It’s the ‘Liar’s Loans Crisis,’ Not the ‘Subprime Crisis’
By: William K. Black
Associate Professor of Economics and Law, University of Missouri-Kansas City
Almost everything conventional economists taught you about the Great Financial Crisis (GFC) is a myth. Each of the myths has a common core taken from the movie “The Wizard of Oz.” When the “little dog” pulls back the screen and reveals that the ‘wizard’ is a con man, he responds: “pay no attention to the man behind the curtain.” The Con pulls back the curtain and shows fraud schemes’ true nature.
The key conclusion is that multiple fraud epidemics hyper-inflated the housing bubble and drove the GFC. You probably know this as the “subprime crisis.” It was not. If you had to pick one type of loan as driving the GFC, it would be “liar’s” loans. This column provides an overview of the liar’s loans that I will expand in future posts. The Con blows the whistle in detail on the primary role that fraudulent and predatory liar’s loans played in driving the GFC.
Liar’s loans emerged as a serious developing problem in 1990 in Orange County, California – the world’s financial fraud epicenter. As fate had it, I was the litigation and enforcement head for the thrift regulator’s ‘West Region’ with jurisdiction over California. Our resources were overwhelmed dealing with the fraud epidemics that drove the debacle’s second phase (which was still raging in 1990).
In one of the great feats of all time, our overwhelmed examiners immediately identified the new emerging fraud-plus-predation scheme even though the toxicity was novel and we had no evidence on loss experience. Our examiners called for us to squash the new pathology before it could become epidemic. We realized we needed to crush the growth curve of fraud epidemics given their exponential growth. Our examiners understood that liar’s loans only made sense if the CEO was ‘looting’ the lender and that the same thrifts were targeting Blacks and Latinx for predatory home loans. We agreed with our examiners and drove the last of these predators out of the industry in 1994.
By 1993, there was a sole survivor among these predators – and its leader paid us the most sincere compliment in 1994 when he decided there was no way to bully, buy, or intimidate OTS’s West Region examiners, supervisors, and enforcers. To survive, he needed to escape to the sanctuary where we had no jurisdiction – the “Shadow” financial sector in which federal financial regulation is virtually non-existent because the lenders have no federal deposit insurance. The thrift leader, therefore, voluntarily gave up federal deposit insurance for the sole purpose of escaping our jurisdiction. He gave up the thrift charter and converted it to an unregulated “mortgage bank” that he renamed Ameriquest.
In future posts, I explain how Ameriquest became the ‘Johnny (Rotten) Appleseed’ that spread the ‘fraud-plus-predation’ scheme throughout the Shadow, and eventually back into insured sector once the Clinton and Bush (II) administrations destroyed all effective federal financial regulation. This is why the debacle’s third phase began in 1990 and ended in 2008. The debacle’s third phase created the GFC. The same financial leaders acted as the ‘vector’ that produced the fraud + predation epidemic that drove the GFC. Our examiners identified as soon as it began in 1990.
Future posts will explain the critical nature of the three “C’s” of prudent underwriting. Liar’s loans fail to verify the borrower’s income. Verifying the borrower’s income is essential to prudent underwriting because it essential to the borrower’s “Capacity” to repay the loan. Lending to borrowers that lack the capacity to repay the loan is a superb way to lose money. Not verifying the borrower’s income allows the lender’s employees and agents to inflate substantially the borrower’s income on the loan application with impunity. The mortgage industry anti-fraud experts’ 2006 report called liar’s loans “an open invitation” by lenders encouraging fraud.
What good is a whistle blower if their warnings are ignored by people we entrust to lead?
Future posts will explain the reason for another unique revelation of The Con – making massive amounts of loans that were likely to default optimized the fraudulent “take” of the officers and agents that the Con enriched. It harmed the firm, but enriched the controlling officers and the hundreds of thousands of allies they perversely incentivized to make fraudulent loans. In 1993, George Akerlof and Paul Romer (both now Nobel Laureates in Economics) published “Looting: The Economic Underworld of Bankruptcy for Profit.” The article endorsed the thrift regulators’ findings that the bankrupting the lender was the best way to enrich the financial CEOs. I know that sounds counter-intuitive and is something no documentary other than The Con has explained.
The fraud incidence in liar’s loans was 90 percent according to the mortgage industry’s fraud experts. They reported that figure as part of their written warning to the industry in early 2006. The industry responded to the warning by substantially increasing liar’s loans. Liar’s loans caused roughly 70% of mortgage product losses.
About 40% of the loans made in 2006 were liar’s loans. That means over one million fraudulent liar’s loans were made in 2006 alone. Liar’s loans grew massively (far more than 500%) between 2003 and mid-2007, while conventional loans fell sharply and subprime loans that were not also liar’s loans grew at a far slower pace and eventually declined. Liar’s loans were the toxic loans most responsible for hyper-inflating the U.S. home real estate bubble and driving the GFC.
Nearly half of all the loans the industry called “subprime” were also liar’s loans – the two categories are not mutually exclusive. Subprime usually means a loan to someone with no, or a poor, credit rating score. (“Credit” is one of the three “C’s” essential to prudent underwriting of secured real estate loans.) In a liar’s loan, the lender does verify (in the most extreme cases does not even seek disclosure of) the borrower’s income and sometimes her employment. It is possible, though insane for an honest lender, to combine both underwriting failures in the same loan. As I noted, it became common for fraudulent lenders to combine both failures of the minimum underwriting requirements essential to profitable lending in the same toxic loan.
Here is the key exception you need to understand. Home lending was pervasively predatory to Black and Latinx households. It was common for lenders and their loan broker agents to place Black and Latinx borrowers with adequate credit rating scores in the subprime lending “channel.” The bankers charged borrowers more for such loans, so they incentivized loan brokers with additional fees if they placed borrowers with adequate credit rating scores in the subprime channel. If you were Black or Latinx, the lender’s inappropriate placement of your application in the subprime channel was like entering ‘Hotel California’ – “you can never leave.”
There is another key fact to keep in mind – and fraudulent bank CEOs loved it – there were no official definitions of virtually anything in mortgages. That includes liar’s loans (and the many industry euphemisms for that concept), subprime, and ‘exploding rate’ adjustable rate mortgages (ARMs). The fraudulent CEOs loved this because of the art of these kinds of frauds is massively overvaluing asset values. In finance, the ‘elegant’ means of grossly inflating asset values is to understate substantially their true credit risk. The optimal fraud scheme is to take an extremely low credit risk asset (such as conventional home loans) that the public knows to be low risk and then pervert it into an exceptionally high-risk asset – a ‘toxic twin.’ A liar’s loan is to a conventional home loan as a napalm bomb is to a sparkler. Having no formal definitions greatly aids this deception about asset quality, risk, and market values.
This deliberate industry failure to define creates a lagniappe for fraudulent bankers. One of the obscenities banks get away with is “paperwork reduction act” that makes it a practical impossibility for regulators to add bank reporting requirements that would impose formal definitions and allow us to spot quickly and quantify the emerging ‘toxic twin.’
ABOUT THE AUTHOR
Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.
He was litigation director of the Federal Home Loan Bank Board, deputy director of the FSLIC, SVP and General Counsel of the Federal Home Loan Bank of San Francisco, and Senior Deputy Chief Counsel, Office of Thrift Supervision. He was deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement.
Black developed the concept of "control fraud"–-frauds in which the CEO or head of state uses the entity as a "weapon." Control frauds cause greater financial losses than all other forms of property crime combined and kill and maim thousands. He recently helped the World Bank develop anti-corruption initiatives and served as an expert for OFHEO in its enforcement action against Fannie Mae’s former senior management.
He teaches White-Collar Crime, Public Finance, Antitrust, Law & Economics (all joint, multidisciplinary classes for economics and law students), and Latin American Development (co-taught with Professor Grieco, UMKC – History).