William K. Black – professor of economics and law, and the senior regulator during the S & L crisis – explained last month before to the Financial Crisis Inquiry Commission why banks gave home loans to people who they knew couldn’t repay. The whole piece is a must-read, but here are excerpts from the introduction:
The data demonstrate conclusively that most liar’s loans were fraudulent, which means that there were millions of fraudulent mortgage loans because liar’s loans became common (Credit Suisse estimates that they represented 49% of new originations by 2006). The data also demonstrate that even minimal underwriting of the loan files was sufficient to detect the overwhelming majority of such fraudulent liar’s loans. No honest, rational lender would make large numbers of liar’s loans. The epidemic of mortgage fraud was so large that it hyper-inflated the housing bubble, which allowed refinancing to further extend the life of the bubble (and the depth of the ultimate Great Recession.***
In the cases where there have been even minimal investigations (New Century, Aurora/Lehman, Citi, WaMu, Countrywide, and IndyMac) senior lender officials were aware that liar’s loans were typically fraudulent. The lenders could not make an honest business out of selling overwhelmingly fraudulent mortgages.
Liar’s loans were done for the usual reason – they optimized (fictional) short-term accounting income by creating a “sure thing” (Akerlof & Romer 1993). A fraudulent lender optimizes short-term fictional accounting income and longer term (real) losses by following a four-part recipe:
A. Extreme Growth
B. Making bad loans at a premium yield
C. Extreme leverage
D. Grossly inadequate loss reserves
Note that this same recipe maximizes fictional profits and real losses. This destroys the lender, but it makes senior officers that control the lender wealthy. This explains Akerlof & Romer’s title – Looting: The Economic Underworld of Bankruptcy for Profit. The failure of the firm is not a failure of the fraud scheme. (Modern bailouts may even recapitalize the looted bank and leave the looters in charge of it.)
The first two “ingredients” are related. Home lending is a mature, reasonably competitive industry. A lender cannot grow extremely rapidly by making good loans. If he tried, he’d have to cut his yield and his competitors would respond. His income would decline. But he can guarantee the ability to grow extremely rapidly by being indifferent to loan quality and charging weaker credit risks, or more naïve borrowers, a premium yield.
In order to become indifferent to loan quality the officers controlling the lender must eviscerate its underwriting.
There is no honest reason for a secured lender to seek or permit inflated appraisal values. This is a sure marker of accounting control fraud – a marker that juries easily understand.
In other words, banks made loans to borrowers who they knew couldn’t really repay because the heads of the banks could make huge bonuses based on high volumes and fraudulent appraisals, and they didn’t care if their own companies later failed.
In short, they looted their companies and the economy as a whole.
Professor Black brings us current to where we are today:
History demonstrates that if the control frauds get away with their frauds they will strike again.
By allowing the banks to use their political power to gimmick the accounting rules to permit them to hide their massive losses on liar’s loans we have made it far harder to take effective administrative, civil, and criminal sanctions against the elite frauds that caused the Great Recession. Hiding the losses also adopts the dishonest Japanese approach that cripples economic recovery and public integrity.
Prosecuting the elites control frauds can be done successfully. Create a new “Top 100” priority list and appoint regulators that will make supporting the Justice Department a top agency priority. That’s how we obtained over 1000 priority felony convictions of elite S&L criminals. No controlling officer of a large, non-prime specialty lender has been convicted of running a control fraud. Only one has even been indicted.
The FBI has written that any discussion of the crisis that ignores the role of mortgage fraud is “irresponsible.”
On a related note, Chris Whalen (co-founder of Institutional Risk Analytics, who has been hailed by Nouriel Roubini as one of the leading independent analysts of the U.S. banking system) told me that the collection of credit default swap payoutsmight also have played into the banks extending loans to borrowers who couldn’t repay:
There are some really bad incentive structures in this industry. Default increases servicing fees, etc. So yes, your example is not outlandish. And the wonder of CDS lets us all bet that the other’s home burns down. Speculative madness, but consistent for a culture that prizes sales about all else.
Whalen also notes that Freddie and Fannie helped to create the epidemic of mortgage fraud, and – like Black – blasts the government for covering it up:
The invidious cowards who inhabit Washington are unwilling to restructure the largest banks and GSEs. The reluctance comes partly from what truths restructuring will reveal. As a result, these same large zombie banks and the U.S. economy will continue to shrink under the weight of bad debt, public and private. Remember that the Dodd-Frank legislation was not so much about financial reform as protecting the housing GSEs.
Because President Barack Obama and the leaders of both political parties are unwilling to address the housing crisis and the wasting effects on the largest banks, there will be no growth and no net job creation in the U.S. for the next several years. And because the Obama White House is content to ignore the crisis facing millions of American homeowners, who are deep underwater and will eventually default on their loans, the efforts by the Fed to reflate the U.S. economy and particularly consumer spending will be futile. As Alan Meltzer noted to Tom Keene on Bloomberg Radio earlier this year: “This is not a monetary problem.”
The policy of the Fed and Treasury with respect to the large banks is state socialism writ large, without even the pretense of a greater public good.
The fraud and obfuscation now underway in Washinton to protect the TBTF banks and GSEs totals into the trillions of dollars and rises to the level of treason.
And in the case of the zombie banks, the GSEs and the MIs, the fraud is being actively concealed by Congress, the White House and agencies of the U.S. government led by the Federal Reserve Board. Is this not tyranny?