Real regulators are vital to a nation. They can stop crises in their tracks — or they can let a them explode on an unsuspecting public. The Federal Reserve was warned by many different people, including appraisers, prosecutors, and industry players that the mortgage industry was rife with fraud. Why didn't they listen?

The Appraisers’ Warning of the Lenders’ Fraud Epidemic

A very large number of appraisers have tried to combat home lenders and their agents who were deliberately extorting them to inflate appraisals. When cheaters prosper, the markets drive honest firms and professionals out of business, something economists call "Gresham's dynamic." Honest appraisers tried to block this dynamic:

“From 2000 to 2007, [appraisers] ultimately delivered to Washington officials a petition; signed by 11,000 appraisers…it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18).

There is a “recipe” by which fraudulent mortgage lenders (purchasers) optimize their reported (albeit fictional income); promptly making their controlling officers wealthy through modern executive compensation. That recipe requires the massive origination (purchase) of bad loans, and inflating appraisals makes bad loans appear to be good loans and helps hyper-inflate bubbles.

The device lenders typically used to ensure the endemic inflation of appraised values was to blacklist honest appraisers. The fraudulent lenders took what had once been a very good practice, refusing to use appraisers who inflated appraisals or were simply incompetent, and perverted it into an instrument of extortion and fraud by blacklisting appraisers who refused to aid their fraud schemes by inflating appraisals.

We worked closely with appraisers and their professional bodies interested in preventing fraud when we regulated the S&L industry. The Bank Board’s appraisal standard (R-41c) was considered the platinum standard for professional home appraisals. The appraisers determined to stamp out appraisal fraud were the only professionals that supported our effort to crack down on the roughly 300 S&L control frauds. The “Big 8” audit firms, the legal profession, and economists were impassioned opponents of our efforts to reregulate the industry and to hold the senior officers running the control frauds accountable.

The FBI’s Warnings of the Fraud Epidemic and the Financial Crisis it Would Create

In September 2004, Chris Swecker, the FBI official charged with responsibility for mortgage fraud, began warning publicly that an “epidemic” of mortgage fraud was developing. Swecker predicted that it would cause a financial “crisis” if it were not contained.

Representatives of the Borrowers Warned the Fed about Endemic Mortgage Fraud

I will make this topic the subject of an entire article. My conclusion from reading the transcripts of several hearings on mortgage abuses that Congress mandated the Fed to conduct is that representatives of nonprime borrowers overwhelmingly opposed the loans, typically explaining that they were frequently fraudulent and predatory. ACORN was one of these groups warning the fed about nonprime loans.

State Prosecutors Warned the Fed about Endemic Mortgage Fraud

“Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete”

“[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer” Miller, T. J., Iowa Attorney General (August 14, 2007).

Other state and local prosecutors issued warnings in earlier Fed hearings, but the Iowa witnesses provided some of the most compelling analysis.

Steven Krystofiak, President of the Mortgage Brokers Association for Responsible Lending

Krystofiak’s testimony put the Fed on notice that stated income loans were the major problem and that the lenders and brokers often put the lies in the liar’s loans:

“Currently we see stated income and stated asset loans as the largest problem in the real estate industry.

1. Stated income loans are associated with fraud, and started to become popular in 2002.

A stated income loan is a loan where the income that is put on a home loan application is not verified at all by the banks. The banks simply take your word for it. Home buyers might be unaware of the fraudulent income that is being stated on the loan application because the loan officer, or bank representative have the power to falsify the income on the application.

Stated income loans became popular in 2002, and have since become mainstream. According to one survey it was discovered that 37% of all loans sold in the United States are originated without income being proven. In areas where homes are the least affordable (i.e. California, and Florida) that number grows to over 50%.”

Krystofiak explained that the fraudulent CEOs used financial incentives to enlist their fraud allies.

3. Fraud is encouraged by the banks

A large problem as to why these loans have become so prevalent is because the first line of defense against stated income loan fraud are individuals who are commission based; the loan originator, the bank representative, and in many cases the managers for the bank reps have a large portion of their income derived from bonuses based on loan production. Bank employees, i.e. underwriters and bank processors, return applications back to mortgage brokers with instructions to send back an application with a higher stated income. The mortgage industry has become comfortable with stating incomes higher on loan applications.

Online underwriting systems that are used by Fannie Mae and some banks are being exploited by bank representatives and loan officers wanting to obtain a loan with stated income underwriting standards but with fully documented interest rates. The systems allow mortgage brokers to “play” with different incomes more than 15 times until they get the results they want.

4. Stated income loans help no one. Stated income loans cost consumers hundreds of dollars a year because of higher interest rates.

Krystofiak then closed all the loops by explicitly warning the Fed that appraisal fraud was common, that lenders caused the fraudulent appraisals, that the appraiser profession had warned the federal regulators of these facts, and the FBI, after warning of endemic fraud, had gone missing in action.

11. Appraised values are often inflated. Underwriters are basing their decision on inflated home values, inflated incomes and inflated assets.

Loan officers have a lot of pressure to find a “liberal” appraiser so the home can be bought. This pressure to find a “liberal” appraiser is often coming from both the home buyer and the real estate agent. This pressure is then applied to the appraisers who are often forced into coming up with a predetermined value for a homes in order for the “deal to go through.” Don Kelly from the Appraisal Institute stated in a letter to federal regulators, “For years- and more so recently- our members have reported the loss of appraiser independence, when they are directed to provide predetermined opinions of value to help facilitate transactions. Failure to adhere to such requests from loan officers, mortgage brokers, and others has resulted in honest and ethical appraisers being placed on exclusionary or “do-not-use” list.”

12. Rules are not enough, they must be enforced.

The FBI has acknowledged that mortgage fraud is a problem that is a growing epidemic. Reports of suspicious activity has rose from 3,088 in 1999 to 21,994 in 2005. After 9/11 the FBI has made mortgage fraud a low priority. Within the FBI mortgage fraud is in a section for white collar crime that is ranked number seven, (1 through 6 is related to terrorist) and within that mortgage fraud is a smaller subsection which is only priority number four.”

The Industry’s Anti-Fraud Entity’s (MARI’s) Warnings in Early 2006

MARI was the mortgage lending industry’s anti-fraud group during the recent crisis. In early 2006, it issued a report to the Mortgage Bankers Association (MBA) that the MBA sent to each of its members. MARI’s report issued five key warnings about “stated income” loans.

Stated income and reduced documentation loans . . . are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.

One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan.’

Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans.”

The “customer” MARI was referring to in that passage was Steven Krystofiak’s association. Note that MARI reminds the industry that stated income loans “were the rage in the early 1990s” and caused “hundreds of millions of dollars in losses.” I explain the significance of this point in the next section.

It is also important that MARI makes no claim that lenders make liar’s loans because “the government” makes them do it. To the contrary, “federal regulators … have expressed safety and soundness concerns over these loans.” This means that both “barrels” of the mortgage fraud assault on our Nation by loan originators serve as “natural experiments” that allow us to determine why the CEOs caused the lenders to make endemically fraudulent liar’s loans and extort the appraisers to commit appraisal fraud. The CEOs did it because it was a “sure thing” guaranteed to make them promptly wealthy.

What any Competent Regulator Would have Known

There are many vital inferences any competent private or public actor knowledgeable about mortgage lending, the secondary market, and collateralized debt obligations (CDOs) should have made on the basis of the appraisers’ petition. The most critical points arose from the appraisers’ warning that there was widespread inflation of appraisals extorted by home mortgage lenders. This allowed experts to realize that (1) no honest lender would inflate appraisals, (2) they would only engage in widespread inflation of appraisals in aid of knowingly making widespread bad loans which means they were engaged in widespread mortgage origination fraud (largely through “liar’s” loans), (3) this means that the problem is a twin-barrel fraud assault (liar’s loans plus appraisal fraud) by loan originators, (4) this should have led immediately to massive rejections of the bad loans by the secondary market; an action that would quickly bankrupt the fraudulent lenders, (5) because that did not happen we knew that the widespread fraudulent loans were propagating through the CDOs, which would hyper-inflate the financial bubble and cause catastrophic losses that would pose a systemic risk.

People generally recognized as experts in power in the private and public sectors recognized none of these things. Indeed, they purport to recognize none of these things even now (though that convenient claim of ignorance is so preposterous that it could be swallowed only with a full mine shaft worth of salt).

In reading Krystofiak’s testimony again in researching this article I realized that I was giving Greenspan and Bernanke too much credit by concluding that they were unaware of the implications of the twin fraud epidemics. Krystofiak connected the dots for the Fed in his testimony. Greenspan and Bernanke ignored an expert mortgage broker, an ethical insider determined like the most ethical appraisers to clean the rot from his profession, who explained how the frauds worked, the fact that they were often initiated by the lenders and their agents, and the fact that mortgage fraud would harm everyone except the controlling officers driving the frauds. Greenspan and Bernanke did have to do any heavy intellectual lifting by making logical inferences about a subject, fraud, that he had spent entire careers ignoring. All they had to do was to listen to Krystofiak; who did all the hard work for the Fed.

The appraisers’ warnings were amazingly early – they had reached the stage of creating a formal petition by 2000. Their warning came before the Enron-era epidemic of accounting control fraud!

There are books and articles celebrating the purported genius of John Paulson and Jamie Dimon based on their purported brilliance in figuring out in late 2006 that the housing market was going to tank. These books and articles make it clear that these vaunted experts missed entirely the many warnings about the twin mortgage fraud epidemics that began with the appraisers in 2000 and continued over many years from multiple sources. Paulson and Dimon were years over six years behind the appraisers and 15 years behind the savings and loan (S&L) regulators.

The Lenders’ CEOs’ “Revealed Fraud Preferences”

The finance industry responded to all of these warnings by massively increasing the fraud.

“Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007” (Iowa AG).

Krystofiak’s explained to the Fed in his testimony that liar’s loans grew massively – well after the appraisers’ warnings and the FBI’s warnings. The lenders’ CEOs’ revealed their preferences in response to these fraud warnings and their preference was overwhelmingly for ever greater fraud.

Many Private and Public Sector Actors Could Have Prevented the Crisis

There was ample time and means to prevent any financial crisis from arising from the incipient epidemic of fraudulent lending. A large number of actors, the regulators, prosecutors, credit rating agencies, secondary market purchasers, inside and outside auditors – and, of course, the CEOs of the lenders making the fraudulent loans – could have stopped the appraisal fraud epidemic in its tracks. It is obvious why the CEOs of the fraudulent lenders did not stop the endemic appraisal fraud that was designed to cover up the endemic mortgage origination fraud. The spread of the mortgage fraud epidemics throughout the secondary market participants and CDOs is a testament to the power of the CEOs who lead accounting control frauds to suborn myriad private sector firms and professionals to aid their frauds.

The fact that no federal banking regulatory agency responded to the appraisers’ warning with effective action (or even a warning about the fraud epidemic) reveals how severe the damage is when three Presidents in a row (Clinton, Bush, and Obama) appoint anti-regulatory leaders for the agencies. Appointing anti-regulators is, of course, a self-fulfilling prophecy of failure. That is what the industry intends when it influences presidents to appoint anti-regulatory leaders. This particular regulatory failure to take the epidemics of fraudulent liar’s loans and appraisals is one of the most inexcusable in history.

We Know That Real Regulators Would Have Prevented the Crisis (Again)

It is not a hypothetical to say that real regulators would have reacted promptly, long before the crisis, to end the twin control fraud epidemics. We did so a decade before the appraisers first began their petition. We did so against exactly the same twin barrel fraud assault – led by the same CEO and the same lender. Only the name of the firm and the identity of its potential federal regulator had changed. We acted in 1990-1991 to halt this incipient epidemic of accounting control fraud because we were the regional regulators (OTS West Region) with jurisdiction over Orange County, California – the traditional birthplace of U.S. financial frauds.

We acted to end liar’s loans because we listened to our examiners who explained why no honest home lender would make liar’s loans and commit appraisal fraud. The alert reader will know that our struggle against the Orange County frauds in 1990-1991 constituted a “second front” in the war that the S&L control frauds were waging against our Nation. We were exceptionally busy during that period. We were driving the anti-regulator who controlled our agency, OTS Director Danny Wall, to resign in disgrace through our testimony in a series of explosive congressional hearings. Wall had removed our jurisdiction over Lincoln Savings under political coercion from the five U.S. Senators who became known as the “Keating Five” because we refused to rescind our recommendation that the government take over Lincoln Savings. If we failed to demonstrate that Wall had disgraced his office we would have been fired. We also had to end Darrel Dochow’s tenure as OTS’ head of supervision. Dochow had led the effort to cave in to Keating’s political intimidation. I considered him the worst professional banking regulator in the Nation. When Wall resigned in disgrace his successor removed Dochow as head of supervision.

We were closing scores of failed S&Ls in our region, many of them exceptionally large. We were making thousands of criminal referrals, bringing scores of civil suits, and hundreds of enforcement actions. We were testifying before the Senate Ethics investigation of the Keating Five and the House ethics investigation of Speaker Wright. We were adopting new rules in conformance with the 1989 and 1991 legislative acts. I was defending a $400 million civil suit brought by Charles Keating against me in my individual capacity. We were training FBI agents and Assistant U.S. Attorneys. A material number of our top examiners were “detailed” to work for the FBI to serve as internal experts on their highest priority investigations. (This allowed them access to confidential Rule 6 (e) grand jury materials.) Many of us spent material time testifying in criminal cases as percipient and expert witnesses.

In our era, the industry did not yet call stated income loans “liar’s” loans. Our examiners had to figure out that the loans were endemically fraudulent.

The schwerpunkt of the Orange County control fraud’s “liar’s loan” assault on the public was Long Beach Savings, led by Roland Arnall. Arnall caused Long Beach to be the pioneer in making liar’s loans. Arnall also caused it to be a leader in appraisal fraud and a pioneer in predatory mortgage lending targeting blacks and Latinos.

We drove stated income loans out the S&L industry in 1990-1991. Because of our supervisory crackdown on stated income loans, Arnall voluntarily gave up federal deposit insurance and converted to a mortgage bank for the sole purpose of escaping our regulatory jurisdiction. He changed Long Beach’s name to Ameriquest. A husband/wife team that we had “removed and prohibited” from the federally insured financial industry started a mortgage bank that became one of Arnall’s material competitors. Michael W. Hudson’s 2010 book The Monster provides a superb history of Ameriquest. In addition to our supervisory actions that led Arnall to flee our jurisdiction we made the referrals to the Department of Justice about Long Beach’s predatory lending that included discrimination against black and Latino borrowers. Those referrals eventually led to DOJ sanctions against Ameriquest. Once Arnall was able to convert Long Beach into a mortgage bank, however, we lost all ability to protect the public from Arnall and Ameriquest.

The FTC and the state attorneys general, however, continued to have jurisdiction over aspects of Ameriquest’s mortgage lending. Their investigations prompted the third and fourth major sanctions against Ameriquest.

The Fed, the OCC, and the OTS Have No Excuse for Not Heeding the Warnings

The Fed had the unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to stop all “liar’s” loans by any lender regardless of whether the lender had federal deposit insurance. The Fed held the hearings at which Krystofiak testified because Congress mandated that it did so because of continuing concerns in Congress about predatory lending.

The Fed was never dealing with a crisis from 2000-2007. It was “busy” not dealing with the crisis. The Fed had far greater staff than we, the OTS West Region, had. The Fed finally used HOEPA to ban liar’s loans in mid-2008. Even then, it acted in response to Congressional demands that they do so. Worse, Bernanke delayed the effective date of the rule by 15 months – because one would not want to inconvenience a fraudulent lender.

The Fed had the immense advantage of our experience with liar’s loans, the testimony of Krystofiak and dozens of other witnesses, the fact that the industry now called the loans “liar’s loans,” and the warnings from the appraisers, the FBI, MARI, and the state attorneys general. The frauds were massively greater in their era because they failed to act.

The OCC and the OTS failed when Ameriquest’s fraudulent lending operations were sold. Citicorp and Washington Mutual’s (WaMu) holding company eagerly acquired Ameriquest’s operations and pumped out tens of thousands of additional fraudulent loans. The OCC and the OTS had all the advantages not simply of our general crackdown on liar’s loans but our two actions against Long Beach Savings and the subsequent actions of the FTC and the state attorney’s general. It was insane to allow Citicorp and WaMu to acquire Ameriquest’s fraudulent and predatory lending arms. OTS gets the prize for worst of the worst because it promoted Dochow repeatedly and put him in charge of the West Region where he again failed to regulate. OTS compounded the insanity of allowing WaMu’s holding company to acquire Ameriquest’s mortgage operations (called “Long Beach Mortgage) by permitting the holding company to transfer Long Beach Mortgage to WaMu, the federally insured S&L. That transfer put the FDIC fund and the Treasury at risk of loss. Long Beach Mortgage had fraudulently sold so many fraudulent and predatory liar’s loans, often with fraudulent appraisals, that its potential liability was enormous. .

It is only in retrospect that we can see how valuable real regulators are to a nation. They can stop crises in their tracks. As MARI warned in 2006, the early 2000 move to make liar’s loans cost the lending industry “hundreds of millions of dollars.” The appointment of the anti-regulatory leaders in the current crisis allowed over a $10 trillion loss – roughly 4000 times larger. We cannot afford the price of creating a self-fulfilling prophecy of regulatory failure by continuing to appoint dogmatically anti-regulatory leaders and judges.