The Wall Street Journal Lies About Liar's Loans (Pt 1)

It is time to break out one of our two family rules again: It is impossible to compete with unintentional self-parody. How fraudulent is finance even now? The Wall Street Journal reports that "big money managers" want to bring back "liar's loans." The WSJ article exemplifies the lies that the industry and the media told about liar's loans before and after 2008.

Liar's loans, as the name admits, are pervasively fraudulent. Only fraudulent lenders make liar's loans as a regular business practice. These home loans make the officers wealthy through the "sure thing" of the "fraud recipe" for "accounting control fraud." The WSJ, of course, ignores these facts and presents instead falsehoods provided by fraudulent officers.

This column addresses the lie in the WSJ article that invokes our family rule: "The money managers think that risk is manageable with rigorous underwriting [of liar's loans]..." If this were written for the Onion it would have been a stellar example of irony. Instead, it is an oxymoron crafted by someone who thinks that WSJ reporters and their readers are regular morons. Because the reporter regurgitated such a clumsy lie about liar's loans as if it were revealed truth, we know that the "big money managers'" opinion about the reporter's abilities proved correct.

The definition of a liar's loan is that it is designed for the purpose of avoiding not simply "rigorous" underwriting, but rather for the purpose of avoiding even the most minimal underwriting any property lender must do to have any chance of surviving. Yes, "rigorous underwriting" is the absolute essential to managing risk in property lending. Yes, in the case of conventional home lending, rigorous underwriting can reduce credit risk to tiny proportions.

One of the "Four C's" of minimally competent underwriting for such loans is "Capacity." That means that the lender, must at a minimum, verify that the borrower has adequate income to have the capacity to repay the home loan.

The definition of a liar's loan is that the lender does not verify the borrower's income (and more extreme liar's loans do not verify the borrower's job or assets). The CEO causes the lender to make liar's loans for the purpose of inflating the borrower's reported income, which makes it possible for the lender to make more and larger loans at higher interest rates, which enriches the CEO.

The failure to verify the borrower's income produces massive fraud and what economists call "adverse selection." As a result, at the time the loans are made, they represent in economic reality a loss. The loans have a "negative expected value" at the time they are made. This exemplifies the great truth that the WSJ cannot seem to comprehend -- underwriting appears to the ignorant to be a cost center for a home lender, but it is actually an honest bank's most important profit center.

Proper GAAP accounting would require the lenders making liar's loans to report at the time they made the loans that they produced a net loss, but one key to the frauds is for the lender's controlling officer to set aside only pathetically inadequate "allowances for loan and lease losses" (ALLL). The CEO knows that the fraud "recipe" produces three "sure things." The lender will promptly report record profits, the officers will be made wealthy through modern executive compensation, and the lender will ultimately suffer catastrophic losses (unless, of course, the public bails it out).

Remember these events when someone claims that the government forced lenders to make bad loans. "Big money managers" are desperate to bring back fraudulent liar's loans only a few years after they blew up the global economy. Even Bush's regulators warned lenders against making liar's loans -- they simply failed to regulate when the bankers ignored the regulatory warnings.