Repo Man

You may have heard about some charges laid against Lehman Brothers, the first domino in the ongoing financial collapse. Those charges are starting to ripple out and hit others in the financial arena.

First, a primer on what they did. According to a bank examiner’s  2,000-plus page report, Lehman Brothers engaged in what is called repo transactions, repo being short for repurchase.

A parable: You are looking to get a second mortgage on your home. Problem is, your financial situation is not great. Chief among your problems is that you loaned $50,000 to your no-good Cousin Vinnie, and he isn’t making payments all that regularly. You realize that you will be lucky to get half the dough out of him.

You have a clever idea. You go to your rich Uncle Bob with a proposition. You will sell him Vinnie’s loan for $50,000 cash. Then, a month later, you’ll buy the loan back for $50,000 cash, plus a little for his trouble. Uncle Bob agrees and you deposit the $50,000. Then you apply for a loan with this big wad of cash in your account. The bank considers you a decent risk and gives you the loan. A few weeks later, Uncle Bob gets his $50k back and you are still stuck with Vinnie. The law has a word for this: Fraud.

Lehman Brothers did the exact same thing, substituting worthless bundled mortgages for Cousin Vinnie’s loan, other banks for Uncle Bob, and fifty billion, with a “b” for that fifty thousand. They temporarily ditched a mass of their CDOs when they were about to file quarterly reports and called it a permanent sale. Thus they managed to look good on paper at the moment that people, including regulators, were looking. Their CEO, Richard Fuld, and several top managers have been implicated, as well as Ernst & Young, the firm that audited them.

So far, no shocker. Big Wall Street firm gets in too deep and commits acts of fraud. But then there are the ripples. Timothy Geithner, once Chair of the New York Fed, now Treasury Secretary, is getting increasing criticism for his lack of oversight. He’s accused of cronyism and bad judgement. Geithner is widely considered to be the one who could have and should have acted earlier to end both the risky business and the fraud that covered it.

Over at Naked Capitalism there is a letter from an anonymous employee at a financial firm reporting multiple instances of non-Lehman repo transactions. Widespread repo fraud in the financial industry? Again, no shock, but a growing sense of unease. As rotten as it all looks on the surface, could it be even less resilient with the whitewash rinsed off?

Mike Konczal at New Deal 2.0 writes cogently about the problem of second liens, that is second mortgages and home equity loans. Apparently the big four of the banking industry, Citi, Bank of America, Wells Fargo, and JP Morgan, are holding just under half a trillion dollars in second liens. The problem with this is that a number of other banks are under pressure to devalue the first mortgages to be in line with actual house values. Since the second liens are second in line for payment, in that case that half a trillion dollars becomes, well, zero. The big four can fight to be first in line for repayment, but that leaves the homeowners under water and financially tapped out. This would mean that the other banks that hold the first mortgages end up with the big holes in their balance sheets. It’s like a twin-sized blanket on a king-sized bed; not everyone is going to be able to cover their asses.

When this deficit hits the mainstream consciousness we can expect a major loss of confidence and a problem for the Obama Administration. Do they pitch another few hundred billion down the fraud hole? Or do they stand by and watch the big four slowly topple? It’s both politically and financially wretched either way. It’s looking like a double dip recession, both in Washington and Wall Street.