Daily Archives: November 8, 2011

The Virgin Crisis: Systematically Ignoring Fraud as a Systemic Risk

By William K. Black
(Cross-posted from Benzinga)

One of the most revealing thingsabout this crisis is the unwillingness to investigate whether “accountingcontrol fraud” was a major contributor to the crisis.  The refusal to even consider a major role forfraud is facially bizarre.  The bankingexpert James Pierce found that fraud by senior insiders was, historically, theleading cause of major bank failures in the United States.  The national commission that investigated thecause of the S&L debacle found:

“Thetypical large failure [grew] at an extremely rapid rate, achieving highconcentrations of assets in risky ventures…. [E]very accounting trick availablewas used…. Evidence of fraud was invariably present as was the ability of theoperators to “milk” the organization” (NCFIRRE 1993)  

Two of the nation’s topeconomists’ study of the S&L debacle led them to conclude that the S&Lregulators were correct – financial deregulation could be dangerouslycriminogenic.  That understanding wouldallow us to avoid similar future crises. 

“Neitherthe public nor economists foresaw that [S&L deregulation was] bound toproduce looting.  Nor, unaware of theconcept, could they have known how serious it would be.  Thus the regulators in the field whounderstood what was happening from the beginning found lukewarm support, atbest, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (GeorgeAkerlof & Paul Romer.  “Looting: theEconomic Underworld of Bankruptcy for Profit.” 1993: 60).

The epidemic of accounting controlfraud that drove the second phase of the S&L debacle (the first phase wascaused by interest rate risk) was followed by an epidemic of accounting controlfraud that produced the Enron era frauds. 

The FBI warned in September 2004that there was an “epidemic” of mortgage fraud and predicted that it wouldcause a financial “crisis” if it were not contained.  The mortgage banking industry’s ownanti-fraud experts reported in writing to nearly every mortgage lender in 2006that:

“Stated income and reduced documentation loans speedup the approval process, but they are open invitations to fraudsters.”  “When the stated incomes were compared to theIRS figures: [90%] of the stated incomes were exaggerated by 5% or more.[A]lmost 60% were exaggerated by more than 50%. [T]he stated income loandeserves the nickname used by many in the industry, the ‘liar’s loan’” (MARI2006).

Weknow that accounting control fraud is itself criminogenic – fraud begetsfraud.  The fraudulent CEOs deliberatelycreate the perverse incentives that that suborn inside and outside employeesand professionals.  We have known forfour decades how these perverse incentives produce endemic fraud by generatinga “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace.

“[D]ishonest dealings tend to drive honest dealingsout of the market. The cost of dishonesty, therefore, lies not only in theamount by which the purchaser is cheated; the cost also must include the lossincurred from driving legitimate business out of existence.”  George Akerlof (1970).

Akerlofnoted this dynamic in his seminal article on markets for “lemons,” which led tothe award of the Nobel Prize in Economics in 2001.  It is the giants of economics who haveconfirmed what the S&L regulators and criminologists observed when wesystematically “autopsied” each S&L failure to investigate its causes.  Modern executive compensation has madeaccounting control fraud vastly more criminogenic than it once was asinvestigators of the current crisis have confirmed.

“Over the last several years, the subprime markethas created a race to the bottom in which unethical actors have been handsomelyrewarded for their misdeeds and ethical actors have lost market share…. Themarket incentives rewarded irresponsible lending and made it more difficult forresponsible lenders to compete.”  Miller,T. J. (August 14, 2007).  Iowa AG.

Liar’s loans offer what we call asuperb “natural experiment.”  No honestmortgage lender would make a liar’s loan because such loans have a sharplynegative expected value.  Notunderwriting creates intense “adverse selection.”  We know that it was overwhelmingly thelenders and their agents that put the lies in liar’s loans and the lenderscreated the perverse compensation incentives that led their agents to lie aboutthe borrowers’ income and to inflate appraisals.  We know that appraisal fraud was endemic andonly agents and their lenders can commit widespread appraisal fraud.  Iowa Attorney General Miller’s investigationsfound:

“[Manyoriginators invent] non-existent occupations or income sources, or simplyinflat[e] income totals to support loan applications. Importantly, ourinvestigations have found that most stated income fraud occurs at thesuggestion and direction of the loan originator, not the consumer.”

New York Attorney General (nowGovernor) Cuomo’s investigations revealed that Washington Mutual (one of theleaders in making liar’s loans) developed a blacklist of appraisers – whorefused to inflate appraisals.  No honestmortgage lender would ever inflate an appraisal or permit widespread appraisalinflation by its agents.  Surveys ofappraisers confirm that there was widespread pressure by nonprime lenders andtheir agents to inflate appraisals.

We also know that the firms thatmade and purchased liar’s loans followed the respective accounting controlfraud “recipes” that maximize fictional short-term reported income, executivecompensation, and (real) losses.  Thoserecipes have four ingredients: 
  1.  Growlike crazy
  2.  Bymaking (or purchasing) poor quality loans at a premium yield
  3.  Whileemploying extreme leverage, and
  4.  Providingonly grossly inadequate allowances for loan and lease losses (ALLL) against thelosses inherent in making or purchasing liars loans

Firms that follow these recipesare not “gamblers” and they are not taking “risks.”  Akerlof & Romer, the S&L regulators,and criminologists recognize that this recipe provides a “sure thing.”  The exceptional (albeit fictional) income,real bonuses, and real losses are all sure things for accounting controlfrauds.

Liar’s loans are superb“ammunition” for accounting control frauds because they (and appraisal fraud)allow the fraudulent mortgage lenders and their agents to attain the unholyfraud trinity: (1) the lender can charge a substantial premium yield, (2) on aloan that appears to relatively lowerrisk because the lender has inflated the borrowers’ income and the appraisal,while (3) eliminating the incriminating evidence of fraud that realunderwriting of the borrowers’ income and salary would normally place in theloan files.  The government did notrequire any entity to make or purchase liar’s loans (and that includes Fannieand Freddie).  The states and the federalgovernment frequently criticized liar’s loans. Fannie and Freddie purchased liar’s loans for the same reasons thatMerrill, Lehman, Bear Stearns, etc. acquired liar’s loans – they wereaccounting control frauds and liar’s loans (and CDOs backed by liar’s loans)were the best available ammunition for maximizing their fictional reportedincome and real bonuses. 

Liar’s loans were large enough tohyper-inflate the bubble and drive the crisis. They increased massively from 2003-2007.

“[B]etween2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent,respectively.

Thehigher levels of originations after 2003 were largely sustained by the growthof the nonprime (both the subprime and Alt-A) segment of the mortgage market.”  “Alt-A: The Forgotten Segment of the MortgageMarket” (Federal Reserve Bank ofSt. Louis 2010).
The growth of liar’s loans wasactually far greater than the extraordinary rate that the St. Louis Fed studyindicated.  Their error was assuming that“subprime” and “alt-a” (one of the many misleading euphemisms for liar’s loans)were dichotomous.  Credit Suisse’s early2007 study of nonprime lending reported that roughly half of all loans called“subprime” were also “liar’s” loans and that roughly one-third of home loansmade in 2006 were liar’s loans.  Thatfact has four critical implications for this subject.  The growth of liar’s loans was dramaticallylarger than the already extraordinary 340% in three years reported by the St.Louis Fed because, by 2006, half of the loans the study labeled as “subprime”were also liar’s loans.  Because loansthe study classified as “subprime” started out the period studied (2003) as amuch larger category than liar’s loans the actual percentage increase in liar’sloans from 2003-2006 is over 500%.  Thefirst critical implication is that it was the tremendous growth in liar’s loansthat caused the bubble to hyper-inflate and delayed its collapse. 

The role of accounting controlfraud epidemics in causing bubbles to hyper-inflate and persist is anotherreason that accounting control fraud is often criminogenic.  When such frauds cluster they are likely todrive serious bubbles.  Inflating bubblesoptimize the fraud recipes for borrowers and purchasers of the bad loans bygreatly delaying the onset of loss recognition. The saying in the trade is that “a rolling loan gathers no loss.”  One can simply refinance the bad loans todelay the loss recognition and book new fee and interest “income.”  When entry is easy (and entry into becoming amortgage broker was exceptionally easy), an industry becomes even morecriminogenic.    

Second, liar’s loans (and CDOs“backed” by liar’s loans) were large enough to cause extreme losses.  Millions of liar’s loans were made and thoseloans caused catastrophic losses because they hyper-inflated the bubble,because they were endemically fraudulent, because the borrower was typicallyinduced by the lenders’ frauds to acquire a home they could not afford topurchase, and because the appraisals were frequently inflated.  Do the math: roughly one-third of home loans made in 2006 were liar’s loans and theincidence of fraud in such loans was 90%. We are talking about an annual fraud rate of over one million mortgageloans from 2005 until the market for liar’s loans collapsed in mid-2007. 

Third, the industry massivelyincreased its origination and purchase of liar’s loans after the FBI warned of the developing fraud “epidemic” andpredicted it would cause a crisis and then massively increased its originationand purchase of liar’s loans after the industry’s own anti-fraud experts warnedthat such loans were endemically fraudulent and would cause severe losses.  Again, this provides a natural experiment toevaluate why Fannie, Freddie, et alia, originated and purchased theseloans.  It wasn’t because “thegovernment” compelled them to do so. They did so because they were accounting control frauds.

Fourth, the industry increasinglymade the worst conceivable loans that maximized fictional short-term income andreal compensation and losses.  Making (orpurchasing) liar’s loans that are also subprime loans means that the originatoris making (or the purchaser is buying) a loan that is endemically fraudulent toa borrower who has known, serious credit problems.  It’s actually worse than that because lendersalso increasingly added “layered” risks (no downpayments and negativeamortization) in order to optimize accounting fraud.  Negative amortization reduces the borrowers’short-term interest rates, delaying delinquencies and defaults (but producingfar greater losses).  Again, thisstrategy maximizes fictional income and real losses.  Honest home lenders and purchasers of homeloans would not act in this fashion because the loans must cause catastrophiclosses.

To sum it up, the known facts ofthis crisis refute the rival theories that the lenders/purchasersoriginated/bought endemically fraudulent liar’s loans because (a) “thegovernment” made them (or Fannie and Freddie) do so, or (b) because they weretrying to maximize profits by taking “extreme tail” (i.e., an exceptionallyunlikely risk).  The risk that a liar’shome loan will default is exceptionally high, not exceptionally low.  The known facts of the crisis are consistentwith accounting control frauds using liar’s loans (in the United States) astheir “ammunition of choice” in accordance with the conventional fraud “recipe”used that caused prior U.S. crises. 

It is bizarre that in suchcircumstances the automatic assumption of the Bush and Obama administrationshas been that fraud isn’t even worth investigating or considering in connectionwith the crisis.  It is as if millions ofliar’s loans purchased and resold as CDOs largely by systemically dangerous institutionsare an inconvenient distraction from campaign fundraising efforts.  Instead, we have the myth of the virgincrisis unsullied by accounting control fraud. Indeed, contrary to theory, experience, and reality, the Department ofJustice has invented the faith-based fiction that looting cannot occur. 

“BenjaminWagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases inSacramento, Calif., points out that banks lose money when a loan turns out tobe fraudulent. “It doesn’t make any sense to me that they would be deliberatelydefrauding themselves,” Wagner said.”

Wagner’s statement isembarrassing.  He conflates “they”(referring to the CEO) and “themselves” (referring to the bank).  It makes perfect sense for the CEO to lootthe bank.  Looting is a “sure thing” guaranteedto make the CEO wealthy.  “Looting”destroys the bank (that’s the “bankruptcy” part of Akerlof & Romer’s title)but it produces the “profit” for the CEO. It is the deliberate making of masses of bad loans at premium yieldsthat allows the CEO to profit by looting the bank.  When the top prosecutor in an epicenter ofaccounting control fraud defines the most destructive form of financial crimeout of existence he allows elite fraud to occur with impunity.   

As embarrassing as Wagner’s statement is, however,it cannot compete on this dimension with that of his boss, Attorney GeneralHolder.  I was appalled when I reviewedhis testimony before the Financial Crisis Inquiry Commission (FCIC).  Chairman Angelides asked Holder to explainthe actions the Department of Justice (DOJ) took in response to the FBI’swarning in September 2004 that mortgage fraud was “epidemic” and its predictionthat if the fraud epidemic were not contained it would cause a financial“crisis.”  Holder testified:  “I’m not familiar myself with that [FBI]statement.”  The DOJ’s (the FBI is partof DOJ) preeminent contribution with respect to this crisis was the FBI’s 2004warning to the nation (in open House testimony picked up by the national media.  For none of Holder’s senior staffers whoprepped him for his testimony to know about the FBI testimony requires thatthey know nothing about the department’s most important and (potentially)useful act.  That depth of ignorancecould not exist if his senior aides cared the least about the financial crisisand made it even a minor priority to understand, investigate, and prosecute thefrauds that drove the crisis. Because Holder was testifying in January 14,2010, the failure of anyone from Holder on down in his prep team to know aboutthe FBI’s warnings also requires that all of them failed to read any of therelevant criminology literature or even the media and blogosphere.

In addition to claiming that the DOJ’s response tothe developing crisis under President Bush was superb, Holder implicitly tookthe position that (without any investigation or analysis) fraud could not anddid not pose any systemic economic risk. Implicitly, he claimed that only economists had the expertise tocontribute to understanding the causes of the crisis.  If you don’t investigate; you don’tfind.  If you don’t understand“accounting control fraud” you cannot understand why we have recurrent,intensifying financial crises.  If Holderthinks we should take our policy advice from Larry Summers and Bob Rubin,leading authors’ of the crisis, then he has abdicated his responsibilities tothe source of the problem.       

 “Now let mestate at the outset what role the Department plays and does not play inaddressing these challenges” [record fraud in investment banking andsecurities].

“The Department of Justice investigates andprosecutes federal crimes.…”

 “As a generalmatter we do not have the expertise nor is it part of our mission to opine onthe systemic causes of the financial crisis. Rather the Justice Department’s resources are focused on investigatingand prosecuting crime.  It is within thiscontext that I am pleased to offer my testimony and to contribute to your vitalreview.”  

Two aspects of Holder’s testimony were preposterous,dishonest, and dangerous.

“I’m proud that we have put in place a lawenforcement response to the financial crisis that is and will continue to be isaggressive, comprehensive, and well-coordinated.”

DOJ has obtained ten convictions of senior insidersof mortgage lenders (all from one obscure mortgage bank) v. over 1000 felonyconvictions in the S&L debacle.  DOJhas not conducted an investigation worthy of the name of any of the largestaccounting control frauds.  DOJ isactively opposing investigating the systemically dangerous institutions (SDIs).

Holder’s most disingenuous and dangerous sentence,however, was this one:

“Our efforts to fight economic crime are a vitalcomponent of our broader strategy, a strategy that seeks to foster confidencein our financial system, integrity in our markets, and prosperity for theAmerican people.”

Yes, the “confidencefairy” ruled at DOJ.  It is the rationalenow for DOJ’s disgraceful efforts to achieve immunity for the SDIs’ endemicfrauds.  The confidence fairy trumped andtraduced “integrity in our markets” and “prosperity for the Americanpeople.”  Prosperity is reserved for theSDIs and their senior managers – the one percent.

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.