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Fannie, Freddie or Fraud?

Tex

Well-known member
link:

http://www.huffingtonpost.com/william-k-black/the-two-documents-everyon_b_169813.html


William K. Black

Associate Professor, University of Missouri - Kansas City; Senior regulator during S&L debacle
Posted February 25, 2009 | 10:31 AM (EST)
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The Two Documents Everyone Should Read to Better Understand the Crisis
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Read More: Control Fraud, Fbi, Subprime Loan Crisis, Subprime Loans, Subprime Mortgage Crisis, Subprime Mortgages, Tim Geithner, Timothy Geithner, Business News

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As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds. When the person that controls a seemingly legitimate business or government agency uses it as a "weapon" to defraud we categorize it as a "control fraud" ("The Organization as 'Weapon' in White Collar Crime." Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds' "weapon of choice" is accounting. Control frauds cause greater financial losses than all other forms of property crime -- combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a "criminogenic environment" (Big Money Crime. Calavita, Pontell & Tillman 1997.)

The FBI correctly identified the epidemic of mortgage control fraud at such an early point that the financial crisis could have been averted had the Bush administration acted with even minimal competence. To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud.
Don't ask; don't tell: book profits, "earn" bonuses and closet your losses

The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages "underlying" the derivative. A senior manager sends a blistering reply with this forceful punctuation:

Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.

Fraud is the principal credit risk of nonprime mortgage lending. It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, "most investors" (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The "AAA" rating is supposed to indicate that there is virtually no credit risk -- the risk is equivalent to U.S. government bonds, which finance refers to as "risk-free." We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this era rises like a stairway to heaven. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud.

Worse, the S&P document demonstrates that the investment and commercial banks that purchased nonprime loans, pooled them to create financial derivatives, and sold them to others engaged in the same willful blindness. They did not review samples of loan files because doing so would have exposed the toxic nature of the assets they were buying and selling. The entire business was premised on a massive lie -- that fraudulent, toxic nonprime mortgage loans were virtually risk-free. The lie was so blatant that the banks even pooled loans that were known in the trade as "liar's loans" and obtained AAA ratings despite FBI warnings that mortgage fraud was "epidemic." The supposedly most financially sophisticated entities in the world -- in the core of their expertise, evaluating credit risk -- did not undertake the most basic and essential step to evaluate the most dangerous credit risk. They did not review the loan files. In the short and intermediate-term this optimized their accounting fraud but it was also certain to destroy the corporation if it purchased or retained significant nonprime paper.
Stress this: stress tests are useless against the nonprime problems


What commentators have missed is that the big banks often do not have the vital nonprime loan files now. That means that neither they nor the Treasury know their asset quality. It also means that Geithner's "stress tests" can't "test" assets when they don't have the essential information to "stress." No files means the vital data are unavailable, which means no meaningful stress tests are possible of the nonprime assets that are causing the greatest losses.
The results were disconcerting

A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch's report on what they found.

Fitch's analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.


[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.

Fitch also explained why these forms of mortgage fraud cause severe losses.

For example, for an origination program that relies on owner occupancy to offset other risk factors, a borrower fraudulently stating its intent to occupy will dramatically alter the probability of the loan defaulting. When this scenario happens with a borrower who purchased the property as a short-term investment, based on the anticipation that the value would increase, the layering of risk is greatly multiplied. If the same borrower also misrepresented his income, and cannot afford to pay the loan unless he successfully sells the property, the loan will almost certainly default and result in a loss, as there is no type of loss mitigation, including modification, which can rectify these issues.

The widespread claim that nonprime loan originators that sold their loans caused the crisis because they "had no skin in the game" ignores the fundamental causes. The ultra sophisticated buyers knew the originators had no skin in the game. Neoclassical economics and finance predicts that because they know that the nonprime originators have perverse incentives to sell them toxic loans they will take particular care in their due diligence to detect and block any such sales. They assuredly would never buy assets that the trade openly labeled as fraudulent, after receiving FBI warnings of a fraud epidemic, without the taking exceptional due diligence precautions. The rating agencies' concerns for their reputations would make them even more cautious. Real markets, however, became perverse -- "due diligence" and "private market discipline" became oxymoronic. These two documents are enough to begin to understand:

* the FBI accurately described mortgage fraud as "epidemic"

* nonprime lenders are overwhelmingly responsible for the epidemic

* the fraud was so endemic that it would have been easy to spot if anyone looked

* the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a "don't ask; don't tell" policy

* willful blindness was essential to originate, sell, pool and resell the loans

* willful blindness was the pretext for not posting loss reserves

* both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed

* the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses

* the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation

* many of the big banks are deeply insolvent due to severe credit losses

* those big banks and Treasury don't know how insolvent they are because they didn't even have the loan files

* a "stress test" can't remedy the banks' problem -- they do not have the loan files
 

Steve

Well-known member
The ultra sophisticated buyers

while I would agree that loan fraud at all levels played into the "fault"

most of the "local" defaults are from poor people in poor areas.. so how does that add up to ultra sophisticated buyers..

We do know that defaults are closely tied to subprime loans. The most toxic of all, adjustable rate mortgage (ARM) subprime loans, accounted in early 2008 for only six percent of all loans outstanding but 39 percent of foreclosures started

Fixed and adjustable subprimes account for only 12 percent of loans outstanding, but half of current foreclosures.

Compliance Tech, a firm that helps lenders “Manage Diverse Lending Markets,” estimates that in 2004-2006, minorities accounted for 44 percent of all subprime loans, with Hispanics slightly outnumbering blacks.

On the other hand, they likely tend to have lower value mortgages. On the other other hand, many Hispanics are found in expensive states, especially California, epicenter of the crisis. The largest defaults in America as measured in dollar losses (number of defaults times size) appear to have come out of California’s exurban fringe: the Inland Empire, Antelope Valley, and the Central Valley. All these areas tend to have mixed white and Hispanic populations

I don't feel it is as much about ethniticity and it is more about the poor and subprime.... and that doesn't add up to a "ultra sophisticated buyer"

"ignores the fundamental causes. The ultra sophisticated buyers knew the originators had no skin in the game."

I believe,.. the loan originator turned an eye, while the person "stretched" his income.. but to say it was an ""ultra sophisticated buyer" at fault... come on...
 

Tex

Well-known member
Steve said:
The ultra sophisticated buyers

while I would agree that loan fraud at all levels played into the "fault"

most of the "local" defaults are from poor people in poor areas.. so how does that add up to ultra sophisticated buyers..

We do know that defaults are closely tied to subprime loans. The most toxic of all, adjustable rate mortgage (ARM) subprime loans, accounted in early 2008 for only six percent of all loans outstanding but 39 percent of foreclosures started

Fixed and adjustable subprimes account for only 12 percent of loans outstanding, but half of current foreclosures.

Compliance Tech, a firm that helps lenders “Manage Diverse Lending Markets,” estimates that in 2004-2006, minorities accounted for 44 percent of all subprime loans, with Hispanics slightly outnumbering blacks.

On the other hand, they likely tend to have lower value mortgages. On the other other hand, many Hispanics are found in expensive states, especially California, epicenter of the crisis. The largest defaults in America as measured in dollar losses (number of defaults times size) appear to have come out of California’s exurban fringe: the Inland Empire, Antelope Valley, and the Central Valley. All these areas tend to have mixed white and Hispanic populations

I don't feel it is as much about ethniticity and it is more about the poor and subprime.... and that doesn't add up to a "ultra sophisticated buyer"

"ignores the fundamental causes. The ultra sophisticated buyers knew the originators had no skin in the game."

I believe,.. the loan originator turned an eye, while the person "stretched" his income.. but to say it was an ""ultra sophisticated buyer" at fault... come on...

The ultra sophisticated buyers were those buying from the originators, not the home buyer.

Steve, there was a total breakdown between the quality of the loan and pricing of it by everyone after it was originated. The risk premiums charged went largely to the originators, who traditionally had closer ties to the actual underlying debt. When that link was broken or ignored, it allowed sub prime mortgages to be sold as generic "MBS"s instead of risk adjusted securities. This was sold to sophisticated buyers who turned around and sold them to everyone else while taking their cut and passing the "old maid".

To blame this all on those who took the loans and then to socialize the losses of the "sophisticated" part ignores more than half the problem.

I don't like "sophisticated" people hiding risk and profiting from it, and taking a free ride on the taxpayer's dime. I am not going to excuse it all because of the borrower because it was the major breakdown in the system. It created the equivalent of utility cattle being sold as choice meat.

The market for houses artificially inflated because of the "demand" from "good" and able buyers increased due to weakening underwriting standards. This was the housing bubble, which, by the way, was increased because of artificially low interest rates in part because China used their extra dollars to buy U.S. securities instead of goods.

This was part of agman's "brilliant" understandings, I guess, and he was the only one "sophisticated" enough to understand it.
 

hypocritexposer

Well-known member
This was part of agman's "brilliant" understandings, I guess, and he was the only one "sophisticated" enough to understand it.

I haven't seen Agman on here forever, Econ101 used to read alot of his stuff, and comment too!
 

Clarencen

Well-known member
I shouldn't get into this, I am as ignorant about ecconomics as any one can be. I believe all from the top to the bottom were to blame for what has happened. It was there for everyone to see. We all had that as long as it feels good thing evrything is OK. Home buyers should have known when they were taking on mortgages they could not afford. Sellers should have been more honest when they knew they were selling what some could not afford. Then these questionable mortgages were passed on and on. To me a home is a place to live, true it is an asset, but it does not produce income. It doesn't seem honest to sell it as something that would always increase in value. The same goes for selling and buying insecure mortgages, what was behind them for a safety net?

It seems to me that one man's gain is another man's loss. We had people on this board who preached risk management. Now they are gone.

In the 1990's there were people here who had money to invest in the future market. I am told they came into coffee shops and told how much money they were making. They don't come around any more.

When the glitter is gone from what is artificial it is shown to be artificial.
 

Tex

Well-known member
hypocritexposer said:
This was part of agman's "brilliant" understandings, I guess, and he was the only one "sophisticated" enough to understand it.

I haven't seen Agman on here forever, Econ101 used to read alot of his stuff, and comment too!

I went and re read some of those posts and I think he was right too. Hindsight is 20/20 but foresight is a gift.

Sandhusker was right on his assessment of Walmart on this date:

PostPosted: Wed Mar 23, 2005 1:02 pm Post subject:

in regards to Agman on "Wal-Mart facts for Sandhusker Only".

It seems he had a lot of foresight too.

It is funny that there was a huge debate about how much the stimulus bill would help the U.S. economy and the point that we buy so many imports so the money just goes to the world economy instead of just the U.S. economy was brought up. I think Sandhusker's argument was point on.
 
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