A number of analyses of the U.S. and global crisis begin by attempting to explain what they assume to be a paradox -- how could so small a market segment (subprime housing and CDOs backed by subprime) have caused (1) the largest financial bubble in history, (2) a U.S. economic crisis, and (3) a nearly global crisis? To these scholars the obvious answer is that subprime lending could not have caused this traumatic trifecta. It follows that the importance of subprime lending must be overstated and there must be other, more powerful causes of the trifecta.
I will show that the focus on subprime loans was excessive and allude briefly to the points I have made in prior columns about the variant causes of the global crisis. The next column will address in more detail how criminologists determine the true incidence of mortgage fraud. Subprime loans were and are a serious problem, but there has been a destructive overemphasis on subprime loans as the core of the U.S. crisis. "Liar's" loans are a far greater problem, and most problem subprime loans are actually liar's loans. While the nonprime mortgage industry's preferred euphemisms were "alt-a" and "stated income" loans, it was the industry that accurately dubbed them liar's loans. It was the industry that created liar's loans and it is liar's loans that made so many officers wealthy.
The industry pitched liar's loans to the regulators on a series of bright shining lie -- that they were equivalent to the risk of prime loans and simply underwritten on an alternative basis because the borrowers were entrepreneurs who could verify their incomes. The further lie was that liar's loans were distinct from subprime loans, which were only made to those with serious credit defects with conventional underwriting. The reality is that there is an easy means for small business owners to verify their income -- by authorizing the IRS to provide information from their tax returns to the lender via IRS Form 4506. There were two groups of borrowers who had acute needs to avoid disclosing their income and wealth -- those engaged in tax fraud evaders and those seeking to deceive their spouses or defraud their prior spouses and children in order to evade alimony and child support payments. (Remember when one of "C's" in lending referred to "character" and we taught loan officers why one should not lend to those of bad character?) People who will cheat their kids are certain to be willing to cheat their lender.
The purpose of liar's loans was to create endemic fraud throughout the mortgage process - from origination to the sale of collateralized debt obligations (CDOs) backed by liar's loans ("cradle to grave" fraud). The lies in liar's loans were so endemic and so egregious that the financial version of "don't ask; don't tell" was essential at every step of the process. Liar's loans were also perfect for the loan origination level variant of "don't ask; don't tell."
Liar's loans were not underwritten. The borrower did ask about income, but only in the sense made famous by Monty Python ("wink, wink; nod, nod"). The lender agreed that it would not verify the borrowers' "stated income" (and often the borrowers' jobs and assets). As I have explained in prior columns, the lenders that specialized in making liar's loans frequently outsourced much of the job of finding the borrowers who would take out the liar's loans to loan brokers. Studies by various state attorney generals, white-collar criminologists, and private and public investigators have confirmed that it is lenders and their agents (loan brokers and loan officers) who overwhelmingly put the lies in liar's loans. There are independent analytical reasons to believe these findings.
- Doing so maximized the lenders' (and their loan brokers') reported (albeit fictional) income (and their controlling officers' bonuses). The greater the stated income, the more likely the loan would be made, the larger the size of the loan, and the greater the resale value of the loan in the secondary market. Each of these elements drove the agents' and loan officers' compensation up - and by very large amounts.
- By inflating the borrowers' stated income, the lender and its brokers could make the loan appear to be less risky and sell it for a premium to the secondary market greatly inflating the borrower's stated income. The liar's loan lenders could also make the loan appear to be less risky to the regulators (though unregulated mortgage bankers probably made most of the liar's loans), credit rating agencies, and auditors. These entities typically treated the (fictional, far reduced) "debt-to-income" ratio arising from inflating the borrower's stated income as if it were real. (In reality, this willingness to believe, without real due diligence, the lies that would make these professionals wealthy was another variant of "don't ask; don't tell.") It was not exactly difficult for anyone in the trade to figure out that must never treat as truthful the stated income in something the trade called a "liar's" loan. Indeed, the ability of everyone in the trade to know that they should never treat the loans as honest was made even more simple when the mortgage lending industry's own experts as deserving of that label because such loans were "an open invitation to fraudsters" (MARI 2006) - during what the FBI had termed as early as September 2004 to be an "epidemic" of mortgage fraud. Depressing the real debt-to-income ratio by inflating reported income was a useful lie to everyone with a financial stake in the liar's loan machine - which was most of our largest financial firms in the U.S.
- Not verifying the borrowers' stated income simultaneously facilitated the lenders' and their brokers' ability to sell fraudulent loans at a premium in the secondary market and minimized risk of the lenders' and their brokers' controlling officers being sanctioned for their frauds essential to their origination and sale of liar's loans. The brokers and lenders obviously, could not verify the fictional incomes that they had inflated. They would have had three choices. They could have honestly sought to verify something they knew to be false - which would have prevented the loans from being made and dramatically reduced their income. They could have claimed that they had verified the income but provided no records of their efforts at verification or the borrowers' true income. That strategy would have added another act of fraud (a false certification of verification) while providing no credible evidence. The other alternative would be for the brokers and officers to forge documents purporting to show that they had conducted due diligence as to the borrowers' true income and attesting to the accuracy of the stated income. This strategy would have made it simple for the Justice Department to convict the loan brokers and officers. The ideal strategy is for the loan brokers and officers to do no underwriting of the stated income and to purport that the borrowers' credit rating (FICO score), in conjunction with the fraudulent LTV and debt-to-income ratios, proves that the loan has risk characteristics equivalent to prime loans. FICO scores, of course, can never demonstrate that the borrower has the capacity to repay a home loan and there are common scams that use someone with a good FICO score as a shill to obtain a loan.
Liar's loans were equally useful in facilitating accounting control fraud by those involved in the CDO process. The secondary market had to rely on "don't ask; don't tell" to be able to securitize and sell CDOs. CDOs were largely backed by liar's loans and fraud was so endemic and so obvious among liar's loans if one engaged in due diligence that it was ideal to claim that liar's loans required no meaningful due diligence and could not be the subject of meaningful due diligence because there were no underwriting files to review because the lender did no real underwriting. Again, consider what would have happened if the securitizers, credit rating agencies, or auditors had actually looked at any reliable sample of the liar's loans for evidence of fraud. They would have reported, as did Fitch in November 2007, that there was evidence of fraud in the nearly every file. If they asked, they could not sell. Their files would show that they knew they were knowingly selling securities backed primarily by fraudulent loans - and claiming the CDOs were "AAA."
Liar's loan borrowers had no leverage to create a "Gresham's" dynamic among appraisers. There is no honest reason why a mortgage lender would inflate the appraised value and the size of the loan. Causing or permitting large numbers of inflated appraisals is a superb "marker" of accounting control fraud by the lender because the senior officers directing an accounting control fraud do maximize short-term reported (fictional) income (and real losses) by inflating appraisals and stated income. As I have noted, and will return to in future columns in more detail, lenders and their agents frequently suborned appraisers by deliberately creating a Gresham's dynamic to try to induce them to inflate market values, leaked the loan amount to the appraisers, drove the appraisal fraud, and made it endemic. As with inflating income in order to minimize the reported debt-to-income ratio, inflating the appraisal allowed everyone with a financial stake in the lies to minimize the reported loan-to-value (LTV) ratio and allow everyone to pretend that the loan was far less risky because it had such a large (but yet again fictional) equity cushion. Given that we know that appraisal fraud was endemic, that endemic appraisal fraud is impossible without being led or permitted by the lenders and their agents, and that no honest lender would permit or cause widespread inflated appraisals, the logical inference is that the lenders and their agents led both the stated income and the appraisal fraud.
Only the lenders and their agents had the inside information and expertise to know how to optimize the deceit in the loan application process. Many of the housing speculators who bought a material number of homes and sought to flip them were industry insiders, and many of them also committed fraud by indicating that they intended to make each of the houses (simultaneously) their principal dwelling. These professionals would have known of the details of the lenders' term sheets and could have picked the debt-to-income and LTV ratios (and sometimes had illegal side deals with appraisals to inflate the appraisals to secure the desired LTV. The great bulk, however, of those that borrowed through liar's loans were not financially sophisticated and had no way of knowing how much they needed to inflate reported income to hit the "sweet spot" that would maximize the loan broker's and the loan officer's fees and bonuses. Loan brokers willing to specialize in making liar's loans had to be able to lead the lies about the borrowers' income that would maximize the loan broker's fees.
The fact that the lenders and their agents specializing in making liar's loans led the stated income frauds does not, of course, mean that the borrowers had no ethical responsibility or culpability. As I will show in future columns, there are millions of cases of mortgage fraud through liar's loans. There are doubtless hundreds of thousands of borrowers who knew that the incomes the brokers and officers told them to report on the loan applications were false.
Yes, it does appear to have been common for the loan brokers and officers to create the false loan applications and even forge the borrowers' signatures. Some of the lenders are reported to have referred to these practices as "Arts and Crafts" weekends. We don't know how common this level of lender fraud was because the regulatory agencies and prosecutors have not publicly reported their investigations. Indeed, there is no public evidence that the regulators or prosecutors are even conducting comprehensive investigations of the endemic accounting control fraud by the lenders that made large amounts of liar's loans.
We now have the analytical basis to begin to explain the supposed paradox as to how such a relatively small number of subprime loans caused an intense global crisis. Here are the central points, which I will flesh out in future columns.
- Many subprime loans were also liar's loans
- Many hybrid loans existed with greatly reduced underwriting
- There were, and are, no official definitions of the loan categories "alt-a", "subprime", or the many hybrid forms
- Because there is no definition and the categories of "subprime" and "liar's" loans are not mutually exclusive, there is inherent uncertainty and a need to use judgment to form useful estimates. Credit Suisse reported (2007) that 49% of new originations in 2006 were "alt-a" loans (i.e., liar's loans). The incidence of fraud among liar's loans found in most independent studies is 80% or above. If the Credit Suisse figure is even close to accurate (and some caution is vital there), then we are suffering from over a million cases of mortgage fraud annually in 2005 and 2005 and the frauds were growing in 2007 until the secondary market collapsed. Data on criminal referrals are, when extrapolated, consistent with that level of fraud incidence. The supposed paradox arises from a factual error. Nonprime loans were common. Liar's loans grew massively and hyper-inflated the financial bubble. The size of the bubble and the fraud losses were enormous relative to bank capital. Indeed, the very lack of reliable data on the true composition of liar's loans (Fannie, Freddie, and Lehman all reported them as "prime" loans for most purposes) in mortgage portfolios and CDOs was itself one of the factors driving systemic risk. Investors, rightly, feared that most large financial institutions had huge exposures to fraudulent loans.
- At law, fraud's defining element is deceit. The fraudster gets the victim to trust him and then betrays that trust. This is why control fraud by our elite financial institutions is such a powerful acid to erode trust. Trust is vital to an effective economy. Markets shut down in the crisis because bankers no longer trusted other bankers' asset valuations.
- Other nations (Iceland and to a far lesser extent Ireland) that have had moderately serious investigations of the causes of their crises have produced reports that provide compelling evidence of accounting control fraud as major drivers in their crises. Spain is notorious for its' banks' accounting abuses, but Spain has not provided any true investigative reports.
- The FDIC and OTS created a data base well after the crisis began. It sought (false) precision at the cost of analytical usefulness. It creates a false dichotomy between "alt-a" and "subprime" based on reported FICO scores (which it implicitly assumes to be real). The result is that one cannot use the data to study loans made without underwriting. That category - the single most important characteristic for studying, measuring, and predicting losses - does not exist in their data. It is vital that researchers understand that the FDIC mortgage data base is unreliable and it is vital that the FDIC create a new, reliable data base.
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 hisSocial Science Research Network author page and at the blog New Economic Perspectives.
This column appeared originally in Benzinga.
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December 30, 2010
Concerns over Growing Debt Load of the Al-Bukhary Group
Concerns are rising over the growing debt load in Tan Sri Syed Mokhtar Al-Bukhary’s companies now that the tycoon is expected to snap up the multi-billion ringgit tunnelling contract for the city’s RM36 billion train service and the Penang Port.
Former rice trader gets bulk of fortune from Malaysia Mining Corp. (MMC), through which he holds concessions to operate a port and an airport in Johor; owns stake in power producer Malakoff. Through listed Tradewinds, recently took over national rice supplier Padiberas Nasional. Owns Harrods in Malaysia.
Singapore’s Straits Times reported today that the Kedah-born businessman’s debts could be as high as RM25 billion, with RM21 billion itself incurred by his flagship MMC Corp although his officials claimed most of it is due to project financing.
“There are a host of corporate governance issues that plague his group and the chief among them is the rising debt load,” said one chief executive of a boutique financial consultancy.
“The fear is that his group could be the Renong of this decade,” said a senior politician from UMNO, referring to the politically well-connected conglomerate headed by businessman Tan Sri Halim Saad.
Renong feasted on infrastructure projects dished out by former premier Tun Dr Mahathir Mohamad’s government. But when the regional crisis hit in mid-1997, it was crippled by huge debts and was eventually bailed out with public funds.
The Singapore daily reported that in the past year Syed Mokhtar had emerged as “the single biggest beneficiary of state contracts and concessions worth billions of ringgit, making him Malaysia’s most favoured corporate son and the government’s partner of choice.”
But close associates of the lanky and reserved tycoon insist the debt concerns are misplaced and he is not biting off more than he can chew. The newspaper said they acknowledged that the debt load of Syed Mokhtar’s corporate flagship, publicly-listed MMC Corp, which stands at just over RM21 billion, may appear high. But the lion’s share of the debt is project finance, a complex form of financing reserved for large-scale infrastructure projects where the debt is typically repaid from funds generated from the businesses.
“The debt load is manageable and is high because of the nature of the businesses the group is involved in,” said a senior corporate lieutenant of Syed Mokhtar, who insisted it can easily raise funds to finance future projects.
But some Kuala Lumpur-based bankers are not so sanguine, noting that the financial returns from many of the group’s assets — such as its power plants — are poor yielding, and that its ports, which are not performing well, could suffer should the global economy enter a slump.
The newspaper also said the shares of the listed companies in Syed Mokhtar’s corporate empire “do not seem to appeal to conservative foreign and domestic fund managers”.
Born to a family of traders with roots in Bokhara, in present-day Uzbekistan, Syed Mokhtar began his business career peddling Thai rice to the state governments in northern Malaysia before riding the boom on the stock market in the 1990s.
The capital from trading in stocks provided him with financial heft for his first major venture: the purchase of a port in Johor which today is the Port of Tanjung Pelepas.
The Straits Times said by leveraging on his strong ties with politicians such as Dr Mahathir and current Deputy Prime Minister Tan Sri Muhyiddin Yassin, who at the time was the mentri besar of Johor, Syed Mokhtar moved into other areas.
Admirers and close associates told Straits Times that Syed Mokhtar is often favoured because of his lavish donations to Islamic causes and political contributions. His companies contributed around RM350 million last year to his own foundation, which focuses on education and religious causes, the newspaper reported.
However, it said critics argue that the businessman’s clout illustrates how the old patronage system where business and politics intertwine in Malaysia remains in force. “He is a master at the political game first and only then a businessman,” said a financial consultant who has done work for Syed Mokhtar’s group.
SakmongkolAK47 on Sime Darby’s RM2.1 billion Loss: Recovering only RM430 million
For a brief moment, most of us were probably reassured at the solemnness by which Sime Darby attempted to seek retribution. They lost RM 2.1 billion; they seek to recover a total of RM 430 million.
This amount must be what the forensic auditors recommended. RM 430 is a pure loss through breach of duty and management negligence.
The balance of the loss is operational loss and can happen through the ordinary course of business operations. The balance of the loss is therefore justifiable and not subject to recovery.
I don’t know what to say — you lose this amount of money, all you can come up with, is a civil suit? How dumb can that be? Why no criminal charges proffered? Sime doesn’t know the meaning of corruption?
How will Sime seek to prove management negligence and breach of duty? Is there some golden rule, you depart from which constitutes a breach of duty? Breach of duty means what? Negligent? Then when Idris Jala lost many millions of money through his negligent hedging should be asked to pay back the money MAS lost?
Nor Yaakob who has gone crying to see Tun Mahathir, horrified at the thought that he may be shown the exit from cabinet this time, should also be asked to pay back the money he lost when speculating on our currency. There are so many examples which will readily suggest that the move by Sime to recover money through civil suits is a stupid move.
How do you define breach of duty and negligence in business matters? Some people in Sime Darby who were before that, were probably touted as exemplary managers and excellent talent, were found to have caused Sime Darby to lose RM2.1 billion.
Sime is now seeking recovery for RM338 million from 4 people. It is further seeking recovery of another
RM92 million. This means the total amount intended to be recovered is RM 430million. This will also mean that out of the RM2.1 billion lost, if only RM430 billion is the recoverable amount, then the loss of RM1.6 billion is considered loss from business operations. That is acceptable?
Clever, man (left). You come forward to pull wool over public eye by stating with the suitable and accompanying somber tone to say — we shall recover this RM430 million because of principle. People will laugh at this — because you have not fully explained how the RM1.6 billion is a loss that is justifiable and so, there is no need to recover. Sime people think it’s their father’s bloody money which they can lose.
We find it laughable amidst this gargantuan loss; some people in the Board of Directors have no iota of shame not to resign. I have written a long time ago, the entire board of directors should have resigned at the every moment the financial scandal came to light. If they had, they would still be around to be called in as witnesses to help us discover the truth.
So despite Sime’s at first sight, laudable move, there are so many questions unanswered. We shall have to do a bit of sleuthing.
http://sakmongkol.blogspot.com/
Following the maxim that drastic times call for tepid measures, the banking industry continues to pay "lip service" to loan modifications while doing little. On Dec. 15, the Congressional Oversight Committee admitted the government's HAMP loan modification program has failed to help enough homeowners to stem the tide of foreclosures. The vast majority of loan modification requests fail, in part, experts believe, because banks have balked at offering a reduction in mortgage principal, the most effective way to halt costly foreclosures. Trying to revive HAMP, the administration in December announced new regulations designed to push banks into offering more reductions in principal than they have in the past. Fannie Mae and Freddie Mac immediately proclaimed, however, that they remain opposed to making this option available to struggling homeowners. Protecting the interests of the banking industry over the consumer, the Federal Reserve also blocked new foreclosure regulations that would have reined in foreclosure abuses. Although the economic collapse of 2008 has caused the tide to rush in on everyone, there has been no bailout for the "little guy." Left to fend for themselves, increasing numbers of homeowners are turning to a little-known provision in the federal bankruptcy law, which permits the discharge of a second or even third mortgage in its entirety in a Chapter 13 bankruptcy. The American Bankruptcy Institute recently reported that Chapter 13 bankruptcies have risen by 9 percent in 2010 compared to last year.
Flying under the media radar, the right to discharge a second mortgage in a Chapter 13 bankruptcy provides a glimmer of hope to homeowners stuck with a foreclosure because they own a home they can't afford and can't sell. With one in 10 Americans out of work, while others have suffered a pay cut as a condition of keeping their jobs, the amount of disposable income available to pay a mortgage is not what is used to be. Getting rid of a 2nd mortgage payment can sometimes make the difference between keeping a home and losing it to a foreclosure. How then does a homeowner qualify? Quite simply, when a home is worth less than the balance of a first mortgage, federal bankruptcy law -- at least in most states -- permits a homeowner to treat a second mortgage like an unsecured credit card and discharge it in a Chapter 13 bankruptcy.
Housing prices dipped for the third straight month in October, and hope for a recovery in 2011 has started to fade. According to Corelogic, an industry researcher, 11.8 million homes, or more than one out of five mortgages in the United States are "underwater" -- i.e. the total mortgage debt exceeds the value of the home. The U.S. Department of the Treasury estimates eight to 13 million foreclosures will occur from December 2010 through 2012 unless something intervenes. Ironically, the HAMP requirement that a homeowner generally be at least 60 days behind on a mortgage in order to qualify has led to foreclosures on homes where the mortgage payment had been up to date. In fact, a recent National Consumer Law Center's survey of 96 foreclosure attorneys in the US found that mortgage servicers began foreclosure proceedings against 2,500 of their clients even though a loan modification request was pending. Loan servicers do make more in fees from the foreclosure process than from the loan modification process, so this is not surprising.
Bankruptcy is a business decision, no less for a homeowner than it was for General Motors when it filed a Chapter 11 bankruptcy. This economy has sent clients to my door that I seldom used to see -- attorneys, physical therapists, nurses, college professors, and scores of people dependent on the real estate market for their livelihood. A bankruptcy is usually preceded by a loss of income, a divorce or medical issues, sometimes all three. Bankruptcy is not on anyone's list of fun things to do, and clients only consider it when the alternative, like a foreclosure, is worse. Many have tried to do a short sale or loan modification to no avail and have found that the bank would rather foreclose. In New Hampshire, a homeowner will be responsible for a mortgage deficiency for 20 years. These problems will persist until the powers that be decide to offer more than half-measures to address the foreclosure crisis.
For those facing the loss of their home and wondering whether a Chapter 13 bankruptcy may help get rid of a second mortgage, the following information may be helpful:
(1) It is disingenuous of banks to lull homeowners into a false sense of security by scheduling a foreclosure auction when a loan mod request is pending. If this happens to you, don't be too trusting when your bank tells you not to worry about the foreclosure because they'll continue the auction if there's no answer by the auction date. What they are really saying is if you are denied, the foreclosure will happen. One client told me that Bank of America won't even consider continuing a foreclosure auction due to a loan mod request until it was 72 hours before the auction date. I regularly receive panicked calls from homeowners denied a loan mod just before the auction occurs. While a Chapter 13 stops a foreclosure automatically, given how busy most bankruptcy lawyers are these days, finding one who has time to do a court filing at the last minute may be difficult. (2) If you decide to see if you can get rid of a second mortgage, ask a broker to give you an opinion in writing of what your house is worth. Brokers will usually do this as a courtesy, figuring if you ever do decide to sell your house, you'll go through them. Make sure you ask for the potential sales price rather than a list price, which may be somewhat inflated. If the estimate is less than the balance of your first mortgage, then removing it in a Chapter 13 bankruptcy is possible.
(3) Even if you can get rid of a second mortgage, however, a Chapter 13 is not for everyone. Removing a second mortgage only works if you have enough income to complete the plan successfully. If the real problem is that you don't have enough monthly cash flow to pay your first mortgage and other expenses, Chapter 13 won't solve that problem.
(4) Chapter 13 will permit strapped homeowners to discharge most or all of their credit card debt. It usually won't discharge certain debt like taxes and student loans.
(5) Before making a decision, you want to be sure you can keep all property. Most states have exemptions sufficient to permit a homeowner to keep a house, vehicles, and other assets, however, some states are more generous than others.
The above is not intended as legal advice for your particular situation. Questions should be addressed to attorneys admitted to practice within your state. Richard Gaudreau is a lawyer admitted to practice in New Hampshire and Massachusetts and may be reached by email at: richard@attorneygaudreau.com or by phone at: 603-893-4300.
