In my first column in this two-part series I explained how the Department of Justice's (DOJ) non-prosecutorial effort against the banksters' frauds that caused the financial crisis had ended with a pathetic whimper uttered by Deputy Attorney General James Cole during his ritual exit interview with Bloomberg. Cole's explanation for DOJ's failure to prosecute a single senior banker for leading the three fraud epidemics that drove the financial crisis was that DOJ was "dealing with financial rocket science." My first column made the point, which escaped DOJ and Bloomberg that if this were true it would presumably have been modestly important for DOJ to do something about the ability of "rocket scientists" to grow wealthy by leading the frauds that cost the U.S. $21 trillion in lost GDP and 10 million jobs. I also promised this column explaining why it was not true. In light of a reader's comment I'll add a third piece on "rocket science" in the financial context.
I'll begin with a caution. It is not simple to prosecute senior bank officers. Anyone that tells you that it is doesn't know what they are talking about. We did, however, have a 90% conviction rate against them during the savings and loan debacle because thousands of people worked very hard for years and made such prosecutions the regulators' second highest priority and one of DOJ's top priorities. We know how to succeed. In the current crisis we have done none of the things we know is essential to succeed. Instead, we have one senior official after another making pathetic excuses for their failure to take the hard but well understood steps necessary to convict the senior bankers who led the frauds that drove the crisis.
DOJ Attorneys Need 5th Grade Math to Prosecute the Rocket Scientists
The striking feature of the three epidemics of accounting control fraud that drove the crisis is how crude they were. As I emphasized for decades, the key to the most devastating frauds is not "genius," but audacity. The fraud epidemics are off the charts on audacity. The principal fraud schemes have next to nothing to do with "rocket science." They have everything to do with accounting. The most advanced mathematical skill required to understand and explain the fraud schemes was the ability to compute a percentage. Any DOJ attorney who could understand what a percentage is (5th grade math) had all the math expertise required to prosecute the CEOs that led the three fraud epidemics that drove the crisis.
"Fifth graders learn to solve complex problems with complex numbers. They divide whole numbers, with and without remainders. They make connections between decimals, fractions, and percentages."
The Three Epidemics
The first epidemic was appraisal fraud. The second was "liar's" loans. These were the two epidemics of loan origination fraud led by the officers that controlled the home lenders. Because there is no fraud exorcist, once loans are fraudulently originated they can only be sold to the secondary market through fraudulent "representations and warranties." The officers that controlled the lenders that originated massive numbers of fraudulent loans made these fraudulent "reps and warranties."
The Appraisal Fraud Epidemic
The Financial Crisis Inquiry Commission (FCIC) report should be read closely.
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).
Surveys of appraisers in 2003 and 2006 found, respectively, that 55% and 90% of them had been personally subjected to such coercion to inflate appraisals (FCIC 2011: 91). It was lenders and their agents (typically mortgage brokers) who were overwhelmingly responsible for deliberately generating a "Gresham's" dynamic (in which bad ethics drives good ethics out of the profession or market) in order to inflate reported market values. Honest home lenders would never cause, or permit, appraisers to inflate market values. Lenders controlled by fraudulent officers, however, would find it optimal, under the "recipe" for accounting control fraud by those that make or buy home to inflate appraised values. Note that understanding and proving this fraud requires no math. In my experience, lay people understand the point that no honest lender would induce or permit inflated appraisals in under 30 seconds.
It is harder to understand why the officers that control banks find it useful to their fraud schemes to extort appraisers to inflate appraisals. It requires only elementary school math, however, to understand why this is true. Admittedly, Benjamin Wagner, DOJ's lead prosecutor on their mortgage fraud (not RMBS) working group was unable to keep up with even the crudest frauds.
Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. "It doesn't make any sense to me that they would be deliberately defrauding themselves," Wagner said.
The reader can see the obvious -- Wagner's confusion with pronouns arises from his underlying problem with logic. As he uses the pronouns, "they" refers to the bankers and "themselves" refers to the banks. Wagner obviously thinks the bankers and the banks are the same, but this is embarrassing. The bankers are looting the banks. The deeper, catastrophic flaw, however, is that Eric Holder, Lanny Breuer, and Cole chose someone as obviously unfit as Wagner to be the most senior prosecutor on their mortgage fraud working group and have kept him in power despite his total failure to prosecute a single senior banker.
DOJ Has Given Wagner's Team a Top Award -- For Abject Failure