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The Wall Street Journal Pines for the Return of Liar's Loans

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  1. Grow like crazy by
  2. Making crappy loans at a premium yield while
  3. Employing extreme leverage and
  4. Providing only trivial allowances for loan and lease losses (ALLL)

The recipe provides the famous three "sure things."  The bank is guaranteed to report record income in the near term.  The controlling officers will promptly be made wealthy through modern executive compensation.  The bank will suffer severe loan losses vastly in excess of its ALLL.  These "sure things" explain George Akerlof and Paul Romer's famous title for their article -- "Looting: The Economic Underworld of Bankruptcy for Profit" (1993).  The lender may be bankrupted, but the controlling officers can walk away wealthy.

The borrower will be placed into a loan he cannot afford at the peak of the bubble when the home is most overvalued.  The honest borrower will be placed into a liar's loan that is more expensive and exposes him to a possible criminal prosecution.  A liar's loan typically had an interest rate about 100 basis points more expensive than a conventional loan.  It was commonly the lenders and their agents (the loan brokers) who instructed the borrower what income figure to state on the application or even directly wrote the income figure on the loan application (and sometimes forged the borrower's signature on the application).  Each of these actions by the lenders exposed the borrower to being prosecuted.

Lenders such as Ameriquest engaged in endemic predation aimed at blacks and Latinos.  The lenders typically created intense, perverse interests through their compensation system for loan brokers.  The broker and lender got richer by misleading borrowers into paying an interest rate that was higher than that available in the market to similar borrowers.  Brokers targeted the groups they considered to have the least financial sophistication and financial experience.

Once fraudulent mortgages were made they were typically sold to the secondary market.  Fraudulent loans can only be sold through fraudulent "reps and warranties."  Conservative finance scholars describe the fraudulent sales as "pervasive" by our "most reputable" banks.  (Their irony is unintentional.)

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It should now be clear why adopting loan underwriting rules that ban liar's loans is the single most important thing a banking regulator can do.  At no cost to honest lenders, the regulatory agency's underwriting rule can make accounting control fraud far more difficult to commit and far easier to detect and prove.  The rule has many collateral benefits.  The fraud recipe is a superb device for hyper-inflating a bubble.  Liar's loans degrade loan documentation and create a criminogenic environment that encourages a culture of deliberately degrading loan and mortgage documentation.  Widespread fraudulent lending and the collapse of hyper-inflated bubble lead to the bankruptcy of hundreds of lenders specializing in making fraudulent liar's loans.   It can also lead to multiple sales of the fraudulent loans to other control frauds, many of which will also fail.

As the hundreds of fraudulent lenders and secondary market purchasers fail they go into Chapter 7 liquidations rather than Chapter 7 reorganizations.  Indeed, they will often fail so quickly and decisively that they will not even file for bankruptcy because they have virtually no assets to pay the lawyers and their controlling officers simply leave.  The result can be hundreds of thousands, perhaps millions, of original mortgage notes being thrown in dumpsters.  When one adds the mortgage industry's self-inflicted disaster of MERS, what was one of America's crown jewels, our public recordation system for property, has been dealt a terrible blow.  The famous (and conservative) economist who is most famous for explaining this crown jewel is Hernando de Soto.  I explained this point in a recent column that quote him.

"The unforgivable sins of this great success -- our public system of record of title and property descriptions -- are that the system is successful, efficient, and public.  That is unforgivable because it falsifies their ideologies.  You can feel de Soto's pain as he is staggered by the stupidity of the [capitalist] cannibals.

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"The result was the invention of the first massive "public memory systems' to record and classify--in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account--all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, ledgers, contracts, patents, companies, and promissory notes), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: "economic facts.'

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis--and to prevent another one--are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don't know and can't prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.'"

The combination of MERS, the large number of secondary sales, the deliberate degrading of documentation, the mass failure of the fraudulent lenders, lending to millions of borrowers that the officers controlling the fraudulent lenders knew were unlikely to repay their loans, and the enormous loss of housing value once the bubble burst made it certain that there would be millions of loan defaults -- and that the entity foreclosing would frequently lack the documentation required to foreclose.  The fraudulent lenders compounded their loan origination and secondary market frauds by engaging in extraordinary levels of foreclosure frauds.

It is only with the terrible experience of the current crisis that we can appreciate how massive the direct and indirect collateral benefits were of the traditional regulatory mortgage loan underwriting rule that was so disgracefully eliminated in 1993.  The direct effect, had the rule remained law and been enforced, would have been to eliminate the largest and most destructive epidemic of financial fraud in history.  There would have been no crisis and no Great Recession.  The indirect effects are also proving extraordinarily harmful.   The WSJ's attempted analytics are internally contradictory.  It bemoans the (non) fact that:  "The government roots of the crisis are unreformed, especially easy credit and the bias for housing."  The cardinal example of "the government" permitting (not requiring) the fraudulent officers leading the banking control frauds to provide "easy credit " for housing" was the deregulation that killed the traditional mortgage lending underwriting rule.  This allowed the banks' controlling officers -- contrary to the regulators' efforts to discourage liar's loans -- to eventually make millions of liar's loans.  There is no worse form of providing "easy credit" than liar's loans.

Similarly, it was the refusal of Greenspan and Bernanke -- who shared the current disdain of the WSJ and the prior disdain of the ReGonauts for any mandatory loan underwriting rules, particularly rules that would ban the endemically fraudulent liar's loans -- to use HOEPA to ban liar's loans that ensured that the banks' fraudulent controlling officers could continue to provide the easiest conceivable credit, liar's loans.  Note that even Greenspan and Bernanke discouraged banks from making liar's loans and that liar's loans were not prompted by affordable housing goals but by the bank officers' fraud goals.  Recall that liar's loans dramatically inflated the borrower's actual income, which meant they were the worst possible means of purportedly making loans to lower-income borrowers.  In sum, it is precisely what the WSJ is complaining about -- banning liar's loans through rules that "micromanaged" the "kind and quality of loan" that produced an enormous (and desirable) reduction in the fraudulent supply of the "easy credit" that the WSJ claims caused the crisis.

The WSJ ignores all of the points I have made, but that understates how detached from reality they are.  The WSJ brings up the foreclosure frauds -- which consisted of hundreds of thousands of felonies by the banks for which no senior banker will be punished due to a scandalous dereliction of duty by the Department of Justice (DOJ) -- in order to complain that "the government" abused the poor, virginal banks.

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"Regulators have ordered a top-to-bottom overhaul of foreclosure processes even after extorting more than $25 billion in payouts for exaggerated past offenses."

First, everyone honest (which excludes DOJ and the WSJ) knows that the banks are not making anything remotely like "$25 billion in payouts" under the settlement in which they (1) got the investigations of their endemic frauds halted and (2) got a complete pass against prosecution of any senior officer or any bank.  The vast bulk of the $25 billion is not a "payout."  It is actually a figure for reduced payments in negotiated loan workouts (which involve no "payouts" by the lenders) that the lenders would have entered into anyway to minimize their losses.

Second, it isn't "extortion" when the WSJ talks about litigated settlements it favors.  All litigation settlements are the product of "extortion" under the WSJ's definition of the word.

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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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