Steven Krystofiak Warned the Fed 12 Years Ago
By William K. Black
August 6, 2018 Bloomington, MN
Steven Krystofiak formed the Mortgage Brokers Association for Responsible Lending, a professional association dedicated to fighting mortgage fraud and predation. On August 1, 2006. He tried to save our Nation by issuing one of the most prescient warnings about the epidemic of mortgage fraud and predation and the crisis it would so cause.
The context was Congress’ effort to empower and convince the Federal Reserve to take action against what the mortgage lending industry called, behind closed doors, “liar’s” loans. A liar’s loan is a loan in which the lender does not verify (at least) the borrower’s actual income. The industry knew that the failure to verify inherently led to endemic fraud. George Akerlof and Paul Romer’s 1993 article on “Looting” by financial CEOs explicitly cited the failure to verify the borrower’s income as an example of a lending practice that only fraudulent lenders would use on a widespread basis.
Congress gave the Fed the unique authority to ban all liar’s loans in 1994, by passing the Home Ownership and Equity Protection Act (HOEPA). HOEPA gave the Fed the authority to ban liar’s loans even by “shadow” sector financial firms that had no federal deposit insurance.
Liar’s loans began to become material around 1989 during the savings and loan debacle where all good U.S. financial frauds are born – Orange County, California. In that era, they were called “low documentation” (‘low doc’) loans. We (the West Region of the Office of Thrift Supervision (OTS), were the federal regulator for these S&Ls, and we were overwhelmed dealing with the “control frauds” driving the debacle, who overwhelmingly used commercial real estate (CRE) as their accounting “weapon” of choice. Our examiners, however, made two critical points. No honest lender would make widespread loans without verifying the borrower’s income because it was certain to produce severe “adverse selection” and produce serious losses. The examiners’ second warning was that such loans were growing rapidly in Orange County and multiple lenders were involved.
We listened and responded well to our examiners’ timely and sound warnings and made it a moderate priority to drive liar’s loans out of the industry we regulated. The last of the major fraudulent S&L liar’s loan lenders was Long Beach Savings. Long Beach set a common pattern for fraudulent lenders by also engaging in predation primarily against Latinos and blacks. In 1994, the same year HOEPA became law; Long Beach voluntarily gave up federal deposit insurance and its charger as a savings and loan. Long Beach’s controlling owner, Roland Arnall, did this for the sole purpose of escaping our regulatory jurisdiction and our ability to examine, sue, and sanction the S&L and its officers. Arnall changed its name to Ameriquest, and converted it to a mortgage bank. Mortgage banks were essentially unregulated. Arnall successfully sought sanctuary in what we now call the “shadow” financial sector. The S&L debacle did not end. It found sanctuary in the Shadow and grew 50% annually for 13 years.
Ameriquest and its leading mortgage bank competitor, run by former S&L officers we (OTS) had “removed and prohibited” from working in any federally insured lender, became the leading “vectors” spreading the epidemic of fraudulent liar’s loans through (initially) the shadow sector and later back into federally insured lenders. Many of Arnall’s lieutenants eventually left Ameriquest to lead other fraudulent and predatory lenders making predatory liar’s loans. Michael W. Hudson’s book, The Monster, is a great read that presents this history. Ameriquest and its fraudulent and predatory peers grew at extraordinary rates for over a decade. They hyper-inflated the bubble and drove the financial crisis.
Alan Greenspan and Ben Bernake refused to use HOEPA to stop this surging epidemic of fraudulent and predatory liar’s loans. This was the setting when Krystofiak, on his own dime and initiative took advantage of a Fed hearing on predatory lending near his home to warn us all of the coming disaster. Krystofiak was not the first warning. His written testimony cited the appraisers’ and the FBI’s prior warnings. The appraisers’ 2000 petition explaining how lenders and their agents were extorting appraisers to inflate appraisals was superb. Chris Swecker’s 2004 warning on behalf of the FBI that the developing “epidemic” of mortgage fraud would cause a financial “crisis” if not stopped was superb.
Krystofiak was also superb. The Fed did not want to conduct hearings on fraudulent and predatory liar’s loans – Congress forced it to do so. The Fed’s Board members were not interested in stopping fraudulent and predatory liar’s loans. The Fed did not invite Krystofiak to testify. The Fed offered only a brief “cattle call” at the end of the hearing allowing (after a top Fed official had left to fly back to DC) the public to make a very brief statement.
The Fed’s treatment of Krysofiak stood in sharp contrast to its fawning treatment of the Mortgage Bankers Associations’ chosen witness. The MBA chose the leading originator of fraudulent liar’s loans in California – IndyMac – to present the MBA’s position. The MBA’s position was that the Fed should not use its HOEPA authority to ban fraudulent and predatory liar’s loans. The Fed officials cracked jokes with and treated the IndyMac officer like an old pal. They treated Krytofiak with cold indifference. The MBA witness presented utter BS. Krystofiak spoke truth to power. Power loved the BS. The truth discomfited the Fed officials.
Krytofiak’s written testimony made many vital points, but I refer to only two related points here. First, he warned the Fed that the twin mortgage fraud origination epidemics – appraisal fraud and liar’s loans – were so large that they were inflating the housing bubble. Second, his means of quantifying the incidence of liar’s loan fraud showed the regulators and the prosecutors that they could use the same method to document reliably, cheaply, and quickly the incidence of liar’s loan fraud at every relevant financial firm.
Data Collected by the Mortgage Brokers Association for Responsible Lending
- A recent sample of 100 stated income loans which were compared to IRS records (which is allowed through IRS forms 4506, but hardly done) found that 90 % of the income was exaggerated by 5 % or more. MORE DISTURBINGLY, ALMOST 60 % OF THE STATED AMOUNTS WERE EXAGGERATED BY MORE THAN 50%. These results suggest that the stated income loans deserves the nickname used by many in the industry, the “liar’s loan” (emphasis in original).
The MBA’s anti-fraud experts, MARI, appears to have conducted the study for Krystofiak. They featured the 4506-T (the “T” stands for “transcript”) study and its finding of a 90% fraud incidence in liar’s loans. In 2006, MARI presented its fraud study at the MBA’s annual meeting. The MBA sent MARI’s report to every member, which included all the major mortgage players.
Any honest originator, purchaser, or packager of liar’s loans was on notice no later than mid-2006 that they could determine quickly, cheaply, and reliably the fraud incidence in those liar’s loans by using the 4506-T forms to test a sample of those loans. Krystofiak aptly noted that while lenders typically required borrowers to sign the IRS 4506-T form allowing the lender to access their tax information, it was actually “hardly done.” Lenders supposedly require the 4506-T because taxpayers have an obvious interest in not inflating their income to the IRS. The self-employed have to report their income accurately or face potential tax fraud sanctions.
The reason liar’s loan mortgage lenders, purchasers, the packagers of toxic collateralized debt obligations (CDOs ) that typically were composed of large amounts of liar’s loans, and credit rating agencies, “hardly [ever] used” or required the sellers to use their 4506-T authority is also clear if you understand “accounting control fraud.” Any 4506-T study of liar’s loans will document their pervasive frauds. Virtually all liar’s loan and CDO sales required “reps and warranties” that they were not fraudulent. If a firm making or selling liar’s loans conducted a 4506-T study and documented that it knew its reps and warranties were false, and it continued t make, sell, package, or rate those fraudulent loans under false reps and warranties it would be handling its counterparty a dream civil fraud suit. They would be handing DOJ the ability to prosecute them successfully for felonies that caused hundreds of billions of dollars in losses. The fraudulent mortgage money machine relied on the major players following a financial “don’t ask; don’t tell” policy.
The exceptions prove the rule. I have found public evidence of only two cases in which mortgage players (other than Krystofiak) conducted 4506-T audits of liar’s loans. I have never found public evidence that any federal regulator or prosecutor conducted or mandated a 4506-T study. The two known cases of 4506-T audits were Wells Fargo (just disclosed by DOJ) and Countrywide (disclosed by the SEC investigation and complaint). Both audits found massive fraud incidence in the liar’s loans. The risk officers presented these audit results to the banks’ senior managers.
Bank Whistleblowers United’s 4506-T Proposal
Two and-a-half years ago, Bank Whistleblowers United (BWU) discussed the senior officers of Countrywide’s response to its 4506-T audit. We noted that BWU co-founder Michael Winston blew the whistle on Countrywide’s frauds to the bank’s most senior officers to try to prevent these frauds. Mr. Winston eagerly aided potential prosecutors – who failed to prosecute Countrywide’s senior officers leading the frauds. BWU then explained the analogous response of Citigroup’s senior officers to a different but equally reliable audit conducted by BWU co-founder Richard Bowen. We did so in a January 30, 2016 New Economic Perspectives blog urging presidential candidates in the 2016 election to pledge to implement the 60-day BWU plan to restore the rule of law to Wall Street.
As documented in the SEC complaint, Countrywide’s managers conducted a secret internal study of Countrywide’s liar’s loans that, on June 2, 2006, confirmed Krystofiak’s findings of endemic fraud in liar’s loans. Fraud was the norm in Countrywide’s liar’s loans, a fact that it failed to disclose to its stockholders and secondary market purchasers. Instead of stopping such loans, Countrywide’s senior officers caused it to adopt what they termed “Extreme Alt-A” loans offered by Bear and Lehman that “layered” this fraud risk on top of a half dozen additional massive risks to create what Countrywide’s controlling officer described as loans that were “toxic” and “inherently unsound.” “Alt-A” was the euphemism for liar’s loans. Countrywide made massive amounts of “Extreme Alt-A” and acted as a vector spreading these “toxic” loans throughout the financial system. A member of our group, Dr. Michael Winston, tried to stop these kinds of abuses, which enriched top management but bankrupted Countrywide.
Similarly, a member of our group, Richard Bowen and his team of expert underwriters, documented that Citigroup knew that it was purchasing tens of billions of dollars of loans annually on the basis of fraudulent “reps and warranties” – and then reselling them to Fannie and Freddie on the basis of fraudulent reps and warranties. Bowen put the highest levels of Citigroup (including Bob Rubin) on personal notice in writing as the incidence of fraud climbed from 40% to 60%. (It eventually reached an astonishing 80% fraud incidence.) Citigroup’s leadership’s response was to remove his staff. Senior Citigroup officers also responded to the surging fraud by causing Citigroup to become a major purchaser of fraudulently originated liar’s loans.
We can now add the senior leaders that determined Wells Fargo’s response to its 4506-T audit. We draw on the Department of Justice (DOJ) disclosures in conjunction with its indefensible settlement of civil fraud claims against Wells Fargo’s massive mortgage fraud. The DOJ press release revealed that “in 2005, Wells Fargo began an initiative to double its production of subprime and Alt-A loans.” DOJ did not explain that this was after the FBI warned there was an emerging “epidemic” of mortgage “fraud” that would cause a financial “crisis” if it were not stopped. The settlement discloses that Wells’ risk officers alerted senior managers that the plan to increase greatly the number of liar’s loans would greatly increase fraud in 2005 before Wells implemented the plan.
The press release had other bombshells (unintentionally) demonstrating the strength of the criminal cases that DOJ refused to bring against Wells’ senior officers. Wells Fargo’s 4506-T audit found that its liar’s loans were endemically fraudulent, and the amount of inflated income was extraordinary.
The results of Wells Fargo’s 4506-T testing were disclosed in internal monthly reports, which were widely distributed among Wells Fargo employees. One Wells Fargo employee in risk management observed that the “4506-T results are astounding” yet “instead of reacting in a way consistent with what is being reported WF [Wells Fargo] is expanding stated [income loan] programs in all business lines.”
The press release note some other actions by Wells’ senior managers that show what prosecutors term “consciousness of guilt.” Such actions make (real) prosecutors salivate. The press release’s final substantive revelation is the unbelievable rate of loan defaults on Wells Fargo’s fraudulent loans and the exceptional damages those loans and sales caused.
Wells Fargo sold at least 73,539 stated income loans that were included in RMBS between 2005 to 2007, and nearly half of those loans have defaulted, resulting in billions of dollars in losses to investors.
Typical default rates on conventional mortgages averaged, for decades, around 1.5 percent. The Wells Fargo liar’s loans defaulted at a rate 30 times greater.
How Corrupt is Wells? Cheating Customers is “Courageous”
The press release does not contain the Wells Fargo gem that proves our family rule that it is impossible to compete with unintentional self-parody. Paragraph H of the settlement reveals that Wells’ term for doubling its number of fraudulent liar’s loans in 2005 was “Courageous Underwriting.” Wells’ senior managers changed its compensation system to induce its employees to approve even worse loans. Calling defrauding your customers “courageous” epitomizes Wells Fargo’s corrupt culture built on lies and lies about lies.
DOJ’s pathetic settlement with Wells Fargo has no admissions by the bank. It does not require a penny in damages from any bank officer. It does not require a bank officer to return a penny of bonuses received through these fraudulent loans. The settlement contains DOJ’s statement that its investigation found that Wells’ violated four federal criminal statutes. DOJ will continue to grant de facto immunity from prosecution to elite banksters. The Trump administration has again flunked a major test dealing with the swamp banksters.
Section H (b) of the settlement is factually inaccurate in a manner that makes it highly favorable to fraudulent lenders making liar’s loans. There is no indication that DOJ ever investigated Wells’ fraudulent loan origination practices. It was overwhelmingly lenders and their loan brokers that put the lies in liar’s loans. DOJ’s settlement documents do not refer to Wells whistleblowers, even though and competent investigation would have identified dozens of whistleblowers. Throughout its Wells documents, DOJ implies that borrowers overstated their income rather than Wells and its loan brokers.
The Jig is Up on DOJ’s Pathetic Excuses for Refusing to Jail Elite Bank Frauds
We now know with certainty from the whistleblowers and the internal audits that the response of Citigroup, Countrywide, and Wells Fargo’s senior leaders to knowing that most of their liar’s loans and the reps and warranties they made about those loans were fraudulent. We know with certainty that Michael Winston and Richard Bowen’s disclosures were correct. We know with certainty that each served up to DOJ on a platinum platter dream cases for prosecuting Citigroup and Countrywide’s top managers. The senior managers’ response to proof that their banks were engaged in endemic fraud makes sense only if the senior managers were leading an “accounting control fraud,” which enriches the managers by harming the lender.
When the appraisers’ warned of extensive extortion by lenders and their agents to inflate appraisals, when the FBI warned that mortgage fraud was becoming “epidemic” and would cause a financial “crisis” if not halted, and when the MBA publicized Krystofiak and MARI’s warnings that liar’s loans were endemically fraudulent, the fraudulent CEOs’ response was always the same. In each case, they expanded what they knew were endemically fraudulent liar’s loans and increased the extortion of appraisers.
Back to BWU’s 4506-T Proposal
This brings us back to reminding the public what BWU proposed 32 months ago about 4506-T audits. Point 17 of our 60-day plan began:
Within 60 days, each federal financial regulatory agency directs any bank that it regulates to conduct and publicly report a “Krystofiak” study on a sample of “liar’s” loans that they continue to hold. Krystofiak … devised a clever study that he presented to the Federal Reserve in an unsuccessful attempt to try to get the Fed to stop the epidemic of fraudulent liar’s loans. Lenders and secondary market purchasers routinely required borrowers to authorize the lender and any subsequent purchaser of the loan to obtain a “transcript” (4506-T) of the borrower’s tax returns from the IRS to allow the lender to quickly and inexpensively verify the borrower’s reported income.
Other parts of our 60-day plan called for DOJ appointees with the courage, integrity, and skills to restore the rule of law to Wall Street. We also explained the needs (and means) for the banking regulators to conduct the investigations (such as 4506-T audits), activate a legion of whistleblowers, and make the criminal referrals to DOJ essential to bring successful prosecutions.
Had the regulators (particularly the Fed through its HOEPA power) required each bank making liar’s loans to conduct a 4506-T audit, the senior managers would have faced a dilemma. They could stop the fraudulent lending or provide DOJ with a great opportunity to prosecute them. The bank CEOs’ response to the internal audits showing endemic fraud and the retaliation against the whistleblowers combine to offer superb proof of senior managers’ ‘specific intent’ to defraud. The reasons for the failure to prosecute were some combination of cowardice and politics. If Democrats win control of the House they can use their investigative powers to force each bank regulator to cause every relevant financial institution to conduct a 4506-T audit.
Of course, the Republican Senate and House chairs could order those steps today. We are not holding our breath, but BWU’s co-founders are eager to aid either, or both, parties restore the rule of law to Wall Street. Instead, we are rapidly creating an intensely criminogenic environment on Wall Street that will eventually cause a severe financial crisis.