The Virgin Crisis: Systematically Ignoring Fraud as a Systemic Risk

by William K. Black

One of the most revealing things about this crisis is the unwillingness to investigate whether “accounting control fraud” was a major contributor to the crisis. The refusal to even consider a major role for fraud is facially bizarre. The banking expert James Pierce found that fraud by senior insiders was, historically, the leading cause of major bank failures in the United States. The national commission that investigated the cause of the S&L debacle found:

“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization” (NCFIRRE 1993)

Two of the nation’s top economists’ study of the S&L debacle led them to conclude that the S&L regulators were correct – financial deregulation could be dangerously criminogenic. That understanding would allow us to avoid similar future crises.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer. “Looting: the Economic Underworld of Bankruptcy for Profit.” 1993: 60).

The epidemic of accounting control fraud that drove the second phase of the S&L debacle (the first phase was caused by interest rate risk) was followed by an epidemic of accounting control fraud that produced the Enron era frauds.

The FBI warned in September 2004 that there was an “epidemic” of mortgage fraud and predicted that it would cause a financial “crisis” if it were not contained. The mortgage banking industry’s own anti-fraud experts reported in writing to nearly every mortgage lender in 2006 that:

“Stated income and reduced documentation loans speed up the approval process, but they are open invitations to fraudsters.” “When the stated incomes were compared to the IRS figures: [90%] of the stated incomes were exaggerated by 5% or more. [A]lmost 60% were exaggerated by more than 50%. [T]he stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan’” (MARI 2006).

We know that accounting control fraud is itself criminogenic – fraud begets fraud. The fraudulent CEOs deliberately create the perverse incentives that that suborn inside and outside employees and professionals. We have known for four decades how these perverse incentives produce endemic fraud by generating a “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” George Akerlof (1970).

Akerlof noted this dynamic in his seminal article on markets for “lemons,” which led to the award of the Nobel Prize in Economics in 2001. It is the giants of economics who have confirmed what the S&L regulators and criminologists observed when we systematically “autopsied” each S&L failure to investigate its causes. Modern executive compensation has made accounting control fraud vastly more criminogenic than it once was as investigators of the current crisis have confirmed.

“Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete.” Miller, T. J. (August 14, 2007). Iowa AG.

Liar’s loans offer what we call a superb “natural experiment.” No honest mortgage lender would make a liar’s loan because such loans have a sharply negative expected value. Not underwriting creates intense “adverse selection.” We know that it was overwhelmingly the lenders and their agents that put the lies in liar’s loans and the lenders created the perverse compensation incentives that led their agents to lie about the borrowers’ income and to inflate appraisals. We know that appraisal fraud was endemic and only agents and their lenders can commit widespread appraisal fraud. Iowa Attorney General Miller’s investigations found:

“[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.”

New York Attorney General (now Governor) Cuomo’s investigations revealed that Washington Mutual (one of the leaders in making liar’s loans) developed a blacklist of appraisers – who refused to inflate appraisals. No honest mortgage lender would ever inflate an appraisal or permit widespread appraisal inflation by its agents. Surveys of appraisers confirm that there was widespread pressure by nonprime lenders and their agents to inflate appraisals.

We also know that the firms that made and purchased liar’s loans followed the respective accounting control fraud “recipes” that maximize fictional short-term reported income, executive compensation, and (real) losses. Those recipes have four ingredients:

  1. Grow like crazy
  2. By making (or purchasing) poor quality loans at a premium yield
  3. While employing extreme leverage, and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL) against the losses inherent in making or purchasing liars loans

Firms that follow these recipes are not “gamblers” and they are not taking “risks.” Akerlof & Romer, the S&L regulators, and criminologists recognize that this recipe provides a “sure thing.” The exceptional (albeit fictional) income, real bonuses, and real losses are all sure things for accounting control frauds.

Liar’s loans are superb “ammunition” for accounting control frauds because they (and appraisal fraud) allow the fraudulent mortgage lenders and their agents to attain the unholy fraud trinity: (1) the lender can charge a substantial premium yield, (2) on a loan that appears to be relatively lower risk because the lender has inflated the borrowers’ income and the appraisal, while (3) eliminating the incriminating evidence of fraud that real underwriting of the borrowers’ income and salary would normally place in the loan files. The government did not require any entity to make or purchase liar’s loans (and that includes Fannie and Freddie). The states and the federal government frequently criticized liar’s loans. Fannie and Freddie purchased liar’s loans for the same reasons that Merrill, Lehman, Bear Stearns, etc. acquired liar’s loans – they were accounting control frauds and liar’s loans (and CDOs backed by liar’s loans) were the best available ammunition for maximizing their fictional reported income and real bonuses.

Liar’s loans were large enough to hyper-inflate the bubble and drive the crisis. They increased massively from 2003-2007.

“[B]etween 2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent, respectively.

The higher levels of originations after 2003 were largely sustained by the growth of the nonprime (both the subprime and Alt-A) segment of the mortgage market.” “Alt-A: The Forgotten Segment of the Mortgage Market” (Federal Reserve Bank of St. Louis 2010).

The growth of liar’s loans was actually far greater than the extraordinary rate that the St. Louis Fed study indicated. Their error was assuming that “subprime” and “alt-a” (one of the many misleading euphemisms for liar’s loans) were dichotomous. Credit Suisse’s early 2007 study of nonprime lending reported that roughly half of all loans called “subprime” were also “liar’s” loans and that roughly one-third of home loans made in 2006 were liar’s loans. That fact has four critical implications for this subject. The growth of liar’s loans was dramatically larger than the already extraordinary 340% in three years reported by the St. Louis Fed because, by 2006, half of the loans the study labeled as “subprime” were also liar’s loans. Because loans the study classified as “subprime” started out the period studied (2003) as a much larger category than liar’s loans the actual percentage increase in liar’s loans from 2003-2006 is over 500%. The first critical implication is that it was the tremendous growth in liar’s loans that caused the bubble to hyper-inflate and delayed its collapse.

The role of accounting control fraud epidemics in causing bubbles to hyper-inflate and persist is another reason that accounting control fraud is often criminogenic. When such frauds cluster they are likely to drive serious bubbles. Inflating bubbles optimize the fraud recipes for borrowers and purchasers of the bad loans by greatly delaying the onset of loss recognition. The saying in the trade is that “a rolling loan gathers no loss.” One can simply refinance the bad loans to delay the loss recognition and book new fee and interest “income.” When entry is easy (and entry into becoming a mortgage broker was exceptionally easy), an industry becomes even more criminogenic.

Second, liar’s loans (and CDOs “backed” by liar’s loans) were large enough to cause extreme losses. Millions of liar’s loans were made and those loans caused catastrophic losses because they hyper-inflated the bubble, because they were endemically fraudulent, because the borrower was typically induced by the lenders’ frauds to acquire a home they could not afford to purchase, and because the appraisals were frequently inflated. Do the math: roughly one-third of home loans made in 2006 were liar’s loans and the incidence of fraud in such loans was 90%. We are talking about an annual fraud rate of over one million mortgage loans from 2005 until the market for liar’s loans collapsed in mid-2007.

Third, the industry massively increased its origination and purchase of liar’s loans after the FBI warned of the developing fraud “epidemic” and predicted it would cause a crisis and then massively increased its origination and purchase of liar’s loans after the industry’s own anti-fraud experts warned that such loans were endemically fraudulent and would cause severe losses. Again, this provides a natural experiment to evaluate why Fannie, Freddie, et alia, originated and purchased these loans. It wasn’t because “the government” compelled them to do so. They did so because they were accounting control frauds.

Fourth, the industry increasingly made the worst conceivable loans that maximized fictional short-term income and real compensation and losses. Making (or purchasing) liar’s loans that are also subprime loans means that the originator is making (or the purchaser is buying) a loan that is endemically fraudulent to a borrower who has known, serious credit problems. It’s actually worse than that because lenders also increasingly added “layered” risks (no downpayments and negative amortization) in order to optimize accounting fraud. Negative amortization reduces the borrowers’ short-term interest rates, delaying delinquencies and defaults (but producing far greater losses). Again, this strategy maximizes fictional income and real losses. Honest home lenders and purchasers of home loans would not act in this fashion because the loans must cause catastrophic losses.

To sum it up, the known facts of this crisis refute the rival theories that the lenders/purchasers originated/bought endemically fraudulent liar’s loans because (a) “the government” made them (or Fannie and Freddie) do so, or (b) because they were trying to maximize profits by taking “extreme tail” (i.e., an exceptionally unlikely risk). The risk that a liar’s home loan will default is exceptionally high, not exceptionally low. The known facts of the crisis are consistent with accounting control frauds using liar’s loans (in the United States) as their “ammunition of choice” in accordance with the conventional fraud “recipe” used that caused prior U.S. crises.

It is bizarre that in such circumstances the automatic assumption of the Bush and Obama administrations has been that fraud isn’t even worth investigating or considering in connection with the crisis. It is as if millions of liar’s loans purchased and resold as CDOs largely by systemically dangerous institutions are an inconvenient distraction from campaign fundraising efforts. Instead, we have the myth of the virgin crisis unsullied by accounting control fraud. Indeed, contrary to theory, experience, and reality, the Department of Justice has invented the faith-based fiction that looting cannot occur.

“Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. “It doesn’t make any sense to me that they would be deliberately defrauding themselves,” Wagner said.”

Wagner’s statement is embarrassing. He conflates “they” (referring to the CEO) and “themselves” (referring to the bank). It makes perfect sense for the CEO to loot the bank. Looting is a “sure thing” guaranteed to make the CEO wealthy. “Looting” destroys the bank (that’s the “bankruptcy” part of Akerlof & Romer’s title) but it produces the “profit” for the CEO. It is the deliberate making of masses of bad loans at premium yields that allows the CEO to profit by looting the bank. When the top prosecutor in an epicenter of accounting control fraud defines the most destructive form of financial crime out of existence he allows elite fraud to occur with impunity.

As embarrassing as Wagner’s statement is, however, it cannot compete on this dimension with that of his boss, Attorney General Holder. I was appalled when I reviewed his testimony before the Financial Crisis Inquiry Commission (FCIC). Chairman Angelides asked Holder to explain the actions the Department of Justice (DOJ) took in response to the FBI’s warning in September 2004 that mortgage fraud was “epidemic” and its prediction that if the fraud epidemic were not contained it would cause a financial “crisis.” Holder testified: “I’m not familiar myself with that [FBI] statement.” The DOJ’s (the FBI is part of DOJ) preeminent contribution with respect to this crisis was the FBI’s 2004 warning to the nation (in open House testimony picked up by the national media. For none of Holder’s senior staffers who prepped him for his testimony to know about the FBI testimony requires that they know nothing about the department’s most important and (potentially) useful act. That depth of ignorance could not exist if his senior aides cared the least about the financial crisis and made it even a minor priority to understand, investigate, and prosecute the frauds that drove the crisis. Because Holder was testifying in January 14, 2010, the failure of anyone from Holder on down in his prep team to know about the FBI’s warnings also requires that all of them failed to read any of the relevant criminology literature or even the media and blogosphere.

In addition to claiming that the DOJ’s response to the developing crisis under President Bush was superb, Holder implicitly took the position that (without any investigation or analysis) fraud could not and did not pose any systemic economic risk. Implicitly, he claimed that only economists had the expertise to contribute to understanding the causes of the crisis. If you don’t investigate; you don’t find. If you don’t understand “accounting control fraud” you cannot understand why we have recurrent, intensifying financial crises. If Holder thinks we should take our policy advice from Larry Summers and Bob Rubin, leading authors’ of the crisis, then he has abdicated his responsibilities to the source of the problem.

“Now let me state at the outset what role the Department plays and does not play in addressing these challenges” [record fraud in investment banking and securities].

“The Department of Justice investigates and prosecutes federal crimes.…”

“As a general matter we do not have the expertise nor is it part of our mission to opine on the systemic causes of the financial crisis. Rather the Justice Department’s resources are focused on investigating and prosecuting crime. It is within this context that I am pleased to offer my testimony and to contribute to your vital review.”

Two aspects of Holder’s testimony were preposterous, dishonest, and dangerous.

“I’m proud that we have put in place a law enforcement response to the financial crisis that is and will continue to be is aggressive, comprehensive, and well-coordinated.”

DOJ has obtained ten convictions of senior insiders of mortgage lenders (all from one obscure mortgage bank) v. over 1000 felony convictions in the S&L debacle. DOJ has not conducted an investigation worthy of the name of any of the largest accounting control frauds. DOJ is actively opposing investigating the systemically dangerous institutions (SDIs).

Holder’s most disingenuous and dangerous sentence, however, was this one:

“Our efforts to fight economic crime are a vital component of our broader strategy, a strategy that seeks to foster confidence in our financial system, integrity in our markets, and prosperity for the American people.”

Yes, the “confidence fairy” ruled at DOJ. It is the rationale now for DOJ’s disgraceful efforts to achieve immunity for the SDIs’ endemic frauds. The confidence fairy trumped and traduced “integrity in our markets” and “prosperity for the American people.” Prosperity is reserved for the SDIs and their senior managers – the one percent.

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About the Author

William K. Black is Associate Professor of Economics at University of Missouri, Kansas City.  From 1990-1994 Prof. Black was Senior Deputy Chief Counsel, Office of Thrift Supervision, which was formed in 1989 to supervise the thrift industry following the Saving & Loan crisis.  He is the author of the widely acclaimed book “The Best Way to Rob a Bank is to Own One.”  Full bio here.

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