Two Sentences that Explain the Crisis and How Easy it Was to Avoid

By William K. Black

Everyone should read and understand the implications of these two sentences from the 2011 report of the Financial Crisis Inquiry Commission (FCIC).

“From 2000 to 2007, [appraisers] ultimately delivered to Washington officials a petition; signed by 11,000 appraisers…it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18).

Those two sentences tell us more about the crisis’ cause, and how easy it was to prevent, than all the books published about the crisis – combined.  Here are ten key implications.

  1. The lenders are extorting the appraisers to inflate the appraisal.
  2. No honest lender would inflate an appraisal, the lender’s great protection from loss.
  3. The lenders were overwhelmingly the source of mortgage fraud.
  4. The lenders were not only fraudulent, but following the “recipe” for ”accounting control fraud.”  They were deliberately making enormous numbers of bad loans.
  5. This had to be done with the knowledge of the bank CEOs.  One of the wonderful things about being a CEO is the ability to communicate to employees and agents without leaving an incriminating paper trail.  Sophisticated CEOs running large accounting control frauds can use compensation and business and personnel decisions to send three key messages:  (a) you will make a lot of money if you report exceptional results, (b) I don’t care whether the reports are true or the results of fraud, and (c) if you do not report exceptional results or if you block loans from being approved by insisting on effective underwriting and honest appraisals you will suffer and your efforts will be overruled.  The appraisers’ petition was done over the course of seven years.  Even if we assumed, contrary to fact, that the CEO did not originate the plan to inflate the appraisals the CEOs knew that they were making enormous numbers of fraudulent “liar’s” loans with fraudulent appraisals.  It is easy for a CEO to stop pervasive fraudulent lending and appraisals.  Where appraisal fraud was common it was done with the CEO’s support.
  6. Fraudulent loan origination creates a “Gresham’s” dynamic (bad ethics drives good ethics from the marketplace or profession because cheaters prosper) will be created among lenders.   The CEO of lenders that follow the fraud “recipe” can count on three “sure things.”  The lender will report exceptional income in the near term.  The controlling officers will promptly be made wealthy by modern executive compensation.  The lender will (later) suffer severe losses.  The controlling officers of honest lenders will report far lower income and receive far less compensation.  The CFO will rightly fear losing his job.  This turns market forces perverse and makes accounting control fraud surge.
  7. The Gresham’s dynamic and the fraud “recipe” cause an enormous expansion in bad loans.  This can hyper-inflate a financial bubble.  As a bubble grows the fraud recipe becomes even more wealth-maximizing for unethical senior officers.  The trade has a saying that explains why bubbles are so criminogenic – “a rolling loan gathers no loss.”  The fraudulent lenders refinance their bad loans and report (fictional) profits.
  8. Once fraudulent loans are fraudulently originated they cannot be cured.  There is no loan exorcist.  All subsequent sales of the mortgage (or cash flows from the mortgage) in the secondary market will require additional fraud and will transfer bad assets with a greatly increased risk of loss.  (Not every fraudulently originated mortgage loan will default and suffer loss, but a portfolio of such loans has such a greatly increased risk of loss that the portfolio will have a negative expected value.)  Liar’s loans do not “become” bad; they are endemically fraudulent when they are originated and mortgage loans made on the basis of deliberately inflated appraisals are always fraudulent.  Only accounting fraud, failing to provide appropriate allowance for loan and lease losses (ALLL) at the time the loans are made, can produce the fictional income that drives the fraud scheme.
  9. The Gresham’s dynamic that causes us the most wrenching pain as regulators is the one that the officers controlling the fraudulent lenders deliberately created among appraisers.  They created the blacklist to extort the most honest appraisers.  The fraudulent lenders, of course, do not have to successfully suborn every appraiser or even most appraisers in order to optimize their frauds.  A fairly small minority of suborned appraisers can provide all the inflated appraisals required.  The honest appraisers will lose a great deal of income and many will be driven out of the profession by the lost income or because the degradation of their profession disgusts them.  These non-wealthy professionals, the ethical appraisers, were injured by the fraudulent CEOs because the appraisers knowingly chose honesty over maximizing their incomes.  The CEOs of the lenders and the officers and agents they induced (by a combination of de facto bribery and extortion) to assist their frauds chose to maximize their incomes through fraud.
  10. The U.S. government did nothing in response to the appraisers’ petition warning about the black list of honest appraisers.  The federal banking agencies’ anti-regulatory leaders’ hatred of effective regulators caused them to do nothing in response to the appraisers’ petition.  The anti-regulators did nothing for years, as the number of appraisers signing the petition grew by the thousands and surveys and investigations confirmed their warnings about lenders extorting appraisers to inflate appraisals.  The appraisers put the anti-regulators on notice about the fraud epidemic for seven years beginning in 2000.

16 responses to “Two Sentences that Explain the Crisis and How Easy it Was to Avoid

  1. As I read this article, every time I saw “CEO” I said, Lloyd Blankfein. Every time I saw “lender” or “underwriter” or “bank,” I said, Goldman Sachs. This article is very straight forward and points out how all the fraudulent CEOs and all the fraudulent banks acted to create The Great Financial Crisis.

    Such a pity that “fraud” no longer exists and that there are no CEOs who can commit fraud or be criminally prosecuted for fraud. Pity!

  2. I think the English expression here is: Duh. Control Fraud is business as usual and will be until we get the money out of politics. Root$trikers anyone?

    • Carla Rautenberg

      Through an amazing grassroots effort, citizen activists are circulating petitions to put the Move to Amend: Corporations Are Not People and Money Is Not Speech on local ballots all across Ohio. We are having great success and the registered voters who sign our petitions are SO GRATEFUL. They keep thanking us for doing this work. How are things going in your state?

  3. Bill –

    Another focused, clear, relevant, and important recitation of the vast criminal conspiracy that constitutes our current corporatacy. I only wish you were Treasury Secretary, and Randy at the Fed.

    I can hope, can’t I?


  4. Sunflowerbio

    When someone offers you a “hot”, “can’t miss”, “sure thing”; run, don’t walk, away as fast as you can; unless the government is on the hook to bail you out.

    • Agreed. I’ll spell that out in more detail…..

      The problem Bill Black addresses is just one of the several problems solved by the banking system advocated by John Cochrane in this recent WSJ article:

      In particular if depositors are forced to be fairly specific about what a bank does with their money, the problem is largely solved. E.g. if a depositor wants their money put into anything faintly risky, e.g. NINJA mortgages, then the depositor carries the downside risk under Cochrane’s system.

      In contrast, if a depositor opts to have their money put into ultra-safe stuff, e.g. short term government debt or mortgages where householders have a minimum 30% equity stake, then it would be OK to have taxpayers underwrite those deposits: there’s almost no taxpayer exposure there.

      I.e. the problem arises where banks can get hold of money at a low rate of interest, second, put it into high yielding risky investments, third, keep the upside profit, and fourth have the taxpayer carry the downside risk.

      • Sunflowerbio

        Thanks Ralph for the link. I was sarcastically referring to my own experience attending a seminar in which a mortgage company proposed getting in on the “housing boom” by buying distressed homes at auction with “their” money, making cosmetic improvements, and flipping them; sharing the profits. This was about 2004 or 5. I didn’t run away from this, I just walked away. Think of all the money I left on the table until 2008 when the mortgage companies got bailed out by Uncle Sam, while home owners are still twisting in the wind.

  5. My name is Charles and I am a blacklisted appraiser. Of course the listers will say, “What list?” because there isn’t actually a document. They may further add, “Oh, him. He doesn’t do the quality of work we require.” That too has some truth in it. The quality desired is complacent not compliant. You can check some perspectives going back years at my topics page – .

  6. Brian Hanley

    It goes deeper than that Bill. You need to get to the motivation, and the new mechanisms created. The banks were making those loans in order to make more money than ever, because with AIG insuring them against loss (on paper) when a loan failed, they made even more money. This was because they would keep the CDS, but sell off the loan. So they returned the loan to capital by selling it. They returned the loan to capital again by collecting on the CDS. So they nearly doubled their money (assuming they sold at, say 80% of face value, this works). In fact, the banks could make money by making a bad loan, selling that loan off at a steep discount (in theory, as low as 10% or so of book). They could do that because the CDS, when it covered the failed loan would make up the difference.

    But even that doesn’t get to the bottom of this. Because the CDS availability at low price made it possible to return the allocated loan to capital available to loan – AS SOON AS THE CDS WAS BOUGHT. This means that within that sector of the loan universe, the banks had, in a way, tripled their money on every loan. This created a brand new, and novel, set of banking multipliers. It’s not really just one new multiplier, it’s a set of them that could reach into the thousands.

    Conventional multipliers are 1/r, where r is the reserve. Thus in a 5% reserve system, the multiplier is 20. For a 2.5% reserve system, it’s 40. Yes, the Fed, as lender of last resort, has an effect, because the Fed for all practical purposes makes it possible to ignore the limiting effects of loan multipliers on the larger economy. The multiplier on reserve money within a gold standard system forces a boom and bust cycle. The Fed (and the now universal system of fiat money central banks) has greatly tempered the boom and bust cycle. But the Fed and banking regulators depend on those reserve multipliers working normally to control banking.

    This new family of multipliers completely changed that. The paper on it is below. Section 2 is for more sophisticated bankers.

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  9. Jo Ann Meyer Stratton, IFA, SRA

    It appears that after waiting 13 years, somebody finally read our petition, but will it do any good at this late date? With the HVCC and Dodd Frank that has occurred in recent years–it is happening again as prices paid for homes are dramatically increasing in many areas. A huge future foreclosure mess is developing which everybody appears to be ignoring. It might be time for another appraiser’s petition–maybe in fifteen years some body will read it. But I doubt it will help this time around either.

    One of the very early signers of the original Appraiser’s Petition in 2000.

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  12. “The controlling officers will promptly be made wealthy by modern executive compensation. ”
    This is an important point and needs to be emphasized; all corporate structures have carefully organized hierarchies that compensate according to the rule that a step up the ladder equates to a significant pay increase for having gained, at least in theory, a mastery of the positions further down the ladder. The mastery is rewarded and vice presidents and senior vice presidents all have their support staffs in place in well. This Squirearchy expects and usually gets compensated according to the pay scale of the lower rungs. In short, the upper levels, having left the rank and file behind, will gladly go along with pay schemes that involve fraud-the operatives of group think allow guilt to be washed away.

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