The Fraud Shotgun: The Overlapping Fields of Fraudulent Fire that Drove the Crisis

By William K. Black

I have written a series of articles recently that focus on appraisal fraud.

I did so because appraisal fraud allows such “clean” tests of what (and who) drove the financial crisis and how many different private and public sector actors could have easily prevented the crisis had they acted against the fraud epidemics.

  • Only lenders and their agents can cause a substantial amount of appraisal fraud.
  • They did so through extorting appraisers to inflate appraisals by blacklisting the most ethical appraisals
  • No honest lender would induce appraisal fraud
  • Lenders engaged in accounting control fraud find widespread appraisal fraud an optimal strategy
  • Fraudulent mortgage lenders engage in appraisal fraud because it aids their overall strategy of making fraudulent loans
  • No honest lender would permit widespread appraisal fraud
  • Honest lenders can prevent widespread appraisal fraud in the loans they make
  • No honest secondary market purchaser would knowingly purchase loans with inflated appraisals
  • Competent secondary market purchasers could have avoided purchasing large numbers of loans with inflated appraisals
  • The appraisers warned the Nation publicly of the widespread appraisal fraud and that it occurred through extortion and blacklisting by the lenders and their agents
  • The appraisers took special efforts to warn the mortgage lending industry and U.S. government beginning in 2000, and continued those efforts through 2007, about these facts and warned that it would cause a crisis
  • Eventually, over 11,000 appraisers signed the profession’s petition warning about the epidemic of appraisal fraud driven by the lenders and their agents

My earlier articles noted that the fraudulent lenders typically engaged in a two-barreled assault that combined endemically fraudulent “liar’s” loans and appraisal fraud.  Like a shotgun, the overlapping fields of fire can be devastating when lenders combine the two forms of fraud.  The liar’s loans were the underlying fraudulent lending strategy.  Appraisal fraud supplemented this underlying fraud.  This column discusses three important interactions among these fraud schemes that optimized the overall accounting control fraud “recipe.”

The officers controlling a fraudulent mortgage lender (purchaser) optimize their income through the usual fraud “recipe.”

  1. Grow like crazy by
  2. Making (buying) really crappy loans at a premium yield
  3. While employing extreme leverage and
  4. Providing only trivial allowances for loan and lease losses (ALLL)

The recipe combines with modern executive compensation to create three “sure things” – the lender (purchaser) is guaranteed to report record income in the near term, the controlling officers will promptly be made wealthy, and the firm, borrowers, and the world will suffer severe losses on the fraudulent loans.  The fraud recipe is also a superb device for hyper-inflating financial bubbles and did in fact cause the hyper-inflation of bubbles in the U.S. and other nations in the ongoing crisis.

I have explained in prior columns why the controlling lenders found liar’s loans to optimize the fraud recipe in the U.S. and the U.K.  By 2006, 40% of all mortgage loans made that year in the U.S. were liar’s loans.  The comparable figure for the U.K. was 45 percent.  Liar’s loans allow lenders to make fraudulent loans without having to create (or evade) making a paper trial documenting that they knew they were making loans that were unsound and would have exceptionally high default rates as soon as the bubble stalled.  I have shown why the two means of trying to evade documentation requirements present serious risks of imprisonment to the controlling officers if the regulators and prosecutors are vigorous.  Eliminating the documentation requirement for mortgage lending was the single most destructive act of mindless deregulation.  It was done under the Clinton administration as part of Vice President Gore’s “Reinventing Government.”  I have shown in prior columns that his effort was explicitly anti-anti-fraud.  Gore made war on the regulators and regulations that had protected the Nation from the control frauds.

Fleecing the Financially Unsophisticated – Then Blaming Them

Virtually everyone involved in the mortgage lending process made more money if the size of the loan was larger.  This meant that it was optimal for home prices to be greater and for the mortgage loan to be larger.  By inflating the appraisal the lender could purport to justify making a larger loan.  The loan would be greater than the current market price of a home because the borrower would pay a price even greater than prevailing prices during the bubble.  People involved in the mortgage lending process made more money if the borrower paid a premium yield.  This made it optimal to seek out borrowers who lacked financial sophistication.  It was easier to convince such a borrower to overpay (even above the prevailing bubble prices) for a home and to pay a premium yield to the lender for the privilege of being duped.  A liar’s loan provided no benefit to an honest borrower – it simply imposed roughly another 100 basis points of interest costs.  That 100 bps, unfortunately, was simply adding insult to the real injury, which was typically inflicted in the form of hidden fees known as the “yield spread premium” (YSP) and purchasing a home the buyer could not afford at an inflated price well in excess of the home’s true value.  The less financially sophisticated the borrowers were, the more likely the borrowers were to believe that the loan broker was their agent working on their behalf.  That was true of some brokers, but it was untrue of many brokers because their interests were directly antagonistic to the borrower’s interests.  This is how the realtors’ association (disingenuously) explains the role of the brokers and the YSP.

“They do all the work that you need to do in order to originate, process and close the loan. They represent you, not the bank.”

No, they do not “represent you.”  It is true that they do not (formally) “represent … the bank,” but the bank’s controlling officers determine the broker’s compensation incentives so they are the one’s steering the transaction and the broker’s actions.  As I noted, some brokers will seek to act in the borrower’s interests despite these perverse financial interests, but many will act directly contrary to the interests of the borrowers and the lender.

Another large group of brokers will “neutralize” their moral restraints against committing mortgage fraud by purporting to be acting on behalf of the borrowers.  This group will argue that the bank knows that the broker is inflating the borrower’s income and extorting appraisers to inflate the value of the home, so it is not harmed and the borrower is able to buy a home he could not otherwise purchase so he is being helped.  Under this morally myopic view it is fine for the broker to get rich through mortgage fraud because there is no real victim.  The reality is different.  The lender will suffer enormous losses and the borrowers will commonly be induced to overpay for homes (even above the prevailing bubble values) at the top of the bubble.  This will cause the borrower to suffer severe losses that wipe out his equity, particularly if he tries to delay the default by continuing to pay the initial low interest rate (on “exploding rate” ARMs) even though the home is deeply “underwater.”  The borrower will also ruin his credit history.

It is true that the controlling bank officers knowingly created – and continued for many years – the perverse incentives that ensured that brokers would arrange millions of fraudulent loans even after there were multiple warnings about the lenders’ twin mortgage fraud epidemics.  But that occurred because they were leading accounting control frauds.  The fact that the officers who controlled the bank betrayed their fiduciary duties to the bank in order to become wealthy does not change the fact that the bank would suffer severe losses if the loan brokers inflated the borrower’s income and the appraised value.  It was immoral for loan brokers to cause the banks severe losses by making loans that were highly likely to default as soon as the bubble stalled.

The Realtors’ website goes on to (unintentionally) reveal that the loan brokers’ did not represent the interests of the borrowers.

“Back-end compensation
In back-end compensation, the broker gets a check from the lender for increasing the interest rate. The mortgage broker gets more money depending on how much he or she increases the rate. This is called the YSP, the yield spread premium.”

The broker gets paid more the larger the amount of the loan and the higher the rate of interest he can induce the borrower to pay.  The broker can make the most money therefore by trolling for financially unsophisticated borrowers – or those who are not fluent in English.  The broker and the borrower conduct their discussions in Spanish, but the documents are entirely in English.  The opportunities for abusing less sophisticated borrowers are legion.

In addition to the twin fraud schemes that the lenders employed there was a far smaller but still significant fraud scheme led by a subset of borrowers – the most financially sophisticated borrowers, the real estate speculators who purchased multiple homes as investments.  A recent study confirmed the importance of their frauds.  The authors found that real estate speculators often misrepresented their intention to occupy the home they were purchasing as their principal dwelling.  A borrower is far less likely to default on a loan on the home that is his principal dwelling, so lenders charge roughly 100 more basis points for loans to speculators who do not intend to occupy the dwelling.  The study by Piskorski, et al., documented that the default rate by speculators who misrepresented their intent to occupy was considerably higher than for speculators who truthfully represented their intent not to occupy.  That finding demonstrates that the speculators who are willing to lie pose far greater risks of loss to honest lenders than honest speculators.  The most financially sophisticated borrowers did were the most likely borrowers to instigate frauds against the lenders.

Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market

Tomasz Piskorski, Seru & Witkin

February 2013

The claim that the least wealthy homeowners, particularly minorities, were the villains that drove this crisis is facially preposterous.  The idea that among the least financially sophisticated households in America defrauded the most financially sophisticated firms is so delusional and viciously false that it is fitting that it became infamous through a Rick Santelli rant.  He’s certainly right that the small homeowners targeted by the fraudulent lenders were “losers.”  They lost their homes, their very limited savings, and their credit ratings.  The small homeowners were the leading victims of the fraudulent lenders and their allies.  Santelli referred to the financial derivatives traders at the Chicago Mercantile Exchange and said “this is America.”  He called them a “statistical cross section of America.”  The homeowners, particularly minorities, targeted by the frauds that made the derivatives traders wealthy were by implication not really part of “America.”

Three interactions between liar’s loans and appraisal fraud

Fraudulent lenders and those that aid and abet their frauds typically found it optimal to combine liar’s loans and appraisal fraud for three reasons.  First, because the frauds become wealthier the bigger they can make the loans appraisal fraud is desirable because it allows homes to be sold at prices that are well above even bubble-driven market prices.  The less sophisticated borrowers, however, cannot afford to purchase a house at those inflated prices.  Liar’s loans inflate the borrower’s income dramatically, which makes it appear that the borrower can afford to repay the loan.

Second, as I explained in earlier articles the secondary market was so perverted by lenders and purchasers in order to assist the fraudulent sales of fraudulent mortgages that the lenders, purchasers, and (not remotely) “due diligence” firms (Clayton and its competitors) had the audacity to use fraud as a “compensating factor” that purportedly reduced the risk of default caused by the lender’s fraudulent “representations and warranties” about the quality of the loan packages being sold.  Clayton would use a (purportedly) low debt-to-income and loan-to-value ratios as the excuse to ignore misrepresentations (fraud) by the lender about the quality of the mortgages being sold to the secondary market.  But those purportedly unusually low ratios were the direct product of, respectively, liar’s loans frauds and appraisal fraud.

Third, appraisal fraud made it far easier to convince unsophisticated borrowers to take out liar’s loans they could never repay.  A husband who expressed concern whether he could repay such a large home loan could be told, preferably in front of his wife, that he could not afford to pass up the brilliant deal he had negotiated.  He negotiated a purchase price of $200,000 and the appraisal came back at $250,000.  If worse came to worst he could always sell the home and take the $50,000 profit.  The one thing he could not do was make the worst financial mistake of his life and walk away from a minimum $50,000 profit – a profit almost certain to grow as home prices rose.

Fraudulent lenders combined liar’s loans and appraisal fraud to produce a weapon of mass financial destruction.

5 Responses to The Fraud Shotgun: The Overlapping Fields of Fraudulent Fire that Drove the Crisis

  1. Sunflowerbio

    Don’t you think some Congressperson would want to make a reputation by fully exposing these control frauds al la Harry Truman who exposed war contracting fraud and cheating? There is plenty of evidence and no shortage of people who would like to testify under oath.

  2. All of the above is true and accurate, excepting it ignores the ladder or pyramid of fraud, leading to the most egregious item: first there is ultra-leveraging, next, ultra-leveraged speculation, culminating with ultra-leveraged insurance swindles.

    Those naked swaps (uncovered credit default swaps) bought and sold against enormous debt (ultra-leveraging), such as $2 trillion of swaps against Bear Stearns’ external debt of $190 billion (with the potential payout of $200 trillion), and that $460 billion of swaps sold by AIG, with a potential payout of $20 trillion to over $40 trillion, were just two of many insurance swindles going on, which froze the interbank lending, etc.

    Although many people were harmed and destroyed by fraudclosure, etc., those were almost arbitrary when compared to ALL debt vehicles involved!

  3. There is an element in the pervasiveness of fraud, that seems to indicate a competing culture that validates fraud by the apparent outcome. If you will, a validation of means by the apparent result. Along the way. There seem to be many people who have no hesitation in substituting fiction or circumventing authenticity. This to some degree is the absence of a fence (HT to you and J. Swift). I frequently meet people who seem to be unaffected at all by what would be raging cognitive dissonance for me. The Anglo-Irish recordings version continues to be an extreme form. That “liberal” democracy is refurbished as per “libertarian,” not toward progressive. The reduction of a democratic culture to filing into a ballot booth as individuals to decide among a pre-selected set of choices. There is an absence of an authentic democratic culture which would require, as you’ve put it, in the assumption of and the appreciation of the rule of law.

    The history of Iran since 1950 makes for an interesting parallel. The re-installation of a monarchy by the imperial motive, to stifle a yearning for democracy, the resistance to which became exemplified by the imposition of an Islamic revolt led by the mullahs.In some sense the revolt was an effort to establish both a moral democracy and a rule of law. As reactionary movements and revolutions tend to drift toward the means being justified also by the apparent ends.

    FDR’s phrase “economic royalty,” points to the bundling of the control of institutions in the name of a particular “societal stability” and “social order.” The resumption of the “New Era” politic, at the passing of FDR was close to an inglorious restoration. I would venture that Truman’s “investigation” of war contracting fraud, was actually highly selective. The very first HUAC was in 1943, well before McCarthy’s or televisions arrival. There is an irony that the (Im-) moral majority supposed a higher morality and yet displaced an authentic rule of law. That “Re-Inventing Government” was in fact the dismantling and completion of the privatization of governance which erased both the rule of law and a democratic discourse. With the substitution of education by test scores, ignorance was unbound and cheating in multiple forms occupied what had been, at least in theory, a nursery/sandbox for learning democracy. Understanding irony seems to be also under-appreciated, and directly related to increased capacity for cognitive dissonance.

    Someone needs to point out the application of ur-MMT has been going on for a very long time, and it has served private interests well decade after decade. This seems to explain the ease by which the effort at sustaining a “fence,” has been a fiction since the perversity of the US Constitution, absent the after thought of the Bill of Rights. Looking deeper into the so called Compromise of 1792 it becomes the key-note excursion into back room dealing and the placing of private interests above pride in the principles of democracy. To find our way out these woods we have to first realize that we are surrounded by trees and hedges. The socialization to insanity is far too common, and prevents any recognition that the culture has become thoroughly toxic. Again, the only possible fence or defense is the establishment of a communal/community critique, but generally the necessary cultural values or memory seem to be absent by the fictionalizing of both past and present. thanks. Tadit

  4. Louis Paul Hebert

    In the US, MERS destroyed the chain of title of properties and facilitated massive foreclosure fraud. Did the banksters use the same methods in Britain? Iceland? Ireland? Spain? Elsewhere in Europe?

    A comparison of the presumably different methods of frauds in various nations might be enlightening.

  5. Prof Black,

    I don’t think you mentioned this important initial spark that created the inferno of fraud in appraisals.

    In 2005, just as Alan Greenspan was saying that the real estate market was headed for a bust through the Appraisal Standard Subcommittee, a request was received by the Appraisal Foundation Board, with regard to the need for the deletion of one Standard Rule and the creation of a new one called the “Scope of Work Rule” to take effect at the end of 2006. In an unprecedented move the change was effectuated at mid year in July 2006.

    Within this new rule lay the seed of the destruction of America ’s property value. The rule was short and simple and contained within it was this one statement: “The Scope of Work could be used for the “intended use of the client.” There are many appraisal organization blogs during this period that pointed out the vagueness of this new rule; its possible conflicts with their neutrality position-and how to apply it.

    In 2007, in a series of advisories, geared for the 2008 Appraisal Foundation Board changes, the Federal Reserve controlled Appraisal Standards Subcommittee said the Scope of Work Rule could be interpreted as allowing the bank’s “risk management” to be the intended use.

    The advisory went into effect January of 2008 and within eight to nine months, properties values, which had remained stagnate, or in the case of South Florida, actually started to go up again, plummeted like lemmings off a cliff, 40-50%.

    The Appraisal Standard Foundation never changed its rule that sales done in haste or under duress could not be counted as arms-length or as value on an appraisal for a bank or anyone else, and therefore the new “Scope of Work Rule not only violated the neutrality of an appraisal, but also conflicted with this imperative. Nonetheless appraisers began to use duress sales en mass for banks in their appraisals, and the press began to write about them as if they were representative of value, even when they sank to below half what it would cost to rebuild the home, gleefully quoting the now discredited Moody’s who would call them up and wildly report predictions of more falling values to come.

    Conveniently by the time the new Homeowner Valuation Code was effectuated last May, 2008 the American property owner had been robbed of his home and investment property equity.

    Along the way, the Bush administration was approached, in 2006, and asked to request a change to the Fair Debt Collection Practices Act. The change concerned the five day rule, whereby, within 5 days from the first contact of a debt collector, the debtor had to be told who he owed the debt to. In this change, a legal pleading, such as a foreclosure suit was exempted from the rule; thereby granting the lawyer handling the foreclosure immunity from not telling the home owner that his client had no standing and therefore -no right to foreclose on the property.

    During the Savings and Loan scandal of the 80’s, when IRS statutes were not violated; a special government organization called The Resolution Trust Company was created and authorized by the investment trusts to deal with properties that belong to REITS and were collateral for securities; properties were never short saled for less than the amount due on the loan; never sold before foreclosure; appraisers never dared to use duress and foreclosures as value; and the American home owner was not faced by unfair competition in the market place when selling their home. Values of American property stagnated during this period, but they did not fall.

    It is my personal opinion that the Federal Reserve played the role of Neville Chamberlain in this devaluation of the American landscape. They called up the ever faithful, sure to be relied on, national press and started predicting values were going to fall and the press marched out and told that story with a battering ram, never checking the facts once, because if they had called a few county tax role people they would have known that real estate never behaves that way, it just stagnates, because there are no buyers to take the market down and foreclosures cannot count even according to FIRREA guidelines that govern by law in Federally related transactions.

    Of course the Federal Reserve knew that, since it controlled all final appraisal standards, but the press was unaware of that. The Fed had to get around this glitch in their plan, so slowly, so as not to attract attention, they changed appraisal standards and manipulated the Fannie Mae requirements so that they could use the forbidden sales made “under undue stimulus,” as value; then they pulled the plug on the sub prime, and when the housing debacle began, again called up the press and told them it was all the sub prime’s fault, when really the fault was pulling the sub prime. Interest rates were the same when they pulled the plug. Every single one of those buyers that took one of those mortgages was told they could refinance when it came time for their interest rates to escalate to 11-13 percent. All the sub prime was- was conventional lending with FHA credit standards, no more-no less. All the lending tricks to get people into homes had been around for a long time, not doing any harm to anyone or anything.

    At some point in time knowing that the REITS had investing in bad company they had to deal with telling the REITS. The REITS were mostly foreign investors and in good part the Chinese, who to an investor, were most probably livid and rattled their sabers threatening to put anyone involved in jail and those involved were America’s financial elite. So the Federal Reserve talked our government into bailing the bad guys out, and because there were so many fraudulent and non existent loans the devaluation of the American landscape began so that they could get the money for the REIT and also sell the property to the REIT investors as individual investment arms and the REITS agreed to keep quiet. It began in the first quarter of 2008 and nationwide values fell between 25 and 50% in nine short months – an unprecedented event.

    It is quite clear that this had to be what was going on based on the following, know facts. The REITS will not allow the banks to negotiate below the loan value on modification, but once the loan is in their possession they will allow it to be sold at an incredibly discounted price. I have an associate who short saled her home, only to receive paper from the bank marked “unsecured” ( by the note),and then a letter from a REIT trust saying she had no right to sell the home for below her debt, as the bank did not own the loan. She has heard nothing since. A saber rattled just to make sure the Fed knows they will squeal on the . . . what is it they called them…?” institutions “too big to fail” if they do not deliver the missing money. A check of the MLS shows that 60-70 percent of the sales are all cash. And oh yes, because the government did not want to touch this illegal wink, wink, wink activity they are having what the IRS calls prohibited parties with no standing, the bank servicing companies, foreclose on Americans illegally with the courts wink, wink, wink permission.