Liar’s Loans Ain’t “Rocket Science”

By William K. Black

In my first column in this two-part series I explained how the Department of Justice’s (DOJ) non-prosecutorial effort against the banksters’ frauds that caused the financial crisis had ended with a pathetic whimper uttered by Deputy Attorney General James Cole during his ritual exit interview with Bloomberg. Cole’s explanation for DOJ’s failure to prosecute a single senior banker for leading the three fraud epidemics that drove the financial crisis was that DOJ was “dealing with financial rocket science.” My first column made the point, which escaped DOJ and Bloomberg that if this were true it would presumably have been modestly important for DOJ to do something about the ability of “rocket scientists” to grow wealthy by leading the frauds that cost the U.S. $21 trillion in lost GDP and 10 million jobs. I also promised this column explaining why it was not true. In light of a reader’s comment I’ll add a third piece on “rocket science” in the financial context.

I’ll begin with a caution. It is not simple to prosecute senior bank officers. Anyone that tells you that it is doesn’t know what they are talking about. We did, however, have a 90% conviction rate against them during the savings and loan debacle because thousands of people worked very hard for years and made such prosecutions the regulators’ second highest priority and one of DOJ’s top priorities. We know how to succeed. In the current crisis we have done none of the things we know is essential to succeed. Instead, we have one senior official after another making pathetic excuses for their failure to take the hard but well understood steps necessary to convict the senior bankers who led the frauds that drove the crisis.

DOJ Attorneys Need 5th Grade Math to Prosecute the Rocket Scientists

The striking feature of the three epidemics of accounting control fraud that drove the crisis is how crude they were. As I emphasized for decades, the key to the most devastating frauds is not “genius,” but audacity. The fraud epidemics are off the charts on audacity. The principal fraud schemes have next to nothing to do with “rocket science.” They have everything to do with accounting. The most advanced mathematical skill required to understand and explain the fraud schemes was the ability to compute a percentage. Any DOJ attorney who could understand what a percentage is (5th grade math) had all the math expertise required to prosecute the CEOs that led the three fraud epidemics that drove the crisis.

“Fifth graders learn to solve complex problems with complex numbers. They divide whole numbers, with and without remainders. They make connections between decimals, fractions, and percentages.”

The Three Epidemics

The first epidemic was appraisal fraud. The second was “liar’s” loans. These were the two epidemics of loan origination fraud led by the officers that controlled the home lenders. Because there is no fraud exorcist, once loans are fraudulently originated they can only be sold to the secondary market through fraudulent “representations and warranties.” The officers that controlled the lenders that originated massive numbers of fraudulent loans made these fraudulent “reps and warranties.”

The Appraisal Fraud Epidemic

The Financial Crisis Inquiry Commission (FCIC) report should be read closely.

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 (FCIC 2011:18).

Surveys of appraisers in 2003 and 2006 found, respectively, that 55% and 90% of them had been personally subjected to such coercion to inflate appraisals (FCIC 2011: 91). It was lenders and their agents (typically mortgage brokers) who were overwhelmingly responsible for deliberately generating a “Gresham’s” dynamic (in which bad ethics drives good ethics out of the profession or market) in order to inflate reported market values. Honest home lenders would never cause, or permit, appraisers to inflate market values. Lenders controlled by fraudulent officers, however, would find it optimal, under the “recipe” for accounting control fraud by those that make or buy home to inflate appraised values. Note that understanding and proving this fraud requires no math. In my experience, lay people understand the point that no honest lender would induce or permit inflated appraisals in under 30 seconds.

It is harder to understand why the officers that control banks find it useful to their fraud schemes to extort appraisers to inflate appraisals. It requires only elementary school math, however, to understand why this is true. Admittedly, Benjamin Wagner, DOJ’s lead prosecutor on their mortgage fraud (not RMBS) working group was unable to keep up with even the crudest frauds.

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.

The reader can see the obvious – Wagner’s confusion with pronouns arises from his underlying problem with logic. As he uses the pronouns, “they” refers to the bankers and “themselves” refers to the banks. Wagner obviously thinks the bankers and the banks are the same, but this is embarrassing. The bankers are looting the banks. The deeper, catastrophic flaw, however, is that Eric Holder, Lanny Breuer, and Cole chose someone as obviously unfit as Wagner to be the most senior prosecutor on their mortgage fraud working group and have kept him in power despite his total failure to prosecute a single senior banker.


DOJ Has Given Wagner’s Team a Top Award – For Abject Failure

DOJ has just given Wagner’s team its second highest award for their failure to prosecute anyone at JPMorgan (JPM) for committing roughly a dozen of the largest frauds in history. In this case this refers also to the officers that controlled Bear Stearns and Washington Mutual (WaMu) because they were acquired by JPM. Here, I use the term “JPM” to refer collectively to the three financial institutions.

“The four were cited for their work, under the guidance of Shelledy and U.S. Attorney Benjamin Wagner, ‘that led to an unprecedented civil settlement with JPMorgan Chase,’ the nation’s largest bank.

‘The settlement negotiations and the (underlying) fraud investigations they undertook led to what was the largest settlement with a single entity in American history – $13 billion – and the largest … penalty ever recovered by the department – $2 billion’ under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. The measure was enacted in response to the savings and loan crisis of the 1980s.

The settlement resulted in part from an investigation showing that, in the lead-up to the 2007-08 collapse of the economy, JPMorgan sold billions of dollars of residential mortgage-backed securities which included loans that did not comply with underwriting guidelines, were secured by properties with inflated appraisals, were supported by inaccurate loan-to-value or debt-to-income ratios or were otherwise unlawfully originated, according to the citation.

All the while, the citation says, JPMorgan was ‘misrepresenting to investors the (high) quality of the loans … and the (low) risk of loss.’ The efforts of the four award recipients held ‘wrongdoers accountable for reckless and abusive conduct that contributed to the financial crisis,’ the citation says.

Wagner said Wednesday the four attorneys ‘exemplify what it truly means to be a public servant.’”

Let’s parse those statements. JPM’s senior officers led a series of fraud schemes (only two of which are discussed in the quoted passage) that contributed to the “collapse of the economy.” JPM sold “billions of dollars of [RMBS] … that did not comply with underwriting guidelines, were secured by properties with inflated appraisals, were supported by inaccurate loan-to-value or debt-to-income ratios or where otherwise unlawfully originated.” JPM sold the RMBS to the secondary market by “misrepresenting to investors” the condition of the loans.

What we have here is a confession by DOJ that JPM’s, Countrywide’s, and Merrill Lynch’s controlling officers led the three most destructive financial fraud epidemics. They originated hundreds of billions of dollars in mortgages “unlawfully” through extorting appraisers to inflate appraised values and by making “liar’s” loans they knew to be pervasively fraudulent. No honest lender would do that, but accounting control frauds found it to be optimal. Fraudulently originated loans, of course, remain fraudulent so they can only be sold to the secondary market through “misrepresenting” the quality of the loans. That misrepresentation comes in the form of fraudulent “representations and warranties.” Loan origination fraud begets secondary market sales fraud.

And yes, if you are wondering, each of these frauds is a federal crime (actually, a whole series of federal crimes). Collectively, DOJ found roughly a million fraudulent acts led by JPM’s officers just in the three fraud categories listed in the award citation. (The civil case against JPM involved additional frauds.)

Of these roughly million frauds, Wagner prosecuted zero JPM officers. Wagner’s civil suit (made possible largely by a whistleblower ignored in DOJ’s award citation) named no JPM officer. Each of the officers was able to keep 100% of their fraud proceeds. DOJ has just proved that fraud pays massively for senior bank officers and that the most destructive financial frauds in history can be committed by senior bank officers with total impunity.

The total recovery in Wagner’s civil suit was not actually $13 billion (DOJ routinely inflates the numbers in its settlements by adding in loan restructurings that the banks would do on their own initiative as workouts), but $13 billion is a pittance compared to the damage JPM’s three frauds discussed here. It is important to remember that DOJ’s civil suit alleged that JPM committed many other types of frauds.

But here’s another less obvious but amazing “tell” that Wagner insured that there would be no successful prosecution or even civil suits against JPM’s controlling officers  Wagner’s team for the JPM non-prosecution consisted of four attorneys – all from the civil division. That is a ludicrously inadequate number of attorneys to investigate and prosecute the three most destructive financial frauds in history. The fact that the team consisted entirely of four civil attorneys instead of criminal attorneys also demonstrates that Wagner had no intention of prosecuting any senior officers or JPM.

This shameful record should have led to Holder, Breuer, and Cole to remove Wagner from any position of authority in DOJ’s mortgage fraud working group. Instead, they put him in charge of the JPM case – their single most important case. And then, when the case ended in ignominy, with no prosecutions and not even a civil suit against a single officer. There has rarely been a worse strategic failure by DOJ than the JPM non-prosecution. But the true extent of DOJ”s rot is shown by the fact that it now gives its top honors to those that lead such failures. When the award announcement states that it is based on actions against three massive frauds – yet never even attempts to explain why such massive frauds led to zero prosecutions – you know that integrity has long since died at DOJ.

I explain below why making enormous numbers of bad loans optimizes the senior bankers’ ability to loot “their” banks.

The Fraud “Recipe” That Shaped the Crisis

The officers that controlled home mortgage lenders (purchasers) could optimize their frauds by causing the firm to follow the fraud recipe’s four “ingredients.”

  1. Grow extremely rapidly by
  2. Making (buying) massive amounts of bad loans at premium nominal yield, while
  3. Employing extreme leverage, and
  4. Providing only trivial allowances for loan and lease losses (ALLL)

The Recipe Guarantees Three “Sure Things”

  1. The lender (buyer) will promptly report record (albeit fictional) profits
  2. The senior officers will promptly be made wealthy by modern executive compensation
  3. The firm will eventually suffer catastrophic losses

The title of George Akerlof and Paul Romer’s 1993 explains the resulting “agency” problem – “Looting: The Economic Underworld of Bankruptcy for Profit.” The firm will suffer terrible losses, but the controlling officers can walk away wealthy.

The recipe is well known to bankers. Jamie Dimon, JPMorgan’s CEO, almost stated the fraud recipe correctly in his March 30, 2012 letter to shareholders:

“Low-quality revenue is easy to produce, particularly in financial services. Poorly underwritten loans represent income today and losses tomorrow.”

The correct statement is that “poorly underwritten loans represent fictional income today because lenders engage in accounting fraud to avoid establishing the necessary ALLL provision that would demonstrate that the loan was actually made at a loss. Loss recognition can be (improperly) delayed for years. To complete the logic loop, the unlawful recognition of “income today” leads to a “sure thing” that will promptly make the controlling officers far wealthier.

The Rocket Scientists Typically Do Not Understand the Fraud Recipe

The top “quant” at Enron, the honest and brilliant top risk officer, Vincent Kaminski, wrote recently about his regrets that he was unable to spot the fraud, at a firm that was “rotten to the core,” because he did not understand accounting control fraud techniques. The financial rocket scientists rarely study accounting and they were virtually never the CEOs of the financial firms that led the frauds that drove the crisis. Indeed, the CFOs of the financial firms were rarely rocket scientists. The most senior rocket scientists at these firms were, like Kaminski, often risk officers – and the CEOs and CFOs routinely ignored their warnings.

This does not mean that rocket scientists in the units that priced assets were incapable of gaming their models to increase their bonuses. I will explain this point in my third column in this series.

The Second Loan Origination Fraud Epidemic: “Liar’s” Loans

The Mortgage Asset Research Institute (MARI), the Mortgage Bankers Association (MBA’s) experts on fraud, warned in 2006 in its 8th Periodic Report to the industry that “low doc” lending caused endemic fraud. The MBA sent the MARI report to its members (virtually every lender) making five points about such loans.

[1] Stated income and reduced documentation loans … are open invitations to fraudsters.

[2] It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.

[3] One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%.

[4] These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.”

[5] Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans.

Note that “low doc” loans were not new. They began, as do most U.S. financial frauds, at in Orange County, California in 1990. More specifically they began at Orange County savings and loans (S&Ls). We (OTS West Region) were their regulators and our examiners figured them out almost immediately. Despite being slammed dealing with the boarder S&L debacle we created a special effort that drove such loans out of the S&L industry beginning in 1991. The worst of the lenders (which also targeted blacks and Latinos) gave up its S&L charter and FDIC insurance for the sole purpose of escaping our jurisdiction. It renamed itself “Ameriquest” and became a predatory mortgage bank. Liar’s loans caused “hundreds of millions of dollars in losses … in the early 1990s” before we could purge them from the industry. We acted quickly enough, however, to avoid any costly failures, much less allow them to cause a bubble and a crisis.

Our examiners were able to immediately make the correct call on a brand new loan product (which were not then called “liar’s loans” – a term that lacks any subtlety about the criminal nature of the lending) because they understood that the key to honest, prudent lending is high quality underwriting. Underwriting, to those who do not understand lending, seems like a cost center, but it is actually the most critical profit center for a lender. A lender that does not underwrite properly creates “adverse selection,” which creates a “negative expected value” for one’s loans. In plain English, the lender will lose money on such loans. We have known this for over a century.

No honest home lender would make liar’s loans – period, full stop

From the fraudulent controlling officers who are the bank’s decision-makers perspective, however, liar’s loans are ideal. Indeed, liar’s loans combined with loans with reduced payments in the early years (which serve the double fraud function of “qualifying” borrowers for loans for which they lack adequate income to repay the loan once it “resets” to the “fully indexed rate” and delaying “early payment defaults (EPDs), which trigger buy back demands for loans sold to the secondary market).

Most people still call it “the subprime crisis,” but it would be more accurate to call it the “liar’s loan and appraisal fraud” crisis. Between 2003 and 2006, liar’s loans grew by roughly 500% (while conventional loans declined). By 2006, half of all the loans that the industry called “subprime” were also liar’s loans (the two categories are not mutually exclusive) and 40% of all home loans originated that year were liar’s loans. At the 90% fraud incidence figure, that means that lenders originated over two million fraudulent liar’s loans in 2006 alone.

It was liar’s loans that hyper-inflated the housing bubble. The bubble, in turn, was optimal for accounting control fraud because it meant that the fraudulent officers controlling the lenders could refinance bad loans and minimize defaults. The saying in the trade is: “a rolling loan gathers no loss.”

The officers controlling the lenders, however, did not have too “little historical appreciation for the havoc” caused to the banks that made liar’s loans. They had excellent historical appreciation for the fact that making such fraudulent loans was a “sure thing” that would make them wealthy even as it caused grave losses to “their” bank.

Note that the claim, which DOJ, sometimes (shamefully) makes, that liar’s loans were necessary for the self-employed is false. IRS Form 4506 T has long obviated any problem with verifying the incomes of those who are self-employed. Liar’s loans are ideal for accounting control frauds because they remove the paper trail created by verifying the borrower’s true income that would normally incriminate the lenders’ officers when they documented in the loan files that they were lending to borrowers they knew lacked the income to ensure that the loan would be repaid.

Also note that the government never encouraged lenders to make liar’s loans. Even the Bush administration, an opponent of vigorous financial regulation, warned lenders against making liar’s loans. The lenders’ trade associations pushed back vigorously against any effort to limit or even warn lenders against making liar’s loans while the NAACP and ACORN fought hard to end such loans because they were inherently anti-consumer. The Federal Reserve finally agreed to ban liar’s loans in 2008, citing the MARI data on how such loans were endemically fraudulent. Dodd-Frank also banks liar’s loans. Banks charged borrowers higher interest rates and fees to make liar’s loans rather than conventional loans and borrowers lost their wealth when they were convinced to buy homes they could not afford. The Consumer Financial Protection Bureau (CFPB), therefore, banned liar’s loans as an inherently deceptive financial product that harms consumers.

DOJ admits that the lenders’ decision-makers knew that liar’s loans were endemically fraudulent. Wagner, his capacity as the senior prosecutor or DOJ’s Mortgage Fraud Working Group, took the lead in the creation of the May 2010 DOJ training materials for AUSAs prosecuting mortgage fraud. The training materials end with critical definitions.

“Mortgage Fraud Terms, Participants, and Documents

I. Terms

Alt-A Loans:

Sometimes referred to as ‘stated income’ or ‘liars loans,’ Alt-A Loans are those which require little or no verification or documentation of the buyer’s assets and income. They are ideal for fraud exploitation. Alt-A loans are offered by both prime and sub-prime lenders.”

DOJ knows that the lenders referred to the loans behind closed doors as “liar’s loans” and that the lenders knew that such loans “are ideal for fraud.” There is no good answer as to why honest lenders would make loans they knew to be “ideal for fraud.” There is an excellent answer as to why the dishonest decision-makers who controlled the banks that made liar’s loans would find it “ideal” to create a “criminogenic environment” that they knew to be “ideal for fraud.”

Wagner claims that lenders were indifferent to fraud because housing prices were rising. For reasons of brevity I will simply provide my conclusion: his argument is nonsensical. He concedes facts that refute his claim. An honest lender is never indifferent to fraud. Wagner concedes that the officers controlling the lenders knowingly “created an ideal environment for fraud” through the “relaxation of underwriting standards.”

“A host of professionals—real estate agents, appraisers, closing agents, attorneys, title insurance agents, and mortgage brokers—are expected to ensure the legality and soundness of real estate transactions. During our recent real estate boom, however, many of the financial incentives provided to these professionals were solely directed at ensuring that real estate transactions closed, regardless of whether the mortgage loans were prudently made.”

The obvious questions are who created these “financial incentives” and why they created incentives so perverse that Wagner labels them “an open invitation” to fraud. The controlling officers of the lenders are decision-makers that shaped these perverse incentives, knew they were creating “an open invitation” to fraud, and continued and often made more perverse those incentives even as they received multiple warnings and data on endemic fraud. Wagner also admits that the group that “took advantage of the opportunities presented” by this “open invitation” to commit fraud includes “mortgage lenders.” To state what should be obvious, the only logical reason the lenders’ controlling officers would act in this manner is that they were leading accounting control frauds. No honest banker creates and maintains for years perverse “financial incentives” to corrupt the work of everyone critical to prudent lending and sends “an open invitation” to defraud the bank while simultaneously gutting underwriting so as to “create an ideal environment for fraud.”

It is important to understand that the lenders’ controlling officers deliberately created overwhelmingly powerful and perverse incentives for even the lowest agents and employees in the mortgage “food chain.”

“More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan officers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about 10,000 loan originators a year in auditoriums and classrooms.

His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs ‘flipping burgers,’ he told the FCIC. Given the right training, however, the best of them could ‘easily’ earn millions.

‘I was a sales and marketing trainer in terms of helping people to know how to sell these products to, in some cases, frankly unsophisticated and unsuspecting borrowers,’ he said. He taught them the new playbook: ‘You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed. In fact, you were in a way encouraged not to worry about those macro issues.’ He added, ‘I knew that the risk was being shunted off. I knew that we could be writing crap. But in the end it was like a game of musical chairs. Volume might go down but we were not going to be hurt.’”

On Wall Street, where many of these loans were packaged into securities and sold to investors around the globe, a new term was coined: IBGYBG, “I’ll be gone, you’ll be gone.” It referred to deals that brought in big fees up front while risking much larger losses in the future. And, for a long time, IBGYBG worked at every level.

The fraudulent lenders often did more than craft powerful, perverse incentives. They also trained employees to make fraudulent loans (while maintaining plausible deniability for the controlling officers). They frequently harmed the employees and officers who tried to stop bad loans rather than praising and promoting them. They refused to remove the perverse incentives.

Cruise explains that by making hundreds of bad loans annually a minor loan employee could “easily” earn millions. (FCIC should have put the words “earn” and “best” in quotations.) Their quintessential prior job (flipping burgers) paid roughly $17,000 annually. Lenders created intense, perverse incentives for loan brokers to seek out and take advantage of unsophisticated borrowers. As the CFPB explained:

“[C]ompensation was frequently structured to give loan originators strong incentives to steer consumers into more expensive loans. Often, consumers paid loan originators an upfront fee without realizing that the creditors in the transactions also were paying the loan originators commissions that increased with the interest rate or other terms.”

A loan broker, even lower in the food chain than the loan officials who worked for the lenders, could make $20,000 by brokering a single large “jumbo” loan in which the broker was able to convince the borrowers to pay a materially higher interest rate than the lender was willing to loan to those borrowers at. Most of the compensation was in the form of a kickback from the lender called a “yield spread premium” (YSP). But loan brokers only received these enormous fees if the loan closed, and inflating the borrower’s income and the value of the home appraisal was ideal for the fraudulent decision-makers controlling the banks so they created overwhelming incentives to produce millions of frauds yet maintain plausible deniability.

The leaders of accounting control frauds understand how effective compensation is in producing endemic fraud while maintaining a sheen of deniability. The Business Roundtable (lobbyist for the 100 largest U.S. corporations) had to appoint a spokesperson to explain the Enron-era frauds to the media. They, because it is impossible to compete with unintentional self-parody, chose Franklin Raines, Fannie Mae’s CEO, and Business Weekasked him to explain why there were so many elite securities frauds. Raines responded:

“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.’”

Given that the SEC would soon sue Fannie Mae claiming that Raines had created just such perverse incentives this is another case of unintentional irony (and candor).

Financial CEOs knew that the perverse financial incentives they crafted would prove decisive. Consider these two statements by another unintentionally ironic CEO, William Dallas, whose bank made the OCC’s “worst of the worst” list. Ask yourself how Dallas expected others to respond to the perverse incentives that he admitted led him to make loans he knew would cause grave losses.

Savor the facts reported in the introductory paragraph in the May 8, 2007 New York Times article entitled “East Coast Money Lent Out West” that sets out how much money one was “routinely” guaranteed to make through accounting control fraud. The context is a report on the 2006 failure of the Dallas mortgage banking firm, Ownit:

“Gone are the lavish parties, the extravagant trips and the executive salaries and sales commissions that routinely topped a million dollars.”

It paid – spectacularly – for the officers controlling the lenders to run an accounting control fraud.

“William D. Dallas, the founder and chief executive of Ownit, acknowledges loosening lending standards but says he did so reluctantly and under pressure from his investors, particularly Merrill Lynch, which wanted more loans to package into lucrative securities.

He recalls being asked to make more ‘stated income’ loans, in which lenders do not verify the information provided by borrowers and brokers with tax returns, pay stubs or other documentation. The message, he said, was simple: You are leaving money on the table — do more of them.

Mr. Dallas, a trim 51-year-old who has been in the mortgage business for more than 25 years, said he disagreed, but complied.

‘If I can sell it at a profit,’ he said, ‘why would I not do it?’”

Dallas liked the sound of that last clause. He used it in another interview to explain why any right-minded CEO of a home lender would make endemically fraudulent liar’s loans.

“‘The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans,’ he said. ‘What would you do?’”

To give the reader a more complete context, Ownit specialized in subprime lending. Merrill Lynch, which bought huge amounts of bad loans from Ownit (because doing so made its corporate decision-makers wealth pursuant to the fraud recipe) wanted Ownit to sell it far more, and far worse loans. Merrill invested in Ownit and pushed it to make subprime liar’s loans and sell more of the resultant toxic mortgages to Merrill. The inevitable result was that Merrill’s officers were made wealthy and Merrill failed and had to be acquired. Hint: “Looting: The Economic Underworld of Bankruptcy for Profit.”

Dallas knew that what Merrill wanted Ownit to do would be fatal to Ownit and cause severe losses to Merrill. He explained why to Merrill’s officers. Merrill’s officers decided that this was their optimal strategy to enrich them and paid Ownit a premium for originating, and selling to Merrill, toxic mortgages with a premium nominal yield. (The securities were the opposite of “lucrative” in any real economic sense since they were sure to cause fatal losses. They create “lucrative” accounting “income” only because of endemic accounting fraud involving establishing pathetically inadequate ALLL provisions for those losses.) Note that the Ownit loans were so toxic that they killed Ownit nearly two years before Lehman collapsed and doomed Merrill despite its vastly larger size.

Dallas is stating his confidence that any right-minded CEO would make hundreds of thousands of fraudulent loans that he knew would eventually doom “his” bank as long as he could, for a time, gain the “sure thing” of selling toxic loans at a higher profit through fraudulent reps and warranties – to the secondary market. The obvious point is that he knew that his loan brokers and loan officers would typically make the same choice and get wealthy under the perverse compensation incentives that Dallas crafted to ensure that Ownit and Merrill’s fraudulent decision-makers never committed the sin of “leaving [any of the home buyer’s] money on the table” rather than in the officers’ offshore accounts.

Thomas Miller, Iowa’s Attorney General, testified before the Federal Reserve on August 14, 2007 about the critical need to adopt a rule ending liar’s loan frauds.

“Industry participants often refer to stated income loans as ‘liar loans’ and for good reason. Our investigations have found that stated income loans are frequently used to fraudulently qualify borrowers for loans they cannot afford.

Because of the substantial pressures and economic incentives to make as many loans as possible, many originators have engaged in a pattern of inventing non-existent occupations or income sources, or simply inflating income totals to support loan applications. A review of 100 stated income loans by one lender found that a shocking 90% of the applications overstated income by 5% or more and almost 60% overstated income by more than 50%. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.”

To sum up liar’s loans – they were among the crudest banking fraud schemes. They required only kiddie math to understand. They were all about audacity, not “rocket science.”

The Secondary Market Fraud Epidemic

You may “know” that the crisis occurred because home lenders did not care about loan quality and loan fraud because they could sell their bad loans to the secondary market at a profit. The claim is that lenders had “no skin in the game.” That is not correct. Loans could only be sold to the secondary market based on “representations and warranties” that the loans were not fraudulent and had been originated in accordance with the lender’s loan guidelines. The problem is that there is no such thing as a loan fraud exorcist. Once the loans are originated fraudulently it will remain fraudulent throughout all subsequent sales. Loan origination fraud epidemics must lead to an epidemic of fraudulent sales to the secondary market if the loans are resold. Nonprime loans were, overwhelmingly, resold to the secondary market so there must be an epidemic of fraudulent sales to the secondary market because one could not sell to that market through reps and warranties that said “we’re selling you fraudulent loans.” This is pure logic, it requires no math skills to understand and “rocket science” plays no role in the frauds or the ability to prosecute.

Clayton was the dominant (roughly 70% of the market) “due diligence” firm hired by secondary market purchasers to review a sample of the loans offered for sale by the loan originators to determine whether the sample actually met the loan guidelines. Clayton was not a paragon of virtue, but its managers had the good sense to cut an immunity deal. Clayton was a deliberately weak grader (which produced a passel of whistleblowers), so the reality is much worse than the results I am about to report. (See the FCIC testimony of the Citigroup whistleblower, Richard Bowen, to see the fraud incidence found in more competent and vigorous due diligence.)

The national average for the 18 month period January 2006-June 2007, was that Clayton found that 46% of the reps & warranties were false. Note that this demonstrates that it was normal for both that the loan quality of the lenders was pathetic and that they lied endemically when they claimed that the loans were made in accordance with their loan guidelines. That means that as weak as those guidelines were they were shams intended to hide an even more pathetic reality.

I do not know anyone that would continue to buy from Amazon if they cheated him 46% of the time, but trillions of dollars of toxic mortgages were sold through pervasively fraudulent reps and warranties for years. This only makes sense if the officers running the purchasers are also following the accounting control fraud recipe. This huge incidence of fraud grew: the share of false reps & warranties found by Clayton in their loan reviews grew every quarter from 4th Quarter 2006 on: rising from 43% to 47% to 53% as of June 30, 2007. Yes, you read that correctly, a majority of the reps and warranties reviewed by Clayton were false by the second quarter of 2007. Note that the secondary market purchasers did not, and could not (without moving to 100% sampling), use the Clayton sampling to exclude more than 10% of the fraudulent loans. Again, DOJ prosecutors have to understand percentages, not “rocket science.”

What is going on, of course, is the financial variant of “don’t ask; don’t tell.” The fraud recipe works simultaneously for the senior officers of the loan originators and the senior officers of the banks that acquire the loans. This makes it much more difficult to establish reliance in a civil suit because the purchasers knew that the loans they were buying were toxic and that the originators’ reps and warranties were false. This fact produces a very unusual result. Normally, it is harder to prosecute a defendant than to bring a civil case against them, but because reliance is not an element of a criminal fraud case it is actually easier to prosecute loan originators for their fraudulent sales to the secondary market than to bring a successful civil case against the lenders’ senior officers.

DOJ uses the Clayton reports, which exist for every loan package that Clayton reviewed (and recall that it had 70% of the due diligence market), in its major cases and key offices have hundreds of thousands of pages of Clayton documentation.

The other particularly useful source of information on the sham underwriting by loan originators is lawsuits filed by agencies of the United States, including NCUA, the FHFA, the FDIC, and the SEC as well as actions filed by DOJ. In many of these lawsuits agencies of the United States cite the fact that the loan standards of the lenders that they are suing are shams and that the lenders are on the OCC’s list of the “worst of the worst” lenders.

Consider these brief excerpts from a NCUA action against Credit Suisse, et al. Note the tenor of NCUA’s descriptions of what investigations of the fraudulent lenders have disclosed. The numbers in brackets are the paragraphs of the complaint that I excerpted.

“[7] [T]he Originators had systematically abandoned the stated underwriting guidelines in the Offering Documents. Because the mortgages in the pools collateralizing the RMBS were largely underwritten without adherence to the underwriting standards in the Offering Documents, the RMBS were significantly riskier than represented in the Offering Documents. The property values supporting the average LTV, CLTV and mixed LTV ratios were routinely overvalued at the time of origination, rendering the average LTV, CLTV and mixed LTV ratios inaccurate. Further, the rates of owner occupancy were far lower than represented in the Offering Documents. Indeed, a material percentage of the borrowers whose mortgages comprised the RMBS were all but certain to become delinquent or default shortly after origination. As a result, the RMBS were destined from inception to perform poorly.

[57] A. The Surge in Mortgage Delinquency and Defaults Shortly After the Offerings and the High OTD Practices of the Originators Demonstrate Systematic Disregard of Underwriting Standards

96. During the housing boom, mortgage lenders focused on quantity rather than quality, originating loans for borrowers who had no realistic capacity to repay the loan. The FCIC Report found “that the percentage of borrowers who defaulted on their mortgages within just a matter of months after taking a loan nearly doubled from the summer of 2006 to late 2007.” Id. at xxii. Early Payment Default is a significant indicator of pervasive disregard for underwriting standards. The FCIC Report noted that mortgage fraud “flourished in an environment of collapsing lending standards…” Id.

97. In this lax lending environment, mortgage lenders went unchecked, originating mortgages for borrowers in spite of underwriting standards:

Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September 2004, Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.” Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop [FCIC 2011: xxii].

105. In sum, the disregard of underwriting standards was pervasive across originators.”

There are even more detailed complaints about WaMu’s systematic disregard of its purported loan underwriting standards.

DOJ’s Shameful Pursuit of the Fraud “Mice”

While Wagner provides only four attorneys to fail to prosecute JPM he devotes the great bulk of his grossly inadequate resources to prosecuting the fraud “mice.” In those cases DOJ turns around and claims that these same lenders that agencies of the U.S., including DOJ, have found to have engaged in the “systematic disregard of underwriting standards” supposedly consistently comply with their loan standards and would reject any loan that failed to comply with those standards.

Indeed, though multiple organs of the U.S. have banned liar’s loans on fraud and predatory lending grounds, DOJ’s pursuit of the fraud mice – and implicit defense of the fraud lions – is so extreme that it even sponsors “expert” testimony by a Bank of America official in mortgage fraud prosecutions of the fraud “mice” that claims that liar’s loans were fine products and that the lender is “shocked, shocked” that 90% of them are fraudulent. All of this is typically done through the testimony of very low level loan underwriters for the lenders who are (implicitly) asked: “did you commit a fraud in making this loan?” The answer, of course, is inevitable unless the underwriter has been flipped.

Because mortgage fraud is vastly more common in loans made by lenders that are accounting control frauds and because DOJ never prosecutes the senior bankers running those frauds the cases it prosecutes are heavily weighted against borrowers of the most fraudulent lenders. It is the norm that the loans are liar’s loans and it is common that the lenders make the OCC’s “worst of the worst lenders” lists. This is so perverse and unjust that it should be a national scandal. It also, of course, destroys effective deterrence.

My goal has never been to “deter” DOJ from prosecuting mortgage fraud. I want them to start prosecuting mortgage fraud. The shameful record is that DOJ has not even attempted to prosecute a single senior officer of any of the lenders on the government’s list of the “worst of the worst lenders” even though DOJ knows that they were endemically fraudulent lenders and drove the financial crisis that cost our Nation $21 trillion (a trillion is a thousand billions) in lost GDP and over 10 million jobs.

DOJ invariably seeks to bar courts and juries hearing mortgage fraud cases from considering all evidence, even evidence from other agencies of the United States with far greater financial expertise and evidence from cooperating unindicted co-conspirators such as Clayton, that demonstrate that the lenders’ underwriting standards are shams and that the lender’s decision-makers are leading accounting control frauds. DOJ does not merely invariably fail to provide defendants with exculpatory evidence such as the Clayton reports, it does everything possible to prevent the jury from being made aware of all exculpatory evidence about the criminal nature of the lenders’ decision-makers and portrays the Nation’s worst financial fraudsters as “victims” of alleged fraud mice. DOJ’s approach to prosecuting mortgage fraud cases is Orwellian.

Unsurprisingly, the DOJ and the FBI take this victim meme from their “partner” in mortgage fraud prosecutions against the mice – the Mortgage Bankers Association (MBA) – the trade association of the “perps.” DOJ and the MBA have adopted a fake “definition” of “mortgage fraud” in which the controlling bank officers are always the victims and the people who brought down the global financial system are purportedly the clever, ethnic, hairdressers who outwitted the guys at Bear Stearns with starting salaries of $300,000. We are supposedly experiencing the first “Virgin Crisis,” conceived without sin in the C-suites. It would be very funny as satire, but alas, as the satirical riff in Men in Black put it: “We at the FBI do not have a sense of humor we’re aware of.”

DOJ is systematically misleading courts and juries through this testimony in order to convict the fraud mice. This strategy, of course, would make it vastly more difficult for DOJ to prosecute the senior officers who led history’s most destructive (and personally lucrative) epidemics of accounting control fraud because DOJ ends up vouching for these lenders’ compliance with their sham loan underwriting standards. DOJ, however, sees no cost in vouching for the officers that led the fraud epidemics. DOJ has no intention of prosecuting those elite (and not terribly elite) senior officers of the fraudulent lenders, no intention of suing them in civil cases, and no intention of “clawing back” the enormous wealth they gained by leading the three fraud epidemics.

DOJ’s strategy is a legal obscenity and has produced the greatest strategic failure to prosecute elite (and not so elite) white-collar criminals in DOJ’s modern history. DOJ has made it clear to senior (and even middling) bank executives that they can loot with absolute personal impunity. This guarantees future financial crises will be far more severe. But DOJ has reached a new nadir by giving top agency awards to those who lead its abject failures and by claiming that it cannot prosecute bank officers (hilariously rebranded by DOJ as “rocket scientists”) because DOJ attorneys cannot do 5th grade math.