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Cutting the Gordian Knot of Bad Contracts to Save the Economy

by Roel 1943

Gordian Knot by Roel 1943

One of the main reasons why the financial crisis is not getting significantly better is that governments are not willing to forcefully break contracts.

This may seem like a good thing. Who wants governments to break contracts? But the problem is that contracts as now written are adding to the crisis. Mortgages, for example, cannot be lowered to costs that homeowners can actually carry because the ownership of the derivatives those mortgages were packaged into makes too many people into owners. Even if you were able to figure out all the owners, getting dozens or even hundreds of people to all agree to modify the contract is effectively impossible. And if you modify it anyway, all it takes is one person to sue for breach of contract. In short, banks can’t modify the terms of most mortgages, because they are only intermediaries servicing the mortgages, they don’t own them.

When mortgages aren’t rewritten to make them more affordable, homeowners have to walk away from them. When they do that the cost is much higher than if the default had occurred in the first place – the municipalities lose the tax income, the owners of the mortgage wind up with a property that can’t pay back the loan either, more losses cascade into the system, causing one of the spirals we discussed above.

And it all happens in slow motion-one house at a time, one contract at a time, one family at a time. It drags on and on. No floor is being put under the market, and uncertainty abounds. No one can know how long this will go on or how bad it’s going to be. If a wholesale rewrite was allowed, then the losses could be figured out.

Even if a retail rewrite was allowed, as in the proposed changes to bankruptcy law, which would allow judges to rewrite the terms of mortgages, estimates could be made. Such rewrites, done properly, would follow the principle of "what can the family manage" and rules of thumb like "30% of earned income typical of the neighborhood". You can much more easily figure out what the value of collateralized debt obligations are in such a case.

The problem, though, is larger than this. Fundamentally, most of the instruments at the heart of the financial crisis were sold based on fraud.

The mortgage backed CDOs were sold based on the assumption that a bubble in housing would continue forever, many of the homeowners’ financials were deliberately not checked, and the mortgages were designed with resets which made higher default rates quite likely, but those high default rates weren’t factored into the returns and risk sold to investors. Meanwhile homeowners were sold mortgages with the implicit assumption that housing prices would go up forever and there would never be another recession so "sure, you’ll always be able to make the payments."

This was fraud—it was fraudulent to the investors who bought repackaged securities and it was fraudulent to the homeowners. Yes, caveat emptor, but the fact of the matter is that consumers rely on banks to explain these things to them, and assume that banks won’t sell them loans they can’t service. This assumption was wrong in the bubble years, because unlike banks in prior years the banks issuing the mortgages knew they were going to sell the mortgages on the secondary market and therefore thought that if they went bad they wouldn’t be holding the bag. And if they weren’t going to hold the bag, well why worry about if the homeowners could pay the vig or if the assumptions that underlay the promised earnings were in any way valid?

In other words banks and other mortgage brokers sold mortgages to homeowners without due diligence and based on fraud, and they then sold the repackaged mortgage revenue streams to investors based on fraudulent promises about due diligence, revenue and risk. And buyers of those revenue streams didn’t look very closely at it either. They wanted, in most cases, bonds with the risk of treasuries, but with higher earnings. They wanted, in effect, free money. What they got, instead, was a pig in the poke.

This is also true with credit default swaps. Credit default swaps are just insurance. If Fred doesn’t pay up on the money he owes you, Jeanne will make it up. But unlike regular home or life or car insurance, there were no mandated actuarial tables and no mandated reserves. Anybody could write the things, whether they had the money to back it up if large numbers of them went bad, and anyone could use any math they wanted to figure out what the likely risk and premium was. As with the mortgage industry, the assumptions they baked into the formulas were flawed. In essence, most CDS’s assumed that there could never be a time when a lot of defaults all happened at the same time. Of course, the way economies work is that defaults and bankruptcies do tend to cluster. As a friend of mine likes to say "recessions are like death. You may not know when the next one is going to happen, but you do know that it IS going to happen." The models, in essence, assumed no recession, in many cases not even a mild one.

All of this was done explicitly in ways intended to avoid regulation. Contracts were sold which stated that they could never, ever be sold on an open traded market – never be sold on something like the Chicago Board of Trade or the New York Stock Exchange. If they had been, regulators could have gotten their dirty hands on them and started to insist on some standards. But writing that into them means that they were in effect designed to make sure that they were illiquid – that there would be no large public market where large numbers of them could be sold and prices could be set in an open way.

Illiquid, based on fraud and designed specifically to avoid regulators forcing them to be based on proper mathematical principles and assumptions of risk.

In other words, fraudulent.

Now the fraud here goes all the way around. The banks were fraudulent, the customers were complicit. The people who were least complicit, in my mind, were unsophisticated individuals involved who took out mortgages. That’s not to say there was no complicity, many people took on debts they should never have taken on, a subset lied on the applications (knowing the bank wouldn’t check, since the bank told them it wouldn’t check) and so on. The customers who bought these sophisticated instruments were much more complicit. If you’re buying a CDO, and you’re rich or you represent a large corporation, investment fund, municipality or what have you, you are assumed to have the financial knowledge that ordinary people don’t have, you are expected to do much more due diligence. And if you don’t understand the instrument, the old rule applies: never invest in a business where you can’t figure out how it works.

The most complicit, the most fraudulent, were the organizations that designed, packaged and sold these instruments. As with so much in the past 8 years the question is "stupid, or evil?" The answer is "why not both?" If they didn’t know that the instruments were based on completely BS assumptions and lack of due diligence then they were incompetent and stupid. If they did and sold them anyway, they were evil.

Either way an entire financial economy was built up around fraud.

Modern capitalist civilization, perhaps even older civilizations, may have as one of its most important tasks the enforcement of contracts, but it has long been a principle that a contract entered into which was based on fraud or force is not a valid contract and the government does not have to enforce it.

Or rather, the government is not required to pay it off. What is happening now, what has been happening, is the government either making good or guaranteeing losses. Not making good the losses of the little people, the people who took out the mortgages or who are losing their jobs as a result of the financial meltdown, but making good the losses of the investing class and the financial sector. The Fed and Treasury together as of November 28 had already spent, loaned, committed, guaranteed and floated 7.36 Trillion dolars. By now we can assume it’s well over 8 trillion.

Now all of that money isn’t gone forever, some of it will come back. Other reports are now saying that the banking sector is down 2 trillion (I’m pretty sure that’s too low, remembering that we’re in a downward spiral), which as Dean Baker notes, means that the banks are, as a group, bankrupt.

If the decision is made to pay this stuff off, essentially at close to face value rather than real value, then not only has what amounts to fraud been rewarded, but the full cost must be paid. That money will be borrowed, and in this context, what that means is this: the future will pay for the fraud of the past. For twenty years or more American citizens will pay higher taxes and have lower incomes than they would have otherwise, because they will be paying off bets based on fraud. It will be the most massive transfer of wealth from ordinary Americans to the wealthy in the history of America.

And the best case scenario is that it will lead to Japanification, which is to say, to a long period of lousy economic growth, where you never, ever seem to get a decent economy for very long and you are constantly slipping back into recession. The reason it will lead to this is that the money which should be used to invest in growth will be used to pay back the money taken out to pay off the bad bets of the financial sector. And proceeds from what growth there is will also have to be used to pay it back, which means there will be less money for reinvesting in the economy.

The fraud of the past will strangle the prosperity of the future.

Now this isn’t to say that money isn’t going to have to be spent. It is. The money has been lost. There is an entire bankrupt financial sector, there are houses losing value by the day and there are businesses, municipalites and states which are hurting badly.

What it does mean, however, is that these contracts are going to have to be broken so that losses can be apportioned fairly and because asking the government to enforce contracts based on fraud is fundamentally unfair. What it also means is that the investing and financial class needs to be forced to take rather more than a haircut, they need to bleed. Every bank that is bankrupt needs to be nationalized and the stockholders need to be wiped out. Every bank that is bankrupt needs to have auditors go over the books and claw back all bonuses paid which were based on fraud. Every financial firm which is bankrupt needs to be nationalized and the creditors need to take a haircut, because if it wasn’t nationalized or subsidized by taxpayers, it’d go bankrupt and at best they’d get cents on the dollar. So cents on the dollar is all they can reasonably expect, but if they cooperate, perhaps they can get a few more cents on the dollar.

All of this will allow us to take as much of the losses now as possible, so that as few of them are being paid for forever. Get the monkey of debt off the back of both the public and firms, so that they can grow again.

In this scenario, everyone’s going to take it on the chin. Taxpayers, investors, bank executives, homeowners — everyone. But the people who will take it on the chin the most are people who benefited in the past from the fraud that was committed.  Not only is this fair, not only does it mean that they are less likely to do it again thinking they’ll be bailed out again, but it means that as much as possible the mistakes of the past, the debts of the past, will not burden the future.

But doing this requires cutting a number of Gordian knots. It means invalidating or forcing rewrites of whole classes of contracts. It means wiping out huge numbers of shareholders. It means forcing writedown by bond holders. It means hurting, badly, the financial executive class who have virtually run the US economy for twenty years. It means you’re going to have to hurt a lot of very powerful, very rich people who have bought a lot of influence with both Democrats and Republicans over decades.

The alternative, however, is for the fraud of the past to strangle the hopes and prosperity of the future, and for ordinary Americans to foot the bill for the fraud and extravagance of the rich, and receive nothing in return.

If your first goal is the well being of America and the majority of most Americans, this shouldn’t be much of a choice.

Let us hope that it comes to be seen that way.

Further Reading:

Bad Modeling, Early Profit Taking and Undercapitalization in Credit Default Swaps

An Explanation of what CDOs are and the process of securitization

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Ian Welsh

Ian Welsh

Ian Welsh was the Managing Editor of FireDogLake and the Agonist. His work has also appeared at Huffington Post, Alternet, and Truthout, as well as the now defunct Blogging of the President (BOPNews). In Canada his work has appeared in and BlogsCanada. He is also a social media strategy consultant and currently lives in Toronto.

His homeblog is at