How Fraud Became the Banking Business Model

“Fraud was not the problem, fraud was the solution”.

-economist James Galbraith

By 2004, the pool of qualified applicants dried up. With the perverse incentive allowed by so much upfront cash, when they couldn’t find eligible applicants, the loan officers did the expected: they altered failing applications so they appeared to conform to the lending standards. And who knew better how to fix the applications than the loan officers.

Countrywide Financial rose as if proof of the American dream. A butcher’s son, Angelo Mozillo, on borrowed money, no less, created a private label mortgage business that eventually beat Warren Buffet’s Hathaway in returns to shareholders. In 2006, Countrywide originated 20% of all mortgages in the United States. No praise was too high. Fortune eulogized it as a 23,000% stock. It seemed too good to be true.

In 2007, Eileen Foster, Countrywide’s executive vice president in charge of fraud investigations, sent a team to the Boston area to search several branch offices of Countrywide’s subprime division — the division that lent to borrowers with lower credit scores. The investigators rummaged through the office’s recycling bins and found evidence that Countrywide loan officers were forging and manipulating borrowers’ income and asset statements to help them get loans they weren’t qualified for and couldn’t afford.

Foster was interviewed by Steve Kroft of 60 minutes in 2011.

* She told him that she reported the loan officer fraud to the executives in Countrywide, * * They wanted her to cover it up.

*When she refused, she was fired.

Here is what she said to Kroft:

“Foster: All of the — the recycle bins, whenever we looked through those, they were full of, you know, signatures that had been cut off of one document and put onto another and then photocopied, you know, or faxed and then the — you know, the creation thrown — thrown in the recycle bin.

They wanted you to spin it and you said you wouldn’t?

Foster: Uh-huh (affirm).

Kroft: And the next day you were terminated?”

Foster added that although she was the senior officer in charge of fraud prevention at Countrywide, the Department of Justice did not ask to interview her when it investigated Countrywide regarding allegations of fraud.

Foster was not alone. There were other Countrywide employees of conscience willing to testify about fraudulent practices at Countrywide. In 2013, when former Countrywide executive Edward O’Donnell heard that the DOJ was about to settle with Countrywide without speaking to him, he filed his own complaint under the False Claims Act, setting out specific allegations of fraud that he could testify to in a program called Hustle after its initials, HSSL (High Speed Swim Lane).

O’Donnell said that, after the HSSL program was introduced in August 2007:

* His staff conducted an audit of its loans to determine how many were deemed “defective” or “severely unsatisfactory” and therefore could not be rated for sale to Fannie or Freddie.

* They found that 92.3% of them were deemed high-risk and therefore unsuitable.

The DOJ ignored his evidence.

How Widespread Was It?

Law professors Kathleen Engel and Patricia McCoy investigated how loan officers from numerous lenders coaxed new applicants after the supply of credit worthy applicants dried up:

“ Brokers and lenders perfected marketing strategies to find naïve homeowners and dupe them into subprime loans. Some hired “cold callers” who would contact homeowners to see if they were interested in a new mortgage . . . Brokers and lenders . . . scoured files at city offices to find homes with outstanding housing code violations, betting that the homeowners needed cash to make repairs. They read local obituaries to identify older women who had recently lost their husbands, surmising that widows were financially gullible. They also identified potential borrowers from consumer sales transactions. For example, in Virginia, Bennie Roberts, who could neither read nor write, bought a side of beef and over 100 pounds of other meat from a roadside stand on credit from the notorious subprime lender Associates First Capital. In talking with Mr. Roberts to arrange the consumer loan, the loan officer from Associates learned that Mr. Roberts had no mortgage on his home. He soon convinced his new client to take out a loan using the equity in his home. Associates refinanced that mortgage ten times in four years. The principal after the refinancings was $45,000, of which $19,000 was paid to Associates in fees.”

In The End of Normal: The Great Crisis and the Future of Growth, economist James Galbraith reviewed many other examples of fraud in the 2008 crisis by former employees, and wondered how extensive it was. He found this report by Fitch Ratings:

“Base-Point Analytics LLC, a recognized fraud analytics and consulting firm, analyzed over 3 million loans originated between 1997 and 2006 …Their research found that as much as 70% of early payment default loans contained fraud misrepresentations on the application.” (Fitch Fraud Report 2007, emphasis added)”

In the 10 years following the 2008 near meltdown, many academic economists inquired into its cause. Investigative economist John M. Griffin reviewed some 38 studies in his article, Ten Years of Evidence: Was Fraud a Force in the Financial Crisis? . The research was consistent in finding fraud a significant cause of the 2008 crisis:

“Overall, the evidence builds a cohesive narrative that the conflicts of interest, misreporting, and outright fraud in RMBS and CDOs were not sideshows, but central features of the crisis”. (p1296)

Since fraud was such a significant cause of the 2008 meltdown and the banks got cleanly away with it, it’s only a question of how they’re gaming the system now?

The banks that bought these mortgages and securitized them for sale to investors had a quality control department that reviewed the individual mortgages. That unit reviewed and certified toxic mortgages as AAA. How the securitization banks didn’t just cover up but encouraged fraud, next.

Acknowledgement: Bank image by wal-172619, Pixabay

Originally published at https://jandweir.substack.com.