I have noted before a family maxim -- one cannot compete with unintended self-parody. Andrew Kahr has recently written a column in the American Banker entitled "Spread the Word: Lying to Banks is Illegal." Mr. Kahr is one of the architects of subprime lending. He warns:
Federal law provides that anyone who knowingly makes a false statement to a[n] ... insured institution ... shall be fined not more than $1,000,000 or imprisoned for not more than thirty years, or both.
To say the least, this criminal law, intended to protect banks and hence the deposit insurance fund, is very, very rarely enforced against consumers. Why?
How is a U.S. attorney to know that a customer has defrauded a bank by giving false information, unless the case is referred to him or her by the bank? And we're not doing that, at least not for mortgages, credit cards or other everyday consumer lending.
Hence, the plethora of consumers giving willfully and materially false information to banks on applications and during loan servicing has mushroomed. With "liar's loans," this went from a cottage industry to an epidemic.
Mr. Kahr neglects to mention that "insured institution[s]" are required to file Suspicious Activity Reports (SARs) (criminal referrals). As the FDIC explains:
The U.S. Department of the Treasury's financial recordkeeping regulations (31 CFR 103.18) require federally supervised banking organizations to file a SAR when they detect a known or suspected violation of federal law meeting applicable reporting criteria.
Collectively, banks make massive numbers of SARS filings with regard to mortgage fraud, over 67,000 annually, but a mere 10 institutions file 72% of those referrals. The typical nonprime lender deliberately violates its legal requirement to file a criminal referral when it discovers mortgage fraud even though that practice would be irrational for an honest lender. The federal regulatory agencies have not taken any effective action against these pervasive violation of their rules despite an "epidemic" of mortgage fraud that drove the ongoing financial crises.
Mr. Kahr continues by complaining that
[T]he news often encourages consumers to believe that you can lie to get a loan, or to forestall collection action, and that this is perfectly normal, common and acceptable. After all, "he told me that my income would not be verified." Nonverification, even if advertised in advance, is not an invitation to lie, and it does not exempt the liar from criminal consequences.
Occasionally you can see a newspaper story about a tattoo parlor operator who managed to buy six houses with nothing down and false applications. But the multiple and professional fraudsters are relatively few. Surely the great bulk of the fraudulent applications come from individuals who just want to buy and live in the house, or to do so on better terms.
Mr. Kahr sees only two sources of mortgage fraud -- and both are by the borrowers. He correctly states that there appear to be "relatively few" "professional fraudsters" among borrowers. To him, that leaves only one alternative -- "surely" millions of homeowners have defrauded the banks. The FBI, however, reports that 80% of mortgage fraud losses occur when "industry insiders" are involved in the fraud (FBI 2007).
Mr. Kahr then returns to his primary theme -- nonprime lenders acted irrationally by recurrently taking actions that were certain to increase mortgage fraud.
In days gone by, some loan application forms included, in bold type at the bottom, an excerpt from the criminal law ... defining fraud and specifying the penalties for it. Even before "the class of 2006," we stopped doing that. After all, it reduced loan volume -- both by discouraging bad applications and by increasing the decline rate based on less inflated claims by applicants.
Let's now do a thought experiment with "the bank where I work." Suppose you let it be known to applicants and loan customers that your policy is to detect and to refer for prosecution cases in which a knowingly false statement is made by an applicant or borrower. What would happen then?
"Well, then they would all go across the street, to my competitor."
We can certainly hope that the fraudsters would do so! And that your loan losses would correspondingly decline, giving you a dramatic edge over that competitor. You could charge lower rates and still earn a higher return.
But why would the honest customer have any fear of doing business with you? He knows what his income, occupation and phone number are.
Mr. Kahr is explaining the concept of "adverse selection." If an honest bank does not underwrite effectively its controlling officers know that the bank will inevitably attract the worst borrowers and suffer severe losses. No honest bank would operate in the fashion Mr. Kahr described as being characteristic of nonprime mortgage lenders. An honest, competent lender would gain a "dramatic edge" in "return" over any lender that permitted adverse selection. Mr. Kahr explains that nonprime lenders invariably "made bad loans because [they] knew [they] could sell them [to Fannie and Freddie] and make taxpayers cover the losses...." Again, Mr. Kahr is blind to the implications of the strategy he suggests nonprime lenders followed. We need to review the bidding. Mr. Kahr has explained that nonprime lenders characteristically:
- Cared solely about maximizing loan volume and (nominal) yield
- Deliberately removed underwriting procedures and anti-fraud warnings in order to increase volume and (nominal) short-term yield even though they knew this would produce an epidemic of fraud and substantially reduce (real) yield (because it would cause massive losses)
- Were aware that these steps led to endemic mortgage fraud, yet the nonprime industry norm was to fund loans known to be fraudulent and to violate the law requiring that the lender file criminal referrals on the endemic frauds
- And, though they knew the loans they were selling were commonly fraudulent and would produce enormous net losses, the banks followed this strategy because they intended to sell the loans to Fannie and Freddie and transfer the catastrophic losses to the taxpayers
The obvious point, ignored by Mr. Kahr, is that the banks could not lawfully sell endemically fraudulent loans to Fannie and Freddie. If they had disclosed the endemic fraud they would have been unable to sell toxic waste to Fannie and Freddie (and the private label secondary participants -- who also bought hundreds of billions of dollars of fraudulent nonprime loans). The lenders had to make false "reps and warranties" to be able to sell fraudulent loans to Fannie and Freddie. The strategy that Mr. Kahr suggests the nonprime lenders followed required fraudulent representations by the lenders as to millions of loans. Mr. Kahr is describing the largest and most destructive financial fraud in human history. Recall that Mr. Kahr makes clear that the nonprime lenders knew two things they needed to deceive Fannie and Freddie about -- the fact that the loans were endemically fraudulent and the fact that the lenders identified many fraudulent loans and characteristically failed to file criminal referrals and instead sold loans they knew to be fraudulent to Fannie and Freddie. Note also that Mr. Kahr asserts that the lenders knew that their strategy would cause hundreds of billions of dollars in losses to the American people -- who were innocent, but would have to pay the cost of the frauds.
Note something else implicit in Mr. Kahr's analysis -- the banks could have prevented virtually all serious mortgage fraud and prevented the entire crisis by using traditional underwriting practices -- and doing so was certain to produce superior bank profits. It was the epidemic of mortgage fraud that hyper-inflated the bubble and caused the catastrophic losses. The combination of the hyper-inflated bubble and catastrophic losses is what drove the economic crisis in the U.S. and produced extreme unemployment.
Mr. Kahr does not consider the interplay of the practices he ascribes to the nonprime industry. It is perfectly sensible for a bank that originates fraudulent loans not to file criminal referrals about the frauds if its strategy is to sell the loans to Fannie and Freddie and transfer the losses to the taxpayers. Consider four reasons why nonprime mortgage lenders typically do not file criminal referrals. One, if the lender files a referral alerting the FBI that it believes the loan may be fraudulent it cannot sell the loan to Fannie and Freddie without exposing itself to massive punitive damages for fraudulent sales.
Two, the fraud incidence on liar's loans that have been studied by independent reviewers is 80% and above. The regulatory agency gets a copy of the criminal referral. Even Bush's crew of anti-regulators would have found it impossible to allow Indymac, WaMu, Countrywide to make hundreds of thousands of liar's loans if they were also filing hundreds of thousands of criminal referrals.
Three, Mr. Kahl's arguments mean that the typical nonprime lenders was violating the rules requiring that they make criminal referrals and engaged in widespread fraud in selling the fraudulent loans to private label securitizers and Fannie and Freddie. When you are running a massive fraud you are reluctant to file adequate criminal referrals that might attract the FBI to investigate tens of thousands of fraudulent loans.
Four, it was overwhelmingly the lenders that put the "lie" in "liar's" loans. The "recipe" for a fraudulent lender to maximize its short-term (fictional) accounting income has four parts.
1. Grow rapidly by
2. Lending even to the uncreditworthy at premium yields
3. Extreme leverage
4. Pitiful loss reserves
This recipe inherently means that the fraudulent lender ("accounting control fraud") wants to maximize the dollar amount of the loans. It does so by making more, and larger, loans at premium yields while providing grossly inadequate reserves for future losses (ALLL). This requires the lender (directly, or through its agents -- primarily loan brokers) to emasculate its underwriting standards and internal controls (maximizing adverse selection and vulnerability to fraud). Now consider what happens when one adds the additional perverse incentives that arise if the lender can sell its bad loans at a profit. The optimization strategy now has an added element -- making the loans appear safer than they really are while providing premium (nominal) yields would increase the price at which the bad loans could be sold.
Fraudulent nonprime lenders and their agents commonly found that fraud made the ideal paradox -- charging premium yields for assets they made to appear relatively safe - possible. (Another variant was predatory nonprime lending -- charging customers that were creditworthy, but less financially sophisticated, premium yields.) The two most effective fraudulent tactics were to overstate the borrowers' income and the value of the house. Liar's loans were the ideal device to produce a fictionally reduced debt-to-income ratio and appraisal fraud was ideal for producing a fictionally reduced loan-to-value (LTV) ratio. Fraudulent lenders and their loan brokers frequently used both of these tactics.
Now consider whether (1) the borrowers or (2) the lenders and their agents were best able to create liar's loans and to use these two fraudulent tactics which maximized yield while making the loan appear to be far less risky. Mr. Kahl answers the first question. Liar's loans were created by lenders even though they were known to create intense adverse selection and severe losses. As Mr. Kahl stresses, competitive pressures cannot explain the rapid spread of liar's loans because honest competitors would gain "a dramatic edge over that competitor. You could charge lower rates and still earn a higher return." Lenders, therefore, created liar's loans because their controlling officers found liar's loans to be ideal. Liar's loans were optimal for the four part recipe for optimizing (fictional) short-term income (and the officers' bonuses) and had the added advantage of making the loans more valuable when sold by fraudulently understating the true debt-to-income ratio.
No one disputes that it was nonprime lenders and their agents, not borrowers, that caused the "echo" epidemic of appraisal fraud, but there has been a critical failure to consider the logical implications of the appraisal fraud epidemic. Honest lenders would never cause, or permit, inflated appraisals. Honest lenders have the ability to prevent virtually all cases of deliberately inflated appraisals. Nonprime lenders and their agents typically created a deliberate "Gresham's" dynamic to ensure inflated appraisals.
The New York Attorney General's investigation of Washington Mutual (WaMu) (one of the largest nonprime mortgage lenders) and its appraisal practices supports this dynamic.
New York Attorney General Andrew Cuomo said [that] a major real estate appraisal company colluded with the nation's largest savings and loan companies to inflate the values of homes nationwide, contributing to the subprime mortgage crisis.
"This is a case we believe is indicative of an industrywide problem," Cuomo said in a news conference.
Cuomo announced the civil lawsuit against eAppraiseIT that accuses the First American Corp. subsidiary of caving in to pressure from Washington Mutual Inc. to use a list of "proven appraisers" who he claims inflated home appraisals.
He also released e-mails that he said show executives were aware they were violating federal regulations. The lawsuit filed in state Supreme Court in Manhattan seeks to stop the practice, recover profits and assess penalties.
"These blatant actions of First American and eAppraiseIT have contributed to the growing foreclosure crisis and turmoil in the housing market," Cuomo said in a statement. "By allowing Washington Mutual to hand-pick appraisers who inflated values, First American helped set the current mortgage crisis in motion."
"First American and eAppraiseIT violated that independence when Washington Mutual strong-armed them into a system designed to rip off homeowners and investors alike," he said (The Seattle Times, November 1, 2007).
Note particularly Attorney General Cuomo's claim that WaMu "rip[ped] off ... investors." That is an express claim that it operated as an accounting control fraud and inflated appraisals in order to maximize accounting "profits." A Senate investigation has found compelling evidence that WaMu acted in a manner that fits the accounting control fraud pattern.
Pressure to inflate appraisals was endemic among nonprime lending specialists.
Appraisers complained on blogs and industry message boards of being pressured by mortgage brokers, lenders and even builders to "hit a number," in industry parlance, meaning the other party wanted them to appraise the home at a certain amount regardless of what it was actually worth. Appraisers risked being blacklisted if they stuck to their guns. "We know that it went on and we know just about everybody was involved to some extent," said Marc Savitt, the National Association of Mortgage Banker's immediate past president and chief point person during the first half of 2009 (Washington Independent, August 5, 2009).
Inducing endemic appraisal fraud is an optimal strategy for a lender that is engaged in "accounting control fraud." Accounting control frauds drove the second phase of the S&L debacle, the Enron era crisis, and the ongoing crisis.
To sum up situation to this point:
- Mr. Kahr says that "the banks" created liar's loans, knowing they would produce endemic mortgage fraud. They even redrafted their loan documents to encourage fraud.
- The nonprime lenders did not create liar's loans due to competitive pressures because such loans cause severe losses.
- The banks identified widespread fraud - and deliberately violated the law by failing to file criminal referrals.
- The nonprime lenders and brokers encouraged the mortgage fraud because they profited from it. The fraud produced more loans that they could sell at a profit to Fannie and Freddie. The officers controlling the nonprime lenders and brokers knew that a strategy of endemic fraud would make them wealthy and transfer the losses to the taxpayers.
- The strategy that Mr. Kahr describes is fraudulent. Indeed, it is a classic accounting control fraud.
- The controlling officers of the fraudulent nonprime lenders and their brokers created the "echo" epidemic of appraisal fraud in order to maximize the firms' accounting income and their personal compensation.
- Yet, Mr. Kahr, assumes that the nonprime lenders are the victims of an epidemic of fraud committed primarily by financially less sophisticated working class borrowers. He offers no proof -- it is self-evident to him. He has no idea that the strategy he ascribes to the nonprime lenders is fraudulent. He has no apparent sympathy for the working class borrowers induced by fraudulent lenders and brokers to borrow money to buy homes (at the peak of the bubble) that they could never afford to repay -- and the inevitable destruction of working class wealth.