The Lessons Richard Bowen’s FCIC Testimony Should Have Taught the Nation

By William K. Black
Quito: March 20, 2015

This is the first of three columns prompted by Richard Bowen’s interview this morning on Bloomberg.  Richard Bowen, a Citi SVP, blew the whistle within Citi on Citi’s massive fraudulent sales of fraudulently originated mortgages, primarily to Fannie and Freddie.  Even Attorney General Eric Holder now repeatedly labels these mortgages “toxic.”  Had Citi’s leadership been honest, Bowen’s warnings could have substantially reduced the three fraud epidemics driving the financial crisis and Bowen would be one of Citi’s most senior leaders.  No spoiler alert is required because even my readers who know anything about Bowen know how the story actually ended.  Citi’s senior managers did not ignore Bowen’s warnings – they actively made the frauds he documented worse and they destroyed Bowen’s distinguished career in banking.  Citi, Fannie and Freddie, and Treasury lost billions of dollars and Citi’s senior officers were made wealthy by the “sure thing” of the accounting control fraud “recipe.”

This first column is unapologetically long and technical.  Indeed, its technical nature is a large part of the point I am making.  The financial crisis was driven by history’s three most destructive epidemics of financial fraud:  appraisal fraud, liar’s loans, and the sale of fraudulently originated mortgages to the secondary market through fraudulent reps and warranties.  One cannot understand, effectively investigate, or prosecute the senior financial officers who led these fraud epidemics without a detailed technical understanding of the fraud schemes and the financial markets.  This first column is intended as a resource for those willing and able to make the investment towards achieving that understanding.  Because people like me and Bowen no longer train FBI agents and prosecutors, and because the Obama administration’s most senior officials have been unremittingly opposed to prosecuting the financial officers that led the three fraud epidemics, no FBI agent or prosecutor has the necessary technical understanding.  My second column explains why this makes the FBI, the SEC, and the Department of Justice’s (DOJ) failure to draw on Bowen’s expertise all the more harmful and indefensible.

No spoiler alert is required either about Holder’s reaction to Bowen providing the Department of Justice (DOJ) with a criminal case against Citi’s controlling officers on a platinum platter.  Holder, as always, refused to prosecute the banksters whose frauds drove the financial crisis.  He eventually brought a civil action to get some useless fines from Citi rather than from the Citi officers who looted Citi, Fannie and Freddie, and Treasury.  Holder also failed to thank Bowen when Holder announced the civil settlement with Citigroup and refused to use the golden opportunity of the press conference announcing the settlement to ask other whistleblowers to come forward.  All of this, of course, is SOP for Holder and Loretta Lynch, President Obama’s choice to be his successor.  Lynch failed to prosecute HSBC or its responsible officers for its extraordinary crimes on behalf of genocidal regimes, terrorism sanction busters, and massive money laundering for the Sinaloa drug cartel.  You can only read it in right wing publications, but she is also accused of not speaking to either of the two key whistleblowers about HSBC.  Lynch’s nomination is being held hostage by the Republicans for all the wrong reasons.

My second column in this series will discuss the DOJ’s and the SEC’s refusal to act on Bowen’s evidence and their refusal to draw on Bowen’s expertise.  Bowen, of course, is simply a telling example of the broader failures by the DOJ and the SEC.  If Americans understood the extent to which the DOJ and the SEC refuse to do even the simple things any investigator and prosecutor would do out of normal professionalism Obama would have been forced to ask for Holder’s resignation during his first term.

My third column will discuss how Bowen’s testimony before the Financial Crisis Inquiry Commission (FCIC) was stripped of some of his most damning evidence.  My first column makes a point that may seem contradictory to Bowen’s charge that the FCIC lawyer sought to sanitize his testimony in response to pressure from Citi’s top managers and armada of attorneys.  I write to provide what I feel to be critical link between the various threads of Bowen’s struggles to get Citi, FCIC, and now the DOJ and the SEC to do the right thing.  This column explains that the testimony Bowen gave to FCIC, despite the sanitizing, was devastating and blew open history’s three most destructive financial fraud epidemics.

Even a well-educated reader with a knowledge of finance would not glean that fact from reading the FCIC report.  That means that the DOJ, FBI, and the SEC almost certainly do not understand the significance of Bowen’s testimony (and many other matters).  They do not understand that Bowen gave them not only Citi’s top managers on a platinum plate for a criminal prosecution, but also the roadmap for how to investigate and prosecute the CEOs of Citi’s controlling officers’ fraudulent peers and the (typically) smaller fraudsters that dominated the shadow financial mortgage sector.

The Accounting Control Fraud “Recipe” Explains Why Citi’s Leaders Crushed Bowen

The fraud recipe for a lender, or loan purchaser, allows us to explain what the senior bank officers who controlled Citi and its equally fraudulent peers’ strategy was.  The “recipe” has four ingredients.

  1. Grow extremely rapidly by
  2. Making (purchasing) terrible quality loans with a premium nominal yield, while
  3. Employing extreme leverage, and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL) and loan repurchase obligations

The first two “ingredients” in the fraud recipe require the lenders and loan purchasers to gut their underwriting standards and their “controls” that are supposed to ensure compliance with those standards.  Bowen ran Citi’s key internal control:  testing for compliance with Citi’s loan underwriting standards.  This explains why Bowen’s blunt, recurrent warnings to Citi’s top managers were so critical.  In a fraud strategy that depended on the financial version of “don’t ask; don’t tell” about the toxic nature of the mortgages being originated and sold Bowen was Citi’s top management’s worst nightmare.  He asked, he told, he documented, he warned Citi’s senior managers (accurately, urgently, and bluntly), he demanded integrity, and he put Citi’s senior managers on written notice of the frauds they were leading and the consequences of those frauds.  Citi’s leaders had only two choices, stop their massive fraudulent sales of toxic mortgages to Fannie and Freddie or crush Bowen.  The fraud recipe’s tie to their compensation made that choice an easy call.

Bowen Imperiled Citi’s Leaders’ “Sure Thing”

The recipe produces the famous three “sure things” – but only if the Bowens of the world are bought, bamboozled, bullied, or butchered.  Bowen was too honest to be bought by Citi’s perverse compensation system, too competent to be bamboozled, and too tough to be bullied – so Citi’s leadership team butchered his career.  Here are the three “sure things” that Citi’s leaders were so eager to obtain that they were willing to butcher Bowen.  Following the fraud “recipe” guarantees that:

  1. The firm will promptly report record (albeit fictional) profits
  2. The firm’s officers will promptly be made wealthy by modern executive compensation
  3. The firm will suffer severe losses that will only be recognized years later

The recipe and the three “sure things” make understandable a host of actions by senior officers that would be insane for honest bankers, but make perfect sense when running a control fraud.  Citi’s senior officers’ actions, particularly in response to Bowen’s stark warnings provide a classic example of this seeming irrationality.

It also explains why the same basic fraudulent loan strategy could work simultaneously for the officers controlling the loan originator/mortgage seller and the officers controlling the purchaser of those loans – as long as both adopted the financial version of “don’t ask; don’t tell.”  This explains why the officers implementing the frauds on both sides of the secondary market transactions pretend that toxic mortgages that were fraudulently originated and resold through fraudulent reps and warranties were superb assets.  It is also why Bowen and similar competent, brave, and honest underwriting officials who refused to go along with this series of big lies and tried to halt the endemic frauds had to circumvented, bullied, crushed, or fired.  The fraud recipes also explain why the fraudulent leaders designed and employed compensation systems for employees, officers, agents, and external “controls” to create perverse incentives to pretend that the endemically fraudulent mortgage originations and sales that produced the millions of toxic mortgages had produced high quality assets generating real profits.

Understanding the fraud recipe also makes clear how comically bad the alternative explanations for the banksters’ conduct are.  Consider this gem that Jamie Dimon provided to FCIC, which seemed to buy his hilarious claim.

“Jamie Dimon, the CEO of JP Morgan, told the Commission, “In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income’” (FCIC 2011: 111).

JPM just forgot that lenders need to underwrite their loans and that financial bubbles cannot continue indefinitely.  JPM is the world’s largest bank.  Tens of thousands of people would have to simultaneously forget the same points that had been drilled into them over the course of their education and professional employment.  Tens of thousands of JPM employees would also have to forget that their loan manuals existed.  Dimon’s claim is the stuff of bad science fiction.

Dimon’s tall tale requires that while the industry called the loans they knew to be endemically fraudulent “liar’s” loans, this didn’t jog any banker’s memory that originating millions of fraudulent loans to borrowers who could not repay those loans would (a) cause losses and (b) was driving the rise in home prices.  Liar’s loans were not new.  The last time they became substantial (in the early 1990s) they caused hundreds of millions of dollars in losses when home prices fell and the “low doc” loans (as they were then called) produced much higher default rates than competently underwritten loans.

We know that Dimon knew full well the fraud “recipe” and the “sure things” it created for he made both points in his March 30, 2012 letter to JPM’s shareholders.

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

Dimon’s statement is pithy and captures the essence of the fraud recipe and its sure things.  We can make his statement precise by adding a few words. “Poorly underwritten loans represent [fictional] income today and losses [whose recognition is improperly delayed to] tomorrow.”  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, Dimon knows from personal experience that the unlawful recognition of “income today” leads to a “sure thing” that will promptly make the controlling officers far wealthier.  Indeed, he and his peers at Citi and other banks ensured that their compensation, and the compensation of their subordinate officers, created this perverse incentive to ensure that those subordinates would make vast numbers of “poorly underwritten loans” that would make the CEO wealthy.

One can see from Dimon’s letter to JPM’s shareholders why Bowen had to be crushed – and why honest bankers would have praised and promoted Bowen instead of crushing him.  Given the perverse compensation incentives that Citi’s senior leaders created, the officer who objected to “poorly underwritten loans” that were producing high (albeit fictional) “income” was considered quadruply insane.  If he blocked the poorly underwritten loans, he (1) reduced his compensation, (2) reduced his staff’s compensation – and he’s personally responsible for their well-being, (3) reduced his colleagues’ compensation, and (4) reduced his bosses’ compensation.  As we said in the large law firm where I began my professional career, this constitutes a “CLG” (career limiting gesture).

It was, of course, Bowen’s job to warn that the “income” from Citi buying scores of billions of “poorly underwritten” loans and then selling them through false reps and warranties to Fannie and Freddie was not real.  Bowen’s greatest expertise is in underwriting and loan quality.  Bowen is unusual, but not rare in blowing the whistle even when he knew he was committing a CLG.  When you spend a career as a professional you often develop a professional ethos and when that is combined with integrity and courage it leads a significant number of Americans (far more than in other nations that despise whitstleblowers) to commit CLGs and blow the whistle.

Honest senior bankers at Citi would have seen immediately that Bowen was doing Citi (and the financial system) a great benefit at enormous personal risk.  It is the very real bonuses that arise from the faux profits that are the “sure thing” from the fraud recipe that are so seductive and perverse.  They are designed by the senior managers to be seductive and perverse.  There is nothing so valuable to honest bank CEOs, therefore, to have a Bowen acting as he is supposed to act.  Bowen was supposed to function as a truly independent “control” and promptly warn senior management when the bank’s lending standards were being violated and the bank was making fraudulent reps and warranties claiming that the loans it was selling to the secondary market complied with the bank’s lending standards.  An SVP who performs as Bowen did displays such exemplary integrity, dedication to the bank, and courage that he should be fast-tracked into bank’s top leadership ranks.  Fraudulent senior bankers, of course, would do the opposite.  The treatment of Bowen by Citi’s controlling managers is a classic example of “revealed preferences.”  We do not have to guess, we know exactly what Citi’s controlling officers preferred – continuing and even expanding the frauds that were making them wealthy instead of choosing integrity.  Indeed, their despicable effort to savage Bowen’s reputation by giving him negative reviews for what was indisputably exemplary performance shows the depths of their depravity.  Citi’s fraudulent leadership was willing to destroy the very best managers at Citi if the honest managers threatened the leadership’s looting of Citigroup.

Senior Citi managers gave to Bowen a different, and even more tragicomic, explanation than the one Dimon provided of their decision to buy scores of billions of dollars in liar’s loans.

“Richard Bowen, a veteran banker in the consumer lending group, told the FCIC, “A decision was made that ‘We’re going to have to hold our nose and start buying the stated product if we want to stay in business’” (FCIC 2011: 111).

My guess is that I’m not the only one with a mother who responded to me telling her that I should be able to do something because my friends did it with the query: “and if they jumped off a cliff?”  Making bad loans is how a bank goes out of business.  If a bank does not make liar’s loans it is more profitable and it stays in business.  If your competitor makes bad loans, suffers critical losses, and fails you not only “stay in business” – you dominate the business.  What the senior Citi managers really were describing was a “Gresham’s” dynamic (“bad ethics drive good ethics from the markets”) triggered deliberately by perverse compensation incentives.  The rival banks’ controlling officers who caused their banks to make large amounts of liar’s loans before Citi did were made wealthy by the “sure thing” of accounting fraud.  Citi’s senior managers wanted to get wealthier through the same “sure thing.”  It was easy for Citi’s controlling officers to mimic their fraudulent rivals’ strategy of using the fraud recipe to grow wealthy.  Citi simply had to buy scores of billions of dollars in liar’s loans.  There was only one impediment to the strategy – and it wasn’t their ethics.  Bowen was the man blocking Citi’s senior managers’ fraud strategy.  The response was inevitable, “will no one rid me of that accursed [SVP]?”

The recipe also demonstrates how we successfully prosecuted elite banksters’ frauds.  Once the fraud recipe is explained to them by a competent expert, jurors understand quickly that the officers were acting in a manner that makes no sense for honest bankers but is optimal for officers leading frauds.  The next subsection explains how FCIC got that concept so wrong.

FCIC Resurrects the Banksters’ Long-Falsified “Gambling for Resurrection” Excuse

FCIC attempted to explain the absurdity of the excuses that Dimon and Citi’s managers offered for JPM and Citi’s endemic mortgage fraud and for tolerating endemic fraud by their secondary market counterparties in this passage.

“In the end, companies in subprime and Alt-A mortgages had, in essence, placed all their chips on black: they were betting that home prices would never stop rising.  This was the only scenario that would keep the mortgage machine humming” (FCIC 2011: 111).

FCIC’s tone is this passage is plainly negative, but its analysis fails on multiple levels.  FCIC’s economists were resurrecting a nonsensical theory that apologists for the CEOs leading the savings and loan control frauds made infamous during the debacle.  Economists and lawyers working for these fraudulent CEOs claimed that the CEOs were honest and had simply lost their “gamble for resurrection.”  As the FCIC passage quoted above shows, FCIC’s economists brought back the same metaphor.  Here, in summary form, are the problems with the metaphor.

  • “Companies” don’t bet – officers (may) bet. The motivations of the officers are what matter, not what is best for the bank.  Bowen and his team demonstrate that integrity, professionalism, and good leadership can sometimes trump perverse incentives, but while he was not rare he was an example of the exceptions.
  • As George Akerlof and Paul Romer observed in their classic 1993 paper on “looting,” why gamble when accounting fraud provides a “sure thing” guaranteed to make the officer wealthy?
  • Betting on “black” in (double 00) roulette has a 47.37% chance of success. Gambling against the house has a negative expected value.
  • A 47.37% probability of a successful gamble is, relative to other gambles, a gamble with a high probability of success and the negative expected value of betting on “black” is fairly small relative to many gambles, so there should have been many winners who made very high profits from making liar’s loans if that lending strategy were analogous to betting on “black.” Instead, lenders that specialized in making liar’s loans uniformly suffered catastrophic losses.
  • The FCIC passage is internally inconsistent about the probability of success of the (honest) gambling strategy it purports to describe: “[the banks] placed all their chips on black: they were betting that home prices would never stop rising.  This was the only scenario that would keep the mortgage machine humming.”  As I explained, gamblers that places “all their chips on black” have a 47.37% chance of success.  We would expect to see many hundreds of bank winners from that strategy in the metaphor were accurate.  But FCIC, in the very next clause in the same sentence, shows that it knows its own analogy is not remotely analogous.  FCIC, correctly, says that the “only scenario” in which a strategy of making liar’s loans with a sharply negative expected value could succeed is an infinite bubble in home prices.  What FCIC failed to state was that the probability of that scenario is zero.  The “honest gambler” theory cannot explain the massive number of liar’s loans that the lenders’ officers made.  That strategy, as the officers knew full well, had zero chance of success because there is no such thing as an infinite bubble.
  • Making good home loans has a positive expected value
  • The way a bank makes good home loans is to do highly competent underwriting
  • Making liar’s loans means doing bad-to-terrible underwriting
  • This produces “adverse selection” (e.g., a high incidence of fraud)
  • This means that the liar’s loan lending strategy inherently has a deeply negative expected value – far worse than betting on “black” in roulette
  • Liar’s loan lenders exacerbated the inherently unsafe nature of making liar’s loans by adding copious additional risks
  • “Subprime and Alt-A” is a phrase disguising multiple analytical problems
  • It implies that the two forms of loans were mutually exclusive, but by 2006 roughly half of the loans that the industry called “subprime” were also liar’s loans
  • It is these loans that were both subprime and fraudulent liar’s loans that were the most toxic
    • “Alt-A” is an euphemism for “liar’s” loans, which had a 90% fraud incidence
    • “Alt-A” is a double lie
      • “A” indicates that the loan was a “prime” loan – as I explained above by 2006 roughly half of liar’s loans were also subprime “C” loans
      • “Alt” stands for “alternative” and is intended to lead the reader to believe that the loans were underwritten through an “alternative” (reliable) means. In reality, the borrower’s income was not verified, producing endemic fraud.  This is like saying that one guarded a bank’s assets through the “alternative” means of not guarding the bank’s assets.

All of these detailed analytics were worked out by the S&L regulators over 30 years ago and described in the regulatory literature 25 years ago.  Economists consistently got the analysis completely wrong in the 1980s and adopted the “honest gambler” metaphor for the S&L debacle 30 years ago.  Akerlof and Romer wrote their 1993 “looting” article in large part to explain why the metaphor was false.  I am deliberately going to provide a lengthy quotation from that article to demonstrate how expressly and comprehensively they buried the “honest gambler” metaphor and show that they cited our work (“Black 1993b”) on the point.  Note that they even used liar’s loans as an example of why the “honest gambler” metaphor was nonsensical (Akerlof & Romer 1993: 4-5, emphasis added).

“Some economists’ accounts acknowledge that something besides excessive risk-taking might have been taking place during the 1980s.6 Edward Kane’s comparison of the behavior at savings and loans (S&Ls) to a Ponzi scheme comes close to capturing some of the points that we emphasize. Nevertheless, many economists still seem not to under-stand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?

In contrast to popular accounts, economists’ work is typically weak on details because the incentives economists emphasize cannot explain much of the behavior that took place. The typical economic analysis is based on moral hazard, excessive risk-taking, and the absence of risk sensitivity in the premiums charged for deposit insurance. This strategy has many colorful descriptions: ‘heads I win, tails I break even’; ‘gambling on resurrection’; and ‘fourth-quarter football’; to name just a few. Using an analogy with options pricing, economists developed a nice theoretical analysis of such excessive risk-takings trategies.4 The problem with this explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.5 Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem. They were right
4. See Merton (1978).
5. Black (1993b) forcefully makes this point.

The “gambling for resurrection” theory at least had the virtue of the fact that many S&Ls were market value insolvent before their CEOs used them as “control fraud” “weapons.”  FCIC is buying the banksters’ claims that they were running honest, solvent, and profitable banks – and decided in those circumstances to bet their banks’ survival on making liar’s loans that they knew were endemically fraudulent and produced net losses because they generated severe “adverse selection.”  That is so facially absurd that you know you’re not simply being lied to – you’re being lied to by bank CEOs who think that you are so stupid that they can make up farcical lies that you will swallow whole.

In their concluding paragraph, Akerlof and Romer were plainly talking to their own profession and urging them not to repeat that terrible analytical blunder that caused so much harm during the debacle when economists and lawyers combined to be the great enablers of the elite frauds.

“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations 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).

Sadly, economists demonstrated, and continue to demonstrate, that they do not “know better.”  They continue to repeat the old fictions even when the internal logical contradictions caused by trying to contort to the facts to fit long-falsified dogma are so terrible that they occur within the same sentence.

The FCIC Report Gave Bowen’s Disclosures Prominence

The FCIC report gives Bowen’s testimony prominent attention in its introduction (2011: 19).

“At Citigroup, meanwhile, Richard Bowen, a veteran banker in the consumer lending group, received a promotion in early 2006 when he was named business chief under writer. He would go on to oversee loan quality for over $90 billion a year of mortgages underwritten and purchased by CitiFinancial. These mortgages were sold to Fannie Mae, Freddie Mac, and others.  In June 2006, Bowen discovered that as much as 60% of the loans that Citi was buying were defective. They did not meet Citi group’s loan guidelines and thus endangered the company—if the borrowers were to default on their loans, the investors could force Citi to buy them back.”

Bowen’s sanitized testimony made far more powerful points than the FCIC report conveys.  The FCIC report is at its analytical weakest in dealing with two of the three fraud epidemics that drove the financial crisis – appraisal and secondary market frauds.  As I will explain, any competent investigation of secondary market fraud would inherently produce an investigation of the two great loan origination fraud epidemics (appraisal fraud and liar’s loans).  Bowen’s testimony provided the FCIC a superb opportunity to get its analysis of secondary market fraud correct and therefore make it possible for FCIC to get its analysis of the two great epidemics of loan origination fraud correct.  This column demonstrates how FCIC failed to understand the importance of Bowen’s sanitized testimony.

FCIC, DOJ, and the SEC’s Failure to Understand Secondary Market Fraud

The FCIC report (and its dissents) fail to point out the financial insanity at the core of Citi’s senior managers’ secondary market strategy on which Bowen blew the whistle.  I am being unfair to the senior officers, for their strategy was the classic accounting control fraud “recipe” for a purchaser of loans that produced the classic “sure thing” of making those officers wealthy by “looting” Citi.  The strategy was only insane for Citi, Fannie and Freddie, and Treasury.

Citi’s senior officers’ strategy was to be the third (of at least five) firms in the chain of that was purchasing the right to part of the (deeply inadequate) cash flows arising from making fraudulent liar’s loans.  They were starting, increasingly, with liar’s loans, which had a negative expected value – they were going to cause losses rather than generate profits.  Typically, and increasingly, these toxic mortgages were arranged by loan brokers.  Akerlof and Romer warned against the inherent risks of this practice (as we did as S&L regulators).

“Loan brokers, who match borrowers and lenders in exchange for a commission, have a deservedly bad reputation. The incentive to match bad credits with gullible lenders and to walk away with the initial fees is very high. It can also take several years for this kind of scheme to be detected because even a bad creditor can set aside some of the initial proceeds from a loan to make several coupon or interest payments” (Akerlof & Romer 1993: 46).

The officers of lenders in the current crisis, however, crafted their financial incentives to the loan brokers to be exceptionally generous and perverse in order to exacerbate the brokers’ inherently perverse incentives.  The goal in crafting these perverse incentives was to encourage the loan brokers to help the lenders’ CEO to meet the first two ingredients of the fraud recipe.  The brokers were (statistically) sure to respond to these supercharged perverse incentives by becoming the leading generator of the two great epidemics of loan origination fraud – liar’s loans and extorting appraisers to inflate market values.

The portion of Citi’s strategy that Bowen blew the whistle on was worse than relying on brokers to originate its nonprime home loans.  Citi purchased very large amounts of liar’s loans from lenders who in turn relied overwhelmingly on loan brokers to put the lies in liar’s loans and, frequently, to compound that fraud by extorting appraisal fraud.   This meant that the brokers got a big cut of the (non-existent) “profits” of originating fraudulent liar’s loans as a reward for their fraudulent efforts.  Then the bank got a big cut.  Then, for Citi’s strategy to be “profitable,” Citi would have to get a substantial cut of the (non-existent) profits from making the liar’s loans.  But Citi’s strategy required it to sell the liar’s loans to another entity, usually Fannie and Freddie.  That strategy should, if one assumes, contrary to fact, that Fannie and Freddie’s leaders were not themselves running an accounting control fraud, only succeed if Fannie and Freddie can pool those endemically fraudulent liar’s loans to create MBS that they can sell for a profit.  This is only possible if the liar’s loans are generating so much (non-existent) profitable cash flow that Fannie and Freddie – and the purchasers of their MBS – make money from borrowers who receive liar’s loans.

In sum, a lender that makes liar’s loans to buy homes will lose money.  Citi’s business model in buying liar’s loans required liar’s loans not simply to be profitable – it required them to be so extraordinarily profitable that five different firms would make money on the cash flow – the loan broker, the lender, Citi, Fannie and Freddie, and the purchasers of Fannie and Freddie’s MBS.  Even modestly efficient markets are always to drive middlemen out of business.  Citi’s liar’s loans strategy required four middlemen to be simultaneously profitable – on a toxic “asset” that was really a net liability.  Citi’s liar’s loan strategy makes sense solely as an example of the fraud recipe.  As a business plan it is beyond preposterous.  (I have deliberately, for reasons of space, considerably understated the number of firms, individuals, and professionals who would all have to get a cut of the non-existent profits from making, selling, and packaging liar’s loans for Citi’s business plan to make any sense.)

A False Hypothetical that Offers Analytical Insights about Citi’s Frauds

Citi, of course, is a totally unnecessary middleman in this liar’s loan chain.  FCIC does not seem to recognize this fact and therefore misses its implications.  Why didn’t the banks sell their liar’s loans directly to Fannie and Freddie rather than Citi?   Selling to Citi adds a pure dead weight cost.  There is only one legitimate basis for adding Citi to the chain – the combination of exceptional expertise and integrity on Citi’s part and Fannie and Freddie’s reasonable fear that the bank originating the loan lacks similar expertise and integrity.  In this scenario Citi provides a valuable service to Fannie and Freddie by providing a reliable assurance that Citi will diligently review the quality of the bank’s loans and purchase and resell to Fannie and Freddie only properly underwritten loans of acceptable quality.  In particular, Citi’s due diligence review will screen out any fraudulently originated loans.  Citi’s reps and warranties to Fannie and Freddie would have to be accurate and candid under this scenario.

There is the question even under this scenario as to why Citi is selling these (hypothetical) high quality liar’s loans that offer a premium yield to Fannie and Freddie.  Citi could hold them in portfolio or create and sell its own MBS backed by these wondrous liar’s loans.  Maybe Citi’s top managers were just generous types who wanted Fannie and Freddie, rather than Citi, to capture the supra normal profits of these (fictional) super-duper liar’s loans.

There is also the question why Fannie and Freddie were in essence contracting out their due diligence process to Citi.  Fannie and Freddie were huge corporations so it made far more sense for them to develop superb loan underwriting teams.

Putting aside these two questions about the scenario for the purposed of analysis, we come to the key implications of this hypothetical scenario.  First, the indispensable key to Citi’s success under this scenario was Bowen.   Bowen was the perfect man in the perfect position for this sole legitimate scenario.  Citi needed someone with expertise, vigor, thoroughness, courage, and integrity to ensure that Citi only bought the (hypothetical) super-duper liar’s loans from the banks that originated the loans and ensure that that Citi knew the quality of the super-duper liar’s loans it purchased so well that its representations to Fannie and Freddie about the quality of the loans would be accurate and that the loans would perform well for Fannie and Freddie.  Toughness and expertise would be required, for the (hypothetical) share of super-duper liar’s loans would be tiny.  Recall that the incidence of fraud in liar’s loan originations was 90 percent (MARI 2006) and that fraudulently originated loans could not be sold to Fannie and Freddie.  Only a subset of the 10% of liar’s loans that were not fraudulently originated would be super-duper.  The CEOs of the banks originating liar’s loans to sell to Citi would be enraged by Bowen only approving roughly one-in-twenty of those loans for purchase – on the grounds that 90% were fraudulently originated and that half of the remainder had an undue risk of loss.

It was a common practice for the originators of toxic mortgages to sell to another secondary market purchaser loans rejected by another secondary market purchaser because they were fraudulently originated and being offered for sale through fraudulent reps and warranties, but Bowen’s hypothetical rejection of 95% of liar’s loans would have posed far greater problems for the originators.  It was rare for loans to be rejected for purchase in the secondary market, so it was easy to sell the small number of rejected loans to another secondary market purchaser.  Citi would be rejecting 95% of liar’s loans, so the originators of liar’s loans would rarely be able to sell their loans to the vigilant Bowen – and even then they could sell only their very best loans – the hypothetical super-duper loans.  Lenders typically keep their very best loans in portfolio and retain the profits, so selling such loans to Citi would likely reduce the toxic lenders’ only honest source of profit.

There are two more subtle problems that unleashing the honest, tough, and competent Bowen on the originators of toxic mortgages would have caused.  First, it would have penetrated the markets that Citi realized that 95% of liar’s loans were toxic and should not be purchased.  Liar’s loans were growing massively, by over 500% between 2003 and 2006.  Shareholders would begin to ask questions about why their bank was buying endemically fraudulent loans that Citi refused to buy.  Even the somnolent regulators might have emerged from their torpor.  A bank that presented a package of liar’s loans to Citi and had virtually the entire package rejected, overwhelmingly on the basis of fraudulent origination and fraudulent reps and warranties might be able to sell the same package to Bank of America – but only by not telling B of A about Citi’s actions and making fraudulent reps and warranties about the package.  That would mean that B of A would have the ideal fraud suit against the seller when the wave of defaults hit.

Second, Bowen would only have two underwriting sampling strategies available to him under this hypothetical scenario.  He could have his team review a substantial portion of the liar’s loans, e.g., a 20% sample.  With a 90% fraud incidence a 20% sample of 1,000 loans would reject 180 of the 200 loans reviewed.

An important technical note needs to be made here.  The 90% fraud incidence in liar’s loans refers solely to the frequency of inflating the borrower’s income by at least five percent.  There would be far more false reps and warranties in a package of liar’s loans than those limited to inflating the borrower’s income.  There would be widespread frauds involving inflated appraisals, failure to disclose piggy back loans, intent to occupy the dwelling as the borrower’s principal residence, and missing, required documentation.  These frauds would, of course, greatly overlap with the 90% incidence of fraud through inflating the borrower’s income.  Bowen’s team could often reject 99% of liar’s loans in our hypothetical loan packages simply on the basis of fraudulent reps and warranties or missing required documentation.  His team would then reject some portion of the 1% of the loans that were not rejected on fraud and documentation grounds as unduly risky even if not fraudulent.

At a 99% rejection rate, with the 20% sample discussed above the number of rejected loans would rise to 198 of 200 loans reviewed.  At this juncture, Bowen would have to end his hypothetical sampling practice of reviewing only 20% of the loans in the package.  If he rejected “only” the 198 loans his staff reviewed and rejected then Citi would be buying 800 loans his team had never reviewed – and the projected rate of rejections from his sampling would predict that 792 of those 800 loans should be rejected.  Note that Bowen and his team would have no way of knowing which 8 super-duper loans in the 800 loans his team had not reviewed he should approve for purchase by Citi.

Bowen’s only remaining choices are to reject the entire package (which is what any honest banker would do) or go to 100% sampling.  Going to 100% sampling for loan packages with rejection rates that should be higher than 90% is not a commercially reasonable option.  It is expensive to conduct high quality due diligence.  The cost of conducting high quality due diligence for 100% of a typical package of liar’s loans would vastly outweigh the benefits of Citi buying a tiny percentage of hypothetical super-duper liar’s loans.  I need to emphasize an important point about the last sentence.  Loan underwriting, viewed from a simplistic accounting perspective, looks like a cost center.  The reality for a lender, or loan purchaser, is that the underwriters are the bank’s most important profit center.  There are ew things in life for a lender that are more expensive than making or buying bad loans.  Bowen was Citi’s single most valuable officer.  Had Citi’s controlling officers wished to for Citi to make money honestly they would have treasured Bowen’s contributions to their leading profit center.

What Citi Actually Did

Instead of the hypothetical scenario of Citi serving as a superb loan underwriter rooting out endemically fraudulent loan originations by bad banks and providing Fannie and Freddie, Citi’s senior managers settled on the opposite strategy.  They sought out fraudulent lenders in order to purchase large amounts of fraudulent liar’s loans that Citi then resold to Fannie and Freddie through fraudulent reps and warranties.  Bowen had to be butchered by Citi’s top officers because he posed a fatal threat to Citi’s fraud strategy.  Citi’s senior officers crafted a fraud strategy that traded on Citi’s former reputation – as exemplified by Bowen – for strong underwriting ability of home loans.

FCIC’s Misses Bowen’s Key Contribution

FCIC neglects the key fact in Bowen’s testimony – Citi was making endemically fraudulent “reps and warranties” that the $50 billion of loans it was selling overwhelmingly to Fannie and Freddie complied with Citi’s “loan guidelines” when in fact the majority of those loans did not comply.  The reasons that the loans did not comply meant that they had a far higher risk of default, and loss upon default, than loans that met Citi’s loan guidelines.  At the 60% figure for the incidence of fraud, that meant that Citi was annually selling $30 billion in toxic mortgages to Fannie and Freddie through fraudulent reps and warranties.  That’s called “fraud.”

Because Citi’s reps and warranties were fraudulent, the borrowers do not have to “default on their loans” before Fannie and Freddie could “force Citi to buy them back.”  Indeed, the civil remedies available to Fannie and Freddie for fraud include punitive damages.  If Fannie and Freddie had been controlled by honest managers they would have used Citi’s endemically fraudulent reps and warranties to force Citi to buy back nearly $100 billion in toxic mortgages no later than early 2007 when house prices were already falling throughout the Nation and the secondary market in nonprime mortgages was about to collapse.  Fannie and Freddie’s demand that Citi repurchase over one hundred billion dollars in toxic mortgages because (by 2007) 80% of Citi’s reps and warranties were false would have immediately tanked the secondary market in nonprime mortgages, further exacerbating the enormous losses Citi would have taken as a result of the buyback.  (I use the 80% incidence of fraudulent Citi reps and warranties rather than the 60% figure FCIC cited in the quotation above because Bowen actually informed FCIC that the incidence of false reps and warranties by Citi rose – after Bowen’s stark warnings to Citi’s top leadership – from 60% to 80 percent by 2007.  It is unclear why FCIC missed this point since Bowen stated expressly on p.2 of his written testimony to the FCIC that “We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.)  Citi’s insolvency would have been obvious and Treasury would have been forced to bail out Citi in early 2007.  None of this happened, of course, because Fannie and Freddie’s leadership was fraudulent and was using the accounting control fraud “recipe” for a purchaser of toxic mortgages to attain the “sure thing” of making themselves wealthy through accounting fraud that triggered reporting huge (but fictional) profits and extreme compensation for Fannie and Freddie’s officers.

Bowen, for obvious reasons in trying to cajole Citi’s unethical managers to do the right thing and end this massive fraud, “stressed to top managers that Citi faced billions of dollars in losses if investors were to demand that Citi repurchase the defective loans,” FCIC has no excuse for stressing that point.  Citi was the fraud perpetrator, not the victim.  Bowen was risking his career because he knew what Citi’s controlling officers were doing was morally wrong and could cause catastrophic harm to the public.

Bowen’s testimony demonstrated conclusively Citi’s senior managers’ response to being put on notice that they were running a massive fraud in excess of $30 billion annually.  The FCIC report chokes on this point.

“Rubin told the Commission in a public hearing in April 2010 that Citibank handled the Bowen matter promptly and effectively. ‘I do recollect this and that either I or somebody else, and I truly do not remember who, but either I or somebody else sent it to the appropriate people, and I do know factually that that was acted on promptly and actions were taken in response to it’” (FCIC 2011: 19).

Rubin’s statement is absolutely, cynically, accurate.  Somebody in Citi’s top leadership team that Rubin carefully does not identify “acted … promptly” “in response” to Bowen daring to put the leadership team on notice that their fraudulent operation was being documented by Bowen’s underwriters.  Here is how they acted:  “Bowen told the Commission that after he alerted management by sending emails, he went from supervising 220 people to supervising only 2, his bonus was reduced, and he was downgraded in his performance review” (FCIC 2011: 19).  It helps to recall that Citi’s leaders destroyed Bowen’s career because he was ethical, competent, and brave and doing exactly what he was supposed to do under Citi’s own (purported) standards.

But that isn’t all that Citi’s top leaders did “in response” to Bowen’s warnings that their massive fraud scheme would eventually bite Citi.  Citi’s top leaders increased the scale of Citi’s fraudulent reps and warranties by both increasing volume and the incidence of false reps and warranties to 80% in accordance with the first two ingredients of the fraud recipe.

‘[T]here was a considerable push to build volumes, to increase market share.’ Indeed, Bowen recalled, Citi began to loosen its own standards during these years up to 2005: specifically, it started to purchase stated-income loans” (FCIC 2011: 19].

It would aid the reader considerably to know five facts that the quoted portion of the FCIC report did not explain.

  • “Stated income” is an euphemism for what the industry called “liar’s” loans because they were endemically fraudulent
  • The incidence of fraud in liar’s loans was 90%
  • It was overwhelmingly lenders and their agents that put the lies in “liar’s” loans
  • As a result of Citi further, and severely, worsening its lending standards the percentage of loans that Bowen’s team’s reviews found to have been sold through false reps and warranties grew to 80% in 2007
  • Only banking leaders engaged in “looting” (aka “accounting control fraud”) would create such fraudulent practices because they are suicidal for the bank (Bowen used the “lemming” metaphor to make this point) while producing the “sure thing” of guaranteed wealth for the controlling officers

Collectively, these five facts provide a strong basis for prosecution.  Juries get it – the senior bankers knew they were directing a loan purchase and resale program that was massively fraudulent and they made that worse in a way that would create large losses for the bank but large bonuses for the officers.  They also retaliated against their SVP who documented the fraud, allowing Citi’s frauds to reach epidemic levels (80%).  Juries understand that honest bankers would not engage in any of these practices.  The excuses that Citi’s and JP Morgan’s leaders gave for making and purchasing vast amounts of liar’s loans (FCIC 2011: 111) are facially preposterous and would make for devastating cross-examination by any competent prosecutor.

FCIC’s Combined Failure to Understand Bowen’s Testimony and Clayton’s Data

There’s an obvious question – why didn’t Citi use Bowen’s team to review the loans it was purchasing before Citi bought them?   What kind of “due diligence” was Citi employing before it bought the loans – and what did Citi’s managers do in response to those “due diligence” findings?  FCIC never asked this obvious question, but it offers data that allows us to understand that the answer is damning for Citi’s managers.  We know that Citigroup hired Clayton – the dominant (and deliberately weak) “due diligence” firm for secondary market sales of residential mortgages.  The FCIC web site includes a selection of Clayton’s “Trending Reports” from 2006-mid-2007 (when the secondary market for nonprime loans collapsed).  Clayton was a contributor to the third epidemic of mortgage fraud that drove the financial crisis – the sale of toxic mortgages to the secondary market through fraudulent reps and warranties.  Clayton’s leaders did one very bright thing, cutting a non-prosecution deal in return for giving prosecutors access to their due diligence reports for secondary market sales.

FCIC had key Clayton “Trending Reports,” but failed to understand their implications.  Citigroup’s Clayton report is a good example of the importance of those implications.  FCIC gives a naïve explanation of the Clayton methodology that demonstrates how completely it was taken in by Clayton’s representatives.

“And, critically: to the degree that a loan was deficient, did it have any “compensating factors” that offset these deficiencies? For example, if a loan had a higher loan-to-value ratio than guidelines called for, did another characteristic such as the borrower’s higher income mitigate that weakness? The due diligence firm would then grade the loan sample and forward the data to its client. Report in hand, the securitizer would negotiate a price for the pool and could “kick out” loans that did not meet the stated guidelines” (FCIC 2011: 166).

Well, no.  The central weakness is that FCIC ignores the fact that the seller made reps and warranties and that even Clayton, which was designed to conduct pathetically weak reviews found that those reps and warranties were lies in nearly half of all loans reviewed.  Nothing “compensates” for lies by the seller – much less endemic lies by the seller.  How many of us would continue to buy from Amazon if half the time they lied to us about what they were going to ship us?

The lenders weren’t making random reps and warranties.  The accuracy of the lenders’ representations was critical as to the risk of loss that the purchaser was taking on by buying the loans.  Honest bank officers have no reason to make false reps and warranties, for doing so pointlessly exposes them to civil liability and prosecution.  The only reason for a lenders’ officers to make a material number of false reps and warranties to a purchaser is avoid revealing widespread loan origination fraud.  Again, nothing can “compensate” for the lenders’ officers trying to deceive the purchaser about widespread loan origination fraud.

The FCIC’s example of legitimate “compensation” is the most (unintentionally) hilarious sentence in the report.

“For example, if a loan had a higher loan-to-value ratio than guidelines called for, did another characteristic such as the borrower’s higher income mitigate that weakness?”

What this would typically mean is that Clayton reviews the appraisal submitted by the lender.  Clayton finds that the lender has fraudulently inflated the value of the home (one of the two great epidemics of loan origination fraud).  Clayton reduces the market value of the home pledged as security for the loan to eliminate (or, more likely, simply reduce somewhat) the inflated value.  At the reduced home valuation the loan violates the lender’s maximum “loan-to-value” (LTV) ratio and the loan should be rejected by Clayton.  But Clayton doesn’t do that.  Instead, Clayton claims that “the borrower’s higher income mitigate[s] that weakness.”  The “weakness” is that the lender has (a) successfully extorted the appraiser to inflate the appraisal (something only a fraudulent bank officer would do) and (b) lied to the secondary market purchaser about the fraud, which materially increases the risk of default and loss upon default.  The overwhelming means that lenders’ officers used to produce borrowers that the lender claimed had “higher income” than the loan requirement was fraudulent liar’s loans.  The FCIC’s example of appropriate “compensation” is a scam in which fraudulent lenders’ officers use one epidemic of loan origination fraud to “compensate” for the other epidemic of loan origination fraud.  FCIC has, unintentionally, exposed the insanity of the “compensation” concept.

It is important to emphasize that the officers conducting the loan purchases wanted Clayton to conduct pathetically weak reviews of small samples of loans and wanted Clayton to find large numbers of fictionally “compensating” characteristics.  The officers controlling the loan purchases could have instructed Clayton to conduct vigorous reviews of large samples of loans and to refuse to purport to compensate for fraudulent reps and warranties by the lender’s officers.  They officers purchasing the loans religiously did not do so.

The purchasers, who purport to be the world’s greatest experts in evaluating credit risk, could also have conducted the reviews in-house.  That would, under their own claims, have produced far superior reviews.  The purchasers could have also refused to buy loan pools composed largely of toxic mortgages – which would have quickly caused the secondary market (premised on endemic fraud) to collapse and would have greatly reduced losses.

Once we cut through the “compensating factors” nonsense, FCIC should have ensured that Clayton provided data that was in a format allowing direct comparisons to what Bowen’s team found so that FCIC could make sounder judgments on the incidence of fraud in loan originations and reps and warranties.  Sadly, FCIC was so effectively conned by Clayton and the bankers that its key chart (FCIC 2011: Figure 9.1, p. 167) removes the data needed to compute the percentage of false representations detected by Clayton that were made to each of  the nine banks (including Citi) listed in the chart.  Clayton could have easily provided the data on the number of false representations made to each of the nine banks, but FCIC appears to have accepted the “compensating factors” scam so uncritically that it never understood the significance of the excluded data and never sought it from Clayton.

The Trending Report, for example shows that for the Q1 2006 Clayton initially rejected 56.7% of the loans in the packages submitted for sale to Citi.  Applying the nationwide average percentage for 2006-mid-2007 that Clayton found for false reps and warranties that Clayton purported to find “compensating factors” for (18%) this yields an estimated total percentage of false reps and warranties detected by Clayton in loans it reviewed for Citi in Q1 2006 of 75 percent.  Given Clayton’s (designed) weaknesses that percentage is extraordinary.  It indicates that Citi must have chosen to purchase its loans from the Nation’s most fraudulent lenders who didn’t even hide their frauds.  Clayton’s “Originator Trending Reports” provided to the FCIC do not permit direct comparisons to the data for Citi.  (FCIC’s “mining” of the treasure that Clayton’s easily available data represented was a critical failure.  If FCIC had accessed Clayton’s data properly we would be far better able to understand how the three great fraud epidemics were perpetrated.)   The (indefensibly sparse and incomplete) originator reports include three notorious fraudulent originators: New Century, Fremont, and Countrywide.  None of them show a Clayton rejection rate for Q1 2006 even remotely close to Citi’s rate for that quarter.  Citi must have buying its loans from originators that made New Century, Fremont, and Countrywide look competent and honest in comparison.

Figure 9.1 does show, however, that the quality of the loan packages that Clayton reviewed for Citi was substantially worse than at the other eight major loan purchasers.  This again indicates that Citi’s senior officers were causing it to selectively buy loans from some of the Nation’s most fraudulent originators of liar’s loans.  Such loans would typically have higher nominal yields and far higher default rates and losses upon default.

For the period 2006-mid-2007, Clayton’s nationwide average finding was that 46% of the reps and warranties were false or unsupported (FCIC 2011: 166).  Clayton’s Trending Reports reveal (but the FCIC does not note) that this incredible percentage rose to 53% by the time the secondary market for nonprime loans collapsed in mid-2007.  As I ask my students at this juncture in the lectures: how many of you would keep buying from Amazon if they lied to you about the quality of the product half the time?

The FCIC report ignores this point and puts its overwhelming emphasis on banks purchasing (waiving in) loans so toxic that even the pathetic Clayton reviews rejected them.  Those waivers are analytically important and add further support for the mutually reinforcing fraud epidemics of the loan originators and secondary market purchases through the “don’t ask; don’t tell” accommodation, but they are far from the headline findings.  In addition to the extraordinary frequency of false reps and warranties – designed to cover up the lenders’ officers’ participation in the two great epidemics of loan origination fraud – the sampling issue is the key takeaway.

As I explained in discussing the hypothetical scenario in which Citi provided exemplary underwriting services to protect Fannie and Freddie from fraudulent lenders, sampling simply does not work for a loan purchaser when there is a substantial fraud incidence – unless the loan purchaser is willing to say no to the entire package.  Note two critical things immediately about the FCIC report on this analytical insight – they do not recognize it and they do not express any surprise that loan purchasers did not routinely refuse to buy loan packages where Clayton found that roughly half the reps and warranties were false.  Indeed, I have been unable to find in the FCIC report any reference to a loan purchaser rejecting the entire loan package because Clayton reported endemic fraud in the package’s reps and warranties.  Instead, there is this bizarre clause in the FCIC report that leads to no analysis:  “In theory, the banks could have refused to buy a loan pool….” (FCIC 2011: 166).  Yes, it is such a bizarre “theor[etical]” possibility that a banker making secondary market purchases might behave honestly that it never happened and isn’t worth analysis!

Bank officers do not gratuitously make endemic false reps and warranties given the legal liability such frauds can create for them.  They make endemic false reps and warranties to cover up their endemic loan origination fraud that ensures that the loans will suffer severe losses as soon as the bubble slows.  Recall also that the loan purchasers in the secondary market purported to be the most skilled evaluators of credit risk in the world.

Consider a hypothetical example that would be realistic for early 2006.  Clayton does a 10% sample of a loan package of 1000 loans and finds that 46% of the reps and warranties are false.

Total loans: 1000                                                                              Sampled loans:   100

False reps:     460 (projected)                                                          False reps found:   46

False reps:     414 (undetected and purchased)

The example shows why sampling cannot address the problem of substantial secondary market loan fraud unless the purchaser is willing to reject the entire loan package.  Clayton looks at 100 loans, finds 46 to be have false reps and warranties and the purchaser rejects those 46 loans.  (That’s an unduly favorable assumption because the purchasers frequently waived the rejections.)  The problem is that the sample projects that a total of roughly 460 of the loans in the package are being sold through false reps and warranties.  But the sampling process has only identified 10% of the loans being sold through false reps and warranties.  Even if the purchaser rejects all 46 of those loans it knows that there are roughly an additional 414 frauds that have gone undetected.  If it simply rejects the 46 loans it will be buying a package that is over 40% fraudulent – a great way of suffering massive losses.  With 10% sampling, 90% of the bad loans that should be rejected would be purchased – and typically resold to others.

The example shows that the entire Clayton “due diligence” process was a sham designed to create the illusion of due diligence.  As employed by the purchasers – who instructed Clayton on how to proceed – the system led to the purchase of millions of fraudulently originated loans that were sold through fraudulent reps and warranties.

The reality was even worse than this hypothetical because by early 2006 sample sizes were often being reduced by the purchasers in order to reduce the number of bad loans rejected and supercharge the accounting control fraud recipe for loan purchasers in the secondary market.

“Only a small portion—as little as 2% to 3%—of the loans in any deal were sampled, and evidence from Clayton shows that a significant number did not meet stated guidelines or have compensating factors. On the loans in the remainder of the mortgage pool that were not sampled (as much as 97% (sic)), Clayton and the securitizers had no information, but one could reasonably expect them to have many of the same deficiencies, and at the same rate, as the sampled loans. Prospectuses for the ultimate investors in the mortgage-backed securities did not contain this information, or information on how few loans were reviewed, raising the question of whether the disclosures were materially misleading, in violation of the securities laws” (FCIC 2011: 169-170, emphasis added).

The clause that I have highlighted demonstrates that FCIC knew that loan sampling was a sham.  With 2% sampling 98% of the toxic loans that should have been rejected would instead be purchased and resold to “the ultimate investors” with no warnings that they were buying toxic waste.  My second hypothetical shows the combined effect of 2% sampling and the 80% false reps and warranties rate that Bowen’s team found at Citi in 2007.

Total loans: 1000                                                                              Sampled loans:     20

False reps:     800 (projected)                                                          False reps found:   16

False reps:     784 (undetected and sold to Fannie & Freddie)

Bowen testified that Citi went to 2% sampling in 2006, violating its own underwriting rules.

“Another part of Bowen’s charge was to supervise the purchase of roughly $50 billion annually in prime loan pools, a high percentage of which were sold to Fannie Mae and Freddie Mac for securitization. The sampling provided to Bowen’s staff for quality control was supposed to include at least 5% of the loan pool for a given securitization, but ‘this corporate mandate was usually ignored.’ Samples of 2% were more likely, and the loan samples that Bowen’s group did examine showed extremely high rates of noncompliance. ‘At the time that I became involved, which was early to mid-2006, we identified that 40 to 60 percent of the files either had a ‘disagree’ decision, or they were missing critical documents’” (FCIC 2011: 168).

This passage further demonstrates FCIC’s analytical incoherence about the secondary market fraud epidemic.  The first key point is that Citi’s managers’ sampling decision ensured that Bowen’s teams’ highly competent efforts were useless.  They were effectively forbidden from identifying more than 2% of the specific loans that were fraudulently originated and sold to Citi through fraudulent reps and warranties.  That meant that Citi would resell to Fannie and Freddie the overwhelming majority of the toxic loans it purchased from the fraudulent originators.  Honest bankers, of course, would halt not only their sales to Fannie and Freddie in this situation, but also cease all purchases from the loan originators that sold them such toxic product.  Instead, Citi’s senior managers pushed for increased volume despite Bowen’s stark warnings.

The second key point is that the FCIC passage is logically inconsistent.  It says that Bowen’s underwriting team found, in 2006, that 40-60% of Citi’s reps and warranties to Fannie and Freddie were false or unsupported by essential documentation.  That figure rose to 80 percent by 2007.  FCIC says that Bowen found this overwhelming fraud in Citi’s purchases of “prime loan pools.”  This is impossible unless Citi was selectively buying its “prime loan pools” from the most audacious of the fraudulent lenders who routinely engaged in false disclosures concerning their rampant appraisal fraud, piggy back loans, and borrowers’ occupancy representations.  While those three forms of fraud were depressingly common, in prime loans they should not have come remotely near an 80% incidence.  What is likely going on is that Citi called liar’s loans “prime loans” and FCIC was so credulous that it accepted this false classification.

There were only two ways to prevent this process from causing a catastrophe, both of which I’ve discussed.  The secondary market purchasers like Citi could have gone to 100% sampling, but that would have destroyed the market in toxic mortgages for two reasons.  It would have been too expensive to conduct real, complete due diligence, particularly given the staggering rejection rate this would have produced for liar’s loans.

Conducting 100% sampling would also have been too revealing.  What if it became public that Bowen’s due diligence found an 80% incidence of false reps and warranties?  What if Bowen had peers at the banks making the enormous loan purchases who shared his courage and competence and they too found an 80% fraud incidence?  The financial version of “don’t ask; don’t tell” on which roughly half of the secondary market depended would have collapsed as the Bowens of the world asked and told the truth.  The lenders originating the fraudulent liar’s loans would have choked on their toxic loans that they could no longer sell.  They would have collapsed within months.  This is, of course, what “private market discipline” is supposed to do to cleanse markets of fraud.  If it does not do so markets become dominated by fraud through the Gresham’s dynamic in which bad ethics drives good ethics from the markets.

The only other way to prevent a catastrophe would be to conduct limited sampling and reject the entire loan package if there were any material fraud in the sample.  That too would have caused the secondary market in toxic mortgages to collapse as the fraudulent lenders choked on their toxic mortgages and failed within months.

The sampling problem was compounded in Citi’s case by three factors that arose because its officers intended to resell the fraudulent loans to Fannie and Freddie.  First, if they told Fannie and Freddie that the loan package Citi was selling had over 40% (much less 80%) fraudulently originated loans in it Fannie and Freddie’s officers would not buy the package of toxic loans.  Citi’s honest disclosures would have destroyed the “don’t ask; don’t tell” de facto deal that made it possible for the officers of the lenders and the officers of the loan purchasers to pursue mutually their fraud recipes by pretending that the toxic mortgages were pristine assets.

Citi’s senior officers decided on a fraud strategy.  Though they knew from Bowen’s team that the loans there were selling Fannie and Freddie were not “prime loan pools” but rather endemically fraudulent, they deliberately disclosed none of these facts to Fannie and Freddie.

“Citigroup’s Bowen criticized the extent of information provided on loan pools: “There was no disclosure made to the investors with regard to the quality of the files they were purchasing” (FCIC 2011: 169).

Second, Citi employed Bowen and his team of competent due diligence specialists.  Unlike Clayton, which was hired to give substantially inflated grades to toxic loans, Bowen’s team found not a 46% incidence of fraudulent reps and warranties by Citi, but an 80% incidence.  This means that Fannie and Freddie have a golden lawsuit against Citi for fraud and DOJ has a great criminal case against Citi’s leadership.  Citi’s senior leaders could not know in 2006 that Holder would become Attorney General and exempt them and their peers at other banks from the criminal laws.

Third, because Citi’s senior officers could not successfully buy, bully, or bamboozle Bowen their only remaining option (other than honesty) was to butcher Bowen’s career.  Butchering Bowen would provide Fannie and Freddie, DOJ, and the SEC with the perfect witness.  It would also provide them with the perfect consultant who could explain how the loan origination and secondary market frauds occurred.  My second column in this series expands on this point.

FCIC’s unwillingness to call a fraud a fraud (when it came to elite banks and bankers) is exemplified in this sentence that I quoted above.

“Prospectuses for the ultimate investors in the mortgage-backed securities did not contain this information, or information on how few loans were reviewed, raising the question of whether the disclosures were materially misleading, in violation of the securities laws” (FCIC 2011: 170).

Recall the context of the statement was that Citi went to 2% sampling of loans with an 80% incidence of false or unsupported reps and warranties so that it would not find 98% of the false or unsupported reps and warranties.  It then sold those endemically toxic mortgages to Fannie and Freddie without any meaningful disclosures of these facts.  FCIC thinks this “rais[es] the question of whether the disclosures were materially misleading.”  Let’s see, how may purchasers would want to know that the seller knew that 80% of the reps and warranties it made about the quality of the loans were false?  The FCIC report choked when it came to elite frauds.


Stop and consider how devastating these observations are for neo-classical dogmas about market choice, private market discipline, and efficient markets.  Pervasive accounting control fraud makes financial markets and their fraudulent participants perform in a manner that falsifies every modern finance dogma and can cause catastrophic harm.  No one can predict when “don’t ask; don’t tell” will collapse – but it will collapse and the result will be the complete collapse of major financial markets.  After lasting for a decade, and becoming increasingly worse at an accelerating rate as liar’s loans exploded in 2003-2007, the secondary market in nonprime loans collapsed in mid-2007.  Lenders that specialized in making subprime liar’s loans began failing in 2006.  By 2007, there was a financial holocaust with mortgage banks that made large numbers of liar’s loans failing at the rate of roughly two per week.  Federally insured lenders that specialized in making liar’s loans lasted a little longer because they could raise liquidity through deposits, but they were doomed.  Bear, Lehman, and Merrill were all doomed.  Because of their famous names they were able to delay their collapse by borrowing large amounts of money that they could never repay.  The Fed and the Treasury’s dogmatic decision to allow Lehman to fail in a chaotic manner sparked a global recognition of the financial disaster wrought by the three great epidemics of accounting control fraud.  As financial institutions’ officers began to see the scope, and concentration of the losses bringing down many massive financial firms within days they no longer trusted their counterparties’ asset valuations and hundreds of financial markets ceased trading.

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