By William K. Black
Kansas City, MO: December 2, 2014
The Financial Crisis Inquiry Commission (FCIC) report described one of three epidemics of accounting control fraud that drove the financial crisis in these terms.
“Some real estate appraisers had also been expressing concerns for years. From 2000 to 2007, a coalition of appraisal organizations circulated and ultimately delivered to Washington officials a public petition; signed by 11,000 appraisers and including the name and address of each, it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” [FCIC 2011: 18].
The FCIC Report then documents scale of this epidemic of loan origination fraud.
“One 2003 survey found that 55% of the appraisers had felt pressed to inflate the value of homes; by 2006, this had climbed to 90%. The pressure came most frequently from the mortgage brokers, but appraisers reported it from real estate agents, lenders, and in many cases borrowers themselves. Most often, refusal to raise the appraisal meant losing the client” [FCIC 2011: 91].
A clarification is in order. The “client” was rarely the buyer because, for obvious reasons, we do not allow the borrower to select the appraiser. Even moderately-sized lenders have vastly greater power to successfully extort appraisers than does any residential borrower. It may be true that “many” borrowers tried to “pressure” appraisers to increase the appraisal, but the overwhelming source of such pressure was from lenders and their agents and virtually all of the successful pressure came from lenders and their agents.
Then New York State Attorney General Andrew Cuomo’s investigation confirmed that the largest mortgage lenders were leading the extortion of the appraisers to inflate appraised values.
“[I]n 2007the New York State attorney general sued First American: relying on internal company documents, the complaint alleged the corporation improperly let Washington Mutual’s loan production staff ‘hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to close, and improperly permit WaMu to pressure …. appraisers to change appraisal values that are too low to permit loans to close’” [FCIC 2011: 92].
These three findings allow us to understand a great deal about the appraisal fraud epidemic.
- Appraisal fraud was endemic
- Appraisal fraud was led by the controlling officers of lenders and their agents
- No honest lender would ever coerce, or permit, the inflation of the appraised value because the home’s true value provides a critical protection to the lender
- The lenders’ controlling officers were deliberately creating a “Gresham’s” dynamic in which bad ethics drives good ethics out of the appraisal profession
- Honest lenders’ controlling officers could easily block such a Gresham’s dynamic by creating desirable financial incentives and internal controls that will block inflated appraisals
- Appraisal fraud optimizes accounting control fraud by lenders (and loan purchasers)
In the late 1980s and early 1990s I trained regulators, special agents (FBI, IRS CID, and Secret Service), state prosecutors, and AUSAs these same implications of appraisal fraud and testified about those implications before Congress and in criminal trials. Regulators, law enforcement personnel, jurors, and even members of Congress readily understood the implications I just set out. Jurors typically “got it” within 15 seconds. The WSJ, writing about the third epidemic of appraisal fraud in 30 years, still doesn’t “get it.”
We now have well documented experience with two epidemics of appraisal fraud – the savings and loan debacle and the current crisis plus the developing epidemic. It should be very hard to get appraisal fraud wrong given these painful experiences and the appraisers’ astounding petition that made it inescapably clear no later than the year 2000 that there was an epidemic of appraisal fraud led by the lenders’ controlling officers. Unfortunately, the Wall Street Journal is up to the task of getting it horrendously wrong.
Stop Me If You’ve Heard This Before: The WSJ Blames the Fraud Mice
The WSJ’s title for its article on appraisal fraud makes obvious that it has learned nothing from two fraud epidemics in two crises a quarter-century apart. “Dodgy Home Appraisals are Making a Comeback: Industry Executives See Parallels With Pre-Crisis Valuations, Regulators are Wary.” Every aspect of the title is disingenuous. The bank “executives see parallels” because they have run the same appraisal fraud scheme twice only a few years apart. That is one of the immense social costs of failing to prosecute the banksters that led the fraud epidemics that drove the financial crisis. “Dodgy” is a misleading euphemism for “fraud.” The article uses the word “fraud” only once. Even then, it uses the word “fraud” only to describe civil investigations of appraisal fraud by Freddie Mac.
The WSJ’s key sources for the article – “Industry Executives” – are the “perps” leading the frauds. The WSJ article, however, never even considers the possibility that they are (again) leading the effort to extort appraisers to inflate the appraised value. The analytics-free nature of the WSJ article’s analysis is exemplified by this passage, which purports to explain the impact of decreasing home sales and a declining rate of home price appreciation.
“That has put increasing pressure on loan officers, who depend on originating new mortgages for their income, as well as real-estate agents, who live on sales commissions. That in turn is raising the heat on appraisers, whose valuations can make or break a sale.”
The obvious question, except to the WSJ, is why the banks’ controlling officers continue to design perverse compensation systems for loan officers. The loan officers don’t design their own compensation systems. Everyone saw in the most recent crisis that the compensation systems designed and implemented by the banks’ controlling officers were exceptionally criminogenic and had the inevitable effect of creating the three fraud epidemics that drove the financial crisis. We have known for over a century that if you pay loan officers on the basis of loan origination volume you will produce endemic fraud. No bank CEO can claim with a straight face to be “shocked, shocked” that when he creates perverse compensation incentives the result is endemic fraud.
The WSJ, however, tries to make it appear that the ever-so-honest managers are paragons of virtue who first create compensation systems that create overwhelming incentives that produce endemic loan origination fraud by loan officers – and then strive mightily to limit the resultant endemic fraud that they caused.
“While loan officers may be trying to boost the number of home loans they give out, their superiors and risk officers are charged with ensuring the quality of those loans.”
Here is a novel idea (that was once an exceptionally effective reality): why not pay loan officers in a manner that leads them to “ensur[e] the quality of those loans?” Honest lenders make money by “ensuring the quality of those loans.” Banks lose money when loan officers are compensated in a manner that “ensur[es] the [bad] quality of those loans.” Banking is not a game in which you create incentives for your own people to loot the bank – and then tell “their superiors and risk officers” to try to stop the looting that you have encouraged.
For sheer incoherence, this passage in the WSJ article is tough to beat.
“Banks turned to [appraisal-management companies] AMCs to help maintain a distance between loan officers and appraisers. That distance is intended to eliminate pressure on the appraiser to hit a certain price. But some in the industry say AMCs are now applying pressure in a bid to keep the lenders’ business.”
The first sentence claims that “banks” were hiring AMCs in an effort to try to prevent the bank’s corrupt loan officers from extorting appraisers to inflate appraisals. “Banks,” of course, are incapable of having any true intent. The article actually means to claim that the banks are run by honest CEOs who are making strident efforts to ensure that their corrupt loan officers do not extort appraisers to engage in appraisal fraud. Given that premise, the obvious question is the one I raised above – why do those same CEOs create the perverse incentives that corrupt the loan officers and create their overwhelming incentive to extort appraisers to commit appraisal fraud if the CEO is dedicated to preventing appraisal fraud? There is also an obvious way for bank CEOs to end promptly the coercion of appraisers by the bank’s corrupt loan officers – fire the corrupt loan officers and the appraisers who succumb to their extortion.
The second sentence adds to the incoherence. It states that the AMCs are now extorting appraisers to inflate appraisals. The article reports that “some” claim that the reason that the AMCs are extorting appraisers to inflate the appraisals is that the AMC’s are being extorted by the “lenders.” This should, of course, lead the author to explain what that word refers to. In context, it seems to admit the truth – that the extortion is led by the officers that control corporate policy, i.e., the bank CEOs. So much for the WSJ’s claim that the banks’ controlling officers are the good guys betrayed by the fraud mice.
The cherry on this incoherent sundae is provided by the Mortgage Bankers Association (MBA) – the trade association of the “perps.”
“‘The lender is held accountable—they need the appraisal to be accurate and to defend it years down the road,’ said Michael Fratantoni, chief economist at the Mortgage Bankers Association. He cited the agreed-upon purchase price as among the best measures of a home’s value.
Except, the “lender” was not held “accountable” for the endemic appraisal fraud that was a major cause of the financial crisis and the Great Recession. More importantly, the officers that control “the lender” were made wealthy by leading the three fraud epidemics that drove the financial crisis but were never held accountable. They did not even have their fraud proceeds clawed back.
The “agreed-upon purchase prices” is “among the best measures of a home’s value” – except where there is accounting control fraud. Appraisal fraud is an example of accounting control fraud in which the “agree-upon purchase price” is often dramatically inflated and is “among the [worst] measures of a home’s value.”
The funniest line in the title is “Regulators are Wary.” The Clinton and Bush administration anti-regulators were the recipients of the appraisers’ petition. They took no meaningful action to block the Gresham’s dynamic and the resultant epidemic of appraisal fraud. The Obama administration anti-regulators and anti-prosecutors have not prosecuted or sanctioned any senior banker for his role in leading the epidemic of appraisal fraud. The anti-regulators are so far from “wary,” and have been for so many years, that picturing them as vigilant rather than oblivious is very funny. An extremely careful reader of the article would realize that the article does not report that the supposedly “wary” regulators actually did anything that would be effective in stopping endemic appraisal fraud. The only thing the article describes the “wary” regulators as doing is this:
“The Office of the Comptroller of the Currency is reviewing the mortgages banks are doling out, concerned that some of them are based on inflated values….
The OCC found cases in which bank staff didn’t have enough training, Mr. Benhart said. In some cases, for example, they didn’t have experience with the type of property or the area, he said. It also found banks that didn’t thoroughly check reports or provide oversight of AMCs.”
No bank officer was sanctioned administratively by the regulators, sued by them, or prosecuted. No enforcement action is described as being taken by the OCC against any bank. The OCC is not described as adopting any rule. The OCC is not described as having made a single criminal referral. If this is what the WSJ thinks describes a “wary” regulator’s response to a fraud epidemic then they are delusional. I have explained in prior articles that the head of the OCC is an anti-regulator who has expressly refused to make ending control frauds led by bank CEOs a regulatory priority. Note that the OCC not only failed to use the word “fraud” to describe appraisal fraud, it also attributed the endemic appraisal fraud to preposterous explanations such as insufficient staff “training” and “oversight.”
Is it any wonder that voters are disgusted with both Democrats and Republicans who cannot agree on anything but more money for fraudulent bankers is good for the economy?
Your light never dims.
My first memories of appraisal fraud go back to the wild west days of Billy Sol Estes. In some cases it was not a question of an inflated appraisal but rather a question of whether the collateral even existed. Estes defrauded a number of lenders along these lines for years.
The next kind of fraud I encountered was when state insurance commissioners in Texas permitted insurance companies to keep two sets of books: statutory and GAAP. This made it possible for the insurance companies to play games with life insurance policy cash values. They started investing part of premiums received in mutual funds and earned a fee from the fund for each purchase, and some even tried to play games with how assets were reported between the two sets of books. So, things had gotten more sophisticated and the fraud was originating with the owners of some miscreant companies.
Then the sophistication increased and the S&L debacle occurred of which you are the noted expert. The companies were bigger the crooks were higher up the political ladder.
But throughout these frauds it seems that the regulators were just a bunch of bunglers at best and crooks at worst. I guess naivete comes with each new generation.
It seems to me that the best way to deal with all of these frauds is to shut down the vulnerable institutions.
Of course, many or most of the AMC’s are owned by banks, thanks to the Governor of NY.
“The Wall Street Journal Still Refuses to Grasp Accounting Control Fraud via Appraisal Fraud”
The Wall Street Journal’s very job is to refuse to grasp any concept that does not increase money and power for the Far Right Wing.
“It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”
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Fraud in mortgage based appraisals is the most obvious. Flying under the radar are phony appraisals made for clients trying to lower their ad valorem assessments for real estate taxes and the attorney that collects 25% of the tax savings; inflated condemnation award appraisals to unjustly enrich the property owner and the attorney who collects 1/3 of the increased award for a fee; conservation donors who get a large tax right off and the appraiser that collects a large fee for an inflated appraisal; divorce attorneys who coax appraisers into low or high appraisals in marital settlements to benefit their client; and the list goes on…….
Two causes of these abuses are the clients trying to unjustly enrich themselves and their attorneys who’s fees are dependent upon a favorable outcome–even if they seek and reward appraisers that will “see things their way”. But what makes the whole thing possible is the national appraisal organizations that do not enforce their professional codes of ethics because of fear of lawsuits and state appraisal boards that are comprised of politically appointed members who protect each other and their friends from disciplinary actions. The regularly offending appraisers are known to their peers and appraisal organizations, but it’s a “live and let live” mentality that allows it to persist.
And last but not least, the Federal agencies that are supposed to oversee appraisal boards and are more concerned with form than substance.
It’s all hanging out there is anyone is interested in reporting it!
I can testify that Mr. Black’s take on the causes of the Great Recession and agree with the comments above. The problem is not with regulations, but regulators who didn’t do their job. It is always some guy at the top making tons of money on deals they want financed by lenders who pay lower-level, unqualified workers to do their dirty work. This dirty work has been despised as a hitch in getting any loan where the borrower gets a favorable position, thereby leverage. The Wall Street guys gambled with the American (& World) population and injected greed into having a roof over your head. Now, these same “investors” bought up foreclosed homes, pushing out millions of Americans out of their too expensive homes. The guys with smoke and mirrors never got punished and the most powerful and unethical corporations benefitted handsomely for driving the world’s economy to the brink. Since 1% of the population controls the wealth and pulls the strings of power and advantage we have a plutocracy. CEOs making thousands of dollars per hour are not worth their pay when they do not add value to the society as well as profit for their company. The workers in banking and regulating appraisers now are unqualified and have made a bigger mess than we had in 1989 with the S&L Bailout. I was a review appraiser back then and we required good quality appraisals and did thorough reviews. I thought the trend would be toward a higher quality appraisals when we had a 2nd Bailout in 2008. What was needed was enough time and fee to complete a credible report, assigned to the right person. Reviews are more frequent in the current lending enironment, unfortunately, many are performed by non-licensed clerks with no experience. At a time when we needed it most, we didn’t get the regulators changed out and I am astonished to see the deterioration of our appraisal profession due to non-appraisers making decisions about who is to do a particular appraisal in a specific location with that property type. It appears the writing of regulations by non-appraisers in Washington D.C. and monied lobbyists have gotten away with the treasure pillaged from the former castle built on a crumbling foundation.