Step one: Understand the three “control fraud” epidemics that drove the crisis.
Control fraud occurs when the person that controls a seemingly legitimate entity uses it as a “weapon to defraud.” In finance, accounting is the “weapon of choice.” Lenders engaged in accounting control fraud display the four “ingredients” of the fraud “recipe.”
- Grow massively by
- Making loans at a premium yield that are so bad that they will produce losses
- Employing extreme leverage and
- Providing only trivial allowances for loan and lease losses (ALLL)
The recipe produces three “sure things.” The lender will report record profits in the near term, the controlling officers will promptly be made wealthy through modern executive compensation, and the firm will suffer catastrophic losses. The recipe is also an ideal means to hyper-inflate a financial bubble in real estate, which can delay loss recognition for many years. Minor variants on this recipe drove the savings and loan debacle and the Enron-era frauds.
An honest home lender would never engage in two fraudulent loan origination practices that became epidemic – appraisal fraud and making endemically fraudulent “liar’s” loans. The Financial Crisis Inquiry Commission (FCIC) found:
“From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets.
One 2003 survey found that 55% of the appraisers had felt pressed to inflate the value of homes; by 2006, this had climbed to 90%” (FCIC 2011: 18, 91).
The appraisal is the lender’s great protection against loss so no honest lender would extort appraisers to inflate appraisals, but extortion was the norm at lenders making endemically fraudulent liar’s loans (FCIC 2011: 110-111). Fraudulent lenders inflated the appraised value in order to make the loans appear safer by purportedly “compensate[ing]” for the borrower’s fraudulently inflated income (FCIC 2011: 166). It was overwhelmingly the lenders and their agents who put the lies in liar’s loans. (Yes, you read that correctly – the fraudulent lenders had the chutzpah to use fraudulently inflated home values to “compensate” when reviews discovered that the lenders had had fraudulent inflated the borrower’s income, and vice versa.) This aided the third control fraud epidemic – the sale of fraudulently originated mortgages to the secondary market through endemically (45%) fraudulent “representations and warranties” (FCIC 2011: 166). There is no fraud exorcist, so fraudulently originated loans stay fraudulent and can only be sold to the secondary market through fraud.
Step 2: Restore the destroyed criminal referral process, restore the partnership with the banking regulatory agencies, and end the partnership with the “perps”
To produce over 1,000 felony convictions in cases the Department of Justice (DOJ) designated as “major” during the S&L debacle, the Office of Thrift Supervision (OTS) made over 30,000 criminal referrals. In this crisis, which is over 70 times larger than the debacle in terms of losses and fraud, OTS made zero criminal referrals, as did the Office of the Comptroller of the Currency and the Federal Reserve. (The FDIC is smart enough to refuse to answer how many referrals it made.) The OTS “Criminal Referral Coordinators” that once provided the finest criminal referrals were eliminated during the run up to the crisis. It was open season on America for fraudulent bank CEOs.
Criminal referrals by the banking regulators are not “important” – they are essential to prosecute an epidemic of control financial control fraud. There are only 2,300 FBI white-collar investigators and there are over 1,000 industries. There are two FBI agents per industry so they rarely have industry expertise (particularly after the section’s best financial investigators were transferred to fight terrorism) and they cannot “walk a beat.” They investigate when there is a criminal referral and banks don’t make criminal referrals against their own CEOs. Whistleblowers are helpful, but only come forward episodically. The recent civil case that DOJ won against Bank of America was made possible by a whistleblower. It was a travesty that at the press conference announcing the filing of the civil case (which should have been a criminal prosecution) the DOJ did not praise the whistleblower and urge other whistleblowers to come forward. Only the banking regulators have the expertise, resources, and (if properly led) the incentives to make the successful prosecution of the CEOs that lead the fraud epidemics possible and a top priority.
The criminal referral process is only one vital aspect of what the regulators must add to the DOJ and the FBI’s efforts. The regulators must provide the expertise to the FBI and DOJ to allow them to understand the arcane, complex financial world we inhabit. During the S&L debacle we were critical contributors to the training of FBI agents and DOJ attorneys, we served as internal experts to the FBI on the highest priority investigations (we “detailed” examiners to report to the FBI so that our personnel could have access to grand jury materials and help the FBI and DOJ analyze those statements and documents), we worked with the FBI and DOJ to prioritize the 100 worst fraud schemes (involving 300 S&Ls and over 600 individuals) so that the highest priority, most elite defendants were prosecuted. We serve as the “Sherpas” – we do the heavy investigative lifting that allows DOJ to climb mountains and we serve as the trial guides that show how to get to the summit by explaining to the FBI, DOJ, judges, and juries why these frauds are led by the CEO.
None of the steps I have just described are happening now. The FBI and the DOJ did not have to reinvent the wheel. Sadly, they are acting as if they have forgotten that wheels exist. The FBI, desperate for industry expertise because the regulators deserted the field by ending criminal referrals, formed a “partnership” with the Mortgage Bankers Association (MBA) in 2007. The MBA is the trade association of the “perps” – the mortgage lenders who committed the three mortgage fraud epidemics. The MBA’s “contribution” to the “partnership” was a faux definition of “mortgage fraud” under which the lender is always the victim and the purported villains are cunning hairdressers defrauding the poor Wall Street bankers who make $500,000 annual salaries when they are hired (and whose bonuses far exceed those salaries). As astonishing as it may seem, the FBI and DOJ swallowed this facially ridiculous myth of the Virgin Crisis conceived without sin in the C-suite whole. The DOJ prosecutor who is conducting the criminal investigation of JPMorgan exemplifies the crippling effects of the myth.
“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. ‘It doesn’t make any sense to me that they would be deliberately defrauding themselves,’ Wagner said.”
Wagner has forgotten the leading fraud scheme that drove the S&L debacle and the Enron-era frauds – accounting control fraud by which the CEO (“they”) loots the firm (“themselves”). Wagner thinks the CEO and the bank are the same entities. JPMorgan will probably call him as their first defense witness if he does ever prosecute them.
Collectively, our efforts produced a 90% conviction rate in these elite cases despite going up against the best criminal defense lawyers in the world. We know how to successfully prosecute the most elite financial frauds. It is desperately late in terms of the statute of limitations, but if President Obama instructed the banking regulators to make the steps I’ve outlined a top priority we can snatch victory from DOJ’s most embarrassing strategic defeat. As of today, there are still zero prosecutions of the elite bankers who led the three mortgage fraud epidemics that drove the crisis. Not a single elite banker who grew wealthy by leading the fraud epidemics has had that wealth removed, or even dramatically reduced by DOJ.
Is there another control fraud brewing with the various hedge funds starting single family home rental real estate empires?
With the difficulties in making money with such far flung rentals, and the expected exit strategy for the hedgies of going public. It seems to me the expected result is control fraud to get the numbers to look good for the IPO. Maybe stretch it out a little after the IPO to squeeze out some more wealth, and then see the whole enterprise crash as the difficulties of running thousands of single unit rentals come crashing down.
Bill, I’m sympathetic to this cause and want to learn more about the fraud that in many ways drove the financial crisis, but I find it very difficult to actually understand the mechanics of these allegations when you say the word “fraud” every 4 words. Can someone point me to a barebones, calm mechanical explanation of what is being alleged.
I appreciate your passion, but I can’t read this without my head exploding:
“The appraisal is the lender’s great protection against loss so no honest lender would extort appraisers to inflate appraisals, but extortion was the norm at lenders making ENDEMICALLY FRAUDULENT LIARS LOANS (FCIC 2011: 110-111). FRAUDULENT lenders inflated the appraised value in order to make the loans appear safer by purportedly “compensate[ing]” for the borrower’s FRAUDULENTLY inflated income (FCIC 2011: 166). It was overwhelmingly the lenders and their agents who put the LIES in LIAR’S LOANS. (Yes, you read that correctly – the FRAUDULENT lenders had the chutzpah to use FRAUDULENTLY inflated home values to “compensate” when reviews discovered that the lenders had had FRAUDULENT inflated the borrower’s income, and vice versa.) This aided the third control fraud epidemic – the sale of FRAUDULENTLY originated mortgages to the secondary market through ENDEMICALLY (45%) FRAUDULENT “representations and warranties” (FCIC 2011: 166). There is no FRAUD exorcist, so FRAUDULENTLY originated loans stay FRAUDULENT and can only be sold to the secondary market through FRAUD.”
Maybe I’m alone on this, but I’d love for the fraud to be explained (or defined), not in terms of itself. I realize its not the exact same topic as alot of the more mechanical economics discussed on this blog. But I think your argument could really be strengthened by taking a page out of the Scot Fullwiler playbook occasionally.
Didn’t gain much from Potomac’s wild tale below. But rereading and thinking about Bill’s post…
I sort of get it. I just want us to be clearer I guess.
The real fraud Bill seems to be talking about is a CEO looting his firm through the classical “agency problem” where an executive is paid handsomly to make short term decisions for his firm, that in this case are more extremely malevolent for the long term health of the firm (compared to the much more common and acknowledged mere negligence of a firm’s longterm outlook in favor of short term results). I can buy this, the idea that its sort of tough to pin down an executive’s bad decisions as fraudulent in the sense that he was purposefully damaging the firm (and thus the shareholders who elected him). I could see how its real hard to bring someone to jail for that. You could get him on financial statement fraud, if purposefully hiding accounting position in SEC financials, problem here is auditors really aren’t there to catch this sort of “treacherously bad decision fraud.” They’re there to make sure there’s no fraudulent GAAP misrepresentations. And for most part, it seems to be easy to follow GAAP and still screw your firm.
But this overarching gripe gets a little overshadowed by the other claims which I have a harder time understanding. Like at the mortgage origination level, who’s defrauding who…mortgage originating bank perhaps is defrauding the other ibanks who purchase the bad mortgages and then repackage them? But originator would only be defrauding here if it misrepresented the nature of the assets to the other ibank, which I suppose happened at some level. And banks defrauding each other doesn’t seem to be the message I hear in all caps. Isn’t the story that there’s some sort of massive wall street collusion. Like were the banks originating the mortgages guilty as sin, but the financial institutions buying, repacking, and selling on clean? If they both understand the nature of the asset, then it doesn’t seem like fraud yet. If everyone knows the value of something. So I guess there’s some sort of fraud on the very back end, where the packaged securities are being sold to the public — help me understand the warranties at this point — if there aren’t really any, is it just risk being priced wrong, or is there still some fraud here I don’t totally see.
The appraiser thing seems bad for sure. But appraisals are very subjective. Should we be sending appraisers to jail who trended up home values to match the explosive home buying environment around them? Seems tough.
This is an honest enquiry. Something bad certainly happened here. But I guess I’m still trying to figure out a way to articulate it myself. To be able to explain to a friend (let’s say) methodically what happened here. I guess I suspect there should’ve just been more regulation and required disclosure/warranties in general, but some part of me says its hard to demand jail sentences to executives, and at the same time demand more regulation and guidelines out there. At the very least though, I still hold that parrying down the explosive fraud language would help get the point across clearer and better.
SG,
Unknown to almost everyone, there is something VERY fraudulent that happens with your “Mortgage Note” immediately after closing. Your “Mortgage Note” is endorsed and deposited in the bank as a check and becomes “MONEY”!
The document that you just gave the bank with your signature on it, that you believe is a promise to pay them for money loaned to you, has just been converted to money in THEIR ACCOUNT. You just gave the “lender” the exact dollar value of what they said they just loaned you! Who is the REAL creditor in his “Closing Transaction”?
Who really loaned who anything of value or any money? You actually just paid for your own home with your promissory “Mortgage Note” that you gave the bank and the bank gave you what in return? NOTHING!!! For any contract to be valid there must be consideration given by both parties. But don’t they tell you that you must now pay back the “Loan” that they have made to you?
How can it be that you could just write a “Note” and pay for your home? This leads us back to the bankruptcy of the United States in 1933. When FDR and Congress took all the property and gold from the people in 1933 they had to give something in return for that confiscation of property.
What the people got in return was the promise that all of their needs would be met by the government because the assets and the labor of the people were collateral for the debt of the United States in the bankruptcy. All of their debts would be “discharged”. This was done without the consent of the people of America and was an act of Treason by President Franklin Delano Roosevelt.
The problem comes in where they never told us how we could accomplish that discharge and have what we were entitled to after the bankruptcy. Why has this never been taught in the schools in this country? Could it be that it would expose the biggest fraud in the history of this entire country and in the world? If the public is purposely not educated about certain things then certain individuals and entities can take full financial advantage of virtually the entire population. Isn’t this “selective education” more like “indoctrination”? Could this be what has happened?
In Fina Supply, Inc. v. Abilene Nat. Bank, 726 S.W.2d 537, 1987 it says “Party having superior knowledge who takes advantage of another’s ignorance of the law to deceive him by studied concealment or misrepresentation can be held responsible for that conduct.” Does this mean that if there are people with superior knowledge as a party in this “Loan Transaction” that take advantage of the “ignorance of the law”, (through indoctrination) of the public to unjustly enrich themselves, that they can be held responsible? Can they be held responsible in only a civil manner or is there a more serious accountability that falls into the category of criminal conduct?
It is well established law that Fraud vitiates any contract that arises from it. Does this mean that this intentional “lack of disclosure” of the true nature of the contract we have entered into is Fraud and would make the mortgage contract void on its face? Could it be that the Fraud could actually be “studied concealment or misrepresentation” that makes those involved in the act responsible and accountable? What happens to the “Note” once it is deposited in the bank and is converted to “money”?
Are there different kinds of money? There is money of exchange and money of account. They are two very different things. Walker Todd explains in his expert witness affidavit that the banks actually do convert signatures into money. The definition of “money” according to the Uniform Commercial Code: “Money” means a medium of exchange authorized or adopted by a domestic or foreign government and includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more nations. Money can actually be in different forms other than what we are accustomed to thinking. When you sign your name on a promissory note it becomes money whether you are talking a mortgage note or a credit card application! Did the bankers ever “disclose” this to us? Were we ever taught anything about this in the school system in this country? Could it be that this whole idea of being able to convert our signature to money is a “studied concealment” or “misrepresentation” where those involved become responsible if we are harmed by their actions? What happens if you have signed a “Mortgage Note” and already paid for your home and they come at a later date and foreclose and take it from you? Would you consider yourself to be harmed in any way?
Interestingly enough, I was the bank regulator who showed the need for TARP a year before Congress approved the bailout bill. My analysis when I headed up the FDIC large bank program showed the largest five banks were some $20 billion in loss reserves that they should have booked for accounting purposes – a full year before TARP. The banks did not account for their losses because they wanted to make their bottom line consensus earnings estimates to keep their stock prices from plummeting. The big CPA firms are hired hacks and allowed the banks to skip along easy street because the banks paid these consultants/CPAs for their audit opinions.
Sadly, the Office of Special Counsel, Inspector General, Financial Crisis Inquiry Commission, and Merit System Protection Board would not allow my analysis and comments to be used in any of my whistleblower disclosures. Of course, this prevented my account from being made public. This is an indictment of the government whistleblower protection watchdogs. The system is set-up to deny rights to government whistleblowers so as to protect government authorities.
Bill Black understands this more than anyone. And Matt Taibbi. The truth will likely never come out because Bill and Matt are voices blowing in the wind when other journalists sit in their easy chairs and refuse to do any investigative journalism.
This is a very well written article and description of how the criminal minds of the ‘bankster’s and their equally crooked government crony counterparts took down and looted the entire real estate sector and crippled the American economy from which neither has really recovered yet- thanks to the marginal (at best) economic policies of the obama administration these past 5 years. Don’t forget that bill clinton greased the skids for this to happen when he repealed the Glass Steagal Act during his disasterous presidency, where he also sold us out to the communist chinese government. The Glass Steagal Act must be reinstated at once to prevent this type of criminal behavior from repeating itself yet again. If you are expecting obama to take any kind of proactive action to prosecute the criminals who did this you will be waiting forever because these are the same people who put him in office and he works for. So don’t hold your breath on that one- they’re all just ‘whistling past the graveyard’ ’till the statute of limitations is up. Its a nice thought, but don’t expect to see any any indictments occur in that filthy nest of vipers. Very sad indeed.