questions about MERS are not frivolous.

Some may think MERS will eventually be found to be a proper and legal mechanism for handling mortgages. It has to be, they may believe, because otherwise, the financial system would again be put at risk, and, after all, those foreclosed on are in default on their loans.  Perhaps.  But it may not go that way. One hopes that some creative thinking in the government is being done about what might be done to resolve the MERS issues in a fair, workable, and legal manner.