March 29th, 2015
in Op Ed
by William K. Black, New Economic Perspectives
This is the third column in what I intended to be my three-part series (see end of this article) about Citi's most famous whistleblower, Richard M. Bowen, III. In this column I discuss Bowen and Citi's senior (but not controlling) officers' presentations before the Financial Crisis Inquiry Commission (FCIC).
Upon further research I realize that a fourth column is required to bring in the related story of Bowen's estimable colleague and fellow-whistleblower, Sherry Hunt. Hunt's story is not simply important and necessary to understand the scandals of the Department of Justice (DOJ) and the SEC and Citi's top managers the FCIC's spurning its one chance at greatness - it also deserving of a movie. It's too complex and rich to add it to this column. Hunt also deserves full length treatment devoted to her attempted service to Citi, her service to the Nation, and to DOJ's and the SEC's failure to act against any of Citi's fraudulent officers despite her offering them up tied with a bow.
Some Background for Bowen and Citi's FCIC Testimony
FCIC provided a prominent and early focus on mortgage fraud. Its first witness was Alan Greenspan, but it heard from two other panels the same day. The second panel included Bowen and three other witnesses who testified that there were epidemic levels of fraud during the crisis and that it was the norm for brokers and lenders to ignore or even encourage these frauds. Bowen's testimony, as he had originally prepared it for FCIC, would have fit well with the testimony and provided data not only on Citi's frauds, but also the fraudulent originators who sold Citi vast amounts of fraudulent loans through false reps and warranties.
Richard Bitner testified that 70% of the loan files submitted by loan brokers had false information, including significantly inflated appraisals in half the cases. Patricia Lindsay, from New Century, testified that loan brokers routinely inflated the borrower's income (because they knew what ratios were required). Susan Mills (Citi, securitizations) testified that early payment defaults (EPDs) were a strong indicator of likely fraud and had nearly tripled in frequency among mortgages sold to Citi in 2006-2007.
But there were five odd things that happened at the interrelated second and third FCIC panels. First, Bowen's testimony was sanitized at the request of a FCIC attorney. Bowen felt the request was a direction and that his testimony would be barred if he had not followed the request/direction. Bowen was told to take out of his prepared testimony (a) the names of Citi officers, (b) the details of Citi's officers' misconduct, (c) the fact of his providing information to the SEC and the SEC's failure to follow up, (d) his prior experience as a whistleblower with another bank, I his concerns concerning the truthfulness of Citi's senior officers' attestations under Sarbanes-Oxley, and (f) Citi's retaliation against him. These exclusions were particularly bizarre because during his interview with FCIC's investigative staff they had asked him to include the materials that the FCIC attorney now wanted removed. The exclusions reduced the length of Bowen's testimony by 10 pages (one-third).
The exclusion was inconsistent in that Bowen was not asked to remove from his testimony his attachment of his email that constituted his written warning to Robert Rubin and Citi's chief risk officer (CRO).
The exclusions were so severe that FCIC, when preparing the majority report, felt it necessary to draw for two critical points on statements he made during his interviews with FCIC's staff.
"Speaking of lending up to 2005 at Citigroup, Richard Bowen, a veteran banker in the consumer lending group, told the FCIC, 'A decision was made that 'We're going to have to hold our nose and start buying the stated product if we want to stay in business'" (FCIC 2011: 111).
"Bowen told the Commission that after he alerted management by sending emails, he went from supervising 220 people to supervising only 2, his bonus was reduced, and he was downgraded in his performance review" (FCIC 2011: 19).
These were critical aspects of Bowen's knowledge, but they were excluded from his testimony and from FCIC's public questioning of Bowen. As I have explained, FCIC then issued a directive barring the public from having any access to Bowen's FCIC interviews. Other witnesses' FCIC interviews, such as mine, are freely available to the public. As I also explained, the SEC has also barred public access to the materials Bowen gave it documenting Citi's frauds.
Second, the topic of the second panel was limited to "subprime origination and securitization." One can infer two very bad things about FCIC's presumptions from that title. Prior to gathering the facts, FCIC had decided (a) that subprime loans were the problem, not liar's loans, and (b) that subprime loans were a category that excluded liar's loans. These are both common factual errors, but they are very harmful errors, particularly because they were based on implicit assumptions by FCIC. Implicit assumptions require no justification because we do not even recognize that we have made them. By 2006, half of all the loans the industry called "subprime" were also liar's loans - the two categories are not mutually exclusive.
Third, the last FCIC panel that day was composed of former senior Citi officers testifying about Citi's creation of, and investment in, collateralized debt obligations (CDOs). Citi had been sued the SEC for securities fraud for claiming in its financial disclosures to have little exposure to risk of loss from subprime loans. Citi's investment bank arm suffered severe losses from subprime loans due to its retention of "super senior" CDO tranches that it issued and sold primarily to other investors. Citi had direct exposure to loss on those tranches and litigation exposure to those it sold the CDOs. Neither the Citi witnesses nor the FCIC commissioners seemed to grasp that the two last panels were inherently and powerfully related.
One of the demonstrations that FCIC did not understand, or did not wish to emphasize, the significance of Bowen's testimony is FCIC's treatment of the testimony of Citi's senior managers. FCIC arranged a panel consisting of four of these senior managers that discussed almost exclusively Citi's investment retention of the super senior tranches of the CDOs that it issued.
Fourth, it was clear that the FCIC commissioners could not even fathom that the three fraud epidemics that drove the financial crisis (a) existed, (b) hyper-inflated the bubble, or (c) could really cause a financial crisis. It wasn't that they asked hostile questions to seek to rebut such a theory - they never even explored the theory. Bitner and Lindsay's testimony was virtually ignored by FCIC's report. Mills' testimony was used in the report only to demonstrate the stove piping at Citi between units. Mills was still with Citi and her testimony on Citi's underwriting attempted to put it in the best, wildly favorable light. The portion of the report that cites her testimony does not even mention her testimony about EPDs' ties to fraud. One might expect that having experts testify under oath to fraud incidences of 70-80% and tripling over the period 2005-2007 would leave the Commissioners in a state of shock. The testimony, even in the sanitized version in Bowen's case should have led to three major conclusions by the commissioners.
- It refuted the Citi officers' claims that there was no way anyone could think that CDOs could suffer material losses, which should have led to devastating cross examination of the Citi witnesses about CDOs
- It created a powerful line of cross-examination that needed to be pursued with Citi's top risk officer, who Bowen testified to be a leading cause of Citi's fraudulent reps and warranties
- It created a need to take fraud seriously as a candidate as a primary cause of the financial crisis
Fifth, none of this happened. FCIC spurned its one chance for success despite its limited resources. It had the perfect witness set up for the perfect confrontation with Citi's chief risk officer. It had the perfect evidence to blow apart the "perfect storm" that no one could see coming claim. Bowen saw it coming, warned about it in writing, and was crushed by Citi's senior leaders because he was correct. FCIC never even took a swing and tried. Desultory is the politest word possible for its questioning.
This is not to say that FCIC could not have arranged the testimony even more effectively. For example, no one explained why lenders' controlling officers and the loan purchaser's controlling officers can become wealthy together through their mutually compatible fraud "recipes." Without that explanation, the fraud seems incoherent and one cannot understand why Citi's managers were so eager not only to continue to buy vast amounts of toxic loans, but also to embrace the financial version of "don't ask; don't tell." FCIC could have added a witness to explain these points.
The cumulative result was that the force of the testimony on fraud was lost completely. The New York Times report on the three panels is all about the commissioner's metaphors. It uses the word "fraud" only to set up a joke. It does not even report the 70-80% fraud incidence testimony. It isn't that the commissioners were hostile to Bowen and supportive of the Citi witnesses, quite the opposite. But the individual commissioners lacked the combined financial and legal expertise and understanding of accounting fraud to formulate the necessary questions. FCIC needed to bring together Bowen's insider knowledge and expertise with the most powerful testimony from him that was possible, expert legal ability to cross-examine, and a thorough understanding of accounting control fraud. Instead, FCIC's attorney greatly weakened Bowen's testimony and FCIC struck out and squandered its one great opportunity to wake up the public and produce an accurate understanding of the crisis.
FCIC made another terrible tactical mistake in its insipid questioning of Robert Rubin about his response to Bowen's warnings to him. Rubin was not required to answer tough questions about Citi's retaliation against Bowen and Rubin's boss. FCIC settled for a written response from "Citi" - and instead got an utterly useless letter from Citi's litigation counsel, which FCIC accepted rather than requiring a response personally from Rubin.
Fraudulent Loan Origination = Bad Loans = Bad CDOs
The value of Citi's collateralized debt obligations (CDOs) depended on the value of the mortgages "backing" those CDOs. If the mortgages were toxic, the CDO would be toxic and whoever purchased part of the CDO would suffer losses. By 2004 (according to a Citi presentation in 2008) CDOs were primarily-to-overwhelmingly backed by toxic nonprime mortgages. That meant that the CDOs were going to experience severe losses because the CDOs get their value from the cash flow from the mortgages. Liar's loan fraud and appraisal fraud make mortgages far more likely to default and substantially increase the loss upon default. CDOs are very complex, but the point I have just made is very straightforward and all of Citi's financial types understood it.
Citi's managers of CDOs and risk were particularly well-situated and trained to understand the point I just made because of their positions, but also because of Bowen's blunt reports to Citi's risk managers.
Citi's Senior Managers Knew that its Mortgage Assets and Deals Were Toxic
The number of experts that provided data and expertise warning Citi's senior managers that their mortgage assets were toxic is large.
In the FCIC panel immediately after Bowen testified that the quality of the mortgages Citi was buying was so toxic that by 2007 it was selling 80% of the mortgages to the secondary market through fraudulent reps and warranties, four Citi officials testified. Each of them focused on Citi's CDOs. None of them mentioned Bowen's findings in their testimony. As I have explained, this is nonsensical. The risks and value of Citi's CDOs was dependent on the quality of the mortgages backing the CDOs and Bowen had just testified that Citi's top managers systematically ruined the quality of the mortgages Citi was purchasing.
Similarly, Citi obviously had access to the reports that Clayton provided it on the quality of the loans it was being offered for purchase from originators. As I explained in the first column in this series the quality of those loans was horrific. The Trending Report, for example shows that for the Q1 2006 Clayton initially rejected 56.7% of the loans in the packages submitted for sale to Citi. Applying the nationwide average percentage for 2006-mid-2007 that Clayton found for false reps and warranties that Clayton purported to find "compensating factors" for (18%) this yields an estimated total percentage of false reps and warranties detected by Clayton in loans it reviewed for Citi in Q1 2006 of 75 percent. Given Clayton's (designed) weaknesses that percentage is extraordinary. It indicates that Citi must have chosen to purchase its loans from the Nation's most fraudulent lenders who didn't even hide their frauds.
Citi's chief risk officer didn't simply know of the frauds - he acted to increase the frauds.
Citi perceived its mortgage loan quality as far superior to the industry norm, so this demonstration that it was being offered mortgages so toxic that even such a weak grader as Clayton viewed them as worthy of rejection the necessary inference that CDOs were pervasively "backed" by toxic waste consisting of mortgages that were fraudulently originated and then fraudulently sold to the secondary market through false reps and warranties. But the Clayton report also quantified the extent to which Citi's managers were deliberately adopting a weaker quality standard than even the pathetically weak Clayton by purchasing loans that Clayton found to be fraudulently originated and offered for sale through fraudulent reps and warranties. Bowen's written testimony revealed to FCIC the name and title of the Citi official who took the lead in greatly increasing Citi's exposure to fraud risk from these endemically fraudulent originators and greatly increasing Citi's exposure to the risk of being sued by Fannie, Freddie, and CDO purchasers for Citi's fraudulent reps and warranties.
(If you are counting, and you should, note who was rewarded and who was punished at Citi when it came to anti-fraud efforts.)
"During 2006 and 2007 I witnessed many changes to the way the credit risk was being evaluated for these pools during the purchase processes. These changes included the Wall Street Chief Risk Officer's reversing of large numbers of underwriting decisions on mortgage loans from 'turn down' to 'approved.'
In the third quarter of 2006 the Wall Street Chief Risk Officer started changing many of the underwriting decisions from 'turn down' to 'approve.' This was done either personally or by direction to the underwriters. This artificially increased the approval rate on the sample. This higher approval rate was then used as justification to purchase these pools.
In the sample on one $300+ million Merrill Lynch subprime pool the underwriters turned down 716 mortgages as not meeting Citi policy guidelines. The Wall Street Chief Risk Officer personally changed 260 of these 'turn downs' to 'approved.' The pool was purchased.
Risk also started approving subprime pools for purchase with low approval rates, without an expanded sample.
It was generally believed that Citi subprime credit policy was more restrictive than the policies followed by most of the industry. And many of the correspondent mortgage companies loudly complained about Citi's more restrictive policies. They complained that Citi was 'cherry picking' according to Citi policy. And they noted that our competition was not as restrictive.
Underwriters were then many times instructed by Risk to underwrite according to the selling mortgage company guidelines, not Citi's.
First NLC was a mortgage company that Citi had been regularly purchasing subprime mortgages from for two years. Citi guidelines were always followed in the underwriting and purchasing of their pools.
The Wall Street Chief Risk Officer then instructed the underwriters that they would begin underwriting against First NLC guidelines. The decision was made retroactively. First NLC was told that they could now sell to Citi the mortgages underwritten against their guidelines which had been turned down in previous months by Citi underwriters.
Warnings on Subprime Bulk Issues
Beginning third quarter 2006 I sent many warnings and objections to credit decisions which were being made on specific pools of subprime mortgage loans. These were through email, conversations with the Wall Street Chief Risk Officer and other personnel, and weekly reports.
My manager, the REL Chief Underwriter, also joined me in objecting to some of the practices we witnessed.
At the end of 2006 and early 2007 all of the REL Chief Underwriter's responsibilities were assigned to other managers. In 2007 my former manager retired.
On Saturday, November 3, 2007, I sent an email to Robert Rubin, Chairman of the Executive Committee David Bushnell, Senior Risk Officer Gary Crittenden, Chief Financial Officer Bonnie Howard, Chief Auditor [warning them of the Citi's false reps and warranties]."
Citi's Managers' First Victim
The first victim of Citi's senior managers' retaliation was Bowen's boss, who had not only supported Bowen's warnings but made his own efforts to warn Citi's senior managers. Bowen's written testimony revealed that: "At the end of 2006 and early 2007 all of the REL Chief Underwriter's responsibilities were assigned to other managers. In 2007 my former manager retired."
Citi's Managers' Second Victim
You would not learn this fact from Bowen's written FCIC testimony because he was directed to remove it from his testimony, but the FCIC report cites its staff interviews of Bowen to note this fact:
"Bowen told the Commission that after he alerted management by sending emails, he went from supervising 220 people to supervising only 2, his bonus was reduced, and he was downgraded in his performance review" (FCIC 2011: 19).
FCIC followed an excellent policy of keeping a record of its staff interviews and posting them on its website so the public can view them. The public can, for example, listen to hours of interviews of me by the FCIC staff. Bowen is an exception to that normal rule, for FCIC ordered his interviews to be kept secret from the public for five years. I will return to that point.
Citi's Managers' Third Victim
FCIC should have had another witness testifying with Bowen on their own panel devoted to Citi's frauds. Her name is Sherry Hunt and she will be the subject of my fourth column in this series.
The MARI/MBA Warnings
My readers will recall MARI's famous warnings, disseminated by its client, the MBA, to the entire mortgage industry in Spring 2006.
"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."
Credit Suisse's warnings
By late 2006, liar's loans represented roughly 40% of all loans originated (45% according to a Citi presentation). At the 90% fraud incidence that represented over two million fraudulently originated loans in 2006 alone. From 2003-2006, liar's loan volumes increased over 500 percent. By 2006, roughly half of all the loans that the industry called "subprime" were also liar's loans. This meant that liar's loans were the loans that hyper-inflated the bubble. By 2006, the bubble had already burst and home prices were falling. By 2006, despite massive increases in risk, the home mortgage industry's allowances for loan and lease losses (ALLL) had fallen to record lows last seen in the S&L debacle.
Law Enforcement Warnings: The AG's
By 2007, law enforcement investigators were confirming that it was overwhelmingly lenders and their agents that were putting the lies in liar's loans.
The Appraisers' Warnings
By 2000, everyone in the mortgage industry was put on notice that there was an epidemic of mortgage fraud led by the lenders' who were deliberately generating a "Gresham's" dynamic by extorting honest appraisers.
"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 2011:18).
By 2006, 90% of appraisers surveyed reported that they had personally been subject to efforts to induce them to inflate appraised values (FCIC 2011: 91).
The FBI's Warnings
By 2004, everyone in the mortgage industry knew that the FBI described mortgage fraud as "epidemic" and warned that it would cause a financial "crisis" if it the developing epidemic were not promptly contained.
More precisely, everyone in the mortgage industry would have known these facts if their bosses were honest because their bosses would have spread this information throughout their banks as a matter of the highest and most urgent priority. Instead, Citi's "experts" on collateralized debt obligations (CDOs) provide bizarre testimony to FCIC - and escaped without any effective questions exposing the absurdity of their claims.
The Non-Warning from Citi's Securitization Unit
"Also, in early 2006, Susan Mills, a managing director in the securitization unit-which bought mortgages from other companies and bundled them for sale to investors-took note of rising delinquencies in the subprime market and created a surveillance group to track loans that her unit purchased. By mid-2006, her group saw a deterioration in loan quality and an increase in early payment defaults-that is, more borrowers were defaulting within a few months of getting a loan. From 2005 to 2007, Mills recalled before the FCIC, the early payment default rates nearly tripled from 2% to 5% or 6%. In response, the securitization unit slowed down its purchase of loans, demanded higher-quality mortgages, and conducted more extensive due diligence on what it bought. However, neither Mills nor other members of the unit shared any of this information with other divisions in the group, including the CDO desk. Around March or April 2007, in contrast with the securitization desk, Citigroup's CDO desk increased its purchases of mortgage backed securities because it saw the distressed market as a buying opportunity" (FCIC 2011: 260-261).
This passage demonstrates that FCIC did understand that the quality of the loans determined the quality of the CDOs. It obviously demonstrates "stove piping." More subtly, the passage implies that the problem lay with Mills' and her unit's failure to communicate the facts to the CDO unit. She should have done so, but surely the far greater problem lay with the CDO unit's perverse incentives. They knew Citi was a major lender and purchaser of loans and that loan quality determined CDO quality. They knew that accessing Citi's proprietary information on mortgage quality would provide Citi with a powerful advantage in the CDO market, allowing it to profit, for example, by shorting the market as soon as the early indicators of increased fraud losses appeared. But the CDO managers had made a different bet - the same one Merrill's managers were making and for the same reason. The faux income from holding the super senior tranches with their zero risk weighting was very good for the CDO managers' compensation. It created a "sure thing" for several years. Shorting is risky, you may be right that the market will collapse but wrong about how long it will take it to collapse.
Citi: We Don't Look at Loan Quality (or Listen to Anyone Who Does)
David Bushnell, Citi's former CRO and the man savaged in Bowen's testimony, testified as part of the panel immediately after Bowen's panel. As I noted, the failure of the FCIC to vigorously pursue Bowen's charges was an unforced error on FCIC's part. Even if FCIC lacked the guts to challenge Bushnell through vigorous cross-examination based on Bowen's testimony, his testimony opened himself (and Citi's controlling officers) to devastating cross-examination when he tried to defend Citi's CDO operations and holdings.
"At the time, risk modeling of these securities-at Citi, other financial institutions, and the rating agencies-was not designed to consider loan-level information.
Nor did any market participants engage in full underwriting review of the portions of these investments that they determined to hold."
Bushnell was confessing to incompetence, or far worse. He was not testifying that Citi could not have underwritten a sample of the loans backing the CDOs, he was testifying that Citi chose not to check the quality of the CDOs. He implicitly admits that the quality of the mortgages determines the quality of the CDOs. That means that he had to investigate the quality of the mortgages to know the quality of the CDOs. But Bushnell and other senior Citi managers, like their peers, were the leading proponents of "don't ask; don't tell." I have explained the many sources of warnings and the incredible fraud incidence contained in those warnings. Bushnell knew he could not look at the quality of the underlying mortgages. If he did, the CDO prices would collapse and Citi would lose tens of billions of dollars on its super senior tranches. Citi's creation of CDOs and sales of CDO tranches would cease. At fraud incidences vastly lower than the evidence before the FCIC from Bowen's panel had established, CDOs (including super senior tranches) were certain to suffer catastrophic losses.
Here are the types of questions you would ask Citi's CDO "experts" if you were actually investigating the causes of the crisis.
When did you first become aware of MARI's 2006 report noting a 90% fraud incidence in liar's loans?
What other warnings did MARI make in that same publication about liar's loans?
Were you aware of those defects prior to reading the 2006 MARI report?
[You take them through each of the other warning sources.]
What percentage of your CDOs' cash flows came from (or were based on if synthetic) liar's loans in the years 2005-2008?
How did that percentage change over that time period?
What was the percentage of liar's loans backing Citi's CDOs that had inflated income in 2005-2008?
What was the average extent by which income is inflated?
How did you determine those figures?
What incidence of false reps and warranties had Bowen found in the loans Citi was selling?
How did that incidence found by Bowen's team change over time?
What was the incidence of appraisal fraud in the loans backing Citi's CDOs in 2005-2008?
How did you determine that figure?
Had the United States ever suffered similar epidemics of mortgage fraud in modern history?
You knew that if mortgage fraud reached unprecedented levels losses on CDO backed by fraudulent mortgage loans could reach unprecedented levels, correct?
Explain please to the public the meaning and implications of the industry phrase: "a rolling loan gathers no loss." Specifically, what is its implication for artificially suppressing reported defaults during the expansion phase of a bubble?
What fraud incidence assumptions did you use in your stress tests? Why did you chose those assumptions?
Then you ask in exacting detail how their bonuses and compensation was determined and what the effect of recognizing massive losses on Citi's CDO holdings could have done to their compensation.