The housing appraisers warned us about the crisis but we didn’t listen

by William Black / on 11 July 2013

https://www.creditwritedowns.com/2013/07/housing-appraisers-warnings-fraud-crisis.html

On July 9, 2013 I participated in a radio interview with a lobbyist for the 100 largest financial firms.  The San Francisco radio program host asked me what question I would ask the lobbyist and I said that any discussion should begin with allowing him to state his view of what caused the crisis.  In the course of his explanation, he bemoaned the fact that there was no warning about the crisis.

I found this ironic because I had just published that morning an article about how the appraisal profession warned us that the senior officers controlling the mortgage lending firms were engaged in pervasive “accounting control fraud.”

That article discussed the ten logical implications about the developing fraud epidemic that any competent financial regulator could have explained to FBI agents and Assistant U.S. Attorneys (AUSAs) on the basis of the facts contained in these two sentences:

“From 2000 to 2007, [appraisers] ultimately delivered to Washington officials a petition; signed by 11,000 appraisers…it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18).

Note that the appraisers’ petition began in 2000 and was public.  When the regulators and prosecutors did nothing in response to the appraisers’ warning the appraisers delivered it to government officials to ensure that no one could say they were not warned.  What tends to be forgotten is that the mortgage industry’s leaders did nothing to restrain the fraud epidemic and a great deal to expand it.  A finance industry representative claiming in 2013 that no one warned the industry of the coming crisis when the warnings began no later than 2000 epitomizes the industry’s death of accountability, integrity, and candor.

Any of the following federal actors could have responded to the appraisers’ warning and prevented the crisis: the Federal Reserve, the FBI/Department of Justice, the lenders’ CEOs, the secondary market purchasers’, Clayton and the other “due diligence” firms, the lenders’ and secondary market purchasers’ internal and external auditors, the credit rating agencies, the SEC, Congress, and President Bush.  Several of the state Attorney Generals had sufficient staff to prevent the crisis.  The industry and federal leaders took no effective action.  The states took two major actions against appraisal fraud, but neither was effective because they never understood the significance of the facts they found.

Public Integrity’s Article on Appraisal Fraud    https://www.publicintegrity.org/2009/04/14/2895/appraisal-bubble

It turns out that by reading a single article, and adding some analytics, one can explain why the industry and the federal government failed to act and why the Department of Justice (DOJ) still refuses to prosecute the controlling officers of the mortgage lenders and secondary market purchasers.  The most depressing aspect of the ineffective responses to the appraisers’ warnings, however, is the two efforts by state prosecutors to respond to the epidemic of appraisal fraud.  These efforts were well-intentioned but failed to even slow the epidemic of accounting control fraud because they failed to understand the implications of appraisal fraud.

The single article, published in 2009, that allows us to understand the myriad failures is entitled “The Appraisal Bubble.”    https://www.publicintegrity.org/2009/04/14/2895/appraisal-bubble

The article is excellent in its presentation of many of the essential facts, but incomplete on several vital analytical areas.  One of the odd factual weaknesses, which produces several analytical weaknesses, is that a story devoted to discussing appraisal fraud does not mention the appraisers’ petition.

The Pack of Dogs that Didn’t Bark about Appraisal Fraud

The federal banking regulators and the SEC are the dogs that do not bark in the Public Integrity story.  This is a testament to how effective a strategy of appointing anti-regulatory leaders is to producing a self-fulfilling prophecy of regulatory failure.  The article does not mention the SEC or the federal banking regulatory agencies.  In one sense, this is perfectly understandable, for they did not launch a national investigation of appraisal fraud despite the federal banking examiners documentation of widespread appraisal fraud.  The leaders of the federal banking regulatory agencies never understood the implications of appraisal fraud even for the individual banks they were supposed to regulate.

The Federal Reserve had unique statutory authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to regulate all mortgage lenders – even those whose deposits were not federally insured and were not normally subject to federal banking regulations.   The Fed refused to use that authority to halt the epidemic of mortgage fraud (including appraisal fraud), until July 2008, when it finally adopted a rule barring (endemically fraudulent) liar’s loans.  Even then, it delayed the effective date of the rule by well over a year because one would not wish to interfere with mortgage fraud.

The SEC had limited, but sufficient, regulatory jurisdiction over the credit rating agencies.  It could have forced them to take mortgage fraud (including appraisal fraud) seriously, which would have spiked the secondary market.  The SEC also had, in the key years of the frauds, “consolidated supervision” authority over the five largest investment banks.  The SEC approved this program in April 2004.  The program was a scam to aid the largest investment bank escape EU regulation through the creation of a fake U.S. regulatory regime, but the SEC could have used the authority to investigate the appraisers’ petition and the epidemic of mortgage fraud.  The investment banks and their affiliates were among the worst of the worst in committing appraisal and mortgage fraud and purchasing fraudulent mortgages and then reselling them in the form of collateralized debt obligations (CDOs).

The fact that an article all about the response to the epidemic of appraisal fraud never mentions the federal banking regulatory agencies and the SEC is immensely revealing – but it also reveals that the authors of the article did not understand the implications or it would have been a major focus of their article.  The problem is in part circular. It is the job of the regulators to sound the alarm about incipient or raging fraud epidemics and to explain the implications to the public and journalists.  This is a function Bank Board Chairman Gray assigned to me during the S&L debacle, but this crisis had no Gray, so it had no Black.  Instead, it had anti-regulators eager to see anything but control fraud.

The article begins well, but notice that it lets the myriad private sector actors that could have prevented the epidemic of accounting control fraud off the hook.

“Before real estate prices began to plummet in 2006, some sounded the alarm on fraudulent appraisals and lender pressure, but few listened to the warnings, least of all Congress, industry regulators, and the Justice Department.”

Appraisal Fraud is a Marker for Accounting Control Fraud

In fairness, the phrase “least of all” applies to the private actors for they actively encouraged the fraud epidemic.  The private sector vigorously opposed any governmental discouragement, much less crackdown, on the raging fraud epidemic.  One element of the federal government, the FBI, performed well in the early years of the epidemic.  Chris Swecker, the FBI official assigned to take the lead on mortgage fraud, issued the famous twin warnings on mortgage fraud in September 2004.  The FBI warned that there was an “epidemic” of mortgage fraud and predicted that if it were not stopped it would cause a financial “crisis.”  The fundamental limitation of the FBI’s twin warnings was a failure to understand that they were confronted with an epidemic of accounting control fraud.

The authors of the article do not note the twin FBI warnings in 2004 and they do not note that the warnings did not identify the source of the mortgage fraud epidemic – the officers controlling the lenders.  That is doubly unfortunate in terms of the analytics for it means that the article about appraisal fraud does not discuss the single most important analytical lesson that the endemic appraisal fraud should have taught contemporaneously.  Widespread appraisal fraud is the cleanest “marker” of widespread accounting control fraud by mortgage lenders and secondary market purchasers.  The appraisal is one of the most important protections against loss a mortgage lender has.  No honest lender would inflate appraisals.

Only lenders can induce widespread appraisal fraud.  They do so by causing a “Gresham’s” dynamic in which cheaters prosper, which causes markets and professions to become perverse and causes those with the worst ethics to drive those with the best ethics out of the markets and professions.  Lenders create the Gresham’s dynamic by leading the sales price to the appraiser and blacklisting appraisers who refuse to inflate the appraisal to be at least as large as the sales price.  Honest mortgage lenders have known for decades how to prevent inflated appraisals fraud.  They create the proper financial incentives for the appraisers and they use review appraisers to ensure competence and honest appraisals.  They refuse to hire appraisers who are incompetent or unethical.  Episodic appraisal fraud may still occur, but it is exceptionally difficult to commit widespread appraisal fraud against an honest lender.  It is impossible to do so for any material time against an honest, competent mortgage lender.

Widespread appraisal fraud by mortgage lenders optimizes accounting control fraud.  The fraud “recipe” for a mortgage lender (purchaser) has four “ingredients.”

1.      Grow like crazy by

2.      Making (purchasing) really crappy loans at a premium yield (interest rate) while

3.      Employing extreme leverage (very high debt to equity ratios), and

4.      Providing only grossly inadequate allowances for loan and lease losses (ALLL)

George Akerlof and Paul Romer wrote a famous article in 1993 entitled “Looting: The Economic Underworld of Bankruptcy for Profit.”  They agreed with the central finding of competent financial regulators and white-collar criminologists: following this recipe produces a “sure thing.”  More precisely, following the recipe produces three sure things.  The lender (purchaser) will report record (albeit fictional) profits in the near term, the controlling officers will promptly be made wealthy by modern executive compensation, and the lender (purchaser) will suffer severe losses in the longer term.  Akerlof and Romer also agreed with our findings that the first two “ingredients” optimized the fraud “recipe” as a device for hyper-inflating financial bubbles and that hyper-inflating the bubble greatly increased the life and damage caused by the epidemic of accounting control fraud.  The frauds can simply refinance the bad loans and report additional (fraudulent) income.  The saying in the trade is “a rolling loan gathers no loss.”

Note that deliberately making (purchasing) bad mortgage loans means that the “expected value” of those loans is negative at the time the loans are made (purchased).  The bubble may postpone the losses for years, but bubbles must stop.  As soon as the bubble stops expanding, even before prices collapse, it becomes impossible to refinance the bad loans and the lenders (purchasers) begin to suffer serious losses.  By late 2006, a wave of mortgage bank failures began that by the end of 2007 had largely swept away the fraudulent mortgage bankers.

Widespread appraisal fraud is also a superb marker of a total breakdown of internal and external private sector controls (the auditors, due diligence reviewers, credit rating agencies, and the creditors who are supposed to exert “private market discipline”).  Widespread appraisal fraud that does not lead to massive rejections of mortgages tendered for resale in the secondary market is a sure marker of a secondary market that will produce severe losses.  That same logic applies to the market for collateralized debt obligations (CDOs) and those providing “credit enhancements” to CDOs (the monoline insurers and those selling credit default swaps (CDS) as guarantees of CDOs).

There were no mass rejections by the secondary market of mortgage loans made through appraisal fraud.  There were no mass rejections by those packaging CDOs and there were no adverse consequences for the credit ratings of the mortgages, MBS, or CDO tranches as a result of the widespread issuance of fraudulent mortgages backed by fraudulent appraisals.  There were no effective private sector actors “exorcizing” the mortgages approved as a result of appraisal fraud from the secondary market sales and the CDOs.  That meant that the control frauds spread throughout much of the (often deeply opaque) financial system, which is a recipe for hyper-inflating a financial bubble and causing a systemic financial crisis.

The widespread appraisal fraud allowed one to infer something else that was equally important.  There were two, often overlapping epidemics of mortgage fraud driven by lenders, and those frauds spread to the secondary market and the derivatives market to cause the systemic financial crisis.

Control Fraud Epidemics Render Firms Vulnerable to other Frauds

More subtly, if one understood control fraud and mortgage lenders one would also understand the surge in mortgage frauds that were not committed by control frauds but were made possible by the twin epidemics of accounting control fraud.  The inevitable byproducts of the accounting control fraud “recipe” for a lender or purchaser of loans include the devastation of underwriting and internal controls and the degradation of the integrity of the officers and employees of the fraudulent financial institutions.  That rot frequently extends very low into the ranks.

The CEO sets the ethical tone of a firm and when the CEO is a fraud that ethical tone will celebrate fraud, greed, and arrogance.  Personnel will “vote with their feet.”  The most ethical will leave and the least ethical will join and stay with a control fraud.  A loan officer who spends all day, every work day creating fraudulent loans that will harm the customer and the bank is far less likely to have moral qualms perpetrating a mortgage fraud against his bank that will let him loot the bank for personal gain.  Some portion of these moral misfits will choose to loot the firm in ways the CEO does not desire.  The destruction of controls and underwriting (an honest lender’s chief bulwarks against fraud) combined with their insider knowledge about how best to commit mortgage fraud against their bank will lead to moderately sophisticated mortgage frauds led by insiders.