Why would the fraudulent nonprime lenders and brokers rely on financially unsophisticated borrowers to not only lie — but lie astutely? Why would working class borrowers know the amount of income they would have to falsely claim so that the loan would appear to meet the magic debt-to-income ratios that would get the loan approved and allow it to be sold at a premium? Why would the borrowers know that they could rely on the brokers and lenders to not verify income and to wink at claims that hairdressers made $100,000 annually? It strains all credulity to think that millions of working class Americans managed to defraud financially sophisticated lenders.
It is even more absurd to believe that honest lenders, finding themselves the victims of an epidemic of mortgage fraud by these clever working class Americans, responded by (1) massively expanding the number of liar’s loans they made, (2) spreading them to subprime borrowers with severe credit defects, (3) made defaults on the loans, and the loss upon default, far greater by layering risk and inflating appraisals, and (4) slashed their allowances for losses (ALLL) to trivial levels to ensure that the inevitable fraud losses would cause catastrophic losses.
Investigations, to date, have confirmed this logic. The fraudulent nonprime lenders and brokers typically initiated, directed, and sometimes even directly created the lies on the liar’s loans. The testimony of Thomas J. Miller (Miller, 2007), Attorney General of Iowa, at a 2007 Federal Reserve Board hearing began by describing the Gresham’s dynamic that the interaction of accounting control fraud and modern executive compensation produces:
Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete. Strong regulations will create an even playing field in which ethical actors are no longer punished. (p. 3)[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. A review of 100 stated income loans by one lender found that a shocking 90% of the applications overstated income by 5% or more and almost 60% overstated income by more than 50%. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer. (p. 10)
Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007. (note 2)
A small sample review of nonprime loan files by Fitch, the smallest of the three large rating agencies, adds support for the view that fraud became endemic in nonprime mortgage lending. Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files.
The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools. (Pendley, Costello, & Kelsch, 2007, p. 4)
Fitch did not investigate these loans. It simply reviewed the loan files and servicing files to identify frauds obvious on the face of the documents. They were able to identify likely frauds “in almost every file.” Any honest, mildly competent review of the loan files by the loan brokers and lenders would have prevented these loans from being closed. The logical conclusion is that the lenders and brokers encouraged fraudulent loans.
Michael W. Hudson’s new book, The Monster, reports on the results of numerous interviews with nonprime lenders. (He focused on Ameriquest.) Hudson reports that fraudulent nonprime lender personnel were compensated through perverse bonus programs that successfully encouraged them to do whatever it took to get liar’s loans approved. That included forging the borrower’s signature and changing information provided by the borrower to inflate income. He notes that:
One former loan officer and branch manager testified that inflating property appraisals served the “dual purpose of both making sure the loan was approved by the home office as well as making the loan more attractive to sell to investors” (p. 156).
Hudson also explains the tactics that loan officers use to intimidate borrowers to ensure that they did not read the false disclosures that the officers had fabricated (p. 157).
Recent studies by criminologists show the leading role that lenders and loan brokers took in creating fraudulent loan applications. Tomson H. Nguyen and Henry N. Pontell recently published an article reporting the results of their interviews with lender personnel and loan brokers. (I published the responsive policy essay on their article.)
The lender personnel overwhelmingly justified their actions by claiming that they were helping the borrower obtain the financing essential to permit them to become homeowners. They took the lead in creating the fraudulent values in the application because they knew the desired values. They perceived the lenders as not caring about the accuracy of the loan applications. There’s no real fraud from their perspective because everyone – the lender, the broker, and the borrower – knows that the numbers are fictions.
Mr. Kahr’s suggested remedy – to an epidemic of mortgage fraud numbering in the millions – is:
What is the best way to make defaulters aware of their potential criminal liability if they lie? Send all of them a brochure from a reputable, independent organization laying out the law and giving a few examples.
Been there, done that, the poster’s already on the bank’s wall. The FBI entered into what it terms a “partnership” with the Mortgage Bankers Association (MBA) to respond to the epidemic of mortgage fraud.
The MBA web page lists the accomplishment of this partnership: a poster warning borrowers that the FBI investigates mortgage fraud by borrowers.
The poster, of course, does not warn borrowers about mortgage fraud by…
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