08/28/2013 06:34 am ET Updated Feb 24, 2014

Bernanke's Deposition: AIG, Goldman, Merrill and Bailouts

The SEC has lost steam in its already very weak push against mortgage lenders and the investment banks that supplied them with money for alleged fraudulent lending. The investment banks supplied funds by allegedly defrauding investors in residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), CDO-squared (and more).

The alleged securities fraud in the sale of mortgage backed securities, CDOs, and related credit derivatives, is only one part of a widespread Ponzi scheme. Mortgage lenders made multi-billion dollar settlements after allegations of fraudulent lending, while producing phony documents that disguised violations of lending standards. They could not have continued this alleged fraud without funding from investment banks.

Banks and Investment Banks Lost Money Due to Control Fraud

Some banks claimed that they are innocent, because they lost money. But as William K. Black explains, in a control fraud, banks and investment banks can lose money, because bonus-seeking officers prosper in the same way that parasites eat their host.

Banks supplied credit lines, IPOs, bond offerings, securitization, and other fee-generating services to corrupt mortgage lenders. For example, JPMorgan Chase had credit lines to mortgage-lender Ownit that it yanked in November 2006, a month before Ownit's bankruptcy. Merrill's Mike Blum was on Ownit's board. Countrywide, a large mortgage lender that settled fraud allegations is now owned by BofA. There are many more examples of suspect interconnected relationships.

Officers of TBTF banks and investment banks signed off on accounting statements for their mortgage-related businesses that suggested the activity was more honest and healthier than it was, and they were off by a very wide margin. Yet they have not faced responsibility for Sarbanes-Oxley violations.

Instead, investment banks sought new investors to supply money for old investors. In this case, money from new investors allowed soon-to-collapse mortgage lenders to buy back fraud-riddled loans. This funding kept the Ponzi scheme going far longer than it otherwise would have.

Even worse, investment banks leveraged against doomed-to-fail mortgage backed securities.

For example, in 2007, Merrill Lynch accelerated CDO activity, and MBIA wrote protection against some of its fraud-riddled CDOs.

Bernanke's Potential Deposition

Hank Greenberg's lawyers are trying to get U.S. Federal Reserve Chairman Ben Bernanke to testify in his lawsuit over the U.S. taxpayer bailout of American International group Inc. (AIG). As a sophisticated investor, AIG had responsibility for due diligence on the CDOs against which it sold protection. The underwriters of the CDOs had responsibility for alleged securities fraud. But wait. Those allegations have not even yet been made by the SEC.

Now that taxpayer money has been used to bailout AIG, the ballgame has changed. This is no longer a case of two big dogs in a brawl. It is now a matter of public interest.

The SEC sued Goldman Sachs for alleged securities fraud involving an Abacus CDO. AIG wrote protection against several Abacus CDOs, yet the SEC hasn't investigated those deals. Likewise it hasn't investigated the fact that Goldman Sachs was a key beneficiary of the AIG bailout. This was revealed by the SIGTARP's November 17, 2009 report.

Five years ago, I publicly challenged AIG's representation that it would take no losses against super senior CDO tranches. See: "In Subprime, AIG Sees Small Risk; Others See More," WSJ, August 13, 2007. Within months, AIG was cited for "material weakness" in its accounting. AIG's officers have not been held accountable for this accounting travesty.

Moreover CDOs that Goldman Sachs either underwrote, or against which it bought protection from AIG, were a chief cause of AIG's distress in September 2008, and were the primary cause of the U.S. taxpayer's bailout. Goldman's cronies included Calyon, Societe General, Merrill and more. (See: "Goldman's Undisclosed Role in AIG's Distress," TSF, November 10, 2009.)

Goldman's list of negative basis trades featured many of Merrill's CDOs as underlying risk. Merrill's own list of deals with AIG amounted to around $9.9 billion as of November 2007. Merrill Lynch was also a beneficiary of the AIG bailout. In September 2008. Bank of America had just agreed to merge with Merrill, which had $6 billion in suspect super senior risk hedged with AIG.

Merrill's nonsense didn't begin and end with AIG. Merrill's CDOs issued in 2007 -- and many before that -- were a classic situation for fraud. (See: "Dead Calm: No One Trusts You," TSF, July 30, 2008):

As of June 10, 2008, of 30 CDOs totaling more than $32 billion in notional amount, 19 have declared an event of default, are in acceleration, or have been liquidated. Ten others are "toast," as evidenced by downgrades of their "triple A" tranches to junk status.

Merrill Lynch is being sued for some CDOs, but not for the CDOs involved in the AIG mess.

If Ben Bernanke is made to testify, perhaps he can explain why the names of AIG's counterparties and the names of the CDOs were kept from the public eye and redacted from SEC filings. He might also explain why it was denied for so long that Goldman Sachs was a beneficiary of the AIG bailout. He might also explain why Goldman Sachs was made a bank holding company without a thorough investigation into these matters.

Likewise, the allowed merger of Bank of America and Countrywide, and the quick merger of BofA and Merrill Lynch, deserve further scrutiny.

A few CDO lawsuits should merely be the small beginning of investigations into a much wider pattern of problematic activity combined with taxpayer bailouts. The Fed and the SEC have not yet provided needed investigations or proper context to the global financial crisis, accounting obfuscation, or to the ongoing bailouts.

This commentary is excerpted and adapted from a longer article that originally appeared at The Financial Report.

Update: Several Congressional investigations revealed the facts of widespread mortgage origination fraud as well as securities fraud wherein material information about the problems of the underlying mortgages were not disclosed to investors. Also not disclosed was the fact that for many securitizations, the security interest in the collateral was never perfected, meaning the trusts may hold loans, but they are not backed by property. That is why we are seeing a wave of forclosure fraud where documents have been falsified after the fact. A handful of lawsuits have been setteled, for example the $8+ billion settlement by Countrywide, the $550 million settlement for alleged Abacus CDO securities fraud by Goldman and others. The fact that widespread fraud occurred is not in dispute. There has been an absence of the will to prosecute.