The tragedy, however, is that economists' anti-regulatory, pro-corporate biases have proven so all-consuming that most economists are so anti-scientific that they have refused to learn from the control fraud epidemics that drive our recurrent, intensifying financial crises. The industry and the regulators during this crisis had the advantage of our crackdown on liar's loans and the fact that the industry was now calling the loans "liar's" loans. There was no subtlety to this first aspect of the loan origination fraud epidemic. No government agency or law required or recommended that lenders make liar's loans. But economists also had the advantage of Akerlof and Romer's 1993 article about "looting." Akerlof and Romer's general point that accounting control fraud existed and could drive crises and the admonition that now we (economists) know better and that if we learn from the looting we need not suffer a recurrence of the crises should have alerted every economist to the danger. Even better, the article specifically warned that we could recognize the frauds by looking for lenders that failed in "maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications." They warned their field against the specific fraud scheme that drove the current crisis -- a full decade in advance. Their article also warned about fraudulent lenders exploiting loan brokers' perverse incentives to originate bad loans and then sell the loans in the secondary market (1993: 29, 46). Economists did not simply fail to warn about the fraud epidemics -- they recommended doubling down on the criminogenic policies (the three "de's" -- deregulation, desupervision, and de facto decriminalization) that Akerlof and Romer warned were "bound to produce looting." Economists, in the rare cases where they mentioned fraud, claimed that fraud posed no risk in "sophisticated" financial markets. Complacency is one of the most destructive mindsets a regulator can have.
I have explained in depth the lead role that fraudulently originated liar's loans played in driving the crisis. The brief summary is that the incidence of fraud in liar's loans, according to the industry's own anti-fraud experts was 90 percent. The massive expansion of liar's loans caused the bubble to hyper-inflate. Liar's loans grew by roughly 500% from 2003-2006. By 2006, roughly half the loans that the industry called "subprime" were also liar's loans (the two categories are not mutually exclusive) and about 40% of all home mortgage loans originated in 2006 were liar's loans. In 2006 alone, the industry originated over two million fraudulent liar's loans.
The other aspect of the loan origination fraud epidemic, appraisal fraud, was even more blatant.
"From 2000 to 2007, a coalition of appraisal organizations " delivered to Washington officials a public petition; signed by 11,000 appraisers". [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] "blacklisting honest appraisers" and instead assigning business only to appraisers who would hit the desired price targets" ( FCIC 2011: 18).
The petition was corroborated by two surveys of appraisers. A survey in 2003 found that 55% of appraisers reported being coerced to inflate at least one appraisal that year. A repeat of the survey in 2007 found that the percentage that had experienced coercion that year had risen to 90 percent. Sixty-eight percent of appraiser reported having lost a client and 45% reported that they were not paid for their work when they resisted coercion. Demos published a study in 2005 that reported that appraisal fraud had become "epidemic." Then New York Attorney General Cuomo reported that his investigation had confirmed that Washington Mutual (WaMu) had blacklisted appraisers who refused to inflate appraisals and that this practice was the norm for the industry.
The mortgage lending industry and the regulators could have figured out everything necessary to prevent the crisis had they understood accounting control fraud and the import of the petition. Here are the key conclusions that the industry and regulators should have drawn.
- Lenders and their agents are causing inflated appraisals
- Appraisal fraud had become epidemic
- No honest lender would inflate appraisals or allow them to be inflated
- The lenders' strategy is to generate a Gresham's dynamic and suborn appraisers
- Only rational if covering up underlying mortgage fraud, i.e., liar's loans
- There is no fraud exorcist, so the fraudulent loans are sold fraudulently
- The MBS and CDO are backed by fraudulently inflated appraisals
Individually, each of the three control fraud epidemics (liar's loans, appraisals, and secondary market sales through fraudulent "reps and warranties") would have represented the most destructive financial frauds in world history. Collectively, they caused catastrophic, global damage and unprecedented fraudulent enrichment of the officers that led the control frauds.
As remarkable as the near total failure of economists to "know better" about twin loan origination fraud epidemics that we had seen, and successfully suppressed before, the truly remarkable demonstration of how self-destructive economists' dogmas are of their ability to go beyond a shambolic parody of the scientific method is their work after the crisis that purports to explain what caused the crisis. In virtually all cases (1) they never consider the possibility of accounting control fraud, (2) they do not discuss or even cite Akerlof and Romer 1993, and (3) they do not discuss the relevant criminology literature. They purport to use natural experiments "testing precise hypotheses" but they implicitly exclude accounting control fraud as a possibility. Because the exclusion is implicit, it is not supported by reasoning. Indeed, it is unlikely that the researchers consciously know that they have excluded control fraud. Ideology and mono-disciplinary blinders consistently trump the scientific method. We have the worst of all worlds because the researchers believe they are the very model of the modern scientific economist while the reality is that they are in thrall to their dogmas, which implicitly censor out alternative theories of causation that would falsify their ideologies. To gleefully mix Gilbert and Sullivan tunes, the economists that Chetty praises became the equivalent of admirals in their field because they stuck close to their desks and never went to sea to battle the three most devastating epidemics of financial fraud in world history.
I'll end with one such example, of over a hundred. I picked it because it explicitly discusses liar's loans at one of the large accounting control frauds, Bear Stearns (Bear). It is a 2009 study entitled "Taking the Lie Out of Liar Loans."
The researchers studied loans made by Bear and its affiliates. They explain that Bear's mortgage loan originations became increasingly dominated by liar's loans. The authors do not attempt to explain why Bear's leadership chose to increasingly originate overwhelmingly fraudulent loans that the industry called "liar's" loans. The article exemplifies economists' tribal taboo about the frightening power of the "f" word. An article focused on fraudulent loans never uses the word "fraud." The article never cites Akerlof and Romer (1993), the relevant criminology literature on control fraud, or the fact that the other two modern financial crises (the S&L debacle and the Enron-era scandals) were driven by epidemics of accounting control fraud. It ignores our 1990-1991 experience with liar's loans.
The article implicitly assumes that accounting control fraud by lenders cannot exist -- even when lenders employ a type of loan that they know will produce endemically fraudulent loan originations. Indeed, Bear massively increased its liar's loans knowing that they were frequently fraudulent.
The authors' seemingly sensible, but actually bizarre presumption underlying the article is that they are developing a proposed means of underwriting to reduce the fraud incidence of inflated borrowers' incomes in liar's loans. The obvious, except to economists, analytical point that explains why the authors' presumption is bizarre is that lenders have known for centuries how to underwrite home loans in a manner that reduces fraud by borrowers to trivial levels. The officers controlling fraudulent home lenders created the perverse compensation systems of loan officers and loan brokers and enthusiastically embraced endemically fraudulent liar's loans because they did not wish to engage in effective underwriting. Effective underwriting would prevent them from attaining the "sure things" offered by the fraud recipe. The authors' crude underwriting substitute could not reduce fraud remotely as effectively as real underwriting. Neither fraudulent nor honest officers would use the authors' underwriting substitute. The fraudulent officers did not want to exclude bad loans and honest officers would have found the authors' underwriting substitute grossly inferior to real underwriting.
Using euphemisms for fraud, the authors repeatedly confirm the endemic inflation of the borrower's income in liar's loans. In no case, however, do they even consider that the officers controlling the lender could have been engaged in accounting control fraud. The closest they come was to note that a journalist assumed that liar's loans were actually profitable to the lender because "lenders may have incentives to encourage brokers to solicit stated-income loans because such loans may produce "excessive rates and penalties.'" The authors did not bother to analyze the journalist's claim.
The authors also implicitly assumed appraisal fraud out of existence because they rely uncritically on reported "loan-to-value" (LTV) ratios. In one case the authors note the possibility that the "the borrower (and/or broker) may have exaggerated income to qualify for a loan that is greater than they can really aï¬ord." The possibility that the officers controlling the lender knew that brokers and loan officers would encourage or even directly cause the inflation of the borrower's income pursuant to the fraud "recipe" was ignored. In eight places in their article the authors assumed that it was solely the borrowers who must be inflating their incomes and implicitly assumed that the lender's controlling officers would have been determined to prevent such frauds. The authors ignored all the investigators who testified that it was lenders and their agents that put the lies in liar's loans and all the warnings to the lenders that liar's loans were endemically fraudulent (I have detailed these in prior articles).
The mono-disciplinary authors emphasize that they were the first to study the effect of liar's loans on loan defaults (by which they mean the first economists to study). Consider how crazy that is for a field that pretends to science. The biggest development in real estate, by far, was the rise of nonprime loans, particularly liar's loans and most particularly subprime liar's loans. The context was that even many economists were warning about a massive housing bubble. The rise in liar's loans was so rapid from 2003-2006 that they were the marginal loan driving the bubble to hyper-inflate. The Federal Reserve's supervisors were so worried about the spread of non-prime loans that, despite Greenspan's disapproval they conducted an exceptionally limited inquiry into the largest banks' origination of non-traditional mortgages.
"Sabeth Siddique, the assistant director for credit risk in the Division of Banking Supervision and Regulation at the Federal Reserve Board, was charged with investigating how broadly loan patterns were changing. He took the questions directly to large banks in 2005 and asked them how many of which kinds of loans they were making. Siddique found the information he received "very alarming,' he told the Commission.