Brown Web of Debt The Shocking Truth about our Money System (3rd ed)

Postscript

face value – right now almost 10 times their market worth. The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

. . . The catastrophic consequences of bond investors forcing originators to buy back loans at face value are beyond the current media discussion. The loans at issue dwarf the capital available at the largest U.S. banks combined, and investor lawsuits would raise stunning liability sufficient to cause even the largest U.S. banks to fail, resulting in 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 a lot of people to go to prison. If they knew about the fraud, they should have to buy the bonds back.23

The thought could send a chill through even the most powerful of investment bankers, including Henry Paulson himself. Olender notes that Paulson headed Goldman Sachs during the heyday of toxic subprime paper-writing from 2004 to 2006. Mortgage fraud was not limited to representations made to or by borrowers or in loan documents. It was in the design of the banks’ “financial products” themselves. One design flaw was that the credit default swaps used to insure against loan default contained no guaranty that the counterparties had the money to pay up. Another flaw was discussed in Chapter 31: securitized mortgage debt was made so complex that it was nearly impossible to know who owned the underlying properties in a typical mortgage pool; and without a legal owner, there was no one with standing to foreclose on the collateral. That was the procedural problem prompting Federal District Judge Christopher Boyko to rule in October 2007 that Deutsche Bank did not have standing to foreclose on 14 mortgage loans held in trust for a pool of mortgagebacked securities holders. The pool lacked standing because it was nowhere named in the recorded documents conveying title.24 If large numbers of defaulting homeowners were to contest their foreclosures on the ground that the plaintiffs lacked standing to sue, trillions of dollars in mortgage-backed securities could be at risk. Irate securities holders might then respond with litigation that could well threaten the existence of the banking Goliaths; and a behind-the-scenes bailout would be hard to engineer in those circumstances, since investor

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lawsuits are not easily hidden behind closed doors.

“We’re Not Going to Take It Anymore!” City Officials File Suit Against the Banks

The banks are facing legal battles on another front: disgruntled local officials have started taking them to court. A harbinger of things to come was a first-of-its-kind lawsuit filed in January 2008 by Cleveland Mayor Frank Jackson against 21 major investment banks, for enabling the subprime lending and foreclosure crisis in his city. City officials said they hoped to recover hundreds of millions of dollars in damages from the banks, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned houses. The defendants included banking giants Deutsche Bank, Goldman Sachs, Merrill Lynch, Wells Fargo, Bank of America and Citigroup. They were charged with creating a “public nuisance” by irresponsibly buying and selling high-interest home loans, causing widespread defaults that depleted the city’s tax base and left neighborhoods in ruins.

“To me, this is no different than organized crime or drugs,” Jackson told the Cleveland newspaper The Plain Dealer. “It has the same effect as drug activity in neighborhoods. It’s a form of organized crime that happens to be legal in many respects.” He added in a videotaped interview, “This lawsuit said, ‘You’re not going to do this to us anymore.’”

The Plain Dealer also interviewed Ohio Attorney General Marc Dann, who was considering a state lawsuit against some of the same investment banks. “There’s clearly been a wrong done,” he said, “and the source is Wall Street. I’m glad to have some company on my hunt.”

The Cleveland lawsuit followed another the same week, in which the city of Baltimore sued Wells Fargo Bank for damages from the subprime debacle. The Baltimore suit alleged that Wells Fargo had intentionally discriminated in selling high-interest mortgages more frequently to blacks than to whites, in violation of federal law. But the innovative Cleveland suit took much wider aim, targeting the investment banks that fed off the mortgage market by buying subprime mortgages from lenders and then “securitizing” them and selling them to investors.25

On February 1, 2008, the State of Massachusetts filed another sort of lawsuit against a major investment bank. The complaint was for

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fraud and misrepresentation concerning about $14 million worth of subprime securities sold to the city of Springfield by Merrill Lynch. The complaint focused on the sale of “certain esoteric financial instruments known as collateralized debt obligations (CDOs) . . . which were unsuitable for the city and which, within months after the sale, became illiquid and lost almost all of their market value.”26 The suit set another bold precedent that bodes ill for the banks.

The dark cloud hanging over Wall Street, however, has a silver lining for debtors and taxpayers. If Massachusetts prevails in its suit, tax burdens will be relieved; and if Cleveland prevails in its suit, the city could retrieve 10,000 abandoned homes that are now health hazards to their communities and sell them or rent them as low income housing. Following the precedent established by Judge Boyko in Ohio, home buyers served with foreclosure actions can demand to see proof of recorded title before packing their bags. And these legal successes, in turn, may empower other victims to rise up and say, “We’re not going to take it anymore.”

Private litigation can thwart the culture of greed, but a real solution to the debt crisis will no doubt take coordinated public action. As Mike Whitney observed in Counterpunch in February 2008:

When equity bubbles collapse, everybody pays. Demand for goods and services diminishes, unemployment soars, banks fold, and the economy stalls. That’s when governments have to step in and provide programs and resources that keep people working and sustain business activity. Otherwise there will be anarchy. Middle class people are ill-suited for life under a freeway overpass. They need a helping hand from government. Big government. Good-bye, Reagan. Hello, F.D.R.27

The problem with FDR’s solution was that he borrowed from banks that created the money as it was lent, putting the taxpayers heavily in debt for money the government could have created itself. A better solution would be for the government to spend without borrowing, using its own debt-free Greenback dollars.

That would be the better road to Oz, but whether the Emerald City can be reached before the land falls into anarchy and a police state is imposed remains to be seen. Will Dorothy’s house come crashing down on the Witch? Will she pull the silver slippers from the Witch’s feet and step into their magical power? Or will she keep running after humbug Wizards who are under the Witch’s spell themselves? Stay tuned . . . .

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GLOSSARY

Adjustable Rate Mortgage (ARM): a type of mortgage loan program in which the interest rate and payments are adjusted as frequently as every month. The purpose of the program is to allow mortgage interest rates to fluctuate with market conditions.

Bankrupt: unable to pay one’s debts, insolvent, having liabilities in excess of a reasonable market value of assets held.

Bear raid: the practice of targeting the stock of a particular company for take-down by massive short selling, either for quick profits or for corporate takeover.

Bears versus bulls: Bears think the market will go down; bulls think it will go up.

Book value: the total assets of a company minus its liabilities such as debt.

Bubble: an illusory inflation in price that is grossly out of proportion to underlying values.

Business cycle: a predictable long-term pattern of alternating periods of economic growth (recovery) and decline (recession).

Capitalization: market value of a company’s stock.

Cartel: a combination of producers of any product joined together to control its production, sale and price, so as to obtain a monopoly and restrict competition in that industry or commodity.

Central bank: a non-commercial bank, which may or may not be independent of government, which has some or all of the following functions: conduct monetary policy; oversee the stability of the financial system; issue currency notes; act as banker to the government; supervise financial institutions and regulate payments systems.

Chinese walls: information barriers implemented in firms to separate and isolate persons within a firm who make investment decisions from persons within a firm who are privy to undisclosed material

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Glossary

information which may influence those decisions, in order to safeguard inside information and ensure there is no improper trading.

Compound interest: interest calculated not only on the initial principal but on the accumulated interest of prior payment periods.

Conspiracy: an agreement between two or more persons to commit a crime or accomplish a legal purpose through illegal action.

Counterfeit: to make a copy of, usually with the intent to defraud.

Counterparties: parties to a contract, usually having a potential conflict of interest. Within the financial services sector, the term market counterparty is used to refer to national banks, governments, national monetary authorities and multinational monetary organizations such as the World Bank Group, which act as the ultimate guarantor for loans and indemnities. The term may also be applied to companies acting in that role.

Currency: Money in any form when in actual use as a medium of exchange, facilitating the transfer of goods and services.

Customs: duties on imported goods.

Deficit spending: government spending in excess of what the government takes in as tax revenue.

Deflation: A contraction in the supply of money or credit that results in declining prices; the opposite of inflation.

Demand deposits: bank deposits that can be withdrawn on demand at any time without notice. Most checking and savings accounts are demand deposits.

Depository: a bank that holds funds deposited by others and facilitates exchanges of those funds.

Derivative: A financial instrument whose characteristics and value depend upon the characteristics and value of an “underlier,” typically a commodity, bond, equity or currency. Familiar examples of derivatives include “futures” and “options.”

Discount: The difference between the face amount of a note or mortgage and the price at which the instrument is sold on the market.

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Equity: ownership interest in a corporation.

Equity market: the stock market – a system through which company shares are traded, offering investors an opportunity to participate in a company’s success through an increase in its stock price.

Excise taxes: internal taxes imposed on certain non-essential consumer goods.

Federal funds rate: the rate that banks charge each other on overnight loans made between them.

Federal Reserve: the central bank of the United States; a system of federal banks charged with regulating the U.S. money supply, mainly by buying and selling U.S. securities and setting the discount interest rate (the interest rate at which the Federal Reserve lends money to commercial banks).

Federal Reserve banks: The banks that carry out Federal Reserve operations, including controlling the money supply and regulating member banks. There are 12 District Feds, headquartered in Boston, New York, Philadelphia, Cleveland, St. Louis, San Francisco, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and Dallas.

Floating exchange rate: a foreign exchange rate that is not fixed by national authorities but varies according to supply and demand.

Fiat: Latin for “let it be done;” an arbitrary order or decree.

Fiat money: Legal tender, especially paper currency, authorized by a government but not based on or convertible into gold or silver.

Fiscal year: The U.S. government’s fiscal year begins on October 1 of the previous calendar year and ends on September 30.

Float: The number of shares of a security that are outstanding and available for trading by the public.

Fraud: a false representation of a matter of fact, whether by words or by conduct, by false or misleading allegations, or by concealment of that which should have been disclosed, which deceives and is intended to deceive another so that he shall act upon it to his legal injury.

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Free trade: trade between nations unrestricted by import duties, export bounties, domestic production subsidies, trade quotas, or import licenses. Critics say that in more developed nations, free trade results in jobs being “exported” abroad, where labor costs are lower; while in less developed nations, workers and the environment are exploited by foreign financiers, who take labor and raw materials in exchange for paper money the national government could have created itself.

Globalization: the tendency of businesses, technologies, or philosophies to spread throughout the world, or the process of making them spread throughout the world.

Gold standard: a monetary system in which currency is convertible into fixed amounts of gold.

Gross domestic product: the value of all final goods and services produced in a country in a year.

Hedge funds: investment companies that use high-risk techniques, such as borrowing money and selling short, in an effort to make extraordinary capital gains for their investors.

Hyperinflation: a period of rapid inflation that leaves a country’s currency virtually worthless.

Inflation: a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.

Infrastructure: the set of interconnected structural elements that provide the framework for supporting the entire structure. In a country, it consists of the basic facilities needed for the country’s functioning, providing a public framework under which private enterprise can operate safely and efficiently.

Investment banks help companies and governments issue securities, help investors purchase securities, manage financial assets, trade securities and provide financial advice. Unlike commercial banks, they do not take deposits or make commercial loans; but the lines have blurred with the 1999 repeal of the Glass Steagall Act, which prohibited the same bank from taking deposits and underwriting

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securities. Leading investment banks include Merrill Lynch, Salomon Smith Barney, Morgan Stanley Dean Witter and Goldman Sachs.

Legal tender: money that must legally be accepted in the payment of debts.

Leveraging: buying with borrowed money. Leverage is the degree to which an investor or business is using borrowed money.

Liquidity: the ability of an asset to be converted into cash quickly and without discount.

Margin: an investor who buys on margin buys with money he doesn’t have, borrowing a percentage of the purchase price from the broker, to be repaid when the stock or other investment goes up. People usually open margin accounts, not because they’re short of cash, but because they can “leverage” their investment by buying many times the amount of stock they could have bought if they had paid the full price.

Margin call: a broker’s demand on an investor using borrowed money to deposit additional money or securities to bring the margin account up to a certain minimum balance. If one or more of the investor’s securities have decreased in value past a certain point, the broker will call and require the investor either to deposit more money in the account or to sell off some of the stock.

Monetize: to convert government debt from securities into currency that can be used to purchase goods and services.

Money market: the trade in short-term, low-risk securities, such as certificates of deposit and U.S. Treasury notes.

Money supply: the entire quantity of bills, coins, loans, credit, and other liquid instruments in a country’s economy. “Liquid” instruments are those easily convertible to cash. The money supply has traditionally been reported by the Federal Reserve in three categories – M1, M2, and M3, although it quit reporting M3 after March 2006. M1 is what we usually think of as money – coins, dollar bills, and the money in our checking accounts. M2 is M1 plus savings accounts, money market funds, and other individual or “small” time deposits. M3 is M1 and M2 plus institutional and other larger time deposits (including institutional money market funds) and eurodollars (American dollars circulating abroad).

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Moral hazard: the risk that the existence of a contract will change the behavior of the parties to it; for example, a firm insured for fire may take fewer fire precautions. In the case of banks, it is the hazard that they will expect to be bailed out from their profligate ways because they have been bailed out in the past.

Mortgage: A loan to finance the purchase of real estate, usually with specified payment periods and interest rates.

Multiplier effect: according to Investopedia, “the expansion of a country’s money supply that results from banks being able to lend.”

Oligarchy: government by a few, usually the rich, for their own advantage.

Open market operations: the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system.

Ponzi scheme: a form of pyramid scheme in which investors are paid with the money of later investors. Charles Ponzi was an engaging Boston ex-convict who defrauded investors out of $6 million in the 1920s, in a scheme in which he promised them a 400 percent return on redeemed postal reply coupons. For a while, he paid earlier investors with the money of later investors; but eventually he just collected without repaying. The scheme earned him ten years in jail.

Posse comitatus: a statute preventing the U.S. active military from participating in American law enforcement.

Plutocracy: a form of government in which the supreme power is lodged in the hands of the wealthy classes; government by the rich.

Privatization: the sale of public assets to private corporations.

Proprietary trading: a term used in investment banking to describe when a bank trades stocks, bonds, options, commodities, or other items with its own money as opposed to its customers’ money, so as to make a profit for itself. Although investment banks are usually defined as businesses which assist other business in raising money in the capital markets (by selling stocks or bonds), in fact most of

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the largest investment banks make the majority of their profit from trading activities.

Receivership: a form of bankruptcy in which a company can avoid liquidation by reorganizing with the help of a court-appointed trustee.

Reflation: the intentional reversal of deflation through monetary action by a government.

Republic: A political order in which the supreme power lies in a body of citizens who are entitled to vote for officers and representatives responsible to them.

Repurchase agreement (“repo”): The sale or purchase of securities with an agreement to reverse the transaction at an agreed future date and price. Repos allow the Federal Reserve to inject liquidity on one day and withdraw it on another with a single transaction.

Reserve requirement: The percentage of funds the Federal Reserve Board requires that member banks maintain on deposit at all times.

Security: A type of transferable interest representing financial value; an investment instrument issued by a corporation, government, or other organization that offers evidence of debt or equity.

Short sale: Borrowing a security and selling it in the hope of being able to repurchase it more cheaply before repaying the lender. A naked short sale is a short sale in which the seller does not buy shares to replace those he borrowed.

Specie: precious metal (usually gold or silver) used to back money.

Structural adjustment: a term used by the International Monetary Fund (IMF) for the changes it recommends for developing countries that want new loans, including internal changes (notably privatization and deregulation) as well as external ones (especially the reduction of barriers to trade); a package of “free market” reforms designed to create economic growth to generate income to pay off accumulated debt.

Tariff: a tax placed on imported or exported goods (sometimes called a customs duty).

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