The housing appraisers warned us about the crisis but we didn’t listen

By William K. Black

On July 9, 2013 I participated in a radio interview with a lobbyist for the 100 largest financial firms.  The San Francisco radio program host asked me what question I would ask the lobbyist and I said that any discussion should begin with allowing him to state his view of what caused the crisis.  In the course of his explanation, he bemoaned the fact that there was no warning about the crisis.

I found this ironic because I had just published that morning an article about how the appraisal profession warned us that the senior officers controlling the mortgage lending firms were engaged in pervasive “accounting control fraud.”

That article discussed the ten logical implications about the developing fraud epidemic that any competent financial regulator could have explained to FBI agents and Assistant U.S. Attorneys (AUSAs) on the basis of the facts contained in these two sentences:

“From 2000 to 2007, [appraisers] ultimately delivered to Washington officials a petition; signed by 11,000 appraisers…it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18).

Note that the appraisers’ petition began in 2000 and was public.  When the regulators and prosecutors did nothing in response to the appraisers’ warning the appraisers delivered it to government officials to ensure that no one could say they were not warned.  What tends to be forgotten is that the mortgage industry’s leaders did nothing to restrain the fraud epidemic and a great deal to expand it.  A finance industry representative claiming in 2013 that no one warned the industry of the coming crisis when the warnings began no later than 2000 epitomizes the industry’s death of accountability, integrity, and candor.

Any of the following federal actors could have responded to the appraisers’ warning and prevented the crisis: the Federal Reserve, the FBI/Department of Justice, the lenders’ CEOs, the secondary market purchasers’, Clayton and the other “due diligence” firms, the lenders’ and secondary market purchasers’ internal and external auditors, the credit rating agencies, the SEC, Congress, and President Bush.  Several of the state Attorney Generals had sufficient staff to prevent the crisis.  The industry and federal leaders took no effective action.  The states took two major actions against appraisal fraud, but neither was effective because they never understood the significance of the facts they found.

Public Integrity’s Article on Appraisal Fraud

It turns out that by reading a single article, and adding some analytics, one can explain why the industry and the federal government failed to act and why the Department of Justice (DOJ) still refuses to prosecute the controlling officers of the mortgage lenders and secondary market purchasers.  The most depressing aspect of the ineffective responses to the appraisers’ warnings, however, is the two efforts by state prosecutors to respond to the epidemic of appraisal fraud.  These efforts were well-intentioned but failed to even slow the epidemic of accounting control fraud because they failed to understand the implications of appraisal fraud.  The single article, published in 2009, that allows us to understand the myriad failures is entitled “The Appraisal Bubble.”

The article is excellent in its presentation of many of the essential facts, but incomplete on several vital analytical areas.  One of the odd factual weaknesses, which produces several analytical weaknesses, is that a story devoted to discussing appraisal fraud does not mention the appraisers’ petition.

The Pack of Dogs that Didn’t Bark about Appraisal Fraud

The federal banking regulators and the SEC are the dogs that do not bark in the Public Integrity story.  This is a testament to how effective a strategy of appointing anti-regulatory leaders is to producing a self-fulfilling prophecy of regulatory failure.  The article does not mention the SEC or the federal banking regulatory agencies.  In one sense, this is perfectly understandable, for they did not launch a national investigation of appraisal fraud despite the federal banking examiners documentation of widespread appraisal fraud.  The leaders of the federal banking regulatory agencies never understood the implications of appraisal fraud even for the individual banks they were supposed to regulate.

The Federal Reserve had unique statutory authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to regulate all mortgage lenders – even those whose deposits were not federally insured and were not normally subject to federal banking regulations.   The Fed refused to use that authority to halt the epidemic of mortgage fraud (including appraisal fraud), until July 2008, when it finally adopted a rule barring (endemically fraudulent) liar’s loans.  Even then, it delayed the effective date of the rule by well over a year because one would not wish to interfere with mortgage fraud.

The SEC had limited, but sufficient, regulatory jurisdiction over the credit rating agencies.  It could have forced them to take mortgage fraud (including appraisal fraud) seriously, which would have spiked the secondary market.  The SEC also had, in the key years of the frauds, “consolidated supervision” authority over the five largest investment banks.  The SEC approved this program in April 2004.  The program was a scam to aid the largest investment bank escape EU regulation through the creation of a fake U.S. regulatory regime, but the SEC could have used the authority to investigate the appraisers’ petition and the epidemic of mortgage fraud.  The investment banks and their affiliates were among the worst of the worst in committing appraisal and mortgage fraud and purchasing fraudulent mortgages and then reselling them in the form of collateralized debt obligations (CDOs).

The fact that an article all about the response to the epidemic of appraisal fraud never mentions the federal banking regulatory agencies and the SEC is immensely revealing – but it also reveals that the authors of the article did not understand the implications or it would have been a major focus of their article.  The problem is in part circular.  It is the job of the regulators to sound the alarm about incipient or raging fraud epidemics and to explain the implications to the public and journalists.  This is a function Bank Board Chairman Gray assigned to me during the S&L debacle, but this crisis had no Gray, so it had no Black.  Instead, it had anti-regulators eager to see anything but control fraud.

The article begins well, but notice that it lets the myriad private sector actors that could have prevented the epidemic of accounting control fraud off the hook.

“Before real estate prices began to plummet in 2006, some sounded the alarm on fraudulent appraisals and lender pressure, but few listened to the warnings, least of all Congress, industry regulators, and the Justice Department.”

Appraisal Fraud is a Marker for Accounting Control Fraud

In fairness, the phrase “least of all” applies to the private actors for they actively encouraged the fraud epidemic.  The private sector vigorously opposed any governmental discouragement, much less crackdown, on the raging fraud epidemic.  One element of the federal government, the FBI, performed well in the early years of the epidemic.  Chris Swecker, the FBI official assigned to take the lead on mortgage fraud, issued the famous twin warnings on mortgage fraud in September 2004.  The FBI warned that there was an “epidemic” of mortgage fraud and predicted that if it were not stopped it would cause a financial “crisis.”  The fundamental limitation of the FBI’s twin warnings was a failure to understand that they were confronted with an epidemic of accounting control fraud.

The authors of the article do not note the twin FBI warnings in 2004 and they do not note that the warnings did not identify the source of the mortgage fraud epidemic – the officers controlling the lenders.  That is doubly unfortunate in terms of the analytics for it means that the article about appraisal fraud does not discuss the single most important analytical lesson that the endemic appraisal fraud should have taught contemporaneously.  Widespread appraisal fraud is the cleanest “marker” of widespread accounting control fraud by mortgage lenders and secondary market purchasers.  The appraisal is one of the most important protections against loss a mortgage lender has.  No honest lender would inflate appraisals.

Only lenders can induce widespread appraisal fraud.  They do so by causing a “Gresham’s” dynamic in which cheaters prosper, which causes markets and professions to become perverse and causes those with the worst ethics to drive those with the best ethics out of the markets and professions.  Lenders create the Gresham’s dynamic by leading the sales price to the appraiser and blacklisting appraisers who refuse to inflate the appraisal to be at least as large as the sales price.  Honest mortgage lenders have known for decades how to prevent inflated appraisals fraud.  They create the proper financial incentives for the appraisers and they use review appraisers to ensure competence and honest appraisals.  They refuse to hire appraisers who are incompetent or unethical.  Episodic appraisal fraud may still occur, but it is exceptionally difficult to commit widespread appraisal fraud against an honest lender.  It is impossible to do so for any material time against an honest, competent mortgage lender.

Widespread appraisal fraud by mortgage lenders optimizes accounting control fraud.  The fraud “recipe” for a mortgage lender (purchaser) has four “ingredients.”

  1. Grow like crazy by
  2. Making (purchasing) really crappy loans at a premium yield (interest rate) while
  3. Employing extreme leverage (very high debt to equity ratios), and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL)

George Akerlof and Paul Romer wrote a famous article in 1993 entitled “Looting: The Economic Underworld of Bankruptcy for Profit.”  They agreed with the central finding of competent financial regulators and white-collar criminologists: following this recipe produces a “sure thing.”  More precisely, following the recipe produces three sure things.  The lender (purchaser) will report record (albeit fictional) profits in the near term, the controlling officers will promptly be made wealthy by modern executive compensation, and the lender (purchaser) will suffer severe losses in the longer term.  Akerlof and Romer also agreed with our findings that the first two “ingredients” optimized the fraud “recipe” as a device for hyper-inflating financial bubbles and that hyper-inflating the bubble greatly increased the life and damage caused by the epidemic of accounting control fraud.  The frauds can simply refinance the bad loans and report additional (fraudulent) income.  The saying in the trade is “a rolling loan gathers no loss.”

Note that deliberately making (purchasing) bad mortgage loans means that the “expected value” of those loans is negative at the time the loans are made (purchased).  The bubble may postpone the losses for years, but bubbles must stop.  As soon as the bubble stops expanding, even before prices collapse, it becomes impossible to refinance the bad loans and the lenders (purchasers) begin to suffer serious losses.  By late 2006, a wave of mortgage bank failures began that by the end of 2007 had largely swept away the fraudulent mortgage bankers.

Widespread appraisal fraud is also a superb marker of a total breakdown of internal and external private sector controls (the auditors, due diligence reviewers, credit rating agencies, and the creditors who are supposed to exert “private market discipline”).  Widespread appraisal fraud that does not lead to massive rejections of mortgages tendered for resale in the secondary market is a sure marker of a secondary market that will produce severe losses.  That same logic applies to the market for collateralized debt obligations (CDOs) and those providing “credit enhancements” to CDOs (the monoline insurers and those selling credit default swaps (CDS) as guarantees of CDOs).  There were no mass rejections by the secondary market of mortgage loans made through appraisal fraud.  There were no mass rejections by those packaging CDOs and there were no adverse consequences for the credit ratings of the mortgages, MBS, or CDO tranches as a result of the widespread issuance of fraudulent mortgages backed by fraudulent appraisals.  There were no effective private sector actors “exorcizing” the mortgages approved as a result of appraisal fraud from the secondary market sales and the CDOs.  That meant that the control frauds spread throughout much of the (often deeply opaque) financial system, which is a recipe for hyper-inflating a financial bubble and causing a systemic financial crisis.

The widespread appraisal fraud allowed one to infer something else that was equally important.  There were two, often overlapping epidemics of mortgage fraud driven by lenders, and those frauds spread to the secondary market and the derivatives market to cause the systemic financial crisis.

Control Fraud Epidemics Render Firms Vulnerable to other Frauds

More subtly, if one understood control fraud and mortgage lenders one would also understand the surge in mortgage frauds that were not committed by control frauds but were made possible by the twin epidemics of accounting control fraud.  The inevitable byproducts of the accounting control fraud “recipe” for a lender or purchaser of loans include the devastation of underwriting and internal controls and the degradation of the integrity of the officers and employees of the fraudulent financial institutions.  That rot frequently extends very low into the ranks.  The CEO sets the ethical tone of a firm and when the CEO is a fraud that ethical tone will celebrate fraud, greed, and arrogance.  Personnel will “vote with their feet.”  The most ethical will leave and the least ethical will join and stay with a control fraud.  A loan officer who spends all day, every work day creating fraudulent loans that will harm the customer and the bank is far less likely to have moral qualms perpetrating a mortgage fraud against his bank that will let him loot the bank for personal gain.  Some portion of these moral misfits will choose to loot the firm in ways the CEO does not desire.  The destruction of controls and underwriting (an honest lender’s chief bulwarks against fraud) combined with their insider knowledge about how best to commit mortgage fraud against their bank will lead to moderately sophisticated mortgage frauds led by insiders.

More generally, the degradation of underwriting and controls, which will quickly become known to real estate participants, makes fraudulent lenders prime targets for outsider mortgage frauds.  Tens of thousands of mortgage loan brokers, appraisers, real estate developers, and real estate agents dealt on a daily basis with the fraudulent mortgage lenders.  Many of these people helped the fraudulent lenders commit their frauds.  The outsiders could pick the fraudulent banks that provided the optimal targets for outsider fraud because they eagerly approved vast numbers of fraudulent loans and were very unlikely to detect frauds even if they episodically tried to do so.  Real estate speculators, for example, could borrow at a lower interest rate (roughly 100 basis points) if they represented that the homes they were purchasing would be their “principal dwelling.”  People are far less likely to default on their home loans if the consequences are that they and their family will lose their home.  Speculators frequently lied on their loan applications about intending to live in the home.  Speculators were far more common in a small number of local real estate markets, so they tended to hyper-inflate local real estate bubbles wherever the speculators clustered.

To sum it up, savvy banking regulators would have known from the widespread appraisal fraud and widespread liar’s loans that there were twin, overlapping forms of mortgage fraud that were becoming epidemic.   They would have known that the twin fraud schemes were growing massively and were most common in the real estate markets undergoing the worst hyper-inflated bubbles.  They would have known that the twin fraud schemes indicated that fraudulent lenders (purchasers) were following the fraud “recipe” and that the inevitable consequences of these control fraud epidemics would be a surge in other insider and outsider mortgage frauds.  Lenders following the fraud recipe figuratively place a blazing neon sign on their branches announcing:  “We’re Fraud Friendly – Come in and Rip us off while we’re Ripping Your Neighbor Off.”

Control Fraud in the Secondary Market

A real regulator would have known that the banks, the borrowers, and the public would be gravely harmed by the twin mortgage fraud schemes run by the accounting control frauds.  The Nation was taking both barrels of the combined fraud scheme right in the gut, and the frauds were constantly reloading and firing.

A real regulator that investigated the fraudulent mortgage lenders (purchasers) would have discovered a more subtle fact about the mortgage frauds.  That fact was critical to understanding the audacity, arrogance, and cynical sense of humor of the senior officers leading the control frauds and their allies.  These traits aided their fraudulent sales of fraudulent mortgages to the secondary markets.  One of the myriad travesties that make sense once one understands accounting control fraud was the use of the concept of “compensating factors” to resurrect crappy loans.  The resurrection, of course, was fictional.  The leading “compensating factors” used to label loans that failed to meet even the pathetically weak criteria for the origination or sale of endemically fraudulent mortgages “acceptable” were a purportedly low loan-to-value ratio (LTV) or a purportedly low debt-to-income ratio (DTI).

Entities like Clayton would review a horribly inadequate sample of a package of thousands of mortgage loans that a lender proposed to sell to an investment bank in the secondary market.   They would find that most of the loans in the packager were what the industry called “liar’s loan” and that Clayton knew was endemically fraudulent.  An honest secondary market purchaser would never buy such a loan package because they would know that only fraudulent mortgage lenders would make liar’s loans.  In real life, however, the secondary market purchasers routinely purchased millions of “liar’s” loans.  At this point we can infer that the seller and the purchaser are accounting control frauds.

But it gets worse.  Clayton found that nearly half of all the mortgage loans sold to the secondary market were sold under fraudulent misrepresentations by the lenders.  The overall percentage (a regulator or law enforcement official who investigated Clayton would have found) of loans with false “representations and warranties” was 43 percent.  Pull back and think hard before you proceed.  Would you deal with any seller of goods that lied to you 43% of the time about the quality of the goods being sold?  Recall the mantra of neoclassical economists and the efficient market hypothesis – these are the most sophisticated buyers in the world (pause and come back to think about that phrase in a bit) operating in the area of their greatest expertise, for transactions so large that they warrant the utmost in underwriting and due diligence because the firm’s reputation and even survival are on the line.  Unlike the government, these private parties have no “due process” constraints so they can refuse to purchase loans if they become even the least bit concerned about the quality of the loans or the integrity of the loan originator.  Any honest secondary market purchaser would run away screaming from an industry that lied 43% of the time in its reps and warranties.

But it gets much worse, for it turns out that Clayton was like the old Catskill joke about the resort:  “The quality of the meals here is so bad; [pause] and the portions so small!”  The quality of Clayton’s reviews was pathetic – and it was pathetic because the loan purchasers wanted the reviews to be pathetic.  The affidavit of a former Clayton loan reviewer describes in sickening detail how nearly every aspect of the review was deliberately soft.

The reviewer confirmed what an investigation of Clayton (and the rival firm the same whistleblower also worked at that followed equally pathetic reviews) would have showed about its use of “compensating factors”

“23. When loans did have defects, Clayton and Watterson leads told us to find compensating factors and approve the loan anyway. We often approved loans using compensating factors that I believed were insufficient to overcome the defects.

24. We often considered as compensating factors items such as the number of years the borrower worked in his current employment, the borrower’s assets, and the LTV and CLTV ratios. At both Clayton and Watterson, due diligence underwriters like myself were required to be creative in order to find compensating factors. On many jobs, the leads gave us a cheat sheet of compensating factors to make it easier for us to find them.”

Recall that I noted that it was passing curious that the allegedly most financially sophisticated mortgage purchasers in the world, in a matter in which the firm’s reputation and even survival was dependent on superb underwriting of loan quality would not use their supposedly unmatched financial expertise to do the due diligence.  Remember that the purchasers had plentiful warnings about the endemic mortgage fraud and knew that it could destroy their firms if they failed to detect and exclude the fraudulent mortgages.  If they were going to make money and avoid harming their reputation and creating immense legal liability for selling fraudulent CDOs that were so toxic that they would cause severe losses to their customers and damage their reputations they should have made superb due diligence their highest priority.  The FCIC report, the testimony of Clayton’s officials, and the affidavit of the Clayton whistleblower (who combine to demonstrate that in over a dozen ways the purchasers designed and responded to Clayton’s reviews in a manner that demonstrates that they wished to purchase (and resell, often as CDOs) enormous numbers of fraudulent loans.

“Compensating factors” provided multiple demonstrations that the purchasers often wanted to purchase fraudulent loans.  The Clayton reviewer would find that the loan was a “liar’s” loan, which meant that it had an exceptionally high probability of being fraudulent.  The Clayton reviewer would then find that the loan originator had misrepresented the loan quality in material ways, in plainer English, the Clayton reviewer would find that the originator of the fraudulent loan was trying to sell it through fraudulent reps and warranties.  The Clayton reviewer, however, would then consult his “cheat sheet of compensating factors” to try to find an excuse to reclassify the already twice fraudulent loan as a loan that should be purchased.  That is significantly insane – nothing can “compensate” for fraud, much less repeated fraud (in the origination and in the reps and warranties).  There was no science or historical loss experience supporting the purported ability of other factors to “compensate” for fraud.  There was science and historical loss experience that said that it was disastrous to make home loans to frauds or to buy loans from those that lied to you about the quality of the loans.

The “compensating” concept was also exceptionally asymmetrical.  Particularly after 2004, it became vastly more common for the fraudulent loans to have “layered risk.”  The dishonest portion of the industry used this dishonest euphemism to describe toxic loans that simultaneously added multiple characteristics that we have long known are likely to produce higher defaults and losses on mortgage loans.  The number of what I call “exacerbating factors” in loans was exceptional and they were far more important than the so-called “compensating factors.”  Clayton, however, did not balance the multiple exacerbating factors against the supposed compensating factors.

During the crisis, the industry implicitly treated fraud as if it were simply another variant of “layered risk” and implicitly assumed that accounting control fraud did not exist.  (CEOs love to implicitly assume out of existence any scenario in which they are crooks.)  Fraud is not like other “risks.”  Taking some risks, e.g., competently underwriting loans; produces a “positive expected value.”  In plain English, the bank is likely to be profitable.  When a home lender fails to underwrite it produces acute “adverse selection” and the expected value of its lending becomes negative because the adverse selection produces widespread fraud and fraud causes losses to the lender.  The industry, neoclassical economists, and the anti-regulator “layered” a series of implicit assumptions about mortgage fraud and CEOs.  Their criminogenic policies produced “layered fraud” – multiple forms of accounting control fraud that propagated through multiple industries and professions to produce the systemic crisis.  Fraud begets fraud.  Honest home lenders do not “manage” fraud or “compensate” for it – they avoid it through competent underwriting that had proven its success for many decades even in terrible financial crises.

The crisis then made the world even more criminogenic.  The banks’ massive losses and predation led millions of Americans to lose their homes.  The banks took possession of their homes through foreclosure fraud – a form of anti-purchaser control fraud.

The height of the industry’s audacity in using its cheat sheets of “compensating factors” to administer fake cures for doubly fraudulent loans with myriad exacerbating factors occurred when the industry used “low” LTVs and DTIs as its compensating factors for doubly fraudulent loans.  The “V” in the LTV stands for the market value of the home.  The “I” in the DTI stands for the borrower’s reported income.  The two massive mortgage frauds that the accounting control frauds used millions of times annually to commit mortgage fraud were extorting appraisers to inflate the market value of the home and bribing loan brokers and officers to inflate the borrower’s reported income.  Liar’s loans were the “weapon of choice” for lenders (purchasers) engaged in accounting control fraud during the crisis because they did not verify the borrower’s income – eliminating what would have otherwise have been an incriminating “paper trail” that the lender knew that the borrower’s income was greatly inflated and made the loan despite knowing of the fraud.  To sum it up, Clayton and its ilk used the fraudulent ratios produced by the two most destructive forms of mortgage fraud to “compensate” for the “risks” posed by loan originators’ twice-fraudulent sales of fraudulent mortgages.  Fraud cured fraud.  Only in America!  It gets better – the actions of the most sophisticated financial specialists in the world, with the firm money riding on the decision almost invariably said “great idea.”

This is, of course, so nonsensical under neoclassical economic and finance theories that it falsifies the entire corpus of dogma pretending to science.  That, however, is not an acceptable answer to neoclassical economists.  The result is one of the most disgusting efforts in economic history to blame the primary victims of the predatory lending (the non-wealthy, disproportionately minority borrowers induced to purchase greatly overvalued homes at the peak of the bubble).  Variants on this theme include the claims that the Community Reinvestment Act (CRA) and Fannie and Freddie forced the poor banks to make bad loans.  Liar’s loans, appraisal fraud, and the myriad secondary market insanities revealed by Clayton’s deliberately inept reviews and the secondary market purchasers’ response to those not remotely diligent reviews all put the lie to the claims of the virtuous banks beset by the evil government and minorities. No governmental entity never recommended or forced an entity to make or purchase a liar’s loan (and that includes Fannie and Freddie), to extort an appraiser to inflate an appraisal, to hire a farce like Clayton, to direct Clayton to conduct an inept review, and to ignore massive fraud.  The only rational explanation for the results of this pattern of activity is endemic control fraud among mortgage lenders and secondary market purchasers.

The Justice Department’s Collapse: Appraisal Fraud is merely a “Regulatory Issue”

The article about appraisal fraud provides a devastating indictment of federal law enforcement – in a single sentence that reads like an aside.  Its failure represents a secondary explosion triggered by the collapse of financial regulatory agencies.

“Since the bubble burst, the FBI has focused most of its real estate efforts on appraisers and other fraudsters who developed intricate schemes to defraud banks. The Justice Department is not going through the wreckage looking at the institutionalized lender pressure on the appraisal process. An FBI official, asking not to be identified because the agency has no official position on the matter, said they view the matter as a regulatory issue to be addressed by Congress not a matter of law enforcement.”

The FBI official demonstrates, of course, a total lack of understanding of appraisal fraud and accounting control fraud.  Most people assume that FBI officials who discuss elite white-collar crimes have expertise in particular industries and with the fraud schemes used in each industry.  There are over 1,300 industries in the United States and there were only about 2,000 FBI agents assigned to investigating white-collar crimes.  There are fewer than two FBI agents per industry, so few FBI agents can have any expertise in any particular industry and its fraud schemes.  The typical FBI agents assigned to white-collar crime would not understand loan underwriting, the secondary market, CDOs, or CDS.

It is the regulators who must have the expertise about the industry and its control fraud schemes.  The regulators must train the FBI and DOJ attorneys to understand how the industry functions, the nature of accounting control fraud, and the fraud recipe for a lender.  So when we have a complete breakdown of understanding on the part of the FBI we know that we also have a complete breakdown of the regulators.

The FBI: “Chasing Mice while Lions Roamed the Campsite”

The first two sentences of the passage I quoted above demonstrate that the FBI focused its investigations on individual appraisers’ frauds.  The FBI so completely failed to understand the importance of appraisal fraud as a “marker” for accounting control fraud.  The FBI did not even understand that widespread appraisal fraud had to originate with the lenders’ controlling officers.  The FBI view that a lender that extorted inflated appraisals was committing a minor “regulatory issue” indicates such a degree of ignorance of accounting control fraud as to guarantee the FBI’s abject failure against the twin epidemics of accounting control fraud that drove the crisis.  The most famous insult that arose from the S&L debacle was that of an industry executive who described the Washington Post reporter who was viewed as the dean of journalists writing about debacle as “chasing mice while lions roamed the campsite.”  The FBI chased bacteria in the gut of fleas infesting mice while a T-Rex horde demolished the campsite. It is not simply that the FBI approach failed – it had to fail.  As late as fiscal year 2007 there were only 120 FBI agents investigating mortgage fraud cases and they were virtually all assigned to trivial cases because criminal referrals by the banking regulatory agencies disappeared.

Not a single controlling bank executive has been charged with extorting appraisers to inflate appraisals.

The Two Key State Investigations of Appraisal Fraud Misfire

The FBI and DOJ’s record of abject failure despite the petition signed by over 11,000 appraisers warning that fraudulent lenders were blacklisting honest appraisers in order to extort appraisers to inflate appraisals is all the more disturbing because two state investigations confirmed widespread appraisal fraud by prominent fraudulent lenders.  The Public Integrity article explains that (then) New York Attorney General Cuomo investigated WaMu and other lenders and documented the practice of blacklisting honest appraisers in order to create a Gresham’s dynamic.  The purpose was to extort appraisers to inflate their appraisals so that the lenders could make fraudulent loans.  Cuomo make key findings of his investigation public in 2007 at a point where the secondary market for liar’s loans was collapsing because of the already large fraud losses inherent in making and purchasing the endemically fraudulent loans.

“Cuomo wrote that his office had ‘uncovered a pattern of collusion between lenders and appraisers that has resulted in widespread inflation of the valuations of homes.’ Further, Cuomo wrote that evidence shows mortgages Fannie and Freddie purchased from Washington Mutual ‘may be premised on fraudulently inflated appraisals’ that do not meet regulatory standards. ‘We are, therefore, expanding our investigation to determine the extent of [Fannie Mae and Freddie Mac’s] knowledge of, and actions regarding, these problems as they relate to past mortgage purchases and securitizations.’”

Cuomo’s investigation came far too late to prevent the crisis, but it also veered off course by becoming focused on a purported remedy that was civil in nature and could not stop accounting control frauds.  Cuomo’s investigation ended with no prosecutions despite documenting actions by lenders that were clear markers of accounting control fraud.

The Public Integrity article notes the Ameriquest investigations and civil actions by the Attorneys General of 49 states and the District of Columbia came earlier, but it too ended with no prosecutions despite finding accounting control fraud by Ameriquest at a time when it was the Nation’s largest originator of nonprime loans.

“In 2006, Ameriquest, then the largest subprime lender in the country, paid $325 million and agreed to reform its business practices to settle a 49-state investigation into its predatory lending practices. Among the allegations, the lawsuit claimed [15] Ameriquest engaged in deceptive or misleading practices to obtain inflated appraisals substantially beyond the market values of homes. The company, which closed in 2007, denied the allegations.”

The Ameriquest case demonstrates again how lost an investigation can become without regulatory expertise – and how the resultant weaknesses will be spread by even a fine journalistic coverage of the investigation.  Ameriquest is the “patient zero” in the fraud epidemic, but also the “vector zero” that spread the epidemic.  Ameriquest specialized in making predatory liar’s loans.  Note that the article refers solely to Ameriquest as a “subprime lender.”  By 2006, half of all the loans the industry called “subprime” were also liar’s loans.  The categories are not mutually exclusive.  The massive growth (over 500%) from 2003-2007 was in fraudulent liar’s loans.  Ameriquest was infamous for making fraudulent liar’s loans.  Michael W. Hudson’s classic book, The Monster tells Ameriquest’s story.  If you read only one book about the crisis this is the book that will best allow you to understand why it occurred.

Ameriquest began as Long Beach Savings.  As with nearly all large American frauds the original epicenter of an incipient epidemic of fraudulent liar’s loans was in Orange County.  Long Beach Savings led the way.  We (the Office of Thrift Supervision’s (OTS) West Region) had jurisdiction over the epicenter of this new outbreak of S&L fraud in 1990-1991.  We listened to our examiners and used normal supervisory means to drive such loans out of the S&L industry.  Back then, the industry did not yet call the loans “liar’s loans,” but it was still an easy supervisory call that lending without essential underwriting of the borrower’s capacity to repay would produce severe adverse selection and a negative expected value to the loans.  In English, it was clear that no honest mortgage lender would make such loans because they would lose money.  Only an accounting control fraud would make liar’s loans.

Roland Arnall, Long Beach’s dominant owner gave up Long Beach’s charter as a federal insured savings and loan and became an uninsured mortgage banking firm for the sole purpose of escaping our regulatory jurisdiction and evading our crackdown on liar’s loans.  He renamed the company “Ameriquest.”  Ameriquest did not simply specialize in making fraudulent liar’s loans.  It specialized in doing so by preying on less financially sophisticated purchasers who were disproportionately less wealthy and minority (black and Latino).  The Monster documents that one of Ameriquest’s early competitors in making liar’s loans was another mortgage bank controlled by a husband/wife time that we had “removed and prohibited” from the federally insured financial sector.

The 2006 action against Ameriquest was the fourth major governmental action against it.  OTS brought the first action and prompted the second through a referral to DOJ about Ameriquest’s discriminatory lending.  ACORN’s complaints of continuing discrimination led to a FTC investigation.  The fourth action, after OTS lost jurisdiction, was by the states.  Despite Arnall’s long, despicable record, President Bush named him our ambassador to the Netherlands and the Senate confirmed him immediately after he settled the action brought by the state AGs.  At one juncture, Arnall was Bush’s leading political donor.

Far more disturbing was that two financial giants rushed to acquire Ameriquest’s fraudulent and predatory lending operations and personnel – Citi and Washington Mutual (WaMu).  Citi’s acquisition was done over the protests of their top mortgage quality guy, Mr. Bowen.  Mr. Bowen eventually testified before the Financial Crisis Inquiry Commission.

The Federal Home Loan Bank of Boston’s civil fraud complaint notes Bowen’s opposition to the acquisition of Arnall’s fraudulent operations.

“711. Mr. Bowen recommended that Citigroup not purchase Ameriquest, because his due diligence found that the loans originated by Ameriquest’s affiliate, Argent, did not meet the standards they had represented to Citigroup. Specifically, Mr. Bowen testified that ‘we sampled the loans that were originated by [Ameriquest affiliate] Argent and we found large numbers that did not—that were not underwritten according to the representations that were there.’ 

712. Mr. Bowen submitted with his testimony an email that he sent to Citigroup’s then CEO, Robert Rubin, in late 2007 documenting his concerns. One email indicated, among abundant other information of abuses, that: ‘During 2006-7 there were pools of mortgage loans aggregating $10 billion which were purchased from large mortgage companies with significant numbers of files identified as ‘exceptions’ (higher risk and substantially outside of our credit policy criteria). These exceptions were approved by the Wall Street Channel Chief Risk Officer, many times over underwriting objections and with the files having been turned down by underwriting. These pools involved files aggregated and originated by Merrill Lynch, Residential Funding Corp, New Century, First NLC and others.’

Citigroup disregarded the red flags and completed the acquisition.”

The other major acquirer of Arnall’s fraudulent liar’s loan operations (Long Beach Mortgage) was WaMu’s holding company.  The Senate investigation of WaMu’s failure contains the revealing details on the OTS’s eventual decision to allow the holding company to transfer Long Beach to WaMu (the federally insured S&L).  That transfer would put the FDIC and Treasury on the hook for unlimited potential losses from Long Beach’s fraudulent lending.  The FDIC and Treasury would also be liable for Long Beach’s fraudulent sales of its fraudulent mortgages in the secondary market.  The proposal was insane from the government’s standpoint.  It is a testament to the extent that OTS was controlled by anti-regulators that they approved a deal that put the Nation at risk for losses that the FDIC feared could exceed its entire insurance fund.

The Senate report also documents WaMu’s massive growth in originating fraudulent liar’s loans and gives an example of its fraudulent sales of those fraudulent mortgages in the secondary market.  The Public Integrity article ignores liar’s loans, missing the second accounting control fraud barrel.  As with real shotguns, the blast patterns of the barrels overlap.  It was common for lenders to make liar’s loans in which the lender ensured that the borrower’s reported income was substantially inflated and in which the lender extorted the appraiser to ensure that the appraisal was inflated.  I explained above that WaMu was notorious for extorting inflated appraisals.

The state actions against Ameriquest and WaMu should have been coordinated and gone after both epidemics of accounting control fraud, but without the vital criminal referrals and support from the banking regulatory agencies there was little chance that the states would understand the significance of two of the clearest accounting control fraud signals – liar’s loans and appraisal fraud by lenders – that have ever been sent.


We cannot afford the price of continued ignorance about control fraud.  We cannot afford the continuation of neoclassical economics and finance dogmas that criminologists and competent regulators falsified decades ago.  We cannot afford to continue to have appoint anti-regulators to run our agencies and to lead the DOJ and the FBI.  During the S&L debacle I was part of the very professional training effort by DOJ that trained over 1,000 law enforcement personnel about control fraud (and many other topics).  We provided similar training to our regulatory staff.  Training has been reduced, but the key is that it no longer includes training in identifying, investigating, and prosecuting control fraud.  That has proved untenable.  Here is the kind of madness that it produces.  Benjamin Wagner remains the United States Attorney based in Sacramento – on of the epicenters of the twin mortgage fraud epidemics.  Here is how he responded in July 2010 when a reporter asked him about accounting control fraud’s role in the current crisis.

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 cannot keep his pronouns straight when he uses them in the same sentence.  When he uses “they” he is referring to the CEO.  When he uses “themselves” he is referring to the bank.  It makes perfect logical sense that the CEO could choose to loot the bank.  Anyone who knew anything about banking history would know that such looting has caused many of the worst bank failures.  Our top prosecutors get so little aid from the banking anti-regulators that they say things like Wagner does that are embarrassing and display why elite bankers now commit accounting control fraud with impunity.  No economy or democracy can survive when the elites can loot with impunity.

This post originally appeared at New Economic Perspectives

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