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Creating Effective Regulation is the Imperative Issue at the Federal Reserve

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In 2000-2007, the Fed was not overwhelmed by a crisis and did not suddenly have to divert resources to counter a "second front."  The Fed had vastly greater resources than we did and they had a means of preventing the crisis.  The Fed had explicit statutory authority to adopt a rule that would have immediately stopped the epidemic of fraudulent liar's loans.  The Home Ownership and Equity Protection Act of 1994 (HOEPA) gave the Fed unique authority to ban all liar's loans by lenders even if they did not have deposit insurance and were otherwise not subject to federal regulation.  The Fed had many allies urging it to stop the epidemic of fraudulent liar's loans.  Congress mandated that the Fed conduct hearings on HOEPA that produced overwhelming evidence, including from the leader of an association of honest loan brokers, of widespread fraud and predation by lenders.  As S&L regulators, we had no allies when we were vilified for reregulating the industry.

The home lending industry and the secondary market ignored the warnings of the twin barrels of endemic mortgage loan origination fraud (appraisal and liar's loans) and increased the origination of liar's loans by over 500% from 2003 to 2006.  By 2006, half of all the loans originated that year that the industry called "subprime" loans were also liar's loans (the categories are not mutually exclusive).  Consider how crazy that would be for an honest lender -- making loans to borrowers with known bad credit histories that the lenders knew were exceptionally likely to have grossly inflated reported borrower's income and appraised values.  Loans that met that trifecta of terribleness, however, were ideal means of making the fraudulent officers controlling such lenders wealthy.  Roughly 40% of all home loans originated in 2006 were liar's loans (the comparable figure for the UK that year was 45%).  That means that, at a fraud incidence of 90%, over two million fraudulent liar's loans were originated in the U.S. in 2006.  The loans that hyper-inflated the residential real estate bubbles in the U.S. in 2003-2006 were overwhelmingly fraudulent liar's loans.  Fraudulent loans are particularly likely to default and cause larger losses.

There was no fraud exorcist.  Once the fraudulent loans were originated they could only be sold to the secondary market through fraudulent "reps and warranties."  It was inherent in the structure of the secondary market that the frauds had to propagate throughout the chain of transactions.  So many of the purchasers of fraudulent mortgages were themselves accounting control fraud that the secondary market became dominated by the financial version of "don't ask; don't tell."

The Fed, and only the Fed, could have stopped all these epidemics of accounting control frauds in their tracks within weeks by issuing an emergency rule under HOEPA banning the origination of liar's loans.  The Fed was urged repeatedly to do so.  It refused to do so until July 14, 2008 when Ben Bernanke, finally caving in to intense congressional pressure, finally adopted a rule under HOEPA banning liar's loans.  Even then, Bernanke delayed the rule's effective date by 15 months lest he inconvenience any surviving fraudulent lenders.

We can measure the cost of the Fed's refusal to ban liar's loans and prevent the crisis.  The wealth loss to U.S. households was $11 trillion.  Over 10 million Americans lost their existing jobs or jobs that the economy would have created but for being forced into the Great Recession.  All the monetary policy mistakes the Fed has made since the Great Depression pale in comparison to the catastrophe Bernanke and Greenspan caused through their refusal to stop the fraud epidemics.

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)

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