An Open Letter to California Attorney General Harris

By William K. Black

First, let me join with New York Attorney General Schneiderman in congratulating you for your decision to withdraw from the mortgage foreclosure settlement. Two of the states with the largest number of victims have decided that the proposed settlement is inadequate and dangerous because of the scope of the releases. Your explanation for your decision in your letter to Attorney General Miller was concise, polite, and persuasive. Attorney General Miller deserves credit for his efforts – four years ago – to warn the Federal Reserve about endemic mortgage fraud by nonprime lenders. I quote key passages from his warnings below.

Second, I congratulate you on creating the California Mortgage Fraud Strike Force and have several suggestions for its leaders.

“Months ago, I began California’s independent work in this respect by establishing aMortgage Fraud Strike Force, and I have given the Strike Force attorneys a broad mandate to investigate all stages of the mortgage lending process, from origination to servicing and foreclosures to securitization of loans into investments in the secondary market. I am committed to doing as thorough an investigation as is needed – and to taking the time that is necessary to set the stage for achieving appropriate accountability for misconduct.”

This is precisely what the U.S. Justice Department (DOJ) needed to do – seven years ago when the FBI warned that there was an “epidemic” of mortgage fraud and predicted that it would cause a financial “crisis” if it were not contained. Obviously it was not contained. You are correct to investigate “all stages,” for fraud was endemic at multiple stages of the mortgage process. The central problem is that the DOJ’s failure to hold criminal elites that caused the ongoing financial crisis “accountable” for their crimes will make future crises even more destructive.

Without a regulatory road map the FBI gets farblondget 

It is now apparent that DOJ has gone so horribly wrong for three related reasons. The sine qua non for DOJ’s successful efforts to prosecute elite S&L officials was the extraordinary support that the S&L regulators provided. Our agency made well over 10,000 criminal referrals that provided the detailed “road maps” making successful investigations and prosecutions possible. We “detailed” dozens of senior examiners to serve as in-house experts for the FBI. We provided extensive training for the FBI and DOJ on detecting, investigating, and prosecuting “control frauds.” Control fraud occurs when those that control seemingly legitimate entities use them as “weapons” to defraud. In finance, accounting is the “weapon of choice.” We also provided key expert and fact witnesses for the trials.

None of this has happened in the current crisis. My agency (OTS) and the Office of the Comptroller of the Currency (OCC) made zero criminal referrals during the crisis, and the Fed apparently made three – none of them against the major nonprime frauds. The FDIC did the best, but it did little better that its sister agencies.

California is such a problem because it was beset by the trio of problems generated by the federal anti-regulators. The federal regulators used claims of “preemption” to eviscerate state efforts to crack down on predatory mortgage bankers. The Fed, under Greenspan and Bernanke, refused to use its unique authority under HOEPA (enacted in 1994) to regulate the fraudulent mortgage bankers, investment banks, and bank affiliates who were exploiting the regulatory “black holes” created by federal deregulation and preemption to make millions of fraudulent loans. These first two factors harmed every state, but California’s exposure to these regulatory black holes was far greater because of its enormous housing market and the fact that it was home to so many of the mortgage banks making fraudulent loans. The third problem was concentrated in California and the state of Washington. OTS gave increasing regulatory power to the most notorious professional regulator in the U.S. Ultimately, it made him head of its West Region, which was responsible for regulating the worst federally regulated lenders specializing in liar’s loans – Washington Mutual (WaMu), Countrywide, and IndyMac.

Absent the “road maps” and assistance from the regulators the FBI simply investigated cases that came across the transom in scores of field offices according to whatever priority the local leaders established. As recently as FY 2007 there were only 120 FBI agents assigned to investigate mortgage fraud – and over a million cases of mortgage fraud annually. They lacked the resources to investigate a single major control fraud. There has not been a real FBI investigation of any large control fraud that made tens of thousands of fraudulent mortgage loans. This anti-prioritization strategy provided U.S. Attorney General Mukasey’s excuse for rejecting the FBI’s recommendation to completely rethink the anti-mortgage fraud strategy and target the control frauds. Mukasey opined that mortgage fraud was simply “white-collar street crime.” He never understood the circularity of his conclusion. Because he sent the FBI to investigate smaller frauds they found smaller frauds.

DOJ entered the Dark Ages in which it forgot all understanding of Control Fraud 

The second problem is that DOJ is now led by individuals who have no understanding of accounting control fraud. They are unaware of the relevant literature in law, criminology, regulation, and economics. Here is the barest of overviews. Control frauds cause greater financial losses than all other forms of property crime – combined. The Nobel Prize winning economist George Akerlof and his colleague Paul Romer authored the key article in 1993 – “Looting: the Economic Underworld of Bankruptcy for Profit.” They explained why accounting control fraud is a “sure thing.” Akerlof & Romer emphasized that the S&L regulators had first identified, and targeted, the accounting fraud mechanism led by S&L CEOs.

“Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself (1993: 60).”

The National Commission on Financial Institution Reform, Recovery and Enforcement issued its report on the causes of the S&L debacle in 1993. It found that at the “typical large failure” fraud was “invariably present.” It identified that fraud as accounting fraud led from the top.

Unfortunately, rather than “learn from experience” we have forgotten it and with no anti-regulators in charge they took no equivalent action to contain the developing fraud epidemic. The result was the largest financial bubble in history, the greatest financial crisis in 75 years, and the Great Recession.
As Akerlof & Romer emphasized, the S&L regulators recognized by 1984 that there was a “sure thing” “recipe” for a lender to maximize the amount of fictional short-term income produced by accounting control fraud. The classic lender’s fraud “recipe” for maximizing (fictional) short-term reported income has four ingredients.

  1. Extreme growth through making
  2. Exceptionally bad loans at a premium yield (very high interest rate) while
  3. Employing extreme leverage (the lender has far more debt than equity), and
  4. Providing grossly inadequate allowances for future losses inherent in making bad loans

Our early identification that the typical expensive S&L was a control fraud and that it followed a distinctive pattern allowed us to take a series of effective actions against the frauds. The short version is that we could identify the frauds while they were still reporting record profits and minimal losses and prioritize them for takeover and other protective measures. We were able to block the entry of many likely frauds. We realized that growth was their Achilles’ heel – so we adopted a rule restricting growth that doomed even the frauds we could not close because we had spent all available sums from the insurance fund. We worked to remove many factors, e.g., accounting abuses, that made the S&L environment so criminogenic. In 1990-1991, we used our understanding of accounting control fraud to force the S&Ls (overwhelmingly in Orange County, CA) that were beginning to make substantial amounts of “liar’s” loans to cease such lending. Unfortunately, this was the genesis of Ameriquest and some of its major competitors, who left the federally insured and regulated industry and became mortgage banks for the sole purpose of escaping our jurisdiction.

We also used our understanding of accounting control fraud to prosecute the elite frauds. This effort was exceptionally effective. With our aid, DOJ obtained over 1,000 felony convictions in S&L cases designated as “major.” That understates the degree of prioritization, for most of the convictions arose from the “Top 100” list of highest priority cases. We developed the Top 100 list in conjunction with the FBI and DOJ in a rigorous process. We were able to explain to jurors why no honest lender would deliberately adopt a lending strategy premised on making bad loans at a premium (nominal) yield without remotely adequate loss reserves. We explained other “markers” of fraud, e.g., inflated appraisals. Jurors understand that an honest lender would not inflate, or permit to be inflated, appraisals.

The same recipe maximizes the senior executives’ compensation and actual losses. Accounting control frauds cluster because there are assets that make better “ammunition” to feed their accounting fraud “weapon.” The fraud recipe causes lenders to rapidly increase lending into the teeth of a glut. The combination means that accounting control fraud epidemics can hyper-inflate financial bubbles. Bubbles allow fraudulent lenders to refinance their bad loans in order to delay the inevitable defaults. The saying in the trade is: “a rolling loan gathers no loss.”

In the current crisis, it was common for the control frauds to add a fifth ingredient – fraudulent “reps and warranties” to sell the fraudulent mortgages to the “secondary market.” The Federal Housing Finance Administration (FHFA), in its capacity as conservator for Fannie and Freddie, has recently sued 17 of the largest sellers of nonprime loans because its investigation revealed that they made fraudulent reps and warranties to induce Fannie and Freddie to purchase the fraudulent loans. The critical aspect of the FHFA suits is that they demonstrate that there is a paper trail that the major originator and sellers of liar’s loans and collateralized debt obligations (CDOs) backed by liar’s loans knew they were making false “reps and warranties” (and the typical falsity was designed to hide the fraudulent nature of the loans).

Theoclassical economists’ dogma predicted that it would be impossible to sell large amounts of fraudulent mortgage loans to what purported to be the most sophisticated investment banks. The controlling officers of caused the investment banks to purchase large amounts of fraudulent liar’s loans because doing so maximized their accounting fraud recipe.

Nonprime mortgage lenders followed the recipe and drove the current crisis.

  1. 1. Growth was extreme.In summary, the bank in our analysis pursued an aggressive expansion strategy relying heavily on broker originations and low-documentation loans in particular. The strategy allowed the bank to grow at an annualized rate of over 50% from 2004 to 2006. Such a business model is typical among the major players that enjoyed the fastest growth during the housing market boom and incurred the heaviest losses during the downturn (Jiang, Aiko & Vylacil 2009: 9).
  2. 2. Loan standards collapsed. Bo Cutter (2009), a managing partner of Warburg Pincus, explains:In fact, by 2006 and early 2007 everyone thought we were headed to a cliff, but no one knew when or what the triggering mechanism would be. The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.
  3. 3. Leverage was exceptional. Unregulated nonprime lenders had no meaningful capital rules. Indeed, they had no capital – they were insolvent on any real economic basis because they made fraudulent loans.
  4. 4. Allowances for loan and lease losses (ALLL) fell when they should have grown.

GAAP required the allowances for loan and lease losses (ALLL) to reflect the massive and ever increasing risk of future losses inherent in making liar’s loans. Nonprime lenders routinely violated GAAP by doing the opposite. The officers that controlled liar’s lenders provided ludicrously inadequate ALLLs; and then made them ever more farcical in order to report record income and obtain larger bonuses. “The industry’s reserves-to-loan ratio has been setting new record lows for the past four years” (A.M. Best 2006: 3). The ratio fell to 1.21 percent as of September 30, 2005 (Id.: 4-5). Later, “loan loss reserves are down to levels not seen since 1985” (roughly one percent) (A.M. Best 2007: 1). A.M. Best noted that these inadequate loss reserves in 1985 led to the banking and S&L crises. In 2009, the IMF estimated losses on U.S. originated assets of $2.7 trillion (IMF 2009: 35 Table 1.3) (roughly 30 times larger than the ALLL).

Liar’s loans hyper-inflated the housing bubble 

Rajdeep Sengupta, an economist at the Federal Reserve Bank of St. Louis, reported in 2010 in an article entitled “Alt-A: The Forgotten Segment of the Mortgage Market” that:

[B]etween 2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent, respectively.The higher levels of originations after 2003 were largely sustained by the growth of the nonprime (both the subprime and Alt-A) segment of the mortgage market.

These figures greatly understate the role of “Alt-A” loans (the euphemism for “liar’s loans”) for they ignore the fact that by 2006 half of the loans called “subprime” were also liar’s loans. (Credit Suisse: 2007). Credit Suisse also reported that roughly one-third of the mortgage loans made in 2006 were liar’s loans. Fraudulent liar’s loans hyper-inflated and greatly extended the life of the bubble.

This occurred after the lenders and purchasers were repeatedly warned of endemic fraud 

The FBI warned in September 2004 that there was an “epidemic” of mortgage fraud that would cause a financial “crisis” if it were not contained. The Mortgage Bankers Association (MBA) – the trade association of the “perps” – sent each of its members this warning in 2006 from its anti-mortgage fraud group (MARI): “Stated income and reduced documentation loans … are open invitations to fraudsters.” The MBA transmitted to its members MARI’s warning that the incidence of fraud in such loans was 90 percent and MARI’s conclusion that “the stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan.’” Demos warned the nation in 2005 that there was an “epidemic” of appraisal fraud.

Liar’s loans let us test the validity of rival hypotheses about the causes of the crisis 

If the lenders that specialized in making liar’s loans were innocent victims of rapacious, but financially unsophisticated borrowers, then we would expect to see several observable characteristics. First, we would expect that honest lenders would never make liar’s loans because doing so must cause them to fail. Second, we would see very little, and decreasing, appraisal fraud. Third, we would see sharply declining amounts of liar’s loans after the FBI and MARI warnings of fraud epidemics in 2004 and 2006. Fourth, we would see sharp reductions in the liar’s loans made to borrowers with poor credit histories (i.e., the percentage of subprime loans that are also liar’s loans should quickly reach zero). Fifth, we should see a sharp reduction in liar’s loans that exhibit “layered risk” – other loan characteristics that add to risk such as negative amortization and reduced down payments. Sixth, we should see sharp rises in capital and allowances for loan and lease losses (ALLL) so that the honest lenders could be prepared for the massive losses inherent in making liar’s loans. Seventh, we would see the end of sales of liar’s loans to the secondary market because honest lenders would not sell fraudulent liar’s loans to others and because honest investment banks would not purchase them. Eighth, we would see the investment banks bring aggressive suits against the lenders that sold them liar’s loans under false “reps and warranties.” Each of these characteristics went in the direction that falsifies the “honest lender” theory – and jurors can readily understand why if the prosecutors have been trained to understand how honest lenders function and why accounting control frauds operate in a contrary manner.

Alternatively, we could look at case studies and investigations of the lenders that made liar’s loans. Honest lenders would support employees who insisted on prudent underwriting and discipline employees who made bad loans. They would monitor lending operations and adjust them to prevent any developing problems. The case studies and investigations of lenders specializing in making large numbers of liar’s loan show a consistent pattern inconsistent with the honest lender theory.

We could also investigate incentive structures. CEOs’ primary function is the creation of incentive structures. Honest CEOs would create virtuous incentive structures. Dishonest lenders would create perverse incentive structures. Again, we observe the creation – and maintenance despite warnings of endemic fraud – of intense, perverse incentives at lenders and investment banks that issued and purchased large amounts of liar’s loans.

Focusing on the perverse incentive structures of mortgage bankers offers a clear example for most people of how to test the rival hypotheses. Because the overwhelming majority of liar’s loans were sold to the secondary market the means to optimize the sale of fraudulent loans was to combine high (nominal) yield with apparent reduced risk. (These two characteristics are supposed to be antagonistic under the efficient market hypothesis, but traders have long realized that the efficient market hypothesis is false.) The way to reduce apparent risk was to lower the reported loan-to-value (LTV) and debt-to-income ratios. The lender could reduce the reported LTV by inflating the appraisal and reduce the debt-to-income ratio by inflating the borrowers’ income. Fraudulent lenders created compensation systems for loan brokers that paid them very large fees if they simultaneously charged a premium yield and low reported LTV and debt-to-income ratios. Ask yourself whether loan brokers would typically ignore their financial interests and leave it to the borrower to game the ratios sufficiently to maximize the broker’s fees. Only the lender and its agents (including the loan broker) can inflate large numbers of appraisals, so we know that the endemic appraisal fraud (discussed immediately below) was generated by the lenders and their agents. Why would they not take the lead in inflating the borrower’s stated income?

Appraisal fraud was endemic and it is a “marker” of accounting control fraud 

There is no honest reason why a mortgage lender would inflate the appraised value and the size of the loan. Causing or permitting large numbers of inflated appraisals is a superb “marker” of accounting control fraud by the lender because the senior officers directing an accounting control fraud maximize short-term reported (fictional) income (and real losses) by inflating appraisals and stated income. Lenders and their agents frequently suborned appraisers by creating a Gresham’s dynamic to induce them to inflate market values, leaked the loan amount to the appraisers, drove the appraisal fraud, and made it endemic. A national poll of appraisers in early 2004 found that 75% of respondents reported being subjected to coercion in the last 12 months to inflate appraisals. A follow-up survey in 2007 found that the percentage that had been subjected to coercion had risen to 90 percent. In 2005, Demos warned of an “epidemic” of appraisal fraud.

New York Attorney General Cuomo’s investigation of Washington Mutual (WaMu) (one of the largest nonprime mortgage lenders) found endemic appraisal fraud and concluded it was “an industrywide problem.” (The Seattle Times, November 1, 2007).

It is often said that “there is no smoking gun” in this crisis. There are entire batteries of smoking howitzers.

Investigations have found that it was lenders that put the lies in liar’s loans

The officers controlling the lying lenders designed and implemented the perverse incentives that produced the intended “echo” fraud epidemics among loan brokers, loan officers, appraisers – and some borrowers. Liar’s loans prevented the creation of an incriminating underwriting paper trail documenting that the lender knew the information on the loan application was false.

The fraudulent nonprime lenders and brokers typically initiated, directed, and sometimes even directly created the lies on the liar’s loans. Thomas J. Miller (Miller, 2007), Attorney General of Iowa, at a 2007 Federal Reserve Board hearing, gave the Fed the key facts.

Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete. Strong regulations will create an even playing field in which ethical actors are no longer punished. (p. 3)

Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007. (note 2)

[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer. (p. 10)

Miller, T. J. (August 14, 2007). Home Equity Lending Market Request for Comment. Docket No. OP-1288. 

Despite a wealth of factors demonstrating epidemics of control fraud DOJ fails to indict 

The failure to prosecute any of the major accounting control frauds that made and sold tens of thousands of fraudulent liar’s loans is a national scandal. DOJ’s primary excuse for its failure to prosecute the control frauds that caused the ongoing financial crisis is that control fraud cannot exist because it would be irrational. Sacramento, California is one of the areas hardest hit by the control frauds, but there have been no federal prosecutions of the frauds. Indeed, there have been no serious FBI investigations of any of the control frauds that victimized the Sacramento area. Why investigate something that cannot exist?

UFOs (unidentified financial objects)

Too Big to Jail?

Not everyone agrees that such a case can be successful. Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. An investor in loans who documents fraud can force a bank to buy the loan back. But convincing a jury that executives intended to make fraudulent loans, and thus should be held criminally responsible, may be too difficult of a hurdle for prosecutors.

“It doesn’t make any sense to me that they would be deliberately defrauding themselves,” Wagner said.

I have more sympathy for Mukasey’s circular error than Wagner’s statement, which is based on the simplest of errors. The context of his statement is that that he was asked to discuss the difficulties of prosecuting the senior officers engaged in looting the banks that they control. His response, at best, represents an inability to understand the meaning of his own incoherent use of pronouns. The key words are “they” and “themselves.” He uses “they” to refer to the CEO and “themselves” to refer to the bank. The problem is that he forgets he is doing so and treats “they” and “themselves” as equivalent when they in fact represent two different entities. It makes perfect “sense” for a CEO to loot the bank. Doing so can make the CEO wealthy and powerful. We were able to explain this successfully to thousands of jurors in the S&L debacle. I have difficulty understanding Wagner’s inability to comprehend that the CEO and the bank are not the same entity. Of course the bank loses money when its controlling officers cause it to make fraudulent loans (that’s the “bankruptcy” part of Akerlof & Romer’s title), but accounting control frauds don’t recognize those losses for years and until that time the fictional income that is a “sure thing” from accounting fraud allows the CEO to loot the bank (that’s the “for profit” part of their title).

Here’s the broader point. If Wagner, a U.S. Attorney in one of the epicenters of mortgage fraud has never heard of control fraud or “Looting: the Economic Underworld of Bankruptcy for Profit” then neither he nor any of his prosecutors has ever received even marginally competent training. During the S&L debacle we made major commitments to ensuring that we trained hundreds of FBI agents and AUSAs on these fraud mechanisms. Something epic has gone wrong at the Justice Department. It is as if they entered the dark ages and lost knowledge that was common to earlier generations before Rome and Constantinople were sacked.

Geithner’s “Confidence Fairy” 

Paul Krugman, the Nobel laureate in economics, refers derisively to the belief of some economists in the elusive “Confidence Fairy.” These economists claim that recessions don’t result from a sharp drop in private sector demand, but from a lack of “confidence.” This lack of confidence can be ended instantaneously without any change in economic fundamentals by the mystical visit of the Confidence Fairy. For example, if we were to repeal the Dodd-Frank Act, some economists claim that the banks would start lending and businesses would start hiring.

Geithner is not an economist, but he does believe in variants of the Confidence Fairy. Gretchen Morgenson and Louise Story’s investigative reporting for the New York Times has disclosed the third reason why DOJ has failed to prosecute the control frauds that caused the crisis. Geithner has opposed even investigating the control frauds on the grounds that the investigations would reduce “confidence” in our banking system.

Here is how I responded to Kai Ryssdal, Marketplace’s business journalist, who asked about Geithner’s rationale:

Ryssdal: What about the argument, though, that the financial system is so fragile still, and these cases so complicated, that we can’t really tear things apart with substantive investigations and prosecutions because it will all fall apart again?
Black: Yeah, that’s an excellent point. We should leave felons in charge of our largest financial institutions as a means of achieving financial stability.

The Obama administration has, overwhelmingly, left in place President Bush’s anti-regulators or (after considerable delay) replaced them with failed anti-regulators. Indeed, Geithner and Bernanke are prominent, failed anti-regulators that Obama, respectively, promoted and reappointed. Bernanke then promoted one of the Fed’s failed anti-regulatory economists to run the Fed’s examination and supervision. It is no surprise that these federal regulators have been pushing the state Attorneys General to limit their investigations of the epidemics of accounting control fraud that caused the Great Recession. The first rule of investigation of elite control frauds is that if you don’t look; you don’t find. I commend your decision to look.

Your task force can draw on California’s special talent 

California has some unique potential assets available to assist your effort. Three of the leading investigators who brought to book many of the worst S&L control frauds work in California. Michael Patriarca (who led our region), Chris Seefer (who served recently as the Financial Crisis Inquiry Commission’s (FCIC) chief investigator), and Bart Dzivi (who also served with FCIC and previously with the Senate Banking Committee staff) are all attorneys who have conducted extensive investigations. California also provided FCIC’s chair, Phil Angelides, who has developed a wealth of useful information. UC Irvine has one of the top white-collar criminology programs in the world. Henry Pontell has an international reputation for his work on elite white-collar frauds, including the S&L control fraud. I hope that your task force will draw on their talents and experience.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

One response to “An Open Letter to California Attorney General Harris

  1. Very interesting. Why was S&L crisis handled so differently, no less under a Republican administration. Was it simply the ppl in charge (Black), and/or was the nature of the event easier to prove as a control fraud?