William K. Black was a federal regulator during the Savings and Loan crisis and appears in Michael Moore's 'Capitalism: A Love Story'
Written with L. Randall Wray
Our call for closing down control frauds and stopping the foreclosure frauds typically meets with three objections. First, it is claimed that while there were some bad apple lenders, much of the fraud was committed by borrowers. Our proposal would let fraudulent borrowers remain in homes to which they are not entitled, punishing the banks that were duped. Second, the biggest banks are too important to foreclose. And third, it is not possible to resolve a "too big to fail" institution.
Who is Guilty?
Let us deal with the "borrower fraud" argument first because it is the area containing the most erroneous assumptions. There was fraud at every step in the home finance food chain: the appraisers were paid to overvalue real estate; mortgage brokers were paid to induce borrowers to accept loan terms they could not possibly afford; loan applications overstated the borrowers' incomes; speculators lied when they claimed that six different homes were their principal dwelling; mortgage securitizers made false reps and warranties about the quality of the packaged loans; credit ratings agencies were overpaid to overrate the securities sold on to investors; and investment banks stuffed collateralized debt obligations with toxic securities that were handpicked by hedge fund managers to ensure they would self destruct.
That homeowners would default on the nonprime mortgages was a foregone conclusion throughout the industry -- indeed, it was the desired outcome. This was something the lending side knew, but which few on the borrowing side could have realized.
The homeowners were typically fraudulently induced by the lenders and the lenders' agents (the loan brokers) to enter into nonprime mortgages. The lenders knew the "loan to value" (LTV) ratios and income to debt ratios that they wanted the borrower to (appear to) meet in order to make it possible for the lender to sell the nonprime loan at a premium. LTV can be gimmicked by inflating the appraisal. The debt to income ratios can be gimmicked by inflating income. "Liar's" loan lenders used that loan format because it allowed the lender to simultaneously loan to a vast number of borrowers that could not repay their home loans, at a premium yield, while making it look to the purchaser of the loan that it was relatively low risk. Liar's loans maximized the lender's reported income, which maximized the CEO's compensation.
The problem is that only the most sophisticated nonprime borrowers (the speculators who bought six homes) (1) knew the key ratios they had to appear to meet, (2) had the ability to induce an appraiser to inflate substantially the reported market value of the home, and (3) knew how to create false financial information that was internally consistent and credible. The solution was for the lender and the lender's agents to (1) instruct the borrower to report a certain income or even to fill out the application with false information, (2) suborn an appraiser to provide the necessary inflated market value, and (3) create fraudulent financial information that had at least minimal coherence.
When the overburdened homeowner began missing payments, late fees and higher interest rates kicked-in, boosting the stated income of mortgage servicers and the value of the securities. Not coincidentally, the biggest banks own the servicers and could maximize claims against the mortgages by running up the late fees. It was quite convenient to "misplace" mortgage payments, so even homeowners who were never delinquent could get hit with fees and higher rates. And when payments were received, the servicers would (illegally) apply them first to the late fees, meaning the homeowners were unknowingly still missing mortgage payments. The foreclosure process itself generates big fees for the SDI banks.
And, miracle of miracles, the banks would end up with the homes and get to restart the whole process again -- from resale of the home through the financing, securitizing, and fee-for-servicing juggernaut.
Unfortunately, it did not go quite as smoothly as planned. The SDIs were supposed to act like neutron bombs -- killing the homeowners but leaving the homes standing, to be resold. The problem is that wiping out borrowers lowered the value of real estate, crushing not only the real estate market but also construction and through to all associated sectors from furniture and home restoration supplies to big ticket purchases that rely on home equity loans. It also led to questions about the value of the securitized toxic waste manufactured and held directly or indirectly by financial institutions.
Next, a few judges began to question the foreclosures, as they saw case after case in which the banks claimed to have lost the paperwork or submitted amateurishly forged documents. Or, several banks would go after the same homeowner, each claiming to hold the same mortgage (Bear sold the same mortgage over and over). Insiders began to offer depositions exposing fraud and perjury. It became apparent that in many and perhaps most cases, the trusts responsible for the securities (often these are "special purpose" subsidiaries of the banks) never received the "notes" signed by the borrowers -- as required by both IRS tax code and by 45 of the US states. Without the notes, billions of dollars of back taxes could be due, and the foreclosures violate state law. Finally, the Attorneys General of all fifty states called for a foreclosure moratorium.
What to do? We suggest an immediate moratorium on foreclosures and a requirement that all notes be produced by purported holders of mortgages within a reasonable length of time. If they cannot be found, the mortgages -- as well as the securities that pool them -- are no longer valid. That means that the homeowners are not indebted, and that the homes are owned free and clear. And that, dear bankers, is a big, big problem. It is also the law -- without evidence of debt, there is no debtor and no creditor.
Commentators are horrified that a foreclosure moratorium would let "deadbeat" borrowers remain in their homes while delinquent in their payments. The speculators that purchased "MacMansions" and stated on six separate loan applications that each house was their principal dwelling are frauds. The moratorium would (briefly) reward fraudulent borrowers while (briefly) punishing the fraudulent banks. This is true.
It is not possible to separate "worthy" borrowers who were duped by banks from all "unworthy" borrowers who knew the loan applications were false. Indeed, given the millions of borrowers that received liar's loans, even if the borrowers were all frauds we could not possibly prosecute all of them due to lack of resources. We currently prosecute roughly 1,000 mortgage fraud cases annually at the federal level. If we used all of our resources to investigate and prosecute fraudulent mortgage borrowers exclusively we would be able to prosecute less than one-tenth of one percent of those frauds.
The losses that the fraudulent nonprime lenders caused are vastly greater than the losses caused by fraudulent borrowers, so no rational prosecutor would use his scarce resources to prosecute individual nonprime borrowers. Moreover, prosecutions of individual borrowers for alleged fraud in the applications would be difficult to win against competent defense counsel because it will not be possible to infer the borrower's intent and knowledge and whether the loan agent instructed him to enter specified information on the application. We are not arguing that the speculator who committed fraud while buying six homes should be allowed to walk free. We are simply arguing that it makes no sense to use limited judicial resources to go after owner-occupier households where it will be almost impossible to prove intent to defraud.
On the other hand, we can infer a lender's fraudulent intent because it is financially sophisticated and has expertise in lending. An honest mortgage lender would not make "liar's loans" because absence of proper underwriting inherently produces loans that are expected to default. Yet, in 2006 just about half of all mortgages originated were liar's loans. Banks happily advertised specialization in "no doc" and NINJA loans. There can be no question about intent -- the intent was fraud, plain and simple. Fraud on the part of credit raters is equally easy to infer -- we have the internal emails that document intent to defraud securities purchasers by "pay to play" schemes. And the fraud committed by the investment banks that pooled the mortgages is also well documented. These entities committed tens of thousands and even millions of frauds each. For obvious efficiency reasons, that is where our judicial resources ought to be directed.
Macro Effects and Culpability
There is one other consideration that biases the case in favor of borrowers. Many homeowners were sold on the idea that "real estate values only go up" -- and quite a few planned to refinance on better terms, or even to flip the house at a price that would allow them to pay-off a mortgage they could not otherwise afford. We realize that it is not easy to shed tears for speculators foiled by the market, and that is not our point.
What is important to understand, however, is that the financial sector is largely culpable for the generation of speculative frenzy, the creation of the "financial weapons of mass destruction", and the transformation toward financial fragility that finally collapsed in 2007. In the aftermath we lost 10 million jobs and millions of homeowners lost their homes. The "collateral damage" inflicted by the SDIs is now endangering tens of millions of American families -- most of whom played no role in the speculative euphoria. Almost half of American homeowners are already underwater or on the verge of going under. In short, it was Wall Street that turned our homes over to a financial casino -- and so far virtually all the losses have been suffered on Main Street.
This culpability is at the aggregate scale and of course no individual bank can be held liable in court for the collapse of the financial system. Rather, each bank's guilt must be assessed according to its own fraud. However, a national moratorium on foreclosures must be evaluated at the macro level, and justified on the basis of the aggregate costs, benefits, and moral implications. And certainly at the aggregate level that must be considered by President Obama, the benefits to the majority of Americans clearly outweigh the costs imposed on the relatively few. And the morality is also on the side of homeowners and clearly against the banks.
Closing the control frauds would actually benefit honest bankers by eliminating the "Gresham dynamics" created by fraudulent institutions -- a race to the bottom in underwriting. Since fraudulent banks use accounting fraud to manufacture high profits, they do not actually have to use a viable business model. By eliminating control fraud from the financial sector, it will be much easier for honest banks to succeed.
Further, the financial system has massive excess capacity -- as evidenced by the need to create bubble after bubble to find outlets for capacity. Almost all of the innovations in practice and instruments of the past two decades were spurred not by demand but rather by excess capacity. Downsizing the financial sector is critical to restoring it to a size that is commensurate with the needs of the economy.
The cost of not closing control frauds, by contrast, can be staggering. The business practices that maximize the fictional reported income (e.g., making "liar's loans to people who cannot repay their loans) maximize real losses and hyper-inflate financial bubbles. Control frauds destroy wealth at a prodigious rate. The one thing we certainly cannot afford is leaving the control frauds under the control of fraudulent CEOs.
Can the Frauds be Foreclosed?
The assertion that the SDIs cannot be resolved because of their size is unsupported. Very large institutions have already been resolved both in this country and abroad. The "too big to fail" (TBTF) doctrine has always been unproven, dangerous, and counter to the law. An institution that is not permitted to fail faces obvious adverse incentive problems. It also destroys healthy competition with institutions that are not considered TBTF. It encourages risk-taking and fraud. And it subverts the law, which requires that insolvent institutions must be resolved.
As we write this piece, the markets are taking it upon themselves to begin to close down the control frauds -- with homeowners fighting the foreclosures and investors demanding that the banks take back the toxic waste. Unfortunately, following the market solution will be a long-drawn-out and costly process -- both in terms of tying up the judicial system but also in terms of the uncertainty and despair that will persist. At the end of that process, the banks will have to be resolved. No matter how much the politicians dislike it, they will end up with the banks in their hands -- either now or later. Taking them now is the right thing to do.
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