Lenders’ Lies about Liar’s Loans and “Rigorous Underwriting”

William K. Black
February 2, 2016     Bloomington, MN

It is time to break out one of our two family rules again – it is impossible to compete with unintentional self-parody.  How fraudulent is finance even now?  The Wall Street Journal reports that “big money managers” want to bring back “liar’s loans.”  I am trying to write much shorter columns, so there will be many columns in this series because the WSJ article so beautifully exemplifies the lies that the industry and the media told about liar’s loans before and after 2008.

Spoiler alert:  liar’s loans, as the name admits, are pervasively fraudulent.  Only fraudulent lenders make liar’s loans as a regular business practice.  These home loans make the officers wealthy through the “sure thing” of the “fraud recipe” for “accounting control fraud.” The WSJ, of course, ignores these facts and presents instead falsehoods provided by fraudulent officers.

This column addresses only the lie that invokes our family rule:  “The money managers think that risk is manageable with rigorous underwriting [of liar’s loans]….”  If this were written for The Onion it would have been a stellar example of irony.  Instead, it is an oxymoronic fable devised by someone who things that WSJ reporters and their readers are regular morons.  Because the reporter regurgitated such a clumsy lie about liar’s loans as if it were a great truth, we know that the “big money managers” proved correct about the reporter.

The definition of a liar’s loan is that it is designed for the purpose of avoiding not simply “rigorous” underwriting, but rather the most minimal underwriting any property lender must do to have any chance of surviving.  Yes, “rigorous underwriting” is the absolute essential to managing risk in property lending.  Yes, in the case of conventional home lending, rigorous underwriting can reduce credit risk to tiny proportions.  One of the “Four C’s” of minimally competent underwriting for such loans is “Capacity.”  That means that the lender, must at a minimum, verify that the borrower has adequate income to repay the home loan.

The definition of liar’s loan is that the lender does not verify the borrower’s income (and more extreme liar’s loans do not verify the borrower’s job or assets).  The CEO causes the lender to make liar’s loans for the purpose of inflating the borrower’s reported income, which makes it possible for the lender to make more and larger loans, which enriches the CEO.

The failure to verify the borrower’s income produces massive fraud and what economists call “adverse selection.”  As a result, at the time the loans are made, they represent in economic reality a loss.  The loans have a “negative expected value” at the time they are made.  This exemplifies the great truth that the WSJ cannot seem to comprehend – underwriting appears to the ignorant to be a cost center for a home lender, but it is actually an honest bank’s most important profit center.  Proper GAAP accounting would require the lenders making liar’s loans to report at the time they made the loans that they produced a net loss, but one key to the frauds is for the lender’s controlling officer to set aside only pathetically inadequate “allowances for loan and lease losses” (ALLL).  The officers that control the lender know that the fraud “recipe” produces three “sure things.”  The lender will promptly report record profits, the officers will be made wealthy through modern executive compensation, and the lender will ultimately suffer catastrophic losses.

5 Responses to Lenders’ Lies about Liar’s Loans and “Rigorous Underwriting”

  1. Robert Ferraro

    Thanks for the shorter articles. This should help the excellent analysis reach a wider audience.

  2. I have been helping homeowners fight foreclosures for 7 years, trying to get their predatory loans modifiedand now Fannie Mae as the investor is using “federal Preemption” to deny homeowners due process.

    • Elaine Williams

      Bless you Keith Tierney – but it’s all in vain. A predatory loan will NEVER get or be modified because they really don’t even have standing to foreclosure. You should know that by now. You can’t modify a debt you don’t own. They won’t work with you because if they do it will expose the underlying fraud.

  3. Bill Black, you have just described what is happening in the Canadian mortgage market right now:

    “Earlier this year, Home Capital Group Inc., the country’s largest alternative mortgage lender, revealed it had cut ties with 45 mortgage brokers after an anonymous letter to the company’s board of directors sparked an investigation into forged documents, such as fake employment letters and income statements. Collectively, the brokers who were fired generated nearly $1-billion worth of mortgages for the company last year.

    While scandals such as the one at Home Capital occasionally shed light on the dark side of Canada’s $1.3-trillion mortgage industry, much of the problem of mortgage fraud remains hidden from public view.” ( from http://www.theglobeandmail.com/report-on-business/economy/housing/mortgage-fraud-on-the-rise-among-brokers-trying-to-help-clients-qualify/article27051297/ )

    In Vancouver, dinky, shabby little houses are selling for $2.4 million because the land is desired for building some monstrosity of a house. (See: http://www.huffingtonpost.ca/2016/01/29/point-grey-teardown_n_9115958.html )

    I guess we are going to have a burst bubble in the near future.

    Can’t human beings learn that fraud leads to disaster, not for the fraudsters, but the victims?

  4. Liar loans were permitted by Ronald Reagan and both parties which passed the St Germain Depository Act in 1982. The loans were intended for rich people with uneven income. However, one wonders if the plan to introduce them to the masses was always the goal of the Thatcherites. Big finance in the UK was behind liar loans, called self certified loans in the UK, where they were born.

    The FIRREA Act in 1989 was passed after the S&L crisis to make it illegal, with civil penalties, to loan money to people who could not afford to pay it back. Needless to say W Bush ignored the law, as the housing bubble and crash happened on his watch. It was made worse by tight money from the Fed, as NGDP was dropping while inflation held steady. But still, liar loans should not be legally applied to those who cannot pay them back.