Fraud Revealed as Key to Financial Crash

Fraud in asset-backed securities was an underrated cause of the most recent financial crash — and it could bring on another one.

Based on the research of John Griffin

If those who can’t remember the past are condemned to repeat it, then Professor John Griffin has a reminder for economic policymakers. A dozen years ago, he says, rampant fraud helped to bring down the U.S. financial system. Today, he fears it could happen all over again.

The importance of falsified and concealed information to the home mortgage meltdown has been underestimated, says the Texas McCombs finance professor. Despite anecdotal evidence, in books like “The Big Short,” economists have put more blame on macroeconomic causes, like loose credit and housing speculation.

In a new study, Griffin synthesizes more than 80 peer-reviewed papers about fraud and its contributions to the crash. He connects them with admissions that 11 banks made in legal settlements with the U.S. Department of Justice. Collectively, he finds, the research makes a case for taking fraud more seriously and taking stronger steps to prevent it.

“A lot of academics believe that conflicts of interest and fraud are things the media like to talk about, but they’re not of major economic importance,” Griffin says. “This paper and all the research that it summarizes says the opposite. That they did play a major role in the financial crisis.”

His interest is not just academic. The industry of pooling loans together into asset-backed securities is still with us. Griffin warns that players in that world still have incentives to fudge their numbers, with inadequate penalties to discourage them.

“There are a lot of parallels in today’s markets. Checks and balances are supposed to be in place, but a lot of them don’t work.” — John Griffin

Portrait of the Players

Conflicts of interest, Griffin says, are the root of the problem. Entities such as investment bankers and credit rating agencies are supposed to be independent and keep one another honest. But in the 2003–2006 housing boom, the research shows, they supported one another in duplicitous dealings. Griffin singles out four types of offenders:

Loan Originators. A mortgage-backed security is only as good as the loans that back it. In securities issued by private firms before the crash, 48% of the underlying loans misreported key information such as home values, the existence of a second mortgage, and whether the owner planned to live in the house.

Appraisers. Originators often shopped for friendly appraisers, who would overestimate home values to justify larger loans. Despite industry guidelines against targeting, in 45% of appraisals that got securitized, the value exactly matched the amount of the loan as shown by McCombs assistant professor of finance Sam Kruger. Appraisers who valued homes under their contract prices got less repeat business.

Investment Bankers. When banks packaged home loans into securities, they hired third parties to double-check them. Then banks knowingly put false figures into prospectuses — as many banks admitted to the DOJ while paying at least $137 billion in fines.

“They paid money to get due diligence,” Griffin says. “But then, they acted as if it didn’t exist. They sold mortgage-backed securities as good securities while they knew they were problematic.”

Credit Rating Agencies. Agencies such as Moody’s and Standard & Poor’s use mathematical models to rate securities. For many mortgage-backed securities, they adjusted their models to inflate ratings. Without such adjustments, one study found, a top-quality AAA security would have fallen to a barely-investment-grade BBB.

“In most markets, competition is a good thing,” says Griffin. “In these cases, rating agencies competed to give less accurate ratings to please investment banks. It was a race to the bottom.”

Preventing the Next Crash

A lot has changed on Wall Street since the Great Recession. But Griffin fears that one thing has not: the back-scratching system of lenders, appraisers, banks, and rating agencies. They’re creating new kinds of asset-backed securities, which pool commercial real estate and other business loans — adding a level of complexity beyond pooling home mortgages.

“It’s easier to hide behind complicated models when you’re baking the numbers. When you combine that with potential conflicts of interest, you have potential for fraud.” — John Griffin

The best way to deter fraud, Griffin believes, is to stiffen penalties for individuals, not just for banks. He notes that only one U.S. investment banker went to jail for the financial crisis. In an earlier study, he and Kruger found that 47% of workers in mortgage-backed securities departments were promoted after the crash.

He recommends that prosecutors seek prison time in addition to fines. Statutes of limitations, he suggests, should be longer for some kinds of financial crimes. Says Griffin, “By the time people had figured out a lot of the fraud, the statute of limitations had expired, and people couldn’t sue.”

The other remedy, Griffin says, is to watch for fraud in the newer kinds of securities, like commercial mortgage-backed securities and collateralized debt obligations, before they can cause another crash.

“Previously, most of the evidence wasn’t uncovered until three to 10 years after the crisis,” he says. “We need to get out in front of it this time.”

“Ten Years of Evidence: Was Fraud a Force in the Financial Crisis?” is forthcoming, online in advance in the Journal of Economic Literature.

Story by Steve Brooks