Bill Black: Lenders’ Lies about Liar’s Loans and “Rigorous Underwriting”

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. Originally published at New Economic Perspective

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.”  I am trying to write much shorter columns, so there will be many columns in this series because the WSJ article so beautifully exemplifies the lies that the industry and the media told about liar’s loans before and after 2008.

Spoiler alert:  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 only the lie 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 oxymoronic fable devised by someone who things 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 a great truth, we know that the “big money managers” proved correct about the reporter.

The definition of a liar’s loan is that it is designed for the purpose of avoiding not simply “rigorous” underwriting, but rather 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 repay the home loan.

The definition of 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, 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 officers that control the lender know 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.

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  1. Synoia

    The Lender will suffer Catastrophic losses.

    The Lender will suffer? The shareholders will suffer, the borrowers may suffer, the employees will suffer, but the lender will be bailed out, or maybe now bailed in.


    1. perpetualWAR

      The lenders will be bailed out????

      Over my dead body. Perhaps if people join me in permitting and building guillotines from coast-to-coast, TPTB will think twice about not only spreading these lies, but spreading these toxic loans!

      Housing Crisis II will not be received well on my front lawn!

    2. NotTimothyGeithner

      I don’t think a bailout is viable anymore. In 2008, the election with a few exceptions was set in stone, and 43 did much of the heavy lifting. He didn’t dump it on Pelosi or Reid. The electorate is ready for rapid rise and falls of enthusiasm. One or two losers can cash out, but 50 losers won’t find as many cushy jobs out there.

      Obama was hailed as a candidate of change. The subsequent actions would in the court of the Democratic President and Congress.

      This might be why so many 2010 Republicans have left or are retiring. They can’t all be Speaker or powerful chairman, and if they don’t lineup a post-congressional spot now, they might not have one if they wind up with the loser label.

    3. steelhead23

      I agree, but wish to go further. I believe the likelihood of bailouts plays a role in the issuance of “loser loans.” Back in 08, virtually the entire banking system was bankrupt. Had the contagion been allowed to run its course governments all over the globe would have had to nationalize banks while somehow maintaining the globe’s payments systems. Huge sums would have gone to money heaven. I am nowhere near smart enough to see how that would end – and neither are the globe’s pols – and the fear of horrific outcomes caused them to kowtow to the banks. Hence, there were forced mergers, bailouts, QE, ZIRP, payments on reserves, etc., etc., and let us never forget – bonuses for the control frauds. Given those incentives, why the heck not issue liar’s loans. They are sub-prime, meaning higher interest rates (even more enticing than in 06 as the FFR is even lower now), regulation is lax, and the same financial bombshell (or worse) is facing the globe’s pols. In a nutshell, the global banking industry is extorting protection from global governments and will continue to do so until we put a stop to them.

    4. Yves Smith Post author

      The eventual “lender” is an investor, since these loans are securitized. They were not originated to be kept. So yes, the lender loses.

      1. monday1929

        But Bill’s point, as you know, is that the Bank’s (“lenders”) officers feed like leaches off of the body of the bank, ( and yes, the investors, and anyone else within reach) They get rich whether or not the bank gets bailed out, but the bailout does give them fresh blood to drain.
        I wonder if Bernie understands Control Fraud?

  2. JEHR

    Bill Black, you have just described what is happening in the Canadian mortgage market right now:

    “Earlier this year, Home Capital Group Inc., the country’s largest alternative mortgage lender, revealed it had cut ties with 45 mortgage brokers after an anonymous letter to the company’s board of directors sparked an investigation into forged documents, such as fake employment letters and income statements. Collectively, the brokers who were fired generated nearly $1-billion worth of mortgages for the company last year.

    While scandals such as the one at Home Capital occasionally shed light on the dark side of Canada’s $1.3-trillion mortgage industry, much of the problem of mortgage fraud remains hidden from public view.” ( from )

    In Vancouver, dinky, shabby little houses are selling for $2.4 million because the land is desired for building some monstrosity of a house. (See: )

    I guess we are going to have a burst bubble in the near future.

    Can’t human beings learn that fraud leads to disaster, not for the fraudsters, but the victims?

    1. perpetualWAR

      What the criminal “lenders” learned:
      1) they can make shit-loads of money for themselves
      2) the populace when targeted with shameful foreclosure will mostly go away silently and in the middle of the night
      3) the rest of the populace will not support those homeowners brave enough to fight back
      4) and then they can begin all over again because the populace would rather be entertained by their football and tv shows than do anything of meaning with their lives

      1. Eric377

        Of course the rest of the populace will rarely support those homeowners because their problems manifest themselves primarily in two ways, neither of which creates a condition for which they have experienced unique harm. First, the value of the property is maintained and the only issue is that the borrower can’t handle the loan. Not being able to handle $500,000 of debt on a property for which that amount is a reasonable debt is not the general populace’s problem at all, no matter how misleading the lender was…if they have a case against the lender for damages, bravo, but they have no proper claim on public revenue for this problem. Or the value of the property has suffered a severe reversal shortly after assuming the debt. But this doesn’t happen to one house on the block – everyone’s value rides down with the market and the fact that it gets to maybe even big negative equity is an anecdote. Again there is no good reason to uniquely care about this borrower as they are experiencing exactly the same negative event as all their neighbors. Give them all $70,000 if you think the market is an unfair burden.

        1. GuyFawkesLives

          You are assuming that the pretender lender has any validity in collecting the debt.
          HINT: they don’t.

          Your just a jackass is all.

    2. cnchal

      In Vancouver, dinky, shabby little houses are selling for $2.4 million because . . .

      Chinese escapees.

      The Vancouver housing market will eat lots of money eventually. So will Toronto’s.

  3. flora

    ” How fraudulent is finance even now? The Wall Street Journal reports that “big money managers” want to bring back “liar’s loans.” ”

    What? You mean going govt slapping Wall St. on the wrist and telling them to ‘cut it out’ wasn’t enough to stop the fraudulent practice? I’m shocked, shocked.

    1. flora

      My comment above was a snark. More seriously: this is a straight up, in your face power play by the ‘big money managers’ to show who’s still the boss. My 2 cents.

      1. SomeCallMeTim

        Power play? Given the relative response to the last bubble pop, both immediately after and ongoing, maybe the ‘big money managers’ have just judged that the hubbub has subsided enough to lather up again.

      2. lightningclap

        I’m not even sure she actually told them to “Cut it out”. Even that is an misrepresentation on her part.

  4. griffen

    There just might be a serious disconnect between the “rigorous underwriting” and the Alt-A category. Nothing that hasn’t been done before, just relatively newer (and amazingly unaware).

  5. templar555510

    I saw ‘ The Big Short ‘ movie yesterday . As well as it is possible to do so it sets out the environment in which financial fraud becomes normalised . And it is really important to understand that as humans we can normalise any behaviour we are capable of imagining . And a couple of days ago I finished reading Michael Rowbotham’s book ‘ Grip of Death ‘ which explains the effects locally and globally of money creation as debt – which in case you are new to this blog , or haven’t been paying attention – is the recurring theme of the numerous and diverse posts that appear on it. Bill Black is a tireless advocate of regulation and protection of the bankers and I much admire him for his stance, but I fear that – earth shattering as it was – the collapse of 2008 wasn’t sufficient to bring home to the average person just how parlous a state our financial system had brought us . Why ? I don’t have an easy answer to this because I don’t think there is one, but I do think that nothing of significance will change in the financial sector unless and until the perception of money as a thing changes and how that might happen I have no idea, but I do think it will take something much more terrible than what happened in 2008 .

  6. Tom Stone

    I’m a Broker Associate in the Wine Country and I started getting emails from lenders about these last June.

  7. Paul Tioxon

    The liar’s loan was not called that by the brokers or mortgage companies. These were No Income No Asset, NINA or NO Income, No Job, Asset Verification, NINJA loans. The house had to be appraised, which it did or else the appraiser never saw another order from the broker. Clear title was always a hurdle to be cleared, because you can’t foreclose if you are not first in line with a secure lien. But there was no lying on the part of the applicant, or the broker because there was no underwriting. They said these were credit score driven, but you could be discharged from a recent bankruptcy and get an approval, higher rates, lower LTV. But credit scores not really an issue. So, no one lying there either.

    As nearly as I can tell, lying came into the narrative to shift the blame away from what were clearly mortgages designed to be handed out like leaflets on a street corner to one and all and towards the mythical conniving applicants who weaseled their way into undeserving home ownership by tricking hapless mortgage bankers. And of course, all of this was fueled by US Government interference into banking by the Community Reinvestment Act.
    The right wing media frequently claims the banking system collapsed because liberals passed this law forcing sober bankers into politically correct lending practices, literally with a legal gun to their heads to make bad loans to poor people who could not possible qualify otherwise and then of course, being dead beats, defaulted as soon as they moved in and lived there with Community Legal Assistance Act lawyers for years under protection from foreclosure. Those were the liars at the bottom of this financial mess. From Forbes:

    “The Community Reinvestment Act of 1977. If you haven’t heard of it, I wouldn’t be surprised. I wasn’t surprised when nobody mentioned it after the housing market collapsed in 2008, and I wasn’t surprised when few noticed in 2010 when the federal banking executives proposed changes expanding the act. I was surprised, however, when The Big Short, a movie claiming to explain the housing collapse so as to prevent another one, left out not only the CRA but also any responsibility of the federal government, since the act–and the government–is the major cause of the 2008 housing collapse yet still remains a part of the U.S. Code of Laws.”

    Mr Black, I know your writings well, but I believe calling these liars loans is a buy in to the misrepresentation of the cause of the financial collapse. No Income No Asset, Nina loans were the products that were lies, because they abandoned all pretense to underwriting for risk. Applicants have no idea about any of this, and mortgage brokers, armies of unlicensed salespeople at that time, simply took orders and passed them to the lending outfits, like Ameriquest or World Savings or whoever who gave them simple instructions to follow in order to get the loan to the closing table. Applicants wouldn’t know how to fake this stuff and were overjoyed to be placed into a special loan that didn’t ask too many questions or require too much paper work. It was all just the miracle of capitalism during the maiden voyage of SuperTanker America. Remember SuperTanker America, the Titanic of the Business Cycle, able to ride out any storm no matter how high the waves or how turbulent the global markets!! Lying ratings agencies, YES. Lying securitized tranches of crap, YES. Lying Default Insurance from AIG, YES! But the loans were upfront in saying just what they were, non verification of income, job or assets. So who’s lying now?

    1. monday1929

      Very good points all. But, unless I am mistaken, many applicants, generally with coaching from the “underwriters”, did submit false information which was, as you say, never verified.
      I still have not seen a numbers based takedown of the CRA meme, and hope that NC, or Bill Black could drive the final nail through its heart.

      The CRA did not force ANY of the criminal lenders to forego underwriting procedures, and huge numbers of bad loans were made by lenders who did not fall under the CRA requirements.
      I find it helps when straightening out misguided Conservatives to start the explanation by acknowledging the criminality of Freddie and Fannie, and Barney and Nancy (and Hillary) etc.- it makes them less defensive.
      And, let’s acknowledge that there were borrowers who were not as pure as the driven snow- there was a bubble and they played their role too. But most of them paid the price, unlike the criminal brokers and bankers.

      1. Will

        I’m sure many borrowers submitted false information knowingly. However, there is plenty of evidence that quite often they did not need to do that; the brokers did the lying for them. One example: there was a disproportionate number of loans where the borrowers magically stated exactly the income needed to qualify for the loan they were requesting. There was no way for (often financially unsavvy) borrowers to know this number; often the borrowers left the income blank and the brokers or whomever filled in the blank for them.

  8. Uncle Gary

    Liar Loans were listed on the mortgage application documents as N.I.V. (No Income Verification) or S.I. (Stated Income).
    The bottom line for both was that no pay stubs or W-2’s were required to validate the incone stated on the application. The liars were the borrowers, the brokers who persuaded the borrower, the banks that knew full well that sub prime loans were being wrapped into high grade pools and the credit reporting companies who permitted the banks to upgrade sub prime loans.
    Deceit and fraud was required from top to bottom for the scheme to be successful for the Executive Suite Swindlers.

  9. Enquiring Mind

    Here are a few ideas about the mortgage market:

    Tie broker and loan officer compensation to longer term performance of the loans, with some payout from a servicing strip after some intervals, such as 1, 2 and 3 years.

    Grade brokers and loan officers based on how their originated loans perform, and disqualify them or suspend their license or other qualification if their shadow portfolio underperforms some benchmark.

    Since it would take a while to get those or similar policies in place, in the meantime, you can short the lenders and real estate.

  10. kay

    I swear if socialism weren’t a failed system I would vote for Bernie just to get the money out of the banker’s & Facebook’s pockets.

    1. Yves Smith Post author

      You need better information about Sanders. He’s not talking about state ownership of businesses. You are falling for scare-mongering about him. And the closest thing we’ve ever had to socialism is Sweden, which is widely seen as a very successful, prosperous economy.

      1. Paul P

        Not so socialist Sweden where the Wallenberg family owns controlling interest
        in 1/3 to 1/2 of the stocks on the Stockholm stock exchange.

        1. EB

          You are right. Sweden has a lot of wealth in a few families and the Wallenbergs are probably Sweden wealthiest family. But unlike the US style neoliberals, Sweden’s wealthiest don’t seem to hate ordinary people and seem to realize that a productive, well educated and wealthy population helps their bottom line as well.

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