By William K. Black
Bloomington, MN: February 15, 2015
I will be writing a series of articles concerning the three mortgage fraud epidemics that hyper-inflated the bubble and drove the financial crisis prompted by four recent economic studies of mortgage fraud. My goal is to integrate the results of those studies with the work of criminologists, investigators, and data from other sources such as Clayton.
In economics and white-collar criminology, we teach our students the very useful concept of “revealed preferences.” We take what potential perpetrators say they would do and why they claim they took an action with cartons of salt. Their actions generally speak far louder and more candidly than do their words. I will show in this series how valuable revealed preferences are in analyzing the data and testing rival research hypotheses. (I will explain why I feel the recurrent failure to state these hypotheses expressly leads to serious error.)
I have come to the view that a concept that I term “revealed biases” is a useful corollary to “revealed preferences.” The National Institute of Justice virtually never funds empirical studies of elite white-collar criminals (a classic “revealed bias”). OMB suggests research programs exclusively for blue collar crime – in the midst of the largest and most destructive epidemics of elite white-collar crime in history. I wrote my first column in this series about an example of revealed biases in discussions of econometric studies of mortgage fraud.
The Piskorski, Seru, and Witkin (PSW) Study
The four studies can be read without charge. (The most recent study was behind a pay wall when I wrote by first article in this series.) In this and my next column I discuss two excellent studies by multiple authors. I have written previously about a February 2013 study entitled: “Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market.” The co-authors are Tomasz Piskorski (Columbia GSB), Amit Seru (University of Chicago and NBER), and James Witkin (collectively, PSW). (RMBS is an acronym for Residential Mortgage-Backed Securities.) (I discussed the PSW study extensively in an academic talk I gave on February 26, 2013 at Columbia that Piskorksi was able to attend.) This column begins the process of showing how adding the research findings and theoretical developments of criminologists, (effective) regulators, and economists on “control fraud” (aka “looting”) to the excellent work by of these finance authors can be useful to understanding the ongoing crisis and limiting or even preventing future crises. This column focuses on the PSW study’s findings and a few key interpretations of those findings. The next column discusses the most recent study on liar’s loans by Amir Sufi and Atif Mian.
The PSW study looked at two forms of mortgage fraud – misrepresentation as to the borrower’s intent to occupy the home as his primary dwelling and the absence of a “piggy-back” loan (in which the borrower pays the down payment on the first lien loan partially or completely from the proceeds of the “second” (contemporaneous) lien loan). Both forms of misrepresentation increase the probability of default and the likely loss upon default. There were four key findings from the PSW data. First, our most elite banks defrauded secondary market purchasers by falsely claiming that the loans were not piggy-backs.
“[A]lthough there is substantial heterogeneity across underwriters, a significant degree of misrepresentation exists across all underwriters, which includes the most reputable financial institutions” (PSW 2013: 29).
Second, the result was the sale of piggy-back loans that suffered significantly greater defaults and losses. I explained in my earlier column:
“The PSW 2013 study documents that the officers controlling the home lenders knew the representations they made to the purchasers as to the lack of a second lien were often false (pp. 2, 5 n. 6), that such deceit was common (p. 3), that the deceit harmed the purchasers by causing them to suffer much higher default rates on loans with undisclosed second liens (pp. 20-21), and that each of the financial institutions they studied – the Nation’s “most reputable” – committed substantial amounts of this form of fraud (Figure 4, p. 59).”
Third, the banks often misrepresented (frequently unintentionally) to secondary market purchasers whether the borrower would occupy the home as his principal dwelling. The study infers from the pricing that the lenders were often dubious of the speculators’ representations about their intent to occupy and partially compensated for this risk by charging them a higher interest rate despite their representation to the lender that they intended to occupy the home
Fourth, the data suggest that, as a group, the borrowers who misrepresented their intent to occupy were more likely to default, but that the borrowers in the cases where the piggy-back loans were misrepresented were not materially more likely to default than borrowers with (disclosed) piggy-back loans. The contrast can be seen in Figure 2 (p. 56), Panels A & B. Panel A shows that the default rate for misrepresented non-occupants is much higher than the default rate for those who disclose that they plan to be non-occupants. This is consistent with severe adverse selection when lending to borrowers who misrepresent their intent to occupy. By contrast, Panel B shows that default rates are very similar between borrowers in which there is a piggy-back loan regardless of whether the piggy-back loan was disclosed. Loans that were not piggy-back loans (i.e., loans with a real down payment) had a substantially lower default rate than loans with a piggy-back regardless of whether the piggy-back was disclosed on the loan application. This suggests that there is no material adverse selection in this context arising from differences in the borrowers’ integrity. It also suggests that it was the lenders’ officers’ idea to misrepresent the existence of the piggy-back second lien.
These two forms of mortgage fraud were very large – except compared to the two great epidemics of mortgage origination fraud (liar’s loans and inflated appraisals) and the resultant secondary market frauds when these fraudulently originated mortgages could only be originated through fraudulent “reps and warranties.” The piggy-back fraud was obviously generated by the lenders because they had made both the first and second lien loans contemporaneously, but the made reps and warranties that they were not piggy-back loans. The lenders obviously did not rely on any representation from the borrowers that the contemporaneous piggy-back loans that the banks were making to the borrowers were not piggy-back loans.
The situation with misrepresentations about the borrower’s intent to occupy the home as his principal dwelling is more complex. The borrowers made the misrepresentations and they are investors or “speculators” who buy multiple homes either to rent them or “flip” them. It is difficult for a lender to check on the validity of the “intent to occupy” representation, but verifying the borrower’s assets and checking his tax returns will disclose any substantial speculators. The complexity in interpreting the results is that while the lending officials would prefer to make the loan with the risk premium added for non-occupancy, many of them would prefer to make the loan without that risk premium if the alternative was losing the loan to a rival lender that did not charge such a premium. It is certain that some lenders signaled their willingness not to check on the accuracy of occupancy representations by borrowers. It is also very likely that some lenders reached an intermediate position of not checking vigorously on occupancy representations and not charging the full non-occupancy risk premium, but charging an intermediate rate with a moderately higher risk premium while pulling a “wink, wink; nod, not” when it came to loan approvals to borrowers the lenders believed to be likely speculators. Econometric studies cannot answer these questions, though detecting a partial risk premium is helpful in drawing inferences.
The critical takeaway from the PSW study is that the most elite lenders and RMBS underwriters were shown to have knowingly and intentionally have engaged in fraud in a significant number of piggy-back loans. Those loans were far more likely to cause severe defaults and more severe loss upon default because the loan-to-value (LTV) ratio was so extreme. The loan servicer was certain to discover that there were two, simultaneous liens when the loans defaulted. The lender that made the rep and warranty that there was no second lien was the lender that made both loans, so the fact that the bankers involved knew or should have known that they were making a false rep and warranty was indisputable.
The result of the brazen nature of the piggy-back mortgage fraud – a fraud that was certain to be uncovered frequently because it would lead to much higher default rates – was that the lenders and underwriters were on the hook for these losses. Because they made blatantly false representations they would be forced contractually to repurchase the defaulting the piggy-back loans. Worse, they could be sued in tort for fraud, which might well lead to the imposition of punitive damages and the ability to put back the entire purchase to the seller.
Making a “rep and warranty” that there is no second lien when the lender has made a simultaneous piggy-back first and second lien loan is a far more brazen fraud than appraisal and “liar’s” loan frauds because the lender has knowledge of a vital, objective fact – and deliberately misrepresents the fact in a manner harmful to the purchaser. The PSW findings about fraudulent piggy-back loans demonstrate that there is no basis for assuming that the same elite bankers would not have knowingly and intentionally have engaged in mortgage fraud in other contexts in which it would be far more difficult for the loan, MBS, or CDO purchaser to establish a contractual right to “put back” the loan or sue for tort relief.
We know from the PSW study that our most elite bankers were willing to engage in piggy-back frauds that were so brazen that they were sure to be discovered in large numbers of cases and lead to huge losses to the elite banks. The logical inference is that the same elite bank officers would be far more willing to engage in other forms of fraudulent reps and warranties that were far harder for the victim, regulators, and prosecutors to discover and sanction.
The Fundamental Unaddressed Question: Why?
The fundamental question, however, was not addressed by the PSW study – why did the officers controlling the lenders deliberately make terrible piggy-back loans that we have known for a century will produce much higher default rates and losses? The authors know that the answer is not “the lenders had no skin in the game” because they were selling the loans to the secondary market. The PSW authors know that the fraudulently originated loans could only be sold to the secondary market through fraudulent reps and warranties and that this meant that the loan originators had serious-to-fatal levels of skin in the game.
The more subtle, but even more important “why” question is: what has changed to produce a vastly more criminogenic environment, particularly in the U.S. and the EU? Decades ago, if a bank made terrible loans that would cause it to suffer catastrophic losses it created no Gresham’s” dynamic. Changes in executive compensation created an intense Gresham’s dynamic that now creates perverse incentives for bank managers to cause “their” banks to make enormous numbers of bad loans.
The Missing Literature that Explains Why
The PSW authors were not aware, however, of the answers to these fundamental questions provided by the criminology, regulatory, and economics literature, such as the creation of an environment that is so criminogenic that it creates a powerful incentive for the banks’ controlling officers to make vast amounts of bad loans. Our analysis differs critically from the PSW authors’ understanding of fraud by lenders.
“These misrepresentations are not instances of the classic asymmetric information problem in which the buyers know less than the seller. Rather, we contend that they are instances where, in the process of contractual disclosure by the sellers, buyers received false information on the characteristics of assets. (PSW: 1).”
The use of the word “classic” indicates an important (retrograde) movement in economics. The “classic” treatment of asymmetry in the economics literature is George Akerlof’s 1970 article on a market for “lemons.” It is all about “buyers receiv[ing] false information on the characteristics of assets” in the process of “contractual disclosure by the sellers.” Akerlof presented a dynamic process in which the seller makes false disclosures as to the quality of its goods in order to maximize the asymmetry of information with the borrower and aid the seller in defrauding the borrower. Fraud maximizes the asymmetry between the buyer and the seller. Indeed, Akerlof emphasized the propagation of that fraudulent asymmetry through the industry as a result of what he dubbed a “Gresham’s” dynamic.
“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence “(Akerlof 1970).
The fact that top economists, 40 years later, claimed that fraud does not represent a “classic” pathology of asymmetrical information demonstrates how far economics has fallen. Criminologists and competent regulators have recognized since Akerlof’s classic article that countering the Gresham’s dynamic is the paramount function of the rule of law and regulation. The PSW authors (as with the other three co-authored articles I will discuss in this series) cite none of the relevant criminology or regulatory literature, which is of course the norm for economists. But they also cite neither Akerlof (1970) nor Akerlof and Romer (1993), the seminal economics article about lending fraud (“Looting: The Economic Underworld of Bankrutpcy for Profit”). Akerlof and Romer drew on the literature, theories, and data of effective regulators (which incorporated criminology) in developing their theory of “looting.”
In no other discipline would you find a Nobel Laureate who has authored the two most important theoretical articles in the discipline about a subject (fraud in this case) ignored by scholars from that same field. In future articles in this series I will explain how the relevant literature answers the “why” questions in greater detail. For now, I will simply issue the “spoiler” – because, given modern executive compensation, the “fraud recipe” is optimized by making (and buying) terrible loans at premium nominal yield. The fraud recipe produces the three “sure things” that make those officers wealthy while minimizing the risk of prosecution. PSW help illustrate the fact that this hard-gained knowledge disappeared from the ken of financial economists and regulators – but not from bank officers. George Akerlof and Paul Romer proved vastly too optimistic about economists and economics in the conclusion to their famous 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit.”
“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the [deregulations] of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (Akerlof & Romer 1993: 60).
The Dog That Didn’t Bark: The Lack of Federal Regulatory Studies of Mortgage Fraud
We also need to emphasize the dog that has not barked – the federal financial regulators, the bankruptcy trustees, and the FBI. They have unique access to data that would allow superb studies of the role of fraud in the crisis. I have called on them (publicly and privately) for many years to conduct the studies. Our “autopsies” of failed S&Ls provided the data essential to our ability to understand the “fraud recipe” and how the lenders’ controlling officers generated the Gresham’s dynamics that suborned the purported “controls” into becoming the most valuable fraud allies. The federal and state regulatory and criminal justice agencies have found endemic fraud at our most elite financial institutions – but the federal government’s most senior officials, President Obama and Attorney General Holder, are fraud deniers. If the regulatory agencies, bankruptcy trustees, and the FBI used their resources, including their unique access to data and examination powers, to study mortgage fraud in the origination and secondary (and tertiary, e.g., CDOs) markets they could have documented and acted decisively to end the fraud epidemics a full decade ago and prevented the crisis.
In addition to examination reports, the regulators, federal bankruptcy trustees, and the FBI have unique ability to investigate non-regulated entities and actors, locate and learn from whistleblowers, require detailed admissions from the banks when they reach civil settlements and criminal pleas, require the banks to pay for experts chosen by DOJ to conduct detailed, truly independent investigations of the fraud schemes, conduct intensive bankruptcy trustee investigations, and the Clayton materials. The Clayton materials, in particular, are a treasure trove for research. (Clayton was the dominant “due diligence” firm for secondary market mortgage purchasers. The due diligence reports from the less than handful of material competitors would also prove highly valuable. The FBI and the DOJ should be commissioning in depth analyses using the Clayton data – and documenting through the many Clayton whistleblowers the nature and extent of the efforts to ensure that the Clayton reports substantially underreported the incidence of false “reps and warranties.” Similarly, the instructions that Clayton received from the secondary market purchasers and the responses from those purchasers to the extraordinary levels of false reps and warranties found by Clayton would be highly incriminating and vital to researchers.
The continuing refusal of the federal banking regulatory agencies, the failure to appoint bankruptcy trustees and resultant failure to conduct bankruptcy examinations of notorious lenders like GreenPoint, and the FBI and DOJ’s failures to conduct major studies of mortgage fraud are indefensible. They should be putting together research teams of criminologists, effective (former) regulators, and economists with funding and access to the data to conduct these studies. The current crisis is so horrific in the damage it has inflicted that the failure of the federal government to conduct superb mortgage fraud studies is incomprehensible.
In subsequent articles in this series I will discuss two studies of liar’s loans by Federal Reserve economists as sole or co-authors. Neither study was done on behalf of the Federal Reserve. Neither study took advantage of the regulators’, FBI and DOJ’s, and bankruptcy examiners’ unique access to institution-specific data. Neither study involved co-authorship by actual regulators. Neither study gives any indication of regulatory or prosecutorial insights. Neither study cites Akerlof’s articles or any of the literature of criminologists or effective banking regulators. This helps explain why both studies are embarrassingly weak. They are credulous in accepting industry characterizations of liar’s loans. Neither study discusses fraud. Only one of the studies even contains the word “fraud” – and the single use of the word is relegated to a quotation in a footnote that the authors do not analyze.
Good Data on Mortgage Fraud Would Embarrass DOJ’s Leaders
Real federal research on mortgage fraud poses two dangers to the Department of Justice (DOJ), which should have been publicly demanding that the regulators conduct superb fraud studies. The first danger is obvious. There is no excuse for the DOJ’s continuing refusal to prosecute the elite bankers (the fraud “lions” the regulators allowed to roam the campsite with impunity) who led the frauds that drove the crisis. Any serious research effort by the financial regulators would make that outrage even clearer.
The more subtle problem is that while DOJ refuses to prosecute elite bankers, it does annually chase hundreds of the fraud “mice” into prison. As we demonstrated in the Sacramento mortgage fraud defense, the facts disclosed by every relevant study and investigation of mortgage fraud demonstrate that the loan application misrepresentations were not “material” (a necessary legal element to demonstrate fraud in federal prosecutions) to the typical originators (and purchasers) of fraudulent liar’s loans. DOJ views these facts as the gravest threat to its prosecution of the purported fraud mice. DOJ routinely portrays to juries that lenders it knows to have engaged in endemic loan origination fraud are the innocent victims of the rapacious and endlessly clever hairdressers. That fable would be impossible to spread – and use to send the mice to prison – if the regulators had published studies demonstrating that the originators of liar’s loans were frauds. I have also explained how the FBI compounds the outrageous nature of that fable by falsely claiming on its web site that mortgage fraud is widely driven by disfavored ethnic groups. PSW put the conclusive lie to the clever hairdresser fable about the causes of the crisis two years ago when their study was made public in February 2013.