Floyd Norris’ Apologia for Citi’s Frauds

By William K. Black

I have just written a column about the New York Times’ financial journalist, Floyd Norris’ August 20, 2014 column decrying attacks on those who detect and seek to sanction elite frauds.  Norris’ focus was on the Chinese government attacks on whistleblowers who “detect” elite frauds.  Norris bemoaned that those who detect elite fraud suffer far more than those that commit it.

My column pointed out that the practice of elite frauds, in league with their protectors in government and the media, attack those that detect and seek to sanction elite frauds in every country.  Indeed, I showed that Norris had aided and abetted the SEC’s leadership’s smears of Gary Aguirre, the SEC whistleblower who detected evidence of what he (and his superiors) considered likely fraud by elites.  His SEC superiors, however, blocked the investigation when they discovered it would lead to John Mack, the soon-to-be CEO of Morgan Stanley, one of the world’s largest investment banks.

Writing that column about Norris’ spectacular hypocrisy led me to reevaluate Norris’ July 17, 2014 column about the Citigroup settlement of the Department of Justice’s mortgage fraud claims.  Norris’ column about Citigroup is full of indications that he understands aspects of the three mortgage fraud epidemics that drove the crisis, but also indicates repeatedly his refusal to even consider the possibility that any elite banker led an accounting control fraud.  The bottom line is that Norris continues to be an apologist for the worst banksters, but tries to justify fines against the banks as payback for their bailouts.  Norris’ column is as incoherent as the Department of Justice’s (DOJ’s) (unstated) rationale for refusing to prosecute the banksters.

Norris Assumes that Consumers were not Victims of Citi’s Mortgage Fraud

Norris has missed completely many of the most important aspects of the financial crisis.  First, he assumes that homeowners were not harmed by the mortgage fraud epidemics.

“The bad actions cited by the Justice Department damaged investors, but there is nothing in the settlement to benefit most of those affected.”

Yes, accounting control fraud damages shareholders and, absent a governmental bailout, the creditors.  But for the federal bailout of Citi both groups would have suffered severe losses.  Homeowners and the government, however, were among the worst victims of the three epidemics of mortgage fraud led by the banksters.  Millions of homeowners were induced to purchase prices at the peak of a bubble hyper-inflated by the combination of the three epidemics of mortgage fraud.  They suffered trillions of dollars of losses.

Similarly, Norris admits that the federal and state governments were major victims of Citi’s frauds.  They suffered losses in the form of dramatically reduced tax revenues and increased expenses for families with workers who lost their jobs and through losses in their pension funds and investments.  The federal government also bore the cost of massive bailouts of financial institutions.  Both levels of government bore substantial costs for attorneys and agents assigned to the civil and criminal cases involving the three mortgage fraud epidemics.

The connection between the secondary market mortgage fraud epidemic and the twin epidemics of mortgage origination fraud is also obvious.  Norris knows full well that the originators were overwhelmingly following the “originate-to-sell” model and depended on secondary market sales for their survival.  The DOJ settlement with Citi is outrageous and the vastly inflated dollar amounts attributed to householder relief by DOJ’s propaganda is part of that outrage.  It is not, however, objectionable to require control frauds like Citi to provide relief to distressed homeowners.

Norris’ Willful Blindness about Citi’s Frauds

Norris repeatedly notes damning facts about Citi while attempting to trivialize those facts.  His description of the Clayton reports typifies this practice.

“In its legal papers, the Justice Department describes incident after incident in which consultants hired by Citigroup to assess the quality of mortgages that the bank planned to securitize found loans that did not come close to meeting the standards that the bank claimed to be following. In some cases, Citigroup pressed the consultants to change their views; in others, it seems to have largely ignored the reports.”

Clayton representatives have testified that they controlled roughly 70% of the “due diligence” market for secondary market sales of mortgages.  In this column I will use Clayton as representative of the due diligence industry that it dominated.  The Financial Crisis Inquiry Commission (FCIC) report demonstrates the pervasive nature of the three fraud epidemics, and the Clayton reports are exceptionally incriminating.

I begin by clearing up several misconceptions about Clayton.

  1. It was not retained “to assess the quality of mortgages.”  That would have required it to do actual due diligence.  Clayton was (purportedly) retained to evaluate whether the loans complied with the lender’s loan program guidelines.  Those guidelines were frequently preposterously bad.  No remotely competent “due diligence” reviewer would ever approve such loans.
  2. Clayton is not one of the good guys.  Its controlling officers sought immunity from prosecution and there are many Clayton whistleblowers who have revealed its complicity with the fraudulent sellers and buyers in the secondary market.
  3. None of the purchasers in the secondary mortgage market would have used Clayton had they been interested in ensuring the quality of the loans they purchased.  They were all highly financially sophisticated – vastly more sophisticated than Clayton.  The survival of the purchasers depended on the credit quality of the mortgages being high.  There was no rational basis for an honest bank to hire Clayton rather than use its own, far superior internal resources to conduct due diligence.  There were, however, compelling reasons for the controlling officers leading accounting control frauds to hire Clayton to implement the financial version of “don’t ask; don’t tell” that dominated the secondary market.  Had the purchasers used their superior internal resources to review the quality of the loans they were purchasing they would have had to reject most of the loans they purchased, which would have crippled their ability to run an accounting control fraud.
  4. The only reason for an originator/seller of mortgages to make false “reps and warranties” to the purchasers was that the originations were fraudulent.  Clayton’s data tells us not only that the secondary market sales were pervasively fraudulent but also that the originations were pervasively fraudulent.

Norris greatly understates how incriminating Clayton’s data and testimony would be in a criminal case against Citi and scores of other financial institutions.  He notes that the DOJ complaint details:

“[I]ncident after incident in which consultants hired by Citigroup to assess the quality of mortgages that the bank planned to securitize found loans that did not come close to meeting the standards that the bank claimed to be following. In some cases, Citigroup pressed the consultants to change their views; in others, it seems to have largely ignored the reports.”

Only a firm engaged in accounting control fraud would act in that fashion.  We need to be clear, since Norris is not, about why Citi’s response to the Clayton’s (not remotely) “due diligence” reviews makes it certain that it was an accounting control fraud.  In each of the statements below when I refer to a firm “knowing” or “telling” I am using that phrase as a short form for “the officers that controlled the firm knew or told.”  Clayton told Citi – and purchasers of Citi’s toxic mortgages – that they were purchasing mortgages that were overwhelmingly fraudulently originated and that did not meet the Potemkin “loan guidelines” of the originators, Citi, or the purchasers from Citi.  Clayton told Citi and purchasers from Citi the nature of the frauds and failure to comply with guidelines.  Those frauds and failures were of a kind that is powerfully associated with increased defaults and losses upon defaults.  Citi and the purchasers knew these defaults and losses were being delayed by refinancing the toxic mortgages.  Citi and the purchasers knew that there is no such thing as an infinite financial bubble.  By 2006, Citi and the purchasers knew that home prices were falling – the bubble had burst.  Citi and the purchasers had been warned by the appraisers and MARI, the Mortgage Bankers Association’s (MBA’s) own anti-fraud experts, about the twin epidemics of loan origination fraud, yet with rare exceptions they continued to make, sell, or purchase the same bad loans.  Indeed, they often made even worse loans and to grow exceptionally rapidly.

Norris, however, immediately attempts to minimize the incriminating nature of these facts about Citi.

“But the department stops short of identifying which securitizations were affected and never bothers to say whether the securitizations with problems performed worse than others. There is no indication that officials checked to see whether the loans identified as substandard were more likely to default than those the consultants deemed to be proper. There seems to have been no effort to quantify just how much Citigroup’s improper behavior cost investors.”

Norris’ statements in the paragraph are accurate and they are important, but they do not reduce Citi’s culpability. They do offer a window from which we can witness how pathetic financial regulation and prosecutions of banksters have become. Norris misses each of these points.

  1. Yes, the statements of fact that DOJ negotiates with the elite banks are deliberately crafted to be worth as little as possible to plaintiffs against the banks and to be incredibly obscure so that the general public will not understand the extent and nature of the elite bankers’ crimes. That is deliberate and it reveals how screwed up DOJ is. It does not indicate that it had a weak case against Citi, indeed, it indicates the opposite.
  2. The loans were typically not “identified as substandard” by Clayton. They were identified as fraudulent. The originator/sellers made fraudulent reps and warranties about the mortgages. Making a false rep and warranty can constitute a felony. Mortgage sellers do not gratuitously commit felonies. They lie for good reasons. They lie because the underlying mortgages were originated fraudulently – and fraudulently originated mortgages typically overstated substantially the borrower’s income and the value of the home pledged as collateral for the loan. They lie precisely because they know the things they are lying about are major causes of horrific levels of default and loss. We know empirically that both epidemics of mortgage origination fraud (inflating appraisals and inflating the borrower’s income) lead to much higher default rates and much greater losses upon default.
  3. DOJ and the banking regulatory agencies should be doing large scale forensic studies demonstrating what loan characteristics (solely and in combination) produce the highest default rates and the greatest losses. The regulatory agencies and DOJ have conspicuously refused to conduct this essential research. Again, the results reflect badly on DOJ and the regulators, who do not want to report on the scope of three mortgage fraud epidemics, the wealth it created among banksters, and the massive harm it caused our Nation and much of the world (not just “investors”).
  4. DOJ and the regulators are not about to quantify how much damage the fraudulent banks cost our Nation (not just “investors”) and the global economy. DOJ and the regulators are not about to quantify how much compensation the banksters received due to leading or participating in the three fraud epidemics. The numbers would be so large that it (a) would be obvious that DOJ’s fines represent a pittance (b) it would be obvious that the three accounting control fraud epidemics led by the banksters drove the financial crisis, (c) it would be obvious that the banksters had become fabulously wealthy through the “sure thing” of leading the three epidemics of mortgage fraud, and (d) DOJ and President Obama would be compelled by the public to make the prosecution of the elite banksters a national priority.

Norris Ignores Richard Bowen, Citi’s Heroic Whistleblower

While the Clayton studies are damning, DOJ had even better evidence that Citi was an accounting control fraud because of the work done by Richard Bowen, the Citi whistleblower who led the vastly more competent Citi internal reviews of the quality of the loans Citi was purchasing and then reselling to the secondary market. Bowen’s group also had far more integrity than Clayton. There are a number of telling aspects of Bowen’s work and the reaction to it of Citi’s controlling officers (including Bob Rubin, who Bowen personally put on notice of Citi’s endemic frauds).

  1. The incidence of fraud by Citi in its secondary market sales of loans purchased from other originators was extraordinary – 40-60% when Bowen’s team of reviewers first examined how many of Citi’s “reps and warranties” were accurate
  2. That incidence of fraud means that the originators were engaged in endemic mortgage fraud in the making of the loans
  3. The Citi managers running the purchase and resale program had to know about the endemic fraud by the originators Citi selected as its primary partners given such an extraordinary level of fraud incidence
  4. The reaction of the Citi managers to the endemic fraud in the loans they were purchasing adds to the incriminating nature of their conduct
    1. They continued the program knowing that it was endemically fraudulent – no honest banker would do so
    2. They continued to buy loans from originators whose fraud incidence had to substantially exceed the already extraordinary 40-60% fraud incidence suffered by the overall program. No honest banker would do so.
    3. They covered up the endemic loan origination frauds and the originators’ endemically fraudulent “reps and warranties” to Citi by creating false entries on Citi’s books that claimed that originators and Clayton’s faux “due diligence” had documented that the loans Citi purchased complied with the originators’ and Citi’s loan standards. The files for the loans that Citi purchased were, however, replete with incomplete and false documentation.
    4. They got worse – far worse – after Bowen’s warnings. Bowen eventually found that the fraud incidence in the program rose to 80 percent. This means that rather than using the results of Bowen’s reviews to (i) weed out all originators who sold Citi fraudulently originated mortgages through fraudulent “reps and warranties,” and (ii) to “put” the bad loans back to the fraudulent originators en masse for breach of those reps and warranties, Citi increasingly selected the most dishonest sellers of toxic mortgages as its suppliers. No honest banker would run such a loan purchase and resale program.
    5. Note that Citi could have used Bowen’s group to conduct real due diligence on the originators from whom it bought mortgages – prior to making those purchases. Post-purchase reviews are inherently risky because the sellers of endemically fraudulent loans are insolvent (in economic reality and under GAAP, which they violate). When (no “if”) the fraudulent originators/sellers fail Citi was certain to suffer severe losses. Citi did not use Bowen’s group to conduct due diligence, despite its far superior skills and integrity and track record of independence and Bowen’s willingness to “speak truth to power.”
    6. Instead, Citi’s senior managers removed Bowen’s staff and his authority to review loans. Bowen suffered the retaliation inevitable when an officer blows the whistle on a control fraud. The reader should recall that such attacks on those that detect fraud, rather than those that commit fraud, was the theme of Norris’ recent column. Bowen is one of the perfect examples of Norris’ point, yet his Citi column ignores Bowen. Of course, alerting the reader to Bowen’s disclosures would refute Norris’ theme in his column on the Citi settlement, so it is no surprise that Norris edits Bowen out of the Citi story. No honest bank management would respond to Bowen’s immense service to the bank’s “investors” by demoting him for detecting and quantifying Citi’s endemic frauds and warning Citi’s senior managers of those frauds.

Norris purports to be very disturbed at DOJ’s failure to quantify the costs of Citi’s endemic mortgage fraud. He is not disturbed by Citi’s failure to quantify the costs of its endemic mortgage fraud. Citi’s senior managers knew that those frauds were making them wealthy through the accounting control fraud “recipe” for a purchaser of bad loans. Citi’s senior managers also knew that the same fraud recipe was certain to render Citi insolvent, jeopardize its survival absent a government bailout, cause severe losses to its “investors,” and help blow up the global financial system. Worse, Bowen provided Citi with the essential information it needed in order to quantify each of these vital matters. Citi’s reaction to this selfless service by Bowen – he literally sought to save Citi with his timely warnings to Citi’s top managers – was to punish Bowen and suppress his data in order to prevent any “paper trail” quantifying the losses Citi’s frauds would cause the “investors.” No honest banker would act in this manner. (And no honest banker would have required a quantified study to know not to make, purchase, or sell “liar’s” loans.)

It is even more revealing, however, that while DOJ’s feeble “investigation” of Citi confirmed Bowen’s findings DOJ never mentioned that Bowen’s whistleblowing handed them a criminal case (which they spurned) against Citi’s controlling officers on a platinum platter. DOJ never thanked Bowen. DOJ never praised Bowen for his courage and integrity. DOJ did not have Bowen attend its press conference announcing its deal with Citi. DOJ did not use that press conference to make a public call for whistleblowers to emulate Bowen and alert DOJ to similar elite frauds. No entity worth of the name “Department of Justice” would act in this manner. Again, economists believe in “revealed preferences” – and Attorney General Eric Holder and President Obama have consistently revealed that their true preference is not to prosecute the elite banksters who grew wealthy and obtained dominant political power by leading the three fraud epidemics that caused the financial crisis and the Great Recession.

Did I Mention That Norris’ Column Never Uses the “F” Word?

Norris’ column about Citi’s frauds never uses the word “fraud.” This is a bit subtle, but Norris’ failure to discuss Citi’s endemic frauds is a double failure. Not only does he refuse to use the “f” word, he also refuses to discuss Citi’s frauds. Norris does believe that there was endemic mortgage fraud, but he portrays Citi as the Virginal Victim of the riff-raff. Surely the scores of elite Wall Street officers he knows on a first name basis could not be frauds. Norris eagerly seeks to redirect the public, and DOJ, to go after the scruffy folks and stop bothering the elites.

“Many of those most responsible for the worst abuses are long gone or simply untraceable. That includes the mortgage companies that failed early in the crisis and the loan officers and borrowers who lied to get loans approved.”

The first sentence and the first clause of the second sentence are pure misdirection by Norris. Yes, the mortgage companies that were accounting control frauds have failed. No, that does not mean we cannot prosecute their controlling officers. Indeed, it is vital that we do so for. The Center for Public Integrity has detailed how those officers are overwhelmingly active again in the industry in leadership positions.

This is what happens when you fail to prosecute. You have a cadre of fraud experts that can jump start the next fraud epidemics, just as we saw in the savings and loan debacle when the unprosecuted leaders of the “Texas Rent-a-Bank” scandal played key roles in creating the infamous Texas (actually, Southwest) “daisy chain” of accounting control frauds.

The only people that Norris’ column accuses of having engaged in a crime are at the little people: “the loan officers and borrowers.” Yes, Norris is one of the mythmakers peddling the claim that this was the first Virgin Crisis – conceived without sin in the C-suites. Norris knows that the prior to crises were driven by epidemics of accounting control fraud. Norris knows, and writes, that regulation collapsed prior to the crisis and that the collapse was engineered by what Tom Frank terms “the wrecking crew” that created the self-fulfilling prophecy that government would fail – spectacularly – under their anti-regulatory dogmas. Norris knows that prosecutions of elite banksters have collapsed. Norris knows that the rewards to leading an accounting control fraud given modern executive compensation are a “sure thing” that is mathematically guaranteed to make the controlling officers promptly wealthy. Norris knows, and as I will discuss writes in the column I am discussing, that the banksters easily suborned professionals that are supposed to serve as “independent controls” by using the ability to hire, fire, blacklist, and selectively compensate those (not very) professionals to suborn them into become the CEO’s most valuable fraud allies. Given that Norris knows that the Enron-era frauds and the S&L debacle were driven by accounting control fraud epidemics, that the rewards to such frauds remain a “sure thing” and are vastly larger today, and that the risk of prosecution of the CEO for leading such a fraud are now less than negligible, it makes no sense to assume that accounting control fraud miraculously disappeared at the same time that there has never been a more criminogenic environment in finance for such frauds.

Norris exemplifies every dysfunctional class trait that Edwin Sutherland emphasized 75 years ago when he announced the concept of white-collar crime in his presidential address to the annual meeting of sociologists. Nothing has changed among substantial sections of the elite media. As Sutherland observed so acutely, the rule of law frequently fails when it comes to elite white-collar criminals.

“The statement of Daniel Drew, a pious old fraud, describes the criminal law with some accuracy, ‘Law is like a cobweb; it’s made for flies and the smaller kinds of insects, so to speak, but lets the big bumblebees break through. When technicalities of the law stood in my way, I have always been able to brush them aside easy as anything.’”

Sutherland explained that while elite fraudsters’ raw political power and wealth partially explained their relative immunity from the criminal laws, the larger problem lay in their high social status.

“The privileged position of white-collar criminals before the law results to a slight extent from bribery and political pressures, principally from the respect in which they are held and without special effort on their part. The most powerful group in medieval society secured relative immunity by ‘benefit of clergy,’ and now our most powerful groups secure relative immunity by ‘benefit of business or profession.’ In contrast with the power of the white-collar criminals is the weakness of their victims. Consumers, investors, and stockholders are unorganized, lack technical knowledge, and cannot protect themselves. Daniel Drew, after taking a large sum of money by sharp practice from Vanderbilt in the Erie deal, concluded that it was a mistake to take money from a powerful man on the same level as himself and declared that in the future he would confine his efforts to outsiders, scattered all over the country, who wouldn’t be able to organize and fight back. White-collar criminality flourishes at points where powerful business and professional men come in contact with persons who are weak. In this respect, it is similar to stealing candy from a baby.”

In his August 14, 2007 testimony to the Federal Reserve urging the Fed to use its authority under HOEPA to ban liar’s loans, Thomas Miller explained how little has changed since Sutherland’s era.

“Industry participants often refer to stated income loans as “liar loans” and for good reason. Our investigations have found that stated income loans are frequently used to fraudulently qualify borrowers for loans they cannot afford. Because subprime lenders seek out homeowners with high consumer debt, originators face the problem of finding borrowers with adequate income to make the payments on the refinanced loan, and yet stay within an acceptable debt-to-income ratio. In other words, can the originators find borrowers who actually have the income to pay for their substantial consumer debt after it is rolled into the home mortgage.

Because of the substantial pressures and economic incentives to make as many loans as possible, many originators have engaged in a pattern of inventing non-existent occupations or income sources, or simply inflating 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%.16 Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.17”

I have done this about a thousand times, but it never gets through the perceptual barriers of elites like Norris that Sutherland warned about.

  • The federal government has known since 2000 that the banks were laeding the epidemic of appraisal fraud by blacklisting honest appraisers in order to create a Gresham’s dynamic. No honest banker would do this.
  • The state and federal governments have known since 1990 that liar’s loans were endemically fraudulent and that it was overwhelmingly lenders and their agents that were putting the lies in liar’s loans. At all times, the government discouraged liar’s loans – even under Bush’s worst wrecking crew. In 1991, before they were called liar’s loans, we drove such loans out of the S&L industry.
  • The officers controlling the banks and investment banks created the perverse incentives that, in conjunction with the banks’ decision to make liar’s loans they knew to be “an open invitation to fraudsters” that ensured endemic appraisal and liar loan fraud. The banks maintained, and frequently magnified these perverse incentives that made defaults and losses upon default surge by increasing the perverse compensation incentives and adding what they euphemistically called “layered risk” even after they were repeatedly warned that it was producing endemic fraud.
  • The officers controlling the banks and investment banks created the perverse compensation systems, hired Clayton due to – not despite – its critical weaknesses, instructed Clayton to use faux due diligence process, ignored Clayton findings of endemic fraud in the loans being sold, repackaged and resold the toxic mortgages through false reps and warranties, ignored hundreds of warnings about the twin epidemics of mortgage origination fraud, and sold toxic mortgage products through false reps and warranties that hid their detailed information about the endemic fraud in the toxic mortgages.

Loan officers and borrowers could not have committed widespread fraud absent the banks and investment banks’ controlling officers gutting their underwriting and internal and external controls, encouraging liar’s loans, punishing whistleblowers like Richard Bowen rather than acting on their warnings, and creating the perverse compensation systems that suborned professionals and actively encouraged widespread fraud.

All of this should be inescapable to anyone who follows the crisis at this juncture in mid-2014. The fact that Norris is still oblivious and assumes that the elite bankers are virginal victims proves that Sutherland’s insights remain true. Norris’ claim is that our Nation’s true financial savants, the hairdressers and loan officers that occupy the lowest rung of the mortgage fraud food chain, are so financially sophisticated that the poor, underpaid, financial rubes at Citi, Merrill, Bear, and Lehman were helpless pawns unable to protect themselves, for years, against their ultra-sophisticated fraud schemes. Indeed, they remained helpless despite numerous warnings and the passage of many years. Nobody can stop the hairdressers when they set their minds to defrauding Wall Street. Norris’ fraud story is a farce, but it doubtless puts a rueful grin on the face of Sutherland’s spirit.

Norris’ Bizarre Defense of Citi as “Hardly the largest or the worst”

Norris implies that because Citi was not the largest accounting control fraud it is somehow not all that culpable.

“Citigroup was hardly the largest, or the worst, purveyor of bad mortgage securitizations. A financial crisis would have happened even if Citigroup and other banks that put together securitizations had acted far more responsibly than they did.”

To start with the obvious, it is no defense of Citi that there were (two or three) larger accounting control frauds. Second, it is true that securitizations were less important than the conventional wisdom suggests. The S&L debacle and the Irish accounting control frauds demonstrate that securitization is not essential to a lender acting as an accounting control fraud. A lender that follows the accounting control fraud recipe is mathematically guaranteed to report record (albeit fictional) profits in the near term and it can use those fake profits to borrow huge sums and hold the toxic loans in portfolio rather than selling them to the secondary market. It is true that the primary accounting control frauds were the originators and that makes DOJ’s sole emphasis on RMBS sales in the secondary market a bizarre, harmful decision.

The nonprime lenders who were the primary leaders of the twin mortgage origination fraud epidemics overwhelmingly chose to operate in the shadow financial system because of the absence of any meaningful regulation in that sector. (This puts the lie to your crazy Uncle George who is always sending you rants blaming the crisis on the Community Reinvestment Act (CRA), Fannie and Freddie, and Senator Dodd and Rep. Frank.) But it is also true that many of these shadow lenders were affiliates of the huge commercial and investment banks. Further, the mortgage bankers’ “originate to sell” model was (successfully) premised on the willingness of the huge banks to buy millions of mortgages they knew to have been fraudulently originated by the mortgage bankers. Wall Street’s controlling officers lie at the core of this crisis. They caused Wall Street to create, fund, and use the shadow financial system in which the mortgage bankers operated.

Third, Citi exemplifies this pattern. It relied on the mortgage bankers in the shadow financial sector to provide it with hundreds of thousands of fraudulent mortgages which it promptly flipped and fraudulently sold through false reps and warranties to the secondary market. Citi also eagerly acquired the operations of the most notorious mortgage banker in America – Ameriquest. Ameriquest was infamous for originating fraudulent loans that targeted blacks and Latinos. At the time Citi acquired Ameriquest’s operations its controlling officers knew that those operations specialized in making predatory, toxic loans that would produce enormous real losses. The acquisition, however, would initially maximize the bonuses of Citi’s officers by promptly creating fictional reported profits.

Norris Wearies and Simply Writes Things He Knows to be False

Near the end of his column Norris simply gives up on any pretense of analysis and creates a myth that he knows is false.

“With the benefit of hindsight, it seems clear that no one involved in buying or rating these securities thought they posed any real risk. Fitch concluded that securities representing 99 percent of the $1.8 billion raised were investment grade — and 94 percent of them were AAA. Moody’s was a little more conservative. It rated only 89 percent of the certificates as Aaa, its best grade, although most of the rest were Aa1, just one notch below and a very high rating.

Moody’s was not retained to rate some of the securities that Fitch thought were investment grade, which could have been a sign that it was unwilling to give them high ratings. Because the underwriter — Citigroup — decided which rating agencies would be hired, the agencies had a clear incentive to be generous. An agency that was too critical might not get any business.”

The first paragraph is Norris’ version of the myth of the Virgin Crisis. The second paragraph demonstrates that what he is saying is a myth. There was an actual investigation, under Senator Levin, of the rating agencies and there are facts in the record that document that the first paragraph is a crude reinvention of history by Norris.

Let’s start with the “sellers” of the toxic mortgage products. What “facts” does Norris marshal to support his claim that the sellers of mortgage products that they knew were endemically fraudulent “clear[ly] thought they posed [no] real risk”? None. Instead, Norris notes that the toxic mortgage products were rated virtually without exception as “investment grade” and overwhelmingly rated the toxic components “AAA” – the same highest-possible rating given then to U.S. Treasury securities. To state what we know was obvious even to Norris (given what he wrote in the second paragraph), the ludicrously inflated credit ratings that Fitch and Moody gave to the toxic product did not represent proof that either the seller of the toxic mortgage product or the rating agencies “thought” that the toxic mortgage product represented no “real risk.”

We do not have to engage in any hypotheticals. Citi’s senior managers knew in detail, in writing, from Bowen’s underwriting team that that mortgage product it was selling (largely to Fannie and Freddie) was toxic and posed a certain risk of enormous loss to Citi because it was sold to the secondary market through false “reps and warranties” that rose to 80% of all sales by Citi.

Similarly, we know from the Clayton reviews that the sellers of toxic mortgage product were informed that 46% of the loans they purchased to create their toxic mortgage products that received the hyper-inflated ratings were sold through fraudulent “reps and warranties” by the loan originators during the 18 months beginning January 2006. We also know that the percentage of fraudulent “reps and warranties” found by Clayton grew every quarter from mid-2006 through mid-2007 and eventually represented a majority of all loans reviewed. (Each of these facts was made public in Clayton’s testimony and submissions to the Financial Crisis Inquiry Commission.) We know empirically therefore, that the sellers of the toxic product knew with certainty that the instruments they were creating posed a grave risk of loss to the purchasers and that the sellers consistently did not disclose these grave risks documented by Clayton to the purchasers of the toxic mortgage products. The sellers knew that the toxic mortgage products that they were selling were not remotely “AAA” or even “investment grade” product. Whistleblowers at Citi, JPM, and Bank of America confirmed these facts and the efforts of the sellers of the toxic mortgage products to hide these risks.

We know that the sellers of the toxic CDOs worked with the rating agencies in clear conflicts of interests in which the agencies acted as both “consultants” and “independent” raters to give AAA ratings to a facially preposterous percentage of the CDO at times when they knew the underlying mortgages were the product of the twin origination fraud epidemics (ensuring unprecedented defaults and losses upon default), they knew housing prices were falling, and they knew the loans had “layered” risks certain to magnify defaults and losses upon default. Norris admits this later point, though he falsely portrays it as a story of “strategic” defaults when overwhelmingly it was a case of inherent default.

“The worst-performing of the six groups of loans — with losses so far equaling almost a quarter of the money lent — had a heavy concentration of loans to borrowers who had virtually no equity in their homes. Most of those loans also required only the payment of interest for the first several years. Some of these borrowers no doubt chose to walk away when prices fell.”

Yes, if you make loans in which you “qualify” the borrower’s “ability to repay” the loan on the basis of the initial, far lower monthly payment, if you require no downpayment, and if you make the loan interest-only in the early years you guarantee that enormous numbers of borrowers will be unable to make their monthly payments once the loan “resets” to the “fully indexed” interest rate that requires a substantially larger monthly payment. Note that while these practices would be insane for an honest lender, they optimize accounting control fraud. First, by qualifying the borrower at the teaser rate and requiring no downpayment the lender is able to make a dramatically larger loan. The lender’s controlling officers crafted their compensation system to loan officers and loan brokers to create a perverse incentive (from the bank’s standpoint, not the CEO’s standpoint) that would encourage making the most and largest loans at the highest accrued rate of interest.

Second, under (abusive) accrual accounting, the bank was able to book its interest income account at the fully indexed (significantly higher) interest rate rather than the interest rate that the borrower was actually paying. This created huge amounts of non-cash “phantom interest.”

Third, by reducing the borrower’s monthly payments for two-to-three years the CEO was able to artificially depress “early payment defaults” (EPDs). The definition of an EPD varies from a failure to pay that occurs during the first 90 days, six months, or first year. EPDs are a clear indicator of potential mortgage origination fraud. EPD soften trigger “buyback” demands of mortgages sold on the secondary market. By delaying and reducing EPDs the lenders’ controlling officers were able to extend the life of their accounting control fraud schemes.

While some professional investors with no equity doubtless engaged in “strategic” defaults it is revealing that Norris ignores all the defaults driven by the lenders’ loan practices. The defaults driven by the lenders’ loan practices are far more common. Norris is an instinctive apologist for the elite banksters.

The exceptional percentage of the CDO structure receiving AAA ratings that Norris refers to demonstrates that the CDOs had only a thin crust of subordination that was inadequate to provide serious “first loss” protection. That means that the CDO was structured to be horrendously risky, not risk free, and that the AAA rating for the top tranches was a sham and the investment grade rating for virtually all of the (incredibly thin) subordinated interests was a sick joke.

Yes, as long as the bubble is hyper-inflating the home loan losses can be hidden by refinancing the defaulting loans. That is why the saying in the trade is that “a rolling loan gathers no loss.” But that demonstrates, not disproves, the fact that the twin epidemics of loan origination fraud posed a fatal risk of loss to banks like Citi and to purchasers of its toxic mortgage sales.

Senator Levin’s committee released many of the shocking statements by employees and officers of the credit rating agencies documenting that they knew that the CDOs posed severe risks of loss. It was the credit rating agencies that decided to religiously avoid doing any due diligence on the mortgages that were the “underlying” for the CDOs. The agencies knew that if they conducted due diligence they would find and document endemic fraudulent reps and warranties in the origination and sales of mortgages. Documenting the CDOs’ critical risks would have prevented the rating agencies to give even investment grade ratings to the top CDO tranches. The credit rating agencies could have simply reviewed the Clayton reports – they refused to do so. No honest credit rating agency would act in this manner.

Norris also admits (and the Senate record proves) that the banks’ controlling officers deliberately created a Gresham’s dynamic among the credit rating agencies (as they did with appraisers) to drive good ratings out of the system. Indeed, Norris (correctly) states that the banks’ senior officers were successfully generated this coercion in order to suborn the credit rating agencies’ controlling officers. The credit rating agencies’ controlling officers were made wealthy by the banks because they allowed themselves to be suborned by the fraudulent bank officers.

The Next Norris Myth: “People” Believed “There Was No Risk” in CDOs

As bad as Norris’ article has been to this point, he chose to end on a disgraceful note. Norris claims that the problem is “they” – the purchasers of the toxic mortgages that Wall Street’s most elite institutions sold them through fraudulent disclosures. Wall Street was simply the local heroin dealer that sold a product that the addicts wanted to buy. Norris begins by discussing the “spread” investors thought they might earn by purchasing Wall Street’s toxic CDOs.

“Yet none of those factors seemed important when the securitization was sold. The initial interest rates on the tranches ranged from 5.7 to 6.3 percent. At the time, 10-year Treasury notes were yielding 5.1 percent. It was not much of a premium, but people were confident there was no risk. That was, after all, what triple-A was supposed to mean.

Norris often hides his analytical sloppiness through vague phrases such as “people were confident there was no risk.” The difference between two interest rates is referred to as the “spread.” If markets were efficient the spread would represent the risk premium that investors required to be induced to purchase the riskier investment. Norris is correct to talk about spreads, but he misses the key spread and he misses the need to distinguish among “people” in this context.

The even more important spread was nominal spread between various types of nonprime loans and prime loans. That spread generally declined as the incidence of fraud in nonprime loans grew sharply, the housing bubble grew and then burst and home prices fell in 2006-2007, and the risk characteristics of nonprime loans reached epic proportions as a result of “lawyered” risks. Each of these factors dramatically increased the risk of nonprime loans relative to traditional prime loans and collectively they should have caused the spread to surge by many hundreds of basis points. Instead, the spread fell or remained flat. There is no explanation for that result under conventional finance. An epidemic of accounting control fraud by lenders, however, produces that result. As large numbers of lenders follow the fraud recipe they compete against each other to grow rapidly by attracting borrowers who represent such poor credit risks that they are willing to promise to pay a premium interest rate. The spread that the fraudulent lenders can extract from the borrowers falls in response to this competition to attract borrowers.

Similarly, the Allowance for Loan and Lease Losses (ALLL) fell while these three factors that dramatically increased the risk of nonprime loans surged and as the percentage of total loans represented by nonprime loans grew enormously. Collectively, this should have caused the nonprime lenders to increase their ALLL provisions by hundreds of basis points. Instead, the ALLL fell to a record low last seen during the accounting control fraud epidemic of the savings and loan debacle. This violates GAAP, but optimizes accounting control fraud.

The spread that Norris focuses on is between various CDO tranches and the (credit) “risk-free” rate for 10 year Treasury notes. The spread is even smaller than it appears because U.S. mortgage securities have substantial prepayment risk that Treasury notes do not pose. If markets were efficient finance theory provides that one should compute an “option adjusted spread” to make the two rates comparable. Computing an OAS adjustment would further reduce the apparent spread and enhance Norris’ observation that the spread is far too small, but it would also conflict with his analysis. Indeed, the OAS adjustment could easily leave the spread between the most senior CDO tranche and the 10 year Treasury note negative.

Those very small CDO spreads over the 10 year Treasury, however, were not a result of “people” being “confident” that “there was no risk” in buying CDOs. First, there was a premium, indicating that there was a known credit risk in purchasing CDOs even if that risk was viewed as small. Second, there is every reason to believe that the DCO market was one of the most anti-efficient markets in history. CDO assets were massively overvalued, which mean that risk was massively underpriced. Why did some “people,” rush to acquire CDO tranches while most investors refused to purchase them? One of the principal reasons for the demand to purchase CDO tranches was the perverse incentives that led the investment banks to “eat their own cooking.” A large part of this demand to purchase CDO tranches arose not because the investment bankers were “confident” that “there was no risk” in buying CDOs, but because they knew the opposite to be true. It was in large part the investment banks’ knowledge that they could not sell many CDO products except at a discount (because of their risk) that led them to purchase them for their own account to make it appear that there was strong demand for the products.

The other reason that investment banks like Merrill Lynch “ate their own CDO cooking” is that it allowed Merrill officials to game Merrill’s compensation system. If one is paid for investing the firm’s capital on a risk-adjusted return basis then investing in a faux “risk-free” asset like a super senior CDO tranche that paid even a small premium over Treasuries was a “sure thing” that was guaranteed to lead to large bonus because of its superior risk-adjusted yield. The executives who followed this “sure thing” strategy made tons of money – right up until the point where the CDO market collapsed and the reality emerged. The risk adjusted spread on CDOs, of course, was massively negative. Buying CDOs was a superb means of destroying the firm’s wealth. Nominal yield is not an economically meaningful number. The ABX indices demonstrate that sophisticated investors viewed CDOs as having very large, and sharply increasing credit risk.

The customers who purchased CDO tranches at par or at a premium do appear to have been the naïve participants that assumed that the big three credit rating agencies had blessed CDOs and declared them to be virtually risk free. That was a distinctly minority view within the financial community. The people that crafted the CDOs worked hard and consciously to keep these naïve investors ignorant of the massive risks embedded in CDOs.

Norris Successfully Struggles to End on a Disgraceful Note

Norris is so eager to be an apologist for the elite bankers that he throws anything available at the wall in the hopes that something will stick. The five things he argues are logically inconsistent and (logically) condemn rather than excuse the elite bankers’ actions. If Norris were right about these points the implications for our Nation and the global economy would be catastrophic. Norris is so focused on defending the banksters that he is blind and blasé about each of these points.

“The banks have paid tens of billions of dollars to put this mess behind them, and no doubt their bosses have many regrets. But I doubt they really believe they did anything illegal, or at least think they had no real choice at the time. It was telling that in settlement negotiations Citigroup argued that its fine should be based on its low market share in the securitization market, not on any evaluation of what it actually did.

And it may well be true that actions like Citigroup’s were necessary for any bank that wanted to stay in what then appeared to be a highly profitable business. Imagine for a minute what would have happened in 2006 if Citigroup had listened to its consultants and canceled the offerings. To the mortgage companies making the loans, that might have simply marked Citigroup as uncooperative. The business would have gone to less scrupulous competitors.

Many years ago, a promoter who was trying to justify selling some bad investments explained his actions by saying, in effect, ‘Sometimes you just have to sell what they want to buy.’”

The five points Norris made in his closing apologia are:

  1. The bank CEOs don’t “really believe they did anything illegal”
  2. Alternatively the elite bank CEOs “at least think they had no real choice at the time”
  3. “[A]ctions like Citigroup’s were necessary for any bank that wanted to stay in what then appeared to be a highly profitable business.”
  4. “[I]f Citigroup had listened to its consultants and canceled the offerings … [t]he business would have gone to less scrupulous competitors.”
  5. “Sometimes you just have to sell what they want to buy”

I submit that if your teenage child made any of these excuses to you it would have prompted an immediate parental lecture on ethics and the paramount need to do the right thing. Norris’ excuses would cause us to cringe even if they were uttered by a child.

First, none of us care what the banksters claim now that they “really believe.” They will obviously claim to “really believe” that they never act illegally. On the facts shown they acted illegally, in breach of their fiduciary duties, and unethically – and they did so solely for the purposes of personal greed. Citi’s senior managers caused it to purchase billions of dollars in fraudulently originated loans on the basis of reps and warranties they knew to be false and then sold them to the secondary market on the basis of reps and warranties by Citi that they crafted to be false. This inherently meant that they engaged in accounting and securities fraud. The senior managers then retaliated against the whistleblower who warned them of these massive violations of law and fiduciary duty that put Citi in a situation that would cost it over $10 billion in losses.

If Citi’s senior managers don’t “really believe” that these actions are “illegal” they are even more dishonest and dangerous than we feared. There is an urgent need to place Citi in receivership and replace the entire management team if Norris is correct.


Second, Norris’ claim that the bank CEOs “at least think they had no real choice” but to purchase hundreds of thousands loans they knew to fraudulently originated and then to sell them to the secondary market through fraudulent reps and warranties is self-refuting. Citi would have been vastly more profitable had it not committed these massive frauds. Integrity and competence are superior choices that were readily available to Citi’s managers. Richard Bowen showed the path of integrity and competence.  Norris’ invocation of “there is no alternative” to dishonesty demonstrates his inability to gin up an apology for the elite banksters that can pass the “pass out from continuous laughing test.”

Third, let’s examine the logical and ethical holes in Norris’ claim that “actions like Citigroup’s were necessary for any bank that wanted to stay in what then appeared to be a highly profitable business.” Every aspect of that sentence is absurd. I’ll begin with the concept that banks must make loans that “appear” to be profitable based on their nominal yield. That claim is financially illiterate. Nominal yields are at best a starting point. Citi’s senior managers decided to go heavily in buying and reselling liar’s loan at a time when they knew that the fraud incidence in such loans was ninety percent. That made it obvious that any appearance of “high profitability” in liar’s loans was a lie – that such loans had a “negative expected value” at the time they were made. The only way that such loans could (falsely) appear profitable even in the near term was to violate GAAP and fail to establish the (huge) loss reserves required to cover the losses inherent in making such endemically fraudulent loans.

Then there is the critical matter of Norris’ novel claim that if fraudulent “actions like Citigroup’s were necessary” to appear to be profitable the banks senior managers must lead a massive fraud that inherently makes Citi liable for billions of dollars in losses. Fraud by Citi was never “necessary,” it was always strictly unnecessary and wrong. Did Norris ever stop to think that he was running a seminar teaching our most elite banksters the most banal of excuses for elite frauds? What conceivable legitimate purpose did he pretend to himself he was pursuing?

Fourth, if Citi controlling officers hadn’t committed the massive frauds that caused Citi and those that purchased its loans to suffer billions of dollars in losses then some “less scrupulous” bank would have committed the massive frauds and both caused and suffered billions of dollars in losses. Yes, if I hadn’t committed armed robbery against the drunk businessman some “less scrupulous” armed robber might have done so. And the point of this apologia for armed robbery is? If Norris were capable of embarrassment he would have retired when he read that sentence of his draft column. What exactly makes Norris think that Citi’s controlling officers are more “scrupulous” fraudsters than other frauds? I look forward to reading in his next column his list of the “less scrupulous” banksters.

Norris ends his apologia for the elite banksters with this whimper: “Sometimes you just have to sell what they want to buy.” No, you don’t. No one has to sell crack, meth, or heroin even if millions of people want to buy it. No bank has to make fraudulent loans or sell fraudulent loans through fraudulent reps and warranties, or sell fraudulent CDOs through fraudulent reps and warranties. The “they” that wanted to buy was not an honest, competent banker but banksters who were looting “their” banks through the fraud recipe. Norris decide to end his apologia with a plea to his readers to cheer banksters when they adopt moral depravity as their ethical standard.

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