William K. Black
Lenders Put the Lies in Liar’s Loans
I have noted before a family maxim — one cannot compete with unintended self-parody. Andrew Kahr has recently written a column in the American Banker entitled “Spread the Word: Lying to Banks is Illegal.” Mr. Kahr is one of the architects of subprime lending. He warns:
Federal law provides that anyone who knowingly makes a false statement to a[n] … insured institution … shall be fined not more than $1,000,000 or imprisoned for not more than thirty years, or both.
To say the least, this criminal law, intended to protect banks and hence the deposit insurance fund, is very, very rarely enforced against consumers. Why?How is a U.S. attorney to know that a customer has defrauded a bank by giving false information, unless the case is referred to him or her by the bank? And we’re not doing that, at least not for mortgages, credit cards or other everyday consumer lending.
Hence, the plethora of consumers giving willfully and materially false information to banks on applications and during loan servicing has mushroomed. With “liar’s loans,” this went from a cottage industry to an epidemic.
Mr. Kahr neglects to mention that “insured institution[s]” are required to file Suspicious Activity Reports (SARs) (criminal referrals). As the FDIC explains:
The U.S. Department of the Treasury’s financial recordkeeping regulations (31 CFR 103.18) require federally supervised banking organizations to file a SAR when they detect a known or suspected violation of federal law meeting applicable reporting criteria.
Collectively, banks make massive numbers of SARS filings with regard to mortgage fraud, over 67,000 annually, but a mere 10 institutions file 72% of those referrals. The typical nonprime lender deliberately violates its legal requirement to file a criminal referral when it discovers mortgage fraud even though that practice would be irrational for an honest lender. The federal regulatory agencies have not taken any effective action against these pervasive violation of their rules despite an “epidemic” of mortgage fraud that drove the ongoing financial crises.
Mr. Kahr continues by complaining that
[T]he news often encourages consumers to believe that you can lie to get a loan, or to forestall collection action, and that this is perfectly normal, common and acceptable. After all, “he told me that my income would not be verified.” Nonverification, even if advertised in advance, is not an invitation to lie, and it does not exempt the liar from criminal consequences.
Occasionally you can see a newspaper story about a tattoo parlor operator who managed to buy six houses with nothing down and false applications. But the multiple and professional fraudsters are relatively few. Surely the great bulk of the fraudulent applications come from individuals who just want to buy and live in the house, or to do so on better terms.
Mr. Kahr sees only two sources of mortgage fraud — and both are by the borrowers. He correctly states that there appear to be “relatively few” “professional fraudsters” among borrowers. To him, that leaves only one alternative — “surely” millions of homeowners have defrauded the banks. The FBI, however, reports that 80% of mortgage fraud losses occur when “industry insiders” are involved in the fraud (FBI 2007).
Mr. Kahr then returns to his primary theme — nonprime lenders acted irrationally by recurrently taking actions that were certain to increase mortgage fraud.
In days gone by, some loan application forms included, in bold type at the bottom, an excerpt from the criminal law … defining fraud and specifying the penalties for it. Even before “the class of 2006,” we stopped doing that. After all, it reduced loan volume — both by discouraging bad applications and by increasing the decline rate based on less inflated claims by applicants.
Let’s now do a thought experiment with “the bank where I work.” Suppose you let it be known to applicants and loan customers that your policy is to detect and to refer for prosecution cases in which a knowingly false statement is made by an applicant or borrower. What would happen then?“Well, then they would all go across the street, to my competitor.”
We can certainly hope that the fraudsters would do so! And that your loan losses would correspondingly decline, giving you a dramatic edge over that competitor. You could charge lower rates and still earn a higher return.
But why would the honest customer have any fear of doing business with you? He knows what his income, occupation and phone number are.
Mr. Kahr is explaining the concept of “adverse selection.” If an honest bank does not underwrite effectively its controlling officers know that the bank will inevitably attract the worst borrowers and suffer severe losses. No honest bank would operate in the fashion Mr. Kahr described as being characteristic of nonprime mortgage lenders. An honest, competent lender would gain a “dramatic edge” in “return” over any lender that permitted adverse selection. Mr. Kahr explains that nonprime lenders invariably “made bad loans because [they] knew [they] could sell them [to Fannie and Freddie] and make taxpayers cover the losses….” Again, Mr. Kahr is blind to the implications of the strategy he suggests nonprime lenders followed. We need to review the bidding. Mr. Kahr has explained that nonprime lenders characteristically:
- Cared solely about maximizing loan volume and (nominal) yield
- Deliberately removed underwriting procedures and anti-fraud warnings in order to increase volume and (nominal) short-term yield even though they knew this would produce an epidemic of fraud and substantially reduce (real) yield (because it would cause massive losses)
- Were aware that these steps led to endemic mortgage fraud, yet the nonprime industry norm was to fund loans known to be fraudulent and to violate the law requiring that the lender file criminal referrals on the endemic frauds
- And, though they knew the loans they were selling were commonly fraudulent and would produce enormous net losses, the banks followed this strategy because they intended to sell the loans to Fannie and Freddie and transfer the catastrophic losses to the taxpayers
The obvious point, ignored by Mr. Kahr, is that the banks could not lawfully sell endemically fraudulent loans to Fannie and Freddie. If they had disclosed the endemic fraud they would have been unable to sell toxic waste to Fannie and Freddie (and the private label secondary participants — who also bought hundreds of billions of dollars of fraudulent nonprime loans). The lenders had to make false “reps and warranties” to be able to sell fraudulent loans to Fannie and Freddie. The strategy that Mr. Kahr suggests the nonprime lenders followed required fraudulent representations by the lenders as to millions of loans. Mr. Kahr is describing the largest and most destructive financial fraud in human history. Recall that Mr. Kahr makes clear that the nonprime lenders knew two things they needed to deceive Fannie and Freddie about — the fact that the loans were endemically fraudulent and the fact that the lenders identified many fraudulent loans and characteristically failed to file criminal referrals and instead sold loans they knew to be fraudulent to Fannie and Freddie. Note also that Mr. Kahr asserts that the lenders knew that their strategy would cause hundreds of billions of dollars in losses to the American people — who were innocent, but would have to pay the cost of the frauds.
Note something else implicit in Mr. Kahr’s analysis — the banks could have prevented virtually all serious mortgage fraud and prevented the entire crisis by using traditional underwriting practices — and doing so was certain to produce superior bank profits. It was the epidemic of mortgage fraud that hyper-inflated the bubble and caused the catastrophic losses. The combination of the hyper-inflated bubble and catastrophic losses is what drove the economic crisis in the U.S. and produced extreme unemployment.
Mr. Kahr does not consider the interplay of the practices he ascribes to the nonprime industry. It is perfectly sensible for a bank that originates fraudulent loans not to file criminal referrals about the frauds if its strategy is to sell the loans to Fannie and Freddie and transfer the losses to the taxpayers. Consider four reasons why nonprime mortgage lenders typically do not file criminal referrals. One, if the lender files a referral alerting the FBI that it believes the loan may be fraudulent it cannot sell the loan to Fannie and Freddie without exposing itself to massive punitive damages for fraudulent sales.
Two, the fraud incidence on liar’s loans that have been studied by independent reviewers is 80% and above. The regulatory agency gets a copy of the criminal referral. Even Bush’s crew of anti-regulators would have found it impossible to allow Indymac, WaMu, Countrywide to make hundreds of thousands of liar’s loans if they were also filing hundreds of thousands of criminal referrals.
Three, Mr. Kahl’s arguments mean that the typical nonprime lenders was violating the rules requiring that they make criminal referrals and engaged in widespread fraud in selling the fraudulent loans to private label securitizers and Fannie and Freddie. When you are running a massive fraud you are reluctant to file adequate criminal referrals that might attract the FBI to investigate tens of thousands of fraudulent loans.
Four, it was overwhelmingly the lenders that put the “lie” in “liar’s” loans. The “recipe” for a fraudulent lender to maximize its short-term (fictional) accounting income has four parts.
You can check out the rest here…
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As a mortgage loan processor, the banks would routinely come in to teach us how to overrule their system and get an automated underwriting approval. All lenders have their own software and their account executives would come in to teach us to “tweak” their origination software. My question to them would always be, “why would I want a false approval?” How did we do this? Let’s say the lender wants a certain borrower to have $10k in the bank for an approval. We were supposed to put in the $10k in the software so that the lender’s approval would say, subject to verification of $10k in the bank. This is what fueled the fraud. If a client does not have the money in the bank, then he should be declined. That is not what all the lenders that came in the door said. A sample of lenders, Washington Mutual, National City, Citi, Flagstar, IndyMac, Countrywide, Irwin National, all came in to teach us how to use their system.
Fannie Mae and Freddie Mac did buy liar loans, they just don’t want to talk about it. The next round of foreclosures will come the moment the rates rise and these clients were PRIME borrowers with over 720 credit scores. These were stated income and no doc loans. The sub-prime mess had nothing to do with “poor people”. The poor people had excellent loans which were under the Community Reinvestment Act. These clients were fully documented with very cheap mortgage insurance, cheap rates and were better loans than FHA. The loan to value was up to 107 percent. They just put down $800.
Sub-prime had to do with clients getting higher rates but they could close in seven days!!!!! Realtors loved these loans and would pull their loans from mortgage brokers who would not close the loans fast enough. Realtors also would send their clients to mortgage brokers and receive ILLEGAL KICKBACKS of one percent of the loan amount. Nevermind that realtors already made three percent on the sale! Realtors would control the deal and if the mortgage broker’s appraiser did not get the “value” the realtor thought it had, they would take the loan and send it to the mortgage broker that could close it faster! Why can’t a loan close in thirty to forty-five days? We are not talking about five dollars, but thousands of dollars. The realtors got away with their dirty schemes and no back lash against them when they are the first point of contact in a home sale.
In a nutshell… the American people got screwed by the banksters. I am sure that won’t ever happen again. (sac)
Most sub prime No Doc, Low Doc or whatever they wanted to call them had a 4506 Tax transcript request form that the borrower signed at the time of Loan Application and also at the settlement table.
If I as a borrower wanted to cheat, it was quite easy to do. However, it would generally take some one with the actual expertise and inside knowledge to know all the ins and outs. how to set the proper Front and back ratios, how to generate the deposit verifications (some realtors and loan officers had bank accounts where they placed their clients and or used other clients accounts without their knowledge and approval to do deposit verifications), as far as the income, some loan officers had call centers and companies where they paid the individual verifying the income or employment reference, taking advantage of the fact that no income or low doc meant the verification of income would not include the tax form 4605 since they knew the warehouse lender would not run the 4506 because the account reps were making sure all the brokers and their loan officers knew that fact. They did not care, they all made money at different levels but the juiciest commissions came from the volume and the yields generated by the upselling of the interest rates (Yield Spread premiums), on top of that they brokers and lenders made money in the securitization or structuring
of the loans in packages to be sold to the banksters such as Goldman, Lehman, Merrill, etc.
the kick backs and gifts were the rule of the day, underwriting standards came in second.
The fact that most people used all their savings and hard earned money to pay the mortgage did not matter, as it still does not. After reading the transcripts of the testimony given by the Head Underwriter of Citi under oath in which he states the large degree of fraud present in all their loans and whatever they acquired, only reaffirms this fact.
It only surprises me to see that most people still believe that we the borrowers are at fault. Well We never designed the loan products, we never lowered the underwriting guidelines, we were not given kick backs, nor did we were fully informed of all the hands that were in the pot.
When are the regulators going to stop all foreclosures and start forcing the real crook fix the problem, their toxic mortgages and now the fraudulent foreclosures.
Both forgot that systemic sub-prime origination fraud increased housing prices for all home buyers and renters; anybody who was not locked into a long-term mortgage before the fraud became rampant.
By allowing too much money into the system prices swelled for both home buyers, but also for renters: for anybody who hadn’t purchased a home before the bubble which, not coincidentally, is when the fraud became rampant.
Obviously the overwhelming majority of origination fraud came from mortgage lenders. Even if borrowers wanted to defraud banks in such large numbers bank underwriting systems could, would, and should have prevented that. The only way fraud on this scale could exist is if banks were engaged either explicitly, by perpetrating it, or implicitly, via defective fraud-screening products and processes. Hint, hint lawyers: quantifiable, enormous damages caused by defective products.