William Black has an important story highlighting two documents that are crucial to understanding the financial crisis. They may not be vital documents in and of itself, but they’re representative of what happened to nearly bring down the US financial system. Black, an expert on white-collar crime, keys in on the documents that show the extent of fraud in the system. Here’s the first:
The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages “underlying” the derivative. A senior manager sends a blistering reply with this forceful punctuation:
“Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.”
In other words, even the senior officers at the rating agencies were warning against examining the loan files at this time. That would be tantamount to meddling with the primal forces of nature. Examining the loan files would reveal a widespread amount of mortgage fraud. Not only could the mortgage lenders not have that, the rating agencies and the banks they worked for couldn’t have it, because it would have ruined their entire scam of playing hot potato with clearly fraudulent loans. Allowing fraud, then, was good for business in the short-term across the entire securitization chain. As Black says, “The entire business was premised on a massive lie — that fraudulent, toxic nonprime mortgage loans were virtually risk-free.”
Here’s the second document.
A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch’s report on what they found.
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.”
Fitch also explained [PDF] why these forms of mortgage fraud cause severe losses.
“For example, for an origination program that relies on owner occupancy to offset other risk factors, a borrower fraudulently stating its intent to occupy will dramatically alter the probability of the loan defaulting. When this scenario happens with a borrower who purchased the property as a short-term investment, based on the anticipation that the value would increase, the layering of risk is greatly multiplied. If the same borrower also misrepresented his income, and cannot afford to pay the loan unless he successfully sells the property, the loan will almost certainly default and result in a loss, as there is no type of loss mitigation, including modification, which can rectify these issues.”
This reveals that the crime could have been prevented very early on, but the various layers in the chain – the regulators, the rating agencies, the banks accepting the bad loans – made a choice to ignore it. Black calls it a “don’t ask, don’t tell” policy; as long as everyone looked away at the fraud around them, everyone could profit. For a while. This grew the bubble with values that were essentially fictional. Finally, we still have no handle on the solvency of the banks who were deeply involved in this practice, and without the loan files, we’ll essentially never know.
Now, you can ignore this fraud and questionable solvency, and barrel through desigining a new mortgage finance system. You could even come up with some pot of money for the real victims of this crisis, those subject to illegal foreclosures and modification processes. But you still wouldn’t touch the fraud at the heart of the system.