By William K. Black
Washington, DC: January 4, 2015
George Akerlof and Paul Romer’s famous 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit” introduced what criminologists call “accounting control fraud” to the economics literature. The people who control the firm (typically the CEOs) use its seeming legitimacy as a “weapon” to loot shareholders, creditors, and, if the resultant losses are large enough, the U.S. Treasury. Their article discussed several examples of such fraud epidemics, including the savings and loan debacle. Criminologists, the S&L regulators, and over 1,000 successful felony prosecutions of the S&L looters confirmed Akerlof & Romer’s insights.
The most recent crisis was driven by the three most destructive epidemics of financial looting in history. The three fraud epidemics hyper-inflated the financial bubble and caused the enormous losses that led to the financial crisis and the Great Recessions in the U.S. and in Europe. In the U.S., the Great Recession is projected to cause a loss of $21 trillion in GDP and over 10 million jobs. Both of those catastrophic figures are far larger in Europe.
The amazing fact is that the Department of Justice has refused to prosecute any of the senior bank officers who led the three fraud epidemics – appraisal fraud, liar’s loans, and secondary market sales through false “reps and warranties.” Akerlof & Romer warned that looting was a “sure thing” and was “bound” to become common under financial deregulation, but the current leadership of the Department of Justice (DOJ) has ignored both the experts and experience. The poster child for this is Benjamin Wagner, the most senior prosecutor that Attorney General Eric Holder assigned as a leader of the mortgage fraud task force.
“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.”
As Wagner used the pronouns, “they” refers to the CEO and “themselves” refers to the bank. Wagner’s “reasoning” is that the CEO and the bank are the same entity, which is nonsensical. It makes perfect economic “sense” for the CEO to loot the firm – as Wagner knows full well.
This article explains why it is so ironic that Jamie Dimon, JPMorgan’s CEO, explained the accounting fraud “recipe” that the CEO uses to loot “his” bank. Dimon’s March 30, 2012 letter to JPM’s shareholders explained: “Low-quality revenue is easy to produce, particularly in financial services. Poorly underwritten loans represent income today and losses tomorrow.”
Wagner, Dimon, Whistleblowers, and Looting: A Surfeit of Irony
Wagner, Dimon, and the Wall Street Journal interact in ways that are instructive as to why leaders of the three fraud epidemics that drove the financial crisis were able to grow wealthy with total impunity from the criminal laws and virtually complete impunity from even civil and administrative sanctions. The WSJ editors, who exist to attack the Obama administration’s failures (particularly faux failures), have been conspicuously silent on the administration’s refusal to hold accountable the banksters who grew wealthy by looting “their” banks by leading the three fraud epidemics. The WSJ editors have also been silent aboout the abusive and biased prosecutions of alleged fraud “mice” by DOJ in general and Wagner in particular. The WSJ’s increasingly Murdoched news section recently printed a piece of pure propaganda ignoring the whistleblowers who made possible the DOJs major civil fraud cases against the three big banks and instead praising Wagner and his team for their refusal to hold any JPM officer accountable for a series of massive frauds. This column was prompted by a WSJ editorial attacking Wagner’s office – including one of Wagner’s senior attorneys who received a top DOJ award and the praise of the WSJ’s puff piece for failing to hold any JPM officer personally accountable – for allegedly seeking to “loot a company.” The case was exposed in large part by one of Wagner’s attorneys who blew the whistle on misconduct in Wagner’s office and alleges that he was the victim of reprisal.
Dimon’s Dictum on Looting
No one can accuse the WSJ of inconsistency – they consistently favor the interests of the CEO, even when the CEO is looting “his” company. With that in mind, I will return to explicating Dimon’s dictum on how banks’ controlling officers use accounting fraud to loot a bank by deliberately making massive amount of bad loans.
To clarify, “poorly underwritten loans represent [fictional] income today and losses tomorrow.” “Poorly underwritten [mortgage] loans” produce adverse selection and a negative expected value – in plain English, the bank will lose money on the loans. Generally Accepted Accounting Principles (GAAP) require banks – when the loans are made – to provide an Allowance for Loan and Lease Losses (ALLL) that reflects the future risk of loss of those loans. That means that if a bank makes “poorly underwritten [mortgage] loans” it is required to establish – today – ALLL provisions that reflect what Dimon refers to as the “losses tomorrow.” GAAP’s requirement that banks that make “poorly underwritten [mortgage] loans” establish today ALLL provisions reflecting the “losses tomorrow” means that the ALLL will be larger than the nominal yield spread. A proper ALLL reflects economic reality – from year one – their portfolios of badly underwritten mortgage loans are net liabilities rather than an assets.
An example may help. Consider a bank that was making home mortgage loans in 2005. Assume that it could charge 7% (the fully indexed rate) to make liar’s loans with other non-traditional features such as negative amortization and 5.5% to make traditional fixed rate mortgages that are properly underwritten. “Negative amortization” means that the mortgage payments made in the early years of the mortgage are not sufficient to pay the interest that would normally be currently due on the loan – which means that the principal amount of the debt grows. Due to accrual accounting, however, the bank is able to book as income at the nominal interest rate even when the cash flow is much lower during the early years of the loan. This produces what was known in the trade as “phantom” interest – which was nearly one-half of the reported income of some lenders.
The nominal spread between those (fully-indexed) nominal yields in my example is 7 – 5.5 = 1.5% (or 150 basis points). That nominal spread is broadly representative of the crisis. Most people understand immediately that the two kinds of loans are not (remotely) the same. The liar’s loan with negative amortization is vastly more likely to default and suffer greater losses upon default. Making traditional mortgage loans is, typically, profitable for banks. Making liar’s loans is, on a portfolio basis, enormously unprofitable for banks.
Publicly traded corporations must follow GAAP, so when they engage in accounting fraud by not providing required ALLL provisions they are also committing securities fraud. ALLL provisions during the crisis were preposterously low and they declined materially as the crisis grew when they should have been increasing by roughly twenty times.
The obvious question is why the CEOs got the banks into the business of making millions of bad loans that had a negative expected value at the time they made the loans. No one in the government made the CEOs make liar’s loans or negative amortization loans. Even the Bush administration regulators, who were far from vigorous, discouraged liar’s loans and negative amortization loans. As Dimon’s remarks reflect, bankers have known for over a century that making mortgage loans in a manner that creates serious adverse selection leads to enormous losses. There is only one answer that makes sense – looting. The fraud “recipe” for a lender (or loan purchaser) has four ingredients.
- Grow like crazy
- By making (or purchasing) really crappy loans at a premium nominal yield
- While employing extreme leverage, and
- Providing only grossly inadequate allowances for loan and lease losses (ALLL)
The recipe only works when the loans made are awful quality. Testing the counterfactual is helpful. What if bank CEOs sought to grow very rapidly by making well underwritten, prudent loans? Home lending is a mature, highly competitive product. Banks that sought to grow at least 25% annually (the first “ingredient” of the fraud “recipe”) by making prudent home mortgage loans would have to “buy market share.” They would have to cut the interest rates they charged for making prudent home mortgage loans materially in order to induce high credit quality borrowers to become customers. Their competitors would promptly match those rate cuts – and banks making prudent home mortgage loans would report materially reduced profits.
Conversely, there are tens of millions of far less creditworthy potential borrowers who cannot buy a home because they cannot get a mortgage loan. CEOs can cause “their” banks to grow extremely rapidly by lending increasingly to such borrowers – and they can charge such borrowers a premium nominal yield. If the banksters also violate GAAP and provide grossly inadequate ALLLs three “sure things” arise. The bank will promptly report huge profits. Indeed, if the bank adds extreme leverage to the mix it will report record profits. The second sure thing is that the bank’s senior officers will promptly be made wealthy through modern executive compensation. The third sure thing is that the bank will, eventually, recognize severe losses.
Wagner: The Nexus
Wagner is the U.S. attorney for the Eastern District of California (based in Sacramento), one of the epicenters of the three mortgage fraud epidemics. He claims to have prosecuted more mortgage fraud cases than any other DOJ office. He has prosecuted none of the senior bank officers who led the three fraud epidemics. He has focused his prosecutions increasingly on minor alleged mortgage frauds by Russian-Americans. I have written previously to explain the disgraceful ethnic profiling conducted by the DOJ/FBI.
Holder assigned Wagner to take the lead in the investigation and (non) prosecution of JPM. Wagner quickly shunted it to a handful of civil attorneys in his office. Those attorneys had the case handed to them on a platinum platter by a whistleblower involved in a particularly infamous JPM deal with a particularly infamous fraudulent lender – GreenPoint. Here is the text of the GreenPoint ad pushing “NINJA” loans (no income, no job, and no assets) – complete with a cartoon of the famous “three monkeys” that makes clear how obvious the frauds were.
Hear No Income, Speak No Asset, See No Employment.
-Don’t Disclose Your Income, Assets or Employment on this hot new flexible adjustable rate mortgage!
-With a 30-year term, you can choose an initial fixed-rate period of 3, 5, 7 or 10 years with either Interest-Only payments or Principal & Interest
-Unrestricted Min. Loan Amounts on 5-year with P&I and no prepay penalty
-Minimum 620 Credit Score
-Purchase or Refinance with just 5% down up to $500,000; 10% down to $650,000
-Rate & Term Refinance allows up to $3,000 cash out for debt consolidation only
-Short Application Form
-Gift Funds Allowed and Not Verified
-Primary Residence Only – Single Family Attached/Detached, Condo, PUD & 2-Unit
-First-time homebuyers allowed with 10% down and 680 credit score
Wagner and his prosecutors knew that GreenPoint was a criminal enterprise, but in the case I testified pro bono as an expert they tried to imprison the Russian-American defendants for loans made by GreenPoint and several other accounting control frauds that caused such catastrophic losses to our Nation. Wagner’s prosecutors sponsored testimony from witnesses from these lenders that was designed to mislead the jurors into believing that they were well-run, prudent lenders. The prosecutors knew from whistleblowers at both GreenPoint and JPM that managers of both entities knew about endemic mortgage origination and secondary market fraud and actively aided and abetted it as well as covered up the fraudulent practices. Wagner and his prosecutors knew from the Clayton (not remotely) “due diligence” reviews that the lenders engaged in pervasive mortgage origination fraud, that the same lenders then made pervasive fraudulent “reps and warranties” to sell the fraudulently originated loans to the secondary market, and that JPM knew that the loans it was purchasing from lenders like GreenPoint were pervasively fraudulent and being sold on the basis of fraudulent reps and warranties. Instead of rejecting such doubly fraudulent loan purchases, JPM typically acquired vast amounts of loans it knew were fraudulent and did not disclose that fact when they resold the loans or loan securities.
To date, Wagner has refused to prosecute any of these bank officers who became wealthy through leading the fraud epidemics or even sue them in a civil action. That represents a monumental legal and moral failure. He has compounded that failure by imprisoning hundreds of alleged fraud “mice,” who were induced by the fraudulent lenders and their agents to borrow funds. In essence, Wagner has turned the U.S. into a collection agency for the worst financial frauds in America. In doing so his attorneys routinely fail to disclose to the defense exculpatory evidence that Wagner’s office has from whistleblowers and Clayton and routinely presents testimony that falsely pictures the fraudulent lenders as sound banks devoted to making only prudent loans. Wagner isn’t simply a failure as a prosecutor – batting .000 against the officers that led the three fraud epidemics – he is a failure as an ethical leader.
The Shame of DOJ Defining Abject Failure as a Record Success
It tells the Nation everything we need to know about DOJ, Holder, and Obama in this context that they would give Wagner and his team a top departmental award for failing to hold a single JPM officer accountable for what even Wagner admits were massive frauds led by JPM’s senior officers. When the department, the AG, and the President award abject failure and call it brilliant success they smear the name “Department of Justice” by making it an oxymoron.
Compounding the Failure through Propaganda
Given the WSJ attack on the ethical failures of Wagner’s office, it is ironic that the WSJ fell hook, line, sinker, rod, and reel for Wagner’s propaganda effort about the DOJ awards. In a dishonest and fawning article that does not even mention the whistleblowers from JPM, Bank of America, and Citigroup that presented criminal fraud cases on a platinum platter to DOJ, all credit for the civil cases was given to an attorney in Wagner’s office who read a document that was one of tens of thousands of incriminating documents DOJ knew existed because of the whistleblowers. The whistleblowers involved are particularly worthy of praise because they tried to stop the frauds and suffered reprisals for doing so. The WSJ, however, does not admire whistleblowers who reveal the crimes of senior corporate officers.
The senior official under Wagner who also received the DOJ award is named David Shelledy. He reappears in this saga immediately below.
The WSJ Loves Whistleblowers Who Aid CEOs
A January 2, 2015 WSJ editorial is enraged at what it believes was misconduct by Wagner’s office in pursuing a claim against a large timber corporation. It is upset in this context that a whistleblower in Wagner’s office suffered retaliation. “Among other problems, government investigators and prosecutors doctored reports, misrepresented facts and retaliated against employees whose questions threatened their strategy.”
The details of the misconduct by Wagner’s office alleged by the whistleblowers in this case are sickening.
“Leading the federal fire investigation was then-head of the Eastern District of California’s Affirmative Fire Litigation Team, Robert Wright. A specialist in fire litigation, Mr, Wright says in a 15-page declaration in federal court that prosecutors withheld material information in the case, including a change in the fire’s stated point of origin.
Mr. Wright says he also discovered an error in calculating the damage of part of a separate wildfire, which reduced the potential liability to $15 million from $25 million. Mr. Wright felt he was under a professional obligation to disclose the document, and he confirmed this with the Justice Department’s Professional Responsibility Advisory Office. But he says his boss, Civil Chief David Shelledy, pushed back, saying, ‘That’s a beginning. Now what can you do to avoid creating an ethical obligation to volunteer a harmful document.’
When Mr. Wright disclosed it anyway, he says he was kicked off the Moonlight Fire case by Mr. Shelledy, days after he received a commendation for his performance on another case by U.S. Attorney Benjamin Wagner. Mr. Shelledy declined to comment, but Mr. Wagner told us that “we very strongly disagree with the assertions” made by Mr. Wright, “particularly insofar as they allege misconduct by individual AUSAs and retaliation by our office against a former employee.”
Mr. Wagner adds that Mr. Shelledy was ‘recently awarded the Attorney General’s Award for Distinguished Service from Attorney General Holder.’
A second federal prosecutor, Eric Overby, joined the case in 2011, only to withdraw promptly on discovering what he called prosecutorial abuse directed squarely at raising revenue. He told defense counsel that in “my entire career, I have never seen anything like this. Never.”
The WSJ should be enraged at acts of retaliation against whistleblowers. The WSJ should be enraged at the looting of companies. The WSJ should be enraged at Wagner’s office’s recurrent refusal to provide exculpatory evidence to the defendants and the courts when it prosecutes the alleged fraud mice among the Russian-American community. But the WSJ exhibits a very selective rage that depends on who the defendant is. It is up in arms when the victim is the CEO and silent when the CEO is the perpetrator. It does not really believe in a single rule of law.
They have suspiciously impeccable timing.
Post the fall of the USA, they’ll be outraged that WSJ subscribers would loot a Middle Class?
Thank you for your continuing articles on bank fraud and its consequences. But I have to point out that when you utilize the conclusory statement, made by “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.” a statement that may be true for some “mortgage fraud” cases, it continues the myth that Big Bank’s did not engage in mortgage fraud, and that Banks lose money on foreclosures.
When you add up the monies Banks receive from a loan that has “gone bad”, for whatever reason, and is foreclosed, you will find that more often than not, the Banks come out way ahead of the game, and the payoff is quicker than waiting for a homeowner to pay off his mortgage:
Mortgagee’s 5% or 10% down-payment reduced Bank risk
Mortgagee paid X number of Loan payments equity and/or interest = X x $$
Mortgagee’s Private Mortgage Insurance (PMI) pays off the Bank = pays off the Loan
If there are Title Insurance issues the Bank gets paid = unknown % of the Loan
Bank either sells the loan or keeps the property to sell when prices are up = unknown % of the Loan
Bank can sue Mortgagee for the “perceived loss” in most states = unknown % of the Loan
FDIC pays the Bank 80% of what the Bank says remains on the loan = pays off 80% of the Loan
The Bank carries PMI on the Loan = pays off the Loan
Every time the Loan is transferred/assigned there is additional Bank PMI = pays off the Loan 1 or more x
= 2.8x – 6x or more, of the Loan
So you can see how the Bank(s) make more money on a foreclosure, now, rather than waiting 20 or 30 years for the Mortgagee to pay off a Loan that was improperly made, with a lost or shredded Note, forged assignments, etc. In fact it is to the Banks advantage to foreclose in non-judicial foreclosure states where the Bank doesn’t have to produce a wet-note, on a home with “problems” in the origination file, illegal assignments and empty trusts. And I have evidence that Big Banks indulge in civil fraud, criminal frauds and criminal acts to actively pursue stealing homes and property from the American people. Wells Fargo and the other Big Banks have subverted Banking Regulations to allow Big Banks to own and sell/mortgage properties.
Thank you for your time and interest,
My Bank of America Small Business Express ™ line of credit
originated in New York as it was a former Fleet product.
The intro letter stated “wall street prime + 4.25 fixed margin”
But they did not follow this. Bank America kept the highest prime rate
In 2008 @ 8.5% and never lowered the interest rate as prime fell down to 3.5%.
In 2013 they said they mailed to me back In 2007 purportedly a letter indicating they were
Going to double the margin amount exactly to fill in what was to be the drop
In the forthcoming prime rate drop.
So Bank America rigged the LIBOR rate to fall to win the CDO swap game against municipalities like Alabama’s and Detroit; while also
Rigging the Lines of Credit interest to rise to make sure no losses.
Although BoA vs Barr in Maine establishes a contract there is no
one helping out small businesses get refunds on over charges.
It seems irrelevant to post my comment regarding Becker’s Crime theory here, but the original blog does not accept comment anymore. If Black or anyone finds this posting inappropriate, I do not mind it being deleted. Perhaps, someone can move this posting to the proper place.
I have proved that Becker’s mathematics is wrong, and worked out a new theory of crime. For details, pls follow: http://ssrn.com/abstract=2544817.
The looting and burning of Ferguson took three days and cost $25M. A modern bank does that much business in 15 minutes.
If the WSJ were an organization that carries out journalism in the service of the public good, it would indeed”be enraged at acts of retaliation against whistleblowers.” But we all know that isn’t what it is.