The Moral Hazard of the Fed’s Current Policy: The Resurgence of Fraudulent Paper

"As a dog returns to its vomit, so a fool returns to his folly."

Proverbs 26:11

A reader who works in commercial real estate finance shared a warning, informed by his own private industry perspective today. This was in response to my post this morning on the Fed's policy error of indiscriminately pumping money into an unreformed banking system, without adding safeguards and provisions for its employment in productive investment rather than wealth transfer control frauds.

It is almost tragically funny to see the economic principles learned from the Great Depression applied so blindly and haphazardly as advocated by some economists and policy makers.  

It is hard to explain the realities of things to people who see the rough world of the markets through the abstractions of their theory and models.

Yes, what my acquaintance Richard Fields calls the 'FDR framework' would have favoured the stimulus of government work and investment programs for a depression and liquidity trap, and a certain amount of financial security to ease the pain.  

But it would have never been so wilfully complacent about the underlying fraud that caused it in the first place.  And austerity without reform is a form of economic suicide.  FDR came right at Wall Street and the Banks with serious reform that saved capitalism from itself, and worked for a generation to hold back its darker impulses.  This is a lesson that we have apparently forgotten.

If the Fed attempts their old fix once again, they may do what I thought was almost inconceivable, and go a step beyond mere stagflation which is bad enough, and cause an actual break in confidence, and the bond of their word, the currency. The people of the world will not be fooled forever. 

As Hyman Minsky once said, and the moderns seem to have forgotten, "Anyone can create money; the problem is in getting it accepted." He should have added, except by force.

Reform goes hand in hand with recovery.

From a reader:

CDO Resurgence Could Meet Resistance From RE Investors: Law360

A recent bump in demand for collateralized debt obligations has some experts predicting an onslaught of new deals in the coming months, but real estate attorneys caution that even with a more conservative structure, CDOs could be a hard sell with those still reeling from their role in the 2008 crash.

Also, Commercial Mortgage Alerts reflected commercial mortgage backed securities issuance of $48 billion last year (2012) – up from about $33 billion (2011). Remember the Fed is buying up to $45 billion in mortgage backed bonds per month!  Law360

Reader: I believe the Fed has succeeded in provide the banks the incentive to begin issuing fraudulent paper again, the infamous CDO's. That's the only way the banks can meet the demand for higher yielding paper given their reluctance to engage in productive investments.

They know the game now, despite the real estate lawyers who are either wrong or just propagandizing. Open-ended QE. 

The banks will issue large amounts of the CMBS paper and CDO paper and probably come up with other bond schemes and even LBO's that are fraudulent and probably worthless. 

They'll sell them to whomever, because if the fraud is ever revealed, it will get charged to the Fed who will buy the paper from the investors or off the banks' books for near 100 cents on the dollar. 

The great fraud machine is stirring. The debt bubble is reflating. 

There is no underlying strength in the economy, so the loans being securitized will not be repaid in real terms and the banks and the investors will ultimately offer them to the Fed, who will buy them at non-market prices. 

What's to stop this? There's nothing stopping it. 

There is no threat of prosecution for fraud. There is no shame or sense of morality.

There is only a ton of money to be earned by the banks/hedge funds/private equity with no threat of punishment for engaging in massive fraud.

To be fair, CDO's are not in and of themselves bad assets, but they do tend to operate nicely in lending themselves as a vehicle for misstating risks because of their complexity and sometimes convoluted terms.  Therefore in that spirit, Deutschebank Selling CDO's to Meet Its Capital Goals.  And Private Equity Getting Deeper into Debt as Multiples Rise as well as Hampton's Average Home Price Hits Record.  

If this is productive debt with risks well-priced then no worries.  But I wonder if we will see a return to the LBO's, bond abuses, and dodgy IPO's of the past given the current climate of loose regulation and increased pressure to make easy money.