Creating Effective Regulation is the Imperative Issue at the Federal Reserve

By William K. Black
(Cross posted at Benzinga.com)

The only positive aspect of the public contest to pick a successor for Ben Bernanke that the White House has inexplicably sparked is that economists are acknowledging that the next head of the Fed must act to create (not “restore”) effective regulation by the agency.  It is long past time to have a serious discussion about the collapse of regulation by the Fed.  In this column I make the first of what will become four points.  First, the consequences of the Fed’s regulatory collapse have proven catastrophic for our Nation.  Second, the Fed’s supervisory structure inherently creates a conflict of interest identical to the one that existed in the Savings and Loan (S&L) debacle until Congress and the President decided the conflict was intolerable and eliminated it in 1989.  Third, the supervisory culture of the Fed ensures recurrent supervisory failure – and the Fed’s economists are largely responsible for these failures.  Fourth, the Fed’s economists’ dogmas and ignorance of fraud mechanisms have combined to create to create intensely criminogenic environments.  The Fed does not simply fail to prevent the epidemics  of control fraud that cause our recurrent, intensifying financial crises – its policies are so perverse that they aid the fraud epidemics.

Absent the Fed’s Supervisory Collapse There Would Have No Crisis

The world would be a vastly better place had the Fed been run by competent regulators.  There would have been no hyper-inflated bubble, no financial crisis and no Great Recession.  This is not a heroic hypothetical.  We know how competent financial regulators reacted to a growing practice of savings and loans (S&Ls) making endemically fraudulent “low” and “no” “doc” loans in 1990-1991.  We know how competent regulators reacted to growing appraisal fraud by S&Ls in the early-to-mid 1980s.  The examiners of the West Region of the Office of Thrift Supervision (OTS) identified a new, dangerous practice known as “no” or “low” “doc” (documentation) loans.  Our examiners realized that such loans inherently produced severe “adverse selection” and that the inevitable consequence was that such loans had a “negative expected value” (in plain English that means that the lender would invariably lose money).  Our examiners also realized that this meant that no honest lender would make such loans – but that the officers leading “accounting control frauds” would find such loans to be the optimal fraud “ammunition.”  OTS was in the middle of stopping an epidemic of accounting control fraud (largely based on making fraudulent commercial real estate loans) in 1990-1991, so the “no doc” loans represented a “second front.”  Nevertheless, the OTS West Region diverted some of its already overwhelmed resources to address the “no doc” loans before they could become epidemic.  By 1991, we had substantially driven such loans out of the industry.

Similarly, the S&L regulators recognized immediately the implications of widespread appraisal fraud.  Only lenders and their agents can induce widespread appraisal fraud.  Honest lenders can prevent widespread appraisal fraud by well proven means that the industry has perfected for many decades.  Only a fraudulent lender would inflate appraisals, for the appraisal is the great protection from loss for an honest lender.  The officers leading an accounting control fraud, however, often find it optimal to inflate the appraisal.  This means that appraisal fraud represents a superb “signal” of the presence of accounting control fraud.  The S&L regulators worked closely with honest appraisers to identify and prevent appraisal fraud.  We prioritized any S&L with widespread inflated appraisals for intense examination designed to identify and document the broader loan fraud.

The Fed had immense advantages compared to the S&L regulators during the debacle.  By the early part of the decade of the 2000s the industry called its endemically fraudulent “no doc” loans “liar’s loans.”  This was equivalent to the mortgage lenders placing a giant blinking red neon sign in front of the Fed saying “stop us before we steal again.”  They had the advantage of our experience and analytics.  They did not have to reinvent any wheels or engage in the trial and error practices we used to learn how to counter epidemics of accounting control fraud employing liar’s loans and inflated appraisals.

The Fed received repeated warnings that had no analog during the S&L debacle.

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

Consider how early that warning came – 2000 – before the Enron-era collapses began.  The warning is also unambiguous.  It is a clear, widespread fraud by lenders that only makes sense if the officers controlling the lender are engaged in an underlying practice of making widespread fraudulent loans.  The appraisers aggressively took the warning contained in their steadily growing petition to the public, the lending industry, and Congress and the regulatory agencies.

In September 2004, the FBI sounded its own alarm.  It warned that mortgage fraud was becoming “epidemic” and predicted that it would cause a financial “crisis” if it were not contained.

In early 2006, the mortgage lending industry’s own anti-fraud experts (MARI) issued its famous five warnings that were sent in writing to every significant home lender.

“[1] Stated income and reduced documentation loans … are open invitations to fraudsters.  [2] It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.

[3] One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. [4] These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.”

[5] Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans.”

The fifth warning demonstrates that the Fed understood that liar’s loans endangered the safety of lenders.  In fact, Federal Reserve Member Gramlich famously warned Fed Chairman Alan Greenspan of his concerns about nonprime loans early in the 2000s and urged Greenspan to send the Fed’s examiners into the bank holding company affiliates that were making enormous amounts of nonprime loans to find the facts about the extent of the risk such lending was creating.  Greenspan refused to send in the examiners and took no effective action against nonprime lending.  As I noted, the HOEPA hearings that Congress mandated that the Fed conduct also led to over a dozen explicit warnings about nonprime lending being endemically fraudulent and predatory.  Greenspan and Bernanke refused to act in response to these warnings.

The Fed’s supervisory leaders used their very limited internal political capital to convince the Fed’s leadership to allow them to brief the board on critical supervisory concerns.  In both cases the supervisors warned the Fed about likely fraud by many of the Nation’s largest banks. The first case occurred when Enron’s bankruptcy examiner documented that the banks aided and abetted Enron’s frauds involving its special purpose vehicles (SPVs) and the second resulted from the Fed’s supervisors, blocked by Greenspan from using their examiners to get the facts, simply sent a letter to the largest banks asking for data on their nonprime lending.  Banks rarely provide the full scope of the problem in response to such a letter inquiry, but the numbers the banks did provide were horrific.  The Nation’s largest banks were frequently making massive amounts of liar’s loans and the rate of growth in such loans was stunning.  In both cases the Fed’s leadership was enraged by the supervisory briefing – at their supervisors – for daring to criticize the largest banks.

In 2000-2007, the Fed was not overwhelmed by a crisis and did not suddenly have to divert resources to counter a “second front.”  The Fed had vastly greater resources than we did and they had a means of preventing the crisis.  The Fed had explicit statutory authority to adopt a rule that would have immediately stopped the epidemic of fraudulent liar’s loans.  The Home Ownership and Equity Protection Act of 1994 (HOEPA) gave the Fed unique authority to ban all liar’s loans by lenders even if they did not have deposit insurance and were otherwise not subject to federal regulation.  The Fed had many allies urging it to stop the epidemic of fraudulent liar’s loans.  Congress mandated that the Fed conduct hearings on HOEPA that produced overwhelming evidence, including from the leader of an association of honest loan brokers, of widespread fraud and predation by lenders.  As S&L regulators, we had no allies when we were vilified for reregulating the industry.

The home lending industry and the secondary market ignored the warnings of the twin barrels of endemic mortgage loan origination fraud (appraisal and liar’s loans) and increased the origination of liar’s loans by over 500% from 2003 to 2006.  By 2006, half of all the loans originated that year that the industry called “subprime” loans were also liar’s loans (the categories are not mutually exclusive).  Consider how crazy that would be for an honest lender – making loans to borrowers with known bad credit histories that the lenders knew were exceptionally likely to have grossly inflated reported borrower’s income and appraised values.  Loans that met that trifecta of terribleness, however, were ideal means of making the fraudulent officers controlling such lenders wealthy.  Roughly 40% of all home loans originated in 2006 were liar’s loans (the comparable figure for the UK that year was 45%).  That means that, at a fraud incidence of 90%, over two million fraudulent liar’s loans were originated in the U.S. in 2006.  The loans that hyper-inflated the residential real estate bubbles in the U.S. in 2003-2006 were overwhelmingly fraudulent liar’s loans.  Fraudulent loans are particularly likely to default and cause larger losses.

There was no fraud exorcist.  Once the fraudulent loans were originated they could only be sold to the secondary market through fraudulent “reps and warranties.”  It was inherent in the structure of the secondary market that the frauds had to propagate throughout the chain of transactions.  So many of the purchasers of fraudulent mortgages were themselves accounting control fraud that the secondary market became dominated by the financial version of “don’t ask; don’t tell.”

The Fed, and only the Fed, could have stopped all these epidemics of accounting control frauds in their tracks within weeks by issuing an emergency rule under HOEPA banning the origination of liar’s loans.  The Fed was urged repeatedly to do so.  It refused to do so until July 14, 2008 when Ben Bernanke, finally caving in to intense congressional pressure, finally adopted a rule under HOEPA banning liar’s loans.  Even then, Bernanke delayed the rule’s effective date by 15 months lest he inconvenience any surviving fraudulent lenders.

We can measure the cost of the Fed’s refusal to ban liar’s loans and prevent the crisis.  The wealth loss to U.S. households was $11 trillion.  Over 10 million Americans lost their existing jobs or jobs that the economy would have created but for being forced into the Great Recession.  All the monetary policy mistakes the Fed has made since the Great Depression pale in comparison to the catastrophe Bernanke and Greenspan caused through their refusal to stop the fraud epidemics.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @williamkblack