The Two Documents Everyone Should Read to Better Understand the Crisis

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.

Don't ask; don't tell: book profits, "earn" bonuses and closet your losses

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.

Stress this: stress tests are useless against the nonprime problems

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.

The results were disconcerting

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:

• the FBI accurately described mortgage fraud as "epidemic"
• nonprime lenders are overwhelmingly responsible for the epidemic
• the fraud was so endemic that it would have been easy to spot if anyone looked
• the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a "don't ask; don't tell" policy
• willful blindness was essential to originate, sell, pool and resell the loans
• willful blindness was the pretext for not posting loss reserves
• both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed
• the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses
• the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation
• many of the big banks are deeply insolvent due to severe credit losses
• those big banks and Treasury don't know how insolvent they are because they didn't even have the loan files
• a "stress test" can't remedy the banks' problem -- they do not have the loan files

¹ "Mortgage Fraud: Strengthening Federal and State Mortgage Fraud Prevention Efforts" (2007). Tenth Periodic Case Report to the Mortgage Bankers Association, produced by MARI.

 

Comments

[Seattle34]

"...had the Bush administration acted with even minimal competence­."

And what about congress? The dems controlled both houses from 2006. If this was such a problem, why didn't they spring into action?

Remember, the president doesn't make laws. The president APPROVES or VETOES laws that congress makes. Think back to school house rock.

IF the president VETOED somethign that would have prevented this, then he could be blamed. But if congress never proposed anything, then they shoudl all be blamed.

Quit playing sides here. It isn't R versus D. It's PEOPLE versus GOVERNMENT

[bowser]

There are laws that already exist. it is up to the executive branch (justice dept.) to enforce them. Congress had no roll; this is part of the scandal, the justice dept has been shown not to go after republicans. One guess what party was getting donations from the financial industry.

[Craniumdude]

What does the word LEADER mean to you? Did you know there has been a record amount of filibusters since 2006? And yes this might all been a mute point had The gwboy administration acted with even minimal competence. But wait in 2004 we were bogged down in george's folly. Tell me....what was the reason we invaded Iraq that year? But gee, It was only one war, since we essentially at that point had drawn down every thing from Afghanistan in order to throw it at Saddam. Which basically abandoned our original objective, lost us many of our gains and has left the region even more chaotic. I only ask the republican'ts to START taking SOME responsibility! And it should be
PEOPLE vs. BAD Government.

[MikeBoyScout]

@Seattle34, while there is much wrong with your comment, permit me to pick just two.

(1) The Democrats did not control both houses FROM 2006.
The Democrats took control of both houses in the on January 3, 2007; The 110th United States Congress.

(2) In the USA, the People ARE the government (see first 3 words of US Constitution).

[Texas Aggie]

While the president may not make laws (but with the way W was issuing all those executive orders, that statement may not be true), he absolutely does determine which laws will be enforced and against whom. And he does propose laws for Congress to act on. Dubya set some sort of a record for interfering with investigations of his buddies, and initiating groundless investigations of his enemies. Remember the DoJ and Gonzo/Monica? Besides, it was W's administration that set the regulations for how much reserves the banks should have, etc., and appointed the foxes around the chicken houses. Cox wasn't appointed by Obama.

[Elephantinroom]

You're correct that the President does not write laws. He did, however, encourage legislation.
He urged Sen. Chuck Hagel to introduce 2 bills: Housing Enterprise Regulatory Reform Act of
2005 (S.190) and The Act of 1007(S.110­0), Both bills failed.
In July, 2005, Sen. Banking Committee Chairman, Sen. Richard Shelby (R-Ala), released legislation that could force GSE's Fannie/Freddie to reduce their portfolios. This bill failed also.
Rep. Barney Frank, "People tend to pay their mortgages. I don't think we are in any danger here."
Aug. 2007 Pres. Bush calls on Congress for GSE reform, "Congress needs to get them reformed."
WH Press Conference 08-09-07
Chris Dodd calls on President to immediately reconsider his "ill advised position." This from "Fannie Mae's Offer to Help Ease Credit Squeeze is Rejected, as Critics Complain of Opportunism," by Eric Dash NYT 8-11-07.

[MSB]

Where is the jail time?

There need to be arrests.

If there is no accountability then why should people pay their taxes? Trust in the economic system works both ways.

[whtheman]

Does not the whole method of finances thing have a very close resemblance the an institutionalized version of a Ponzi scheme?

[Dvmx]

hmm... like maybe a tax strike until the fraudsters and thieves are actually held accountable?

[peterg76]

We knew all the secrecy and evasiveness in the "bailout" scam wasn't about hiding conscientious ethical behaviour.

[ssg13565]

So if the FBI identified the problem and they carried out many investigations, why didn't the problem get stopped in its tracks? It is not clear from the CNN report that the FBI actually had any clue as what was the real fraud.

Why won't Standard and Poors get sued by all the investors who depended on them to do a competent job of rating securities?

Are there any publicly traded law firms that we can invest in? I suspect that they will have a booming business.

If the Government owns 36% of Citi, does that make Citi immune from lawsuits?

[1differentdrummer]

Lenders initiated 80% of the fraud? And the FBI was reporting the problem? How is this different from 9/11?

[abbeyroad]

" The ONLY credit we can give Bush, is that he didn't distribute ALL of the TARP money to Wall Street. Maybe, he just didn't have enough time. "

Bush doesn't get ANY credit for that because it was the house & senate that wouldn't let him have it all at once.

[Fremon]

While this ties together lots of the individual "frauds" necessary to cause our present financial problems, a lot of people understood some of the individual issues such as a sudden growth of subprime lenders and lending as well as many anecdotal stories about individual purchasers. A story that I witnessed in Oakland, CA was a neighboring house that was being sold by the son whose mother had just died. The house was old and in need of repair. In talking to the son he expressed a price point of the worth based on a recent evaluation. The house fetched about $75k over that price. The new owner quickly invested about $15-20k in repairing and painting the house. The new owner tried to flip the house and finally abandoned the property. This occured during the summer of 2005. A promise of things to come.

[Elephantinroom]

In his address to the Houses on Tuesday, President Obama said our financial crisis was created because too many mortgages were given to unqualified buyers.
Fannie Mae and Freddie Mac underwrote HALF of all the mortgages in the U.S.
Their cause may have been noble, to provide housing to low income people.
Their increase in loans to more and more people caused an increase in housing prices.
When many of those risky loans defaulted, the foreclosed houses back on the market caused a decrease in housing prices. Supply and Demand.
The banks traded bundled assests of mortgages. They took a gamble and they lost and they should fail because they took a gamble and they lost.
The banks could never have traded in those bundled assets in such large numbers if they hadn't been there in the first place. Fannie Mae and Freddie Mac could offer lower guarantees on mortgages because they were a Government Supported Entity (GSE). We need to know what caused a problem before we can fix it.
Barney Frank has been on the oversight committe of Fannie Mae, House Financial Services Committe, since 1991. He is currently the chair. Bills were proposed in 2003 and 2005 to increase regulation on Fannie. Barney Frank opposed both bills.

[blood1]

This appears to be an "independent" look at the problem. So as pundits and bloggers appear to be really busy pointing fingers at their opposing political party, we should take a deep breathe and quit all this silly behavior.

Everyone had a part, some more than others - but now it the time to figure out how to solve the problem and try and get the economy moving again.

[paixa3]

The problem will NEVER be solved until you let banks FAIL. Sorry, there is no other way out in the long run.

[Elephantinroom]

I agree.

[gemzenith]

conservative republicans have convinced the public at large that it is the irresponsible individuals that bought these homes are to blame.Ive long suspected it had something to do with the system and less to do with ones personal decisions.­How is one going to make good personal decisions when that decision is based on fraudulent claims?Deception seems to be the name of the game.Trust no one and ALWAYS cover your own ass.

[Fremon]

What the conservative pundits who blame the individuals don't want us to remember is that the bill made during the Clinton admin to help more persons acquire their homes was that loans were to be made had the stipulation "in keeping with good banking/business processes". That went out the window when the subprime mortgage producers figured out that money was to be made when they could sell these mortgages off to Freddie and Fannie and make them into subprime deritivitives. They well knew that many of these loans could not be paid back but went ahead anyway as there was profits to be made. A couple of my favorite anecdotal stories I heard were the "marichi Mexican restaurant singer who said he made $100k/ the busboy talking about his $600K house/and the WaMu supervisor who was made by mgt to sign off on a house loan that turned out to be an empty lot which she knew was one at the time".

[LizinOhio]

"in keeping with good banking/business processes"

Yes, it went out the window and GREED took over.

[CAPTAINSKIPPY]

And, inflating the values of homes creates larger tax liabilities for estate taxes and real estate taxes.

[1differentdrummer]

Estate taxes? Have you ever known an estate that paid taxes? They are few and far between, in the millions of $$$.

[jayhawk67]

The only thing in shorter supply than ethics in the subprime lender community is the number of prison beds available for those in their ranks who turned a blind eye when they should have pulled the fire alarm lever.
There ought to be sweeping prosecutions, a la Nuremburg, for the lenders, the ratings agencies and affiliated real state sales people involved.
The poison these despicable sorts unleashed has not only brought the economy of the world to its knees but has also wreaked devastating havoc on the credibility and national security of our country.
It is little wonder the world cheered when Obama was elected. Their optimism should be repaid by our showing them that the dirtbags who caused so much misery have received swift justice.
If the government doesn't take steps to prosecute, the whole world will wonder why.
It is sad that steps like this would probably been justified at the onset of Hoover's depression but none was taken. Perhaps that might have avoided our current dilemma.

[garcam]

You are absolutly right here Hawk! We can empty out the prisons of pot heads and victimless criminals and fill them back up with these cons and real criminals and execute the facilators a la' Chinese justice and re-institute sensible financial regulations. One of the great problems here in America, as shown by OJ Simpson is that you can get as much justice in America as you can afford and that punishment has no teeth.
Americans should demand investigations and prosecutions as a #1 priority for re-establishing trust in the American financial system and by making those convicted destitute to return some of the stolen money to Americans!

[senorlou]

Here in LA, people were spending half a million $ to live in the worst parts of town. It was obvious this whole housing "boom" was a crock. People were flocking to buy homes for three times their true value. What a country.

[lmwoolf1953]

Alot of these so called savvy investors need to read a copy of Thomas Paines "COMMON SENSE", when it comes to putting their entire fortunes in these fly by night financial scams. Forensic analysis is a must, so that all of the derivative products these investors put their money in can be substantiated to the nth degree. A saying I learned on Wall Street said " NO PLACE BURIES ITS DEAD SO GRANDLY AND FORGETS THEM SO QUICKLY, WHICH IS UNDERSTANDABLE WHEN LIFE IS PERCEIVED AS A SERIES OF DISCRETE TRANSACTIO­NS"!!!!...­..Another Wall Street saying goes: "THERE ARE 2 THINGS YOU SHOULD NEVER SEE IN YOUR LIFETIME, HOW THE MEAT INDUSTRY MAKES ITS SAUSAGE AND HOW THE INVESTMENT BANKER MAKES HIS DAILY BREAD!!!".­......To Citibank, Bank of America, Chase and Wells Fargo and The Royal Bank of Scotland, Bernie Madoff & Allen Stanford..­..GOOD RIDDANCE TO THE NTH. DEGREE!!!!

[NapiersLaw]

To make money on mortgages 1.) collect the interest on your own money, 2.) sell the mortgage, or 3.) collect the difference between fed money rate and your loan rate. Loaning at rates below prime should be illegal. This eliminates methods 1 and 3. Hence, #2 is your only play, & if some entity will lend you the money at below prime you are set for life. An infinite amount of money is made by simply moving as much paper as the market will allow. That's it, no evil banker guy, no scoundrels in stripe suits, not even an unethical lunch at Hooters. Under Clinton rules you could even legally insure the folks you are selling the paper to ( for the first time since the 1800's when banks failed like clockwork every 30 years). The only people stiffed were the international bankers and the poor misled fool who thought he could get a million dollar home for 200$/mo..
As a country we ended up with a lot of new homes, a market surge that put millions to work, and a bunch of millionaires that didn't have to overly manage all those swell mortgages. OK, so you also end up with WWIII, a bunch of clinically depressed, out of work, government dependency challenged, homeless people, and a lot of low cost real estate. i.e. the problem was never the bankers, it was the Clinton and Bush administrations, future radioactive rubble and all!!! 199%