01 | July | 2009 | New Economic Perspectives

By William K. Black (Via Huffington Post)

As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an “epidemic” of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds.* When the person that controls a seemingly legitimate business or government agency uses it as a “weapon” to defraud we categorize it as a “control fraud” (“The Organization as ‘Weapon’ in White Collar Crime.” Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds’ “weapon of choice” is accounting. Control frauds cause greater financial losses than all other forms of property crime — combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a “criminogenic environment” (Big Money Crime. Calavita, Pontell & Tillman 1997.)

The FBI correctly identified the epidemic of mortgage control fraud at such an early point that the financial crisis could have been averted had the Bush administration acted with even minimal competence. To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud.

Don’t ask; don’t tell: book profits, “earn” bonuses and closet your losses
The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages “underlying” the derivative. A senior manager sends a blistering reply with this forceful punctuation:

“Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.”

Fraud is the principal credit risk of nonprime mortgage lending. It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, “most investors” (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The “AAA” rating is supposed to indicate that there is virtually no credit risk — the risk is equivalent to U.S. government bonds, which finance refers to as “risk-free.” We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this era rises like a stairway to heaven [PDF]. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud.

Worse, the S&P document demonstrates that the investment and commercial banks that purchased nonprime loans, pooled them to create financial derivatives, and sold them to others engaged in the same willful blindness. They did not review samples of loan files because doing so would have exposed the toxic nature of the assets they were buying and selling. The entire business was premised on a massive lie — that fraudulent, toxic nonprime mortgage loans were virtually risk-free. The lie was so blatant that the banks even pooled loans that were known in the trade as “liar’s loans” and obtained AAA ratings despite FBI warnings that mortgage fraud was “epidemic.” The supposedly most financially sophisticated entities in the world — in the core of their expertise, evaluating credit risk — did not undertake the most basic and essential step to evaluate the most dangerous credit risk. They did not review the loan files. In the short and intermediate-term this optimized their accounting fraud but it was also certain to destroy the corporation if it purchased or retained significant nonprime paper.

Stress this: stress tests are useless against the nonprime problems

What commentators have missed is that the big banks often do not have the vital nonprime loan files now. That means that neither they nor the Treasury know their asset quality. It also means that Geithner’s “stress tests” can’t “test” assets when they don’t have the essential information to “stress.” No files means the vital data are unavailable, which means no meaningful stress tests are possible of the nonprime assets that are causing the greatest losses.

The results were disconcerting

A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch’s report on what they found.

“Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.
[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools. “

Fitch also explained [PDF] why these forms of mortgage fraud cause severe losses.

“For example, for an origination program that relies on owner occupancy to offset other risk factors, a borrower fraudulently stating its intent to occupy will dramatically alter the probability of the loan defaulting. When this scenario happens with a borrower who purchased the property as a short-term investment, based on the anticipation that the value would increase, the layering of risk is greatly multiplied. If the same borrower also misrepresented his income, and cannot afford to pay the loan unless he successfully sells the property, the loan will almost certainly default and result in a loss, as there is no type of loss mitigation, including modification, which can rectify these issues.”

The widespread claim that nonprime loan originators that sold their loans caused the crisis because they “had no skin in the game” ignores the fundamental causes. The ultra sophisticated buyers knew the originators had no skin in the game. Neoclassical economics and finance predicts that because they know that the nonprime originators have perverse incentives to sell them toxic loans they will take particular care in their due diligence to detect and block any such sales. They assuredly would never buy assets that the trade openly labeled as fraudulent, after receiving FBI warnings of a fraud epidemic, without the taking exceptional due diligence precautions. The rating agencies’ concerns for their reputations would make them even more cautious. Real markets, however, became perverse — “due diligence” and “private market discipline” became oxymoronic. These two documents are enough to begin to understand:

the FBI accurately described mortgage fraud as “epidemic”
nonprime lenders are overwhelmingly responsible for the epidemic
the fraud was so endemic that it would have been easy to spot if anyone looked
the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a “don’t ask; don’t tell” policy
willful blindness was essential to originate, sell, pool and resell the loans
willful blindness was the pretext for not posting loss reserves
both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed
the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses
the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation
many of the big banks are deeply insolvent due to severe credit losses
those big banks and Treasury don’t know how insolvent they are because they didn’t even have the loan files
a “stress test” can’t remedy the banks’ problem — they do not have the loan files

* “Mortgage Fraud: Strengthening Federal and State Mortgage Fraud Prevention Efforts” (2007). Tenth Periodic Case Report to the Mortgage Bankers Association, produced by MARI.

by L. Randall Wray

As everyone knows, California’s state budget is in dire straits. Unlike the federal government, US state governments really do finance their spending through a combination of tax revenues and borrowing. They are users of the nation’s currency (the dollar), not issuers. The current recession (or depression) has caused their tax revenues to collapse. Their projected budget deficits cause ratings agencies to downgrade their debt—making it too expensive to borrow as this sets off a vicious cycle of further downgrades and ever rising interest rates.

However, California might have discovered a solution. Why not become sovereign? (As a native Californian, I can recall the 1960s pipedream of secession of northern California along with Oregon and Washington to create a utopian, green, peaceful nation—but that is another matter.) As reported this morning by Jim Christie:

“California prepared on Tuesday to resort to issuing IOUs as the giant but cash-strapped U.S. state struggled to approve a new budget in time for the new fiscal year that begins on Wednesday. The IOUs, which are notes promising payment to vendors and local agencies, or shutting down some public services, are among measures that California and other states may have to rely on as they contend with staggering budget gaps caused by the U.S. recession.”

That could be a step in the right direction, but it is still borrowing. Here is a suggested improvement. The state should announce a new currency, the California Dollar. Henceforth, the California Dollar will be accepted in all payments made to the Great State of California (fees, fines, and taxes, including payments made by students to the state’s public universities). The state, in turn, will begin to make a portion of its payments in the form of California Dollars. Of course, no one can actually make payments in the form of California Dollars until the state has actually spent some into existence. State payments using California Dollars will be made, as described above, to “vendors and local agencies”. Over time the state can negotiate with others, including employees, to pay out California Dollars. Note that the state will run deficits in California Dollars only to the extent that the population wants to accumulate those Dollars (in excess of the fees, fines, and taxes paid).

Some readers might worry about anti-counterfeiting laws. So far as I understand it, the California Dollar would be treated like the “local currency” systems already in operation around the nation. In the beginning, California will probably value the California Dollar at par against the US dollar. However, it should not promise to convert the California Dollar on demand since that could lead to insolvency (after all, California’s current problem is that it cannot get enough US dollars to cover its spending). The California Dollar would be freely convertible in private exchanges, however—at a floating rate. Exchange rates are very complexly determined and I would not want to predict how the California Dollar will do over the next few years. However, since this proposal would allow California to halt the “Little Hoover” downward spiral occurring in states all across the country, I expect its new Dollar would do pretty well.

Who knows, maybe Arnold—not Obama–is the next FDR?