Regulator Revenge: There's a New Sheriff in Town

Back in September I did a piece called The Psychology of Asset Cycles where I tried to lay out a roadmap for the unwinding of asset bubbles and the various phenomena that are commonly seen along the way, which might serve as a guide for what was to come. I talked about the outsized leverage employed in a bubble - oftentimes not widely known or understood until after the fact - as well as the high incidence of fraud in bubble assets, etc. We have been seeing all of this play out in the residential real estate market. The deflating of the bubble has been following the script very closely. That's why I want to revisit a concept I call Closing the Barn Door. In my piece I wrote...

The last phase of the saga is the closing of the barn door. This happens of course when the horse is in the next county and wreaking havoc there. The great legislators of our country wake up to the fact that an asset bubble caused misbehavior intentional and unintentional and they create laws to protect the populous from this ever happening again.......... Importantly, these laws make the pain in the asset worse and really put the nail in the coffin. Whereas before you could borrow to your heart's content to leverage an asset, the new rules significantly impede the ability to do this, making the asset less profitable to play in, so more people sell it. The related professions that were supposed to have some watchdog function in the industry that failed, like bond rating agencies and real estate appraisers get, tarred as criminals.

Before we go any further let me state for the record: I don't have anything against bankers, investment bankers, appraisers, mortgage brokers, sub prime borrowers or lenders, regulators, rating agencies, bond insurers, et al. Did some of these guys do nefarious things? Undoubtedly! Are they all evil? No. It's the bubble people. Greed makes people do crazy, illegal, unethical, immoral and flat out stupid things. It's human nature. People who crossed the line into illegal territory will be punished. I view the rest as victims of human nature....same as it ever was.....same as it ever was. The mistakes that will be maid by overzealous lawmakers and regulators are part of the same cycle...so don't hate these guys either.

Let's check out the beginning phases of the Barn Door Closing now underway - and remember the key here is that the closing of the barn door makes the bear market in the asset even worse than it has to be. As you will notice, the allegations, accusations, finger pointing and "regulating" are starting to take place up and down the supply chain of residential housing.

First off, have no worries because the FBI is now on the case. The G-men have reportedly launched a probe of the sub prime crisis with 14 criminal investigations launched. Really makes you want to be in the mortgage business, right? No wonder as Noah noted this morning, mortgage rates are going up while the Fed slashes Fed fund rates.

An appraisal fraud conference was held in St. Petersburg, Florida. Joni Herndon, the incoming Chairwoman of the Florida Real Estate Appraisal board, was interviewed there. She had some harsh things to say about her own peers. "In most cases, you can't have mortgage fraud without an appraiser. A fraudster is not going to pay cash for a home. They have to get a lender, who hires an appraiser to inflate the value. The appraiser is key to mortgage fraud. She also commented about the increased level of complaints by the public about her colleagues. "In 2000, we had 220 complaints. For the 2006-2007 fiscal year, it was up to 681. At our last meeting, we revoked eight licenses. We're also getting five times as many voluntary surrenders of license". Real punishments are being meted out for illegal behavior. One Arlington, Texas appraiser was sentenced to 5 years in prison.

Now some appraisers are striking back at the system that put them under intense pressure to play ball. WaMu is being sued by an appraiser who claims she was blacklisted for giving a housing market forecast that was too downbeat. She has company: a 2006 national survey of appraisers reportedly found 75% said they got stiffed on fees or didn't get future business if they refused to inflate home values.

Further, up the line from the home valuation process there is an arcane business conducted by mortgage loan due diligence firms. These companies will scrutinize a certain percentage of the loans that are being submitted by a Wall Street firm into a pool of mortgage backed bonds set for securitization. Apparently, some of these firms warned their Wall Street clients that a decent percentage of the bonds going into securitization pools did not conform to their clients' own quality standards, but they were overridden and these mortgages were allowed to get to market as part of MBSs. Attorney General Andrew Cuomo has reportedly entered a "cooperation agreement" with at least one firm, Clayton Holdings to help him understand how the whole process worked with their various Wall Street clients.....nice of them, eh? Considering that according to the Wall Street Journal New York State Attorney general Andrew Cuomo is said to be poised to use the Martin Act of 1921, which allows securitites fraud suits to be brought, without the persecutor proving intent to defraud, who wouldn't cooperate?

The credit rating agencies, were one group I foresaw coming under scrutiny back in September. Frankly, I think the U.S. government has been going easy on them so far because they are worried about what will happen to markets if their credibility is totally shredded or if they start to really over-react to the political pressure on them. The EU has been less shy about voicing their dissatisfaction: According to the Financial Times

Credit rating agencies were warned last night by European leaders to address conflicts of interest and provide better information to the markets or face new regulation at a "credit crunch" summit in London.

Note that the rating agencies aren't taking this laying down. They are pointing fingers toward the Wall Street firm's and their outsourced due diligence purveyors. According to Tom Brown's excellent BankStocks.com blog, while relaxing in the luxury of the Davos World Economic Forum and Ski A Go Go, the CEO of Moody's opined that. " The key assumptions failed in part because the information policy, completeness and veracity feeding the work agencies were doing was deteriorating."

While we are on the subject of the veracity of data being impugned, we might as well bring your attention to hedge fund manager Bill Ackman's recent letter to the New York insurance regulators regarding MBIA and Ambac's disclosure of the details of their bond guarantee business. Bottom line is according to his letter Ackman is short these stocks. He has had some very sharp, hard working analysts put together a massive model that says these guys are gonna lose a bunch of money and in my opinion is putting indirect pressure on Moody's, Fitch, et al to downgrade them, which will make their situation worse, while pressuring regulators not to bail them out, by making them look like they don't deserve a bailout or that one will be fruitless. These guys are smart, that's why they get paid the big bucks. Apparently, this ploy is working as a downgrade of a smaller bond insurer has just occurred.

Now these are just the initial signs of fear and loathing descending on this residential real estate mess. Not much in the way of new laws have been passed yet (correct me if I'm wrong as there may have been something pushed through on mortgage brokerage professional standards). But don't doubt it for a minute: new laws are coming and they won't make it easier to buy a home, get a mortgage or trade in securities linked to mortgages. They will raise the cost of home ownership and make it less profitable to be a lender. Already the regulatory climate that will cause this is heating up. Tom Brown has another article on his blog about the new chief national bank examiner just promoted at the Office of the Comptroller of the Currency. Bottom line is according to Tom, the guy has a reputation stretching back to the early 1990s real estate debacle as a very tough cookie with regard to bad loans. Others are already calling for overpaid bankers to "pay the price" for their mismanagement.

If my cycle road map is right. The final phase I call "The Hating" is still coming. It happens around the time the bad guys are getting sentenced, and new laws are passed to make sure a bubble like this can never happen again (or at least for 20 years until people figure out how to get around the new regulations). We will know this phase has arrived when bus loads of "bargain hunters" are no longer seen making the rounds of ghost town condo developments looking to make a killing in residential real estate. In the mean time my prediction is there is more pain to come in this asset class.

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