Mortgage firms that have survived through two massive financial crises in the past 25 years will be receptive to the thesis that all financial meltdowns have fraud at their centers.
"Fraud is the force that generates all financial crises," according to "Financial Stability," a new book by Frederick L. Feldkamp and R. Christopher Whalen (Wiley). And to eliminate crises, "we must strongly enforce prohibitions on financial fraud."
The authors, both of whom have long histories in the mortgage industry (Feldkamp is a retired partner at Foley & Lardner LLP, while Whalen is senior managing director at Kroll Bond Rating Agency) take a very long view of fraud, as well. They go back as far as the laws of Moses (banning the use of two financial measures for one item, the source of the word "duplicity") and Christ's turning the moneychangers out of the Temple of Jerusalem.
In their view, what goes around comes around. They tag the great crisis of 2008 as "a moneychangers' fraud," that cost the world economy $67 trillion.
Wringing fraud out of the financial system would help achieve financial stability, the "Goldilocks' economy" of monetary equilibrium where finance is neither too hot nor too cold, they write.
They also have some ideas for positive actions that can help bring this equilibrium about. Chief among these are the elimination of off-balance sheet liabilities and the use of "risk-free arbitrage" as embodied by the proper use of collateralized mortgage obligations.
Risk-free arbitrage, they say, "is the foundation on which investors can sustain financial stability and economic prosperity around the world."
And, there is a mechanism, which can be checked daily, that can be used to take the economy's temperature to see if things are heating up or slowing down too quickly. When corporate bond spreads start getting out of whack, that is a good indication of financial instability, according to the authors.
Feldkamp helped develop the CMO back in the 1970s, and the authors are high on the instrument, if it is used properly.
In their view, the CMO is "the only financial innovation of the past several centuries that, when properly implemented, generates profit merely by altering the intermediation process." Done right, it allows intermediaries to buy mortgages at low prices and to sell securities at higher prices: "a 'perfect' riskless arbitrage."
One big caveat to this, though: if misused, CMOs can generate "toxic waste." And they have, including causing a big part of the meltdown of 2008.
Since both the good and bad CMOs (Whalen calls the bad ones "exploding duration instruments" that morphed from short-term to long-term) have been issued, I asked Whalen which type would win out in the future. The author (he spent four months editing and adding to a manuscript of Feldkamp's) is hopeful the good ones can prevail.
"A lot of structures you see in the markets today are much simpler," he said. These should be "done as public deals. If it's a registered deal you have an obligation to disclose. The question is, can you educate regulators and others to understand the difference and punish those misusing them."
The bad CMOs, used by government-backed banks and GSEs to create off-balance sheet financial monopolies, created $30 trillion of hidden leverage (shadow banking) to manipulate prices in the U.S., the authors write.
But correct use "gives stand-alone CMOs the power to prevent financial crises by drawing credit spreads towards equilibrium." The authors call stand-alone CMOs "a financial shock absorber they solve the last major problem in macroeconomics."
"Financial Instability" is a refreshing change from the kind of business books that trot out bland pronouncements and follow them with mathematical equations understandable only by those with advanced degrees in economics.
So, in addition to Biblical law, these pages quote "The Battle Hymn of the Republic" and a poem by Henry Wadsworth Longfellow and stop to look at some interesting frauds past, like the British "South Seas panic" and the 1980s' thrift disaster, as well as the economies of ancient Rome, China and the Incas of Peru.
Taking the long view again, the authors say the solution to financial instability has been sought for 2000 years. "We submit that it lies in the public reporting of credit spreads and other bond market data, and in the use of financial structures that contain spreads."
Mark Fogarty, Editor at Large at National Mortgage News, brings more than 30 years of experience to his analyses of the mortgage market.