Two Sentences that Explain the Crisis and How Easy it Was to Avoid

By William K. Black

Everyone should read and understand the implications of these two sentences from the 2011 report of the Financial Crisis Inquiry Commission (FCIC).

“From 2000 to 2007, [appraisers] ultimately delivered to Washington officials a petition; signed by 11,000 appraisers…it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18).

Those two sentences tell us more about the crisis’ cause, and how easy it was to prevent, than all the books published about the crisis – combined.  Here are ten key implications.

1. The lenders are extorting the appraisers to inflate the appraisal.
2. No honest lender would inflate an appraisal, the lender’s great protection from loss.
3. The lenders were overwhelmingly the source of mortgage fraud.
4. The lenders were not only fraudulent, but following the “recipe” for ”accounting control fraud.”  They were deliberately making enormous numbers of bad loans.
5. This had to be done with the knowledge of the bank CEOs.  One of the wonderful things about being a CEO is the ability to communicate to employees and agents without leaving an incriminating paper trail.  Sophisticated CEOs running large accounting control frauds can use compensation and business and personnel decisions to send three key messages:  (a) you will make a lot of money if you report exceptional results, (b) I don’t care whether the reports are true or the results of fraud, and (c) if you do not report exceptional results or if you block loans from being approved by insisting on effective underwriting and honest appraisals you will suffer and your efforts will be overruled.  The appraisers’ petition was done over the course of seven years.  Even if we assumed, contrary to fact, that the CEO did not originate the plan to inflate the appraisals the CEOs knew that they were making enormous numbers of fraudulent “liar’s” loans with fraudulent appraisals.  It is easy for a CEO to stop pervasive fraudulent lending and appraisals.  Where appraisal fraud was common it was done with the CEO’s support.
6. Fraudulent loan origination creates a “Gresham’s” dynamic (bad ethics drives good ethics from the marketplace or profession because cheaters prosper) will be created among lenders.   The CEO of lenders that follow the fraud “recipe” can count on three “sure things.”  The lender will report exceptional income in the near term.  The controlling officers will promptly be made wealthy by modern executive compensation.  The lender will (later) suffer severe losses.  The controlling officers of honest lenders will report far lower income and receive far less compensation.  The CFO will rightly fear losing his job.  This turns market forces perverse and makes accounting control fraud surge.
7. The Gresham’s dynamic and the fraud “recipe” cause an enormous expansion in bad loans.  This can hyper-inflate a financial bubble.  As a bubble grows the fraud recipe becomes even more wealth-maximizing for unethical senior officers.  The trade has a saying that explains why bubbles are so criminogenic – “a rolling loan gathers no loss.”  The fraudulent lenders refinance their bad loans and report (fictional) profits.
8. Once fraudulent loans are fraudulently originated they cannot be cured.  There is no loan exorcist.  All subsequent sales of the mortgage (or cash flows from the mortgage) in the secondary market will require additional fraud and will transfer bad assets with a greatly increased risk of loss.  (Not every fraudulently originated mortgage loan will default and suffer loss, but a portfolio of such loans has such a greatly increased risk of loss that the portfolio will have a negative expected value.)  Liar’s loans do not “become” bad; they are endemically fraudulent when they are originated and mortgage loans made on the basis of deliberately inflated appraisals are always fraudulent.  Only accounting fraud, failing to provide appropriate allowance for loan and lease losses (ALLL) at the time the loans are made, can produce the fictional income that drives the fraud scheme.
9. The Gresham’s dynamic that causes us the most wrenching pain as regulators is the one that the officers controlling the fraudulent lenders deliberately created among appraisers.  They created the blacklist to extort the most honest appraisers.  The fraudulent lenders, of course, do not have to successfully suborn every appraiser or even most appraisers in order to optimize their frauds.  A fairly small minority of suborned appraisers can provide all the inflated appraisals required.  The honest appraisers will lose a great deal of income and many will be driven out of the profession by the lost income or because the degradation of their profession disgusts them.  These non-wealthy professionals, the ethical appraisers, were injured by the fraudulent CEOs because the appraisers knowingly chose honesty over maximizing their incomes.  The CEOs of the lenders and the officers and agents they induced (by a combination of de facto bribery and extortion) to assist their frauds chose to maximize their incomes through fraud.
10. The U.S. government did nothing in response to the appraisers’ petition warning about the black list of honest appraisers.  The federal banking agencies’ anti-regulatory leaders’ hatred of effective regulators caused them to do nothing in response to the appraisers’ petition.  The anti-regulators did nothing for years, as the number of appraisers signing the petition grew by the thousands and surveys and investigations confirmed their warnings about lenders extorting appraisers to inflate appraisals.  The appraisers put the anti-regulators on notice about the fraud epidemic for seven years beginning in 2000.