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

Take the Bonus and RunIntroduction. As the Big Bank scandals appear to be diminishing, I’ll admit that it’s probably time to get over the RATs (Rapers of the American Taxpayers), and move on to other more uplifting topics for this blog site. Perhaps I will….

But first, I want to tackle a topic that I’ve never addressed on this blog site – loan fraud. That is, those scams and schemes in which, during the easy money days, circa 2005 – 2007/8, individuals intentionally falsified financial information in order to obtain loans they could not have otherwise qualified for.  There were two basic types: Fraud for Housing [i.e. the borrower falsifies financial information to purchase a home to live in] versus Fraud for Gain [i.e. the borrower, individually, or with others, falsifies financial information to purchase homes to rent out or flip, for personal profit.]  Both types of fraud were made possible as a result of rapidly escalating home prices, alluring [some might say ‘too good to be true’] loan programs and non-existent lender underwriting. In those days, if you could fog a mirror, you could get a loan.

Fraud for Housing is probably a couple of clicks closer to True North on the Moral Compass than Fraud for Gain, but both are illegal.  I condone neither. In order to appreciate the risk of falsifying information to a federally insured lender, it is instructive to understand how broadly fraud is defined:

(a) Except as otherwise provided in this section, whoever, in any matter within the jurisdiction of the executive, legislative, or judicial branch of the Government of the United States, knowingly and willfully—

(1) falsifies, conceals, or covers up by any trick, scheme, or device a material fact;

(2) makes any materially false, fictitious, or fraudulent statement or representation; or

(3) makes or uses any false writing or document knowing the same to contain any materially false, fictitious, or fraudulent statement or entry;

shall be fined under this title, imprisoned not more than 5 years or, if the offense involves international or domestic terrorism (as defined in section 2331), imprisoned not more than 8 years, or both. If the matter relates to an offense under chapter 109A, 109B, 110, or 117, or section 1591, then the term of imprisonment imposed under this section shall be not more than 8 years. [See, 18 United States Code, §1001, here.]

One does not need to be a Wall Street lawyer to appreciate how all-encompassing the proscription is; if you intentionally give materially false information, committed either by omission or commission, you could be looking at Hard Time in the Big House.

And to make sure that federally insured lenders are on board – i.e. they don’t turn a blind eye to fraudsters in their zeal to make and securitize loans – the Office of Comptroller of the Currency has a website specifically dedicated to the filing of “Suspicious Activity Reports” or “SARs” with the Financial Crimes Enforcement Network (“FinCEN”).  It provides that:

A financial institution is required to file a suspicious activity report no later than 30 calendar days after the date of initial detection of facts that may constitute a basis for filing a suspicious activity report. If no suspect was identified on the date of detection of the incident requiring the filing, a financial institution may delay filing a suspicious activity report for an additional 30 calendar days to identify a suspect. In no case shall reporting be delayed more than 60 calendar days after the date of initial detection of a reportable transaction. [See, link here.]

As a result, during this time, there were many people caught and prosecuted for loan fraud.  And since this was a federal crime, it involved the FBI and others, bringing the blunt force of Big Brother down on the perps.  It could be scary stuff.

Why and How Did This Happen?  Although I suspect most sentient beings have a pretty good idea why this happened, I’m going to give a short primer for those just returning from the Moon.

  • Instead of making plain vanilla loans as in the past, Big Banks began creating innovative programs that made loans appear to be more affordable, such as interest-only loans, negative amortization loans [where the borrower paid less than interest only, with the shortfall being added back to the principal], and adjustable rate loans, with low “teaser rates” at the front end, making them more attractive and easier to qualify for.
  • Instead of requiring borrowers to come up with a minimum 20% down payment or buy mortgage insurance for the shortfall, banks gave borrowers a second loan, or “piggyback,” to make up the difference. [E.g. the borrower pays $10,000 down on a $200,000 home, and gets an 80% first mortgage for $160,000 and a $30,000 second mortgage.]  In many instances, the second mortgage would be for the entire down payment, perhaps even including closing costs.  Essentially, the borrower could buy a $200,000 home using 100% of OPM [Other People’s Money]. Pretty slick – for a while.
  • Next, the Big Banks threw away all of their underwriting manuals.  No money?  No credit? No problem! Other than adjusting the rate of interest depending on credit score, poor credit did not automatically disqualify borrowers from loans. And to make it even more enticing, the Big Banks made “no doc loans,” where no verifiable proof of household income was required; borrowers were left to fill in their own financial information – wink, wink. Many of these loans were made to folks with “less than perfect” [Read: “poor”] credit, who filled the ranks of the subprime lending market.

Why Didn’t the Big Banks Care if Their Borrowers had no Money?  The answer to this question is a little more complicated.  I wouldn’t blame anyone for not understanding – except of course, Henry Paulson, then Secretary of the Treasury, Alan Greenspan, then Chairman of the Federal Reserve, and all of the others government officials who were supposed to be guarding the henhouse from the Wall Street Wolves, rather than serving as their doormen.

The reason the Big Banks didn’t care if their borrowers had no money was because they were selling these toxic subprime loans almost as soon as they made them.  They were bundled into huge trusts [called “Real Estate Mortgage Investment Trusts” or “REMICS”] by the hundreds of millions of dollars and sold to willing investors for a stream of income – i.e. the borrowers’ monthly principal and interest payments – at attractive rates of return.[1]  But it wasn’t as if investors actually purchased one or more intact mortgages. Instead, the loans were sliced into separate pieces [called “tranches” – a French word meaning” slice,” but having more cache’ than the plebeian English word].  Some tranches contained safer prime loans with lower yields, others contained riskier subprime loans with higher yields, and others contained a bit of each.  And based upon the tricks [called “credit enhancements”], which will be discussed later, taught them by the credit rating agencies, the Big Bank sponsors of these trusts arranged the tranches so that even the riskier subprime loans got investment grade ratings.  There was something for everybody’s risk appetite.

This process is known as “securitization,” since the loans were packaged into products known as “investment securities” which are supposed to be tightly regulated by the Securities and Exchange Commission or SEC.  Unfortunately, like the Federal Reserve, the Office of Comptroller of the Currency, the Secretary of Treasury, and every other federal regulator who was supposed to keep their eye on the ball, the SEC was also asleep at the switch.

One consequence of securitization is “moral hazard,” meaning that people and institutions are more apt to take risks if there is little or no downside. Clearly, the securitization process was awash in moral hazard, since, by making risky loans and then immediately selling them to third parties, the Big Banks had no “skin in the game.”  They were paid back by the investors’ funds, and if a loan failed, it was the investors’ problem, not the banks’.  Low level tranches were designed to take the “first losses” [like rising waters flooding the lower stories of a tall building first] thus insulating higher level tranches from risk.  However, what apparently wasn’t fully appreciated was the fact that the higher level tranches contained subprime loans that were only there because of credit enhancements and other tricks. In other words, the safety of these toxic loans was illusory.

Lest anyone ask, “Well how dumb were these investors?  Didn’t they know this was junk? Didn’t anyone warn them?”  The answer harkens back to a scheme used in the 19th century when travelling snake oil salesmen pedaled their wares from town to town.  And in every crowd listening to the pitchman was a shill – in cahoots with the quack salesman – who loudly proclaimed the health benefits of the snake oil for his aches and pains.  Soon, the rest of the crowd bought both the line and the snake oil.

The 21st century equivalent to this ruse was the ratings agencies, like S&P and Moody’s.  They acted as high paid shills for the Big Banks, and for a handsome fee, would give “investment grade” ratings to the toxic tranches.  This then qualified the investments for purchase by large pension and municipal retirement funds.  For more in-depth discussions of the ruse, go to my blog posts here, here, and here.

Ironically, at the same time the Big Banks were paying Big Bucks to their shills in the ratings industry to hype their securitized loans as spun gold rather than straw, they were also betting against the success of the securities they had bundled and sold. In other words, after making millions on the sale of the securities, they also stood to win big if the junk actually turned out to be junk – i.e. if it failed.

In 2010, Goldman Sachs paid a record fine of $550 million for their Abacus scam which did exactly that.  And Goldman was not alone. All of the Big Banks, such as B of A, Chase, Citi, Wells Fargo, and GMAC [renamed “Ally” to shake off the scarlet letter of its past] each paid millions in fines and damages for their graftAnd these were just a few of the American banks. Foreign banks, such as Barclays, Royal Bank of Scotland (“RBS”), Deutche Bank, Credit Suisse, and HSBC, were also inducted into this Rogues Gallery of miscreants. Of course, it was only money the Big Banks lost – not a single CEO, CFO, or other top executive went to jail – or even had to sit in the corner during recess.  And further, the financial institutions rarely ever admitted “guilt” as a part of their financial settlements.

So, What Happened?  Answer: Murphy’s Law – if something can go wrong, it probably will. In this case, it was just a matter of time before things imploded.  The big banks could pump and dump their securitized bundles of risky loans only so long.  Eventually, it became apparent in the late summer of 2007 that cracks were appearing in the banking system from several sources:

  • Those in the know realized that many subprime loans were failing, sometimes shortly after closing.  The message, of course, was that the securitized loan pools were unsafe investments – i.e. the subprime loans were, indeed, risky.  Many banks and investment houses paid big premiums to the large insurance company, AIG, betting these securitized obligations would fail.  Why AIG took the long side of that bet is anybody’s guess – but it all turned out well for them when they lost their proverbial shirt, since the federal government bailed them out to the tune of $68 billion in TARP funds.[2]
  • Housing prices were starting to slump, due, in part, to overbuilding, as well as prices reaching levels that defied financing.
  • The shadow banking system – an unregulated and opaque intra-bank funding system – added two inter-related problems affecting the Big Banks’ confidence in each other.  The term “shadow banking” describes how banks and investment houses[3] (collectively, “Big Banks”) secured funding:
    • They were used to entering into overnight and very short term secured loans with each other.  This is called the “repo market,” and it was an important and necessary tool for banks to fund their daily operations.
    • All of the securitized loan pools were maintained in off-balance sheet vehicles, making it impossible to know their sponsors’ true financial picture.
  • In July-August, 2007 the shills ratings agencies [ostensibly independently of each other] apparently with collective pangs of conscience, made mass downgrades in the previous “investment grade” ratings they had been giving to the securitized loan pools issued by the Big Banks.  Once they downgraded these investments, the large institutional investors that had purchased them in reliance upon their highly touted investment quality, were forced to dump them; many at huge losses.  This was the death knell for the private securitization market; the source of funding for billions in subprime lending dried up.  Obviously, if banks had to actually retain the loans they made, it meant they would have to live with their own bad underwriting decisions. They would never let that happen, any more than the chef who knew his food was toxic would eat his own fare.  The result was predictable; the Big Banks stopped making subprime loans.

It was not long before some banks began to look at each other with concern.  It was anybody’s guess whether one of the Big Banks would collapse under the weight of its own risk taking.  And thanks to the opaque nature of their books – the securitizations were all carried “off balance sheet” – there was no way to know each other’s true financial picture. Some investment banks, such as Bear Stearns and Lehman Brothers, then two of the largest underwriters of mortgage backed securities, were viewed as being at risk of collapse; investor and lender confidence dried up.  They were viewed as zombies – alive, but dead.  As this was occurring, housing prices had begun to fall, new homes were not flying off the shelf, lender underwriting tightened, and investors migrated elsewhere.  It was the perfect storm; Murphy’s Law, in spades.

Big Banks as “Victims” – A Study in Moral Equivalence.  The term “moral equivalence” is used here as a part of our discussion of Big Banks as “victims” of loan fraud. The concept presupposes the existence of a moral hierarchy, where some wrongs are “less wrong” than others.

I agree that the use of moral equivalence in rhetoric is a poor substitute for logic and objectivity.  If “two wrongs don’t make a right,” then there should be no place in my polemic against the Big Banks for an argument based upon moral relativism.  However, as a human being, it is impossible for me to ignore a certain amount of irony in the criminal prosecution of those committing loan fraud against companies whose very existence requires a complete absence of institutional morality; where success is measured in dollars, regardless of source; getting caught means nothing more than setting up capital reserves for the day of reckoning long after the public has forgotten the event; where there is no such thing as institutional shame; and a lower stock price is the only penance paid for transgressions that would put ordinary mortals behind bars.

Herewith are my thoughts:

[To be continued….]

[1] Remember: Subprime loans were made at higher rates of interest because of the higher risk of default. Thus, their yield to investors was higher – as long as they continued to perform.

[2] Wait! Why didn’t the federal government just let them take out bankruptcy, like Lehman and others?  Hint: Henry Paulson, the Secretary of the Treasury was the former head of Goldman Sachs.  It was his alma mater! Goldman, and many of the other Big Banks, would not have recovered dollar-for-dollar the billions they did on their bets, if AIG declared bankruptcy – instead they would have had to stand in line for pennies on the dollar.  So the government gave AIG billions in TARP funds, compliments of the American Taxpayer, so it could cover the stupid counter-party bets it made with the Big Banks.  If “stupid” is too strong a word, riddle me this:  Why would you bet that an investment would succeed [the “long” side], when the company on the other side of the bet [the “short side”] that designed the investment and filled it with handpicked mortgage securities, was betting it would fail?  Using a more prosaic analogy, it’s like a chef taking out life insurance on the patrons eating his fare.  One might conclude that perhaps the chef knows the ingredients he’s feeding them better than the insurance company on the long side of that bet.

[3] I make the following distinction between “banks” and “investment houses” [or “investment banks”]: The former entity has depositors, while the latter does not.  Goldman Sachs was a large investment bank, until it opportunistically changed its charter and became a federally regulated “bank” so that it could partake in the government’s billion dollar largesse known as the “Troubled Asset Relief Program” or “TARP.”