Mortgage Reform: Why Government Intelligence is Oxymoron

This post first appeared on Minyanville and our sister site Dawn Patrol.

After leading the banking sector to its largest ever one-day drop yesterday, Washington Mutual (WM), in an effort to assuage concerns that it's facing a cash crunch, released a statement claiming that the bank is "well-capitalized."

Though the stock bucked the trend this morning as the broader financial complex continued its unrelenting sell-off, shareholders aren’t likely to be comforted by the WaMu’s pleas for calm.

The largest savings-and-loan in the country has seen share prices fall below $4 following the seizure of IndyMac (IMB) by benevolent federal banking regulators; investors fear WaMu could be next.

IndyMac was reopened on Monday to handle endless lines of depositors hoping to recover their pennies from the bank’s coffers.

In a stark reminder of just how dicey bottom-picking can be, Bloomberg reminded us that private-equity firm TPG led a consortium of investors in providing the bank with $7 billion in much-needed cash in April, when the stock traded at $13. Those daring saviors have seen most of their investment wiped out.

TPG did, however, slip a protective clause into the deal: If the stock drops below $8.75 -- which it clearly has -- TPG is owed the difference, effectively putting the bank on the hook for its own equity losses. While protecting TPG's investment, this feature also makes it considerably more costly, if not impossible, for the bank to raise more capital, which would further dilute shares.

As more details emerge about these and other onerous terms with which banks have been forced to agree in their efforts to raise capital, it's becoming clear just how misguidedly optimistic investors were when such deals were first announced. Banking expert Minyan Peter wrote of the WaMu deal:

“I think the problem for most market participants right now is the assumption [that] what we're experiencing looks something like 'their prior experiences in banking crises.' And to me, that's why we have seen such a big rally over the past two weeks -- because, based on prior experience, a rally feels very right, right about now.

But for all the reasons I shared before, this one is different.”

We’re now seeing just how different this one is.

Professor Depew explained Friday how the Fannie Mae (FNM) and Freddie Mac (FRE) crisis is different from the Long-Term Capital Management failure in 1998: In this case, massive losses by financial institutions around the world are a symptom, not the cause.

A few misplaced bets aren’t to blame for the market turmoil; neither is rumor-mongering. The financial system’s problems, and by extension the economy’s, are rooted in years of mispriced risk and excessive leverage. Markets are now witnessing the destruction of that debt at a rate that’s stomach-churning to the traditional buy-and-hold investor.

The process, though painful, is necessary. The debt will be destroyed, firms will go out of business and the economy will slow, if not contract. All this is healthy. Agonizing, to be sure, but healthy.

As Toddo wrote yesterday on the Buzz and Banter, “The big picture blues will lead to an unfortunate destination, but that’s necessary to rebuild the foundation for sustainable economic growth. Once we get there, those with capital will be in a fantastic position to prosper.”

The Silent Killer

What's the silent killer that's been largely ignored by the financial media as it tries to keep up with the quickly unraveling mortgage crisis? Fraud.

While there are many causes for the current meltdown, the most unexplored and and least discussed is fraud. FraudBlogger.com reported yesterday that there were $1.7 billion active cases of criminal and civil fraud reported in the second quarter of 2008.

While large, this number is painfully low and doesn't come close to capturing what was really going on in the mortgage origination business from 2005-2007. Every time a loan officer put a borrower into a loan he couldn't afford or didn't understand, the loan officer committed fraud. The vast majority of these loans are still out there, and the tabulated fraud data doesn't pick them up.

Every time an appraiser valued a property based on the lender's demand for an overstated value, the appraiser committed fraud. You and I, the taxpayers, will now get to foot the bill for all that equity appraisers created out of thin air to maintain the facade of unbiased property valuations.

Every time an accountant booked the fully amortized interest payment as income for an Option-ARM borrower making the minimum payment, while adhering to GAAP, we can all agree there isn't any chance that money will find its way to the bank's coffers. By the time the loan's written off, it will be lost in a web of billions in writedowns, and the accountant will be on to mis-pricing some other asset sitting on the bank's books.

And people still wonder why the mortgage mess keeps getting worse than even the most boogly bears have expected.