A Beautiful Model for Fraud

Take a look at this:

A Beautiful Model for Fraud and here is the accompanying article:

The great credit unwind of '08.

How To Spot A Scam, Part 5: Tax Scams

Bankrate.com has a list of the "dirty dozen" tax scams and how to spot them. Here are the list of tax scams covered:

1. Telephone tax refund abuses
2. Abusive Roth IRAs
3. Tax-related identity theft phishing
4. Disguised corporate ownership
5. Zero wage claims
6. Return preparer fraud
7. American Indian employment credit
8. Illegitimate trusts
9. Structured entity credits
10. Improper charitable deductions
11. Form 843 tax abatement
12. Frivolous arguments

Number 12 is the most common one that I am aware of. Here is the entry from Bankrate.com:

12. Frivolous arguments

This is probably the most notorious of scams. Promoters have advocated numerous false claims over the years, including that the 16th Amendment concerning congressional power to lay and collect income taxes was never ratified, wages are not income, filing a return and paying taxes are merely voluntary and being required to file Form 1040 violates the Fifth Amendment right against self-incrimination or the Fourth Amendment right to privacy. The IRS and courts have consistently held that such arguments are frivolous. Taxpayers have the right to contest their tax liabilities in court, says the IRS, but no one has the right to disobey the law that allows the government to collect the taxes.

...

The absence of a particular scheme from the annual dirty dozen rankings should not be taken as an indication that the IRS is unaware of it or not taking steps to counter it. While some schemes might not be as active this tax season, the IRS says taxpayers should remain wary because old scams often resurface or evolve.

If you encounter any of these schemes, or are approached with a new one, the IRS wants to know. Report suspected tax fraud by calling toll-free (800) 829-3676.

Turn in tax cheats and con artists

You also can report suspected tax fraud by sending in Form 3949-A, Information Referral. The completed form or a letter detailing the alleged fraudulent activity should be addressed to the Internal Revenue Service, Fresno, CA 93888. Include as much information as you can, including who is being reported, the activity being reported, how the activity became known, when the alleged violation took place, the amount of money involved and any other information that might be helpful in an investigation. You don't have to give the IRS your name or address, although it is helpful to do so. The agency says it will keep your information confidential. And if the IRS recovers any tax revenue based on your tip, you might be entitled to a reward. In that case, tax officials will need to know how to get in touch with you.

And remember: If you are ever offered a "surefire" tax-saving opportunity, it never hurts to be a little skeptical.

"When it comes to taxes, everyone has to pay their fair share," says IRS Commissioner Everson. "I urge taxpayers not to be taken in by hucksters who promise to lower or eliminate taxes. Getting caught up in the dirty dozen or similar schemes can lead to big headaches."

And remember the old adage: "If it seems too good to be true, it probably is." If you have any legitimate tax questions or need help with them, only use a certified state-licensed professional or Certified Public Accountant (CPA). If you feel you cannot afford a professional, there are many tax programs (TaxCut, TurboTax, etc.) available at many retail outlets that are easy to use and they will go through any potential tax credits or breaks you might be entitled to. There are also different versions of each of these products to match your specific need. For instance, the cheapest version can be used if you are merely a wage earner and don't have that many deductions and the more expensive version is for those who may have a business for which they need to use Schedule C. For your convenience (and, potentially, a small monetary gain on my part) I have provided a link to Amazon.com for each of the products I have mentioned.

If you do think you want to do it yourself, give yourself plenty of time (set aside at least a full day; even better: plan an entire weekend to prepare your tax returns, if necessary). You only have to do it once per year; and once it's done, it's done.

New Foreclosure Fraud Scam

Foreclosure Fraud Scam PSA


Don't fall prey to scam artists to promise to "save" your home from foreclosure. The answer they promise will be worse than the disease. If you are having a problem, call your lender or talk to a bankruptcy attorney.

Hat tip: Tanta at Calculated Risk

Eating the Seed Corn

After reading this short article today, Employees Raiding 401(k)s, CFOs Say (hat tip Calculated Risk), all I could do was shake my head. From the short article:

The survey finds that nearly 20 percent of companies have seen increased hardship withdrawals from 401(k) accounts, often to cover mortgage payments or to avoid personal bankruptcy.

"In the last four or five months we have seen an absolute onslaught of people trying to do hardship withdrawals and loans out of 401(k)s," Mark Anderson, CFO of Granite City Electric, told CFO magazine in October. "What has happened with housing and the economy has really blown up for people at the lower end of the spectrum."

Considering that 401(k) accounts are almost always exempt in bankruptcy proceedings, my first thought is that people are eating their seed corn. There are rare situations where this is to the debtor's benefit. But something tells me most of these cases don't fall into those rare exceptions.

Lately, I have been thinking of the song Santa Monica by Everclear. In my own way I can identify with some of the lyrics of the song. The song is actually about a bad relationship breakup; but for me the selected lyrics sound somewhat like my new life by the Gulf Coast.

With my big black boots and an old suitcase
I do believe I'll find myself a new place
I don't want to be the bad guy
I don't want to do your sleepwalk dance anymore
I just want to see some palm trees
(I will) Go and try to shake away this disease

We can live beside the ocean
Leave the fire behind
Swim out past the breakers
Watch the world die

...

I'll walk right out into a brand new day
Insane and rising in my own weird way
I don't want to be the bad guy
I don't want to do your sleepwalk dance anymore
I just want to feel some sunshine
I just want to find some place to be alone

We can live beside the ocean
Leave the fire behind
Swim out past the breakers
Watch the world die

Mortgage Servicers Gouge Debtors

A report in today's New York Times, Dubious Fees Hit Borrowers in Foreclosures, shows how mortgage servicers can profit from the foreclosure process to the detriment of not only the borrower, but the economy as a whole.

Because there is little oversight of foreclosure practices and the fees that are charged, bankruptcy specialists fear that some consumers may be losing their homes unnecessarily or that mortgage servicers, who collect loan payments, are profiting from foreclosures.

Bankruptcy specialists say lenders and loan servicers often do not comply with even the most basic legal requirements, like correctly computing the amount a borrower owes on a foreclosed loan or providing proof of holding the mortgage note in question.

Here are some of the examples from the story:

In one example, [Katherine M. Porter, associate professor of law at the University of Iowa] found that a lender had filed a claim stating that the borrower owed more than $1 million. But after the loan history was scrutinized, the balance turned out to be $60,000. And a judge in Louisiana is considering an award for sanctions against Wells Fargo in a case in which the bank assessed improper fees and charges that added more than $24,000 to a borrower’s loan.

...

On Oct. 9, the Chapter 13 trustee in Pittsburgh asked the court to sanction Countrywide, the nation’s largest loan servicer, saying that the company had lost or destroyed more than $500,000 in checks paid by homeowners in foreclosure from December 2005 to April 2007.

The trustee, Ronda J. Winnecour, said in court filings that she was concerned that even as Countrywide misplaced or destroyed the checks, it levied charges on the borrowers, including late fees and legal costs.

...

Loan servicing is extremely lucrative. Servicers, which collect payments from borrowers and pass them on to investors who own the loans, generally receive a percentage of income from a loan, often 0.25 percent on a prime mortgage and 0.50 percent on a subprime loan. Servicers typically generate profit margins of about 20 percent.

Now that big lenders are originating fewer mortgages, servicing revenues make up a greater percentage of earnings. Because servicers typically keep late fees and certain other charges assessed on delinquent or defaulted loans, “a borrower’s default can present a servicer with an opportunity for additional profit,” Ms. Porter said.

The amounts can be significant. Late fees accounted for 11.5 percent of servicing revenues in 2006 at Ocwen Financial, a big servicing company. At Countrywide, $285 million came from late fees last year, up 20 percent from 2005. Late fees accounted for 7.5 percent of Countrywide’s servicing revenue last year.

But these are not the only charges borrowers face. Others include $145 in something called “demand fees,” $137 in overnight delivery fees, fax fees of $50 and payoff statement charges of $60. Property inspection fees can be levied every month or so, and fees can be imposed every two months to cover assessments of a home’s worth.

...

Jeffrey M. Norton, a lawyer who represents the Trevinos, said that although MERS pays a flat rate of $400 or $500 to its lawyers during a foreclosure, the legal fees that it demands from borrowers are three or four times that.

...

Based on the study, mortgage creditors in the 1,733 cases put in claims for almost $6 million more than the loan debts listed by borrowers in the bankruptcy filings. The discrepancies are too big, Ms. Porter said, to be simple record-keeping errors.

Michael L. Jones, a homeowner going through a Chapter 13 bankruptcy in Louisiana, experienced such a discrepancy with Wells Fargo Home Mortgage. After being told that he owed $231,463.97 on his mortgage, he disputed the amount and ultimately sued Wells Fargo.

In April, Elizabeth W. Magner, a federal bankruptcy judge in Louisiana, ruled that Wells Fargo overcharged Mr. Jones by $24,450.65, or 12 percent more than what the court said he actually owed. The court attributed some of that to arithmetic errors but found that Wells Fargo had improperly added charges, including $6,741.67 in commissions to the sheriff’s office that were not owed, almost $13,000 in additional interest and fees for 16 unnecessary inspections of the borrowers’ property in the 29 months the case was pending.

“Incredibly, Wells Fargo also argues that it was debtor’s burden to verify that its accounting was correct,” the judge wrote, “even though Wells Fargo failed to disclose the details of that accounting until it was sued.”

And to think that this is probably just the tip of the iceberg. Examples like these show why regulation of the mortgage industry is sorely needed.

Tanta, at Calculated Risk, has her own take on the article -- including her questioning of some of the assertions made in the article.

Predatory Lending PSA

Debt Bomb

From CNN Money's The $915B bomb in consumers' wallets:

(Fortune Magazine) -- This past summer's subprime meltdown involved about $900 billion in now-suspect securitized debt, reckless lending, and consumers who buckled under the weight of loans they couldn't afford. Now another link in the consumer debt chain - credit cards - is starting to show signs of strain. And the fear that the $915 billion in U.S. credit card debt (an uncannily similar figure) may blow up has major financial institutions like Citigroup, American Express, and Bank of America strapping on their Kevlar vests.

...

The doomsday scenario would play out something like this: Just like CDOs and other asset-backed securities, credit card debt is sliced, diced, and sold off again as packages of securities. Rising delinquencies would hurt not only the banks involved but the securities backed by the credit card receivables. Those securities would decline in value as consumers defaulted, leading to bank losses as well as portfolio losses in the hedge funds, institutions, and pensions that own the securities. If the damage is widespread enough, it could wreak havoc on the economy much as the subprime crisis has done.

To be sure, there are key differences between the subprime market and the problems brewing with credit cards. The first is that while rising mortgage delinquencies were apparent for months before the subprime market blew up, credit card delinquencies are actually coming off unusually low levels.

...

But credit card debt is different from subprime debt in another way: Unlike mortgages, credit card debt is unsecured, so a default means a total loss. And while missed payments are at a historical low, they show signs of an uptick: The quarterly delinquency rate for Capital One, Washington Mutual, Citigroup, J.P. Morgan Chase, and Bank of America rose an average of 13% in the third quarter, compared with a 2% drop in the previous quarter.

...

If there is an international precedent the U.S. should be watching, it's actually that of the U.K. British consumers are just as overstretched as Americans, but since the real estate market there rose faster and fell earlier, they're about 18 months ahead in the credit cycle. Since the last quarter of 2005, credit card delinquencies and charge-off rates in Britain have risen as much as 50%, forcing banks to take huge write-offs.

It's a sign of the times that, according to one survey last month, 6% of British homeowners have been using their credit cards to pay their mortgages. That's suicidal, of course, given that credit card interest rates are more than double even the heftiest mortgage. Keep your fingers crossed that it's not a trend that crosses the Atlantic.

That doesn't sound good. At. All.

The T.V. pundits tell us that the housing meltdown is not the entire market. But let's see: so far we have seen a problem in:

1. An almost nationwide mortgage and housing meltdown; and

2. Credit card delinquency rates rising and interest rates and fees rising; and

3. Fuel, food, health care and education costs rising far faster than "core" inflation; and

4. A rapidly falling dollar; and

5. Drought in much of the country and flooding in others; and

6. Wages and social security payments not keeping up with inflation; and

7. A crumbling infrastructure (bridges failing and bridges to nowhere).

The credit problems are not the economy. It's just the tip of it.

Bob Herbert: The Long, Dark Night

Read The Long, Dark Night for a sad story of financial disaster due to medical debt.

He reeled off a long list of charges that are coming at him like machine-gun fire, bills that he cannot afford to pay.

“So we’re selling the house,” he said. He sat quiet for a moment, then added in a soft voice, “You shouldn’t have to go live in a tent somewhere just because you don’t have insurance.”

We're All Subprime Now

Today, blogger Tanta, who writes for Calculated Risk, today wrote about predatory practices in the mortgage industry in HMDA Data on High Priced Loans. A clip:

This whole dynamic may be hard for the WSJ and its fellows in the Big Paid Media, so let me explain this very clearly. In 1975, some folks accused lenders of redlining, which means not granting credit at all to some people. The lenders said they weren't doing that. Congress passed HMDA, and then there was actual data about geographic lending patterns to analyze instead of anecdotes. Once we got some HMDA data under our belts, the Community Reinvestment Act came into being (in 1977) precisely because it was clear that redlining had been going on. CRA in essence forces lenders to show that they are willing to make loans in neighborhoods in which they are willing to take deposits (i.e., those deposits need to be "reinvested" in the neighborhood they came from in the form of loans, not just mortgage loans, to that neighborhood. You can't extract deposits from poor people and use them exclusively to fund loans to rich people.) CRA does not mandate price levels, or even address the question of price levels.

You may be surprised to hear this, but over time accusations of discriminatory lending practices did not go away. In a number of cases, "mystery shopper" tests were performed, in which a white applicant and a black applicant each applied for credit at the same instutition with identical credentials (employment, income, credit history, loan terms), and the results showed that black applicants were more likely to be turned down. This cast some doubt on the lenders' claims that loan rates in minority neighborhoods were a function of the lower credit quality of those borrowers. That became a hypothesis in need of some testing, you see, not an accepted explanation.

So the 1989 revision to HMDA forced collection of demographic data, for the precise purpose of testing the assumption that poor and minority people are just always bad credit risks. This resulted, as you might expect, in conjunction with CRA and other fair lending laws, in much higher rates of home mortgage lending in those areas that were once redlined.

But were these poor and minority people happy, at last? Why no, they weren't. Turns out, anecdotal evidence began to emerge that while these good people were finally getting loans, they were getting them at much higher interest rates than higher-income folks and whites generally got, and that this could not be accounted for by the difference in creditworthiness of the borrowers or the quality of the collateral (the latter proxied by census tract).

...

The bottom line is, as [Calculated Risk] notes, that "high-risk" lending was everywhere in the boom years. Of course there is a desire to collapse it all into the easy category of "subprime." And there has for a long time been a lot of political pressure to keep the association of "subprime" and "urban minorities" in place, because it has functioned as a good excuse for the subprime lenders (they "help" the poor and minorities, remember?). My view is that a whole lot of parties are very interested in maintaining rather than seriously analyzing a lot of faulty assumptions about risk, rates, and borrower credit characteristics. If this ain't "just a subprime problem," then an entire debt-based economy in which even the middle and upper middle class cannot afford homes given [real estate] inflation and wage stagnation is suddenly in question. The last thing certain vested interests want to hear is that, basically, "we are all subprime now."

My favorite comments:

At least then, when they say the problem is contained to subprime, they'd be correct.
daveNYC | 10.11.07 - 10:47 am |


What about the revelations coming forward that a lot of these sub-prime loans were to people who would/could /should have qualified for prime loans. My gut feeling is that the lending industry realized that there was more money to be had in the sub-prime market and rationalized the use of the product by telling borrowers your can always refinance. So while I can see the possibility that we are all becoming sub-prime candidates because of high LTV due to lack of down payments or low rates to buy the MacMansion, I cant help but feel it was the lenders looking to sack the borrower for higher fees and on top of that being bale to book unrealized profits from the fully adjusted loans. Now there is a racket!!
formerly known as... | 10.11.07 - 11:41 am | #


Down where the rubber met the road, '04-06 subprime was a broker-dominated and refinance-oriented business. Those brokers tend to chase after big fish. Which would you rather do? ONE loan for a cardiologist with a bunch of lates thanks to the ex-wife or TEN deals involving city bus drivers with gambling problems, immigrant cleaning ladies with thin credit files, single moms with three jobs, dancers with cash wages and voracious drug habits? - oh, wait, that's alt-a - anyhow, you get the gist. It's not that subprime was ever AIMED at low-income - quite the contrary - it's just that median income of those with impaired credit happens to lower.
Shnaps Parlor

The last paragraph raises an interesting point. We have been told that FICO scores are not related to race, sex or economic status. However, it is also true that women, minorities and lower-income individuals not only have less economic power as a group, but also are at a greater risk that the above examples and medical problems/debt are more likely to adversely affect their ability to pay their bills. Hence, lower credit scores.

The end result is that it contributes to the disparity between the wealthiest (who have the highest credit scores, due to the ability to weather unexpected expenses, and therefore who borrow at lower interest rates), and the poor (whose credit scores crash after one adverse event and have to borrow at higher interest rates). (BTW: I have been meaning to write about how banks charge fees on small balances that can quickly sap wealth from poor patrons.)

The answer is to provide social insurance on some costs (medical debt and education) and living wages that allow for even the poorest to save for the future. There are some costs which cannot be defrayed: rent, electricity and natural gas, food, transportation and personal hygiene. Even the lowest wage should be enough to cover these costs and provide enough to save for the future.

Alarming Parallels

An anonymous commenter over at Sudden Debt has alerted me to an article in The American Prospect entitled The Alarming Parallels between 1929 and 2007.

Testimony of Robert Kuttner
Before the Committee on Financial Services
Rep. Barney Frank, Chairman
U.S. House of Representatives
Washington, D.C.
October 2, 2007

Mr. Chairman and members of the Committee:

Thank you for this opportunity. My name is Robert Kuttner. I am an economics and financial journalist, author of several books about the economy, co-editor of The American Prospect, and former investigator for the Senate Banking Committee. I have a book appearing in a few weeks (The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity) that addresses the systemic risks of financial innovation coupled with deregulation and the moral hazard of periodic bailouts.

...

Although the particulars are different, my reading of financial history suggests that the abuses and risks are all too similar and enduring. When you strip them down to their essence, they are variations on a few hardy perennials -- excessive leveraging, misrepresentation, insider conflicts of interest, non-transparency, and the triumph of engineered euphoria over evidence.

The most basic and alarming parallel is the creation of asset bubbles, in which the purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy. This was the essence of the abuse of public utilities stock pyramids in the 1920s, where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers. This only became exposed when the bubble burst. As Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.

...

A second parallel is what today we would call securitization of credit. Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank -- e.g. Morgan or Chase -- as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be commercial banks -- part of the monetary system, closely supervised and subject to reserve requirements, given deposit insurance, and access to the Fed's discount window; or investment banks that were not government guaranteed, but that were soon subjected to an extensive disclosure regime under the SEC.

Since repeal of Glass Steagall in 1999, after more than a decade of de facto inroads, super-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s -- lending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way. And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all, and the whole process is supercharged by computers and automated formulas. An independent source of instability is that while these credit derivatives are said to increase liquidity and serve as shock absorbers, in fact their bets are often in the same direction -- assuming perpetually rising asset prices -- so in a credit crisis they can act as net de-stabilizers.

A third parallel is the excessive use of leverage. In the 1920s, not only were there pervasive stock-watering schemes, but there was no limit on margin. If you thought the market was just going up forever, you could borrow most of the cost of your investment, via loans conveniently provided by your stockbroker. It worked well on the upside. When it didn't work so well on the downside, Congress subsequently imposed margin limits. But anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people. High rollers, with credit derivatives, can use leverage at ratios of ten to one, or a hundred to one, limited only by their self confidence and taste for risk. Private equity, which might be better named private debt, gets its astronomically high rate of return on equity capital, through the use of borrowed money. The equity is fairly small. As in the 1920s, the game continues only as long as asset prices continue to inflate; and all the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.

The fourth parallel is the corruption of the gatekeepers. In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. You can give this an antiseptic academic term and call it a failure of agency, but a better phrase is conflicts of interest. In this decade, it remains to be seen whether the bond rating agencies were corrupted by conflicts of interest, or merely incompetent. The core structural conflict is that the rating agencies are paid by the firms that issue the bonds. Who gets the business -- the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings? All of this is opaque, and unregulated, and only now being investigated by Congress and the SEC.

Yet another parallel is the failure of regulation to keep up with financial innovation that is either far too risky to justify the benefit to the real economy, or just plain corrupt, or both. In the 1920s, many of these securities were utterly opaque. Ferdinand Pecora, in his 1939 memoirs describing the pyramid schemes of public utility holding companies, the most notorious of which was controlled by the Insull family, opined that the pyramid structure was not even fully understood by Mr. Insull. The same could be said of many of today's derivatives on which technical traders make their fortunes.

...

A last parallel is ideological -- the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.

...

One last parallel: I am chilled, as I'm sure you are, every time I hear a high public official or a Wall Street eminence utter the reassuring words, "The economic fundamentals are sound." Those same words were used by President Hoover and the captains of finance, in the deepening chill of the winter of 1929-1930. They didn't restore confidence, or revive the asset bubbles.

The fact is that the economic fundamentals are sound -- if you look at the real economy of factories and farms, and internet entrepreneurs, and retailing innovation and scientific research laboratories. It is the financial economy that is dangerously unsound. And as every student of economic history knows, depressions, ever since the South Sea bubble, originate in excesses in the financial economy, and go on to ruin the real economy.

That is a lot of parallels to think about; and they are alarming parallels at that.

Prisoner's Debt

You all have heard of Debtor's Prison, but how many of you were aware of the fact that many convicts come out of prison with more financial debt than they can repay (and rarely is it dischargeable in bankruptcy).

The New York Times today brings light to this rarely discussed topic in an editorial today.

The scope of the ex-offender debt problem is outlined in a new study commissioned by the Justice Department’s Bureau of Justice Assistance and produced by the Council of State Governments’ Justice Center. The study, “Repaying Debts,” describes cases of newly released inmates who have been greeted with as much as $25,000 in debt the moment they step outside the prison gate. That’s a lot to owe for most people, but it can be insurmountable for ex-offenders who often have no assets and whose poor educations and criminal records prevent them from landing well-paying jobs.

...

A former inmate living at or even below the poverty level can be dunned by four or five departments at once — and can be required to surrender 100 percent of his or her earnings. People caught in this impossible predicament are less likely to seek regular employment, making them even more susceptible to criminal relapse.

Here are the proposed solutions as reported by the Times:

The Justice Center report recommends several important reforms. First, the states should make one agency responsible for collecting all debts from ex-offenders. That agency can then set payment priorities. The report also recommends that payments to the state for fines and fees be capped at 20 percent of income, except when the former inmate has sufficient assets to pay more. And in cases where the custodial parent agrees, the report urges states to consider modifying child support orders while the noncustodial parent is in prison. Once that parent is released, child support should be paid first.

The states should also develop incentives, including certificates of good conduct and waivers of fines, for ex-offenders who make good-faith efforts to make their payments. Where appropriate, they should be permitted to work off some of the debt through community service. Beyond that, elected officials who worry about recidivism need to understand that bleeding ex-offenders financially is a sure recipe for landing them back in jail.

Here is what bothers me about this aspect of the penal system: the people who need to pay hefty fines -- those that commit white collar crimes, for instance (for example: insider stock trading), rarely have to pay fines and restitution equal to the amount they stole, swindled or conned from their victims and many times they are quite capable of paying it (even though it may mean that trusts that they created to be exempt from creditors have to be "pierced").

This is another reform that needs to be addressed, in my opinion.

Relief Bill for Homeowners Passes House

Relief Bill for Homeowners Advance

WASHINGTON (AP) -- Financial relief for homeowners facing foreclosure or in bankruptcy advanced in the House Thursday when the House approved legislation to help financially strapped homeowners.

The bill, passed by a 386-to-27 vote, would give a tax break to homeowners who have mortgage debt forgiven as part of a foreclosure or renegotiation of a loan. No taxes would be owed on the value of any debt forgiven or written off. Currently such debt forgiveness is taxable income.

While the measure is anticipated to reduce taxes of some strapped homeowners by $650 million, the cost to the government would be offset in part by limiting a tax break available on the sale of second homes.

...

The House vote was the latest congressional reaction to a mortgage crisis touched off this spring by a blowup in high-priced home loans for risky borrowers, throwing a pall over the economy. Foreclosures are at record highs and late payments are spiking. Lenders have been forced out of business and investors have taken huge financial hits.

An estimated 2 million to 2.5 million adjustable-rate mortgages - worth some $600 billion - will jump from low initial "teaser" rates to higher rates this year and next. Steep prepayment penalties have made it difficult for some to get out of their mortgages, and some overstretched homeowners can't afford to refinance or sell their homes.

To help offset the $650 million in tax revenue, the legislation makes it harder to get breaks on capital gains taxes for the sale of second homes. The White House supports the measure but wants mortgage relief to be in effect three years, not permanent as approved in the House. Bush also is opposed to limiting tax breaks on the sale of second homes.

The Mortgage Bankers Association expressed strong support for the bipartisan tax-relief bill but fiercely criticized another measure, opposed by Republicans on a House Judiciary subcommittee that narrowly approved passing it to the full committee.

That measure, which faces a contentious future in Congress, would revise the bankruptcy code to aid homeowners facing default and foreclosure. If enacted, it would further trim profits at hard-hit mortgage lenders.

The bill would allow judges to order mortgage lenders to ease terms for homeowners in bankruptcy proceedings. Currently, mortgage lenders can foreclose against a homeowner in default 90 days after a bankruptcy filing.

Mortgage lenders would be "terrified" of getting wrapped up in bankruptcy proceedings, said Brian Gardner, a research analyst with investment firm Keefe, Bruyette & Woods.

The MBA said in a statement: "Lenders will have no choice but to move to foreclosure right away to ensure that they are not covered by the onerous provisions of this bill. In the longer term, investors and speculators who overpaid for homes at the height of the housing bubble will have an incentive to file for bankruptcy, walk away from the loan and property, and reap an undeserved windfall."

The tax-relief bill is H.R. 3648.

The bankruptcy-related bill is H.R. 3609.

In response to the MBA, so the MBA should reap a windfall for engaging in what they knew -- or, at least, should have known -- was an overheated market (that they helped create)? Secondly, if you are in bankruptcy, where is the "windfall?" After all, isn't that a risk that lenders take when they make loans?

Securitization

Today, over at Sudden Debt, an anonymous commenter named Bernard left a comment on the post A Tale of Two Recessions:

Under the Basel Accord for every $100 of AAA securitized assets, a bank need only hold $0.60 of equity, to back up that debt. The theory is AAA assets are among the highest rated and thus the risk of default is virtually nil. However, for every BBB securitized asset, a bank would have to hold almost $5.00 of equity for every $100.

Gold: The Collapse of the Vanities

In other words, if a AAA-rated security is downgraded to BBB, the bank will have post up almost 10 TIMES MORE CAPITAL.

Where are they going to get that capital from at that point?

Are they going to sell the security?

I don't think so--there will be NO BID.

Bernard

The blog's author, Hellasious, responded thus:

Bernard,

You have hit upon a very important element in the whole MBS/ABS situation. While AAA paper won't be downgraded to BBB in one step, the combination of a series of consecutive downgrades and SIV assets going back onto balance sheets (and thus having to be covered by equity) means that the process of painful adjustment will take a long time. In other words, the credit crunch will last.

THIS IS NOT a replay of LTCM, for the simple reason that in its case the banks saved LTCM, so as not to get hurt themselves from the fallout. Today it is the banks/brokers that are in trouble: who's going to save THEM?

Or, to look at it another way: Who will save us from them?

Whose Entitlement Mentality?

David Brooks in his column last Friday in the New York Times, wrote a column entitled The Entitlements People. I am going to respond to some of his statements (and the general underlying presumptions of his argument). Let's start with an alarmist statement:

The U.S. government has $43 trillion in unfunded liabilities, or $350,000 for every taxpayer. Standard & Poor’s projects that in 2012, the U.S. will lose its AAA bond rating.

The current Gross Domestic Product of the U.S. is about $13 trillion. How these unfunded liabilities are supposed to equal over three times the entire annual U.S. economy is beyond me. Total tax revenues in 2006 equaled $2.4 trillion. The unfunded liabilities are supposed to equal almost 20 times annual tax revenues? Somehow that doesn't compute, either.

In a web post by a group called The Social Security Network entitled The "Unfunded Liabilities" Ruse who was responding to a USA Today article claiming that the U.S. Government would have a $53 trillion unfunded liability in the next four years in October 2004:

All of the grotesquely huge unfunded liability numbers spouted by scare mongers depend on forecasts that go out many decades, often hundreds of years. Such forecasts routinely go beyond the point where we could have any firm knowledge of what to expect. Of course, it is technically very easy to trace the implications of assumptions about future productivity, birth and immigration rates, labor force participation levels, and various costs over the next 20, 50, or even 1,000 years. These assumptions have implications for the age structure of the population, the rate of economic growth, and the cost of various government programs. Plugging those assumptions into a spreadsheet can tell us precisely how much Social Security or Medicare will cost us, extrapolated to eternity, if we like.

The problem is that over such long time horizons, small differences in those assumptions compound to huge variations in forecasts. If something (say health care costs) is growing faster than something else (say incomes) and we assume that this continues indefinitely, then eventually, what is growing fast will swamp what is growing slowly. That's arithmetic, not policy analysis.

Here it is in 2007 and now that number has shrunk to $43 trillion in Brook's column. Another assumption is that taxes will not be raised and/or inflation will not cause revenues to increase to meet those obligations. Again, from The "Unfunded Liabilities" Ruse post linked above:

The notion of "unfunded liabilities" in certain programs is based on the arbitrary assumption that certain designated revenue sources should pay for certain classes of government expenditures. The story that Social Security and Medicare should be paid for out of payroll taxes and their trust funds is not a recent creation of critics of those systems. It has been around for decades. But why? Revenues and expenditures are "fungible," meaning that a dollar is a dollar is a dollar. In fact, today's Social Security surplus flows right into the pot with other revenues, while a significant portion of Medicare costs already are paid for out of general revenue. The real question is not "will the designated revenues be enough to pay for the designated programs" but "will we have enough income to afford to keep the promises we have made?"

There is no question that the nation's gross domestic product will be sufficient to meet all of our Social Security promises forever, leaving lots of income for increasing the prosperity of the young. In general, the outlook for economic growth is good. Our average income per person in 100 years is likely to be much, much higher than it is today (more than four times as high). Social Security benefits are predicted to rise from about 4.5 percent of our GDP to about 6.6 percent over the next century. Even though such long predictions are very uncertain, this one should leave us sanguine: if incomes in 100 years are only twice their present level, and incomes of the old rise from 4.5 to 6.6 percent of income, that still leaves us with $1.96 for every dollar we have today, after Social Security obligations are taken care of. We can continue to keep our modest Social Security promises, and young families still will be much better off than families are today.

I agree with the conclusion The "Unfunded Liabilities" Ruse makes when they say:

Imagine if in 1950, someone had calculated the costs of educating the baby boomers in public institutions through their college years. What an immense, unmanageable burden! And nothing-not a penny-had been set aside by 1950 to cover the costs of public universities in the 1960s and 1970s! Using the logic of unfunded liabilities that has fueled alarmist media stories, public universities should have been closed; education should have been left to the private sector.

Yet nobody ever claimed in the 1950s and 1960s that the education of the Baby Boomers was an excessive burden our society, or that our public institutions could not afford to accept the challenge. When we needed more schools, we built them. Why should the Boomers' retirement be unmanageable? We need to strengthen social insurance for old people, and we will be able to afford it.

I hate to beat a dead horse, but I still think that many Americans would take advantage of Social Security as a full pension if they understood how unsecure their current pensions are.

I also want to focus on something else Brooks wrote:

Democrats vow to pay for their grand spending plans by raising taxes on the rich, even though each one percent increase in the top tax rate only produces $6 billion in revenue.

It's nice how he limits the question only to the top tax rate of income taxes. As I have pointed out before, the rich often don't pay income taxes. As Warren Buffett has tried to point out, people in his class almost always pay far lower capital gains taxes (which makes up most of their incomes). I'm curious how much an increase in the capital gains rate to, say, 30% (i.e. doubling the rate) would have on revenues. Tax revenues from capital gains were roughly $80 billion in 2005. Even if we assume that raising the rate would have some adverse effect on tax revenues, I think that $120 billion in revenue per year would not be out of the question. That would be an increase of $40 billion per year.

I think one of the problems is that even as inflation has caused incomes to rise, the payroll tax has not extended beyond $120,000 and taxes on the investor (wealthy) class is too low (even Warren Buffett agrees with this). Instead, it appears that Congress is content to sock it to the middle class through inflation's effect on the Alternative Minimum Tax (AMT).

Another major problem is that we are not paying for the government we know we need. The fact that tax revenues don't pay for the government that our elected representatives allocated ought to be a clue that tax revenues are lacking somewhere. Deficit spending is only supposed to take place during war or economic distress according to Keynesian theory. The debt is then supposed to be paid back when the economy rebounds or when the war is over. But we seem to be in a perpetual cycle of government deficit and ever-increasing government debt obligations.

The fact is that all government is nothing more than a very large service-based industry. Whatever services we deem necessary need to be paid for. With a $9 trillion national debt, we are obviously not paying for the services that we are utilizing.

I guess we all just feel entitled.

Cram Down

Sorry about the lack of posts, but the internet here is rather persnickety. It doesn't work half the time; and when it does work, it seems that I can't post for one reason or another. I also have the problem that sometimes I can only read one e-mail, and then it just locks up.

Anyway, back to reality...

In the news today, Bankruptcy Change Could Save 600,000 Homes:

NEW YORK (CNNMoney.com) -- One consumer group estimates that 600,000 foreclosures could be avoided over the next two years by making a simple change to the bankruptcy code.

The Center for Responsible Lending (CRL) calls it a tweak, but it could be a significant change for homeowners and the market for mortgage-backed securities.

CRL's proposal - reflected in a House bill recently introduced - would make changes to the regulations for Chapter 13 bankruptcies, which don't wipe out debts, but rather establish a repayment plan.

Under current law, when a person files for Ch. 13 bankruptcy, judges cannot reduce mortgage debt owed on a person's primary residence, although they may modify mortgages on investment property or second homes.

Under the House bill, the bankruptcy judge would have the option of reducing what the homeowner owes the lender. Say a homeowner's property is worth less than what he owes. The judge could reduce the principal to match the home's current market value as well as reduce the loan's interest rate.

The rest of the original principal would then be treated as unsecured. That means it becomes a lower priority for repayment than the borrower's secured debt, such as the newly reduced principal on his home. Unsecured debts may be discharged.

OK, indulge me while I give you some "inside" information. Allowing a debtor to pay what the collateral is worth on a secured debt is called a "cram down" in bankruptcy lawyer-speak. A recent Supreme Court case already allowed debtors to cram down the interest rate to the discount rate plus a point or two (or three) on personal items such as cars, furniture and jewelry. Before the 2005 changes, you used to be able to cram down cars, furniture and the like to their value as well. After the BAPCPA law was passed, the feeling among the debtor's counsel was that we should make car dealers "eat steel" unless they agreed to negotiate with the debtor on the price.

The proposed changes in the bankruptcy law would allow debtors to "cram down" the debt to the value of the house in the current market and it seems that they propose that the interest rate rule in Till v. SCS Credit Corp. be extended to houses as well.

I agree with the article that this is more than a tweak, but it is probably a necessary tweak. The representative for the mortgage industry is quoted in the article as saying:

If investors in mortgage debt knew that mortgages could be adjusted by the courts without the consent of the lender, that could increase their perceived risk and change their valuation.

Yes, and some would argue that that is precisely the problem. That is to say: mortgage backed securities (MBS) are not currently getting marked-to-market, but instead are getting marked-to-model.

I admit I am just a lawyer -- not an economist or Wall Street whiz kid. But if I am understanding it right, this article at Sudden Debt: Rocks, Hard Places and Pricing Models probably explains it pretty well. From Hellasious's post:

Which finally brings us to the subject of the pricing models used to issue and mark-to-model all those structured finance securities. It is quite obvious that the primary variable in all pricing models is their sensitivity to credit risk, i.e. the risk of default. During the "virtuous" cycle, when credit risk goes down, such models indicated higher prices, which were used to issue structured finance securities at higher prices and with higher proportions of readily salable AAA-A merchandise. But as the cycle turned "vicious" those models started throwing out lower prices - and when the credit risks signaled by the CDSs jumped suddenly and substantially, as happened in August, those model-calculated prices moved radically down, causing havoc in the balance sheets of existing CDO holders such as banks, SIVs and hedge funds. The trouble was further enhanced by the fact that many holders were highly leveraged, i.e. they had borrowed heavily through ABCPs and prime-bank margin to buy those securities. Judging by market action quite a lot of margin came from the yen carry tactic. Live by the sword, die by the sword...

But why did participants choose to mark-to-model instead of mark-to-market? Two reasons:

(a) Because of the fragmentation in the structured finance business there were thousands of "made to order" issues that had next to zero secondary market liquidity. Usually the issuers pledged they would maintain a secondary market, but for practical purposes this was an empty promise. Even in good times the spreads between quoted bid-offer prices routinely exceeded 5 points ($50 per $1000 face) and in tiny amounts (eg $500k). We call this "trading by appointment only". Therefore, they couldn't truly mark-to-market because there simply was no active market.

(b) During the "virtuous" cycle marking-to-model served to hide the enormous embedded fees paid by real money buyers in the new issue market. For example, pension funds bought large amounts ($50 million and more) of such securities at par, a price that routinely included 5-8% underwriting fees - an atrocious percentage for AAA-A bonds when bought in size. I know of several instances where fees even exceeded 10%. By comparison, highly rated agencies and straight corporates are issued with fees of 0.5-1%.

Which brings us to what could be the "next shoe to drop". As defaults in the mortgage and junk loan sectors rise, as they are already, the models will calculate significantly lower prices, particularly for those issues that were put together with overly optimistic default assumptions. I won't be surprised to see some issues eventually model-priced at 10-20 cents on the dollar, even if their prospects for partial recoveries mean that their true values are double that. In other words, just as the models produced "garbage" prices on the upside, they have the potential to come up with "garbage" prices on the way down.

Also, some mortgage companies don't want to negotiate precisely because they win even if all of their properties go into foreclosure, apparently. From today column by Paul Krugman in the New York Times Enron's Second Coming?:

But Countrywide made more questionable loans than anyone else — and its postbubble behavior does stand out. As Ms. Morgenson reported in yesterday’s Times, Countrywide seems peculiarly unwilling to work out deals that might let borrowers hold on to their homes — even when such a deal, by avoiding the costs of foreclosure, would actually work to the benefit of both sides.

Why block mutually beneficial deals? As the article points out, Countrywide can make money from the fees it charges on foreclosures, while the losses from mortgages that could have been saved, but weren’t, are borne by others.

I think this is an example of moral hazard at work.

Actually, changing the bankruptcy laws to allow debtors to "cram down" their mortgage debts just might be the thing we need to bring back some sanity to this insane housing market in much of the country.

Inflationary Depression Update

Most of the sites I explored to explain an inflationary depression turned out to be right-wing conspiratorial sites or Christian "the end is near" kind of sites (that often were also right-wing in their rhetoric). But I found a site written by David Petch that didn't come across as extremist or conspiratorial. Here is a some of what he wrote:

The US was the world’s power when it was the world’s largest exporter of oil and manufacturing center. Since the end of WWII, the US global output has declined from 50% to an estimated 20-22%. Dollars flow to sources of manufacturing, which now is the domain of China and India. The US economy has been rolling along with the aid of other countries purchasing US debt instruments to fund the current account deficit. Removal of this additional money and the US faces a sudden negative influx of capital. When this situation arises the US government has 2 choices:

Deflation, which would absolutely collapse the entire US economy to a functional level of less than 20% of the population.

Monetary inflation to cover the bills so that the economy hobbles along.

The important item to remember is that ALL global economies are linked and any country that expands its own currency will automatically cause monetary expansion of any country it does trade with. China has nearly 1 trillion US dollars in its reserve, but what if they lost 1 trillion with internal loans to cancel their reserves? They simply print a trillion of their own currency and buy more US debt. This perpetuates the cycle in which we exist, so until the consumer goes into the bunker, this facade will continue.

Once the consumer retreats and the bad loans begin to hit the banks, governments will have to bail out a multitude of companies to keep the economy running. Remember that if the debt is mopped up with mad money, then it matches and raises any money that evaporated, hence inflation. On this basis, it is nearly impossible to consider any form of deflation until the inflationary cycle is over.

War cycles are always inflationary and countries tend to go off of gold standards to ensure supplies and oil are not limiting to try and ensure victory. This has been the case for many currencies of the past 200 years and will continue into the future. Interestingly, Portugal, England, Spain and France during the 1500's to the 1700's were able to grow their economies by stealing gold from the South American countries during their global conquest phases. Their gold was basically free, which was able to feed their fleets and government purchases etc. With the abolishment of slavery and loss of control of the "New World" from feuds with other European countries and the locals, this form of a gold-backed currency system for funding wars and growth no longer exists. Stealing from other countries for nothing was a form of printing money except it came from the ground and went to European banks with no purchase of cash required. Today, instead of robbing countries of gold and silver, banks print money to allow credit expansion for citizens to go into debt to have a household containing the latest gadgets. Money today is basically digital, a total 360 going from physical to money transferred electronically.

Any attempt to implement a purely digital economy never could and never will exist. People would return to bartering and ignore the electronic money system, which would negatively affect government revenues. This would collapse economies, so I would hazard a guess this system would never fully be implemented. Most transactions nowadays are electronic but there always is the basic need to transfer money between individuals. Another reason to own gold and silver: the government can not trace it.

...

As I stated earlier, the amount of money circulating in the globe is expanding and just because the US is going through hard times does not remove inflation from the global scene. The scenario of an inflationary depression is what I would expect and is worse than a deflationary depression. During an inflationary depression the price of food and goods rises above many households’ range of affordability.

In the end, there will be a deflationary collapse following the current period of inflation and it will be due to a zero velocity of money compounded with plummeting manufacturing output. At this point in the future, owning cash and bullion will be important.

I don't know anything about David Petch's politics. But the explanation in Diatribes of Deflationists: Why They Are Still Wrong Pt. 2 comes across as a reasonable explanation of how an inflationary depression could happen.

Our Current Debt Problems Explained

The blog Sudden Debt has a good explanation of our current macroeconomic problems in the post Rocks, Hard Places and Pricing Models.

One great aspect of this post is that it defines commonly used acronyms and abbreviations on economic blogs and in news reports. Sadly, these abbreviations are rarely spelled out for ordinary readers and are thrown around by news reports, bloggers and commenters without definition or explanation. Here they are, with thanks to blogger Hellasious:

Abbreviation Key

ABCP: Asset-backed commercial paper
BIS: Bank for International Settlements
CDO: Collateralized debt obligations
CDS: Credit default swaps
CLO: Collateralized loan obligations
GFM: Global financial meltdown
ISDA: International Swaps and Derivatives Association
LBO: Leveraged buy-out
SIFMA: Securities Industry and Financial Markets Association
SIV: Structured Investment Vehicle

Here is a small snippet from his post:

American monetary policy and financial markets have been caught between a rock (huge debt) and a hard place (fundamental economic dislocations) for a considerable time; the effects have been visible since at least 2000, when the burst of the dotcom bubble necessitated sharp interest rate cuts and the strong dollar policy was abandoned by the Bush administration. The events of 9/11 further accelerated the rate cuts, to protect the US economy from the potential threats of a deflationary spiral.

Many blame Alan Greenspan for the current credit/asset bubble, unjustly in my opinion. The Fed was not responsible for the gutting of the American industrial base and the resulting explosion of the current account deficit, nor the deep neo-conservative tax cuts that ballooned debt. Finally, the Fed was certainly not responsible for the ruinous Iraq war. All the Fed could do was to combat the effects of these deeply misguided political choices with the blunt instrument of short-term interest rates. What was even worse, even this instrument became increasingly ineffective because the explosive rise of credit derivatives (CDSs), short-circuited monetary policy and kept driving long rates lower, even as the Fed was trying to push them higher (this "conundrum" was frequently mentioned by Greenspan). But this post is not an apologia for the past Fed Chairman. He can defend his own record while making a fortune as a best-selling author.

National Debt Madness

Paulson Asks Congress to Lift Debt Limit

WASHINGTON (AP) -- Treasury Secretary Henry Paulson told Congress on Wednesday the government will hit the current debt ceiling on Oct. 1.

He sought quick action to increase the limit, saying it was essential to protect the "full faith and credit" of the country, especially at a time of financial market turmoil.

The limit is $8.965 trillion. Unless Congress votes to raise it, the country would be unable to borrow more money to keep the government operating and to pay debt obligations coming due.

Actually having tax rates reflect what government services we have decided we need would be such a terrible thing, don't you know. According to the neoconservatives, borrowing and spending (and paying interest on the resulting debt) is far preferable to, you know, actually paying for it responsibly. Now if we could just get the Democrats to get a spine and stand up to the fiscally irresponsible neoconservatives, maybe we could actually have real discussion on what this country can really afford.

The real reason the neoconservative Republicans want to keep raising the national debt is to eliminate social spending through the Starve the Beast plan.

It really comes down to a values question of "guns vs. butter." I am curious if anyone has ever studied the return on investment of foreign entanglements where we try to acquire natural resources through military engagement vs. taking that same money and plowing it into America's infrastructure and alleviation of social ills. I think that we promote too much conflict in this world. There is too much spending on "guns" and not enough on "butter."

Countrywide

Hat tip to Calculated Risk

Read this story from the Chicago Tribune and see if you don't agree that that there is some serious need of judicial and congressional intervention to prevent these types of abuses. Here is part of it:

PITTSBURGH - For Donna and Steve Love, the plan seemed perfect.

Priced out of the Boston-area housing market, where 2-bedroom homes can cost about $500,000, the working-class couple thought it was time to head to a more affordable market.

They chose Pittsburgh. They liked the city, thought they could get jobs there and were sure they could afford a home without having to win the lottery.

After finding their home -- a $59,000, 3-bedroom, brick row house near the city's downtown that they paid for with a subprime loan -- they moved in June of 2006 and tried to settle into their new life.

But within a year, they were facing foreclosure, their relationship was strained to the near-breaking point and their emotions were in tatters as they tried to hold onto their home.

"Sometimes I feel like I have post-traumatic stress disorder," said Donna Love, 46.

Their story has been repeated thousands of times this year alone, as the subprime mortgage market, made up of loans to consumers with a higher default risk, continues its dramatic collapse.

...

The Loves qualified as subprime candidates because of their income level and because Steve Love, 30, had so little prior credit history.

"I believe in paying in cash," said Steve, who worked as a night manager at a CVS pharmacy near Boston, a job he expected to replicate by transferring to a Pittsburgh CVS store.

...

In March 2006, they reached what they thought were final terms for the loan: $5,000 down, a 7.75 percent interest rate, fixed for two years and then adjustable for the remaining 28 years, with a cap of 14.75 percent.

The $429 mortgage payments would be higher than they expected, but still within their budget -- equal to less than one week of Steve's salary with CVS. Plus, it was still cheaper than their $700-a-month rent in a suburb of Boston.

Then