To prepare myself for a guest lecture to a class at the University of Kansas I did some research about the House Financial Services Committee, now chaired by Jeb Hensarling (R. TX). I was pleased to learn that the Committee’s home page emphasizes the key role that accounting control fraud played at Fannie and Freddie. The home page has a “spotlight” section designed to draw the reader’s eye to a short series of documents designed to support passage of the Protecting American Taxpayers and Homeowners (PATH) Act, which focuses on eliminating Fannie and Freddie. The documents largely stress that Fannie and Freddie were accounting control frauds.
Hensarling explains that TBTF bank CEOs have an incentive to commit control fraud
Hensarling posted his August 13, 2013 keynote address at the George W. Bush Presidential Center. His central argument is that “Washington promoted moral hazard by protecting Fannie Mae and Freddie Mac, which privatized profits and socialized losses.”
That last clause is accurate. Fannie and Freddie had no explicit government guarantees and they were entirely privately owned. Their gains went partly to home purchasers, but largely to Fannie and Freddie’s shareholders and senior officers. The moral hazard arises from the fact that Fannie and Freddie’s size made them systemically dangerous institutions (SDIs). Moral hazard can lead to either control fraud or “gambling for resurrection.”
Prior to the crisis, America’s SDIs were all private. They consisted of roughly the 20 largest banks, AIG, GMAC, GE, and Fannie and Freddie. Each of these institutions had an implicit federal subsidy that economic theory claims generates serious moral hazard that can induce widespread accounting control fraud and/or extremely high risk gambles. The definition of an SDI is that the administration fears that their unconstrained failure could cause a global systemic crisis.
Every administration since the 1970s has treated the SDIs as “too big to fail” (TBTF). That phrase is misleading. It does not mean that the banks did not fail. In a constrained failure the government ensures that the SDI’s general creditors do not suffer losses lest their losses cause “cascade failures” that devastate the financial system. The sole exception to this policy was the Bush administration’s allowing Lehman to collapse in an unconstrained fashion. That was a deliberate policy change in response to the vitriolic criticism that the Bush administration received from theoclassical economists for preventing the unconstrained failure of Bear Stearns. Lehman’s unconstrained financial collapse did not “cause” the financial crisis, but it triggered a staggering series of cascade failures and the collapse of hundreds of markets.
“Washington” did not make Fannie and Freddie into SDIs. Their CEOs did that by causing them over several decades to grow enormously. “Washington” did make them “privatized” – which is what made their CEOs’ incentives so perverse and created the “moral hazard.” Hensarling’s account of how Fannie and Freddie grew so large is inaccurate. He argues that they were: “private companies awarded monopoly powers by Congress….” Congress did not give Fannie and Freddie “monopoly powers” and during the run up to the crisis they lost large amounts of market share to competitors, particularly to competitors who purchased vast amounts of nonprime mortgage loans.
Hensarling’s speech demonstrates that he almost knows his history.
“We should also never forget that at the dawn of America’s history, it was another crony-run Government-Sponsored Enterprise that needed a bailout– the East India Tea Company – that sparked a revolution and gave birth to a nation teeming with individuals who decided to take control of their destinies.”
Yes, corporations inherently have incentives to leverage their wealth into political power by trying to create crony capitalism. Adam Smith was well aware of this history. It prompted his warning against allowing corporations. The U.K. banned the formation of corporations for many decades. None of this “sparked” the U.S. “revolution.”
Smith explained that their CEOs inherently posed an “agency” problem. The CEO has the incentive, and the ability, to loot the corporation. When the CEO was an unfaithful agent he could use the firm’s seeming legitimacy and funds to suborn private and public-sector officials – making them valuable fraud allies. Hensarling hates the “government” so much that he reinvents that history.
Hensarling’s hypocrisy: SDIs other than Fannie and Freddie = Contributors
Hensarling is right to warn about SDIs. He is right that they are the beneficiaries of an implicit governmental subsidy that make competitive markets impossible. He is right that they seek to subvert democratic government into crony capitalism. We can add to his criticisms – they are also deeply inefficient. They are vastly too large to achieve efficiencies of scale. SDIs pose a global systemic risk when they fail.
We should be fortunate to have Hensarling as the Chairman of the key House committee that can act promptly to pass legislation eliminating the SDIs. Under Hensarling’s logic we should adopt a three-part plan. The SDIs should be forbidden to grow. They should be ordered to shrink within five years to a size at which they no longer pose a systemic risk (under $50 billion in total assets). They should be intensively and extensively examined and supervised by federal banking regulators during the five-year period.
Has Hensarling actually led the fight against crony capitalism and the SDIs? Among the first things he did upon becoming chairman of the committee was to arrange a fundraising ski “vacation” at a luxurious resort with elite Wall Street lobbyists that he hit up for money. Instead of being in the trenches of the struggle against the SDIs to recover our Nation from crony capitalism, Hensarling is in the first (luxury) tranche of the cronies of capitalism.
Hensarling is also on record opposing requiring the SDIs to shrink to the point that they no larger pose the problems I’ve described – and the problems Hensarling described when excoriating Fannie and Freddie. As the reader has doubtless guessed, Hensarling is a hypocrite.
Hensarling stresses that Fannie and Freddie were accounting control frauds
Hensarling’s “spotlight” posted an article on July 18, 2013 that is all about Fannie and Freddie entitled “A Reminder of the Corruption That Helped Birth the Biggest Bailout in History.”
“While Fannie and Freddie’s role in the financial crisis is widely acknowledged, what some may have forgotten is how rank cronyism, Enron-style accounting and outright financial fraud made these GSEs so powerful and unaccountable that they were able to wreck our economy.
Beginning in the late 1990s, executive pay at Fannie Mae and Freddie Mac became tied almost solely to earnings growth. So in order to trigger maximum bonus payouts for themselves, top management at the firms cooked the books to make it appear the companies were producing enough corporate earnings.”
Enron, of course, was an accounting control fraud. Hensarling is correct that Fannie and Freddie were accounting control frauds, but he fails to think through the implications.
Disclosure: I was hired by OFHEO, Fannie’s regulator (it is now the FHFA), as an expert witness in the agency’s enforcement action against Franklin Raines, Fannie’s CEO. My report concluded that Raines was leading an accounting control fraud.
Hensarling is correct that as Fannie and Freddie became fully privatized their CEOs ensured that they adopted lucrative executive compensation plans that optimized the perverse incentives of employees to aid the accounting control frauds that the CEOs were leading.
“When the fraud was finally detected, the Office of Federal Housing Enterprise Oversight (OFHEO) issued a scathing report calling the corporate culture created by the executives ‘unethical.’ The report noted:
‘Senior management manipulated accounting; reaped maximum, undeserved bonuses; and prevented the rest of the world from knowing.
The combination of earnings manipulation, mismanagement and unconstrained growth resulted in an estimated $10.6 billion of losses, well over a billion dollars in expenses to fix the problems, and ill-gotten bonuses in the hundreds of millions of dollars.’”
Hensarling’s blog went on to emphasize a point we always stress about frauds by elite financial institutions – their “weapon of choice” is accounting fraud.
“OFHEO issued a separate report detailing numerous examples of improper accounting practices at Freddie Mac and pointed to improper trades designed to mislead investors and trigger big bonuses for top executives. The report noted Freddie Mac executives had an “obsession” with earnings growth that came “at the expense of proper accounting policies and strong accounting controls” (emphasis in original).
The fraud “recipe” for a loan originator (buyer) has four “ingredients.” It explains why the lenders’ and Fannie and Freddie’s fraudulent CEOs operated in the manner they did.
- Grow like crazy
- By making (buying) bad loans at a premium yield while
- Employing extreme leverage, and
- Providing only grossly inadequate allowances for loan and lease losses (ALLL)
The attraction of accounting control fraud to the CEO is that it is a “sure thing” that also greatly reduces the risk of sanction.
“[M]any economists still [do] not understand that a combination of circumstances in the 1980s made it very easy to loot a [bank] 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?” (Akerlof & Romer 1993: 4-5)
Accounting control fraud produces three “sure things” – the lender (loan buyer) is sure to report record (albeit fictional) profits in the near term, the officers controlling the lender (loan buyer) will promptly be made wealthy, and the firm will actually suffer severe losses. Akerlof and Romer’s point was that it would be the rare executive who would optimize the perverse incentives created through moral hazard by taking an honest but ultra-high risk investment gamble that would be extremely likely to fail rather than engaging in the “sure thing” of accounting control fraud. It takes aggressive and effective regulation and prosecutions to make the CEO’s optimal strategy honest gambling rather than control fraud.
Fraudulent CEOs can easily use modern executive and professional compensation not only to enrich themselves but also to suborn more junior officers and employees and “independent” professionals. By suborning the people who are supposed to function as controls the CEO is able to turn them into his most valuable fraud allies. Fannie provides superb examples of the CEO’s ability to produce this perverse dynamic.
In one of those splendiferous acts of unintentional self-parody, America’s most elite business organization made Frank Raines, Fannie Mae’s CEO, its spokesperson to explain to the public what went wrong in the Enron-era scandals. Businessweek asked Raines what caused the recurrent scandals. Raines reply was accurate.
“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.’ It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.”
Raines was an expert on this subject. The SEC would soon charge that he led an accounting control fraud to hide large losses his business strategy caused so that Fannie Mae could, (fraudulently) report that it hit earning targets that would maximize the controlling officers’ bonuses. The SEC also nailed Freddie Mac for accounting fraud. Fannie and Freddie reprised their accounting control frauds during the recent financial crisis.
The single most revealing document that came out in the investigations was a speech by a Fannie Mae executive to his troops. We know that Raines read the speech because he sent (positive) written comments on his copy of it to the speaker. The speech was about why helping Fannie report that it had hit the earning per share (EPS) target that maximized everyone’s bonus must be the unit’s overriding goal.
“By now every one of you must have 6.46 [EPS] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.
Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.” (Mr. Rajappa, head of Fannie’s internal audit, emphasis in original.)
Internal audit, of course, is a discipline with the mantra of “independence” as its defining characteristic. I refer to Fannie’s internal audit unit as the “anti-canary.” The “canary in the mine,” of course, is chosen because it is more susceptible than humans to carbon monoxide. When the canary becomes unconscious the miners still have just enough time to escape the mine. Internal audit should be the least susceptible unit in a corporation to being suborned. Given how effectively Fannie Mae’s internal auditors were suborned by its controlling officers every other unit at Fannie is likely to have been rotten due to the perverse incentives of modern executive compensation.
Hensarling lacks the courage to follow the logic acknowledging accounting control fraud
To review the bidding to this juncture, Hensarling is correct that Fannie and Freddie were control frauds run by fraudulent CEOs eager to grow wealthy at Fannie and Freddie’s expense. The CEOs’ choice to run a fraud was, according to two of the world’s best economists, criminal and immoral, but rational. White-collar criminologists and effective financial regulators agreed with Akerlof and Romer. Indeed, Akerlof and Romer credited the regulators with the discovery.
“Neither the public nor economists foresaw that [S&L deregulation was] 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” (George Akerlof & Paul Romer.1993: 60).
Economists, criminologists, and effective financial regulators agree on the circumstances that are “bound to produce looting.” Criminologists have a term for it: the creation of a “criminogenic environment.” We would all expect control fraud to be most likely to become epidemic where the “three de’s” (deregulation, desupervision, and de facto decriminalization) combine with modern executive and professional compensation. Akerlof and Romer erred only in believing that economists and anti-regulatory politicians “learn from experience” and are willing to set aside their dogmas and “know better.” The result was that they intensified the three “de’s” and executive and professional compensation while weakening civil accountability. The combined effect made the environment so much more criminogenic that “history” did “not repeat itself” – we vastly exceeded the S&L debacle.
Hensarling, of course, was one of the leading proponents of expanding the three “de’s” and one of the most ideological of the apologists for modern executive and professional compensation while weakening their civil accountability. His hate for Fannie and Freddie and their controlling officers is so overwhelming that it leads him to emphasize that they were control frauds. He also explains how the perverse incentives created by the intersection of modern executive compensation and weak regulation and supervision combined to spur Fannie and Freddie’s managers to lead the control frauds.
What is intellectually bizarre, but perfectly human, is that Hensarling implicitly assumes that Fannie and Freddie ceased to be accounting control frauds later in the crisis – and that other mortgage lenders and purchasers were never accounting control frauds. Hensarling’s ideology requires him to blame the government for the crisis – not private CEOs. Hensarling cannot blame the private managers’ who led the control frauds at Fannie and Freddie that caused massive losses. He certainly can’t blame their actions on perverse compensation and the three “de’s.” That would require him to become a progressive!
Hensarling’s four horsemen of the financial apocalypse – a faux Revelation
Hensarling’s four horsemen of the financial apocalypse are the Community Reinvestment Act (CRA), Fannie and Freddie’s “affordable housing” rules, fraud by homeowners’ on their loan applications, and Alan Greenspan’s low interest rate policy. If Hensarling were to admit that epidemics of accounting control fraud, as with the S&L debacle and the Enron-era, drove our current crisis his four horsemen would be revealed as fantasies. If Hensarling were to admit that the three “de’s” and modern executive and professional compensation along with the evisceration of civil accountability for managers and professionals produce those fraud epidemics then he would be admitting his culpability as one of the craftsmen of the crisis.
Hensarling’s failed apologia for his role in creating the criminogenic environment
I’ll leave the low interest rate claim primarily to others, but the points I’ll make will demonstrate that the crisis did not require low interest rates. Prior to the crisis, theoclassical economists claimed that one of the great benefits of their policies was that they brought lower interest rates which the economists claimed improved economic growth.
Hensarling doesn’t take Hensarling’s claims about the CRA seriously. This is what he claimed in his speech at the Bush Center.
“Proponents of CRA-like mandates have maintained that only a small portion of subprime mortgage originations are related to the CRA. However, that misses the fundamental point. Though they may be small in volume, CRA loan mandates remain large in precedent. They inherently required lending institutions to abandon their traditional underwriting standards to comply with this government mandate. And CRA implicitly put the government’s Good Housekeeping Seal of Approval on such loans.”
The CRA existed for decades prior to the crisis. It was substantially weakened from 2001-2008 under the Bush administration (which didn’t enforce banking rules in general, and was hostile to the CRA in particular). CRA did not “inherently require[] lending institutions to abandon their traditional underwriting standards.” It did not “mandate” making any bad loans. The last sentence is equally fictional. We (OTS West Region), for example, drove “liar’s” loans out of the S&L industry in 1990-1991 while the CRA was in effect. The CRA played no role in our thinking.
What actually caused the crisis is where Hensarling started – accounting control fraud
I have already explained why accounting control frauds’ adoption of the fraud “recipe” causes them to “abandon their traditional underwriting standards” to make their controlling officers wealthy. Indeed, Hensarling has already explained why they do so in his discussion of Fannie and Freddie’s accounting control frauds.
Hensarling’s quoted passage above, unintentionally and unknowingly, constitutes an admission that is fatal to his claim. I explain below why liar’s loans provide the perfect “natural experiment” to test his claims about the CRA, Fannie and Freddie’s affordable housing goals, and his claims about fraudulent borrowers. Hensarling’s key admission is that “traditional underwriting standards” would have prevented the crisis. That is correct. Note that it doesn’t matter whether Greenspan has set relatively high or relatively low interest rates.
Lenders have known for millennia that underwriting is essential. Home lenders have known for over a century that verifying the borrower’s income is essential to effective underwriting and have known for roughly a century that it is essential to obtain a sound appraisal. No honest home lender would inflate, or permit to be inflated, the appraisals or make loans without verifying the borrower’s income.
The Epidemic of Appraisal Fraud by Lenders
The Financial Crisis Inquiry Commission (FCIC) described an example of the deliberate creation of a “Gresham’s” dynamic in order to generate an “echo” epidemic of fraud in the ongoing crisis.
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).
George Akerlof used the metaphor to Gresham’s law in his article on markets for “lemons” – another control fraud variant in which the seller uses his asymmetrical information advantage as to the quality of the goods or services being sold to deceive the buyer.
[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence (Akerlof 1970).
Non-economists have observed the Gresham’s dynamic long before Akerlof’s article.
The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage (Swift, J., Gulliver’s Travels).
A national survey of appraisers in early 2003 found that 55% of them reported that they were the subject of attempted coercion designed to inflate the appraisal during the past 12 months. A follow-up study in 2006 found that percentage rose to 90% and that 67% of appraisers reported losing a client and 45% did not get paid their fee because they refused to inflate the appraisal during the past 12 months.
The epidemic of Liar’s Loan Fraud by Lenders
The Mortgage Asset Research Institute (MARI), the Mortgage Bankers Association (MBA’s) experts on fraud, warned that “low doc” lending caused endemic fraud in early 2006. The MBA sent the MARI report to its members.
“Stated income and reduced documentation loans … are open invitations to fraudsters. 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.
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%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.”
Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans.”
These are extraordinarily important facts. A 90 percent fraud incidence is incredible. It demonstrates how powerful the criminogenic environment was and how what a superb marker liar’s loans are for accounting control fraud. The facts show that the experts knew about the “havoc” caused – “hundreds of millions of dollars in losses” for the S&Ls and mortgage banks that made liar’s loans “in the early 1990s” before we eliminated such loans by S&Ls.
“The result of the [Fitch loan file] analysis was disconcerting…as there was the appearance of fraud or misrepresentation in almost every file.
[T]he files indicated that fraud was not only present, but, in most cases, could have been identified with adequate underwriting …prior to the loan funding” (Fitch November 2007).
Lenders and Their Agents Put the Lies in Liar’s Loans
The testimony of Thomas J. Miller (Miller, 2007), Attorney General of Iowa, at a 2007 Federal Reserve Board hearing began by describing the Gresham’s dynamic that the interaction of accounting control fraud and modern executive compensation produces:
“Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete. Strong regulations will create an even playing field in which ethical actors are no longer punished. (p. 3)
Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007. (note 2)
[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. A review of 100 stated income loans by one lender found that a shocking 90% of the applications overstated income by 5% or more and almost 60% overstated income by more than 50%. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.” (p. 10).
Miller, T. J. (August 14, 2007). Home Equity Lending Market Request for Comment. Docket No. OP-1288.
The investigative findings make logical sense. The loan broker or loan officer only got his (very substantial) fee if the loan was approved. A loan originated with an inflated appraisal and an inflated borrower’s income was more likely to be approved. Unsophisticated borrowers would not know the magic ratios that would maximize the probability of the loan being approved and the loan officer or broker’s fees without being so transparently fraudulent that the loan would be rejected. The loan officers and brokers were not willing to lose their fees to the grave risk that the borrowers would fill out the loan application honestly.
Readers never want to believe that they would have gone ahead and borrowed on such terms. They should watch the documentary about the famous Yale study on obedience to authority conducted by Stanley Milgram. Then consider the effect of the inflated appraisal and the loan broker telling the husband in front of his wife that the house is a steal – there’s a $50,000 profit locked in because purchase price the husband negotiated is that much lower than the appraisal. Brokers even resorted to forging the signatures of borrowers to loan applications prepared by the loan brokers with inflated incomes. Michael W. Hudson’s 2010 book is superb on this subject. The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America–and Spawned a Global Crisis.
The Third Fraud Epidemic: Fraudulent sales of fraudulent loans to the secondary market
There is no fraud exorcist, so the fraudulently originated loans remained fraudulent throughout all subsequent sales and the mortgage product they purportedly “back” will invariably be infected by those frauds. You may have read that the crisis was caused by the “fact” that the lenders had no “skin in the game” because they sold their fraudulently originated loans to the secondary market. That is not true. Loans were sold on the basis of “representations (reps) and warranties” made by the lender. Lenders could not sell their fraudulently originated loans by making reps and warranties that they were selling fraudulent loans. They could only sell the fraudulently originated loans through fraudulent reps and warranties. Fraud begets fraud.
This is not to suggest that the loan purchasers were innocents. They were highly sophisticated specialists who knew the facts I have presented in this article about the loan origination epidemics. It is also easy to figure out that mortgage products that the industry calls a “liar’s” loan and that eliminate a vital underwriting requirement – verifying the borrower’s income – are something one should never buy. The key in the loan origination and secondary market sale contexts is the same – corporations do not make decisions – officers make decisions. The fraud recipe explains why the interests of the banks’ officers are directly contrary to the interests of the firm. The grave danger is when the person who controls the firm, typically the CEO, leads the fraud and uses the firm as a “weapon” to defraud.
In the secondary market context two facts demonstrate the incidence, crudeness, and audacity of the fraudulent reps and warranties. The leading “due diligence” firm for secondary market sales was Clayton. Pass by for this article’s purposes the absurdity that (knowing what I’ve explained above about the incidence of mortgage origination fraud) the most financially sophisticated firms in the world hired Clayton to do their diligence and that the instructions they gave Clayton as to how to conduct the due diligence were farcical. The entire process was a sham designed primarily to create plausible deniability for the purchaser’s officers. A subsidiary purpose was that the reports allowed the buyer to reduce the purchase price slightly. The process was so absurd that it inherently could not exclude more than a tiny fraction of the fraudulently originated loans.
Here are the two extraordinary facts. First, despite the pathetic nature of Clayton’s (not remotely) due diligence, the incidence and crudeness of loan origination fraud was so great that it found that the reps and warranties were false in 46% of the loans it sampled. Financial Crisis Inquiry Commission (FCIC 2011: 166). Would you continue to buy from an on-line company that lied to you and delivered a defective product to you nearly half the time? I fear that my fundamental point will be lost in my analytical treatment of the secondary market sales. None of these processes is real. We are dealing with a farce. The fact that trillions of dollars were paid for fraudulent product on the basis of such a transparent farce is a testament to how easy it would have been for honest private or public sector actors to have prevented the financial crisis.
Second, and my personal favorite because of the chutzpah required, was the fraud trifecta. Another aspect of the due diligence farce was the facially absurd concept that loan characteristics could “compensate” for fraudulent reps and warranties. Yes, you read that correctly, they actually created a concept that one could safely do business with a seller that lied to you about the quality of the product he was selling.
“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?” (FCIC 2011: 166).
If you are in finance you are already rolling in laughter at the double joke. The practice described is a farce – and the FCIC’s treatment of the practice as if it were not a farce is a howler. Recall that the two massive epidemics of loan origination fraud were appraisal fraud and liar’s loans. Appraisal fraud is designed to create a false “loan-to-value ratio” (LTV). By inflating the appraised value one depresses the reported LTV and makes the loan look less risky. Liar’s loans were designed to inflate the borrower’s income to make the loan look less risky. There is something wondrous about the audacity of purporting to use one leading form of loan origination fraud to “compensate” for the other leading form of loan origination fraud in order to aid the third epidemic of fraud – the fraudulent sale of fraudulently originated mortgages to the secondary market. The process was also used in the other direction. If Clayton’s review found that the borrower had made a false rep and warranty about the borrower’s (fraudulently inflated) income it could fail to find the inflated appraisal and rely on the resultant low (falsely reported) LTV to “compensate” for the (multiple frauds of inflating the borrower’s income and making a false rep and warranty about the borrower’s income and the value of the home.
Liar’s Loans and Appraisal Fraud are “Natural Experiments” to test Hensarling’s Claims
Hensarling implicitly assumes that home mortgage lenders and purchasers of loans, absent government mandates, would not make loans, or buy, loans without adequate underwriting. That almost makes sense – failing to underwrite creates “adverse selection” which means the lender or the purchaser will lose money. Inflating an appraisal is even worse than failing to do underwriting. Doing deliberately bad underwriting will cause catastrophic losses. Inflating appraisals and the borrower’s income constitutes doing deliberately bad underwriting.
I wrote that Hensarling almost makes sense because he has already explained why his implicit assumption is false. He has already explained that Fannie and Freddie’s controlling officers used accounting fraud to ensure that their firms would (fraudulently) report extreme profits that would trigger huge pay to those officers. Hensarling even seems to understand the three “sure things” produced by accounting control fraud. The obvious question, which Hensarling never asks, is why other bank CEOs wouldn’t make the same unethical choice to become wealthy by following the fraud recipe. Why would Fannie and Freddie’s CEOs be the only ones leading control frauds? That wasn’t true during the S&L debacle or the Enron-era control frauds.
An honest home mortgage lender would never inflate an appraisal or make a liar’s loans even if it was going to make a subprime loan. Indeed, an honest subprime lender would have unusually strong incentives to do superb underwriting because lending to borrowers with poor credit histories is significantly riskier than lending to borrowers with strong credit histories. By 2006, half of all the loans that the industry called “subprime” were also liar’s loans. There is no mechanical bar to lending to a borrower who has a poor credit history without verifying that borrower’s income. It would be insane for an honest lender to make subprime liar’s loans, but it is a great strategy for an accounting control fraud. Similarly, it would be insane for honest firms to buy those loans or to buy loans made on the basis of fraudulently inflated appraisals. It would be off the charts insane to make or buy mortgage loans that had all three characteristics. Yet that off the charts form of conduct that was sure to cause catastrophic losses became common.
The purchasers of loans, of course, knew that the loans they were acquiring were frequently fraudulent. The purchasers of liar’s loans knew that they were overwhelmingly fraudulent. The purchasers were warned by the appraisers in 2000, by the FBI as early as 2004, and by the mortgage industry’s own anti-fraud experts in early 2006. No one ever required any lender to make a liar’s loan or any entity (and that includes Fannie and Freddie) to buy a liar’s loan.
Hensarling claims (accurately) that Fannie and Freddie had immense political power and claims (inaccurately) that they would not have purchased these fraudulent loans but for a political mandate forcing them to do so. If both of his claims were true, then we should have seen a massive political effort by Fannie and Freddie to save the firms from doom by being released from those mandates. Fannie and Freddie’s CEOs should have been constantly warning the public, Wall Street, the administration, and Congress that the mandate would produce a catastrophe. They could have made an irrefutable case by simply quoting the data I have cited. But they also could have conducted high quality underwriting of samples of the loans they purchased from every large counter party. They could have used those studies to buy further loans from those lenders, to force the fraudulent lenders to repurchase the loans, and to document their case that this (hypothetical) mandate that Fannie and Freddie purchase fraudulently originated loans was an insane policy that would destroy Fannie and Freddie and cause catastrophic losses to the public.
Does anyone seriously think (a) that there was a federal mandate that Fannie and Freddie purchase fraudulent loans and (b) that such a mandate could have survived Fannie and Freddie unleashing their lobbyists and media specialists backed by data and warnings from the appraisers, the MBA, and the FBI that the loans were endemically fraudulent? They also could have quoted the federal regulators warning banks against making liar’s loans. If the banks shouldn’t make such loans, it follows that Fannie and Freddie shouldn’t purchase them. Does anyone recall that massive lobbying and press campaign by Fannie and Freddie begging to be released from [Hensarling’s fictional] government mandate that they purchase hundreds of billions of dollars in fraudulently originated loans?
Now consider the fact that Freddie and Fannie sold hundreds of billions of dollars in mortgage backed securities (MBS) that their managers knew were “backed” largely by fraudulently originated mortgages – and did not disclose that fact to the purchasers. That was, at a minimum, unethical, and more likely fraudulent. Even if Hensarling’s hypothetical federal mandate to Fannie and Freddie to purchase fraudulent loans were real, it would require Fannie and Freddie’s managers to:
- know that what they were buying was frequently fraudulent,
- to fail to object to such practices as a breach of their fiduciary duties,
- to sell the MBS through deceit,
- to become wealthy through lucrative executive compensation plans that made them wealthy for taking acts they knew would cause Fannie and Freddie to fail and have to be bailed out by the Treasury,
- and to do all of this without resigning in disgust and going public with their criticisms.
If Hensarling is willing to believe that hundreds of Fannie and Freddie’s officers were willing to act in such a reprehensible fashion, why can’t he believe that they would do what they actually did – get wealthy through control fraud? Remember that he states that Fannie and Freddie’s officers led accounting control frauds at a time when they were already purchasing substantial amounts of fraudulent liar’s loans.
The mortgage industry recognized that even the Bush administration regulators discouraged liar’s loans due to fears about their “safety and soundness.” Liar’s loans provide the definitive “natural experiment” on the causes of the ongoing United States crisis. The government did not require, or urge, any entity to make or purchase (and that includes Fannie and Freddie) liar’s loans.
“Alt-A mortgages [which were overwhelmingly liar’s loans] were not generally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from counting toward [Fannie and Freddie’s] affordability goals” (FCIC 2011: 125).
When almost 60% of the loan files inflated the borrower’s income by more than 50% it is impossible to claim that the lenders made the pervasively fraudulent loans to qualify for a requirement to make loans to less wealthy Americans. It is also impossible to claim that Fannie and Freddie bought loans they knew to be massively fraudulent because they greatly inflated the borrower’s income in order to meet affordable housing goals that were met by lending to borrower’s with below median incomes. When lenders inflated the size of their loans by inflating appraisals they also made it more likely that the size of the loan would make it too large for Fannie and Freddie to acquire. The CEOs who caused their firms to make or purchase fraudulent liar’s loans did so because the loans were the optimal “ammunition” available for accounting control fraud that made the CEOs wealthy while reducing the risk of prosecution by removing the “paper trail” of loan verification.
MARI’s warnings also show the significance of the evidence that lenders in 2006-2007 greatly increased the number of liar’s loans after receiving MARI’s and the FBI’s warnings. By 2006, roughly 40% of all home loans made that year were liar’s loans (including half the loans called “subprime” – the two categories are not mutually exclusive). At a 90% fraud incidence for liar’s loans, this means that the control frauds made over 2 million fraudulent liar’s loans in 2006 alone. Liar’s loans were so large, and grew so massively (roughly 500% from 2003-2006) that they are the loans that hyper-inflated the bubble after 2003.
By 2006, 45% of the home loans made in the U.K. that year were liar’s loans. The U.K. does not have the CRA or Fannie and Freddie or any analog with an affordable housing goal.
Conclusion
Hensarling’s admission that Fannie and Freddie were accounting control frauds should have led him to understand that the crisis was caused by the three epidemics of accounting control fraud I have explained. His apologies for the three “de’s” are understandable given his role in helping to expand them and the critical role they played in creating the criminogenic environment that drove the crisis. He cannot overcome his ideological dogmas and his political instincts to do the necessary rigorous analysis about the causes of crisis, but readers can readily see his logical inconsistencies.
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