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How Did a Relatively Small Number of Subprime Loans Cause a Record Crisis?

By William Black

A number of analyses of the U.S. and global crisis begin by attempting to explain what they assume to be a paradox -- how could so small a market segment (subprime housing and CDOs backed by subprime) have caused (1) the largest financial bubble in history, (2) a U.S. economic crisis, and (3) a nearly global crisis? To these scholars the obvious answer is that subprime lending could not have caused this traumatic trifecta. It follows that the importance of subprime lending must be overstated and there must be other, more powerful causes of the trifecta.

I will show that the focus on subprime loans was excessive and allude briefly to the points I have made in prior columns about the variant causes of the global crisis. The next column will address in more detail how criminologists determine the true incidence of mortgage fraud. Subprime loans were and are a serious problem, but there has been a destructive overemphasis on subprime loans as the core of the U.S. crisis. "Liar's" loans are a far greater problem, and most problem subprime loans are actually liar's loans. While the nonprime mortgage industry's preferred euphemisms were "alt-a" and "stated income" loans, it was the industry that accurately dubbed them liar's loans. It was the industry that created liar's loans and it is liar's loans that made so many officers wealthy.

The industry pitched liar's loans to the regulators on a series of bright shining lie -- that they were equivalent to the risk of prime loans and simply underwritten on an alternative basis because the borrowers were entrepreneurs who could verify their incomes. The further lie was that liar's loans were distinct from subprime loans, which were only made to those with serious credit defects with conventional underwriting. The reality is that there is an easy means for small business owners to verify their income -- by authorizing the IRS to provide information from their tax returns to the lender via IRS Form 4506. There were two groups of borrowers who had acute needs to avoid disclosing their income and wealth -- those engaged in tax fraud evaders and those seeking to deceive their spouses or defraud their prior spouses and children in order to evade alimony and child support payments. (Remember when one of "C's" in lending referred to "character" and we taught loan officers why one should not lend to those of bad character?) People who will cheat their kids are certain to be willing to cheat their lender.

The purpose of liar's loans was to create endemic fraud throughout the mortgage process - from origination to the sale of collateralized debt obligations (CDOs) backed by liar's loans ("cradle to grave" fraud). The lies in liar's loans were so endemic and so egregious that the financial version of "don't ask; don't tell" was essential at every step of the process. Liar's loans were also perfect for the loan origination level variant of "don't ask; don't tell."

Liar's loans were not underwritten. The borrower did ask about income, but only in the sense made famous by Monty Python ("wink, wink; nod, nod"). The lender agreed that it would not verify the borrowers' "stated income" (and often the borrowers' jobs and assets). As I have explained in prior columns, the lenders that specialized in making liar's loans frequently outsourced much of the job of finding the borrowers who would take out the liar's loans to loan brokers. Studies by various state attorney generals, white-collar criminologists, and private and public investigators have confirmed that it is lenders and their agents (loan brokers and loan officers) who overwhelmingly put the lies in liar's loans. There are independent analytical reasons to believe these findings.

1. Doing so maximized the lenders' (and their loan brokers') reported (albeit fictional) income (and their controlling officers' bonuses). The greater the stated income, the more likely the loan would be made, the larger the size of the loan, and the greater the resale value of the loan in the secondary market. Each of these elements drove the agents' and loan officers' compensation up - and by very large amounts.
   
   
2. By inflating the borrowers' stated income, the lender and its brokers could make the loan appear to be less risky and sell it for a premium to the secondary market greatly inflating the borrower's stated income. The liar's loan lenders could also make the loan appear to be less risky to the regulators (though unregulated mortgage bankers probably made most of the liar's loans), credit rating agencies, and auditors. These entities typically treated the (fictional, far reduced) "debt-to-income" ratio arising from inflating the borrower's stated income as if it were real. (In reality, this willingness to believe, without real due diligence, the lies that would make these professionals wealthy was another variant of "don't ask; don't tell.") It was not exactly difficult for anyone in the trade to figure out that must never treat as truthful the stated income in something the trade called a "liar's" loan. Indeed, the ability of everyone in the trade to know that they should never treat the loans as honest was made even more simple when the mortgage lending industry's own experts as deserving of that label because such loans were "an open invitation to fraudsters" (MARI 2006) - during what the FBI had termed as early as September 2004 to be an "epidemic" of mortgage fraud. Depressing the real debt-to-income ratio by inflating reported income was a useful lie to everyone with a financial stake in the liar's loan machine - which was most of our largest financial firms in the U.S.
   
   
3. Not verifying the borrowers' stated income simultaneously facilitated the lenders' and their brokers' ability to sell fraudulent loans at a premium in the secondary market and minimized risk of the lenders' and their brokers' controlling officers being sanctioned for their frauds essential to their origination and sale of liar's loans. The brokers and lenders obviously, could not verify the fictional incomes that they had inflated. They would have had three choices. They could have honestly sought to verify something they knew to be false - which would have prevented the loans from being made and dramatically reduced their income. They could have claimed that they had verified the income but provided no records of their efforts at verification or the borrowers' true income. That strategy would have added another act of fraud (a false certification of verification) while providing no credible evidence. The other alternative would be for the brokers and officers to forge documents purporting to show that they had conducted due diligence as to the borrowers' true income and attesting to the accuracy of the stated income. This strategy would have made it simple for the Justice Department to convict the loan brokers and officers. The ideal strategy is for the loan brokers and officers to do no underwriting of the stated income and to purport that the borrowers' credit rating (FICO score), in conjunction with the fraudulent LTV and debt-to-income ratios, proves that the loan has risk characteristics equivalent to prime loans. FICO scores, of course, can never demonstrate that the borrower has the capacity to repay a home loan and there are common scams that use someone with a good FICO score as a shill to obtain a loan.
   
   

Liar's loans were equally useful in facilitating accounting control fraud by those involved in the CDO process. The secondary market had to rely on "don't ask; don't tell" to be able to securitize and sell CDOs. CDOs were largely backed by liar's loans and fraud was so endemic and so obvious among liar's loans if one engaged in due diligence that it was ideal to claim that liar's loans required no meaningful due diligence and could not be the subject of meaningful due diligence because there were no underwriting files to review because the lender did no real underwriting. Again, consider what would have happened if the securitizers, credit rating agencies, or auditors had actually looked at any reliable sample of the liar's loans for evidence of fraud. They would have reported, as did Fitch in November 2007, that there was evidence of fraud in the nearly every file. If they asked, they could not sell. Their files would show that they knew they were knowingly selling securities backed primarily by fraudulent loans - and claiming the CDOs were "AAA."

Liar's loan borrowers had no leverage to create a "Gresham's" dynamic among appraisers. There is no honest reason why a mortgage lender would inflate the appraised value and the size of the loan. Causing or permitting large numbers of inflated appraisals is a superb "marker" of accounting control fraud by the lender because the senior officers directing an accounting control fraud do maximize short-term reported (fictional) income (and real losses) by inflating appraisals and stated income. As I have noted, and will return to in future columns in more detail, lenders and their agents frequently suborned appraisers by deliberately creating a Gresham's dynamic to try to induce them to inflate market values, leaked the loan amount to the appraisers, drove the appraisal fraud, and made it endemic. As with inflating income in order to minimize the reported debt-to-income ratio, inflating the appraisal allowed everyone with a financial stake in the lies to minimize the reported loan-to-value (LTV) ratio and allow everyone to pretend that the loan was far less risky because it had such a large (but yet again fictional) equity cushion. Given that we know that appraisal fraud was endemic, that endemic appraisal fraud is impossible without being led or permitted by the lenders and their agents, and that no honest lender would permit or cause widespread inflated appraisals, the logical inference is that the lenders and their agents led both the stated income and the appraisal fraud.

Only the lenders and their agents had the inside information and expertise to know how to optimize the deceit in the loan application process. Many of the housing speculators who bought a material number of homes and sought to flip them were industry insiders, and many of them also committed fraud by indicating that they intended to make each of the houses (simultaneously) their principal dwelling. These professionals would have known of the details of the lenders' term sheets and could have picked the debt-to-income and LTV ratios (and sometimes had illegal side deals with appraisals to inflate the appraisals to secure the desired LTV. The great bulk, however, of those that borrowed through liar's loans were not financially sophisticated and had no way of knowing how much they needed to inflate reported income to hit the "sweet spot" that would maximize the loan broker's and the loan officer's fees and bonuses. Loan brokers willing to specialize in making liar's loans had to be able to lead the lies about the borrowers' income that would maximize the loan broker's fees.

The fact that the lenders and their agents specializing in making liar's loans led the stated income frauds does not, of course, mean that the borrowers had no ethical responsibility or culpability. As I will show in future columns, there are millions of cases of mortgage fraud through liar's loans. There are doubtless hundreds of thousands of borrowers who knew that the incomes the brokers and officers told them to report on the loan applications were false.

Yes, it does appear to have been common for the loan brokers and officers to create the false loan applications and even forge the borrowers' signatures. Some of the lenders are reported to have referred to these practices as "Arts and Crafts" weekends. We don't know how common this level of lender fraud was because the regulatory agencies and prosecutors have not publicly reported their investigations. Indeed, there is no public evidence that the regulators or prosecutors are even conducting comprehensive investigations of the endemic accounting control fraud by the lenders that made large amounts of liar's loans.

We now have the analytical basis to begin to explain the supposed paradox as to how such a relatively small number of subprime loans caused an intense global crisis. Here are the central points, which I will flesh out in future columns.

• Many subprime loans were also liar's loans
• Many hybrid loans existed with greatly reduced underwriting
• There were, and are, no official definitions of the loan categories "alt-a", "subprime", or the many hybrid forms
• Because there is no definition and the categories of "subprime" and "liar's" loans are not mutually exclusive, there is inherent uncertainty and a need to use judgment to form useful estimates. Credit Suisse reported (2007) that 49% of new originations in 2006 were "alt-a" loans (i.e., liar's loans). The incidence of fraud among liar's loans found in most independent studies is 80% or above. If the Credit Suisse figure is even close to accurate (and some caution is vital there), then we are suffering from over a million cases of mortgage fraud annually in 2005 and 2005 and the frauds were growing in 2007 until the secondary market collapsed. Data on criminal referrals are, when extrapolated, consistent with that level of fraud incidence. The supposed paradox arises from a factual error. Nonprime loans were common. Liar's loans grew massively and hyper-inflated the financial bubble. The size of the bubble and the fraud losses were enormous relative to bank capital. Indeed, the very lack of reliable data on the true composition of liar's loans (Fannie, Freddie, and Lehman all reported them as "prime" loans for most purposes) in mortgage portfolios and CDOs was itself one of the factors driving systemic risk. Investors, rightly, feared that most large financial institutions had huge exposures to fraudulent loans.
• At law, fraud's defining element is deceit. The fraudster gets the victim to trust him and then betrays that trust. This is why control fraud by our elite financial institutions is such a powerful acid to erode trust. Trust is vital to an effective economy. Markets shut down in the crisis because bankers no longer trusted other bankers' asset valuations.
• Other nations (Iceland and to a far lesser extent Ireland) that have had moderately serious investigations of the causes of their crises have produced reports that provide compelling evidence of accounting control fraud as major drivers in their crises. Spain is notorious for its' banks' accounting abuses, but Spain has not provided any true investigative reports.
• The FDIC and OTS created a data base well after the crisis began. It sought (false) precision at the cost of analytical usefulness. It creates a false dichotomy between "alt-a" and "subprime" based on reported FICO scores (which it implicitly assumes to be real). The result is that one cannot use the data to study loans made without underwriting. That category - the single most important characteristic for studying, measuring, and predicting losses - does not exist in their data. It is vital that researchers understand that the FDIC mortgage data base is unreliable and it is vital that the FDIC create a new, reliable data base.