In a write-up in The San Francisco Chronicle in December 2007, attorney Sean Olender suggested that the actual basis for the subprime bailout schemes being proposed by the U.S. Treasury Department was not to keep strapped borrowers inside their homes so much as to stave off a spate of lawsuits against the banks. The plan then up for grabs was a pastime rate freeze on a small quantity of subprime loans. Olender wrote:
"The only real goal of the freeze is to prevent owners of mortgage-backed securities, most of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value - today almost 10 times their market worth. The ticking time bomb in the U.S. banking system isn't resetting subprime mortgage rates. The actual problem could be the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there clearly was fraud in the origination process.
" ;...The catastrophic consequences of bond investors forcing originators to buy back loans at face value are beyond the existing media discussion. The loans at issue dwarf the capital offered by the largest U.S. banks combined, and investor lawsuits would raise stunning liability sufficient to cause even the largest U.S. banks to fail, causing massive taxpayer-funded bailouts of Fannie and Freddie, and even FDIC....
"What would be prudent and logical is for the banks that sold this toxic waste to buy it back and for plenty of people to go to prison. If they knew concerning the fraud, they should have to buy the bonds back."1
STATES LEADING THE CHARGE
MBS investors with the ability to bring major lawsuits include state and local governments, which hold substantial portions of their assets in MBS and similar investments. A harbinger of things to come was an issue filed on February 1, 2008, by the State of Massachusetts against investment bank Merrill Lynch, for fraud and misrepresentation concerning about $14 million worth of subprime securities sold to the town of Springfield. The complaint focused on the sale of "certain esoteric financial instruments called collateralized debt obligations (CDOs)...of unsuitable for the town and which, within months following the sale, became illiquid and lost almost all of their market value."3
The prior month, the town of Baltimore sued Wells Fargo Bank for damages from the subprime debacle, alleging that Wells Fargo had intentionally discriminated in selling high-interest mortgages more frequently to blacks than to whites, in violation of federal law.4
"If you ask me, this really is no unique of organized crime or drugs," Jackson told the Cleveland newspaper The Plain Dealer. "It has exactly the same effect as drug activity in neighborhoods. It's an application of organized crime that is actually legal in many respects." He added in a videotaped interview, "This lawsuit said, 'You're not going to achieve this to us anymore.'"5
The Plain Dealer also interviewed Ohio Attorney General Marc Dann, who was simply considering circumstances lawsuit against some of the same investment banks. "There's clearly been a wrong done," he explained, "and the source is Wall Street. I'm glad to own some company on my hunt."
However, a funny thing happened in route to the courthouse. Like New York Governor Eliot Spitzer, Attorney General Dann wound up resigning from his post in May 2008 after a sexual harassment investigation in his office.6 Before they certainly were forced to resign, both prosecutors were hot on the tail of the banks, wanting to impose liability for the destructive wave of home foreclosures inside their jurisdictions.
But the hits continue coming. In June 2008, California Attorney General Jerry Brown sued Countrywide Financial Corporation, the nation's largest mortgage lender, for causing tens and thousands of foreclosures by deceptively marketing risky loans to borrowers. Among other things, the 46-page complaint alleged that:
"'Defendants viewed borrowers as nothing more than the means for producing more loans, originating loans with little if any regard to borrowers' long-term ability to afford them and to sustain homeownership'...
"The company routinely...'turned a blind eye' to deceptive practices by brokers and a unique loan agents despite 'numerous complaints from borrowers claiming which they didn't understand their loan terms.'
" ;...Underwriters who confirmed home elevators mortgage applications were 'under intense pressure...to process 60 to 70 loans per day, making consideration of borrowers' financial circumstances and the suitability of the loan product for them nearly impossible.'
"'Countrywide's high-pressure sales environment and compensation system encouraged serial refinancing of Countrywide loans.'"7
Similar suits against Countrywide and its CEO have been filed by the states of Illinois and Florida. These suits seek not merely damages but rescission of the loans, developing a potential nightmare for the banks.
AN AVALANCHE OF CLASS ACTIONS?
Massive class action lawsuits by defrauded borrowers may also be in the works. In a 2007 ruling in Wisconsin that's now on appeal, U.S. District Judge Lynn Adelman held that Chevy Chase Bank had violated the Truth in Lending Act by hiding the terms of a flexible rate loan, and that tens and thousands of other Chevy Chase borrowers could join the plaintiffs in a class action on that ground. In accordance with a June 30, 2008 report in Reuters:
"The judge transformed the case from the run-of-the-mill class action to a potential nightmare for the U.S. banking industry by also finding that the borrowers could force the financial institution to cancel, or rescind, their loans. That decision was stayed pending an appeal to the 7th U.S. Circuit Court of Appeals, that will be anticipated to rule any day.
"The idea of canceling tainted loans to stem a tide of foreclosures has caught hold in other quarters; a Roundup Lawsuit filed last week by the Illinois attorney general asks a court to rescind or reform Countrywide Financial mortgages originated under 'unfair or deceptive practices.'
" ;...The mortgage banking industry already faces pressure from state and federal regulators, who've accused banks of lowering underwriting standards and forcing some borrowers, through fraud, into costly adjustable loans that the banks later bundled and sold as high-interest investment vehicles."
SHIFTING THE LOSS BACK TO THE BANKS
Rescission can be a remedy available not merely for borrowers however for MBS investors. Many loan sale contracts provide by their terms that lenders must restore loans that default unusually quickly or that have mistakes or fraud. An avalanche of rescissions could possibly be catastrophic for the banks. Banks were moving loans off their books and selling them to investors to be able to allow many more loans to be made than would otherwise have been allowed under banking regulations. The banking rules are complex, however for every dollar of shareholder capital a bank has on its balance sheet, it's supposed to be restricted to about $10 in loans. The issue for the banks is that whenever the method is reversed, the 10 to 1 rule can work the other way: going for a dollar of bad debt back on a bank's books can reduce its lending ability by a factor of 10. As explained in a BBC News story citing Prof. Nouriel Roubini for authority:
You could also have some very bankrupt banks. The sum total equity of the utmost effective 100 U.S. banks stood at $800 billion at the conclusion of the third quarter of 2007. Banking losses are still expected to go up by as much as $450 billion, enough to get rid of more than half of the banks' capital bases and leave most of them insolvent.11 If debtors were to deluge the courts with viable defenses for their debts and mortgage-backed securities holders were to challenge their securities, the end result could possibly be even worse.
PUTTING THE GENIE BACK IN THE BOTTLE
So what can happen if the mega-banks doing these irresponsible practices actually went bankrupt? These banks are widely acknowledged to be at fault, nevertheless they expect to be bailed out by the Federal Reserve or the taxpayers because they're "too big to fail." The argument is that when they certainly were allowed to collapse, they'd take the economy down with them. That's worries, but it's not actually true. We do need a ready supply of credit, so we need banks; but we don't need private banks. It is a little-known, well-concealed fact that banks do not lend their own money or even their depositors' money. They actually create the money they lend; and creating money is properly a public, not an exclusive, function. The Constitution delegates the ability to generate money to Congress and simply to Congress.12 For making loans, banks are merely extending credit; and the correct agency for extending "the entire faith and credit of the United States" could be the United States itself.
A method of truly "national" banks could issue "the entire faith and credit of the United States" for public purposes, including funding infrastructure, sustainable energy development and health care.13 Publicly-issued credit could also be used to relieve the subprime crisis. Local governments could use it to buy up mortgages in default, compensating the MBS investors and freeing the actual estate for public disposal. The properties could then be rented back for their occupants at reasonable rates, leaving people inside their homes without the windfall of acquiring a home without investing in it. A course of lease-purchase might also be instituted. The proceeds could be applied toward repaying the credit advanced to buy the mortgages, balancing the money supply and preventing inflation.
LOCAL AND PRIVATE SOLUTIONS
Andrew Jackson reportedly told Congress in 1829, "If the American people only understood the rank injustice of our money and banking system, there would have been a revolution before morning." A trend of private actions, class actions and government lawsuits directed at redressing injurious banking practices could spark a revolution in banking, returning the ability to advance "the entire faith and credit of the United States" to the United States, and returning community assets to local ownership and control.
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