Tavakoli Structured Finance LLC

Repairing the Damage of Fraud As a Business Model

Address of Janet Tavakoli, president of Tavakoli Structured Finance, Inc. to the Federal Housing Finance Agency’s Supervision Summit on December 8, 2010.

Good morning. First, let me say what an honor and privilege it is to be here today addressing the FHFA’s Supervision Summit on the topic of repairing the damage of fraud as a business model.

In April 2005, I addressed the IMF and talked about emerging issues in the credit derivatives market and in the structured finance market where it was disturbing that many products were mis-rated and ratings did not capture risk. Yet a year later, after the situation had become shockingly worse, the IMF’s Global Financial Stability Report of April 2006 said that dispersion of credit risk through shadow banking’s securitization system “has helped to make the banking and overall financial system more resilient.” Perhaps IMF doesn’t stand for International Monetary Fund rather it may stand for “I’M Fantasizing.”

By April 2006, private label securitization had become a widespread interconnected Ponzi scheme. Thousands of people should be going to jail. Securitization professionals bundled fraud riddled loans into residential mortgage backed securities (RMBS) to raise money from new investors to pay old investors in a fraud-based unsustainable business model. That is the classic definition of a Ponzi scheme. True to form for a Ponzi scheme, securitization exploded in volume and became increasingly complex as more money and complexity was needed to cover up previous fraud. Revenues from securitization and related activities mushroomed at investment banks and rating agencies. As these fraudulent activities contributed a growing and significant share from these fake profits, CEOs and CFOs looked the other way. Pay for managers in these areas soared to unprecedented levels. As the Ponzi scheme began collapsing towards the end of 2006, securitization sped up and became more opaque and complex. Most collateralized debt obligations (CDOs) and virtually every CDO-squared were more fraud to cover up previous fraud.

Example: Merrill Lynch, Now Part of Bank Of America

All of the large legacy investment banks engaged in this activity as did many of our large banks, but I will use a small example from Merrill Lynch to illustrate the problem.

After the Enron implosion, Stan O’Neal, then CEO of Merrill, wrote an OpEd for the Wall Street Journal [“Risky Business,” April 24, 2003]. He wrote that in a system based on risk-taking there may be spectacular failures, but every failure shouldn’t be viewed as fraudulent or criminal.

I agree with Stan O’Neal in principle. One needs to keep an open mind about risk and its consequences. Moreover Merrill’s mission required it to put on more risk than our banking system, and now it is a part of our banking system, since Bank of America was allowed to further weaken our banking system by absorbing Merrill’s mess. It’s great to have an open mind, but don’t leave it so open that your brains fall out. Stan O’Neal apparently did.

Merrill Lynch had strong ties to a California-based mortgage lender that was perversely named Ownit. Merrill was a part owner of Ownit. Merrill’s global finance head sat on Ownit’s board. Merrill securitized Ownit’s loans. William D. Dallas, Ownit’s founder and CEO, declared: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.” Massive widespread securitization fraud occurred on O’Neal’s watch.

One of the myths of the financial meltdown is that criminal activity did not occur at institutions like Merrill Lynch, because it lost billions. But as William K. Black explained in his book on the S&L crisis, The Best Way to Rob a Bank, Is to Own One. Or to “manage” one. Merrill had a bad case of control fraud where managers extract high bonuses and compensation while their institution is run into the ground and in-the-dark shareholders are defrauded by their own managers. New money from securitizations was used to enrich the “managers” who were in this sense “old investors.” Other “old investors” were the shareholders earning high dividends in investments in mortgage lenders and the officers of mortgage lenders that extracted high compensation from these imploding lenders.

By December 2006, Ownit was obviously in trouble. JPMorgan yanked its $500 million credit line, and Ownit filed for bankruptcy protection. One would think that in this post-Sarbanes Oxley world, Merrill’s officer, who sat on Ownit’s board, would ask for a fraud audit, particularly since Merrill was securitizing Ownit’s mortgage loans. As underwriter, Merrill (not the rating agencies) was obliged to perform due diligence and to disclose material information. A fraud audit doesn’t mean anyone is being accused of fraud, it simply means that the audit will be thorough enough to uncover fraud if it exists. Instead, Merrill’s head of global finance faxed in his resignation to Ownit.

Ownit’s bankruptcy was public and both the Wall Street Journal and the New York Times, among other mainstream media, reported it. I assume that Stan O’Neal and Jamie Dimon, then the CEO’s of Merrill Lynch and JPMorgan respectively, are capable of reading a newspaper.

Sarbanes Oxley and Accounting Issues

Moreover, near the same time, HSBC made a preliminary announcement that it would take a $6 billion write-down for subprime activity for 4Q 2006. At the time it was a stunner. I believe they later revised their figures upward, but as I recall that was the initial information. The information about these massive write-offs was in the public domain. The CEOs and CFOs of our financial institutions cannot say they were not aware. Yet, you did not see massive write-offs at U.S. banks and investment banks. It seems to me, officers of these institutions should be made to answer for accounting fraud and for not informing shareholders of the true condition and risky nature of their balance sheets.

Instead of taking losses Merrill madly accelerated its CDO activity in the first half of 2007. You’ll recall the Ponzi scheme completely fell apart after that and private-label securitization ground to a halt. In the first half of 2007, Merrill brought more CDOs to market than it had in the entire year of 2006. JPMorgan had less deal volume, but its hands weren’t clean, either. For example, it closed a deal called “Squared” in May of 2007, and that CDO is now under investigation by the SEC.

Fraud audits are in order for all of our major financial institutions that engaged in the securitization of mortgage loans during this period.

By January 2007, there was so much information in the public domain that officers of our major financial institutions have no excuse. They cannot shift blame or claim that the officers that worked for them deceived them when the newspapers are already on to them.

Specific Warnings in Professional Publications and to Regulators

In January of 2007, I penned an article for the Global Association of Risk Professionals, and they published it in their March edition (“Subprime Mortgages: The Predators’ Fall,” Issue 35, March 2007). I advised risk managers to get out of these institutions so that they didn’t end up being the fall guys. In many cases, risk managers had responsibility, but little authority. Business managers had the boots on the necks of risk managers. This is also a classic characteristic of a control fraud. I gave a tongue-in-cheek suggestion that risk managers should get out and short these positions, otherwise they would go down with the ship.

In February of 2007, I wrote a letter to the SEC that is still posted on its web site. I said the Nationally Recognized Statistical Rating Organization (“NRSRO”) designation for structured products should be revoked for Moody’s, S&P, and Fitch. None of them had adhered to even basic statistical principles.

Merrill Lynch CDOs: A Classic Situation for Fraud

In May 2008, Floyd Norris of the New York Times wrote an article about a deal that Merrill brought to market in 2007 that was populated with loans that came from Ownit. He noted it included piggyback loans, most of the loans were 100% loan-to-value, and around 70% were some form of liar’s loan. Merrill brought this deal when home prices had weakened and were falling. The deal documents failed to disclose that Merrill was Ownit’s largest creditor. By early 2008, the “triple-A” rated tranche had been downgraded to junk. Moody’s forecast 60% of the original portfolio value could eventually be lost. By now the cat was out of the bag, and the rating agencies’ complicity was apparent to all. They had enriched themselves by extracting high fees for very little actual work, and looked the other way as fraudulent securities flooded the market. Investors included a mutual fund, Bond Fund of America, targeted to retail investors, who thought they had made a low-risk investment.

There was very little transparency in the market, and it was difficult to obtain documents. In 2007, I saw perhaps a handful of Merrill’s CDOs, but I had to guess at the magnitude of the problem. But every one of the deals I saw at that time was a classic situation for fraud. None of them should have been allowed to close or to come to market, and I said so in real time. In March 2007, I talked to the Wall Street Journal and Fortune about one of the deals called Forge, and said it was unconscionable that the SEC hadn’t shut down these financial meth labs, and fraud was allowed to continue. I urged them to write about it, but in the first quarter of 2007, mainstream media was reluctant to write about it. The SEC looked the other way while financial institutions violated securities laws. The Wall Street Journal wrote some of the best and earliest articles on CDOs, authored by Serena Ng, Carrick Mollenkamp and others. After things fell apart, the WSJ published Serena Ng’s ground-breaking front page article exposing a Merrill deal called Norma, a deal in which hedge fund Magnetar, among others, had participated.

In the summer of 2008, I revisited this to determine what percentage of Merrill’s 2007 ABS CDOs were problematic. The answer is 100% of the 30 ABS CDOs that Merrill brought to market in 2007 were a classic situation for fraud. That represents a notional amount of $32 billion. All of them should be investigated. Moreover, by June 10, 2008, all 30 had one or more “AAA” tranches downgraded to junk by one or more rating agencies. This was knowable in advance.

Investment banks, and some banks, engaged in securities fraud. Many mortgage lenders engaged in widespread fraud and predatory lending. Rating agencies, when they weren’t pushing junk science were complicit. CDO “managers” were at best crash test dummies and at worst were accomplices. Yet the Fed awarded no-bid contracts to Blackrock to manage its Maiden Lane portfolio that includes toxic CDOs that the Fed bought for 100 cents on the dollar. The AIG bailout benefited Goldman Sachs and its cronies for toxic CDOs and related credit default swaps manufactured when Hank Paulson was CEO of Goldman Sachs, before he became the Treasury Secretary that influenced the bailout and the subsequent cover-up of the details. The CDO underwriters and managers deserve investigation, especially for the later vintage CDOs. The Davis Square and Abacus CDOs would be a good place to start, but the investigation shouldn’t end there. Taxpayer funds should be recovered from the institutions involved. Blackrock Financial was a CDO “manager” to failed 2007 vintage CDOs, all of which deserve investigation. Given Blackrock’s conflict of interest, do not expect it to raise these issues.

FUBAR Finance

We bailed out banks that engaged in FUBAR finance: Frauded Up Beyond All Recognition. Trading of these securities amounted to a complicated game of CDO hawala wherein participants covered-up for each other and buried losses by buying one another’s trash and stuffing it into securities. TBTF may stand for Too Big To Fail, but it also stands for Trust Bernanke to Fund…with no questions asked.

Meanwhile, the average taxpayers and average citizens weren’t as well protected from the consequences of the damage to the economy and the housing market that was exacerbated by the banks’ fraud. Out of 15 million underwater homeowners, four million are more than 50% underwater with average negative equity of $107,000. If these losses come to fruition, they would exceed $428 billion after administration fees, foreclosure fees, and carrying costs. Moreover 7.8 million homeowners are 25% or more underwater. Most of these people are paying higher interest rates than the national average. They aren’t eligible for HAMP and cannot refinance.

Banks held the entire U.S. financial system hostage with the threat of financial collapse. They raised the fear that cash was insufficient to fund revolving lines of credit. That meant corporations would be unable to tap into their credit lines to meet payrolls and make payment for deliveries of ordered supplies. The Fed bailed out the banks after having failed to regulate them. There is some merit to the argument of temporarily bailing out the banks before winding down the largest of the banks. But there is no excuse for what the Fed did next. After failing to regulate the bailed out banks, the Fed failed to investigate them, and then the Fed covered up for them.

Crony capitalists are using a lie to protect financial oligarchs, as if all of this mayhem was a bush-league error of financial nincompoops. Here’s how that lie goes: They thought housing prices would always go up.

Even Warren Buffett has used this sound bite in defense of the actions of banks, rating agencies and other culprits. It is as if one is asked to shrug one’s shoulders and laugh this off. But finance professionals are highly educated and are paid more than 95% of U.S. citizens to do their jobs. Some are paid more than 99% of other U.S. citizens. One would think they could at least try to weasel out of this with a better excuse. No competent structured finance professional uses ever rising prices as the foundation of an analysis. Yet, we are asked to believe that no one was aware of fraud because they failed to do their jobs after relying on an assumption that any untrained person with basic common sense wouldn’t rely upon.

Washington Needs to Investigate Its Investigators

Now I’d like to comment on Washington’s investigations into these matters. Phil Angelides should be tossed off of the Financial Crisis Inquiry Commission (“FCIC”), based on his questioning of Chuck Prince, Citigroup’s former CEO and Robert Rubin, Citigroup’s former “risk wizard.” Angelides mugged for the camera and said that he recalled the implosion of the Bear Stearns hedge funds in June of 2007, because it was near his birthday and that the head of the commission might want to note this for future reference. As he clowned around, he let Prince and Rubin off the hook. Both former Citi officers claimed that the implosion of the hedge funds raised no concerns to them. Rubin claimed problems with subprime and CDOs first became apparent to him in the fall of 2007.

That was odd, because I had been contacted by senior FCIC staffers prior to [Angelides’ interview of Rubin and Prince]. I directed them to my book on the financial crisis, Dear Mr. Buffett. In it I explain that Citigroup was closely connected to the imploded Bear Stearns hedge funds

In May of 2007, Bear Stearns Asset Management (“BSAM”) tried to issue an IPO to stuff a structured purpose vehicle with troubled CDOs. Listed shares would then be available to unarmed retail investors. I objected and was quoted in articles saying this IPO should not be allowed to proceed. Ralph Cioffi, a co-head of Bear Stearns Asset Management called me to try to get me to retract my statements. I refused. BSAM had to pull its IPO, and the hedge funds imploded the following month. The hedge finds tried to sell some of its assets, and the bid lists showed that many of the CDOs were being priced at deep discounts.

Despite the pressure the Bear Stearns hedge funds were under in the second quarter of 2007, despite the poor prices banks and investment banks gave the bid list of assets from the hedge funds, banks and investment banks failed to record accounting losses for assets they were required to mark-to-market. Citigroup was among the financial institutions that failed to report accounting losses.

Proceeds of that failed IPO were earmarked to pay down Citi’s $200 million credit line with the Bear Stearns hedge funds. The failed IPO was a matter of concern to Citi as was the implosion of the hedge funds.

Citigroup underwrote and sold assets to the hedge funds. Among the hedge funds’ assets was Octonion I CDO. It closed March 2007. When I saw it among the IPO’s assets in May, I said it was toxic and even the investors in the “triple-A” would lose money. By February 2008, it was downgraded to junk.

The events surrounding the implosion of BSAM’s hedge funds in 2007 raise serious issues about accounting fraud and securities fraud at Citigroup.

Yet the media enables guys like Robert Rubin. He headed a panel at the Economist’s Buttonwood Gathering at the end of October. The panel role played what would happen if a U.S. state defaulted. The Economist provided a platform for Robert Rubin to spread the lie that no one could foresee problems in 2007, because that is what he said in his opening remarks. He never mentioned Ambac, one of the U.S.’s two largest municipal bond insurers. It sold credit default swap protection on Citi’s toxic CDOs, later sued Citi, and settled some of those transactions for a discount. An editor for the Economist told me the panel showed Rubin’s value. He wasn’t trying to be funny.

Citibank: Jim Rogers (not Meredith Whitney) Predicted Collapse in January 2007 and Shorted the Stock

Citi’s troubles were apparent to many at the beginning of January 2007, yet the media has distorted that fact. Meredith Whitney is a bank analyst, who is hyped in the media for a so-called prescient call, because on October 31, 2007, she said Citi would have to cut its dividend. Not only was her call late, it wasn’t even smart.

Jim Rogers appeared on a televised business show with Whitney early in 2007. Jim Rogers was short Citigroup. Rogers, not Whitney, made an early call in 2007 that Citigroup's stock price would tank, and he was short Citi.Rogers had shorted Citi in late 2006, and he said that Citi would have to cut its dividend. One would think that Whitney could get a clue from Jim Rogers, who is one of the smartest global investors. Instead, she refuted him and had a “sector perform” rating on Citi. (Citi even underperformed its sector during the period in which she awarded that rating.) Rogers said he had a target price of $5 on Citi. At the beginning of 2007 Citi was trading at $55 and it dropped steadily to $42.24 on October 31, 2007. Richard Bove, Charles Peabody, and Michael Mayo already had a sell on Citi. Whitney then rated Citi sector underperform, and said it could trade in ‘30s and must cut dividend, more than 10 months after Jim Rogers gave the finance world a heads up. Her stock price target was well above Rogers’s of $5. By December 27, 2007, Citi was trading below 30 and falling. In January 2009, Citi hid $5, and Jim Rogers took his profit.

The media often gets its fact wrong, but what was Robert Rubin’s motive for the lie about 2007? Citi had massive exposure to put options on CDOs and it had serious issues with its offshore vehicles, the assets of which would boomerang back on its balance sheet. The news made the need for write-offs undeniable. Admission of awareness of these problems would make CEOs and CFOs responsible for allowing wide-spread securities fraud to continue.

Sometimes the media isn’t merely lax; it is actually corrupt and dishonest. I put CNBC in that category. While it sometimes hosts good guests and it has some good anchors, there is no excuse for some of its anchors lying to the public. I appeared on a CNBC segment a few months ago, and when I mention predatory lending, CNBC anchors mocked me and talked over me. The anchors denied the existence of predatory lending on air. Yet, predatory lending, even fraudulent lending, isn’t a matter of opinion, it is a well-documented fact. One can find fine research on this topic at the Columbia Journalism Review, or read a long list of articles from journalist Michael Hudson, or read his new book, The Monster.

Caricature of Capture from FINRA to the SEC

The SEC is a failed and captured regulator. The appointment of Mary Shapiro after her appalling record at FINRA is a poor choice. Christopher Cox, her predecessor, was the anti-Christ of investor advocacy, and the legacy continues. Robert Khuzami’s appointment is puzzling, since he has a conflict of interest. He oversaw Deutsche’s CDO lawyers. Deutsche is entangled with others’ CDOs. For example, Deutsche’s CDO called Carina is interconnected with JPMorgan, Merrill, Morgan Stanley, Citi, Wells Fargo, Goldman, and others. If you investigate CDO hawala, you eventually rope Deutsche into the investigation. How does Khuzami begin that investigation? Perhaps he begins it by looking in the mirror.


SIGTARP has issues, too. It was very late in uncovering damaging facts about Goldman’s deals with AIG. Its November 2009 report omitted Goldman’s key role as underwriter (creator) of CDOs and its relationship with foreign banks that bought protection with AIG. They were all bailed out for 100 cents on the dollar. SIGTARP only footnoted and omitted the name of Goldman’s Abacus CDOs. One of the Abacus CDOs was recently the subject of an SEC late-to-the-party once-over-lightly investigation that resulted in a seemingly large settlement, but the entire show was simply media misdirection. I put much more detailed information about the CDOs in the public domain a couple of weeks prior to SIGTARPs November 2009 report. Since then, SIGTARP played catch-up, but it pulled its punches.

Perhaps our investigators need investigation. The media hypes this investigator as being tough, but don’t you believe it.

Banks (not borrowers) Broke the Law

It’s curious that bank officers that should have known about criminal activity taking place under their noses are quick to say that no one was tossed out of his home that didn’t deserve it. Debtors are shamed and treated as if they committed a crime. They are vilified for owing a debt.

Delinquency is not a crime. Being foreclosed upon is not a crime. Bankruptcy is not a crime. U.S., Banks Agree on Foreclosure Pact, presenting phony affidavits as evidence, fraud on the courts, is a crime. Banks committed front-to-back fraud.

Jamie Dimon: Materially Misleading Statements?

Yet, you wouldn’t know it to listen to Jamie Dimon’s 2010 earnings call. He said that no borrower was “evicted out of a home who [sic] shouldn’t have been.” He also said there is “almost no chance we made a mistake.

Journalist Annie Lowrey had this to say in her October 14, 2010 Washington Independent article: “But the financial statement itself proved the lie. The bank said it was carefully checking 115,000 mortgage affidavits. It set aside a whopping $1.3 billion for legal costs. And it put an extra $1 billion into a now $3 billion fund for buying back bunk mortgages and mortgage products.” (Annie Lowrey, “Too Big to Fail Rears its Head Again,” Washington Independent, October 14, 2010.)

While Jamie Dimon was spinning a story, on October 15, 2010 former Ohio Attorney General Richard Cordray told CNBC that every foreclosure done with falsified affidavits was improper. The fact that it happened repeatedly doesn’t make it more excusable, it makes it worse. In depositions employees of Ally (GMAC), Bank of America, and JPMorgan Chase admitted to this practice. As yet, no one knows the scope of the problem. It may be tens of thousands or hundreds of thousands of instances of fraud on the courts.

Cordray added that apparently they had “fraud as a business model.”

Interested Men

In addition to politics and media distortions, regulators have to beware of people with hidden agendas. Thomas Paine, one of the Founding Fathers of the United States, urged Colonists not to trust the words of “interested men” tied by money and status to the British government and British royalty: “It is the good fortune of many to live distant from the scene of sorrow; the evil is not sufficiently brought to their doors to make them feel the precariousness with which all American property is possessed.”

In the summer of 2008, Bill Ackman, who runs hedge fund Pershing Square gave me a call. He asked me to get involved with Fannie Mae and Freddie Mac issues. I have a high opinion of much of Bill Ackman’s work, and I wrote a book review for a wonderful book, Confidence Game, written by Christine Richard about Ackman’s fight with MBIA when he held a short position in MBIA. But the first time I spoke with him. He may have forgotten to tell me that he was short Fannie’s equity, and he was short the subordinated debt of both Fannie and Freddie.

Unbeknownst to me at the time, he had written a presentation called “Saving Fannie Mae.” He didn’t send it to me; I found it later on the web. I told him I was busy with something that was consuming all of my time and effort. I didn’t tell him more. He kept up the pressure and said it was too important to the country! Apparently what’s good for Ackman is good for America. Yet, he expressed no curiosity about what was keeping me busy. I didn’t tell him, but I will share it with you in a moment.

When I later found his presentation on the web, I noticed the amount of capital provided by his proposal might appear large, but it did not look like enough to me. It seemed to be all about expediency, as if to say, let’s ram this through, and I can collect my winnings and disappear. I was worried about the magnitude of the losses, and other things as well. Fannie and Freddie have foreign investors—as does our entire banking system.

Ackman’s agenda was to push a restructuring that would be advantageous to his financial position. He was an interested man. I understand that the FHFA invited him to speak here today. Initially, he said yes, but then he bailed out. His funds no longer have a position that can benefit from the outcome at Fannie and Freddie, so apparently he is no longer interested.

President Obama and Bone Cement

It is difficult to resist clever and manipulative people with money and status who approach you pushing hidden agendas. Regulators need to be alert and have bone cement for their spines and have to stand up to these special interests.

I wonder if President Obama is tough enough to resist these well-dressed emotional blackmailers. In July of 2007, before his campaign became a really big deal, I had contributed to his campaign and went to a breakfast attended by others who had contributed a threshold amount, so it was a relatively small group of around 200 people. Naturally, we were a very friendly crowd. I was wearing a colorful shirt, and took notes as then Senator Obama was speaking. I had a yellow legal pad on my lap, and as far as I noticed, I was the only one taking notes. Now President Obama noticed my note-taking. I was sitting directly in his line of sight. When it came time for questions, mine was the first hand up, and for a while, it was the only hand up. He saw my hand, and he didn’t take my question. I don’t know what he was thinking. Perhaps he thought I was a reporter. But if he’s intimidated by someone asking a question in a venue like that, how is he going to deal with the pressure tactics of clever manipulators covering up hidden agendas? I realize he’s had more practice since then, but at the time it put me off so much, I voted with reservations for John McCain.

Banks: Broke More Than Twice Over

Why did I wave off Bill Ackman in the summer of 2008? What was I working on that was consuming all my thought and energy?

I was worried about the banks. A much smarter guy, Jim Rogers, was asking a much better question. He was asking, which bank is safe? If you are running a fund or using exchange traded notes issued by banks, you want the safest possible bank. Even JPMorgan was not a save bank. The universe of safe banks is very small. Jim Rogers was well aware of the problems that roped our banking system and Fannie Mae and Freddie Mac together.

In 1984, when Continental collapsed, it had souring oil loans on its balance sheet that it bought after Penn Square collapsed. One of its key employees, John Lytle was involved in fraud and kickbacks to look the other way instead of doing due diligence on the loans. I think his total take was a bit over $2 million and he was sentenced to more than 3 years of prison time. In mid-May of 1984, the Japanese got wind of the bad oil loans, and they yanked $2 billion in overnight deposits from Continental. Europe heard about it and within days yanked their deposits, too. The FDIC, Treasury, and Fed injected $4.5 billion into Continental.

Also in the 1980’s, banks took in a lot of Saudi money, and instead of letting the Saudi’s lend directly to basket case countries in Latin America, they persuaded the Saudis to give them the money so that they could lend the money. That way, bankers collected fees for doing very little actual work. By the late 1980’s, the loans were seriously impaired. If the loans had been marked to market, Bank of America and Manufacturer’s Hanover would have gone under. Losses would have wiped out their equity and around 40% more beyond that. There was a good argument for auditors to force them to do it, since we had just done a Brady bond restructuring of Mexico’s debt. Half of the $20 billion debt was forgiven, and Mexico put up only 20% of the other half in the form of a zero coupon bond.

Banks love earning high fees for doing very little work and fight oversight and regulation.

We have the additional problem, since the U.S. doesn’t save enough. We have to import foreign deposits. We have to import foreign savings. Fannie and Freddie have imported foreign savings from China and Japan, and if these investors go away, we have a big problem. That’s why the Fed had to step in and bail out Continental.

The FDIC does not insure our banks. The FDIC insures small domestic depositors. Foreign deposits are not insured. Large banks insure other large banks. But what if there isn’t enough money in the banking system—the system outside the Fed—to do that? Well, when I took Ackman’s call in the summer of 2008, I was trying to answer that question. Rather than look at an individual bank, I looked at the top ten and the various troubled asset classes.

Based what I knew then about the volume of FUBAR finance backed by mortgage loans, assets from life insurers backed by trash, auction rate preferred securities…student loans, subprime auto loans, credit card exposure, leveraged loans, commercial loans. When one looked at the impairment, if banks truly marked their books to market—the one’s they were required to mark to market prior to April 2009—permanent losses exceeded the capital of the top ten banks, and that was true even if you excluded Lehman. In other words, losses exceeded their combined net worth.

Our banks were broke more than twice over.

That’s why the Fed had to step in. There was no balance sheet big enough to take on this mess. The Fed has our banking system on life support with zero cost money and phony accounting so they can try to earn their way out of this deep dark hole.

This is why Fannie and Freddie were being used as a dumping ground for bank assets. In 2007, when Jim Lockhart said $170 billion of so-called “AAA” RMBS assets, I was appalled. Much more was purchased beyond that. This only served to disguise the magnitude of the banks’ problems. This is also the reason banks are resisting your requests that they buy back faulty loans.

Where does that leave you? How do you repair this damage?

Prosecute Fraud and Accurately Assess Losses

Fannie and Freddie have relied on third parties to meet their underwriting standards. There is no substitute for doing a rigorous statistical sampling of the portfolio to get the two pieces of information you need: the probability of default and the loss given default. It’s a massive job.

Correlation won’t do the trick. If you relied on correlation, as the rating agencies did at times with their models, and as some investors did, you would be relying on a flawed model at the outset. Competent securitization professionals know this. The health of the securitization begins and ends with the cash flows

Here’s an analogy. Suppose your best friend said they would fix you up on a blind date with a movie star. You have in mind two criteria: looks and character. You are thinking Gregory Peck in his prime, and his character as played in The Man in the Grey Flannel Suit. But the guy who shows up at your door is from The Walking Dead. He looks like a zombie and his character is predatory. The correlation is that they are both movie stars. How is that working out for you?

Correlation is a poor way to measure and model credit risk, but it is a great way to throw a tarp over fraud.

You have to examine the loans for probability of default and loss given default. You need to know losses on an actual basis, not an accounting basis. It has to be a realistic assessment of your true financial picture. You need to know where you hit bottom today, and what is likely to happen next.

Moreover, you have to do this continuously, since the economic landscape is changing.

After that, you can decide the best way to restructure to wean yourself off of public funds and get back to a sound mortgage system.

The reason that foreigners don’t want to buy our mortgage backed products any more isn’t because our economy is in such bad shape, it is because everyone is lying about it.

When you tell the truth about the depth of the problem, when you adequately describe the risks, then investors will have the confidence to decide whether or not they want to invest in those risks.

Until we own up to system-wide fraud, until we clean up our system, until we send people to jail for having committed securities fraud, until we call out our interested men, our cronies, and our CEOs on their self-serving agendas, we will never get back to sound finance in the United States, and we will never recover.

Recovery will also mean a return to traditional prudent lending, educated qualified regulators that can stand up to pressure, and reality-based assessments of our businesses.

The first step is to clean up the fraud, find out the true depth of our losses, and tell the truth to the American people. I assure you, America can handle the truth.

Read more finance articles by Janet Tavakoli