Is there any doubt that the federal government is now propping up nearly the entire housing market?
The New York Times reported here that the Federal Housing Administration, FHA, the government agency whose loan-insurance programs have essentially prevented the entire housing market from collapsing, is in severe trouble and has dwindling cash reserves. The agency has admitted that its cash reserves had dwindled to 0.53 of the total portfolio of loans held, far below the mandated 2 percent minimum. The FHA has acted as a backstop for the nation’s housing markets, ensuring that marginal buyers are approved for loans with minimal down payments.
The politicization of the goals and loan policies at FHA was nearly guaranteed following the collapse of the conventional housing market in 2007 and the federal takeover and subsequent bailout of Fannie Mae and Freddie Mac. Freddie and Fannie have been propped-up by the Federal Reserve for the last two years, which has purchased a significant percentage of the securitized mortgage products issued by the two agencies in the absence of conventional buyers. Now, FHA may require federal intervention to prevent its own collapse. With no plan for the eventual re-capitalization of Fannie or Freddie on the horizon, it is now virtually guaranteed that the federal government will continue to play the most important role in the nation’s housing markets for years to come.
What’s truly alarming, though, is FHA’s rather transparent efforts to conceal the extent of its problems. By lowering its loan underwriting criteria and extending loans to larger pools of risky credit borrowers, the FHA is hoping to reduce the overall percentage of currently delinquent loans relative to its total loans outstanding.
In effect, the FHA is extending more loans to marginally poorer credit risks, inflating the size of its overall loan portfolio, and then claiming victory, as the overall percentage of its delinquent loans declines relative to total loans. This may, though, ultimately become a pyrrhic victory of sorts if the housing market continues to deteriorate and foreclosures continue to accelerate. FHA is essentially betting that it can outrun its problems by increasing the size of its balance sheet.
These are the same bets made by speculators and other investors at the height of the national euphoria that engulfed this nation, and it was painfully obvious how this dynamic played out. Politicizing FHA and forcing it to play an even greater role in the housing markets is a recipe for disaster.
The nations leaders and housing “experts” continue to ignore the fact that the only remedy for the ills of the housing market is to ensure that greater numbers of people legitimately qualify to own homes, and only two methods will ensure this: either personal income increases or asset deflation in the housing stock must sufficiently reduce home values. In this time of severe recession, personal income is likely to remain relatively stagnant for years.
Lower home values, while accelerating the pain of those that viewed their homes as retirement portfolios, will ensure that greater numbers of families will ultimately qualify for loans. Attempting to re-inflate the housing bubble by lowering credit standards will simply ensure that another massive federal bailout will soon occur, this time at FHA. By sustaining the unsustainable, the federal government will prevent any real recovery in overall asset valuations and ensure that future economic growth will be tepid at best. Short term housing stimulus will prevent real growth and recovery in the long-term.
Asset valuations, especially the housing sector, should be allowed to fall to levels commensurate with income and sustainability. Absent this, it will be a painful decade, at best.

Another week, another Ponzi scheme emerges: Scott Rothstein, a prominent Broward County, Florida lawyer, has been accused of orchestrating a scheme to bilk investors of hundreds of millions of dollars.
The ruse involved the sale of legal settlements finalized by Rothstein, acting as plaintiffs’ lawyer, to wealthy investors, who would pocket the difference between the present value amount paid to plaintiffs in legal cases and the future value of the installment amounts negotiated with defendants. The spread between the present value of the settlements and their future, installment value represented profit, and was marketed aggressively to high net-worth investors seeking high yields and returns. Broward County’s Sun Sentinel, which has closely tracked the story, reported yesterday that a local bank, TD Bank, apparently maintained the bank accounts for the investment business.
What is remarkable about this purported fraud are the similarities it shares with other, recently discovered financial schemes: Bernard Madoff (fake investment accounts), Allen Stanford (fake certificates of deposit), Marc Dreier (fake securities and notes), Scott Rothstein (fake legal settlements) and a host of other, lesser known individuals, including recent allegations of missing funds leveled at Lewis Freeman, the Miami court receiver and forensic expert.
The substantive similarities between these schemes is remarkable: 1) The schemes themselves were all fairly unsophisticated and noteworthy for their relative simplicity; 2) they were perpetrated over many years and had long “shelf-lives”; 3) most involved industries that were either highly regulated (Madoff and Stanford) or faced Bar review of their activities (Dreier and Rothstein); 4) all involved highly sophisticated investors with the wherewithal and means to conduct extensive due diligence; 5) all involved schemes that should have been easily uncovered by even cursory due diligence or review, and 6) all involved “feeder funds” or hedge funds, which funneled other people’s money into the fraudulent schemes.
Marc Dreier’s scheme is remarkably similar to Mr. Rothstein’s, in that both Mr. Rothstein and Mr. Dreier were prominent attorneys, and both attempted to sell bogus securities, notes or settlements to unsuspecting hedge funds or investors. Mr. Dreier’s story is eloquently discussed by Vanity Fair’s Bryan Burrough, and attempts to discern the motivation that propelled Mr. Dreier to steal hundred’s of millions of dollars from unsuspecting hedge funds.
While understanding what motivated these individuals to misappropriate huge sums of money certainly appeals to our very basic human need to dissect and understand behavior, the truly interesting angle is why sophisticated hedge funds and rich individuals keep getting duped into forking over hundreds of millions of dollars into very unsophisticated financial schemes. Although I will review each fraud in more detail in later articles, a trend begins to emerge that ties these frauds together: either because of greed or ignorance, most investors are not performing adequate due diligence in the United States.
The motivation or rationale that prevented these investors from conducting even minimal due diligence can be discussed ad nauseam, yet no single unifying theme will probably emerge or suffice to explain these lapses. None of these theories will adequately explain why highly sophisticated individuals, feeder funds and hedge funds purposely failed to perform the due diligence required prior to investing hundreds of millions of dollars into third-party financial schemes, with most of these investments being other people’s money, not their own.
After all, most of these schemes could have been detected with even minimal due diligence: 1) Bernard Madoff never actually made any trades on behalf of his clients, yet trade ticket confirmation would have been relatively easy; 2) Marc Dreier never actually had the authority to sell notes or securities to investors, yet the notes were never independently confirmed with the underlying issuer; 3) Scott Rothstein never actually had plaintiffs that settled cases, which a search of the Broward County court cases (or other jurisdictions) might have revealed (or independent verification for un-filed claims), and 4) Allen Stanford never actually invested his clients’ funds into CD’s at third party institutions or other easily confirmable depositories, providing a huge red-flag to investors.
Although discerning the reasons why these investors failed to conduct due diligence is interesting and perhaps compelling, whether it was greed or simple ignorance, it becomes clear that these investors trusted the fraudsters with their money, oftentimes their life savings. How trust can be so easily granted and dispensed is really a defining characteristic of these crimes, how we have allowed fraudsters to so easily seduce us is an important unresolved issue.
More importantly though, has anyone really learned anything from these massive frauds, or are we trapped by our own greed and ignorance to forever repeat the mistakes of the past?

The greatest failure of the last two years is not the collapse of the securitized mortgage markets or the housing collapse that spawned them, but the failure of faulty risk analysis that continues to permeate the financial industry.
The financial industry became enomored of quantification modeling as a strict denominator of risk, and it largely collapsed as a result. Wall Street embraced modeling techniques that attempted to quantify risk by placing numeric valuations on the amount of risk they were holding. Wall Street investment banks, and the “quants” that wrote the programs, truly became enamored of the “simplification” of risk analysis that these models offered.
Finally it seemed, there appeared an easily understood evaluation technique that anyone could understand. Just run the “program”, and a daily benchmark would assess the entities’ risk, which was then comparable and quantifiable. These models became the Holy Grail of risk analysis on Wall Street. One such model, the VaR, or Value at Risk model, expresses risk as a number, or dollar valuation to be precise. VaR, and the hundreds of models like it, became a crutch, a lazy method of quantifying risk and compartmentalizing this part of their operation.
It also became a convenient way of transferring blame should the risks materialize. No one could, after all, shoulder blame when their “quant models” incorrectly assessed their exposure. Reliance on these models was intellectually lazy, a function of ignorance and of management’s inability to perform critical analysis. It may have been unrealistic to believe that many of these Wall Street analysts, most bred as political science, history, or English majors, could realistically understand the dynamics of corporate risk and perform in-depth analysis of their firms’ balance sheets or profit and loss statements.
Models are subject to the same limitations that auditors face, reliance on “cookbook” audit programs or other sampling techniques that provide limited assurance of an entity’s exposure or risk of financial misstatement. The parallels between the audit professions’ failures of the past 20 years and the current failures are striking. Audit firms, especially the “Big 8”, “Big 6” and now the “Big 4”, have spent the last 30 years developing audit “tools” that attempted to quantify risk at a basic level: just plug the numbers and the other miscellaneous variables into the model and the resulting output would quantify the risk, without the need for any independent judgment or critical thinking.
The beauty of these audit models was that any junior auditor could “run” them and divine the financial statement impacts or risk. Auditors became cogs, uniquely interchangeable and completely replaceable. If, after all, anyone could run these models or perform the sampling analysis required without the need for additional analysis, the audit firm could claim that it had established the “knowledge base” required to properly analyze risk. Human analysis and due diligence were divorced from risk quantification. The models could purportedly assess risk independently of their human operators. We know how this story ended, and witnessed the resulting avalanche of audit failures which ultimately led to the collapse of Arthur Andersen, the storied audit house.
What did we learn from these repeated audit failures? Not much it seems, because Wall Street also attempted to compartmentalize risk and develop “programs” that neatly assessed exposure and risk. Why no one has drawn these parallels and linked the two failures is perplexing. Enterprise risk, whether operational or financial, cannot be isolated into unique and disparate fragments of information, analyzed independently from the whole or divorced from human judgment.
The increasing sophistication of today’s business landscape and the financial statement ramifications demands due diligence that defies easy quantification. The failure of Wall Street models was a failure to understand the impact of human behavior, their financial statement impacts, and a failure to acknowledge that if even a few “input” variables were materially incorrect, the entire model and its analysis would be rendered meaningless.
Humans have always been fascinated by “universal” theories that attempt to unite and explain behavior, and these models were merely mirroring this desire. Until we understand that no singular theory completely embraces all behavior, both audit failures and Wall Street failures will continue to occur. Unfortunately, audits have become highly mechanized and automated, given the economic incentives of the audit business model. The high turnover at the Big 4 firms provides an even greater incentive to automate the audits as much as possible. I am not hopeful that this behavior will be significantly altered or modified.

Denial is a powerful emotion, especially when coupled with an avalanche of media hype and feel-good sensationalism.
Our economy has just weathered the most severe downturn in 70 years, and it’s business as usual for Wall Street and bankers. The increasing disconnect between the pain of Main Street and Wall Street’s prosperity is numbing, given the increasingly dour news befalling consumers. The current pain merely illustrates that for average Americans, the last 8 years was a mirage, an episode of magical thinking where debt became income and homes became assets.
Truth be told, though, this illusion has been repeated in every asset bubble of the last thousand years. The resulting collapse, was, sadly, completely predictable. Because humans have such short memories, the past repeats itself in almost eery lock-step, just ask the Dutch about those thousand-dollar tulips.
The housing debacle was an especially prominent episode of magical thinking in our country, which caused wide-spread hysteria and illogical consumerism. Wall-Street, which required vast quantities of loans to bundle and securitize, was happy to oblige in this spectacle. Once banks shredded their loan underwriting processes sufficiently, and loans became available to nearly everyone, the “American dream” became enshrined as a rite of adulthood, and homes became commodities.
The banks, which no longer held these loans on their balance sheets, provided loans to vast segments of the population which could not afford to carry these loans under typical loan underwriting criteria, but which were given “magic” options such as negative amortization loan payments, interest only loan terms, and other Orwellian terms. These magical terms ensured that their owners could remain in the homes long enough to enable the homes to sufficiently rise in market value before they would have to sell the house, at a gain, of course.
As housing values increased exponentially, consumers also tapped their home loans for massive cash withdrawals, falsely fueling our economy to staggering heights. The only fly in this ointment was the expectation (indeed homeowners were financially at the mercy of this increase)  that home values would always increase and had never before decreased, another grand instance of magical thinking. Again, the result of this asset bubble was predictable and completely foreseeable: Home values collapsed and homeowners had no higher-price “bailout” to liberate them from their albatross. Game over.
The long-term horizon does not portend good fortune for our medical system, either. Our health-care “reforms” are full of magical thinking and fairy dust. Runaway medical costs will ensure that insurance will, within 5 years, cost each family an average of $30,000 per year. Yet none of the health care reforms being proposed address the issue of cost containment, which is the third-rail of our “free-market” medical system. Without cost containment, price-caps or massive volume discounting, the medical reforms being proposed will fail within 5-10 years, and are merely a band-aid.
Cost containment, as a category of reform, is anathema to the free market advocates, which reason that the markets are more efficient and can lower costs through free market competition. This is false, as many studies have demonstrated that communities having excess medical providers also have extremely high medical costs. But cost containment and price-caps have been removed from the national dialogue on health care reform, and remain off-limits due to their purportedly anti-free-market attributes. Americans continue to be seduced by advocates of the free-market into believing that only free-market reforms will ensure a healthy, viable and unrestricted medical system for all.
What do the housing bubble and the proposed medical reforms have in common? They are both the product of magical thinking, illogical reasoning and America’s seduction by large, multi-national corporations who do not have our best interests at heart. The unregulated, uncontrolled housing free-market caused the single-greatest asset bubble in the history of the world, and it will likewise bankrupt American families anew with a similarly flawed, yet “reformed”, medical system. Unless we acknowledge our individual and collective failures and our responsibilities to future generations, we will soon face another economic debacle foisted upon us.

The collective failures of the Bernie Madoff ponzi scheme and the collapse of the real estate markets share one common thread: the unwillingness of most commercial investors to perform even basic due diligence on their asset purchases.
I’ll start with Bernie Madoff’s ponzi scheme. Madoff’s scheme continually raised red-flags which were ignored, even by his most sophisticated clients, the feeder-funds which funneled huge sums of money into his ponzi scheme. Even a cursory examination would have revealed that his auditor was a local CPA who was housed in a tiny office. That fact alone should have sent prospective investors running for the exits.
Any individual or organization with millions of dollars to invest is surely sophisticated enough to understand that comprehensive audits of large organizations, such as Mr. Madoff’s, require teams of auditors and large audit firms with the organizational background and experience to complete the audits. A two-person office, even working 60 hours a week for an entire year, likely could not have completed an audit of Madoff’s organization.
Sophisticated feeder funds should have performed extensive due diligence, verifying and independently confirming trade tickets. Their failure to do this is inexcusable, given the purported “monitoring” services being provided to their clients and the fees collected. This, in addition to the most obvious flags of all: that Madoff’s operation would have consumed more options than those publicly traded and purchased on a daily basis. Surely, this calculation could not have been too difficult for these sophisticated organizations. Let’s not even discuss the most obvious flag of all: the near flawless, steady returns that never wavered or spiked. These “smooth” returns should have spurred current and prospective investors to dig deeper and fact-check their portfolios.
Commercial real estate investors, at least those attempting to flip condo’s and other commercial properties, continue to ignore the most obvious red-flag of all: how will they make money from this asset purchase? Assets make money only when they appreciate in value, or, they produce a steady stream of revenue that is non-volatile and which will increase over time. Those investors wading back into the real estate market must ask themselves: if few bulk condo deals have occurred, at least in South Florida, do the largest institutional investors understand basic principles, which other buyers have ignored?
The answer is easily yes, most institutional buyers certainly do understand market fundamentals, which “momentum” investors have ignored or rationalized. This understanding has led institutional investors to conclude that most condo developers are still selling their units at prices which will not ensure positive cash flow and even marginal returns on these bulk purchases. They also understand that rising notices of defaults (at least in South Florida) will eventually lead to increased foreclosure activity, and that the coming Option Arm loan tsunami could swamp the real estate market more painfully than even the subprime debacle. Finally, they understand that in some real estate markets, no asset appreciation will occur for years, perhaps decades.
The common thread between Bernie Madoff and real estate investing is that both investor groups failed (and continue to fail) to perform even minimal due diligence or exercise common sense, choosing instead to rely on the momentum generated by “word-of-mouth” or their “trusted” business advisors. Whether the red-flag is a badge of fraud or merely an indicator of poor business judgment, “market momentum” seems to have replaced judgment. In an increasingly complex world, due diligence and common sense have now been largely abandoned or ignored.
Even sophisticated investor groups oftentimes rely on “check-the-box” due diligence, largely performed by inadequately trained foot soldiers. In isolation, numbers, figures and statistics mean very little, and provide false security when their context is ignored. Counter-intuitively, it seems like the more money requested, the less questions people ask. These failures and frauds will continue to occur as long as investors continue to ignore the red flags that always appear in the face of danger, but which are nearly always rationalized or dismissed.