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Fred Feldkamp on Fraud and True Sale

Below is the text of a lecture that my friend and co-author Fred Feldkamp gave to a group at KBRA last month on the topic of true sale. This discussion is further to our 2014 book, Financial Stability: Fraud, Confidence & the Wealth of Nations. A discussion of true sale naturally lends itself to a discussion of fraud.

Fraud grows in good times because rescission is rarely sought (or granted) when asset values rise.  Fraud is not a problem, till it is.  At the end of the day, there are only two types of financial transactions where assets are transfered from one party to another: 1) sales or 2) secured loans. If an ostensive seller pretends to do the former, but in fact does the latter, then that "imputes fraud conclusively," to paraphrase Justice Louis Brandeis.


There are three PDF/s that accompany the discussion.

Chart 1 Corp Spreads thorugh the 2008 crisis and beyond

Chart 2 Wealth creation/destruction matrix given change in spreads

Chart 3 Six test for Legal Isolation (Also Apprendix A to Financial Stability)




Fred Feldkamp


If any of you feel thoroughly confused at the end of this lecture, folks, congratulations, you listened well.

LET’S START SIMPLE:  A “true” sale is the “legal isolation” that exists when assets are transferred free of fraud.  Now, let’s stop.  Remember--entirely innocent misrepresentations are frauds that permit rescission—they undo earlier transfers.  

Fraud grows in good times because rescission is rarely sought (or granted) when asset values rise.  In deflation, however, rescission is a total remedy.  So, past frauds emerge when the going gets tough, to the “shock” of perpetrators.

The purpose of a rating is to protect investors when times are tough.  Therefore, ALL deception is a rating concern (that’s confirmed by $100 billion of recent penalties).  If support for an entity’s rating relies on its assets, only a “true” sale suffices to end risks arising from prior owners.  

For land and goods, fraud can be obvious (underwater land).  But who knows when money was received by fraud?  Lance Armstrong had $10 million last week.  He was a good rating risk.  This week he owes it back because our courts don’t allow a liar to keep the benefit of a lie—that’s true even when the lie is entirely innocent.  

Rescission for misrepresentation unwinds any transfer.  Courts don’t let liars keep the benefits of lying. 

Therefore, any fraud converts a “sale” into a “secured borrowing” because the transferor (or its creditors) can undo it.  It’s the law everywhere in the US.  

In GAAP, the concept of “legal isolation” is a 19 character acronym:


The former GC of the FDIC, when asked how a bank should confirm this, said:  “Everyone should look over everyone else’s shoulders.”  In the end, the issue is entirely a matter of law.  So, when can a lawyer opine that a transfer is free of fraud that affects a rating?

In a 1,200 lawyer firm, we allowed just three partners to approve true sale opinions.  From the early 1930s until 1973, rating agencies didn’t accept opinions on the subject.  In 1973, I told a partner that I believed the UCC set conditions that made isolation opinions available.  That earned me a 6-month sentence in the firm’s library and the job of getting 48 confirming state law opinions from local counsel before a rating agency agreed with our firm’s opinion.  

On the “good” side, “true” sale is the solution for market instability that causes crashes.  

In 1776, Adam Smith observed that if financial markets, the “Great Wheel of Circulation,” cost more to operate than the minimum cost needed to maintain intermediation, wealth is destroyed.  Instability is what triggers the fear that drives up the cost of intermediation and destroys wealth.

In 1983, Ben Bernanke observed that the crash of 1929-33 caused a fear-driven rise in what he called the cost of credit intermediation (“CCI”).  He found rising CCI caused the macroeconomic damage of the Great Depression.  He said, however, there wasn’t enough data for a proper study of the causes and effects of a fear-driven rise of CCI.  To account for the issue in models, Bernanke created a “dummy” variable:   “PANIC.”

By 1987, Merrill Lynch began publishing CCI data, apparently to compete with Mike Milken’s 1980s junk bond monopoly. 

After Enron fell, Congress ordered the SEC to study “off balance sheet” deals.  In 2005, that study led to instant reporting of bond trades.  That data now gives US investors (and only US investors) reliable daily CCI data.  In our 2014 book, Chris and I use that data to follow CCI from July 2007 on.  CCI explains how the crisis of 2008 occurred and how the 2008 spike in CCI reversed to prevent a Depression. 

Chart 1 tracks the CCI data.  A table (Chart 2, that we’ll cover next) proves Mr. Bernanke’s 1983 theory.  True sale lets firms bridge the Chart 1 CCI gap between high grade and high yield debt by allowing high yield entities to isolate high grade assets.  

So, when markets function smoothly, true sale contains CCI in a range near the bottom of Chart 1.  When fraud is rampant, however, trust in intermediaries falls and rights of rescission rise.  When that cycle becomes self-fulfilling, rising CCI triggers a crisis.  If CCI is not contained, a depression occurs.  The value of a “true sale” (and the profit of a successful scam), therefore, rises and falls with Chart 1’s graph line.  

In Bernanke’s 1983 essay, he found a 5.5% per annum rise of CCI between 1929 and 1933 explained all the Depression’s damage.  On Chart 1, CCI rose nearly 15% per annum in 2007-8.   As Bernanke has noted, 2008 was MUCH worse.

On November 20, 2008, a high grade rating obtained by a true sale would save issuers 16.81% per annum compared to High Yield.  By June 13, 2014, that difference was 1.79%.  [Both are records, by the way.]  That’s how Bernanke’s 1983 theory saved the world in 2008.  

In 2014, the value of a 10-year High Grade rating was about $83 million per billion of bonds (8.3%) more than high yield bonds.  Compared to a slow, mature, high grade firm, the nimble efficiencies of an emerging firm can overcome that gap.  (That’s how the US emerged from the Great Recession.) 

In November 2008, that difference was a $501 million per billion of bonds, HALF THE TOTAL BOND ISSUE.  No amount of agility overcomes that.  (It’s the CCI burden that was destroying US wealth in 2008 and now implodes Russia.)

“Legal isolation” allows high grade ratings for sound assets, separated from the risk of junk rated owners.  It bridges the CCI.  So, Chart 1 tracks (1) the value of legal isolation AND (2) the “damage” of scam isolation that dupes investors and rating agencies, leaving bankruptcy in its wake (for example, 2006-7 subprime mortgage deals).  

Now, turn to the 12-box table with 2 numbers in each box (that’s Table 9.1 in the 2014 book Chris and I wrote).  

This shows the macroeconomic effect of changes in Base Rate (monetary policy) and Spread (CCI) on the wealth of society.  Assuming a constant GDP level for support of capital investment, this shows 12 “Total Wealth” and “Equity” capital levels achieved by applying the law of compound interest, ?(1=i)?^x,and two variables:  (1) 4 CCI conditions (from Chart 1) and (2) 3 base rate environments achieved by application of central bank monetary policy.  

The top middle box represents US capital markets in 2006.  

The bottom right box confirms Bernanke’s 1983 theory that rising CCI caused the damages of the Great Depression.  The bottom left box shows how far the US fell before the Fed programs of 2007-9 took effect.  The top left box represents the US recovery since 2009.

This table confirms the “data driven” Fed policy of today.  It is beyond the law of compound interest to grow wealth further if recovery is not sustained by an increase in GDP cash flows that support growth.  Absent a sustained rise of cash flows, any rise in base rate or CCI will reduce wealth. 

That’s the economics of true sale.  Now, let’s look at factors that confirm true sale using the 6-box table that starts Appendix A.  

This states 6 conditions that must be met to legally isolate a pool of assets so a rating can be given on the strength of assets without regard to claims of prior owners.  That is to say, this says when a true sale gives an entity’s creditors unrestricted rights to its assets.  From that point, it’s up to the owner of the entity to do what is needed to support rated creditors.

The rest of Appendix A describes the legal opinion that meets the six tests. 

That description is “legal shorthand.”  It makes lawyers consider the impact of all laws relevant to fraud, dating (at least) to 1571, the 13th year of the rule of Queen Elizabeth I in England.  Appendix A is as simple and direct as its authors could state this matter, based on decades of debate.  

AS Chart 1 and the 12-box table explain the impact of this test on the wealth (of asset owners and nations), they also explain why EVERY SPECULATOR AND GOVERNMENT IN HISTORY HAS SOUGHT, AT ONE TIME OR ANOTHER, TO HIDE FROM THE REQUIREMENTS OF APPENDIX A.

From 40 years of this work, ONLY ONE TRANSACTION ALLOWS A TRANSFEROR TO MAKE AN “OPINABLE” TRUE SALE WHILE RETAINING ANY “VARIABLE INTEREST” IN TRANSFERRED FINANCIAL ASSETS.  (That’s a transfer to an asset owner’s direct, wholly-owned, bankruptcy remote subsidiary, in exchange for cash and equity, then the grant of good security by that subsidiary to specified creditors.)

Appendix A, states conditions for “isolation” that are entirely defined ONLY by US law. Evaders say US law is too tough.  I reverse that—by 300 years of debate, US law is far more advanced on this matter.  It is the only reliable law, BECAUSE we fought court battles to achieve a rule of law that supports free financial markets while others relied on government control.  

We learned control NEVER “works.”



This is, “the Holy Grail” of securitization, the key to debt ratings for perhaps $50 trillion of securities worldwide.  Failure to understand and accept this test was integral to each of the worst financial crises in history (from the South Seas Bubble to the Great Recession).

That the US alone defines this line (between sale and “leverage”) is both a blessing and a curse.  When we apply the definition correctly, nothing is beyond the grasp of investors. When we “blow it,” 2008 proved, yet again, there is no limit to how badly the world suffers.

True sale is when a financial asset is (1) transferred in (2) a transaction that is not for security.   After centuries of debate, from the 1980s on, US law has mandated that ANY transfer deemed “fraudulent” is “for security,” and then only to the extent an innocent transferee pays money to the transferor.  


By that, ALL frauds CREATE debt of transferors and risks of being a secured creditor of the transferor are then relevant to a rating.  Moreover, disclosing the transfer as a “sale” hides leverage.  Assets are subject to a stay in any transferor’s bankruptcy (by the USBC) and to claims of conflicting creditors of the “true” owner.  

True sale is a very high standard.  It matters little, however, UNTIL it matters A LOT.  

Consider the Madoff bankruptcy.  The trustee has recovered some $15 billion that Madoff investors thought they owned ($7 billion came from the estate of one Florida resident that directed Madoff to send him, in cash, all earnings on his account each month—the right of the trustee to recover ALL that money was so clear that it was not seriously contested by the recipient’s widow). 

Before bankruptcy, “true” sale had no meaning to Madoff investors that profited by conspiring with him or by accident.  After bankruptcy, it meant the loss of $15 billion of what they considered to be profits they had earned.   

For financial institutions, true sale defines when loan losses are absorbed by transferees rather than the institutions’ owners.  

The line measures assets against which a bank should hold capital.  For centuries, this may have been THE most oft-breached line in banking.  After 2008, the lead independent director of a major bank told me the bank had NO problems with assets, EXCEPT “off balance sheet” assets.  

It was 2010, however, when FDIC finally stopped giving banks gigantic exemptions from the GAAP definition of sale.

The GAAP test separates “leverage” from “off balance sheet liabilities” (But that’s an oxymoron, if you think about it—Why is any liability “off balance sheet” and, if it is “off balance sheet,” why is it a “liability”?)  

Since the cost of bank leverage is shareholder capital, the Financial Accounting Standards Board has been lobbied on this aspect of GAAP since FASB was created.  The debate explains why “R.A.P.” was used before 1997, why FDIC waived FASB’s 1997standard in 2000 and why FDIC undid that mistake in 2010.

FASB’s staff told me this is the one area of accounting where almost everyone lies to FASB.  My review of lawyers’ efforts to “opine around” true sale confirms that.  OBS abuses amounted to about $30 T in the US and $60 T worldwide by 2008.  

If a loophole is allowed, inertia demands its support and threats of penalties preclude change.  This is why we now face $60 trillion of potential accounting and tax scams around the world (and why banks and rating agencies paid more than $100 billion of penalties, to date).


In 1990, GMAC was supported by $40 billion of A-1/P-1 CP.  In 1992, GM reported a $23 billion loss.  GM and GMAC, faced downgrades.  GMAC anticipated the threat, extended debt maturities, sold assets and reduced CP to $24 billion as 1992 ended.  

That helped, but in history only Sears maintained as much as $4 billion of CP at the A-2/P-2 level.  Sears pledged all its receivables as security—GMAC HAD CONTRACTS THAT PROHIBITED A PLEDGE OF ASSETS.

$24 BILLION OF CP WOULD COME DUE IN THE 3 MONTHS after downgrade.  IF $1 WENT UNPAID, GM AND GMAC WOULD BE FORCED INTO BANKRUPTCY.  The filings were prepared and everyone who saw the problem circulated resumes.  

1993 came and “TRUE SALE” ALLOWED GMAC to isolate as much of its $200 billion of good financial assets as it needed.  

Free from GM’s problems, properly isolated assets supported enough AAA debt (that was sold at prices far greater than could be obtained without a true sale).  That assured GMAC the ability to repay all unsecured debt.  

Instead of bankruptcy, by April 1993 it had $10 billion of cash and reduced projected interest expense about $8 billion a year.  

By 2001, true sale allowed GM to help save the US economy after 9/11.  True sales let GM promise to “KEEP AMERICA ROLLING” with low cost automotive finance.

[As with many “good” things, this financial boom later doomed GMAC and GM.  As a “shield,” true sale saved GM.  As a “sword,” it created means to manipulate auto demand.  That buried the firm in 2008, as over-stimulated demand dried up in the crisis.  The firm went broke.  No secured creditors, however, were harmed.] 

With freedom from fraud and prices that assure “fair value” for all investors, true sales can be a financial miracle.  By 2008, their abuse became a financial disaster.

In 1993, GMAC so well-assured there would be no default that it maintained up to $15 billion of A-2/P-2 unsecured CP (almost 4 times the prior record).

FOR GM shareholders, TRUE SALE was PRICELESS (at least for a decade).

“TRUE” SALE SEPARATES “LOW” CCI ASSETS FROM “HIGH” CCI OWNERS.  That, and that alone, alone justifies “securitization.”  Abuse of true sale, on the other hand, defines the process that drove the world to the abyss of wealth extinction in 2008.

NOW, let’s see how Appendix A defines “true sale” in terms scammers can’t escape.

The title states our 19-letter “Legal Isolation” password (TS=B[eyond]TROTTAIC,EIBOOR).   

The 6-box table is divided by 2 groups on the side (the transferor and its creditors) and 3 circumstances along the top (normal legal proceedings, bankruptcy and equitable receivership).  To be “true” a transfer must meet all tests.  [“Flashing” this table at a scammer, by the way, waves a red flag in front of an angry bull.] 

Box 6 is hardest:  Are assets beyond the reach of a receiver representing innocent unsecured creditors of a transferor?  

FDIC serves as federal receiver in any insolvency of a US bank.  Receivers are far more powerful than bankruptcy trustees.  Trustees, for example, are “in pari delicto” with those that conspire with a bankrupt to defraud people.  As such, they are generally barred from pursuing damage claims against “fellow crooks.”  

The US court of Appeals for the Second Circuit, let Madoff’s trustee recover $15 billion of assets others received, but denied him a right to pursue damages for innocent creditors against banks that admitted to knowing what Madoff was doing.  That difference, explains why “banksters” fear “orderly liquidation authority” receivers of Dodd-Frank.  [Smart trustees, however, now know how to avoid this limit.]  

Reporting fraud as “debt” is NOT a result defrauders WANT.  Thus, auditors and lawyers need “iron pants” to tell clients the truth.  If a lawyer or auditor does not spot fraud before it renders a “true” sale opinion, IRRESISTABLE FORCE MEETS an IMMOVABLE OBJECT, prior practice—[“change” is a “four letter word” on this issue.] 

What happens when one tries to hide behind layers of entities?

The USSC’s 1939 Deep Rock Oil case compels courts to “disregard” the doctrine of entity when required to so do to correct “fraud or injustice.”  So a “true” sale must be fair to all. 

What’s “fraud” is compounded, moreover, by the 1925 opinion of Justice Brandeis in Benedict v. Ratner.  If any interest is retained by a transferor that is inconsistent with a transfer of ownership, the case says the transaction “imputes fraud conclusively.”  [It’s a legal “boomerang” for scammers—abuse mandates fraud and fraud precludes true sale—THESE matters get far worse with tax considerations]

So, how does a rating agency assure a “true” sale?

In 10 paragraphs, Appendix A meets all 6 tests.  It was prepared by a committee that studied the matter for decades.  FASB looked at every conceivable alternative standard and concluded in 1997 that no other test withstands scrutiny.  In 2010, FDIC agreed.  

Since law deems non-compliant transactions secured debt, FASB’s conclusion seems beyond contradiction.

Nevertheless, as legal responsibility is clarified and penalties rise, so does reluctance to resolve errors.  [Some form of “absolution” is needed here, but at what price?]

By recent decisions, we now know—(1) the SEC deems the use of a lesser standard (allowing firms to hide leverage) an accounting fraud and (2) the IRS deems pretend sales (to hide assets from tax claims) a tax fraud.  Both are revealed by the curious case of Overseas Shipbuilding, where tax and accounting fraud led to bankruptcy.  

To recover for creditors, claims have been served on lawyers and accountants that opined on the existence of a sale.  To my surprise, a court recently allowed those claims to proceed.  [Since the claims are for obligations owed to the bankrupt, not for crimes conducted with the bankrupt, in pari delicto is not a bar]

So, that’s my story.  If you’d like, I can take questions on the Appendix A OPINION, and hopefully give you some EXAMPLES. [To the extent I’m not barred by confidentiality.]


FLF 2/27/15


PS:  [The History of Banking as Delayed Taxation--OBS for Government.

{Religion:  Troy to Reformation:  Priests “tax” for grants of absolution.}

Caesar to 1215:  Dictators tax at will and collect using punishment of death.

1215 to Glorious Revolution:  “Can the king tax to fund whims of conquest?”

1694 to ?  BOE (central bank) borrows OBS and lends so king can speculate on war with France, then hides it in trade speculation until South Seas bubble bursts.

1776-Adam Smith compares “reserve” banking to rate shifting of a central bank.

1776 to Jackson   US debates central bank as OBS/hidden taxation.

1863-Lincoln= National banking system=competition and OBS for Civil War.

1865 to 1933  Gilded Age, impotent Fed and an OBS/non-consolidation bubble.

1933 to 1982  Control=OBS for war, decimated by inflation and Vietnam

1983 to 1997  Direct OBS replaced by “purport to be a sale” (hidden OBS).

1997 to 2010  Hidden OBS stops but few “get the memo,” ends with Armageddon.

2010  to ?  How do we unwind $30-60 T of OBS accounting and tax fraud?]