By 2003 -- the start of the critical massive expansion of liar's loans -- the SDIs were already exceptionally likely (67%) to combine liar's loans with other "nontraditional" lending characteristics known to increase the probability of default and loss upon default. This practice grew dramatically through mid-2007 despite copious warnings of an "epidemic" of mortgage origination fraud and federal regulators discouraging such loans. The best known "nontraditional" lending characteristic was subprime lending, but lenders often "layered" liar's loans with no-downpayment and negative amortization characteristics. The latter two loan provisions had the effect of substantially delaying defaults on fraudulent liar's loans. Home lenders who make liar's loans, by themselves, are certain to suffer grievous losses, but adding any of these non-traditional characteristics to liar's loan -- much less several of them -- is certain to cause catastrophic losses to the lender.
It is important to recall that the officers leading the control frauds also frequently "layered" appraisal fraud to these other fraud-friendly characteristics. The appraisal fraud was designed both to increase the reported (fictional) income (the larger the loan amount, the larger the fictional income) and to provide an excuse for the (not very) "due diligence" firms to declare that the (fictional) low loan-to-value (LTV) ratio that resulted from appraisal fraud to provide a "compensating factor" for other fraudulent "reps and warranties."
I know that the concept that any loan characteristic makes it safe to buy a product from a lender that has deliberately lied to you for the purpose of disguising the product's defects is facially absurd. I know that that it took unbelievable chutzpah for the "due diligence" firms (even their name was ironic) claim that the lower LTVs manufactured by endemic appraisal fraud "compensated" for fraudulent reps and warranties about liar's loans made by loan originators and I know that the officers controlling the secondary market purchasers welcomed the chutzpah of the "due diligence" firms. The twin epidemics of accounting control fraud (appraisal and liar's loan fraud) by loan originators ensured that their endemically fraudulent loans could only be sold through fraudulent "reps and warranties." I know that their pervasively fraudulent reps and warranties were easily spotted -- and ignored -- by the fraudulent purchasers of fraudulent loans who employed the financial version of "don't ask; don't tell. When control fraud became endemic the financial industry became nonsensical to observers who do not understand the fraud recipe for lenders and purchasers. Once one understands the "sure things" that the officers attain by making and buying crappy loans the industry's practices become understandable.
No federal entity ever urged, much less required, lenders to make or purchase (and, yes, that includes Fannie and Freddie) liar's loans. Even the Bush administration anti-regulators like Greenspan who "ignored" the data on liar's loans and launched personal attacks on anyone at the Fed who dared to criticize the SDIs' endemically fraudulent lending, discouraged banks from making liar's loans. The WSJ, in a passage in which they decry purported "fiction" and "spin," spreads the myth that: "politicians and regulators " pulled every lever they could to force capital into mortgage finance"." No politician or regulator ever forced any entity to make or buy a liar's loan or to inflate an appraisal. The fraudulent bank officers are the ones that "forced" the banks they controlled to make and buy millions of liar's loans and extorted appraisers to inflate home values because doing so made them wealthy pursuant to the fraud recipe. The WSJ knows this to be true, which is why it studiously refuses to discuss the reality of how liar's loans became the dominant source of loan growth driving the hyper-inflation of the housing bubble and why it refuses to discuss the twin epidemic of appraisal fraud.
I have previously explained in detail why we know that it was overwhelmingly lenders and their agents (the loan brokers) who put the lies in liar's loans. The lenders chose the compensation system to use with loan brokers and the type of loans they were willing to fund. The lenders not only allowed liar's loans, they designed their compensation system for loan brokers to maximize the number of liar's loans and to incent the brokers to dramatically inflate the borrower's income so that the lender would be provided the pretext of approving the liar's loan based on its purportedly "low risk" nature as demonstrated by the borrower's (fictionally) low reported debt-to-income ratio. The officers leading the fraudulent lenders and the brokers they carefully incented to put the lies in liar's loans and inflate appraisals knew that the entire lending process was a charade pumping out millions of fraudulent loans and hyper-inflating the bubble.
The Nation's leading trainer of loan officers explained the fraudulent charade.
"His clients included many of the largest lenders--Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs "flipping burgers,' he told the FCIC. Given the right training, however, the best of them could "easily' earn millions.- Advertisement -
He taught them the new playbook: "You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.' He added, "I knew that the risk was being shunted off. I knew that we could be writing crap. But " we were not going to be hurt'" (FCIC 2011: 8).
When he refers to the "best" loan officers who moved from "flipping burgers" to "flipping homes" he means, of course, the worst.
"[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer." Tom Miller, Iowa's Attorney General, 2007 Fed testimony
Let's recall the exact language of the WSJ's cry of outrage: "The regulation micromanages bank decisions down to the kind and quality of loan." The "kind and quality of loan" is precisely what must be regulated to prevent epidemics of accounting control fraud -- the frauds that drove our three modern financial crises (the S&L debacle, the Enron-era, and the mortgage fraud crisis from which we are still recovering). The traditional home mortgage underwriting rule that the regulators used before the Clinton and Gore administration's disastrous "Reinventing Government" (ReGo) crusade repealed it in 1993 had three requirements:
- The lender had to underwrite the proposed loan before it was made
- The lender had to document that the borrower had the capacity to repay the loan and that the collateral was adequate to repay the loan
- The lender had to maintain a written record of this underwriting
The traditional rule was an example of the perfect rule. It imposed no cost on an honest lender. It acted to forbid loans that would only benefit the officers leading accounting control frauds and it required lenders controlled by fraudulent officers to create a "paper trail" demonstrating that they knew they were making a bad loan. That paper trail allowed our examiners to identify likely frauds and our enforcers and prosecutors to demonstrate the existence of accounting control frauds and take legal action against the senior officers leading the frauds. The rule had the incidental benefit of ensuring that the bank kept clear evidence of title and the mortgage interest and any transfers. The rule was, deliberately, not a "best practices" standard. It was the minimum standard any honest lender would follow. Honest controlling officers of banks imposed mortgage underwriting requirements far in excess of our minimum requirements.
The traditional underwriting rule is also what we used in 1990-1991 to stop an incipient "second front" in the control frauds assault on the American people during the S&L debacle. "Low documentation" (such loans were not yet called "liar's loans") loans began to become common in Orange County S&Ls. We were regional regulator (OTS-West Region) with jurisdiction over Orange County. We heeded our examiners' warnings that no honest lender would make such loans and largely drove the lenders who made liar's loans out of the industry by 1991. This is what MARI was referring to in its fourth bullet point above.
ReGo substituted a deliberately unenforceable "guideline" that allowed lenders to adopt any underwriting standard they chose, even when the underwriting standard was not to underwrite. ReGo's rationale for destroying the underwriting rule that had proven spectacularly effective in (1) stopping the accounting control fraud epidemics that were driving the S&L debacle, (2) holding the elite officers leading those frauds accountable for their crimes and abuses, and (3) preventing the 1990-1991 outbreak of liar's loans from becoming a crisis had two parts. First, it ignored the three successes. ReGo only presented stories of alleged regulatory successes arising from deregulation. It routinely excluded evidence of success arising from vigorous regulation.
Second, ReGo ignored control fraud and the officers who control banks. It, like the WSJ, implicitly assumed that the officers who run "banks" act in the interest of the bank rather than in the interest of the officers. When they make explicit assumptions, the WSJ and ReGo's leaders typically assume that corporate officers act to further their self-interest. If they had explicitly assumed that fraudulent bank officers did not exist, then the ReGo officials and the WSJ would be forced to defend the validity of that (obviously false) assumption. That is why implicit assumptions are so dangerous. Once the implicit (but false) assumption is made that bank officers invariably act contrary to their self-interest to aid the best interests of the banks, it becomes seemingly obvious that any loan underwriting rule exemplifies the absurd "micromanage[ment]" that the WSJ seeks to ridicule. The lenders' officers will adopt the underwriting standards that best serve the bank. The bank officers will know the bank and the prospective borrowers better than any regulator could possibly know. As best, the regulatory underwriting rule will be unnecessary. At worst, it will prevent the lender from making loans that would aid the bank and its customers. In a typical market transaction the neoclassical economic assumption is that both parties to the transaction (here, the lender and the borrower) will be made better off, so whenever the underwriting rule prevents a loan from being made the world is made worse off.
All of this falls apart, however, as soon as one acknowledges the existence of accounting control fraud and predatory lending and foreclosure fraud. The fraud "recipe" for the officers controlling a lender explains why the first point is true.