As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds.1 When the person that controls a seemingly legitimate business or government agency uses it as a "weapon" to defraud we categorize it as a "control fraud" ("The Organization as 'Weapon' in White Collar Crime." Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds' "weapon of choice" is accounting. Control frauds cause greater financial losses than all other forms of property crime -- combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a "criminogenic environment" (Big Money Crime. Calavita, Pontell & Tillman 1997.)
The FBI correctly identified the epidemic of mortgage control fraud at such an early point that the financial crisis could have been averted had the Bush administration acted with even minimal competence. To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud.
The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages "underlying" the derivative. A senior manager sends a blistering reply with this forceful punctuation:
Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.
Fraud is the principal credit risk of nonprime mortgage lending. It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, "most investors" (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.
The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The "AAA" rating is supposed to indicate that there is virtually no credit risk -- the risk is equivalent to U.S. government bonds, which finance refers to as "risk-free." We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this era rises like a stairway to heaven [PDF]. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud.
Worse, the S&P document demonstrates that the investment and commercial banks that purchased nonprime loans, pooled them to create financial derivatives, and sold them to others engaged in the same willful blindness. They did not review samples of loan files because doing so would have exposed the toxic nature of the assets they were buying and selling. The entire business was premised on a massive lie -- that fraudulent, toxic nonprime mortgage loans were virtually risk-free. The lie was so blatant that the banks even pooled loans that were known in the trade as "liar's loans" and obtained AAA ratings despite FBI warnings that mortgage fraud was "epidemic." The supposedly most financially sophisticated entities in the world -- in the core of their expertise, evaluating credit risk -- did not undertake the most basic and essential step to evaluate the most dangerous credit risk. They did not review the loan files. In the short and intermediate-term this optimized their accounting fraud but it was also certain to destroy the corporation if it purchased or retained significant nonprime paper.
What commentators have missed is that the big banks often do not have the vital nonprime loan files now. That means that neither they nor the Treasury know their asset quality. It also means that Geithner's "stress tests" can't "test" assets when they don't have the essential information to "stress." No files means the vital data are unavailable, which means no meaningful stress tests are possible of the nonprime assets that are causing the greatest losses.
A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch's report on what they found.
Fitch's analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.
[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.
Fitch also explained [PDF] why these forms of mortgage fraud cause severe losses.
For example, for an origination program that relies on owner occupancy to offset other risk factors, a borrower fraudulently stating its intent to occupy will dramatically alter the probability of the loan defaulting. When this scenario happens with a borrower who purchased the property as a short-term investment, based on the anticipation that the value would increase, the layering of risk is greatly multiplied. If the same borrower also misrepresented his income, and cannot afford to pay the loan unless he successfully sells the property, the loan will almost certainly default and result in a loss, as there is no type of loss mitigation, including modification, which can rectify these issues.
The widespread claim that nonprime loan originators that sold their loans caused the crisis because they "had no skin in the game" ignores the fundamental causes. The ultra sophisticated buyers knew the originators had no skin in the game. Neoclassical economics and finance predicts that because they know that the nonprime originators have perverse incentives to sell them toxic loans they will take particular care in their due diligence to detect and block any such sales. They assuredly would never buy assets that the trade openly labeled as fraudulent, after receiving FBI warnings of a fraud epidemic, without the taking exceptional due diligence precautions. The rating agencies' concerns for their reputations would make them even more cautious. Real markets, however, became perverse -- "due diligence" and "private market discipline" became oxymoronic. These two documents are enough to begin to understand:
1 "Mortgage Fraud: Strengthening Federal and State Mortgage Fraud Prevention Efforts" (2007). Tenth Periodic Case Report to the Mortgage Bankers Association, produced by MARI.
I have heard your anger. You feel your retirement savings, homes, and jobs have been fleeced--taxed by Wall Street without your consent. We will put this right.
I understand that widespread fraud was perpetrated in the mortgage market. In 2004, the FBI reported that fraud in the mortgage market was an epidemic. The fraud may have extended from local mortgage brokers to Wall Street firms under the names NINJA, liar, and neutron loans. Here is my plan:
One, the Justice Department will investigate for fraud in diverting homeowners into risky mortgages.
Two, the Justice Department will investigate for fraud all firms involved in creating, rating, securitizing, and selling these toxic loans. In both investigations, we invite the states to join us.
Three, the Justice Department will investigate if AIG was, itself defrauded by domestic and foreign firms. If so, we will pursue criminal cases under applicable law and the RICO statute and demand a return of US taxpayers' money. Any foreign entity not cooperating with the investigation or not returning the money will be banned from conducting business in the US.
And lastly, I have instructed the FDIC to place insolvent banks into receivership immediately. They will be cleaned up and re-privatized as soon as possible.
Tonight, the Wall Street pillaging ends.
And a response to the related issue that the Republicans and Cheney claim that they were sounding the alarm for tighter control of Fannie and Freddie very early and were thwarted by the Dems: Yes, but for a different reason.
In their quest for less government and more Wall Street and Big Bank control of mortgage lending they were trying to bring about the DEMISE and IRRELEVANCE of Fannie and Freddie -not protect the economy and US citizens from anything. Greed was their motivation and they were trying to clear the way for TOTAL monopolization of the lending facilities by Wall Street and the Big Banks.
The CURRENT SPIN by Cheney and other Republicans begs you to believe that their motivation was to do something other than ENABLE Wall Street and the Big Banks to FULLY control home lending.
The GSE's had their accounting problems to deal with and this also allowed the roosters into the henhouse while Fannie/Freddie's attention was shifted away from the lending issues. Their SURVIVAL was at risk as they were being totally shut out if they didn't participate at some level.
It has been a decade of "It's much easier to ask for forgiveness, than to ask for permission" and it has and will cost our great country dearly. Have mercy on the millions of innocent Americans whose jobs and homes have been lost. Their lives and EVEN MORE IMPORTANT - THEIR DREN'S LIVES HAVE BEEN DEVASTATED and this risks our economic future.
President Obama, if you don't give us the bad, but true news, the Republicans will, and it will be too late.
The Crisis of Credit Visualized by Jonathan Jarvis
http://crisisofcredit.com/
Thank you for this systematic and easy to understand lecture explaining how things went weird.
However, just form the street level observations one could notice that this fraudulent process could go on as bankers were receiving commission in real money for moving around inflated assets. Bankers got rich by running banks into bankruptcy, http://www.huffingtonpost.com/henryk-a-kowalczyk/its-time-for-financial-di_b_128466.html.
In my layman’s point of view, the only way of untangling this mess is by giving banks a few months to undo all this complex mortgage bounding. Instead of the government giving money to big banks that caused this mess to begin with, the government can give them a loan covering current payments on defaulting mortgages for the period of six month or so. This would force banks to write-off clearly fraudulent loans. Additionally, with this approach it would be in banks best interest to rewrite all other troubled mortgages to the contracts that homeowners could fulfill. More details at http://www.huffingtonpost.com/henryk-a-kowalczyk/the-simplest-plan-for-hel_b_167642.html
Conveniently forgetting due diligence was a requirement for individuals to avoid accountability.
The whole setup was organized so those involved could avoid jail.
What has the FBI been doing?
Political influence to prevent prosecutions and even disclosure seems certain.
Is it an accident we hear about this massive fraud only after the election?
Smells like a Neil and a Jeb mess, once again.
http://eyeonmiami.blogspot.com/2008/07/miami-herald-uncovers-massive-mortgage.html
Fannie/Freddie. Fed. Housing Enterprise Regulatory Reform Act of 2005 (S.190) and The Act of 2007 (S.1100). Both bills failed.
In 2005, Sen. Banking Committee Chairman Sen. Richard Shelby (R-Ala) released legislation that could force GSE's Fannie/Freddie to reduce their portfolio. It was rejected by Congress and never reached the Senate.
As far back as 2001, The Bush Administration called for more oversight. The WH FY02 budget declared that the size of Fannie/Freddie was "a potential problem."
Oversight was rebuffed, in different instances, by Rep. Barney Frank, "I don't think we are in any danger here." "I see nothing in here that suggests that safety and soundness are an issue." He accused Bush of "creating an artificial issue." "These two entities-Fannie Mae and Freddie Mac-are not facing any knid of financial crisis."
Chris Dodd called on Bush to "immediately reconsider his ill advised position." This was in response to Bush's call on Congress, again, for GSE reform. "FannieMae's Offer to Help Ease Credit Squeeze is Rejected, As Critics Complain of Opportunism," by Eric Dash (NYT 8-11-07)