A must read…
Simply stated, the largest commercial banks became “too big to fail” in large part because they used non-bank vehicles to increase leverage without disclosure or capital backing. Their intent was to reduce the apparent capital needs of banks. Banks’ abuse of non-bank vehicles to issue subprime securities and hide capital deficits was facilitated by legal counsel, auditors, rating agencies and regulators, who all pretended that four centuries of legal precedent regarding financial fraud had somehow never occurred. Until 2011, FDIC rules did not preclude that abuse and even sheltered banks from need to disclose it to auditors and investors.
The failure of Lehman Brothers, Bear Stearns and most notably Citigroup all were attributable to deliberate acts of securities fraud whereby assets were “sold” to investors via non-bank financial vehicles. These transactions were styled as “sales” in an effort to meet applicable accounting rules, but were in fact frauds that must, by GAAP and law applicable to non-banks since 1997, be reported as secured borrowings.
Under legal tests stretching from 16th Century UK law to the Uniform Fraudulent Transfer Act of the 1980s, virtually none of the mortgage backed securities deals of the 2000s met the test of a true sale. Under the UFTA standard, for example, any transfer which is intended to leave the transferor with insufficient capital is a fraud which converts a “sale” into a “secured borrowing” by the transferor.
Since the purpose of most bank asset “sales” via securitization was always “capital relief,” no honest lawyer could say that the transfers met the UFTA standard applied to non-banks. Banks avoided balance sheet treatment for securitizations merely by “purporting to sell” loans to trusts.
Bank regulators allowed theses “off-balance sheet” vehicles to be excluded for the purposes of determining regulatory capital requirements. When the crisis hit, it suddenly became clear that the banks’ capital was insufficient.
Today much of the “shadow banking” system with respect to residential real estate has run off or is in the process of doing so, but hundreds of billions in claims against banks arising from these purported “sales” of assets remain pending before the courts.