by William K. Black, New Economic Perspectives
I have written a series of articles recently that focus on appraisal fraud.
I did so because appraisal fraud allows such “clean” tests of what (and who) drove the financial crisis and how many different private and public sector actors could have easily prevented the crisis had they acted against the fraud epidemics.
- Only lenders and their agents can cause a substantial amount of appraisal fraud;
- They did so through extorting appraisers to inflate appraisals by blacklisting the most ethical appraisals;
- No honest lender would induce appraisal fraud;
- Lenders engaged in accounting control fraud find widespread appraisal fraud an optimal strategy;
- Fraudulent mortgage lenders engage in appraisal fraud because it aids their overall strategy of making fraudulent loans;
- No honest lender would permit widespread appraisal fraud;
- Honest lenders can prevent widespread appraisal fraud in the loans they make;
- No honest secondary market purchaser would knowingly purchase loans with inflated appraisals;
- Competent secondary market purchasers could have avoided purchasing large numbers of loans with inflated appraisals;
- The appraisers warned the Nation publicly of the widespread appraisal fraud and that it occurred through extortion and blacklisting by the lenders and their agents;
- The appraisers took special efforts to warn the mortgage lending industry and U.S. government beginning in 2000, and continued those efforts through 2007, about these facts and warned that it would cause a crisis;
- Eventually, over 11,000 appraisers signed the profession’s petition warning about the epidemic of appraisal fraud driven by the lenders and their agents.
My earlier articles noted that the fraudulent lenders typically engaged in a two-barreled assault that combined endemically fraudulent “liar’s” loans and appraisal fraud. Like a shotgun, the overlapping fields of fire can be devastating when lenders combine the two forms of fraud. The liar’s loans were the underlying fraudulent lending strategy. Appraisal fraud supplemented this underlying fraud. This column discusses three important interactions among these fraud schemes that optimized the overall accounting control fraud “recipe.”
The officers controlling a fraudulent mortgage lender (purchaser) optimize their income through the usual fraud “recipe.”
Grow like crazy by:
- Making (buying) really crappy loans at a premium yield;
- While employing extreme leverage and;
- Providing only trivial allowances for loan and lease losses (ALLL).
The recipe combines with modern executive compensation to create three “sure things” – the lender (purchaser) is guaranteed to report record income in the near term, the controlling officers will promptly be made wealthy, and the firm, borrowers, and the world will suffer severe losses on the fraudulent loans. The fraud recipe is also a superb device for hyper-inflating financial bubbles and did in fact cause the hyper-inflation of bubbles in the U.S. and other nations in the ongoing crisis.
I have explained in prior columns why the controlling lenders found liar’s loans to optimize the fraud recipe in the U.S. and the U.K. By 2006, 40% of all mortgage loans made that year in the U.S. were liar’s loans. The comparable figure for the U.K. was 45 percent. Liar’s loans allow lenders to make fraudulent loans without having to create (or evade) making a paper trial documenting that they knew they were making loans that were unsound and would have exceptionally high default rates as soon as the bubble stalled. I have shown why the two means of trying to evade documentation requirements present serious risks of imprisonment to the controlling officers if the regulators and prosecutors are vigorous. Eliminating the documentation requirement for mortgage lending was the single most destructive act of mindless deregulation. It was done under the Clinton administration as part of Vice President Gore’s “Reinventing Government.” I have shown in prior columns that his effort was explicitly anti-anti-fraud. Gore made war on the regulators and regulations that had protected the Nation from the control frauds.
Fleecing the Financially Unsophisticated – Then Blaming Them
Virtually everyone involved in the mortgage lending process made more money if the size of the loan was larger. This meant that it was optimal for home prices to be greater and for the mortgage loan to be larger. By inflating the appraisal the lender could purport to justify making a larger loan. The loan would be greater than the current market price of a home because the borrower would pay a price even greater than prevailing prices during the bubble. People involved in the mortgage lending process made more money if the borrower paid a premium yield. This made it optimal to seek out borrowers who lacked financial sophistication. It was easier to convince such a borrower to overpay (even above the prevailing bubble prices) for a home and to pay a premium yield to the lender for the privilege of being duped. A liar’s loan provided no benefit to an honest borrower – it simply imposed roughly another 100 basis points of interest costs. That 100 bps, unfortunately, was simply adding insult to the real injury, which was typically inflicted in the form of hidden fees known as the “yield spread premium” (YSP) and purchasing a home the buyer could not afford at an inflated price well in excess of the home’s true value. The less financially sophisticated the borrowers were, the more likely the borrowers were to believe that the loan broker was their agent working on their behalf. That was true of some brokers, but it was untrue of many brokers because their interests were directly antagonistic to the borrower’s interests. This is how the realtors’ association (disingenuously) explains the role of the brokers and the YSP.
“They do all the work that you need to do in order to originate, process and close the loan. They represent you, not the bank.”
No, they do not “represent you.” It is true that they do not (formally) “represent the bank,” but the bank’s controlling officers determine the broker’s compensation incentives so they are the one’s steering the transaction and the broker’s actions. As I noted, some brokers will seek to act in the borrower’s interests despite these perverse financial interests, but many will act directly contrary to the interests of the borrowers and the lender.
Another large group of brokers will “neutralize” their moral restraints against committing mortgage fraud by purporting to be acting on behalf of the borrowers. This group will argue that the bank knows that the broker is inflating the borrower’s income and extorting appraisers to inflate the value of the home, so it is not harmed and the borrower is able to buy a home he could not otherwise purchase so he is being helped. Under this morally myopic view it is fine for the broker to get rich through mortgage fraud because there is no real victim. The reality is different. The lender will suffer enormous losses and the borrowers will commonly be induced to overpay for homes (even above the prevailing bubble values) at the top of the bubble. This will cause the borrower to suffer severe losses that wipe out his equity, particularly if he tries to delay the default by continuing to pay the initial low interest rate (on “exploding rate” ARMs) even though the home is deeply “underwater.” The borrower will also ruin his credit history.
It is true that the controlling bank officers knowingly created – and continued for many years – the perverse incentives that ensured that brokers would arrange millions of fraudulent loans even after there were multiple warnings about the lenders’ twin mortgage fraud epidemics. But that occurred because they were leading accounting control frauds. The fact that the officers who controlled the bank betrayed their fiduciary duties to the bank in order to become wealthy does not change the fact that the bank would suffer severe losses if the loan brokers inflated the borrower’s income and the appraised value. It was immoral for loan brokers to cause the banks severe losses by making loans that were highly likely to default as soon as the bubble stalled.
The Realtors’ website goes on to (unintentionally) reveal that the loan brokers’ did not represent the interests of the borrowers.
In back-end compensation, the broker gets a check from the lender for increasing the interest rate. The mortgage broker gets more money depending on how much he or she increases the rate. This is called the YSP, the yield spread premium.”
The broker gets paid more the larger the amount of the loan and the higher the rate of interest he can induce the borrower to pay. The broker can make the most money therefore by trolling for financially unsophisticated borrowers – or those who are not fluent in English. The broker and the borrower conduct their discussions in Spanish, but the documents are entirely in English. The opportunities for abusing less sophisticated borrowers are legion.
In addition to the twin fraud schemes that the lenders employed there was a far smaller but still significant fraud scheme led by a subset of borrowers – the most financially sophisticated borrowers, the real estate speculators who purchased multiple homes as investments. A recent study confirmed the importance of their frauds. The authors found that real estate speculators often misrepresented their intention to occupy the home they were purchasing as their principal dwelling. A borrower is far less likely to default on a loan on the home that is his principal dwelling, so lenders charge roughly 100 more basis points for loans to speculators who do not intend to occupy the dwelling. The study by Piskorski, et al., documented that the default rate by speculators who misrepresented their intent to occupy was considerably higher than for speculators who truthfully represented their intent not to occupy. That finding demonstrates that the speculators who are willing to lie pose far greater risks of loss to honest lenders than honest speculators. The most financially sophisticated borrowers did were the most likely borrowers to instigate frauds against the lenders.
Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market
Tomasz Piskorski, Seru & Witkin, February 2013
The claim that the least wealthy homeowners, particularly minorities, were the villains that drove this crisis is facially preposterous. The idea that among the least financially sophisticated households in America defrauded the most financially sophisticated firms is so delusional and viciously false that it is fitting that it became infamous through a Rick Santelli rant. He’s certainly right that the small homeowners targeted by the fraudulent lenders were “losers.” They lost their homes, their very limited savings, and their credit ratings. The small homeowners were the leading victims of the fraudulent lenders and their allies. Santelli referred to the financial derivatives traders at the Chicago Mercantile Exchange and said “this is America.” He called them a “statistical cross section of America.” The homeowners, particularly minorities, targeted by the frauds that made the derivatives traders wealthy were by implication not really part of “America.”
Three Interactions Between Liar’s Loans and Appraisal Fraud
Fraudulent lenders and those that aid and abet their frauds typically found it optimal to combine liar’s loans and appraisal fraud for three reasons. First, because the frauds become wealthier the bigger they can make the loans appraisal fraud is desirable because it allows homes to be sold at prices that are well above even bubble-driven market prices. The less sophisticated borrowers, however, cannot afford to purchase a house at those inflated prices. Liar’s loans inflate the borrower’s income dramatically, which makes it appear that the borrower can afford to repay the loan.
Second, as I explained in earlier articles the secondary market was so perverted by lenders and purchasers in order to assist the fraudulent sales of fraudulent mortgages that the lenders, purchasers, and (not remotely) “due diligence” firms (Clayton and its competitors) had the audacity to use fraud as a “compensating factor” that purportedly reduced the risk of default caused by the lender’s fraudulent “representations and warranties” about the quality of the loan packages being sold. Clayton would use a (purportedly) low debt-to-income and loan-to-value ratios as the excuse to ignore misrepresentations (fraud) by the lender about the quality of the mortgages being sold to the secondary market. But those purportedly unusually low ratios were the direct product of, respectively, liar’s loans frauds and appraisal fraud.
Third, appraisal fraud made it far easier to convince unsophisticated borrowers to take out liar’s loans they could never repay. A husband who expressed concern whether he could repay such a large home loan could be told, preferably in front of his wife, that he could not afford to pass up the brilliant deal he had negotiated. He negotiated a purchase price of $200,000 and the appraisal came back at $250,000. If worse came to worst he could always sell the home and take the $50,000 profit. The one thing he could not do was make the worst financial mistake of his life and walk away from a minimum $50,000 profit – a profit almost certain to grow as home prices rose.
Fraudulent lenders combined liar’s loans and appraisal fraud to produce a weapon of mass financial destruction.
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