By William K. Black
April 20, 2016 Bloomington, MN
Holman Jenkins, the ultra-conservative Wall Street Journal columnist who specializes in global climate change denial and elite financial fraud denial, has written recently to join Paul Krugman in defending the systemically dangerous banks. Jenkins is a member of the WSJ’s loopy editorial board. Jenkins’ title was “Big Banks Aren’t the Problem.” Jenkins’ thesis raises obvious and vital questions – he ignores each of them because answering them would falsify his thesis.
The 2008 crisis did not begin in a handful of too-big-to-fail banks, but in incentives cast far and wide among home buyers, mortgage brokers, lenders and others to underwrite tax-advantaged, one-way bets on home prices.
I wrote this during Passover, so I followed the tradition of asking four questions.
- When did “the 2008 crisis” “begin?”
- Who created the “incentives?”
- Why did they create the “incentives?”
- Who had “one-way” incentives?
What Caused the Financial Crisis?
There can be no sure answer to the question of when a massive crisis “begin[s].” Attempting to answer the question implicitly requires understanding the causes of the crisis. The global financial crisis required three elements to come together. We needed huge losses on assets, a hyper-inflated bubble, and the failure of a systemically dangerous financial institution. These three elements may not “begin” at the same time and the elements are so interrelated that trying to date their exact beginning is a useless effort. We can say that the first element, which was critical to causing the second and third element, began to develop by 1988 – twenty years before Lehman failed.
The S&L debacle never caused a crisis or a recession because the regulators under Federal Home Loan Bank Board Chairman Gray began the effective reregulation and resupervision of the agency in 1983 – one year after the key act of federal deregulation and two years after the onslaught of desupervision. The reason the current crisis occurred is that the first (barely) meaningful rule adopted to reregulate the industry (putting aside our actions that began in 2000 to drive liar’s loans out of the S&L industry) was the Fed’s ban on liar’s loans in mid-2008, but even then Bernanke delayed its effective date to November 2009. The anti-regulators led by Greenspan and Bernanke, despite their grant of clear regulatory authority under HOEPA in 1994, refused to adopt any effective rule to ban liar’s loans for 15 years despite repeated warnings of endemic fraud and predation and pleas for action against the lenders making liar’s loans.
In the United States, the losses came from the two great epidemics of loan origination fraud – appraisal fraud and “liar’s” loans. Those losses were then reallocated through the third great epidemic of fraud, sales of the fraudulently originated loans through fraudulent “reps and warranties” to the secondary market and investors. These three fraud epidemics, each an example of “accounting control fraud,” also caused the financial bubble to hyper-inflate. The bubble, in turn, increases losses. Lehman’s failure triggered the global crisis, but if it had not been Lehman it could have been the losses caused by these three fraud epidemics at any of roughly a dozen large financial firms that would have been trigger. Had Lehman survived longer, total losses could have increased if the bubble resumed its expansion (which generally ended, depending on the particular U.S. local housing market, at different times during 2006).
Prior to Lehman’s failure, over a hundred fraudulent mortgage lenders failed without triggering any systemic financial crisis. It took the failure of a single systemically dangerous institution (SDI), Lehman, to trigger the domestic and global crisis.
When Did the Three Fraud Epidemics that Drove the Crisis Begin?
The “Liar’s” Loans Fraud Epidemic
It takes a significant number of fraudulent loans to endanger the solvency of a home lender or purchaser of mortgages or mortgage products (financial derivatives “backed” by the cash flows from the “underlying” mortgages). By 2006, roughly 40% of all the mortgage loans originated that year were liar’s loans, including half of all the loans the industry called “subprime.” The subprime and liar’s loan categories are not mutually exclusive. It is perfectly possible – and became the norm – to make loans to people with no or poor credit histories (i.e., subprime) without verifying critical information about the home buyer’s capacity to repay the loan (i.e., liar’s loans).
The term “liar’s” loans was not invented by regulators to prejudice people about such loans. The term was invented and used by the members of the finance industry because they knew such loans were endemically fraudulent. By 2006, the mortgage lending industry’s own anti-fraud specialists (MARI) reported to the industry that the incidence of fraud in liar’s loans was 90 percent.
When did liar’s loans begin? They first became material in 1990 during the savings and loan debacle. They were not called liar’s loans in that era and they had a lower incidence of fraud when they began. They were called “limited documentation” loans. Like most financial frauds in America, they began in Orange County, California. We, the West Region of the Office of Thrift Supervision (OTS), had jurisdiction over those fraudulent lenders. Our personnel were stretched dealing with the paramount “control fraud” epidemic driving the debacle – commercial real estate loans, there was no track record on liar’s loans, and the liar’s loans were modest in size relative to total lending. Nevertheless, our examiners got it right from the beginning. They understood that it made no sense for an honest lender to deliberately fail to verify the borrower’s income. They also understood that failing to verify the borrower’s income meant excellent sense for an “accounting control fraud” employing the infamous fraud “recipe” for a lender.”
That recipe has four “ingredients” for a lender (or loan purchaser).
- Grow like crazy by
- Making (or buying) crappy loans at a high nominal yield while
- Employing extreme leverage and
- Putting aside only trivial allowance for loan and lease losses (ALLL)
The recipe produces three “sure things.”
- The firm will promptly report high profits
- The officers will be made wealthy by modern executive compensation
- The firm will suffer large losses
The reader can now see why it makes sense from the officers’ perspective to originate and buy massive amounts of fraudulent liar’s loans sure to produce huge losses to the firm. The reader can now understand the title of George Akerlof and Paul Romer’s classic 1993 article about accounting control fraud – “Looting: The Economic Underworld of Bankruptcy for Profit.” What has changed since 1993 is that the systemically dangerous financial institutions are rarely allowed to become bankrupt.
We had trained our examiners to understand the fraud recipe and detect these frauds when they were still reporting record profits. The result of our examiners’ insights and our crackdown was that we drove liar’s loans out of the S&L industry beginning in 1991. By 1994, this effort was so successful that the largest and most politically powerful lender specializing in making liar’s loans – Long Beach Savings – gave up its federal deposit insurance and its charter as an S&L for the sole purpose of escaping our jurisdiction. This fraud scheme began in the federally regulated sector in the late 1980s and then moved to the shadow sector in the 1990s in response to our regulatory vigor. It would later move back to the federally regulated sector (in alliance with the shadow sector) when Presidents Clinton and Bush destroyed that federal regulatory vigor.
Long Beach Savings changed its name to Ameriquest and became a mortgage banking firm not subject to normal federal or state banking regulation. The best book by far about the causes of the recent financial crisis, Michael W. Hudson’s The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America–and Spawned a Global Crisis rightly focuses on Ameriquest’s CEO as the originator (pun intended) of the crisis. This fraud scheme, liar’s loans, that was a primary driver of the most recent crisis, began during the S&L debacle – almost exactly 20 years before Lehman failed.
When liar’s loans first became material around 1988, they were far too small in volume to cause massive losses or to hyper-inflate a bubble. It takes time for the world’s most damaging financial fraud schemes to become epidemic and for the largest bubble in history to hyper-inflate. Vigorous regulators who understood the fraud recipe had no difficulty understanding in 1989 that only firms engaged in accounting control fraud would make liar’s loans a business practice. Our regulatory crackdown on liar’s loans is part of the explanation for why it took years for liar’s loans to become massive. Recall that by 2006, 40% of all the home loans made that year were liar’s loans and one-half of the loans called “subprime” that were made that year were also liar’s loans.
Wall Street and the Shadow Jointly Drove the Fraud Epidemics
Hudson’s book title demonstrates a more sophisticated and honest understanding of the crisis than Krugman and Jenkins. The crisis was not caused by systemically dangerous banks or “shadow” firms that were not federally regulated. It was caused by both – acting together to produce the three fraud epidemics that caused the massive losses, hyper-inflated the bubble, and caused the failure of Lehman and other systemically dangerous financial institutions.
Hudson explains that it was the Orange County S&L owners that we drove out of the S&L industry that first made liar’s loans a major force. Yes, they operated in the mid and late-1990s in the “shadow” sector to escape our regulatory vigor. From very early on, however these shadow frauds were dependent on huge Wall Street firms for their funding and to purchase their loans in the secondary market.
Ameriquest’s former affiliate, Long Beach Mortgage, illustrates another common tie between the systemically dangers and federally regulated firms and the shadow. The officers controlling Washington Mutual (WaMu), which became the largest bank failure in U.S. history, acquired Long Beach Mortgage in 1999 so that it could dramatically increase its origination of fraudulent liar’s loans. WaMu eventually made Long Beach Mortgage a subsidiary of the savings and loan.
Similarly, Citigroup purchased two of the most notorious mortgage lenders’ assets from firms specializing in liar’s loans in 2007 (Ameriquest, after its bankruptcy, and Argent, when it was in reality insolvent but falsely claiming to be viable). Citigroup had been purchasing hundreds of billions of dollars in increasingly fraudulent loans from notorious lenders (and then fraudulently reselling the loans to others) for years. (They also knew that the MARI reported a 90% fraud incidence in liar’s loans.) This meant that Citigroup’s most senior leaders knew that the particularly infamous lenders and mortgages they chose to purchase had horrific fraud incidence and had consistently been sold through false reps and warranties to Citigroup and others. Indeed, Richard Bowen, one of my fellow co-founders of Bank Whistleblowers United, explicitly put Citigroup’s senior management on direct, written notice that Argent. The FHFA, in its capacity as conservator for Fannie and Freddie, made this point in its pleadings.
In 2007, Citigroup acquired Argent from its parent ACC Capital Holdings Corp. This acquisition is notable because Mr. Bowen, who was described above was a Chief Underwriter within Citigroup’s Consumer Lending Group was given the opportunity to review Argent before Citigroup acquired it. He reported that “large numbers” of Argent’s loans were “not underwritten according to the representations that were there.” FCIC Hearing Transcript, Apr. 7, 2010, p. 239. Despite Mr. Bowen’s warnings, however, Citigroup proceeded with the acquisition and in fact touted it, stating that “[t]hrough this acquisition, we gain important operational and pricing efficiencies . . . from point of origination through securitization and servicing.” Citigroup Press Release, Aug. 31, 2007.
HOEPA, Alan Greenspan, and Ayn Rand
In 1994 – the same year that Ameriquest entered the shadow to escape our jurisdiction, Congress passed the Home Ownership and Equity Protection Act (HOEPA). HOEPA gave the Federal Reserve, and only the Fed, the jurisdiction to ban liar’s loans by all lenders, including those in the shadow not normally subject to federal regulation. Recall that our examiners, with far less information about a brand new lending program that lacked any track record, correctly predicted that the loans would have severe fraud levels. By 1994, as MARI would note in its 2006 report to the industry on the endemically fraudulent nature of liar’s loans, our examiners’ predictions about the fraud levels and losses had proven correct. The Fed, therefore, was in a superb position to act immediately. It did not have to invent the wheel. We knew the fraud recipe.
But President Ronald Reagan had appointed Alan Greenspan, an Ayn Rand disciple, to run the Fed in 1987 – after it became public that Greenspan had been a key supporter and ally of Charles Keating, the worst head fraudster of the S&L debacle. Keating ran the S&L industry’s worst accounting control fraud pursuant to the fraud recipe. The remarkable fact, however, is that President Clinton twice reappointed Greenspan – in 1996 and 2000 – even though Greenspan had refused to use his HOEPA authority to ban the rapidly expanding liar’s loans despite urgent requests by law enforcement (like Tom Miller quoted above), state financial regulators, and housing advocates. Greenspan refused to use HOEPA or any other power to take any effective regulatory or supervisory action against the three rapidly growing fraud epidemics that hyper-inflated the bubble and drove the crisis.
Greenspan’s successor, Ben Bernanke, (a Republican appointed by President Bush) also refused to use HOEPA to ban liar’s loans or take any other effective regulatory or supervisory response to the three fraud epidemics. Bernanke finally used HOEPA to ban liar’s loans in July 2008 – a year after such loans had fallen to minimal levels. Even then, he delayed the effective date of the rule until November 2009 lest he inconvenience any fraudulent lenders. Despite his indefensible record of abject regulatory failure, President Obama appointed Bernanke to the Fed in 2009.
The Appraisal Fraud Epidemic
The Financial Crisis Inquiry Commission (FCIC) provides evidence on how early the appraisers’ warned the regulators and the public about the growing epidemic of appraisal fraud.
“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).
The appraisal organization began the warning process in 1998 – a full decade before Lehman’s failure. As with liar’s loans, the appraisal fraud epidemic reprise a key fraud scheme that helped drive the S&L debacle. Appraisal fraud is simple for juries deciding criminal cases to understand. They “get” within 30 seconds that no honest lender would extort appraisers to inflate appraisals (which is itself a crime) in addition to the key role that appraisal fraud plays in the broader accounting fraud scheme.
FCIC also presented data indicating how common appraisal fraud became by 2003 – and how it was endemic by 2006. A survey of appraisers in 2003 found that 55% of them reported personally being pressured to inflate the appraised value. By 2006, the survey found that 90% of appraisers report personally being pressured to inflate values.
The Secondary Market Fraud Epidemics – Fraudulent Mortgage and Mortgage Derivative Sales
There were two, related, epidemics of sales of mortgages and mortgage derivatives through fraudulent reps and warranties to the purchasers. Again, FCIC provides key data, this time from the infamous loan “due diligence” firm – Clayton. Clayton’s managers only act of brilliance was going early to the prosecutors to get immunity from prosecution. Clayton’s data would have allowed hundreds of successful prosecutions of fraudulent lenders, if we had a Department of Justice rather than a department bearing that oxymoronic name.
Clayton was hired by purchasers of mortgages to perform (not very) due diligence reviews of a small sample of the loans to see check whether the seller’s reps and warranties concerning the quality of the loans and the underwriting process that the lenders followed in deciding whether to make the loans. The testimony before FCIC was that Clayton had 70% of the total market. Purchasers chose Clayton on the basis of its lack of merit – the officers of the purchasers did not want to find and document the endemic fraud in the loans they were purchasing. This makes the fact that Clayton found that from January 2006 to mid-2007 46% of the reps and warranties it reviewed were false. By the second quarter of 2007, Clayton found that over half of the reps and warranties it reviewed were false. This exceptionally high level of fraud in reps and warranties, of course, was driven by deceit about the borrower’s income and the appraised value of the home.
The officers of the purchasers of loans from the fraudulent lenders knew (from Clayton and multiple other sources) that the loans were pervasively fraudulent and that the reps and warranties of the originator/seller were false. Officers of the purchasers of these loan packages then commonly resold the loans – often packaged as mortgage back securities (MBS) or collateralized debt obligations (CDOs) – to others (or even to their own firms – “eating their own cooking”) through fraudulent reps and warranties. The firm would eventually suffer losses, but the officers would make out like bandits due to the fraud recipe. The firms would lose because they “ate their own cooking” or because of their liability for knowingly selling fraudulently originated mortgages, or CDOs or MBS backed by those mortgages, to other through fraudulent reps and warranties. FCIC’s review found that the “critical information” on the falsity of the reps and warranties about loan quality and the endemic falsity of claims of compliance with loan underwriting “standards” known to the sellers of MBS and CDOs was not disclosed to purchasers.
Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this critical information was not disclosed (FCIC 2011: xxii).
When did these fraudulent sales through false reps and warranties begin? They began in the 1987. The first CDOs were by the notorious fraud – Michael Milken’s Drexel Burnham Lambert (FCIC 2011: 129). Those CDOs suffered large losses because they were backed by fraudulently overvalued junk bonds. Akerlof and Romer 1993 and my book explain the Drexel fraud scheme and its links to the S&L debacle. In sum, all three fraud epidemics that hyper-inflated the residential real estate bubble and drove the financial crisis that became so acute in 2008 had their roots in the S&L debacle. The crackdown on Drexel Burnham Lambert and the fraudulent (“captive”) S&Ls that aided its frauds slowed the CDO frauds from reaching epidemic proportions.
The next iteration of toxic CDOs was in the late 1990s and beginning of the next decade. The CDOs of this era were a hodgepodge of overvalued, high risk assets such as manufactured housing. These CDOs caused large losses beginning in 2002 (FCIC 2011: 130).
The third iteration of toxic CDOs was overwhelmingly “backed” by toxic home mortgages. These CDOs were far larger than the first two iterations and they caused catastrophic losses.
“The whole concept of ABS [asset backed securities] CDOs had been an abomination,” Patrick Parkinson, currently the head of banking supervision and regulation at the Federal Reserve Board, told the FCIC (FCIC 2011: 129).
Parkinson is correct, but the reader should know that Greenspan chose him to testify before Congress that it should create the regulatory black hole (through the passage of the Commodity Futures Modernization Act of 2000 denying all federal and state regulators any ability to protect counter-parties and the public from the sale of toxic financial derivatives. That Act was strongly pushed by Bill Clinton, Greenspan, Senator Gramm (R. TX), and Larry Summers for the purpose of blocking permanently Brooksley Born’s regulatory initiative to protect the public from toxic derivatives.
Here is how Greenspan explained to Born, in their first meeting in 1996, his disdain for regulator who act to prevent fraud.
“Well, Brooksley, I guess you and I will never agree about fraud’ [Greenspan]
“What is there not to agree on?” [Born]
“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the market would take care of itself.
CDOs and credit default swaps (CDS) are two obvious financial derivatives that led to losses and failures and warranted the term “abomination.” But why, with that record of failure, would an economist who was a Greenspan lackey who had never been a supervisor be made head of the Fed’s supervision? Parkinson told Congress that the derivatives markets took care of themselves. It turns out that Parkinson’s predecessors, Richard Spillenkothen and Sabath Siddique, a senior deputy, experienced supervisors, enraged senior Fed officials by criticizing the massive banks’ frauds. See the FCIC report (pp. 59-60; 172-173) and the Spillenkothen white paper to FCIC for the details, and savor the fact that the Fed’s economists’ example of a derivatives trading operation that warranted the greatest praise was – Enron. Enron’s derivatives trading operation was a leading cause of the criminal actions to cause – and profit from – the California energy crisis. That makes it less surprising that Greenspan and his team were enraged when Spillenkothen warned that at least eight huge financial institutions eagerly aided another Enron accounting fraud involving Special Purpose Vehicles (SPVs) that were the precursors to frauds of the Special Investment Vehicles (SIVs) in the current crisis.
Who Created the Perverse Incentives that Led to the Three Fraud Epidemics?
No government entity ever encouraged liar’s loans, appraisal fraud, or fraudulent reps and warranties. Even the (second) Bush administration’s anti-regulators discouraged liar’s loans – a point emphasized by MARI as one of its famous four warnings to lenders about liar’s loans in early 2006. The appraisers’ petition made clear that the extortion of appraisers was by lenders and their agents, the loan brokers. In economics, criminology, and regulation, we call this the deliberate creation of a “Gresham’s” dynamic in which bad ethics drives good ethics from the markets or professions.
Who created the massive secondary market for liar’s loans and CDOs? Investment banking firms, not Fannie and Freddie. Recall that the purpose of liar’s loans is to inflate the borrower’s income. The obvious point is that inflating the borrower’s reported income is not a good strategy to make more “affordable housing” loans to people reporting below-median income. The less obvious point reinforcing this conclusion is presented in the FCIC report.
Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not. Alt-A mortgages 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 affordability goals (FCIC 2011: 125).
Who created the perverse financial incentives for loan officers and brokers to make liar’s loans and inflate appraisals? The elite bankers created those incentives – contrary to warnings even from Bush’s anti-regulators.
The evidence presented to the Federal Reserve in 2007 by state prosecutors confirmed that the source of the fraud, and the perverse incentives, was the officers of the lenders making liar’s loans. Tom Miller, Iowa’s Attorney General and the head of state attorney generals’ task force on mortgage fraud, stressed this investigative finding in his testimony to the Fed urging it to use HOEPA to ban liar’s loans.
“[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.” Tom Miller, Iowa AG
The elite bankers also maintained those perverse incentives for years in the face of internal and external reports and the warnings of Bush’s anti-regulators that the compensation system was producing endemic fraud and bad loans. Indeed, the bank officers covered up the fraud and defaults by refinancing the bad loans for years, following the industry adage that “a rolling loan gathers no loss.”
The compensation system was more perverse than the initial description I just gave. It also created an incentive to rip off the borrower – the bank’s customer – by inducing him or her to pay an excessive interest rate. Blacks and Latinos were disproportionately victim of this predation. These incentives were created entirely by the lenders’ senior officers – and they were almost always maintained despite internal and external reports confirming that they were ripping off customers.
Who created the perverse incentives to inflate credit ratings and for the engagement partners of the outside auditors to ignore endemic accounting fraud? The officers controlling both sides of those transactions created and maintained those perverse incentives even when they knew that it was producing massively inflated ratings and “clean” opinions for the filthiest firms.
Who created the perverse incentives to destroy effective financial regulation through the global regulatory “race to the bottom?” That was the world’s largest financial entities and their political contributions, revolving doors, and massive speaking fees for former government officials. As Hillary Clinton says – we all do it. Actually, only a tiny minority of us do so, but the two real points are that her “defense” is actually a condemnation of an inherently corrupting practice – and that she is blind to that fact. The corporate speeches that make former government officials wealthy are simply a thinly disguised form of bribery – and everyone in America knows it in their bones. The giant banks don’t bother to bribe (oh so legally) even fairly senior regulators because it is so much more efficient to bribe the agency heads, who as Hillary says know that they will be made wealthy by those bankers when they leave government “service.” The agency heads know that the only thing that will stop the bankers from making them wealthy would be to lead a fundamental transformation of the corrupt culture of Wall Street that would end the rigged system.
The financial system was rigged by Wall Street’s leaders. They created the perverse incentives that Jenkins blames for the crisis. The prominent politicians and anti-regulators’ culpability is part of the same corrupt system of crony capitalism created by Wall Street’s leaders and their parasitic politicians. The problem is bipartisan. The “New Democrats” were and are the Wall Street wing of the Democratic Party. Wall Street financed the New Democrats’ infrastructure and gave large contributions to their candidates. But Republicans are traditionally even more devoted to serving Wall Street’s interests. Jenkins claim that the politicians are corrupting the poor innocent Wall Street CEOs is humorous.
Why Did the Fraudulent Wall Street CEOs Create the Perverse Incentives?
First, doing so optimized the fraud recipe for the officers controlling the fraudulent lenders and the fraudulent purchasers and fraudulent resellers of those mortgages, MBS, and CDOs. Second, creating the incentives was a superb means of creating deniability for the CEO. The really clever CEO could, in conjunction with the Nation’s top lawyers, say and write all the right things to “prove” that he was constantly seeking to promote ethics and honesty. Contemporaneously, the perverse compensation incentives, the CEO’s hiring, promotion, and firing practices (particularly of whistleblowers) ensure that the fraud becomes endemic. Deniability is also optimized by the fact that by stressing the bonus targets and by issuing tracking reports to the staff on whether the projected income for the quarter or year would maximize the bonuses the CEO of a huge firm creates powerful incentives among thousands of officers and employees capable of engaging in accounting fraud that produces enough (fictional) reported income to maximize the bonuses. The CEO can then truthfully, but dishonestly, testify that he knew nothing about the false accounting entries and doesn’t even understand the relevant accounting issues.
Third, liar’s loans optimize fraud and greatly increase the difficulty of prosecuting the lender’s controlling officers. A prudent loan would always require verification of the borrower’s income and the retention of that verification in the loan files that regulators’ bank examiners review. That poses a severe risk for fraudulent lenders if (a) the regulators understand the fraud recipe and (b) they are vigorous in discovering, documenting, and prosecuting fraud. Following the fraud recipe requires the lender to gut its loan underwriting system in order to knowingly make thousands (even hundreds of thousands) of crappy loans. That gutting of underwriting is what competent regulators that understand the fraud recipe use as their “tell” in identifying frauds while they are still reporting record profits.
As long as firms are required to document that they verified the borrower’s capacity to repay the loan and face highly competent and vigorous regulators that understand the recipe and are vigorous and courageous in going after the frauds the officers running the fraud have only bad choices.
Option 1: The lender documents that it knew it was making loans to thousands of people who lacked sufficient income to have the clear ability to repay the loans. The loan files serve as admissions that allow the regulator to take enforcement action against the lender and the officers involved and require the lender to cease all such loans. The examiners are also trained to recognize that an honest lender would not make such loans and promptly alert senior regulators that the lender may well be an accounting control fraud. The lender either ceases the loan practices or the officers expose themselves to prosecution if they continue to make loans that they know are likely to default because the borrower lacks the income to repay the loans.
Option 2: The borrower’s income, required on the loan application, is missing on hundreds of loan files. The examiners investigate a sample of the missing information. If the missing entries characteristically occur when the actual income information would be inadequate to provide reasonable assurance of capacity to repay the loan. The examiners’ review demonstrates both the underlying fraud scheme (the fraud recipe) and the deliberate cover up of that underying fraud through the selective removal of negative information.
Option 3: The fraudulent lender selectively removes the adverse information and inserts forged positive information that makes it appear that the lender has verified that the borrower has sufficient income to have the capacity to repay the loan. Forgeries can, of course, deceive even competent examiners, but forging thousands of documents is harder than most people believe, is vulnerable to whistleblowers or more junior officers being “flipped” by prosecutors, and produces a compelling criminal case if the forgeries are discovered. .
This trilemma does not exist, however, if the lender never has to verify the borrower’s income. Liar’s loans make it far harder prove that the lenders’ officers knew that they were making thousands of loans to borrowers who did not have enough income to have the capacity to repay the loan.
Who Had “One-Way” Incentives?
Home Buyers’ Incentives
Recall that Jenkins claimed that the crisis was driven by “home buyers, mortgage brokers, lenders and others [who] underwr[o]te tax-advantaged, one-way bets on home prices.” Home buyers, however, did not make a one-way bet on home prices. Home buyers suffered, enormously, when home prices fell. The typical home buyer was not buying a home for the purpose of making a bet on future home prices. The typical home buyer buys a home as a primary residence for his or her family.
Loan Brokers and Loan Officers’ Incentives
Mortgage brokers also did not make “one-way bets” on home prices. First, regardless of whether home prices fell or rose, the perverse compensation incentives created by the leadership of the lenders ensured that the loan brokers and loan officers won – and the sleaziest loan brokers won most. Testimony before FCIC contains devastating admissions on this subject.
More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan officers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about 10,000 loan originators a year…. (FCIC 2011: 7)
His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs “flipping burgers,” he told the FCIC. Given the right training, however, the best of them could “easily” earn millions.” (FCIC 2011: 8)
He taught them the new playbook: “You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.” He added, “I knew that the risk was being shunted off. I knew that we could be writing crap. But in the end it was like a game of musical chairs. Volume might go down but we were not going to be hurt” (FCIC 2011: 8).
Similar admissions came from an even more unexpected source.
Marc S. Savitt, a past president of the National Association of Mortgage Brokers, told the Commission that while most mortgage brokers looked out for borrowers’ best interests and steered them away from risky loans, about 50,000 of the newcomers to the field nation-wide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were “absolutely” corrupt (FCIC 2011: 14).
What kind of industry is run by CEOs that design perverse incentives that allow kids whose prior experience was “flipping burgers” to “easily” make (not “earn”) over a “million” dollars annually for “writing crap” loans that were not “suitable for the borrower?” A corrupt industry. What kind of CEO maintains those perverse incentives for years after myriad warnings that the incentives produce endemic crap loans that harm the borrower and will not “perform” (the euphemism for defaulting)? An “absolutely” corrupt CEO.
Loan brokers received (not “earned”) a substantially greater fee for inducing uncreditworthy borrowers to take out a loan – and to pay an above “market” interest rate for the loan. That perverse incentive was created by the officers controlling the lenders and the secondary market purchasers. Second, the loan brokers did not make a “bet” – they had a “sure thing” – and that sure thing was deliberately created by the officers controlling the fraudulent lenders to induce them to make thousands of bad loans that would never be repaid. The perverse incentive was even more malicious than I have explained, for by inducing loan brokers to extort appraisers to inflate values and inflate the borrowers’ reported income the fraudulent officers controlling the lenders made it possible to report far higher income in the loan origination process and to resell the loans to the secondary market at a premium price.
Second, Jenkins’ “bet” metaphor indicates a failed analysis of the crisis. As I have explained, the fraud recipe produces a “sure thing.” That is a key attraction of employing the fraud recipe.
Jenkins appears to be referring to the incentives of the firms (as opposed to the incentives of the lenders’ officers that I just explained). The lenders (commercial banks, S&Ls, investment banks, and mortgage banks) could not make a “one-way bets on home prices” through the fraudulent lending practices that caused the three fraud epidemics. A lender whose officers made huge amounts of liar’s loans or frequently extorted appraisers to inflate home values faced not a “risk” of loss, but a certainty of loss. Even if it sold the loans that it fraudulently originated, it could only do so through fraudulent reps and warranties, which made it liable for the inevitable losses. A seller of loans that it originates to sell to the secondary market also has many loans at any time in the “pipeline” at any given time. It will get stuck with those loans when the bubble inevitable collapses. When such a lender engages in endemic loan origination fraud the losses in the pipeline when the bubble collapses will typically be large enough to prove fatal. Hundreds of home lenders that made large numbers of liar’s loans failed in 2006-2009.
Jenkins Incoherent Ravings about Why He Supports Systemically Dangerous Banks
Jenkins’ assertions are so incoherent, unsupported by facts or logic, ideological, and partisan that it is difficult to try to discern a thesis. He claims “big banks are government creations.” He also claims that we can and should prevent all financial crises by having the public bail out the massive banks’ fraud losses caused by their elite officers’ looting of the bank. That bailout should come in the form of a blank check guarantee of the systemically dangerous banks’ asset values. The blank check should come from the Fed, because that will avoid any messy problems with a democratic populace refusing to write (recurrently) that blank check.
Jenkins was as ideological and fact-free in an earlier related column, but he was at least clearer.
We’re not saying banks didn’t make bad loans; didn’t saddle themselves with opaque assets; didn’t wallow under massive accounting losses when rating agencies belatedly realized assets they had previously blessed were illiquid and hard to value. But neither were banks destined to lose fatal amounts of money by holding these assets till maturity granted the stabilizing role of a lender of last resort to make sure a liquidity panic didn’t metastasize into an economy-wide solvency meltdown [emphasis in original].
How many “bad loans” did they make? Jenkins is not interested in the data. FCIC has data on this issue. For example, by “December 2006, almost 17% of [New Century’s] loans were going into default within the first three months after origination” (FCIC 2011: 157). New Century specialized in making liar’s loans. That default rate at three months is roughly 50 times what an honest lender traditionally suffered. Freddie’s loans were caused vastly disproportionately by liar’s loans (FCIC 2011: 187).
The delinquencies and defaults on liar’s loans, particularly subprime liar’s loans, that the national delinquency rate reached staggering levels.
Mortgages in serious delinquency, defined as those 90 or more days past due or in foreclosure, had hovered around 1% during the early part of the decade, jumped in 2006, and kept climbing. By the end of 2009, 9.7% of mortgage loans were seriously delinquent. By comparison, serious delinquencies peaked at 2.4% in 2002 following the previous recession (FCIC 2011: 215).
FCIC then reported that the delinquency rate in the worst states – which made far more liar’s loans – were double the average rate for the remainder of the nation – which was quadruple the rate of the last recession. “By late 2009, the delinquency rate for subprime ARMs was 40%” (FCIC 2011: 216). The percentage of “exploding rate” ARMs that were liar’s loans was exceptionally high. FCIC reports that a Fed study of the large banks in 2005 found that “two-thirds of the nontraditional loans made by the banks in 2003 had been of the stated-income, minimal documentation variety known as liar loans, which had a particularly great likelihood of going sour (FCIC 2011: 20). Liar’s loans rose dramatically – by roughly 500% — from 2003-3006. (One of the inexplicable weaknesses of the FCIC report is its practice of implicitly making the false assumption that subprime loans were not liar’s loans when, by 2006, half of them were liar’s loans. This failure frequently lead FCIC to analytical mistakes.)
Jenkins’ demons are Fannie and Freddie, which are often referred to as government-sponsored enterprises (GSEs) because they are so massive that they are too big to fail and therefore have the implicit federal guarantee common to the roughly 25 largest financial firms in America. The reality, however, is that losses were far larger in home loans not sold to Fannie and Freddie.
In 2008, the respective average delinquency rates for the non-GSE and GSE loans were 28.3 and 6.2% (FCIC 2011: 219).
CDOs were disproportionately created from the worst loans, producing extraordinary credit rating downgrades to levels indicating default. “More than 90% of Baa CDO bonds and 70.3% of Aaa CDO bonds were ultimately impaired (FCIC 2011: 229). What that jargon means is that even CDO tranches with very high – even the highest – credit ratings either defaulted or suffered a rating decline so severe that it would typically trigger a default under normal loan agreements.
The circular part of Jenkins’ assertions is that “big banks are government creations” because they are able to take advantage of the central banks’ implicit guarantee that they will bail out those banks’ “bad loans.” The central banks can provide this blank check to bail out the giant banks without any vote from the public. The bailout can be done by the central bank accepting even fraudulent, “crap” loans with huge losses as collateral for massive (trillions of dollars) loans from the central bank to the failed giant banks. Even when the fraudulently originated loans default the banks are allowed to pretend that they are “holding these assets till maturity.” Home loans in the U.S. typically have a term of 30 years, and most extant loans in 2008, particularly after the unprecedented refinancing of U.S. home loans a few years earlier in that decade, had over two decades prior to maturity. Jenkins is saying that the banks could simply sell even foreclosed homes at a “profit” if they waited, if necessary for decades, for home prices to rise enough to allow the home to be sold for more than the original amount of the loan.
Wonks may realize that the accounting rules do not allow the banks to avoid recognizing the losses. The banks had an answer for that problem. In another example of crony capitalism, the odd coalition of President Obama, the Congress, the Chamber of Commerce, Wall Street, and the Fed united for the none-to-noble, but oh-so-successful, extortion of FASB to pervert GAAP and allow the banks to avoid loss recognition through this legalized accounting scam.
Jenkins’ assertions are circular. He believes that the Fed should provide massive, off-budget, and unlimited federal guarantees to giant banks so that the crises their CEOs cause when they create fraud epidemics will not be as severe. He wants the Fed to be able to give that blank check from us to Wall Street without any requirement for a democratic vote. He also says that the banks can only grow to become massive because of this undemocratic, blank check from us to Wall Street. In essence, he urges us to continue what his favorite source (the Richmond Fed) says is a corrupt process in which Wall Street is able to hold the American people for “ransom.” (I’m quoting from the Richmond Fed’s research director’s book on macroeconomics.) Jenkins’ latest attempt to shill for the systemically dangerous banks actually condemns them.