The Two Documents Everyone Should Read to Better Understand the Crisis

[RedEarth]

As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds. When the person that controls a seemingly legitimate business or government agency uses it as a "weapon" to defraud we categorize it as a "control fraud" ("The Organization as 'Weapon' in White Collar Crime." Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds' "weapon of choice" is accounting. Control frauds cause greater financial losses than all other forms of property crime -- combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a "criminogenic environment" (Big Money Crime. Calavita, Pontell & Tillman 1997.)

The FBI correctly identified the epidemic of mortgage control fraud at such an early point that the financial crisis could have been averted had the Bush administration acted with even minimal competence. To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud.

Don't ask; don't tell: book profits, "earn" bonuses and closet your losses
The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages "underlying" the derivative. A senior manager sends a blistering reply with this forceful punctuation:

Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.

Fraud is the principal credit risk of nonprime mortgage lending. It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, "most investors" (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The "AAA" rating is supposed to indicate that there is virtually no credit risk -- the risk is equivalent to U.S. government bonds, which finance refers to as "risk-free." We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this era rises like a stairway to heaven. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud.

..........

A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch's report on what they found.

.........

These two documents are enough to begin to understand:

the FBI accurately described mortgage fraud as "epidemic"

nonprime lenders are overwhelmingly responsible for the epidemic


the fraud was so endemic that it would have been easy to spot if anyone looked


the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a "don't ask; don't tell" policy


willful blindness was essential to originate, sell, pool and resell the loans


willful blindness was the pretext for not posting loss reserves


both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed


the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses


the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation


many of the big banks are deeply insolvent due to severe credit losses


those big banks and Treasury don't know how insolvent they are because they didn't even have the loan files


a "stress test" can't remedy the banks' problem -- they do not have the loan files


http://www.huffingtonpost.com/william-k-black/the-two-documents-everyon_b_169813.html

[msongs]

1. so, NO welfare for bank scammers until loan files are examined first? nt

[sui generis]

2. stress testing

That is the most absurd misuse of the phrase; in analytics or otherwise, in this context.

We report financial positions at the end of "bucketed" periods - i.e., monthly, quarterly, annually, and period over period.

What that implies is not how you value the effect of discretionary decisioning in your risk pool or how you choose to factor it in a particular stress model, but that the rate of change between buckets ("populations") is a marker of volatility, and volatility in and of itself is a leading indicator of future instability and risk.

We know it's fucked up. If we run a test against an institutions assets and their death-slope/intercept against their "reliable" operating revenue and try to factor for changes in market indicators, seasonality, the discovery of additional at-risk assets, etc., that's the simplest "stress test". Unfortunately stress tests rely on stacks of assumptions, and a good analytics person is going to want to challenge every one of those assumptions in some quantifiable way before we ever get to the first test and outcomes study.

It's simple minded - sounds like we're being handed a witch-doctor rattle as a placebo; and I despise witch doctors.

[yurbud]

3. I hope stress testing means they put bankers nuts in a vice, and see how much pressure it takes to

pop them.

[eomer]

4. Links to "the two documents everyone should read":

"The first document everyone should read is by S&P, ..."
http://oversight.house.gov/documents/20081022112230.pdf

"The second document everyone should read is Fitch's report on what they found."
http://blenderlaw.umlaw.net/wp-content/uploads/2007/11/fitchfraud1.pdf