By William K. Black, reposted with permission of New Economic Perspectives
On December 13, 2011, the Wall Street Journal published an article entitled “Banks in Push for Pact.” It was an obscure article buried in the real estate section. The article contained this clause: “Under the proposal, banks would be released from legal claims tied to servicing delinquent mortgages as well as certain mortgage-origination practices….” Opponents of this proposed amnesty for mortgage-origination fraud have charged repeatedly that the federal government and Tom Miller, the Attorney General of Iowa, who is leading the settlement negotiations, support the amnesty. Previously, Miller’s key lieutenant, but not the Obama administration, angrily denounced the charge.
The Four Levels of Control Fraud Involving Mortgages
Home lenders, particularly those making liar’s loans, typically committed endemic “accounting control fraud” on multiple levels. Control fraud occurs when the persons controlling a seemingly legitimate entity use it as a “weapon” to defraud. Accounting is the “weapon of choice” for financial control frauds. Mortgage frauds can be grouped into four levels, each of them exceptionally widespread: loan origination fraud by the lenders and their agents, the fraudulent sale of fraudulent mortgages, the fraudulent pooling and sale of collateralized debt obligations (CDOs) in which the underlying was largely fraudulent mortgages, and foreclosure fraud.
Loan Origination Fraud
The classic economics article describing such frauds is George Akerlof and Paul Romer’s “Looting: the Economic Underworld of Bankruptcy for Profit” (1993). The recipe” for accounting control fraud by a lender (or purchaser) has four ingredients.
Extreme growth by making (or purchasing)
Loans of extremely poor quality at a premium yield
While employing extreme leverage, and
Providing grossly inadequate allowances for loan and lease losses (ALLL)
Origination fraud involved a series of mutually supportive frauds: inflating the borrower’s income, inflating the appraised value of the home, providing grossly inadequate allowances for loan and lease losses (ALLL), and failing to recognize losses on fraudulent loans held in portfolio. It was also common for federally insured lenders to file false reports with and make false statements to the regulators. Lenders that made liar’s loans were “accounting control frauds.” Their CEOs cause them to create perverse incentives to suborn the supposedly independent experts to provide opinions that inflate values and understate risk in order to aid and abet the underlying accounting fraud. These perverse incentives create a “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace. The result is “echo” fraud epidemics. Each of these frauds constitutes a federal felony. Most of the frauds I have described are also felonies under state law. Collectively, there were millions of origination frauds with a total dollar amount of fraudulent originations well in excess of $1 trillion.
The Fraudulent Sale of Fraudulent Loans
The second level of fraud is the fraudulent sale by the lenders of the fraudulent loans. This form of fraud required endemic false “reps and warranties.” Roughly 90 percent of liar’s loans were sold, so this second level of fraud also constitutes millions of federal and state felonies and roughly $1 trillion in fraudulent sales.
The Frauds involved in Pooling Fraudulent Loans to Create and Sell Fraudulent CDOs
The third level of fraud is the sale of collateralized debt obligations (CDOs) “backed” by fraudulent liar’s loans through false disclosures. This level of fraud constitutes tens of thousands of federal felonies and roughly $1 trillion in fraudulent sales.
The fourth level of fraud is foreclosure fraud. The best known of these frauds involved the commission of hundreds of thousands of felonies through the filing of false affidavits to secure foreclosures (inaptly called “robo signing”).
Massive Foreclosure Fraud Generated the Global Settlement Discussions
It was this last level of fraud that prompted the settlement discussions. What one must keep constantly in mind when dealing with lenders that are control frauds is that they and their senior officers will be represented by the best criminal defense lawyers. America still does many things superbly, and we do lawyers really well. The fraudulent officers who control banks engaged in control fraud will spend bank funds like water for their defense lawyers. The old joke is that when one is dealt lemons one should make lemonade. In law school, however, we consider that the “C minus” answer. When dealt lemons; the best lawyers seek to make Dom Perignon.
Consider the setting – you represent a systemically dangerous institution (SDI) that was the beneficiary of a federal bailout. Your client has made hundreds of thousands of fraudulent liar’s loans and fraudulently sold the great bulk of them. If your client is held responsible for these frauds it will have to reveal that it is massively insolvent and face receivership. Your client is also one of the largest mortgage loan servicers in the world. A small law firm representing a borrower has taken the deposition of one of your client’s key employees who signed the affidavits necessary to support roughly ten thousand foreclosures a month – and admitted that the key statements she has made in each of those affidavits is false. The somnolent federal government had finally been forced to admit that the banks have engaged in endemic foreclosure fraud. The states are also involved. This would be a nightmare scenario for any normal client. For an SDI, however, it was an opportunity.
L’audace, encore l’audace, toujours l’audace!
(Audacity, more audacity, always audacity: the white collar defense lawyer’s creed)
One of the secrets to being an extraordinarily effective elite criminal is also true of their lawyers – audacity. Elite white-collar criminals can frequently get away with grotesque criminal conduct if they use their exceptional advantages provided by wealth, privilege, and seeming legitimacy. Even within the ranks of elite white-collar criminals, however, the CEOs who control SDIs – particularly during a financial crisis that they caused – are unique in their power to commit crimes with impunity. They hold the national, even global, economy hostage. Treasury Secretary Geithner has made this strategy simple by displaying the “Stockholm Syndrome.” He has fallen in love with the criminals that are holding our economy hostage. Geithner claims that the fraudulent SDIs are so fragile that they would collapse if they were even investigated seriously for fraud. He conveniently ignores the fact that the primary reason for the SDIs’ fragility is that their CEOs looted the banks.
They can also use “their” bank to buy the modern equivalent of indulgences for even the most destructive frauds. There are two non-exclusive means of buying indulgences. The most obvious means is political contributions. The finance industry is the leading funder of both political parties. The less obvious means of buying immunity arises from the dysfunctional nature of DOJ policies for (not) prosecuting major firms for serious felonies and the ability of the CEO to use corporate funds to purchase personal immunity from criminal prosecutions. Five facts about the criminal defense of large firms must be kept prominently in mind when considering the defense of banksters. First, the CEO will gladly trade off billions of dollars in payments by the bank and its liability insurers in order to secure immunity from criminal charges against the CEO and the senior officers who could implicate the CEO.
Second, the Department of Justice (DOJ) has essentially ceased to prosecute large firms for serious felonies. DOJ was so traumatized by the consequences of prosecuting Arthur Andersen that it has decided to allow large firms to enter into “deferred prosecution” agreements (in which prosecution is, in reality, perpetually deferred). Arthur Andersen had entered into two deferred prosecution agreements, and DOJ offered it a third, when AA refused the agreement and went to trial.
Third, while I have referred to the firm as the “client” and the firm and its insurers typically pay for the attorney fees and fines, it is the CEO that can hire and fire outside counsel. Outside counsel, therefore, are chosen by fraudulent CEOs because they are willing to aid and abet the CEO in looting the real client (the firm). This is a classic example of the fraudulent bank CEO deliberately creating a Gresham’s dynamic in which the least ethical members of the “independent” profession drive the most ethical out of lucrative representations. In criminology jargon, control frauds are criminogenic. Fraudulent CEOs use their ability to make compensation for officers, employees, and independent professionals perverse in order to create environments that cause widespread frauds that aid and abet the lender’s fraud scheme. To put it in plainer, biblical English: fraud begets fraud.
Fourth, the settlement payments are typically deductible from taxes. This means that the defendant’s actual burden of paying the fine is much smaller than the announced amount of the fine.
Fifth, defense counsel typically promise to pay some portion of the fines to the victims of the fraud. This is a brilliant tactic. It makes the government attorneys feel good about the settlement and it allows them to bash opponents of the settlement as blocking relief for the victims. The tactic, of course, is cynical and dishonest. The weak settlement is what prevents a far greater recovery for the victims of the fraud. The government does not have to wait for a settlement to aid the victims of foreclosure fraud.
Settlement discussions by counsel for control frauds with the government and shareholders are all about exceptionally able and zealous legal representation of the CEO at the expense of the client, its shareholders, and the public. Only vigorous regulators and prosecutors can protect the firm, shareholders, and public from looting by these CEOs and the allies they generate.
The Proposed Deal: The $1 Trillion Lagniappe
The obvious deal that criminal defense counsel for banks always seek is to trade a showy amount of fines for de facto or even formal immunity for the CEO and other senior officers who led the frauds and became wealthy through the frauds. Here, the defense counsel were far more audacious – they are demanding immunity not only from prosecution, but even from investigation, and they are demanding immunity for crimes they committed that have never been investigated by the state and local prosecutors. The foreclosure fraud cases, while enormous, are by far the least of the banksters’ worries. The potential loss exposure from the foreclosure fraud is measured in the tens of billions of dollars. The potential loss exposure from fraudulent home loan originations is in the trillions of dollars – and a trillion is a thousand billion. The banks’ CEOs are demanding, for a puny $25 billion, a release from liability for foreclosure fraud. That is obscene on multiple levels. Even President Obama concedes that the banks treat such fines as a mere “cost of doing business” (by which he means the “small tax on the wealth obtained by elites through doing fraudulent business”). The senior officers involved in the fraud should be imprisoned. Giving them immunity, allowing them to keep their bonuses “earned” through fraud, and keeping them in leadership roles are all despicable acts that should be anathema to every prosecutor.
But what came next went beyond scandal as usual. The banks then demanded a lagniappe – a little something extra, for free, in a New Orleans restaurant – they wanted immunity for loan origination fraud. The slight difference is that this lagniappe is worth trillions of dollars to the frauds. It sickens me to inform the reader that the Obama administration is eager to provide the frauds with this lagniappe. The Department of Housing and Urban Development (HUD), led by Secretary Shaun Donovan, is actively pushing this scandalous deal, with strong support in the background from Treasury Secretary Geithner. The silence of Attorney General Holder, and President Obama, on this travesty is exceptional.
Worse, the banks are seeking immunity even from investigation of the over trillion dollars in mortgage origination fraud – and the Obama and Bush administrations’ supposed “investigations” of mortgage origination fraud by the large lenders that made the mass of liar’s loans are all unworthy of the word “investigations.” It would take roughly 100 investigators, working for years, to do a serious investigation of any of the largest liar’s loan lenders. There has never been, remotely, such an investigation by the federal government of the any large liar’s loan lender. The Obama administration is reported to support the fraudulent financial CEOs’ dearest dream – de facto immunity even from investigation of over a trillion dollars in fraudulent liar’s loans origination.
The Republican Party and its candidates for the Party’s presidential nomination are not criticizing Obama’s proposed formal surrender to crony capitalism. They only wish they were in complete power and could cash in even more heavily on the tidal bore of campaign contributions flowing out of the finance industry.
Miller, and everyone involved, knows there was endemic origination fraud.
Miller no longer denies that he has joined the administration in favoring the banks’ most cherished dream – amnesty for originating a trillion dollars in fraudulent home loans. Indeed, the settlement is designed to prevent even investigations of the mortgage origination fraud.
I confess that I am so naïve that I would have believed it impossible that any federal or state governmental entity would enter into such an abject surrender to crony capitalism. Once I learned that they were seriously contemplating such a travesty I could not believe that Miller would support it. I believed his lieutenant’s (Mr. Madigan’s) denunciation of criticism of the proposed amnesty. (I have reviewed Madigan’s comments in preparing this piece and I see that they were artfully crafted to be disingenuous.)
The testimony of Thomas J. Miller, Attorney General of Iowa, at a 2007 Federal Reserve Board hearing shows that he knows that the lenders engaged in massive origination fraud.
Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete. Strong regulations will create an even playing field in which ethical actors are no longer punished.
Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007.
[M]any originators … invent … non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. A review of 100 stated income loans by one lender found that a shocking 90% of the applications overstated income by 5% or more and almost 60% overstated income by more than 50%. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.
Miller, T. 2007. “Comments to the Federal Reserve Board ofGovernors on Adopting Regulations to Prohibit Unfair and Deceptive Acts andPractices under the Home Ownership and Equity Protection Act (HOEPA).” (August 14). Miller was correct. We know that it was overwhelmingly lenders and their agents that put the lies in “liar’s” loans. We know that 90 percent of liar’s loans were fraudulent. We know that the industry massively increased the number of liar’s loans after warnings that the loans were endemically fraudulent. The growth rate of liar’s loans was so rapid (over 500% from 2003-2006) that these fraudulent loans caused the housing bubble to hyper-inflate. We know that no government entity ever caused any entity to make or purchase (and that includes Fannie and Freddie) liar’s loans. Indeed, the government repeatedly warned of the dangers of liar’s loans. We know that by 2006 roughly one-third of all home loans made that year were liar’s loans – which means there were millions of fraudulent loans made annually and, collectively, trillions of dollars in fraudulently originated home loans.
What must be done
Our economy and our democracy cannot succeed under crony capitalism. Please join me in writing to Congress, the administration, your state attorney general, the media, and any court that must approve this proposed settlement. It is a disgrace. President Obama is, of course, correct that some actions can be illegal but exceptionally unethical and damaging. He is about to take precisely such an action in derogation of his oath of office to defend and protect the constitution of the United States of America. The fraudulent CEOs of the banks that became wealthy by causing the financial crisis and the Great Recession are treating us as fools who will give trillion dollar plus gifts to the least deserving, most arrogant, and least ethical elites. Have we fallen so low as a people that we will allow this to happen?
Please join me in supporting the Attorney Generals of New York, Delaware, and California who have opposed this settlement.
As for President Obama, I hope that he will make this New Year’s resolution: “I resolve to honor my oath of office and faithfully execute the laws of the United States and defend its constitution, which is premised on justice and the rule of law. No person, no matter how elite, is above that law. I have today asked Messrs. Bernanke, Geithner, and Donovan for their resignations because of their support for bailing out the elite banks and granting de facto amnesty to fraudulent financial CEOs. I, and my new Attorney General and new Secretary of the Treasury, have mutually resolved to make the vigorous prosecution of the elite financial frauds that drove the ongoing crisis our mission. ”