“Pervasive” Fraud by our “Most Reputable” Banks
William K. Black



A recent study confirmed that control fraud was endemic among our most elite financial institutions.  Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market.  Tomasz Piskorski, Amit Seru & James Witkin (February 2013) (“PSW 2013”).

The key conclusion of the study is that control fraud was “pervasive” (PSW 2013: 31).

“[A]lthough there is substantial heterogeneity across underwriters, a significant degree of misrepresentation exists across all underwriters, which includes the most reputable financial institutions” (PSW 2013: 29).

Finance scholars are not known for their sense of humor, but the irony of calling the world’s largest and most harmful financial control frauds our “most reputable” banks is quite wondrous.  The point the financial scholars make is one Edwin Sutherland emphasized from the beginning when he announced the concept of “white-collar” crime.  It is the officers who control seemingly legitimate, elite business organizations that pose unique fraud risks because we are so loath to see them as frauds.

The PSW 2013 study confirmed one form of control fraud and provided suggestive evidence of two other forms that I will discuss in a future column.  The definitive evidence of control fraud that PSW2013 identifies is by mortgage lenders who made, or purchased, mortgages and then resold them to “private label” (non-Fannie and Freddie) financial firms who were creating mortgage backed securities (MBS).  The deceit they documented by the firms selling the mortgage loans consisted of claiming that the loans did not have second liens.  The lenders knowingly sold mortgages they knew had second liens under the false representations (reps) and warranties that they did not have second liens.  (The authors confirm the point many of us have been making for years – the banks that fraudulently sold fraudulent mortgages did have “skin in the game” because of their reps and warranties.  The key is that the officers who control the banks do not have skin in the game – they can loot the banks they can control and walk away wealthy.)  The PSW 2013 study documents that the officers controlling the home lenders knew the representations they made to the purchasers as to the lack of a second lien were often false (pp. 2, 5 n. 6), that such deceit was common (p. 3), that the deceit harmed the purchasers by causing them to suffer much higher default rates on loans with undisclosed second liens (pp. 20-21), and that each of the financial institutions they studied – the Nation’s “most reputable” – committed substantial amounts of this form of fraud (Figure 4, p. 59).

The most interesting reaction to the PSW 2013 study is that of a fraud denier, The Economist’s “M.C.K.”  In his January 25, 2013 column, (“Just who should we be blaming anyway?”)

M.C.K. argued that we should blame the victims of the fraud (“the real wrongdoers were not those who sold risky products at inflated prices but the dupes who bought them….”).

Only three weeks later, in his February 19, 2013 column discussing the PSW 2013 study, M.C.K. admitted that fraud by banks had played a prominent role in the crisis.

“BUBBLES are conducive to fraud. Buyers become less careful about doing their due diligence when asset prices are soaring and financing for speculation is plentiful. Unscrupulous sellers exploit this incaution. The victims are none the wiser as long as the bubble continues to inflate.”

I will explain in a later column why I believe this passage is badly flawed, but my point here is that the fraud denier and “blame the victim” columnist has recanted.

“During America’s housing bubble, mortgage originators were told to do whatever it took to get loans approved, even if that meant deliberately altering data about borrower income and net worth. Many argue that the banks that bundled those loans into securities deliberately and systematically misled investors and private insurers about the risks involved. It is easy to be unsympathetic in the absence of hard evidence. As I argued in a previous post , ‘investors were not forced to take the losing side of so many trades.’

While I stand by that view, a new paper by Tomasz Piskorski, Amit Seru, and James Witkin convincingly argues that banks deliberately misrepresented the characteristics of mortgages in securities they pitched to investors and bond insurers. The misrepresented loans defaulted at much higher rates than ones that were not—a result that would not be produced by random errors. Moreover, the share of loans that were misrepresented increased as the bubble inflated. The authors estimate that underwriters may be liable for about $60 billion in representation and warranty damages (emphasis in original).”

These two paragraphs are worth savoring in some detail.  The central point we have been arguing for years is now admitted – and treated as a universally known fact: “mortgage originators were told to do whatever it took to get loans approved, even if that meant deliberately altering data about borrower income and net worth.”  The crisis was driven by liar’s loans.  By 2006, half of all the loans called “subprime” were also liar’s loans – the categories are not mutually exclusive (Credit Suisse 2007).  As I have explained on many occasions, we know that it was overwhelmingly lenders and their agents (the loan brokers) who put the lies in liar’s loans.

The incidence of fraud in liar’s loans was 90% (MARI 2006).  Liar’s loans are a superb “natural experiment” because no entity (and that includes Fannie and Freddie) was ever required to make or purchase liar’s loans.  Indeed, the government discouraged liar’s loans (MARI 2006).  By 2006, roughly 40% of all U.S. mortgages originated that year were liar’s loans (45% in the U.K.).  Liar’s loans produce extreme “adverse selection” in home lending, which produces a “negative expected value” (in plain English – making liar’s home loans will produce severe losses).  Only a firm engaged in control fraud would make liar’s loans.  The officers who control such a firm will walk away wealthy even as the lender fails.  This dynamic was what led George Akerlof and Paul Romer to entitle their famous 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.”  Akerlof and Romer emphasized that accounting control fraud is a “sure thing” guaranteed to transfer wealth from the firm to the controlling officers.

M.C.K. now admits that liar’s loans were endemically fraudulent and that it was lenders and their agents who “deliberately” put the lies in liar’s loans.   Given the massive number of liar’s loans and the extraordinary growth of liar’s loans (roughly 500% from 200-2006) it is clear that that they were the “marginal loans” that caused the housing markets to hyper-inflate and created the catastrophic losses (in the form of loans, MBS, and CDOs) that drove the financial crisis.  The key fact that must be kept in mind is that once a fraudulent liar’s loan begins with the loan officer or broker inflating the borrower’s income and suborning the appraiser into inflating the home appraisal the subsequent sales of that mortgage (or derivatives “backed” by the mortgage) by private parties will be fraudulent.

The authors of the PSW 2013 study expressly cautioned that their data allowed them to examine only two of the varieties of fraud.  Lenders’ frauds in originating and selling liar’s loans were far more common, and far more harmful, than the two forms of fraud the PSW study was able to study.  The many forms of mortgage frauds by lenders and their agents, of course, were cumulative and the frauds interact to produce greatly increased defaults.

The greatest importance of the PSW 2013 study is that even the fraud deniers have to admit that our most prestigious banks were the world’s largest and most destructive financial control frauds.  Given this confirmation that the banks engaged in one form of control fraud in the sale of fraudulent mortgages (false representations about second liens), there is no reason to believe that their senior officers had moral qualms that prevented them from becoming even wealthier through the endemic frauds of liar’s loans and inflated appraisals.  Appraisal fraud is almost invariably induced by lenders and their agents.  Given the “pervasive” willingness of the officers controlling our most prestigious banks to enrich themselves personally by lying about the presence of second liens, they certainly cannot have any moral restraints that would have prevented them from creating the perverse incentives that caused loan officers and brokers to put the lies in liar’s loans and to induce appraisers to inflate appraisals – two other control fraud schemes that were far more “pervasive” (and even likelier to produce severe losses) than the two forms of fraud studied by the PSW 2013 authors.

Once the fraud deniers have to admit that one form of control fraud involving mortgages was “pervasive” among our most prestigious banks, it becomes untenable to ignore the already compelling evidence that other forms of control fraud involved in the fraudulent origination and sale of mortgages and mortgage derivatives were even more pervasive at hundreds of financial institutions.  The PSW 2013 study destroyed the myth of the Virgin Crisis.  It also exposes the falsity of the ridiculous “definition” of mortgage fraud that the Mortgage Bankers Association (MBA) foisted on the FBI and the Department of Justice that implicitly defines control fraud out of existence for mortgage lenders.  Attorney General Holder and President Obama have no excuse for their faith in the Virgin Crisis, conceived without fraud and should repudiate the MBA definition immediately and train the regulators and agents to spot and prosecute the epidemic of control frauds that drove this crisis (and the S&L debacle and Enron-era frauds).

Category: Legal, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

7 Responses to ““Pervasive” Fraud by our “Most Reputable” Banks”

  1. Hantra says:

    This is merely a symptom IMO. Someone had to first create the massive demand that these guys were all too eager to fill. That someone was the federal government. I’m not excusing the fraud or anything. I just think it is dangerous to ignore the spark that lit the flame in the first place.


  2. rd says:

    I thought fraud was now a feature, not a bug in our financial system as it makes it much easier to remain solvent that way. Bernie Madoff was able to maker a good living for a long time using this model until the rest of the financial sector decided to follow his lead and got too greedy.

  3. Fred C Dobbs says:

    Mr. Black, you care about things that never mattered in the first place. When one makes a secured loan, and the borrower fails to repay the loan, for whatever reason, and there are many legitimate reasons (such as death etc.), the lender looks to the security for repayment. The reason why the lender conditioned the loan on receipt of security in the first place was the lender knew a possibility existed that the borrower might not repay the loan, and, in order to assure itself the loan would absolutely be repaid, the lender conditioned the loan on receipt of a lien on the borrower’s residence. The lenders believed that should the borrowers default, the lenders would still get paid from foreclosure and resale of the security. In substance all of the loans secured by residences, were made, in the last analysis, to the residences, not the borrowers. The lenders bet the value of the residences would remain stable or rise. Fraud, Fraud, Fraud. You seem focused on stuff that doesn’t matter. If home values had remained at the level when the loan was made or, better yet, rose, there would have been no problem. Thus, the source of the problem really shifts to the fools who made too much lendable money available to lenders who are able to do one thing and only one thing to put food on their tables, make loans to anyone who wants to borrow and is able to supply security that at the time the loan is made is adequate. They caused the bust by feed ing the boom. Focus on the invisible government that is taking all sorts of risks (in concert with the G8 and G20) in the name of doing what is good for us, when they have proven they have no such idea of what is good for us, e.g. The Board of Governors of the Federal Reserve System etc. Force them out into the light of day, let us see their ‘secret agreements.’

  4. StudsTerkel says:

    @Hantra: Could you elaborate? Demand for what, MBS? How did the govt “create the massive demand”? BR has spent a lot of time pointing out the flaws in the “government caused the crisis” narrative, recently this: http://www.ritholtz.com/blog/2013/03/the-big-lie-annotated-an-aei-history-of-the-financial-crisis/

    see also: http://www.washingtonpost.com/blogs/wonkblog/wp/2013/02/13/no-marco-rubio-government-did-not-cause-the-housing-crisis/

  5. Frilton Miedman says:

    Is it still fraud if you buy Congress and rearrange the definition of fraud? (thank you Sandy Weil, for at least saying that was a mistake, now that you’ve retired filthy rich)

    While ratings co’s are using the first amendment to claim fraud is a first amendment right, the TBTF’s are citing disclosure of CDO’s wasn’t the “law” since the CFMA doesn’t require derivative disclosure.

    Using this logic, I can hold physical gold plated lead ingot, have it rated “99% pure ” by a third party I pay and sell derivative paper representation of it’s value, take short positions on those derivatives while selling them in the open, and then reveal what’s in the bars after the fact to collect my shorts.

    Enough already, bring Glass-Steagall back, allow the CFTC to do its job and impose position limits that are already law.

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