We know the financial crisis was avoidable because we avoided a financial crisis in 1990-1991 by properly supervising the savings and loans.
“Liar’s” loans, the same loans that drove the current crisis, surged in California in those years until we in the Office of Thrift Supervision’s West Region killed such loans by normal regulatory means. It didn’t take sophisticated financial analysis to predict that loans made without any meaningful underwriting by the mortgage lender should be prohibited.
We have known for decades that the senior officials of banks making liar’s loans are essentially engaged in what white-collar criminologists call “accounting control fraud” and economists call “looting.” Here’s the recipe that maximizes short-term reported (fictional) income and the C.E.O.’s compensation:
1. Grow massively
2. By making liar’s loans at a premium yield (interest rate)
3. With extreme leverage (debt), while
4. Providing only trivial loss reserves relative to inevitable massive losses.
Liar’s loans are ideal for this fraud scheme because the only way large numbers of lenders can grow massively at premium yields is to lend to borrowers who will often be unable to repay the loans. A liar’s loan, by definition not underwritten, means that nobody checks the loan brokers’ lies about the borrowers’ stated income. There’s no audit trail proving the lender’s officers knew they were making a fraudulent loan. A lender that follows the four-part recipe is guaranteed to report record short-term income and maximize the chief executive’s compensation. The same recipe guarantees record real losses. The lender fails but the C.E.O. walks away from the toxic waste site a wealthy man.
When we cracked down in the early 1990s on fraudulent S&Ls making liar’s loans, they escaped our jurisdiction by starting uninsured mortgage bankers. Congress, however, promptly closed this regulatory black hole by passing the Home Ownership and Equity Protection Act of 1994, which gave the Fed regulatory authority to prevent abuses by any mortgage lender. Alan Greenspan and Ben Bernanke, however, refused to use the act’s authority to stop liar’s loans despite repeated warnings of the coming disaster.
The F.B.I. warned in September 2004 that mortgage fraud was “epidemic” and predicted that it would cause an “economic crisis.” In 2006, the mortgage industry’s own anti-fraud experts warned that liar’s loans had a fraud incidence of 90 percent because they were “an open invitation to fraudsters.” The lenders reacted to the warning by greatly increasing the number of liar’s loans.
Credit Suisse reported in early 2007 that 49 percent of new mortgage originations in 2006 were liar’s loans. That means that more than a million fraudulent loans were being made each year and that liar’s loans were causing the bubble to hyper-inflate. Federal regulators and the Securities and Exchange Commission also could have stopped liar’s loans and toxic derivatives supposedly backed by liar’s loans. But the Bush administration appointed senior anti-regulators who did not believe that fraud could be a serious problem, so the regulators refused to act.
In 2008, after it was useless, the Fed finally, under Congressional pressure, used its Home Ownership and Equity Protection Act authority to ban liar’s loans. If it had used its regulatory authority in a manner similar to how we used our authority in 1991 there would have been no financial crisis in the U.S. and no Great Recession.