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Thoughts from the Frontline Weekly Newsletter

Worth a read, but very scary….


Arlene Busch

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*From:* John Mauldin [mailto:wave@frontlinethoughts.com]
*Sent:* Sunday, October 24, 2010 1:06 PM
*To:* abusch@rosemontseneca.com
*Subject:* The Subprime Debacle: Act 2, Part 2 - John Mauldin's Weekly
E-Letter


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*Thoughts from the Frontline Weekly Newsletter*

The Subprime Debacle: Act 2, Part 2

by John Mauldin
October 23, 2010

[image: Visit John's Home Page] <http://www.johnmauldin.com>

In this issue:
*The Subprime Debacle: Act 2, Part 2
They Knew What They Were Selling
Warning to Mr. Robert Rubin and Management
Popping Through
It's Time for Some Putback Payback
The Worst Deal of the Decade?
And Now to the World Series*

<http://ce.frontlinethoughts.com/CT00372801NDA1ODky.html><http://ce.frontlinethoughts.com/CT00372801NDA1ODky.html><http://ce.frontlinethoughts.com/CT00372801NDA1ODky.html>

At the end of last week's letter on the whole mortgage foreclosure mess, I
wrote:

"All those subprime and Alt-A mortgages written in the middle of the last
decade? They were packaged and sold in securities. They have had huge
losses. But those securities had representations and warranties about what
was in them. And guess what, the investment banks may have stretched
credibility about those warranties. There is the real probability that the
investment banks that sold them are going to have to buy them back. We are
talking the potential for multiple hundreds of billions of dollars in losses
that will have to be eaten by the large investment banks. We will get into
details, but it could create the potential for some banks to have real
problems."

Real problems indeed. Seems the Fed, PIMCO, and others are suing Countrywide
over this very topic. We will go into detail later in this week's letter,
covering the massive fraud involved in the sale of mortgage-backed
securities. Frankly, this is scandalous. It is almost too much to
contemplate, but I will make an effort.

But first, let me acknowledge the huge deluge of emails I got over last
week's letter, the most I can ever remember. I thought about just making
this week's letter a response to many of them, but decided I needed to go
ahead and finish the topic at hand. Maybe another time. As a side note, I
quoted a letter that came to me anonymously via David Kotok. I said if I
found out who wrote it, I would give them credit. It was originally written
by Gonzalo Liro, at www.gonzalolira.blogspot.com.

Many of you wrote to point out that his argument about the tracking of title
was not correct, but others pointed out many other issues as well. This is
one of the most complex problems we face, and I got a lot of good
information from readers. It just makes me wish I had our new web site
finished so you could avail yourselves of the wisdom among my readers. We
are close, down to final changes. And now, on to today's letter.
They Knew What They Were Selling

It's hard to know where to start. There is just so much here. So let's begin
with testimony from Mr. Richard Bowen, former senior vice-president and
business chief underwriter with CitiMortgage Inc. This was given to the
Financial Crisis Inquiry Commission Hearing on Subprime Lending andnd
Securitization andnd Government Sponsored Enterprises. I am going to excerpt
from his testimony, but you can read the whole thing (if you have a strong
stomach) at http://fcic.gov/hearings/pdfs/2010-0407-Bowen.pdf. (Emphasis
obviously mine.)

"The delegated flow channel purchased approximately $50 billion of prime
mortgages annually. These mortgages were not underwriten by us before they
were purchased. My Quality Assurance area was responsible for underwriting a
small sample of the files post-purchase to ensure credit quality was
maintained.

"These mortgages were sold to *Fannie Mae, Freddie Mac* [We will come back
to this - JM] and other investors. Although we did not underwrite these
mortgages, Citi did rep and warrant to the investors that the mortgages were
underwritten to Citi credit guidelines.

"*In mid-2006 I discovered that over 60% of these mortgages purchased and
sold were defective*. Because Citi had given reps and warrants to the
investors that the mortgages were not defective, the investors could force
Citi to repurchase many billions of dollars of these defective assets. This
situation represented a large potential risk to the shareholders of
Citigroup.

"I started issuing warnings in June of 2006 and attempted to get management
to address these critical risk issues. These warnings continued through 2007
and went to all levels of the Consumer Lending Group.

"*We continued to purchase and sell to investors even larger volumes of
mortgages through 2007. And defective mortgages increased during 2007 to
over 80% of production.*"

Mr. Bowen was no young kid. He had 35 years of experience. He was the guy
they hired to pay attention to the risks, and they ignored him. How could a
senior manager not get such an email and not notify his boss, if only to
protect his own ass? They had to have known what they were selling all the
way up and down the ladder. But the music was playing and Chuck Prince said
to dance and rake in the profits (and bonuses!). More from his testimony:

"Beginning in 2006 I issued many warnings to management concerning these
practices, and specifically objected to the purchase of many identified
pools. I believed that these practices exposed Citi to substantial risk of
loss.
Warning to Mr. Robert Rubin and Management

"*On November 3, 2007, I sent an email to Mr. Robert Rubin and three other
members of Corporate Management*... *In this email I outlined the business
practices that I had witnessed and attempted to address. I specifically
warned about the extreme risks that existed within the Consumer Lending
Group. And I warned that there were 'resulting significant but possibly
unrecognized financial losses existing within Citigroup.'"*

And now taxpayers own 75% of Citi, and our losses to them are huge. They are
going to get worse, as we will see.

Now let's turn to the testimony of Keith Johnson, who worked for various
mortgage companies and in 2006 became the president and chief operating
officer of Clayton Holdings, the largest residential loan due diligence and
securitization surveillance company in the United States and Europe. This is
testimony he gave before the Financial Crisis Inquiry Commission. Part of
the testimony is by his associate Vicki Beal, senior vice-president of
Clayton. The transcript is some 277 pages long, so let me summarize.

Investment banks would come to Clayton and give then roughly 10% of the
mortgages that they intended to buy and put into a security. Clayton rated
them on whether the documentation was what it was supposed to be, not as to
whether they thought it was a good loan. Still, 46% of the loans did not
have proper documentation (out of a pool of 9 million loans) and 28% had
what was determined to be level 3 disqualifications that simply had no
mitigating circumstances. Understand, these were loans that were already
written, and there was no effort to check the facts, just the documentation.

And ultimately 11% of these loans (39% of the level 3's) were put back in by
the investment bank. And what happened to the loans that were rejected?
(This might require an adult beverage and a few expletives deleted.)
Popping Through

They were put back into another pool, where again only 10% of the loans were
examined. Quoting from the testimony:

"MR. JOHNSON: I think it goes to the 'three strikes, you're out' rule.

"CHAIRMAN ANGELIDES: So this was a case of - okay, three strikes.

"MR. JOHNSON: I've heard that even used. Try it once, try it twice, try it
three times, and if you can't get it out, then put -

"CHAIRMAN ANGELIDES: Well, the odds are pretty good if you are sampling 5 to
10 percent that you'll pop through. When you said the good, the bad, the
ugly, the ugly will pop through."

Yes, you read that right. If a loan was rejected a second time, it went back
into yet another pool for a third try. The odds of coming up three times,
when only 5 or 10 percent are sampled? About 1 in a thousand. Popping
through, indeed.

Clayton presented their data to the ratings agencies, investment banks, and
others in the industry. They were frustrated that no one was really paying
attention or taking heed of their warnings.

*Here is what Shahien Nasiripour, the business reporter for the Huffington
Post,* wrote (his emphasis). For those interested, the entire article is
worth reading. (
http://www.huffingtonpost.com/2010/09/25/wall-street-subprime-crisis_n_739294.html):


"*Johnson told the crisis panel that he thought the firm's findings should
have been disclosed to investors* during this period. He added that he saw
one European deal mention it, but nothing else.

"The firm's findings could have been 'material,' Johnson said, using a legal
adjective that could determine cause or affect a judgment.

"It's unclear whether the firms ended up buying all of those loans, or
whether Wall Street securitized them all and sold them off to investors.

"'Clayton generally does not know which or how many loans the client
ultimately purchases,' Beal said. That likely will be the subject of
litigation and investigations going forward.

"'*This should have a phenomenal effect legally, both in terms of the
ability of investors to force put-backs and to sue for fraud,' said Joshua
Rosner, managing director at independent research consultancy Graham Fisher
& Co.*

"'*Original buyers of these securities could sue for fraud; distressed
investors, who buy assets on the cheap, could force issuers to take back the
mortgages and swallow the losses.*

"'*I don't think people are really thinking about this,' Rosner said. 'This
is not just errors and omissions - this appears to be fraud, especially if
there is evidence to demonstrate that they went back and used the due
diligence reports to justify paying lower prices for the loans, and did not
inform the investors of that.*"

"Beal testified that Clayton's clients use the firm's reports to 'negotiate
better prices on pools of loans they are considering for purchase,' among
other uses.

"*Nearly $1.7 trillion in securities backed by mortgages not guaranteed by
the government were sold to investors during those 18 months,
according to Inside
Mortgage Finance. Wall Street banks sold much of that. At its peak, the
amount of outstanding so-called non-agency mortgage securities reached $2.3
trillion in June 2007, according to data compiled by Bloomberg.* Less than
$1.4 trillion remain as investors refused to buy new issuance and the
mortgages underpinning existing securities were either paid off or written
off as losses, Bloomberg data show.

"The potential for liability on the part of the issuer 'probably does give
an investor more grounds for a lawsuit than they would ordinarily have',
Cecala said. 'Generally, to go after an issuer you really have to prove that
they knowingly did something wrong. This certainly seems to lend credibility
to that argument.'

"'*This appears to be a massive fraud perpetrated on the investing public on
a scale never before seen,' Rosner added*."
It's Time for Some Putback Payback

Investment banks large and small originated a lot of subprime garbage in the
2005-2007 era. This week PIMCO, Black Rock, Freddie Mac, the New York Fed,
and - what I think is key and no one has picked up on - Neuberger Berman
Europe, Ltd., an investment manager to a managed-account client, came
together and sued Countrywide for not putting back bad mortgages to its
parent, Bank of America. This is the first of what will be a series of suits
aimed at getting control of the portfolio and peeking into the mortgages.
(Text of lawsuit at
http://www.ritholtz.com/blog/2010/10/full-text-of-letter-to-bofa-from-ny-fed-maiden-lane-freddie-mac-pimco-western-asset-mgmt-neuberger-berman-kore-advisors/
)

Basically, if buyers of 25% or more of a mortgage-backed security can come
together, they have standing to sue the mortgage servicer to do its duty to
the investors and make putbacks of bad mortgages, and if they fail to do so
the plaintiffs can take control of the process and take the issuer to court
directly (that's a very simplistic description but roughly accurate).

There are two key take-aways. First, note that a European entity is
involved. Hundreds of billions of dollars of this junk was sold to European
banks and funds. And these guys get together at conferences (sometimes they
even invite me to speak). So Helmut will be talking to Lars who will talk to
Jean Pierre and they will realize they all own some of this junk. They will
be watching with very real interest to see how the big boys at PIMCO and
Black Rock and the New York Fed fare in their efforts. And then you can
count on them all piling on (more later on this).

Second, little noticed this week was the fact that *The Litigation
Daily*wrote that Philippe Selendy of Quinn Emanuel Urquhart & Sullivan
has been
retained by the Federal Housing Finance Agency (FHFA), which oversees Fannie
Mae and Freddie Mac, to investigate billions of dollars in potential claims
against banks and other issuers of mortgage-backed securities.

Who? Not on your celebrity list? Just wait. He will soon be getting the best
tables everywhere. He and his firm are the guys representing MBIA in all
their cases against Countrywide and Merrill Lynch. And they are kicking ass.
Slowly to be sure, but very steady. That means Fannie and Freddie are
getting ready to get serious.

They were sold well over $227 billion of the subprime garbage issued in 2006
and 2007. And the bad stuff started before then. But they have one advantage
that the guys at PIMCO, et al. don't have: they (or actually the FHFA) are a
federal agency. That means they have subpoena power. The agency has sent 64
subpoenas to issuers of mortgage-backed securities, and although they have
not said who they went to, they obviously include almost everyone and
clearly all the big players. (They couldn't have ignored Goldman, could
they? Naah. Too obvious.)

From American Lawyer.com (I know, this website is probably already on your
favorites list, but for those souls who actually have a life I provide the
text):

"Through those subpoenas, the agency could gain access to the loan files for
the mortgages that backed the securities it bought and thus establish
whether the mortgages were what the issuers represented them to be in
securities contracts. According to the Journal, the difficulty of obtaining
loan files has been a big obstacle for investors trying to force issuers to
repurchase bonds.

"If the FHFA were to decide down the road to initiate litigation, it would
still have to have the support of a percentage (usually 25 percent) of its
fellow bondholders for each issue. But given what the agency and its Quinn
lawyers will be able to see before bringing suit, it probably won't be too
hard to get other investors on the bandwagon." (
http://www.quinnemanuel.com/media/183456/hurricane%20warnings%20fannie%20mae%20and%20freddie%20mac%20hire....pdf)


It is tough not to jump to the conclusion, but we need one more piece of the
puzzle before we get there.
The Worst Deal of the Decade?

Arguably Bank of America had Merrill shoved down their throats, but no one
can say that about the acquisition of Countrywide. And Countrywide could end
up costing BAC $50 billion or more in losses. That may prove to be a serious
candidate for worst deal of the decade. (Although WAMU is a leading
candidate too!)

Let's look at a report by Branch Hill Capital, a hedge fund out of San
Francisco. And before we start on it, let me point out they are short Bank
of America. You can see the full PowerPoint at
http://www.businessinsider.com/bank-of-america-mortgage-report-2010-10#-1.

(And let me say a big thanks to the author of the report, Manal Mehta, for
all the background material he sent me and his help with this week's letter.
It helped make it a lot better. Of course, any erroneous conclusions or
outrageous statements are all mine.)

First, they point out that the potential size of Bank of America's (BAC)
liabilities is $74 billion (with a B). And that is just for Countrywide.
That does not include Merrill, which is also large. Against that they have
set aside $3.9 billion. You can count on more suits than just the PIMCO, et
al. mentioned above.

In the MBIA case, the judge has ruled that the suit can proceed even though
BAC has denied responsibility. Although on appeal, this is high-stakes
poker. Countrywide originated over $1.4 trillion of mortgages in 2005-2007.
MBIA alleges that over 90% of the defaulted or delinquent loans in the
Countrywide securitizations show material discrepancies. Care to take the
under in the over/under bet on that?

Further to the case on BAC, Merrill was the largest originator of subprime
CDOs during the housing boom, for another $120 billion, along with about
$255 billion of residential mortgage-backed securities.

And then there are all those CDOs (collaterized debt obligations). Merrill
did a lot of those that went sour. This deserves it own leter, but a
gentleman named Wing Chau went from making $140k a year to $25 million in
just a few years, putting together CDOs from Merrill, some of which were
completely bankrupt in just six months.

Countrywide has already settled with the New York pension funds for $624
million, one of the largest securities fraud settlements in US history. And
the line is growing longer.

Of course, BAC CEO Brian Moynihan denied this week that there is a problem.
Let's look at Moynihan's statements at the last earnings call and compare
them to what the judge in the case said earlier. Moynihan:

"... we execute repurchases on a *loan by loan basis*... And as we learn
more, and again, our perspective on this - we're going to be quite diligent
as I said in defending the interest of our shareholders. *This really gets
down to a loan-by-loan determination and we have, we believe, the resources
to deploy against that kind of a review."*

Back in June the judge on the case (a Judge Bransten) said (from the
transcript):

"I think that it makes all the sense in the world that you can use a sample
to prove the case because otherwise I can't imagine a jury listening to 386
thousand cases. Even if you have that available, nevertheless you are not
going to present that to a jury or even to a judge. I'm patient but not that
patient. So therefore it is going to be a sample in the end..."

OK, let me get this straight, Brian. Your company committed fraud, with
robosignings and all the rest, and you won't man up and take responsibility?
You and your lawyers want to thrash this out, case by case, fighting a
trench-warfare, rear-guard action? Well I'm afraid that's not going to work
out for you. There are so many examples of Countrywide outright fraud that
it is going to be hard to convince a jury that BAC is not on the hook. Will
it take years? Of course.

You can read the PowerPoint for details. Bottom line: BAC is probably liable
for putbacks that could total over a hundred billion. And that is just BAC.

Think Citi. And any of the scores of mortgage originators and investment
banks. There were a couple of trillion dollars in these securitizations
issued. Plus how many hundred of billions of second-lien loans? And can we
forget CDOs? And CDOs squared?

And let's not forget all those completely synthetic CDOs that were written
at the height of the mania. Most of it AAA, of course. Frankly, anyone
stupid enough to buy a synthetic CDO should lose their money, but that is
not what the courts will base their decision on. It is all about
representations and warranties. And maybe a little fraud.

I picked on BAC because that is the analysis I saw. But it could be any of
dozens of banks. Look at this list from the Branch Hill PowerPoint.

[image: jm102310image001]

Could we see a hundred billion in losses to the major banks? In my opinion
we will for sure, over time. $200 billion? Probably. $300 billion? Maybe.
$400 billion? It depends on how organized the investors in the securities
get and what gets settled out of court. Out of a few trillion dollars in
securitizations? It's anybody's guess. I just made mine.

But let's not forget the $227 billion sold to Fannie and Freddie. Taxpayers
are on the hook for $300-400 billion in losses. Those putbacks could save us
a lot. Will this threaten the viability of some banks? Maybe. But most will
survive. BAC made $3 billion last quarter. A steep yield curve (with the
help of the Fed) can cure a lot of evils. But it will absorb the profits of
a lot of banks for a long time.

And that of course, will come back to haunt the rest of us as banks have to
raise more capital and get more conservative.

Anyone who owns stocks in banks with relatively large MBS exposure is not
investing, they are gambling that the losses will not be more than
management is telling them. There will be no bailouts (at least I hope not)
this time around. Fool me once, shame on you; fool me twice, shame on me.
There will be little sympathy for shareholders or bondholders this time, if
it comes to that.

One more sad point. The FDIC (read taxpayers) is liable for some of this, as
they took over some of these institutions. It just keeps on coming.

Final rant. If you were part of a group that knowingly created or sold
flawed and fraudulent mortgage-backed securities to pensions and insurance
companies and took home tens of millions in bonuses, up and down the
management chain, maybe you should consider moving yourself and your money
to a country that does not honor US extradition, because my guess is that,
as all this comes out, you may have to hire some very expensive lawyers and
get measured for pinstripes.

And the Mozilo agreement was a sham. Sigh. That would be the equivalent of
fining me $10,000 and letting me keep my tanning bed. I don't have the space
to go into the fraud at Countrywide, but their internal documents show they
all knew what was going on.
And Now to the World Series

Ok, it is past time to hit the send button. There may be a few more gaffs in
this letter than normal. It is 2 AM. I admit I stopped writing to watch the
Rangers beat the Yankees. You gotta have priorities. It is kind of
bittersweet, as for 15 years I had an office in the Rangers Ballpark, where
I could look out my window or walk onto my balcony to watch the games, often
with friends. And the year I leave we get into the World Series! And now I
find I will be in a mad scramble to get tickets, along with the rest of
Texas, and I HAVE TO go to at least one game of a World Series. As do some
of my kids. And friends.

I have to thank Barry Habib for letting me sit in the second row behind home
plate, behind Mayor Bloomberg, for the Monday night Yankees-Rangers game, to
watch Cliff Lee shut down the Yankees. What memories! I got to meet my
favorite all-time musician, Paul Simon. And the Mayor was gracious enough to
autograph a picture we took last year. And of course to I got to meet Nolan
Ryan (and get a picture!), who had seats behind us. (Nolan, any chance you
can sell me a lease for two days to my old office? It's still empty. You
remember me, don't you? Your new best friend?)

There did not seem to be many Ranger fans at the game, unlike when the
Yankees are in Texas, when half the crowd is wearing Yankees jerseys. But
after that 9th inning, where we pasted them for 6 runs, the Yankee crowd
left (even Barry), and so the few hundred Ranger fans stood out. It was a
great night, sharing that moment. You have to understand, this franchise has
been around 49 years without getting past the first round in the playoffs.
We were 1-9 against the Yankees in the three times we even got to the first
round. There were a lot of demons that were haunting this team.

And now we have Cliff Lee ready for three potential games. And what a story
Colby Lewis is. And the Phillies and Giants both have superb pitching. It
will be a great World Series. The good guys have a real shot at this. I
intend to enjoy it.

I will be on *Fox Business* with Liz Claman on Monday at 3:30 Eastern, and
at the Bank Credit Analyst Conference in NYC for the first of the week.

And you have a great week. Despite the financial issues we all face, it is
the real part of life that makes it worthwhile. Family, friends and, every
now and then, maybe a World Series.

Your tired but contented analyst,

John Mauldin
John@FrontLineThoughts.com <johnmauldin@FrontLineThoughts.com>

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