Two Sentences that Explain the Crisis and How Easy it Was to Avoid
William K. Black
July 9, 2013

 

 

Everyone should read and understand the implications of these two sentences from the 2011 report of the Financial Crisis Inquiry Commission (FCIC).

“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).

Those two sentences tell us more about the crisis’ cause, and how easy it was to prevent, than all the books published about the crisis – combined.  Here are ten key implications.

  1. The lenders are extorting the appraisers to inflate the appraisal.
  2. No honest lender would inflate an appraisal, the lender’s great protection from loss.
  3. The lenders were overwhelmingly the source of mortgage fraud.
  4. The lenders were not only fraudulent, but following the “recipe” for ”accounting control fraud.”  They were deliberately making enormous numbers of bad loans.
  5. This had to be done with the knowledge of the bank CEOs.  One of the wonderful things about being a CEO is the ability to communicate to employees and agents without leaving an incriminating paper trail.  Sophisticated CEOs running large accounting control frauds can use compensation and business and personnel decisions to send three key messages:  (a) you will make a lot of money if you report exceptional results, (b) I don’t care whether the reports are true or the results of fraud, and (c) if you do not report exceptional results or if you block loans from being approved by insisting on effective underwriting and honest appraisals you will suffer and your efforts will be overruled.  The appraisers’ petition was done over the course of seven years.  Even if we assumed, contrary to fact, that the CEO did not originate the plan to inflate the appraisals the CEOs knew that they were making enormous numbers of fraudulent “liar’s” loans with fraudulent appraisals.  It is easy for a CEO to stop pervasive fraudulent lending and appraisals.  Where appraisal fraud was common it was done with the CEO’s support.
  6. Fraudulent loan origination creates a “Gresham’s” dynamic (bad ethics drives good ethics from the marketplace or profession because cheaters prosper) will be created among lenders.   The CEO of lenders that follow the fraud “recipe” can count on three “sure things.”  The lender will report exceptional income in the near term.  The controlling officers will promptly be made wealthy by modern executive compensation.  The lender will (later) suffer severe losses.  The controlling officers of honest lenders will report far lower income and receive far less compensation.  The CFO will rightly fear losing his job.  This turns market forces perverse and makes accounting control fraud surge.
  7. The Gresham’s dynamic and the fraud “recipe” cause an enormous expansion in bad loans.  This can hyper-inflate a financial bubble.  As a bubble grows the fraud recipe becomes even more wealth-maximizing for unethical senior officers.  The trade has a saying that explains why bubbles are so criminogenic – “a rolling loan gathers no loss.”  The fraudulent lenders refinance their bad loans and report (fictional) profits.
  8. Once fraudulent loans are fraudulently originated they cannot be cured.  There is no loan exorcist.  All subsequent sales of the mortgage (or cash flows from the mortgage) in the secondary market will require additional fraud and will transfer bad assets with a greatly increased risk of loss.  (Not every fraudulently originated mortgage loan will default and suffer loss, but a portfolio of such loans has such a greatly increased risk of loss that the portfolio will have a negative expected value.)  Liar’s loans do not “become” bad; they are endemically fraudulent when they are originated and mortgage loans made on the basis of deliberately inflated appraisals are always fraudulent.  Only accounting fraud, failing to provide appropriate allowance for loan and lease losses (ALLL) at the time the loans are made, can produce the fictional income that drives the fraud scheme.
  9. The Gresham’s dynamic that causes us the most wrenching pain as regulators is the one that the officers controlling the fraudulent lenders deliberately created among appraisers.  They created the blacklist to extort the most honest appraisers.  The fraudulent lenders, of course, do not have to successfully suborn every appraiser or even most appraisers in order to optimize their frauds.  A fairly small minority of suborned appraisers can provide all the inflated appraisals required.  The honest appraisers will lose a great deal of income and many will be driven out of the profession by the lost income or because the degradation of their profession disgusts them.  These non-wealthy professionals, the ethical appraisers, were injured by the fraudulent CEOs because the appraisers knowingly chose honesty over maximizing their incomes.  The CEOs of the lenders and the officers and agents they induced (by a combination of de facto bribery and extortion) to assist their frauds chose to maximize their incomes through fraud.
  10. The U.S. government did nothing in response to the appraisers’ petition warning about the black list of honest appraisers.  The federal banking agencies’ anti-regulatory leaders’ hatred of effective regulators caused them to do nothing in response to the appraisers’ petition.  The anti-regulators did nothing for years, as the number of appraisers signing the petition grew by the thousands and surveys and investigations confirmed their warnings about lenders extorting appraisers to inflate appraisals.  The appraisers put the anti-regulators on notice about the fraud epidemic for seven years beginning in 2000.

Category: 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.

15 Responses to “Two Sentences that Explain the Crisis and How Easy it Was to Avoid”

  1. Gonzop says:

    great post. As i always try to keep it simple (for my folks) this appraisal problem, together with CFTC unable to enforce margin reduction + the notations agencies was mostly all it took for greed to go frantic

    to wit: guess which appraisers did Spanish banks use during the epic run of Spanish real estate:

    their OWN

    yes, the big banks had their own appraisal units

    ‘Pedro we heard you can’t make the 20% deposit? no worry, the 80% we finance can jump to 100% it’s all about the value of the condo we’ll make a call to our appraiser’

    ‘Good news the deal is approve and we threw in furniture and a 60′ plasma screen too. In 60 installments. Bienvenido!’

  2. postpartisandepression says:

    This is absolutely true however there was a proximal reason to the pressuring of appraisers.

    Once upon a time when a lender made a loan he held that loan for the life of the loan and it was in his interest to make sure that the lendee could pay. As soon as you can package those loans into a mortgage backed security and sell that on to someone else you open the door to fraud. This was just a ponzi scheme and those that got in early came away with gobs of money. Each time the security (and the credit default swaps built for them) is sold profit is made, except there really is no value added to the entity.

    No one cares if some of the wealthy want to gamble and they can create all kinds of instruments to do that but a) we need a normal safe banking system that handles basic things and are regulated and b) we need to make sure that the gamblers are not backed up by the tax payers. I don’t understand why that is hard.

    • Greg0658 says:

      “I don’t understand why that is hard.” ? everyone needs the air of free money for a JOB .. hense they allow – as it’s now someone elses problem

      MEW is an excellent invention for that reason alone and on that level

      next level – food & fuel to run all the bodies of the empires

      ~~

      I’m on a cross posting kick this morning (sorry www robots & HDs)

      “wanna add – say a generation is 20yrs … today we are so interdependent most of us would perish if the OpSys fell into anarchy .. that’s the issue halting that fall – when everyone must play the eat or be eaten game .. the last 5 generations have seen incredible advancements in all but 1 discipline – political science .. I blame the cash standard the world has engrained in its collective generations hense am also very worried – as cash can be gained thru distaster capitalism enterprise .. its 10X easier to destroy than build in this day and age”

  3. Frilton Miedman says:

    If these complaints go back as far as 2000, it proves a strong likelihood that it was intentionally coordinated immediately after the removal of glass-Steagall and the creation of the CFMA

    1 – Remove any requirements to disclose position sizes or require position limits in derivatives & futures (CFMA), and allow institutions to securitize their own fraudulently rated loans (remove Glass-Steagall), later claiming the “first amendment” as legal rationale to lie about their values.

    2 – Create a bubble by fraudulently rating home values & derivatives based on liar loans used to buy those homes.

    3 – Amass short positions in secret while selling those fraudulently rated loans based on fraudulently valued properties. (CDO’s, made possible by removing Glass Steagall and creation of the CFMA)

    Corporate deregulation, good for the economy?…really?

  4. Livermore Shimervore says:

    Which lenders did the appraiser’s cite as the worst offenders of black balling?

  5. farmera1 says:

    A friend’s friend once owned 60 rentals. During the height of the boom he took out second mortgages on all 60 properties. The amount of the second mortgage was established by the properties’ owner and an appraiser riding around in a car. Drive by appraisals so to speak. Reportedly the conversation went like this:

    Appraiser (while driving by in the car); How much do you want this one to be worth?
    Owner: $180,000.
    Appraiser: OK. Where is the next house?

    And so the appraisals (60 of those suckers) for the second mortgages were done in a day. No fuss, no bother, no sweat. Millions of dollars changed hands based on one days drive by appraisals.

    When I heard this story from a reliable source, I knew we were in deep shit.

    Needless to say the property owner is out of the real estate business and back fixing cars.

  6. Robert M says:

    STOP MAKING SENSE!

  7. [...] Black: Two Sentences that Explain the Crisis and How Easy it Was to Avoid: "Everyone should read and understand the implications of these two sentences from the 2011 report [...]

  8. Blissex says:

    «1. The lenders are extorting the appraisers…. 2. No honest lender would inflate an appraisal…. 3. The lenders were overwhelmingly the source of mortgage fraud. 4. The lenders were not only fraudulent, but following the ‘recipe’ for ‘accounting control fraud’…. 5. This had to be done with the knowledge of the bank CEOs…»

    And of the Fed and regulators…

    But the situations that really matters and Fed and other officials don’t want to see discussed is far more devastating: *essentially all derivatives contracts have a clause that says that when the underlying securities are based on fraud, the originator of the derivatives has to buy them back at their face value*.

    Therefore all USA banks would go bankrupt, because the core USA banks originated trillions of derivatives based on fraudulent securities.

    Since nobody in the circles of power wants that, then no securities, in particular no mortgage securities, must be legally recognized as fraudulent.

    That’s one reason why USA bank CEOs (and not just USA ones) have had complete legal immunity from prosecution: if they are convicted of fraud, then the buyers of derivatives based on that fraud can bankrupt the whole USA bank system by demanding to be reimbursed at par.

    That is also another reason why the Fed has been buying enormous amounts of mortgage based securities: because the Fed obviously would never do such a vulgar thing as sue the issuers of those derivatives based on fraudulent securities, or demand that they be paid back at par if the fraud became a legal fact.

  9. Blissex says:

    «The U.S. government did nothing in response to the appraisers’ petition warning about the black list of honest appraisers. The federal banking agencies’ anti-regulatory leaders’ hatred of effective regulators caused them to do nothing in response to the appraisers’ petition. »

    The other and even more important point about this, and one that I make all the time when Bill Black writes, is political: the majority of voters think that they make a lot of money on mortgage fraud, and they hate honest appraisers and effective regulators too. The government of the USA is still in large part a democracy, and if the voters want mortgage fraud to go unprosecuted because they are complicit in it, and they do, they get it.

    When most voters make a lot of fast easy money from an asset price bubble, they hate the envious spoilers of their dreams of living it large effortlessly.

    The usual quotes…

    James Galbraith in “The Great Crash 1929″, an absolute classic, reports that after as an academic expert he told a commission in 1954 that the thought that stocks were dear and this perhaps caused stock prices to fall got a lot of “feedback”:

    «A few wanted to know if I was likely to say anything hat would affect the market in the near future. I promised them silence. The rest merely wished to denounce me for destroying their dream.

    The telephone calls were supplemented, beginning the morning after the testimony, by a mountain of mail. All was unfavourable. Some was denunciatory; more were belligerent; much was prayerful.

    The belligerent threatened various forms of physical violence. My wife professed particular concern over five communications from a man in Florida announcing that he was on his way north to kill me. Her alarm subsided when I pointed out (having thoughtfully checked the point myself) that all were postmarked Palm Beach.

    The prayerful all said they were beseeching their God to have me meet with a bad accident — some were asking that I be deprived of life, some of limb, and the minimum request was that I lose all ability to open my mouth.»

    Other quotes from the same book:

    «Since 1929 we have enacted numerous laws designed to make securities speculation more honest and, it is hoped, more readily restrained. None of these is a perfect safeguard. The signal feature of the mass escape from reality that occurred in 1929 and before — and which has characterized every previous speculative outburst from the South Sea Bubble to the Florida land boom — was that it carried Authority with it. Governments were either bemused as the speculators or they deemed it unwise to be sane at a time when sanity exposed one to ridicule, condemnation for spoiling the game, or the threat of severe political retribution.»

    For a more contemporary related opinion from New Gingrich:

    «If you have a society where almost every middle class person routinely fudges the law, that’s telling us something. We have laws that matter – murder, rape, and we have laws that don’t matter. Speed limits are an example. Why would you think that a regulatory, process-oriented bureaucratic model would work?
    The first thing that every good American says each morning is “What’s the angle?” “How can I get around it?” “What does my lawyer think?” “There must be a loophole!” Then he proceeds to work the angle, and the bureaucracy spends its time chasing that and writing new regs to stop him. America is the most incentive-driven society on the planet.
    »

  10. [...] crisis. It boils down to regulators not constraining certain excessive business practices. Take a look at this post, in which William Black points out that appraisers told Washington they were being pressured to [...]

  11. cudBwrong says:

    Mr. Black gives a fine analysis, but I would like to elaborate on one point:

    “This had to be done with the knowledge of the bank CEOs.”

    It’s remarkable how little some CEO’s of extremely large institutions may know about the details of practices in their own firms. They pressure their directs to make their numbers, but the contact with the appraiser might take place somewhere 19 levels down the management chain. In fact, it is to the CEO’s advantage not to have certain detailed knowledge, as this could expose him to a personal financial or legal risk. The subordinates who earn bonuses on transactions also may wish to obscure many details from senior managers, including potential liabilities to the firm if deal collateral fails to perform.

    In a securities transaction, the underlying loans may have been originated by other firms. Assets may be transferred to special legal entities to get them off the balance sheet. The fine print may require these assets to jump right back on the balance sheet again if bad things happen. The CEO might be new, and his predecessor might or might not have been aware of the fine print on this particular deal. I was amazed to learn, at first hand, that no one at a large firm may have a clear picture of all of the potential issues and obligations.

    The point is that the image of a bank CEO applying pressure to an appraiser, or explicitly directing a subordinate to do so, does not fully capture the complex reality. Even a CEO who is determined to “do the right thing” might face considerable obstacles.

  12. [...] For the past few years, economist William Black has been making the case that the crash of 2008 was an inevitable result of crony capitalist deregulation. He first explained to me on the NewsHour how it led to fraud in an interview a few years ago and has more recently made the case here and here. [...]

  13. [...] For the past few years, economist William Black has been making the case that the crash of 2008 was an inevitable result of crony capitalist deregulation. He first explained to me on the NewsHour how it led to fraud in an interview a few years ago and has more recently made the case here and here. [...]

  14. [...] For the past few years, economist William Black has been making the case that the crash of 2008 was an inevitable result of crony capitalist deregulation. He first explained to me on the NewsHour how it led to fraud in an interview a few years ago and has more recently made the case here and here. [...]