Wednesday, September 21, 2011

Loan Fraud

From New Economic Perspectives an excerpt from an interview by the excellent Jim Puplava with an strongly worded William Black, a Professor of Economics at the University of Missouri, intimately invovling in righting the Savings and Loan Crisis Black speaks vigorously on a subject dear to my heart: why no one has gone to jail for the damage done to the world's economy:

The Savings & Loan crisis was a tragedy in two parts. First part was not fraud, it was interest rate risk. But the second phase, which was vastly more expensive, was to defraud and the National Commission that looked into the causes of the crisis said that the typical large failure fraud was invariably present. And there were real regulators then. Our agency filed well over 10,000 criminal referrals that resulted in over 1,000 felony convictions and cases designated as nature. And even that understates the grade in which we went after the elite. Because we worked very closely with the FBI and the Justice Department, to prioritize cases—creating the top 100 list of the 100 worst institutions which translated into about 600 or 700 executives—and so the bulk of those thousand felony convictions were the worst fraud, the most elite frauds.

In the current crisis, of course they appointed anti-regulators. And this crisis goes back well before 2007 and of course it is continuing, it does not end at 2009. So the FBI warned in open testimony in the House of Representatives, in September 2004—we are now talking seven years ago—that there was an epidemic of mortgage fraud, their words, and they predicted that it would cause a financial crisis, crisis being their word, if it were not contained. Well no one thinks that it was contained.

All right so you have massive fraud driving this crisis, hyperinflating the bubble, an FBI warning and how many criminal referrals did the same agency do, in this crisis. Remember it did well over 10,000 in the prior crisis. Well the answer is zero. They completely shut down making criminal referrals and whichever administration you hate the most, you can hate because while most of this certainly occurred in the Bush Administration, the Obama Administration has obviously not changed it. Obviously did not see it as a priority to prosecute these elite criminals who caused this devastating injury.

Another way to look at it is, how much fraud is there and we know the following: There are no official statistics on sub prime and similar categories because there are no official definitions. So there is a little wishy-wishy in this but the best numbers we have are that by 2006, half of all the loans called sub-prime, were also liars loans. Liars loans means that there was no prudent underwriting of the loan. And total, about one-third of all the loans made in 2006, were liars loans.

Now that's an extraordinary number, especially when you look at the studies. And here I am going to quote from the Mortgage Bankers Association. That is the trade association of the perps and this is their Anti-Fraud Specialist Unit, and they reported this to every member of the Mortgage Bankers Association in 2006. So nobody can claim they did not know. They found three critical things, first they said this kind of loan where you do not do underwriting is, and I am quoting again, “an open invitation to fraudsters.” Second, they said “the best study of this found a 90% fraud incident.” In other words, if you look at 100 liars loans, 90 of them are fraudulent. And third they said, therefore these loans where the euphemism is stated income are Alt-A loans, actually deserve the title that the industry calls the Behind Closed Doors, and that is liars loans. The other thing we know from other studies and investigations, is that it was overwhelmingly lenders and their agents that put the ‘lie’ in liars loans. Now that is obvious when you look at the lies about appraisals, because homeowners cannot inflate appraisals. But lenders can and how they did it was shown in an investigation by then New York Attorney General Cuomo, now Governor, who found that Washington Mutual, which is called WAMU, and is the largest bank failure in the history of the United States, and indeed the history of the world, had a black list of appraisers. But you got on the black list if you were an honest appraiser, and refused to inflate the appraisal.

Similarly, we know that you could get, for example, a California jumbo mortgage, that’s one say the size of $800,000. As a loan broker, just one of these, you could get a fee of $20,000. If it hit certain parameters. And those parameters would have to do with what is the interest rate, but also what is the loan to value ratio, and what is the debt to income ratio. So the loan to value ratio is how big is the loan compared to the value of your house. Well that is an easy ratio to gimmick, and we have just explained why, by inflating the appraisal. If you inflate the appraisal then the loan to value ratio falls and the loan looks like it is a lot safer, and you can sell it to Wall Street for significantly more. The debt to income ratio, well that is even easier to gain. The debt is simply how much are you going to borrow to buy the house. And the income is, what is the income stated on the loan application for the borrower. Except that this is a liars loan, so the lender has agreed that it is not going to check. It is not going to verify whether the income is real. And so the loan broker can write down any income number he or she wants. And that will gimmick that ratio and again it will put it into the sweet spot, for all of these things, so that you could get your $20,000 fee. Now step back and ask yourself, many of these guys who are loan brokers, their previous job was literally flipping burgers, right. So are you going to leave it up to the borrower to come up magically with the right income and the right appraisal when they don’t even know what the magic numbers are and cannot inflate the appraisal? Of course not. You are going to do it as the loan broker. You are going to tell the borrower to write in a greatly inflated income number, or maybe you are afraid that they are too honest, so you may simply write it in yourself, which happened in many cases.

So again, we got thirty, roughly one-third of all the loans by 2006, after these warnings. They rapidly increased the number of liars loans they made. One-third of them are liars loans and 90% of them are fraudulent, which is to say, that the amount of fraud annually was well over a million fraud a year. We are talking about hundreds of billions of dollars in fraudulent instruments.

We have known for centuries, that if you don’t underwrite loans, or if you don’t underwrite insurance, you’ll get something called "adverse selection". And that means you get the worse possible borrowers or people being insured and the expected value of lending to somebody, in conditions of serious adverse selection, is negative. Or to put that in English, that means if you lend this way, you lose money. And we have known this for centuries. This is like betting against the house in Las Vegas. You could win some individual bets, but you stay at the table for three years, and you are going to lose everything. And as we say, you will lose the house, to the house. And, that is exactly what is going to happen here. So yeah, the CEO’s knew all about this. Why did they do it? And the answer is, here is the recipe, it’s got four ingredients for creating what the Nobel Prize Winner in Economics, George Akerlof and his colleague Paul Romer said in 1993 was "a sure thing". And that sure thing is what in criminology we call accounting control fraud.

So control fraud is when the person who controls a seemingly legitimate entity, uses it as a weapon to fraud. In the financial sphere, the weapon of choice is accounting. So here are the four ingredients of the recipe that produce a sure thing of record accounting income.


Grow like crazy
Make preposterously bad loans but at a premium yield.
Have extreme leverage. That means you have a ton on debt.
Put aside only ridiculously low allowances for future loan losses.

You do those four things, you are mathematically guaranteed to report record, albeit fictional, profits in the short term. You are also guaranteed with modern executive compensation, to make the Senior Executives wealthy, and you are guaranteed, because after all, if you think about those four ingredients, they are the perfect recipe as well for maximizing real losses. And that’s why the title of Akerlof and Romer’s article says it all, “Looting: The Economic Underworld of Bankruptcy for Profit.” The firm fails but the executives walk away rich. This is the same concept with my book “The Best Way to Rob a Bank Is to Own One.” It is these internal people who control the seemingly legitimate entity that can get away with financial murder. And here is the really bad news. I mean that is bad news right there, but the really bad news, is that this tends to happen as the FBI warned, and again in 2004, seven years ago. So the next time you hear some moron tell you that no one could have predicted this, it was predicted by the Premiere Law Enforcement entity in the world dealing with white-collar crime.

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