FBI Fraud Finding Could Rock Wall Street

John Browne
Friday, Feb. 1, 2008

After the Fed cut two key rates by 50 basis points Jan. 30th, markets rallied, at least initially.
Some of our readers may agree with me that it is surprising that stock markets would rally, just as real evidence comes through that the recession I have long predicted is coming into view — particularly a recession weighed down by a property bust and a looming solvency crisis.

Added to this, the markets now face the specter of FBI findings of fraud on Wall Street — findings that could rock Wall Street to its very core.

Why, you may ask, don't stock markets plummet when faced by such potential adversity?

Well, as I have often said, including earlier this week, there appears to be an amazing disconnect between Wall Street and the actual economy on Main Street.

is well known that it takes, depending upon circumstances, some nine to 24 months for an interest rate cut to gain traction.

Despite this, it is increasingly clear that the stock markets have turned a blind eye to this time-lag and preferred instead to see interest rate cuts as financial aspirin, capable of alleviating the headache induced by actually looking at the real world.

I feel the Fed rate cuts are too little, too late to avoid the recession now immediately ahead. So the delay and fearfulness of our Fed will, in my opinion, result in a deeper recession than would otherwise have been the case.

That should be really bad news for stocks.

Nevertheless, taken with the aspirin treatment of rate cuts, the Dow has gained 3.8 percent, the banks 18.4 percent, and even the retailers 8.3 percent, all since, in apparent panic, the Fed cut rates by 75 basis points on Jan. 22 — a total cut of 1.25 percent in just eight days!

[Editor's Note: A U.S. Recession Is Now Unavoidable. Take These Urgent Steps Now.


This makes a total cut of 2.25 percent since the Fed began this series of cuts in September 2007. Impressive, you might think, and I might agree, had they been made earlier, in time to allow for a nine to 24 month lead time.

However, these cuts have been made late in a series of timid announcements, giving the impression not of leadership but of reacting, from fear, to worsening news.

Furthermore, the recession I see ahead is not just a normal, healthy one, the result of consumers becoming tired.

This pending recession has come off the back of the greatest series of politically driven liquidity booms of all time. One symptom worth nothing: According to The Economist, the value of residential property in the developed world alone rose by a staggering $25 trillion between 2001 and 2006!

As we have asked before, where did all this money come from?

Until recently, the umbrella reply has been excessive Fed liquidity (under Greenspan) and leverage piled upon leverage, though banks, hedge funds and leveraged derivatives such as collateralized debt obligations (CDOs).

In short, it was motivated by greed of unprecedented proportions. Wall Street grew fat and paid itself bonuses in 2007 reaching $66 billion!

Where did all that money come from? Well, much of it came from commissions on placing and dealing in structured investment vehicles (SIVs) such as CDOs and credit default swaps.

The financial scandal of the subprime CDOs, of which we warned in detail in May 2007, has now been well-aired in the mainstream media and has caused major writedowns of asset portfolios. This in turn, has reduced the capital of our banks, reducing their capacity to lend, even if they wanted to do so!

In addition, the new problem of a potential failure in bond insurance has also received some attention. If not corrected, this could also cause new portfolio asset write-downs in areas beyond subprime credit default swaps.

But there is yet another major financial train wreck coming — it is the issue of fraud, which I raised in my Jan. 3 commentary.

On that day, I said, "If the initial subprime mortgage transactions are deemed by our courts to have arisen either from fraudulent sales inducements or to have involved fraudulent banking transactions at or prior to closing, the vast bulk of subprime mortgages could be rendered not merely discounted but utterly worthless."


Well, on Jan. 30, The Wall Street Journal ran an interesting and inherently worrying article entitled "FBI Begins Subprime Inquiry."

According to The Journal, the Justice Department, SEC and the New York attorney general are all looking into possible wrong doing connected to the mortgage business. In addition, the newspaper report, the FBI has opened criminal inquires into 14 companies over subprime-mortgage issues.

Apparently, the FBI is looking into mortgage fraud. The SEC is investigating the role of mortgage brokers, the procedures at credit rating agencies, and the investment bankers involved in the underwriting and securitization process.

The Wall Street Journal reports that the New York state attorney is looking into possible wrong doing connected to mortgage backed securities brought and sold by Wall Street firms.

It does not take a rocket scientist to be suspicious that it required some pretty fancy (I put it no stronger at this stage) slicing, dicing and repackaging of "toxic subprime waste" to get otherwise prudent international investors, including major banks, trust and hedge funds and even local authority treasurers (as far afield as northern Norway) to invest in CDOs containing that subprime "toxic waste" nevertheless rated triple "A"!

The problem is that, in a very competitive world, New York's reputation for "transparency" now hangs in the balance. With many foreign financial centers anxious to draw highly profitable business from Wall Street, a thorough investigation will likely be called for by Congress.

Worse still is the fact that, according to English law (upon which New York law is based), if a sale is concluded on the basis of fraud, including any fraudulent inducement, the entire contract is null and void.

Well, this means that if the sale of whole batches of tens of billions in CDOs (not to mention the underlying mortgages) were based upon fraud (including even a faulty credit rating and a teaser-rate inducement, the underlying assets would have not just to be written down by an internally judged 30 percent or 50 percent, but by 100 percent!

What then of asset values and their affect upon the credit markets?

Referring to just one aspect of the spread of the virus of fraud, the Financial Times this week ran an important item entitled, "Derivatives boom raises risk of forced bankruptcy for companies."

The article highlighted a study done by two Texas academics. It showed that the existence of derivatives has broken the vital relationship between borrower and lender who have traditionally "worked things out" together to keep solvent companies out of bankruptcy.

Furthermore, companies are not normally forced to disclose their positions in derivatives. This ability of borrowers to cloak their exposure to "toxic waste" causes grave credit concerns among lenders.

So, for these reasons, it is now increasingly in the interests of lenders to force debtor companies into bankruptcy, particularly if the lender is on the right side of a credit default swap!

Such a situation serves to increase systemic risk further within the financial system at a particularly sensitive and potentially dangerous time for our economy.

If the FBI uncovers severe systemic risk, there could be political pressure on them to turn a blind eye or to cover things up. Who knows? Nevertheless, we should be forewarned.

In light of all this, I find it hard to be bullish either on our economy or on our stock markets, even in face of the interest rates cuts our Fed has given us, so far. For this reason, I believe our Fed must give more rate cuts and fast, despite the inflation risks.

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