Meet the Honest Appraisers Whose Warnings Should Have Prevented the GFC
By: William K. Black
Associate Professor of Economics and Law, University of Missouri-Kansas City
The honest appraisers’ warning was ideal. It was timely, blunt, courageous, and unambiguous. If the regulators had acted on the warning, there would have been no Great Financial Crisis (GFC). Unfortunately, the Presidents Clinton and Bush (II) appointed financial regulators because they were anti-regulators, so they ignored the appraisers’ warning.
From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets (Financial Crisis Inquiry Commission (FCIC): 18).
Let me provide some vital context that the FCIC failed to provide, presumably because it did not actually understand the appraisers’ unambiguous warning. As I explained, the second and third phases of the savings and loan debacle (1982-1993 and 1990-2008) were the ‘test beds’ for the fraud strategies that drove the GFC. The first reason the appraisers got it right is that they had seen the identical fraud scheme driven by the elite thrift frauds beginning around 1980, and becoming epidemic by 1982. The (rival) professional appraiser associations were the only organized group of industry professionals that consistently allied with us (the thrift regulators) in countering the fraud epidemics driving the thrift debacle’s second and third phases.
The appraisers were also the earliest warning because they are the essential component of one of three “C’s” of prudent underwriting – they evaluate the market value of the Collateral pledged to secure the real estate loan. Being a secured lender protects against loss only to the extent the market value of the asset the borrower ‘pledges’ as security for the loan is adequate to repay the loan if the borrower defaults. Appraisers are the experts in providing the market value of real estate. Terrible underwriting is always the leading indicator of elite fraud that takes the form of what the Nobel Prize winning economists George Akerlof and Paul Romer described as “Looting: The Economic Underworld of Bankruptcy for Profit” in their famous 1993 article (which explicitly describes how appraisal fraud aided the looting of thrifts in the debacle’s second phase).
The appraisers’ warning was unambiguous because any honest lender would want accurate, conservative appraisals of the market value of real estate pledged as security. No honest lender would permit, much less incentivize, wildly inflated appraisals. Appraisal fraud through extortion is a federal felony. It is also inherently part of a broader conspiracy allowing a host of additional federal felony charges, particularly if the lender is federally insured.
The appraisers’ warning is also unambiguous about the source of the fraud epidemic. Borrowers can almost never extort an appraiser to inflate values. Only lenders and their agents have the power to extort appraisers. Note that this does not require “market power” in the sense that term is used in antitrust cases.
The appraisers’ warning illustrates one of the most toxic forms of elite fraud – what George Akerlof labeled a “Gresham’s” dynamic in his famous 1970 article on a market for “lemons.” That article transformed, indeed defines, modern microeconomics and white-collar criminology’s analysis of elite fraud epidemics. Akerlof warned that when frauds gain a competitive advantage market forces become perverse and tend to drive honesty from the markets, making fraud epidemic in entire industries.
[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.
Effective financial regulation and prosecutions do not harm honest markets – they make them possible and durable. Honest firms and CEOs gain enormously when we drive the elite frauds from the markets.
Bank CEOs incentivize their employees and agents to extort appraisers to inflate market values only if their goal is to loot the bank. Inflating appraisals unambiguously leads to a near certainty of bank failure, but it leads to a near certainty of sharply increase income for the CEO.
The appraisers who signed the public petition were risking their careers. They made it simple for fraudulent lenders and their agents to identify and refuse to employ the honest appraisers. The appraisers’ warning, therefore, required great integrity and courage. There was no reason for appraisers to fabricate their warning.
The appraisers’ warning was even earlier than FCIC reported. It takes years to get rival professional associations to agree there is a crisis, agree on a common strategy to redress the crisis, and implement the common strategy. The appraisal associations began these serious efforts in 1998 (in the middle of the Clinton-Gore administration’s second term). This is critical because each of the four federal banking and thrift regulatory agencies in this era had a chief appraiser who would have been aware of the profession’s consensus that appraisal fraud had become epidemic and was driven by fraudulent lenders. That was a full decade before the onset of acute phase of the GFC in 2008. If any of the federal agencies had responded effectively by championing the appraisers’ warning there would have been no GFC. Each of the federal banking and thrift regulatory agencies knew by 1998 that an epidemic of mortgage fraud led by banking elites was raging in the home mortgage industry.
What good is a whistle blower if their warnings are ignored by people we entrust to lead?
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).