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

[AuntWilma]

"The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivative­s."

National Public Radio had a story about this very topic last May 27. See http://www.npr.org/templates/story/story.php?storyId=90840958

They interviewed an auditor whose job it was to check those "unavailable" loan tapes on behalf of the investment banks. She reported that her findings of serious inconsistencies had been repeatedly overruled overruled by her supervisor.

[Elephantinroom]

Fannie/Freddie were encouraged in 1999, by President Clinton, to ease regulations so more people could own houses. The agencies underwrote or guaranteed many more loans after the deregulation. The institutions grew exponentially, though they were fiscally viable to guarantee only a fraction of those loans.
In 2003, President Bush asked Sen.Shelby to present a bill to Congress to provide more regulation to Fannie/Freddie. He did. It wasopposed­..
In 2005, President Bush asked Chuck Hagel to present a bill to Congress to provide more regulation to Fannie/Freddie. He did. It was opposed.
Barney Frank has been on the oversight committe for 20 years.
Fannie/ Freddie owned or underwrote HALF of the mortgages in the U.S.
Their oversight committe was CHAIRED by Barney Frank when, on Sept, 7, 2008, The Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac in conservatorship.
This means that the U.S. taxpayer now stands behind about $5 TRILLION of Fannie/Freddie debt.
Who was responsible for the oversight? Barney Frank. He never questioned their viability and supported them with quotes:
"I see nothing in here that suggests that safety and soundness are an issue."
""These two entities-Fannie Mae & Freddie Mac-are not facing any kind of financial crisis, said Barney Frank of MA, ranking dem. on the Financial Services Committee. "The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing."

[Bryan Hurst]

ah, the "Fannie/Freddie" bogeyman. I was wondering how long it would take some conservative apologist to drag out that canard. What's next: "welfare queens" and "trees cause pollution"?

[JanusDaniels]

Elephantinroom,
Please read the article before posting, particularly, "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." and the link which apparently did not work in your browser; here's the URL for the specific .pdf:
http://oversight.house.gov/documents/20081022112230.pdf
A brief review of the most documents at
http://oversight.house.gov/
show Fannie/Freddie irrelevant to the major fraud; regardless, do note again that:
"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."

[JDShipley]

How many originators, brokers and mortgage bankers got rich off liar loans? Who are these lenders and are they lining up to rewrite their own toxic loans through FHA now?

[Wiserone]

And, HOW MANY Hispanics and other minorities did this legislation, to push home ownership which was passed by Bush and was the reason for the TARP Bill: 5 MILLION people and at what cost? $440 BILLION!!! And, HOW MUCH from the TARP Bailout has been used to bail out the same folks who gave out these loans? $400 BILLION!! Coincidence? I don't think so. As, I said before, the TARP Bailout was to take care of Bush's Wall Street Cronies BEFORE he left office BECAUSE all of those loans were coming due and Wall Street KNEW that their crimes would not be able to further secure their interests. 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. And, anyone is still surprised that the TARP was ONLY a 2-page document that Bush and Paulson presented to Congress? And, that so-called, quickly called meeting with 'select' members of Congress to explain TARP Bill and exiting that meeting they told the American people that if the TARP isn't passed the country will collapse and it still did! Tells me whoever was in that meeting all of their hands were dirty with Wall Street and was just to cover their you-know-what.

[Shavano]

Holder can still pick this up, this is RICO and it's a continuing conspiracy. We should demand that the AG investigate this and prosecute where applicable.

[Elephantinroom]

I agree completely.

[Juneauwhat]

Now how did we get this far without anyone mentioning RICO?

Any competent prosecutor would have a productive time exploring the Racketeer Influenced and Corrupt Organization Act with respect to the thieves who have orchestrated this mess. What about the spouses who were present at social events where this business was discussed? Do they go down like the ghetto wife in the kitchen when the drug deal went down? Will Madoff's wife just drive away to one of her homes in her pretty new Mercedes? Will they get lighter sentences for turning in their friends and associates?

Or will the people who have almost destroyed us just walk away with their Billions?

[Bitely]

Bill, your comments are illuminating, as usual. Remember your same smart sense from our days at the Bank Board! Same old, same old, only this time the banks, who clamored for receiverships for the S&Ls, are still in denial . . . where did this word "nationalization" come from? In our day, it was simply "merger & acquisition" and open for business on Monday with (almost) everyone's deposits protected. Now we are protecting stockholders and other "risk" capital investors, stringing out and increasing the cost, postponing the inevitable. Geitner is/hopefully was over his head, Fed as usual too close to the institutions for which they were responsible.

[Euroflycars]

TreeTracker wrote:

"...The rating agencies had a duty to properly rate these mortgages and declined to do so. Had they properly done their job, this would have never gotten off the ground."

He seems to designate the rating agencies as the top responsible, explaining why:

"...becaus­e the rating agencies were making tons of money for giving these loans a AAA rating, the banks were allowed to continue to perpetrate the fraud."

…and concluding: "They knew what was going on and chose to ignore it in favor of big bonuses and high profits."

OK, but who cashed-in the lion's share, i.e. the face value of the toxic assets? The question is: how much assets of US banks and investors versus assets of foreign banks and investors were destroyed? There seems to be a 1 : 2 trillion dollar ratio to the detriment of foreigners.

With 1 billion of US losses accounting for assets remaining within the US financial system, and twice this amount of foreign losses accounting for dollars drawn back into America from foreign banks and investors who bought the toxic assets, the balance should read a net profit of 1 trillion dollars for America, shouldn't it?

Hence the top responsible of the crisis may be known by simply asking to whom the crime profits most...

My guess is therefore that the whole thing was nothing less than a US government­-orchestra­ted worldwide hold-up!

[aspertame2]

Hindsight is 20/20. I understand people who took out a little too much loan in the early part of this decade, because I was foreclosed myself earlier, and took it upon myself to try to understand what had happened. By way of reading on more general topics, I found blogs dedicated to the housing bubble/mortgage excesses, and I'm talking 02-03 time frame! But of course no one wants to you to rain on their parade during good times, so I learned to shut up and not warn friends and acquaintances how crazy bad the whole mortgage/home appreciation game was getting.

I doubt I would have known if I hadn't had a life-changing event kind of spin my perspective around. This is not transparent and clear stuff for people who *do* know a little about finance and real estate, let alone the rest of us. With incomes stagnant and prices going up, the home and stock/401K investments have been the big hope for many who would otherwise be very downwardly mobile. People need to believe that it's not all going to hell, and until about week before last, drastic thrift or obvious downsizing of lifestyle carried a real stigma for many. You don't have to sympathize, but it's human. And are you really sure it's not you? If you got hit by a truck, say, and your $1 million health insurance limit capped out, then what would you do?

[geezer33]

You have my sympathy. You are, perhaps, the poster child for the millions of victims of the greed and fraud described in this post. Free market capitalism is as great a myth as the utopian myth set forth by the Bolsheviks in the establishment of the USSR. It took less than 50 years for US policy makers to forget the lessons of the Great Depression and begin to dismantle the governmental protections established to control the greed of an unbridled marketplace; it may take less time for Russia to return to the reality ot the 1970's.

[phloxy]

I remember wondering " How in the heck can so and so get a mortgage on that expensive a home? How could that person get a second and third mortgage on that salary? How could my brother's home in Florida really gain that much value in such a short time without something stopping it at some point? Common sense of the American people saw it coming as easily as this writer did. But, average people have no way to stop it. People making the big bucks had no incentive to stop it. And, Obviously, no one listened to the whistle blowers .

This is another example of the power of the press not doing their job (Iraq being the first). If the major news organizations had pushed and pushed this point, maybe "the people" could have done something. Hey, Rush always says he can get lots of people to yell, where was he in all this? Counting the money he was making in Florida? Oh, yeah, the drug money.

[uglyhumanbeing]

nice use of caps.

[Bugweed]

I suppose none of the comments above or that follow are made by people who:

Fudged, just a little, on a loan application their net worth;

Believed, the moronic dribble from real estate agents, tv shows, investment gurus and the idiot next door, that real property values WILL NEVER DECLINE;

Have perfect credit, always have;

And last but not least, these people will look you in the eye and tell you that their SH%T don't stink.

If you really believe that this whole mess is the fault of one or two parties or a particular government agency or one special bank or credit agency you have been as sound asleep over the last 6 years as Rip Van Winkle was. it is the fault of all of us for believing that real property value cannot decline. Pure and simple. With that assumption in place, any mistake can be forgiven, every fee collected. Start with that premise and believe it, and even lending to people with no verifiable income makes perfect sense. Every mathematical model, every credit decision, every derivative created, starts or started with that completely flawed premise.

[KYZipster]

Oh I dunno, I'm pretty comfortable blaming a particular political ideology that slightly more than half the country bought into for too many years, a belief that deregulated markets, unfettered capitalism would sprinkle wealth down on us all like manna from heaven. I won't claim that one political party is innocent because the Democrats in office bought into it also but I do believe we would not be in this mess if we had allowed the proper regulations to remain in place. Ayn Rand Libertarianism seems unable to factor in the consequences of human greed.

“Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief,” Alan Greenspan

[Nina28]

March 7 2007 Hillary Clinton called it back then -

"Clinton..­.took to the CNBC airwaves Thursday to declare that America was undergoing “a slow erosion of our own economic sovereignt­y.” ....In a letter to Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke, Clinton said Wednesday’s stock market sell-off “underscores the exposure of our economy to economic developments in countries like China. As we have been running trade and budget deficits, they have been buying our debt and in essence becoming our banker.”

Source: http://www.msnbc.msn.com/id/17403964/

[Elephantinroom]

Hillary Clinton is doing a remarkable job as Secretary of State. I am very proud of her.

[PhilipTaylor]

This is the Heart of IT:

FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds, "control fraud" by the Bank using accounting! Control frauds cause greater financial losses than all other forms of property crime. Control fraud epidemics can arise when financial deregulation and de-supervision and perverse compensation systems create a "criminogenic environment" The Best Way to Rob a Bank is to Own One. Black 2005. (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."

A younger Bush pushed Fannie/Freddie and the Investment Banks to fund minority home loans on TV in 2002 to get this scheme started:

http://www.youtube.com/watch?v=kNqQx7sjoS8&feature=related

[Elephantinroom]

In 1999, under the urging of President Clinton, Fannie Mae reduced its regulation so more people could afford mortgages.
In 2003, under the urging of President Bush, Senator Shelby introduced a bill to tighten regulatiinos on Fannie Mae. It was opposed.
In 2005, under the urging of President Bush, Chuck Hagel produced an oversight bill. It was opposed.
Barney Frank has been on the committee that oversees Fannie Mae since 1991. He is currently the chair. The House Financial Sevices Committee.
Fannie Mae owned or underwrote HALF of the mortgages in the U.S.

[Nina28]

The question is where does the trail lead back too? All trails lead back to the Expansion of Red China's economic & military growth through a game plan that took decades in the making.

Let me make this clear, I am not bashing American Chinese citizens but CCP supporters & agents, I support dissidents of Red China.

The Chinese are coming, to buy bargain US (NOT US Chinese but high ranking CCP elite) http://www.boston.com/news/world/asia/articles/2009/02/12/the_chinese_are_coming_to_buy_bargain_us_homes/omes/

"Perfect Sleeper Agent": Chinese Spy 'Slept' In US For 2 Decades - http://www.huffingtonpost.com/2008/04/03/perfect-sleeper-agent-chi_n_94846.html

Let's look at the current build up of RED CHINA. Currently they are our Bankers & Loan Sharks. They own huge stocks in US companies & being so, lay down the rules of outsourcing which goes again, back to CCP. American merchants wither it be Nordstroms or Walmart Carry in their inventory over 70% up to 90% MADE IN CHINA, YOU BUY you support their economic & military might & America's demise & global clout.

What can you do: BOYCOTT CHINA - Stop Feeding the Dragon - Ensure our Sovereignty! Spread the Knowledge. http://buyhard.net46.net/

Write Congress, tell them you want Fair Trade NOT Free Trade with Friendly European and Free Asian Countries who are Democratic or Social Democratic leaning.

[Carolab]

The money trail leads to UBS and other off-shore accounts, THAT'S where.

[Carolab]

The Chinese aren't the only ones buying up "bargains". The UAE has formed asset management groups to score and manage "deals" in the U.S. and the E.U.

This was a planned heist. Get it?

[Jeffrey Goodrich]

Elephantinroom, you make a good point, but the Fannie and Freddie issues are relatively small. Bush was motivated by a desire to see the gsa's driven from the mortgage market so that private mortgage companies could prosper. If you look at a chart of mortgage issuance, that is exactly what happened beginning in 2004 after Bush's SEC Chairman, Christopher Cox, allowed the 5 largest Wall Street investment banks to lever 40:1 the toxic crap they were creating with the rating agencies complicity. Fannie and Freddie's defalcations may cost us $200-400 billion, but the losses on the private issuance are over $2 trillion and growing.

[Elephantinroom]

Fannie Mae and Freddie Mac issues are half of the mortgages underwritten in our country.

I am not trying to exonerate anyone. I am saying that a person making an investment is a risk that they should be willing to take. To win or to fail. The government workers are paid for by tax payers. They should do their jobs. If their job is oversight, they should do the job they are paid to do.
Private companies can invest in whatever they want to. If they win, great. If they lose, that's so sad.
I am livid that we are bailing out businesses. I make stone walls for a living. It's hard work. No one pays me unless they're satisfied. I am definitely not satisfied.

[Cowboylove]

Bad loans form Freddie Mac and Fannie Mae currently account for only about 5% of total bad loans and are not expected to exceed 10% of bad loans in a worst case scenario. Most bad loans were made by real estate speculators not homeowners. Jeffrey Goodrich is correct.

[rbchilds]

Everyone should check out what Ron Paul had to say in 2003:
http://www.lewrockwell.com/paul/paul128.html

[treetracker]

It seems to me a lot of you are missing a crucial point. The rating agencies had a duty to properly rate these mortgages and declined to do so. Had they properly done their job, this would have never gotten off the ground. But because the rating agencies were making tons of money for giving these loans a AAA rating, the banks were allowed to continue to perpetrate the fraud. They knew what was going on and chose to ignore it in favor of big bonuses and high profits.

Anyone want to start a class action lawsuit against the rating agencies? I'd personally like to put them out of business. They were the one check that could have stopped this at the get go and they, too, chose profits. The banks are broke and the money in there is ours anyway. I don't care if I got a dime from the rating agencies. I'd just like to see them go under for their collusion in this.

[Elephantinroom]

The mortgages Fannie Mae and Freddie Mac guaranteed were certainly not AAA rated mortgages.
In 1999, President Bill Clinton encouraged Fannie Mae to lower their requirements so they could make more loans to more people. Fannie Mae and Freddie Mac underwrote almost half of ALL the mortgages in the U.S. As Government Supported Entities (GSE)s they were also exempt from the standard capital/assets ration of =>3%.