The Blame Game

Reuters is reporting Massachusetts subpoenas firms on subprime research and with that subpoena the "blame game" begins.

Massachusetts ordered two prominent Wall Street financial firms on Tuesday to provide information on their subprime research in the first probe by a U.S. state into possible conflicts of interest over the troubled mortgage lenders.

State authorities subpoenaed UBS Securities LLC and Bear Stearns Cos. over their research analysis of lenders specializing in making loans to high-risk borrowers, including New Century Financial Corp.

"We've got some serious questions based upon what we know of the facts relating to the recommendations, the coverage by UBS and Bear Stearns specifically," Secretary of State William Galvin told Reuters after announcing the subpoenas.

Galvin said UBS upgraded New Century 16 days after its Feb. 7 earnings restatement, while Bear Stearns upgraded the lender on March 1, the day it said its annual report was delayed.

"We want to know if there were any conflicts. Were there relationships, investment banking relationships? Did the brokerage company have a financial position in the company? Were there hedge fund clients that might have had those," Galvin said.

The subpoenas, which require responses by March 27, seek all documents created by any subprime lending analyst at the two investment firms.

They also seek information about the fees, commissions and other compensation earned by the firms relating to any subprime lender and any other documents sent between company personnel and hedge fund clients invested in a subprime lender.

UBS declined to comment on the matter but a spokeswoman said: "We are proud of our track record in research."

A Bear Stearns spokeswoman said the firm will fully cooperate with the inquiry and added that its research has been "mischaracterized" in the media.

Cozy Relationships

In Cozy Relationships & Improprieties I took a look at the upgrade rationale of Bear Stearns and had some questions of my own:

Upgrade Rationale

"If management comes up with a sound strategy to stabilize the business and improve liquidity .... shares could rally into the high teens".

So the upside was the high teens from 15 and the downside was obviously zero. What is interesting is the rationale began with a big "If". Given that New Century management was under investigation for criminal fraud, exactly how likely was it that "management would come up with a sound strategy to stabilize the business and improve liquidity"?

Did a cozy relationship between Bear Stearns and subprime lenders influence Coren and Nannizzi, or did Coren and Nannizzi simply make a horrible call? Unless there is a smoking gun memo the truth on this may never be known. What we do know, however, is that relationships between rating companies and analysts offer fertile ground for all kinds of improprieties. The same goes for Moody's, Fitch, Merrill Lynch, Morgan Stanley, and the like. As long as companies are allowed to have business relationships with companies they rate, and/or take positions in the stocks and bonds of companies that they upgrade and downgrade, allegations of improprieties are simply not going to go away.

Comptroller of the Currency

Not only did the allegations of improprieties linger, but Bear Stearns was hit with a subpoena to boot. While some are looking to blame "The Bear" others are pointing fingers at the Fed and the Office of the Comptroller of the Currency for failure to chastise lenders during the boom.

The Federal Reserve and the Office of the Comptroller of the Currency took little action in public to police the $2.8-trillion boom in the U.S. mortgage market -- whose bust now risks worsening the housing recession.

Consumer advocates and former government officials say the regulators, by acting behind the scenes rather than openly advertising the shortcomings of some firms, failed to discipline an industry that loaned too much money to borrowers who couldn't repay it.

"There was tension between the responsibilities not to mess up some banks' businesses and the responsibility to consumers," said Edward Gramlich, a Fed governor from 1997 to 2005 who is writing a book about the mortgage market at the Urban Institute in Washington. The result, he said, is that "we could have real carnage for low-income borrowers."

[Mish: Hmmm that sounds suspiciously like admitting culpability. Well perhaps you will get a best seller out of it. In that regard the more carnage the better I suppose.]

"Making sure people understand what they're getting into is very important," Fed Chairman Ben S. Bernanke said in Stanford, California, on March 2. "We've issued several guidances. We hope that they'll be helpful."

[Mish: It's clear Bernanke wants no part of this action. Here is a simple translation of what he said: "Don't blame me."]

After being rebuked for foot-dragging by Senator Christopher Dodd, a Connecticut Democrat who chairs the Senate Banking Committee, federal regulators issued proposed guidelines aimed at subprime lending on March 2.

The subprime industry's woes have their roots in the tenure of former Fed Chairman Alan Greenspan. The Greenspan-led Fed cut its benchmark rate to 1 percent in 2003 and kept it there for a year, helping foster a housing bubble.

Philosophically Opposed

At the same time, Greenspan was philosophically opposed to heavy-handed intervention or rule-writing, and favored self- regulation and the primacy of markets. The former chairman declined to comment.

Consumer advocates say the Fed has expansive authority and could have stopped abuses. The Truth in Lending Act gives the Fed rule-writing authority over disclosures for consumer credit among all financial institutions. The Home Ownership and Equity Protection Act of 1994 also gave the Fed a role in preventing predatory lending, according to consumer advocates.

In addition, federally regulated banks and Wall Street firms are often the financiers standing behind state-regulated mortgage lenders. New Century Financial Corp., the nation's second-biggest subprime lender, includes Morgan Stanley, Citigroup Inc., and Goldman Sachs Group Inc. -- all regulated by federal agencies -- among its creditors. Gramlich says the Fed should seek an expansion of its authority to supervise mortgage subsidiaries of bank holding companies.

[Mish to Gramlich: Didn't you already have that authority? After admitting culpability, it now seems like you are trying to take it back.]

"There is no question that mortgage brokers are on the street committing systematic fraud on the American homeowner," said Irv Ackelsberg, a Philadelphia attorney who testified at a Fed hearing last year in the city. He said there is a "lack of will" on the part of the Fed to use its power to stop abuses.

Fed officials defend their approach, saying that over- zealous regulation might cut off credit to people who need it most.

"There is going to be a fraction of people that get the wrong product and that is regrettable," Richmond Fed President Jeffrey Lacker said in an interview. "Should we do something to limit that probability? Well, we could, but it would also limit credit to people for whom that is the right product."

[Mish: A fraction of the people got the wrong product? How about 99/100? Every one of these governors is attempting to absolve themselves of blame.]

`Fundamentally Broken'

Ackelsberg told former Fed Governor Mark Olson and Consumer Affairs Director Sandra Braunstein that the subprime market was "fundamentally broken," and presented an example of a loan that left a Social Security recipient with about $10 a day to live on after she paid her mortgage.

He and other critics say the lack of public action is symptomatic of a too-cozy relationship between the overseers and the overseen, with consumers and the U.S. economy paying the price. "We have regulators almost competing with one another to be clients of the industry," said David Berenbaum, executive vice president for the National Community Reinvestment Coalition in Washington "What we need is for regulators to be competing to offer consumer protection."

What's fundamentally broken is not the subprime market but the Fed who is willing to blow bubble after bubble after bubble and then attempt to deal with the aftermath.

Greenspan Remarks

If anyone is wondering why Greenspan declined to comment on the subprime mess, the answer can be found in his remarks at the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005.

... Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants.

... technology has enabled creditors to achieve significant efficiencies in collecting and assimilating the data necessary to evaluate risk and make corresponding decisions about credit pricing. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers.

... Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending;

... Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have.

... This fact underscores the importance of our roles as policymakers, researchers, bankers, and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.

There it is in black and white. Just as he bought into the productivity miracle in 2000 right at the dotcom market peak, he started touting the ability of technology to "quite efficiently judge the risk posed by individual [subprime] applicants and to price that risk appropriately" right at the housing peak.

Well done Maestro!

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/