Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 20-Jun-2008
'Operation Malicious Mortgage' indicts 406 people including Bear Stearns execs

Web Log - June, 2008

'Operation Malicious Mortgage' indicts 406 people including Bear Stearns execs

All kinds of fraud by all kinds of people.

In June of last year, Bear Stearns was forced to bail out two hedge funds that were close to default. The hedge funds had taken investors' money and used the money to invest in CDOs (collateralized debt obligations) that had large nominal values, but which nobody was willing to buy. Investors wanting to withdraw cash from the hedge funds were causing problems, since the hedge fund managers couldn't sell the CDOs to obtain cash.

A month later, Bear Stearns announced that its hedge funds were almost worthless, causing their investors to lose billions of dollars.

According to an FBI press release (or get the entire indictment (PDF) here), there was criminal activity involved.

Two senior Bear Stearns hedge fund managers, Ralph Cioffi and Mathew Tannin, are being charged with conspiracy, securities fraud and wire fraud. Cioffi is also charged with insider trading.

According to the FBI, the managers believed in March 2007 that the funds were in risk of collapse, but lied to investors to keep them from withdrawing cash. The evidence also indicates that that they lied about the level of their own personal investments in the hedge funds.

In a separate action called "Operation Malicious Mortgage," 66 people were arrested and 406 defendants were charged, in 144 mortgage fraud cases across the country. Approximately $1.4 billion in losses were inflicted by these mortgage fraud schemes. The people charged included real-estate developers, brokers, agents, appraisers, lenders, lawyers and "straw buyers."

Three types of mortgage fraud were targeted:

In addition, there are many more to come, according to FBI director Robert Mueller.

I would note that these investigations aren't targeting the many homebuyers who lied on their mortgage loan applications to obtain a mortgage that they would never be able to make the payments on.

Circumstantial evidence becomes hard evidence

As I've said many times, there's no doubt that massive fraud has occurred on Wall Street because of the circumstantial evidence.

The banks, ratings agencies and bond insurers who all colluded to give AAA ratings to near-worthless CDOs and other mortgage-backed securities might claim that they didn't realize what would happen in 2002, or 2003, or 2004, or 2005, or perhaps even 2006. But there can be no question that they knew, or should have known, in 2007 that their valuation models were broken. And yet, the rate of abuses actually INCREASED in 2007.

In fact, I would argue that by the time 2007 came around, financial professionals no longer even cared about their investors or about honesty or about who got screwed. If you look at all the actions and statements by financial executives in 2007, vastly many of which have turned out to be disastrously wrong, you can see that they all had one and only one purpose: Preserving their fat bonuses, fees and commissions, irrespective of honesty or professionalism.

There's one very interesting thing about the Bear Stearns indictments: The use of the date March, 2007. It's possible that March, 2007, will be recognized as a major turning point, the time after which no investment banker or financial engineer could credibly claim that these mortgage-backed investments were still viable. Once March, 2007, had passed, every one of these professionals knew, or should have known, that these investments were in trouble, and any positive statements after that date might be considered as potentially fraudulent.

The ubiquity of fraud

The breadth and depth of this fraud identified by the FBI indictment is breathtaking. It's not just a single company, like Enron, nor a narrow range of companies, like the S&L scandal. This has been happening in all financial and real estate services companies, from workers at the bottom to senior managers at the top.

Furthermore, after the Enron scandal, Congress passed the Sarbanes-Oxley Act, which provided the most far-reaching reforms of business practices since the 1930s. This act was supposed to make it harder for companies to lie to investors, but as it turned out, it had no effect whatsoever on the breadth and depth of mortgage fraud. This goes to the heart of Generational Dynamics: Political decisions really have nothing to do with the major great events of the world. It's generational changes that propel history, and politicians can do no more than stand by and watch.

As I've been saying for years on this web site, this can only be explained generationally. This ubiquity of fraud would not have been possible even ten years ago, and is made possible by the lethal combination of the stupidity, blindness and easy corruptibility of Boomers, combined with the nihilism and destructiveness of Generation-Xers.

I would describe the generational situation in terms of "3 C's":

The result is a fourth C - Catastrophe - as we're seeing now in the collapse of the world's global financial system, resulting in massive homelessness, bankruptcies and starvation, and a spur to the coming Clash of Civilizations world war.

(Incidentally, I'm developing an article about the same generational 3 C's when applied to the IT/software development industry. There's no reason why this generational ubiquity of fraud should apply to just one industry.)

So what happens next? To answer that, I'm going to repeat a passage about what happened in 1929. John Kenneth Galbraith described what happened -- and what will happen again -- in his 1954 book, The Great Crash - 1929, as follows:

"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in -- or more precisely not in -- the country's businesses and banks. This inventory -- it should perhaps be called the bezzle -- amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

The stock market boom and the ensuing crash caused a traumatic exaggeration of these normal relationships. To the normal needs for money, for home, family and dissipation, was added, during the boom, the new and overwhelming requirement for funds to play the market or to meet margin calls. Money was exceptionally plentiful. People were also exceptionally trusting. A bank president who was himself trusting Kreuger, Hopson, and Insull was obviously unlikely to suspect his lifelong friend the cashier. In the late twenties the bezzle grew apace.

Just as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.

After the first week or so of the crash, reports of defaulting employees were a daily occurrence. They were far more common than the suicides. On some days comparatively brief accounts occupied a column or more in the Times. The amounts were large and small, and they were reported from far and wide. ...

Each week during the autumn more such unfortunates were reveled in their misery. Most of them were small men who had taken a flier in the market and then become more deeply involved. Later they had more impressive companions. It was the crash, and the subsequent ruthless contraction of values which, in the end, exposed the speculation by Kreuger, Hopson, and Insull with the moey of other people. Should the American economy ever achieve permanent full employment and prosperity, firms should look well to their auditors. One of the uses of depression is the exposure of what auditors fail to find. Bagehot once observed: "Every great crisis reveals the excessive speculations of many houses which no one before suspected." [pp. 132-35]

And so, what happened in the 1920s has also been happening in the 2000s.

After all, it's been clear since 2004 that we're in a housing bubble -- I said so on this site. There have also been numerous stories in the press about nefarious mortgage practices, but nobody cared much as long as everyone was making money.

But now the social culture is reversing dramatically. Most people don't realize what's going on, unless they read the above excerpt by Galbraith and absorb its consequences. Things are going to get increasingly vicious. Everyone's accounts are going to be examined and audited in detail. Things that were previously ignored will be exposed. People who got away with fraud or embezzlement will be found out after all. Financial advisors who protected themselves while collecting fees and commissions from clients for making bad investments will be come after with baseball bats and shovels.

What we're seeing now is a cultural shift that will last for generations. Boomers will continue bickering with everyone until they die, but Gen-Xers whose nihilism backfired will become increasingly bitter, as the younger Millennial generation begins to take over. It's the cycle of life being repeated, as it has many times before. (20-Jun-2008) Permanent Link
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