Yves here. This is the latest installment of Bill Black’s forensic work into why the FBI, which had in the past been a critically important working oar in investigating banking industry frauds, was nowhere to be found before and after the global financial crisis. This post, on how the Mortgage Bankers’ Association, succeeded in getting the FBI focused solely on frauds made on banks, as opposed to by banks, is an ugly and critical bit of the story.
By Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Cross posed from New Economic Perspectives
This is the third column in my series discussing why the FBI and the Department of Justice (DOJ) have failed to investigate and prosecute successfully the largest and most destructive financial fraud epidemic in history. The series uses the FBI’s 2010 Mortgage Fraud report to tease out how the FBI and DOJ suffered such a defeat.
The MBA conned the FBI into a “partnership” with the trade association of the “perps.” In my prior column I showed the first product of the partnership – a poster warning customers not to defraud banks but ignoring banks defrauding customers. This column discusses the more consequential and damaging product of the FBI/MBA partnership. The MBA presented a definition of “mortgage fraud” under which the bank is always the innocent victim and never a perpetrator. Because the FBI and DOJ did not draw on the banking regulators’ expertise due to the death of criminal referrals by the agencies the FBI fell for the MBA con.
In the S&L debacle, less than 1/70 the magnitude of the control fraud we made over 30,000 criminal referrals to produce over 1,000 felony convictions in cases designated as “major” by the DOJ. In the current crisis OTS made zero criminal referrals. I explained this death of the criminal referral process by the banking regulators in my prior columns. A reader responded:
Dearth. The word is dearth. As in a shortage or scarcity of something. Not only did you feel the need to use the exact same word multiple times within the first few paragraphs (I stopped reading after that) but you misspelled it EVERY TIME.
I did indeed mean “death” and you’ll see more reasons why I chose that word.
These Aren’t the Droids We’re Looking For: The MBA’s Faux Definition of “Mortgage Fraud” Cons the FBI
The second product of the MBA and the FBI’s Faustian bargain is a purported definition of “mortgage fraud.” The FBI’s March 8, 2007 press release announcing its “partnership” with the FBI contained the same fake definition as the FBI’s 2010 mortgage fraud report quoted below. Note that the MBA con of the FBI was so successful that the FBI parrots the definition uncritically, year after year, as if it were revealed truth. Unlike Gaul, all mortgage fraud is divided into only two parts – and the bank and its elite officers are always the victims.
Loan Origination Schemes
Mortgage loan origination fraud is divided into two categories: fraud for property/housing and fraud for profit. Fraud for property/housing entails misrepresentations by the applicant for the purpose of purchasing a property for a primary residence. This scheme usually involves a single loan. Although applicants may embellish income and conceal debt, their intent is to repay the loan. Fraud for profit, however, often involves multiple loans and elaborate schemes perpetrated to gain illicit proceeds from property sales. Gross misrepresentations concerning appraisals and loan documents are common in fraud for profit schemes, and participants are frequently paid for their participation.
Loan origination fraud schemes remain a constant fraud scheme. These schemes involve falsifying a borrower’s financial information––such as income, assets, liabilities, employment, rent, and occupancy status––to qualify the buyer, who otherwise would be ineligible, for a mortgage loan. This is done by supplying fictitious bank statements, W-2 forms, and tax return documents to the borrower’s favor. Perpetrators may also employ the use of stolen identities. Specific schemes used to falsify information include asset rental, backwards application, and credit enhancement schemes.
The two paragraphs I quoted from the FBI’s 2010 mortgage fraud report make it clear that the FBI knows that the actions that the mortgage lenders’ controlling officers caused the lenders and their agents (primarily the loan brokers) to commit the twin epidemics of mortgage origination fraud (appraisal and liar’s loan frauds). It was these officers who “fired” both “barrels” of the fraudulent mortgage origination “shotgun” and produced millions of “gross misrepresentations concerning appraisals and loan documents….” The MBA’s facially preposterous “definition” of “mortgage fraud” implicitly defines out of existence the type of fraud that drove our two recent financial crises (the Enron-era and S&L debacle accounting control frauds). Under the MBA definition the most damaging form of financial fraud (“accounting control fraud”) – one that a Nobel laureate in economics, leading white-collar criminologists, and effective financial regulators have identified as the primary driver of our crises – has ceased to exist.
The MBA’s definition is significantly insane. The honest appraisers – and the MBA – would have made it impossible for the FBI to believe in the MBA’s fiction of the first Virgin crisis if the FBI had received the advantage of competent financial regulators’ expertise.
The Honest Appraisers’ Petition Exposed the MBA’s Lie in 2000 (Hint: it is now 2013)
Recall that the honest appraisers began to warn the FBI and DOJ in 2000 about the growing epidemic of appraisal fraud led by the lenders who blacklisted honest appraisers who refused to commit appraisal fraud by inflating their appraisals.
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 2010:18).
Surveys confirmed that appraisal fraud was pervasive and endemic and that the fraudulent lenders retaliated against honest appraisers and caused them severe economic injury. Many honest appraisers were driven out of the profession by the “Gresham’s” dynamic that the fraudulent lenders’ controlling officers deliberately generated by blacklisting honest appraisers. When cheaters gain a competitive advantage market forces become perverse and bad ethics drives good ethics out of the markets and professions.
As I explained in my first column about the FBI’s 2010 report on mortgage fraud one of the principal demonstrations of why there have been no prosecutions of the elite (or even middling) controlling officers of the fraudulent lenders that drove the crisis is that it never mentions the appraisers’ petition, the surveys confirming endemic, fast-growing coercion of honest appraisers by the fraudulent lenders, or the investigations (e.g., N.Y. Attorney General Cuomo’s of WaMu) confirming the reality of the blacklists by the fraudulent lenders of the honest appraisers. Having ignored the evidence of endemic mortgage fraud by lenders, the FBI failed to reach the three critical conclusions it would have adopted had it received any expert advice from the financial regulators instead of the trade association of the perps.
1. Only the lenders and their agents can cause widespread appraisal fraud
2. No honest lender would cause appraisers to inflate their appraisals
3. Therefore, mortgage lender origination fraud was widespread and could be successfully identified, investigated, and prosecuted by demonstrating the coercion of appraisers
The MBA Exposed the MBA’s Lie in Early 2006
In early 2006, the MBA’s own anti-mortgage fraud experts issued five vital warnings about “stated-income” lending. The MBA sent that warning to every member of the association. If the FBI had received the benefit of the financial regulatory agencies’ expertise it could not have missed the MBA’s own warnings of endemic fraud in stated income loans. Equally importantly, it could not have failed to understand the significance of the accounting control frauds’ reaction to the warnings of endemic loan origination fraud – they frequently increased their fraudulent originations substantially. The MBA’s experts were (then) called the Mortgage Asset Research Institute (MARI). In early 2006, MARI issued these five warnings.
Stated income and reduced documentation loans … are open invitations to fraudsters.
It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.
One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were 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 loan deserves the nickname used by many in the industry, the “liar’s loan.”
Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans.
The MBA Fought to Aid the Control Frauds
In 2006, after MARI’s five warnings, the MBA was invited to testify at a regional Federal Reserve hearing on nonprime lending abuses. The MBA chose as its representative a top officer of IndyMac – one of the largest originators of fraudulent liar’s loans.
The MBA fought tenaciously in 2006 to prevent the federal banking regulators from issuing even an unenforceable guideline discoursing the making of liar’s loans because they produced endemic fraud. The MBA claimed that financial markets were self-correcting and that the secondary market produced rigorous private market discipline that promptly ended any unduly risky loan origination.
The primary influence [sic] for lenders are the signals received from secondary mortgage market investors. A lender originating a large number of mortgages with an unacceptable level of risk will find itself facing significant price disadvantages in the market. These signals prompt lenders to alter product features, introduce new features and remove features that do not work. These product changes are immediate. In this manner, the private market can and does correct for excess risk more quickly than can a regulator who necessarily must move at a more deliberate pace. MBA believes that market signals have already addressed many of the concerns expressed by the Agencies in the Proposed Guidance.
The MBA’s claims can be most charitably described as fictions drummed into the authors’ heads by neoclassical economists. The secondary market funded the fraudulent lenders. It did not discipline them. Home lending became ever more fraud-friendly through mid-2007. The MBA asserted that the following standard should govern any guidance:
Where guidance or regulation imposes a standard that is not aligned with mortgage markets, the net effect is to limit the ability of mortgage lenders to create viable products that respond to consumer demand.
Yes, you read the MBA correctly – no regulatory guideline should be issued it if conflicts with “mortgage market” practices. Of course, if it simply reiterated current mortgage market practices there is no point to issuing a guideline or rule, so the MBA position was that the regulators should issue no rules or even unenforceable guidance. After all, the mortgages that the markets offer are by definition “viable products” “that respond to consumer demand.”
The MBA assured the regulators that the lenders had decades of successful experience with exotic nonprime loans and that they were not risky.
First, the Proposed Guidance should explicitly recognize that Federally-regulated institutions have successfully offered these nontraditional products for decades and should not be disadvantaged in the marketplace from continuing to do so. Secondly, interest-only and payment-option loans are different products that require different underwriting standards and risk management practices. Finally, though defined as products, interest-only and payment-option are actually loan features that, in and of themselves, do not inherently pose significant risks.
There is no charitable way to characterize these claims. The MBA would have destroyed its credibility with any competent financial regulator (and the FBI if it had the benefit of the regulators’ expertise) by this point in its comment letter (and we have only reached the top of page three of an 18 page comment letter). Even casual readers are likely to recall that the standard industry line now is that the industry had only brief experience with such lending and only in benign economic times. In 2006, the industry assured the Nation that the opposite was true.
The MBA reserved its “strong[est]” wrath for the (pathetically weak – and deliberately unenforceable) proposed guideline provision designed to reduce the endemic fraud by originators of “liar’s” loans.
MBA strongly disagrees with the apparent bias in the Proposed Guidance’s caution that lenders “should avoid over-reliance on credit scores as a substitute for income verification in the underwriting process.”
A credit score, of course, cannot establish the mortgage borrower’s capacity to repay the loan. Income verification is the only effective means of verifying the borrower’s capacity and it has a phenomenal track record of success in preventing fraud and reducing default rates to the point that they are exceptionally uncommon. Liar’s loans, by contrast, have a horrific track record in mortgage lending because they inherently produce severe adverse selection and produce a negative expected value to the lender. The MBA reserved its strongest effort to try to continue the most endemically fraudulent lending practice.
In today’s dynamic primary mortgage market, to regress to prescriptive and rigid underwriting standards would be to stunt innovation and limit borrower’s access to credit. Mortgage lending today does not need to solely rely on rigid debt to income (DTI) ratios because automated tools and advanced risk modeling have allowed lenders to go beyond simple thresholds for borrowers that exhibit risk mitigating characteristics, such as a high credit score or sufficient cash reserves.
MBA believes the Proposed Guidance’s language in the Qualification Standards should be rewritten to remove any prescriptions to specific credit policies that a Federally-regulated institution should adopt.”
The MBA was writing in the midst of an epidemic of mortgage fraud through inflated appraisals generated by its hundreds of fraudulent members – six years after the honest appraisers began their petition asking the government to intervene to prevent the fraud. The MBA comments, however, implicitly assume the epidemic out of existence.
“Certainly, a so-called “collateral-dependent loan” with a low LTV and to a borrower with a high credit score would not create undo [sic] financial risk to the Federally-regulated institution.
Well, no, not “certainly” and not even “likely.” It is time for a reality check. First, the lengthier MBA discussion that precedes the sentence quoted above makes clear that the MBA’s real concern is that lenders would be advised to verify the borrower’s income on “collateral-dependent loans.” These loans were largely liar’s loans, which are endemically fraudulent. Borrowers on liar’s loans have to pay roughly 100 additional basis points in interest so liar’s loans are always a terrible deal for honest borrowers. Loan brokers pushed borrowers into liar’s loans because fraudulent lenders structured their compensation to insure that they received additional fees for originating loans at higher interest rates and because they were incented to inflate the borrower’s income to increase the chances that the loan would be approved and they would get their very generous fee for fleecing the client.
Second, “LTV” stands for the “loan-to-value” ratio. “Value” refers to the appraised value. The fraudulent lenders created compensation systems that created an incentive for loan brokers engage in liar’s loan fraud and appraisal fraud. By inflating the appraisal the broker (fraudulently) made the reported LTV far lower than the actual LTV. This helped the fraudulent loan originator to sell the loan to the secondary market at a larger profit, which meant that it also increased the likelihood that the lender would approve the broker’s proposed loan and pay the fraudulent broker a generous fee for aiding the loan origination fraud. The MBA, however, implicitly and conveniently assumed the epidemic of appraisal fraud out of existence and assured the regulators that loans with low reported LTVs were “certainly” not an “undo” [sic] risk.
The MBA was also up in arms about any requirement that lenders police their loan brokers to ensure that they did not commit fraud or engage in racial discrimination.
Federally-regulated institutions should not be held responsible for the actions of unrelated third parties of whom they are not in control, and for whom they may be one of many counterparties.
The MBA knew that mortgage origination fraud was even more epidemic in loans arranged by loan brokers. The MBA’s answer was that it was critical to establish that even federally insured banks had a free pass when it came to creating financial systems they knew would produce endemic fraudulent originations by their networks of loan brokers. The officers controlling the fraudulent banks could get the loan brokers to do the dirty work, become wealthy from the resultant endemic fraud, and have complete deniability and immunity from being prosecuted even though they created the loan brokers’ perverse incentives to commit endemic fraud and then gutted the bank’s underwriting and suborned its controls to assure that the bank would largely approve the broker’s fraudulent loans. It was the perfect crime.
A more fraud-friendly policy would be hard to devise than that the MBA pushed. In fairness to the MBA, the trade associations representing the lenders and the secondary market purchasers of loans were equally committed to stopping any prohibition on liar’s loans even after MARI reported that their fraud incidence was 90%.
MBA members who were not federally insured (the great bulk of its membership) typically refused to make criminal referrals when they discovered mortgage fraud. An honest lender would make superb criminal referrals. The MBA did not support the FBI’s effort to require mortgage lenders to file criminal referrals when they discovered likely mortgage fraud. The MBA designed it fraud report system to not identify the perpetrators in order to ensure that the FBI and the DOJ could not use the information to identify, investigate, and prosecute mortgage frauds. The FBI could not have chosen a worse anti-mortgage fraud partner than the MBA.
The FBI’s 2010 report is a Tea Party fantasy due to the MBA’s con. It reports only on the vastly smaller and less damaging mortgage frauds by lower social status individuals who exploited the fraud vulnerabilities that the officers controlling the lenders created when they gutted their underwriting and suborned their internal controls to make it possible to make hundreds of thousands of bad loans pursuant to the accounting control fraud “recipe” for a lender. The FBI report ignores the twin massive control frauds by mortgage originators that drove the financial crisis and led to endemic fraud in the sale of fraudulently originated mortgages to the secondary market. The MBA has conned the FBI in 2007, and the FBI has remained conned. The result is that the FBI operates under a faux definition of “mortgage fraud” in which it is conceptually impossible for the banks and their controlling officers to be criminals. The FBI is treating even the Nation’s most fraudulent mortgage lenders as the innocent “victims” of fraud by primarily low social status customers who often lack any financial sophistication.