Reader Doug pointed to a Seattle Post-Intelligencer article, “FBI saw mortgage fraud early,” which was sufficiently misleading to get my juices going. Some key sections:
The FBI was aware for years of “pervasive and growing” fraud in the mortgage industry that eventually contributed to America’s financial meltdown, but did not take definitive action to stop it.
“It is clear that we had good intelligence on the mortgage-fraud schemes, the corrupt attorneys, the corrupt appraisers, the insider schemes,” said a recently retired, high FBI official. Another retired top FBI official confirmed that such intelligence went back to 2002….
Both retired FBI officials asserted that the Bush administration was thoroughly briefed on the mortgage fraud crisis and its potential to cascade out of control with devastating financial consequences, but made the decision not to give back to the FBI the agents it needed to address the problem. After the terrorist attacks of 2001, about 2,400 agents were reassigned to counterterrorism duties….
Further complicating efforts to detect and prosecute mortgage fraud, banks and other mortgage lenders were making so much money from the constant churn of transactions and the continually escalating price of homes that the fraud that did arise simply didn’t cost the industry enough money to raise their concerns.
“You had victim banks that would not acknowledge that they were victims,” said the first retired FBI official. ” ‘We’re not out any money,’ they would say. Nothing has been foreclosed. The banks weren’t reporting, the regulators weren’t regulating and the FBI was concentrating on external mortgage fraud as opposed to the underlying internal problem.”
Now what is wrong with this picture? Here is the story line: “We did see the fraud, but no one listened, and we didn’t have the staffing to go after it either.’
Well, in a word, no. Consider what “fraud” is. The FBI subscribes to traditional notions of mortgage fraud: either “fraud for profit” which occurs when groups of people collude to defraud mortgage lenders (there are so many moving parts that fraud for profit is seldom a solo activity). “Fraud for housing” occurs when someone buys a house via misrepresenting themselves on mortgage applications. (indeed, if you read the story closely, it is remarkably unclear as to what type of criminal behavior they thought they might have been able to catch, and who the victim was).
Now here is the clincher: there is ample evidence that the FBI did not understand the new paradigm. As described ad nauseum elsewhere, those who signed low doc and no doc loans were often encouraged by the bank or mortgage broker to exaggerate income , or told to sign forms and let the firm fill in the details.
Technically, that makes the person who misrepresented their income the fraudster. As this FHA mortgage guide suggests, fraud for housing was not seem as that big a deal. The fraudster would intend to make good on the loan, and if the loan was made prudently the bank would still have enough of a buffer (via the down payment) to recover in enough cases for this to be manageable.
Of course, we now know that plenty of loans were imprudent. More important, the real breakdown occurred in two places: the use of third party mortgage brokers as originators. Some of them might indeed have been identified by the FBI, but likely only the worst offenders.
But the big subprime and Alt-A lenders were often as aggressive in pushing borrowers into loans they couldn’t afford (consider WaMu, CountryWide, and IndyMac, for starters). The FBI and regulators were predisposed to see individuals and small firms as criminals, the big players as victims, not big firms victimizing other big firms and investors.
Consider this excerpt from a 2007 post, “Disturbing Conversation with Fed Official on Subprimes” (which is worth reading in its entirety):
I happened to meet an official in the Fed’s Banking Supervision and Regulation division at a cocktail party this evening and chatted him up. He helped brief Roger Cole before met with the Senate Banking Committee last month to defend the Fed’s conduct regarding subprimes, so he is up to speed on this topic…
I was taken aback at what this individual said, and while he was not speaking in an official capacity, I have no reason to think his views were unrepresentative.
His view was that the Fed was not at all at fault in the subprime matter. He said that he disagreed with Roger Cole’s statement that in hindsight, the Fed could have done better. He said the Fed had enforced the laws that were in effect at the time (query why then did the OCC read and enforce HOEPA differently?).
He also asserted that there was a tremendous amount of consumer fraud, that the FBI was pursuing a lot of cases (if so, I wonder why this hasn’t been reported, since people like the Fed and the subprime originators would have every reason to present the institutions, rather than the consumers, as victims). In the narrow sense, there clearly was a lot of fraud, since in the “no doc” loans, a very high proportion of borrowers overstated their income by large amounts. But the implication of the Fed official’s statement was that the fraud was “fraud for profit” meaning the intent was to make off with money, as opposed to “fraud for housing” in which one gets to live in a house one shouldn’t on paper have. In “fraud for housing” a sensible lender will come out whole (even in a no-doc scenario, if the buyer makes a high enough down payment and the lender gets a realistic appraisal, it will come out fine even in a foreclosure, unless the local housing market falls out of bed). So despite the Fed guy’s aggrieved tone, it’s hard to see the lenders as victims.
Equally disturbing was his confidence that the markets were working fine…..
This tidbit also suggests that the FBI was more aware of mortgage fraud than the revisionist history suggests:
An article in eFinance Directory, citing the FBI 2006 Mortgage Fraud Report, reports that mortgage fraud played a role in as many as 70% of early payment defaults. The type of fraud wasn’t specified, but one assumes it was mainly overstatement of income. As the story notes:
A study of more than 3 million mortgage loans found that between 30 and 70 percent of early payment defaults are directly linked to misrepresentations in mortgage loan applications
Defaults are largely concentrated in ARM loans, but are present in nearly every lending sector.
Of the 10 states with the highest concentration of mortgage fraud, 7 of them rank in the top 10 states with the highest default rates.
But this quote from Tanta illustrates why the FBI would not have been very effective, for it would not have been predisposed to see how the big institutions had in some sense become perps too. From a 2007 post:
Tanta made another astute observation about how the shift in liability from lender to borrower enabled borrower recklessness. She contrasts the process for lending to a self-employed person who has trouble verifying income. Number 1 is via a stated income loan; Number 2 is the traditional “full doc” approach, in which the bank notes that the debt-to-income (DTI) is considerably above the bank’s guidelines but is warranted for various good reasons.
…..what happens if it actually goes bad?
Well, with Number 1, it’s “clearly” the borrower’s fault. He or she lied, and we can pursue a deficiency judgment or other measures with a clear conscience, because we were defrauded here. We can show the examiners and auditors how it’s just not our fault….
With Number 2? There is no way the lender can say it did not know the loan carried higher risk. Of course, higher-risk loans do fail from time to time, and no one has to engage in excessive brow-beating over it, if you believed that what you did when you originally made the loan was legit. If you’re thinking better of it now, at least with Number 2 you have an opportunity to see where your underwriting practice or assumptions about small business analysis went wrong….
What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they’re taking risky loans, but instead of doing so with eyes open and docs on the table, they’re putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they’re doing. This practice is not only unsafe and unsound, it’s contemptible.
We use the term “bagholder” all the time, and it seems to me we’ve forgotten where that metaphor comes from. It didn’t used to be considered acceptable to find some naive rube you could manipulate into holding the bag when the cops showed up, while the seasoned robbers scampered…. You aren’t getting those stated income loans because lenders like to do business with entrepreneurs, “the backbone of America.” You’re not getting an “exception” from a lender who puts it in writing and takes the responsibility for its own decision. You’re getting stated income loans because you’re willing to be the bagholder.
And that’s why the “gee if the FBI had more staffing, we could have made a difference” is bunk. Yes, there were some egregious scams they could have caught. But the most common type of fraud was the one Tanta described, and the FBI wouldn’t have gone after it, because, per the FHA, it had been assumed historically to be the sort of problem that didn’t lead to losses all that often.
We’ve learned otherwise.