Market Overview

When all Else Fails, Find the Foreclosure Facts


Sheila Bair, who has chaired the Federal Deposit Insurance Corporation (FDIC) since her appointment by President Bush on June 26, 2006, has been the only top federal banking regulator willing to upset the industry she regulates. Reuters reports on her less than vigorous reaction to the disclosure of endemic foreclosure fraud.

"We have been told that this is a process issue - that all of the information is in the file, the problem is the person who needed to sign the affidavit had not been looking at the file before they'd done so. So we need to independently verify that," Bair said.

"Foreclosure is a very serious thing and it should only being undertaken after loan modification efforts are not feasible. And that the files are fully documented."

In addition, Bair urged banks to do "rigorous internal analysis" about the range of possible risk exposures.
"We need to get a full handle on all of these issues," she said. "If it turns out this is just a process issue then I don't anticipate the exposures to be significant.

"If it turns out to be something more fundamental then we'll have to deal with that. But I think we need to get all the information before we jump to any conclusions."

It does not appear that Ms. Bair, or any senior official in the Obama administration, has focused on the fact that it has been standard operating procedure, for several years, for lenders, CDO holders, and courts to “jump to any conclusion” necessary to foreclose on homes regardless of whether the loan was fraudulently induced by the lender and regardless of whether the entity foreclosing on the mortgage engaged in foreclosure fraud.

She also frames the problem euphemistically as limited to – “process” – instead of the known facts, which constitute fraud by the entities that are foreclosing. “We have been told this is a process issue.” Ms. Bair's statement can only be truthful if the FDIC has only been talking to liars. Ms. Bair cannot have been talking to those representing the debtors. The banking regulators have failed to shake off the corrosive effects of the “reinventing government” movement, which instructed them to refer to the banks and S&Ls as their “customers.”

But the even more important question is what she has been doing as a regulator for over four years. Admittedly, her predecessors emasculated the FDIC and she had to start form a deep hole. The FDIC lost over three-quarters of its staff (using “early outs” that often robbed it of its most productive employees). Worse, it tried to compensate for its grossly inadequate staff resources by adopting “lite” examinations in 2002. The FDIC called this travesty “MERIT” (Maximum Efficiency, Risk-Focused, Institution Targeted Examinations). In a MERIT examination the examiners went to greatly reduced review if the bank reported that it did not have large numbers of bad loans. The result was that the FDIC's examiners heard no evil from the banks and saw far too little of the evil that came to dominate banks' nonprime residential loans and commercial real estate (CRE) loans. (Bair inherited MERIT. She finally killed it in early 2008.) As late as she was in killing MERIT, the community bankers were worse. Their trade association continued to push for the MERIT program after anyone sentient could tell it had proven disastrous.

Recall that we know empirically that the nonprime crisis was driven by millions of fraudulent and predatory home loans – making them the FDIC's highest priority – and Ms. Bair has had years to “get all the information” about such loans and prevent the frauds and predation. Throughout the developing nonprime mortgage crisis, the FDIC failed catastrophically to deal with this top priority (and as I explained in an earlier column, its secondary priority – commercial real estate). The banking regulatory agencies and the Federal Housing Finance Agency (FHFA) (which is supposed to regulate Fannie, Freddie, and the Federal Home Loan Banks) have no excuse for not having “the information” about the state of nonprime residential loans. If, in late 2010, they do not have even the most basic information about the incidence of nonprime mortgage fraud by lenders and the state of underwriting and record keeping of key documents of such loans then the case for removing the head of each agency and changing the top agency supervisors is conclusive.
Here is the principle that President Obama promised Congress would govern our response to the financial crisis. He promised first that we would find the causes of the crisis and address them:

“[I]t is only by understanding how we arrived at this moment that we'll be able to lift ourselves out of this predicament.”

We would address the problems promptly:

“Regulations -- regulations were gutted for the sake of a quick profit at the expense of a healthy market. People bought homes they knew they couldn't afford from banks and lenders who pushed those bad loans anyway. And all the while, critical debates and difficult decisions were put off for some other time on some other day.

Well, that day of reckoning has arrived, and the time to take charge of our future is here.”

Unfortunately, after this clarity the President's logic and policies started to become incoherent.

“But credit has stopped flowing the way it should. Too many bad loans from the housing crisis have made their way onto the books of too many banks. And with so much debt and so little confidence, these banks are now fearful of lending out any more money to households, to businesses, or even to each other.”

Yes, large numbers of banks are insolvent because they hold so much fraudulent nonprime mortgage paper and CRE. The problem with “these banks” is bad assets, not that the insolvent banks lack “confidence” in the economy.

This incoherence promptly infected his discussion of foreclosure:

“[W]e have launched a housing plan that will help responsible families facing the threat of foreclosure lower their monthly payments and refinance their mortgages.

It's a plan that won't help speculators or that neighbor down the street who bought a house he could never hope to afford.”

The problem is that the “neighbor down the street” is the problem. Liar's loans became the norm (Credit Suisse reported that they represented 49% of mortgage originations in 2006). Liar's loans were typically fraudulent. A borrower typically used the proceeds of a liar's loans to buy “a house he could never hope to afford.” The lenders and their agents typically made or directed the false statements about income and occupation. (The lenders and the loan brokers knew the term sheets and the ratios to hit.) While the lenders and the agents typically took the lead in providing the lies that made liar's loans worthy of that name, this does not means that the borrowers were blameless. Many borrowers knew that the loan application contained false information and that they could not afford to purchase the home. We are talking about millions of homeowners, most with families.

But how are we to know that the borrowers knew the loans applications were false and that they could not afford to buy the home? We can infer a lender's fraudulent intent because it is financially sophisticated and has expertise in lending. An honest mortgage lender would not make liar's loans because not underwriting loans inherently produces intense “adverse selection” and means that the loans have a “negative expected value.” In plain English, that means that mortgage lenders that make liar's loans will go broke. (As the recent settlement with Mozilo and other senior officers at Countrywide proved; elite bankers can be made wealthy by making fraudulent nonprime loans because doing so optimizes (fictional) reported income and the value of the senior officers' compensation. This is what George Akerlof and Paul Romer warned about in the title of their famous 1993 article – Looting: the Economics Underworld of Bankruptcy for Profit. The lender fails, the senior officers can get rich.)

We cannot make the same inferences about the borrowers' intent and knowledge. The policy issue is whether to foreclose on over 10 million people (counting family members) where we do not know what the borrower knew but we can infer that the lenders engaged in “fraud in the inducement.” The economic and societal consequences of such mass foreclosures, and the moral issues posed by the lenders' “fraud in the inducement” are massive. The Obama and Bush administration have refused to deal with the pervasive role of lender fraud and the ambiguous role of borrower complicity in such frauds. This is contrary to Obama's critique of the policy failures that led to the financial crisis: “critical debates and difficult decisions were put off for some other time on some other day.” True; and those failures continue.
President Obama was unwilling to use the “f” word (fraud) when describing the financial crisis, but he did promise:

“It is time to put in place tough, new commonsense rules of the road so that our financial market rewards drive and innovation and punishes shortcuts and abuse.”

The administration, however, has not punished the elite financial frauds that made the hundreds of billions of dollars of liar's loans that drove the crisis. Obama was willing to use the “f” word in one context: “[We] will root out the waste and fraud and abuse in our Medicare program….” President Obama could “root out the waste and fraud and abuse” in banking (which is vastly greater than Medicare fraud losses) without new rules or laws. He could appoint regulators and prosecutors that would find the facts and act against the elite frauds that drove the fraudulent nonprime mortgage crisis and the foreclosure fraud crisis.

What to do with the over ten million Americans who will lose their homes to foreclosure even though they were often fraudulently induced to purchase by their lenders is a far more difficult question. There is no perfectly just answer. The losses are so great that the public will have to bear much of the cost whatever we decide.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.


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