Big Banks, Loan Fraud, and Moral Equivalence – Part Two

Posted on by Phil Querin

GavelIn Part One of my latest rant blog post, I took a look at the Big Banks and their sordid activities during the securitization heydays of 2005 – 2007/8. But I was just getting warmed up.  Part Two discusses how the banks have come to the aid of the prosecutors and courts in presenting themselves as “victims” that suffered “actual losses.”  This is patently untrue; the record must be set straight.  Part Two is my effort to do so.  ~PCQ 

In the prosecution of loan fraud, there are generally three components: (a) The guilt of the fraudster(s); (b) The jail sentence, which is measured in federal sentencing guidelines by the dollar amount of the fraud committed; and (c) The restitution imposed on the fraudster, which is also based upon the victim’s actual loss.

(a)    The word “guilt” is a slippery term.  If we were to define it objectively as representing the findings of a judge or jury, it is true that the convicted fraudsters are “guilty,” and the un-convicted CEOs, CFOs, and other Big Bank cronies, are “not guilty.”  The latter paid billions and billions of dollars responding to, and settling, civil and regulatory lawsuits, but it was always without any admission of guilt or threat of jail.

However, if we use the term “guilt” in a moral sense, the Big Banks are guilty.  If little Bobby gets caught with his hand in the cookie jar, but refuses to admit his guilt for stealing cookies, it certainly doesn’t mean he didn’t steal them; there were ten cookies there yesterday, and today there are five.

Let’s look back at just a few of the activities engaged in by some of the Big Banks, and using the prism of moral equivalence, ask whether or not their conduct was just as reprehensible as the fraudsters sitting in jail:

  • In July, 2012, we learned that HSBC, a British bank, was laundering billions of dollars for Mexican drug cartels and Iranian terrorists.  They even had two accounts under the name “Taliban.”  According to Senator Carl Levin’s report on HSBC, some $300,000 in transfers identified for “Persia” [the ancient name of Iran] were made through HSBC’s U.S. operation. Two HSBC U.S. transfers involved a shipping vessel identified as “NITC.”  These transactions were overlooked by the bank’s compliance officers.  If someone had taken the time to find out what “NITC” stands for, they would have learned that it was “National Iranian Tanker Company.” According to Sen. Levin, even though the chief U.S. banking regulator, the Office of Comptroller of the Currency [“OCC”], found hundreds of compliance violations that they had brought to HSBC’s attention, the OCC never issued a single formal – or informal – enforcement action against HSBC.   The American arm of HSBC ultimately paid a fine of $500 million dollars, but didn’t admit that its activities violated the federal Bank Secrecy Act.
  • According to an August 15, 2012 Wall Street Journal online article, another British bank, Standard Chartered, had engaged in 60,000 financial transactions for Iranian clients.  The total amount?  $250 billion.  And this wasn’t the first time Standard Chartered had been taken to the woodshed for money laundering activity. It ended up paying New York’ Department of Financial Services a $340 million fine. Again, with no admission of liability for violating federal laws.
  • As noted above, Goldman Sachs paid the SEC a $550 million fine, but never admitted liability for violations of U.S. securities laws for duping investors in the Abacus scheme, while at the same time, quietly placing big bets that their witch’s brew of toxic tranches would ultimately fail.
  • Also, as noted above, five Big Banks – B of A, Chase, Citi, Wells Fargo, and GMAC – collectively agreed to pay $25 billion for their roles as servicers, for the evils they visited upon distressed borrowers who had sought their help in loan modifications.  Again, no admission of liability for doing anything wrong, but thanks to their shenanigans, the term “robosigning” [i.e. using fraudulent and forged signatures and notarizations to process court foreclosure documents], entered the American lexicon.
  • Lastly, let us not forget the LIBOR scandal, which has not yet gone away.  For many folks who had adjustable rate mortgages during the Easy Credit Era, circa 2005 -2007, they may know about LIBOR, since it was the ubiquitous index to which interest rate adjustments were tied.  And folks may remember being pleasantly surprised when their interest rates adjusted downward, thus reducing the monthly payments on their first or second mortgages.

LIBOR stands for “London Inter-Bank Offered Rate” and it represents the average interest rate at which a select group of Big Banks engage in unsecured borrowing between each other. The story began back in 2008 when questions were being raised about whether these banks were manipulating the LIBOR process by influencing their submissions. As a part of their submissions, the banks were supposed to say how much it would cost them to borrow from each other at different times.   Since this is published information, apparently some Big Banks submitted low-ball rates to avoid looking to be in trouble during the financial and credit crisis. It also appears that some Big Banks, such as Barclay’s, were attempting to profit on their bets that were linked to LIBOR.  In other words, the lowball figures were not just for reputation, but also to manipulate rates for profit.  [In 2012, Barclays agreed to pay $453 million to the U.S. and U.K. regulators. There are 16 other Big Banks under investigation, including B of A, Citi, Credit Suisse, Chase, RBS, and UBS.

Sentencing the Fraudsters.  For sentencing as well as restitution, all the prosecutors appear to do is ask the Big Banks to provide them with (a) the unpaid balance of the loans at the time the bank took control of the property, minus (b) the fair market value of the property.  The jail term is determined by a third grade arithmetic calculation – subtraction. It is an incredibly simplistic – and incorrect – approach to the issue.

Notwithstanding the fact that the Big Banks had already sold their loans as securities into the secondary mortgage market and had been paid back in full from the investors they’d duped, these originating lenders willingly gather the requested information and provide it to the court.  Given the complexity of the securitization process, and the sleight of hand maneuvering by the Big Banks, the fact that they are not “victims” and did not suffer any loss, appears to be lost on the prosecutors and courts.  The fraudster gets the book thrown at him for giving the Big Banks exactly what they asked for – liar loans they could use to feed the Securitization Beast.  And that’s not all:

  • In the securitization trusts they set up for their investors, the Big Banks appointed themselves as the “Master Servicers,” thus paying themselves huge sums to handle the mortgage payments, property tax payments, and insurance payments as they came in for each loan.  It was a great gig.  And safe.  Although the servicers did have an obligation to advance funds to investors for defaulted loans, they kept track of every penny, and when the loan went into default, the servicer née bank, recovered it all back and then some. [1]
  • In addition, per the terms of their servicing agreements with the investors, the banks charged more to service non-performing loans – so long as the loan remained in the pool.  It was due to this fact that banks were incentivized to keep their struggling borrowers circling the financial drain, always on the cusp of foreclosure, but being deluded into believing help, in the form of a modification, was just around the corner.  This is why we hear story after story of people who have tried for years to get a modification, only to be unceremoniously denied when the lender finally pulls the plug, and commences foreclosure.

On October 18, 2010, the New York Federal Reserve, together with investors BlackRock, PIMCO, and others, sent a letter Bank of America, who was acting as servicer for billions of dollars of securitized loans originated by Countrywide, accusing it of, among other things, exacerbating its investors’ losses by continuing:

…to keep defaulted mortgages on its books, rather than foreclose or liquidate them, in order to wrongfully maximize its Servicing Fee, at the expense of the Certificateholders’ best interests, including rights to recover from pool or financial guaranty insurance policies.

In 2011, the matter settled, without any admission of liability, for $8.5 billion.

The point here is that the Big Banks made Big Bucks on bad loans, since they got paid extra by the investors, to service them.  Perhaps B of A and their cohorts should sign and send a huge “thank-You” card to the fraudsters for taking their money on too-good-to-be-true terms, and then defaulting.

  • Another incentive for the Big Banks to keep non-performing loans in the trusts, rather than foreclose them when they should have, was because, through the magic of creative accounting, they had no incentive to take losses sooner rather than later. From an accounting standpoint, recognizing losses requires the Big Banks to hold more capital in reserve. If they were required to account for assets at their market value – as John Q. Public does – it would mean than when their mortgage backed securities fell in value [as they did in 2008 – 2009] they would have to reduce their book value [called mark-to-market accounting or “MTM”] and increase capital on their balance sheets. But in April, 2009, Big Banks’ political hacks in Congress pressured the Financial Accounting Standards Board [“FASB”] to loosen the MTM rules. The result is that they were given wide latitude on their valuations of what were now illiquid securities. They could go back and revalue their toxic tranches, now following their own self-serving methodologies, and burnishing their formerly tarnished balance sheets. This fact acted as a disincentive for banks, as servicers, to quickly foreclose bad loans and recognize the loss.  They could liquidate bad loans on their own time – in order to control the flow of losses and increased capital demands.

So, back to sentencing and restitution.  On top of the fact that the Big Banks were not the “victims” and did not suffer any actual losses for loan fraud, it is clear that in many cases they took their own sweet time in foreclosing, since even though the loans were not performing for the investors – they were generating enhanced servicing fees for the Big Banks.  But these facts also appear lost on the courts when it comes to sentencing – the fraudsters get the book thrown at them based upon a mountain of interest, late fees and penalties that were piled on top of the static unpaid principal balances that never moved from the first day of default. In some cases, the foreclosure was not commenced for years. Yet the interest, late fees and penalties never came out of the banks’ pockets – they were reimbursed by the investors.

In other words, the Big Banks never lost a penny over bad loans made to folks who committed loan fraud.  As sponsors of the investment trusts, they were reimbursed from the investors for originating the loans at closing, and then dutifully packaged them all up, the good, bad, and ugly, and got paid handsomely to service them – even if a penny of payment was never made on the loan.

What About the Investors – Didn’t They Lose When Loan Fraud was Committed?  Maybe, maybe not. But one thing is for sure, it would be impossible to know.  As a part of the entire make-up of the investment trust, it was a given than some loans would fail.  They were the riskiest, and for that risk, investors were scheduled to get a higher rate of interest.  So if a risky loan failed, it would not come as a shock.  Due to the blended nature of the mortgages in the trusts, each tranche resembled a smoothie that consisted of good fruit and no-so-good fruit. The investor could decide what combination of fruit he or she wanted.

Here’s an example of why there may or may not have been any actual loss to investors for a loan fraudulently obtained:  Say a bettor at a horse race places a $100 bet on a long shot, and then hedges that bet by placing five $20 bets on five much better horses.  He could lose on the long shot, but recover well over the $200 invested, thanks to the better horses. If so, it’s hard to say he “lost” money on the overall bet.  He was aware of the risk, the long shot horse may have been in the race precisely to attract such bettors, and his hedge succeeded.  Likewise, it is impossible to say that a fraudulent loan that fails results in an actual loss to any investors.  [In fact, as discussed above, some tranches consisting of risky loans were intentionally placed in lower “first loss” positions, thus giving relative safety to higher tranches that would not suffer any loss until the protection from the lower tranches was exhausted. Moreover, since no investor actually owned a single intact mortgage – just bits and pieces of blended loans there could never be a direct dollar-for-dollar loss to anyone.]

Federal Sentencing Guidelines for restitution are quite specific: There must be actual loss to an actual victim.   Moreover, according to the Pooling and Servicing Agreements – the documents governing the operation of the REMIC trusts – even if the Big Banks could be trusted to take the restitution proceeds from the perps and voluntarily give them to the trustee, any such funds paid into the trust after closing must be allocated to the tranches based upon the priority of the tranche.  In other words, the senior tranches with prime loans would receive proceeds first, before the lower level tranches, even though the losses were more likely to have occurred on loans in the lower level tranches.  Accordingly, there is simply no way to know if an identifiable victim suffered an identifiable loss. The only thing for sure is that the Big Banks did not suffer any loss on any of its securitized loans.  Yet the fraudsters are sentenced by the court, and required to pay restitution, based upon a false narrative – that the Big Banks were victims when they were not.

Moreover, as mentioned above, during the securitization process, the Big Banks learned from their shills rating agencies, that if they purchased mortgage insurance on some of the toxic loans they were packaging, they could get higher ratings, thus getting them placed in higher tranches.  This was not something the borrower would ever know, since it was done after the loan closed, and during the securitization process. It was called, euphemistically, “credit enhancement” and was akin to putting lipstick on a pig. But since it wasn’t well known, do you think the Big Banks ever offered that information to the court during sentencing?[2]
What About Loans Retained by the Originating Bank?  Typically, if a Big Bank retained a loan in its portfolio, it was the second mortgage.  These were the piggy-backs that they piled onto the first loan to make up the 20% down payment. Additionally, even when folks didn’t need a second loan, they were often talked into a mortgage in the form of a home equity line of credit, or “HELOC.”  While it is true that these loans were frequently retained by the bank, they were normally much, much smaller than the 80% first mortgage that was securitized.

If I was fearful of jail time and restitution for one or more loans that I fraudulently obtained, I would much prefer that the court count the second mortgage, rather than the first.  We know the bank didn’t suffer a penny of loss on the first, though it possibly did on the second.  But given that I believe the Big Banks have the same honesty quotient as Lance Armstrong, I would want them to prove to me that they actually still own the loan.

In my opinion, if the second mortgage has been nonperforming for years, it could have been bundled up and sold in a portfolio of similar loans, for pennies on the dollar. If that is the case, it is not the Big Bank that is a victim.  They no longer hold the loan, choosing instead to take pennies on the dollar, rather than carry it on their books. The decision to sell was theirs.  [You can be sure if my car is totaled in an accident, and I sell it for scrap, I’m going to have a very tough time getting its full value from my insurance company.] 

Secondly, we know that the company that bought the loan did so, “in bulk,” with hundreds or thousands of others, paying a negotiated sum, and with full knowledge that most were losers, but some might be winners.  They have no “loss” on account of the loan fraud, since their cost basis in the acquisition of the second position promissory note was fully negotiated as a part of the purchase price.

Conclusion. So let’s revisit the moral equivalence side of loan fraud committed against Big Banks. As I stated above, I do not condone Fraud for Housing or Fraud for Gain. However, I suspect the former is considered a venial sin in the eyes of most, whereas the latter is less forgivable.

But from where is sit, I have little sympathy for the Big Banks, even as alleged “victims” of fraud for profit.  One obvious reason is because at least on their securitized loans, they suffered not a whit, although they act as “victims” when it comes to sentencing. Another reason is because they planned, designed, and executed the entire securitization template that made the frauds possible.  They had no “skin in the game,” passing the entire risk off to their investors within weeks of the actual loan.

First, they said:  “Take our money it won’t cost you a penny in fees.  We’ll finance 100% of your loan.”  Then they said “We don’t care about your credit rating, your income, or your ability to repay the loan.  And best of all, you can fill out your own financial statement – we promise not to peek.”  Next, they created loan products that made it deceptively easy to purchase more than one could afford; and then they proved it, by imposing no underwriting criteria on the loans they made.

Lastly, let’s look at the major players in this ruse. On the one hand we have sophisticated Wall Street bankers, who knew and understood risk; knew they wanted none of the toxic loans they were about to make, and shifted the entire risk to their investors. They intentionally closed their eyes to risk; their goal was simply to feed the Securitization Beast, with any type of loan they could make.[3]

On the other hand, we have folks like Ratso Rizzo in Urban Cowboy, a street smart con man, with no particular skills, but not a charlatan. The opportunity offered by the Big Banks appeared too good to be true.  The banks are faceless monoliths. It’s easy money. If things go wrong, they assume – just like the mortgage brokers and bankers told them – they can quickly sell the property at a tidy profit.  No one gets hurt.

I can’t help it! Moral equivalence begs to be invoked – especially when the fraudsters scam the banksters!


[1] If, at the time a fraudster is sentenced, the Big Banks had any further involvement with the loans they securitized and sold, it is only as self-appointed servicers of the REMIC trusts.

[2] Lest anyone argue that the insurance company has incurred an actual loss, I would disagree.  The insurance company is in the business of risk.  It calculates the risk and determines the premium based upon known statistics.  It then uses the premiums to invest and make money. If the company knows what it is doing, no loss incurred should be unexpected, and certainly, income from premium investments should exceed losses.

[3] The philosophy of Anthony Mozilo, CEO of Countrywide, was to fund all the loans they possibly could, regardless of borrower qualifications. According to an August 28, 2013 Salon story, his license plate read: “FUND-EM”.

Posted in Lenders, Market Conditions, Miscellany, Mortgage Insurance, Ratings Agencies, Real Estate General, Real Estate/Distressed, Servicers, Subprime Mortgages | Tagged , , , , ,
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