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By William K. Black
The Department of Justice’s (DOJ) latest civil suit against Bank of America (B of A) is an embarrassment of tragic proportions on multiple dimensions. In this version I explore “only” seven of its epic fails.
The two most obvious fails (except to the most of the media, which failed to mention either) are that the DOJ has once again refused to prosecute either the elite bankers or bank that committed what the DOJ describes as massive frauds and that the DOJ has refused to bring even a civil suit against the senior officers of the banks despite filing a complaint that alleges facts showing that those officers committed multiple felonies that made them wealthy by causing massive harm to others. Those two fails should have been the lead in every article about the civil suit.
The next most obvious DOJ fail, also ignored, was that the DOJ compounded the first two fails by congratulating itself for holding the frauds “accountable” for their crimes. One can only imagine the hilarity with which B of A senior officers in their mansions they bought with the proceeds of their frauds must have greeted the DOJ’s latest pratfall. If DOJ’s leadership cannot find the intestinal fortitude to renounce their infamous “too big to prosecute” doctrine they can at least have the decency to stop praising themselves for violating their oath of office and their duty to the Nation.
DOJ’s Gratuitous Gift to the Frauds
The fourth fail adds a new means by which DOJ has caused long-term harm to the Nation. It is in paragraph 4 of DOJ’s complaint.
“Unlike countless others at the time, the investors in the Certificates were not attempting to chase additional return by investing in risky “subprime” or “Alt-A” RMBS, which were collateralized by mortgages given to borrowers with shaky credit but that offered higher rates of return.”
The complaint alleges that the Federal Home Loan Bank of San Francisco (FHLBSF) and Wachovia were prudent purchasers of B of A’s mortgage backed securities (MBS) – unlike the normal, imprudent MBS purchasers whose numbers are so large as to be “countless.” Any competent defense counsel for the banks and bankers, credit rating agencies, etc. being sued for fraud will be eagerly quoting DOJ and demanding that the courts dismiss the lawsuits of investors that purchased MBS sold with the aid of fraudulent “representations (reps) and warranties” on the grounds that the investors were imprudent because they were “chas[ing] … higher rates of return.”
Disclosure: I was SVP and General Counsel of the FHLBSF in 1987-1989.
There are five major problems with DOJ’s sentence implying that an investor is imprudent if it purchases a “risky” asset because it “offered higher rates of return.” First, the statement is gratuitous. There was no reason for DOJ to make it.
Second, the statement is financially illiterate. DOJ normally asserts (and the SEC routinely asserts) that to obtain higher expected returns one must typically invest in riskier assets. Anyone who buys any stock or any bond other than the shortest term U.S. government bond is taking greater risk with the goal of seeking a higher return. That includes virtually every investor – including the FHLBSF and Wachovia (who could have purchased very short-term U.S. government bonds with no credit risk and only trivial interest rate risk). FHLBSF and Wachovia did not do so because they wished to obtain “higher rates of return.”
Third, for the reasons I explained this sentence will be used by the banks and bankers who intentionally made fraudulent reps and warranties to the buyer, became wealthy through such fraudulent sales, and wish to escape any civil or criminal liability by arguing that everybody knew our reps and warranties were lies so there was no real deception and we should be able to become wealthy through lies and blow up the global economy with total immunity. This has not been U.S. law on fraud and it would be a terrible policy that would cause catastrophic harm and make the worst elements of society the wealthiest (and give them dominant political power).
Fourth, the complaint makes it clear that DOJ still is clueless about mortgage fraud schemes in origination and the secondary market. They continue to ignore the “recipe” for “accounting control fraud.” The fundamental fact is that B of A’s officers frequently shared a community of interest with the officers controlling the firms that purchased B of A’s fraudulent loans sold through fraudulent reps and warranties. The fraud recipe’s four ingredients are so similar for the officers controlling the lender and the purchaser of loans that both gain at the mutual expense of their firms.
Only the second ingredient differs, and both sets of controlling officers can profit simultaneously by following the recipe and engaging in the twin sides of the same transaction. George Akerlof and Paul Romer captured the dynamic in the title of their 1993 article – “Looting: The Economic Underworld of Bankruptcy for Profit.”
The complaint unintentionally makes clear that DOJ does not understand that B of A was not only selling MBS through fraudulent reps and warranties. B of A was originating massive amounts of fraudulent loans. Making this point would have greatly strengthened DOJ’s complaint, but it would have made it even more inescapable that its failure to prosecute B of A and the other fraudulent mortgage originators was indefensible. I argued from the announcement of the DOJ task force focused solely on fraudulent secondary market sales represented a grave mistake. The origination and sale of fraudulent loans are inherently intertwined and require joint investigation and prosecutions.
Fifth, it is hilarious for DOJ to claim that (in 2008) Wachovia, one of the Nation’s most notorious originators of fraudulent loans; was a victim of unique purity when it bought MBS from B of A. Of course, it was equally hilarious when B of A responded to the complaint by claiming that it could not have engaged in fraud because Wachovia and the FHLBSF were financially “sophisticated.” Criminologists have long observed how vulnerable the allegedly sophisticated are to being defrauded.
DOJ’s Grotesque Ethical Fail
Paragraph 70 of the Complaint revealed reprehensible conduct by B of A and DOJ.
“Prior to the closing of the BOAMS 2008-A securitization, BOA-Bank knew that it had provided Mortgage # *****24342 to a borrower in October 2007 who later that month tried to fraudulently obtain a home equity line of credit on that mortgage through BOA-Bank. The BOA-Bank employee involved in underwriting this mortgage (“Loan Officer JX”) is currently under indictment for mortgage fraud. BOA-Bank terminated her in February 2008 (shortly after the closing of the BOAMS 2008-A securitization). Although BOA-Bank knew the borrower attempted to commit mortgage fraud in October 2007, it nevertheless included Mortgage #*****24342 in the BOAMS 2008-A collateral pool, and it has suffered losses. Moreover, Defendants also included at least thirteen other mortgages originated through Loan Officer JX in the BOAMS 2008-A collateral pool, eight of which have suffered losses.”
DOJ is alleging that a B of A loan officer (JX) approved a loan to a borrower who she knew had previously sought to defraud B of A, that B of A learned of her action and fired her “shortly after” it sold the MBS. She was later indicted for mortgage fraud. B of A put the loan from the fraudulent borrower in the MBS it sold to Wachovia and the FHLBSF, and it suffered losses. B of A also placed “at least 13 other mortgages originated through Loan Officer JX” in the same MBS, and eight of those loans “suffered losses.” The implication of DOJ’s complaint is that B of A knew prior to selling the MBS that it was likely that loan officer JX had committed at least one act of loan fraud in league with a fraudulent borrower. The further implication is that B of A took no action to cure these frauds by investigating Loan Officer JX’s other loans and replacing any fraudulent loans she had originated sold to Wachovia and the FHLBSF in the MBS with good quality loans.
Paragraph 72 explains why B of ‘A originated so many fraudulent loans and sold them through fraudulent reps and warranties in the secondary market.
“72. BOA-Bank’s failure to originate mortgages in substantial compliance with its underwriting standards is not surprising giving the intense pressure placed on BOA-Bank employees involved in the origination process by BOA-Bank management. One BOA-Bank employee involved in the origination of mortgages in the BOAMS 2008-A collateral pool admitted that the emphasis at BOA-Bank was quantity not quality and that he was pressured to increase the number of applications he approved per week. He also admitted that he received bonuses for surpassing mortgage production goals. Another such BOA-Bank employee admitted that that she and her co-workers were instructed by her superiors that it was not their job to look for fraud and stated that her job was ‘basically to validate the loans.’ She also admitted that her superiors pressured her to process applications as quickly as possible but to keep her opinions to herself.”
To state the obvious, except to DOJ, no honest lender would permit any of these practices. Why did B of A’s officers coerce and incent employees to make crappy loans? DOJ provides the answer in paragraphs 23 and 24 of its complaint, which allege respectively:
“The BOA-Securities Managing Director’s annual bonus was largely dependent on Defendants continuing to profitably securitize mortgages originated by BOA-Bank. Thus, he had a strong financial motive to withhold negative information concerning the value of the Certificates from investors.”
“[T]he BOA-Bank Senior VP’s annual bonus and continued employment were dependent on Defendants continuing to profitably securitize mortgages originated by BOA-Bank. Thus, she had a strong financial motive to withhold negative information concerning the value of the Certificates from investors.”
Note that the Complaint fails to make similar allegations about B of A’s top leadership and its top loan officers and underwriting officers even though it virtually certain that their salaries were “largely dependent” on the origination of vast amounts of fraudulent mortgages and the sales of those fraudulent loans through fraudulent reps and warranties.
To summarize the ethical point – B of A followed the fraud recipe for a lender. It did so because it made the controlling officers wealthy through a “sure thing” – accounting control fraud. The senior officers fraudulently originated fraudulent loans and fraudulently sold the fraudulent loans to the secondary market. B of A’s senior officers created the perverse financial incentives (e.g., paying loan officers more for exceeding volume quotas on loans) and coerced employees to make bad loans and criticized them if they acted as competent, honest underwriters. They threw Loan Officer JX to the wolves because she cut an outsider in on the overall fraud without their permission.
DOJ (or the state) is prosecuting Loan Officer JX for acting in response to the perverse incentives B of A’s managers inflicted on the employees in order to induce them to make and approve hundreds of thousands of fraudulent loans. Loan Officer JX had a puny position at B of A. DOJ is refusing to prosecute B of A or its officers who became wealthy by incenting and coercing employees to commit loan fraud and securities fraud. DOJ is refusing to even sue the officers civilly and recover their huge fraudulent gains. DOJ’s prosecutorial ethics have become reprehensible with regard to the systemically dangerous institutions (SDIs) and their officers.
Why Didn’t DOJ Sue B of A’s CEO for Originating “Toxic Waste” Mortgages?
DOJ “buries the lead” by waiting until paragraph 91 of its complaint to quote B of A’s CEO’s infamous line about a major portion of B of A’s operations under his leadership.
“Moreover, even BOA-Corp.’s Chief Executive Officer Kenneth Lewis knew that Wholesale mortgages were riskier than mortgages originated through the Direct Channel. During the July 19, 2007 BOA-Corp. earnings call for the second quarter of 2007, Mr. Lewis responded to an investor question regarding mortgage origination channels by proclaiming that mortgages originated through Wholesale Channel “broker[s] tend to be toxic waste.”
DOJ’s complaint doesn’t simply bury the lead, it buries the analytical point. “Toxic waste” does not refer to “riskier” assets – it refers to assets with a negative expected value. Honest lenders do not make such loans, e.g., “liar’s” loans. “Toxic waste” was the nature of the loans increasingly produced by B of A’s “Wholesale Channel.” That phrase is grandiose language for relying on loan brokers to make crappy, often fraudulent loans pursuant to perverse compensation and underwriting systems chosen by B of A’s managers. Lewis is saying that he knew that he wasn’t going to originate “riskier” loans by relying on loan brokers under the perverse incentives he created – he was going to get “toxic waste.” The problem, once more, is DOJ’s failure to understand accounting control fraud. They simply cannot conceive that deliberately making crappy loans maximized Lewis’ compensation even though the math is indisputable. DOJ fails to make the three obvious, critical points that would greatly strengthen its case – why did B of A controlling officers use loan brokers, why did they create perverse incentives (through their compensation system for loan brokers and their deliberate evisceration of B of A’s loan underwriting process), and why did they continue (until the secondary market collapsed) to use loan brokers when their own internal reports proved that the result was “toxic waste” and fatal levels of mortgage fraud?
Why does DOJ Pretend that B of A’s Fraud Only Occurred in 2008 in One Deal?
The Complaint demonstrates that B of A engaged in widespread fraud, yet it sues only against one of the B of A’s officers’ relatively smaller frauds (though even it, at $885 million, is huge).
“34. BOA-Bank relied on the originate-to-distribute model to originate over $144 billion and $162 billion worth of residential mortgages and home equity loans in 2006 and 2007, respectively.”
Again, it becomes clear that DOJ does not understand the most basic facts about the actual B of A fraud schemes and is unwilling to bring even a civil action large enough to recover a substantial amount of the losses caused by B of A’s vastly larger fraudulent sales of fraudulent mortgages. I have explained that no honest lender would take the actions B of A’s officers took to ensure that its underwriting was pathetic. In the home mortgage lending context this will produce widespread mortgage origination fraud. Fraudulent loans can only be sold to the secondary market through further fraud.
DOJ begins its description of the secondary market with a claim that is common – and overwhelmingly false.
“32. Historically, originators like BOA-Bank provided mortgages to borrowers and held the mortgages on their own books for the duration of the mortgage. Originators profited as they collected monthly principal and interest payments directly from the borrower. Originators also retained the risk that the borrower would default on the mortgage. Thus, originators had strong economic incentives to verify the borrowers’ willingness and ability to repay their mortgages through strict compliance with prudent underwriting standards.
33. Beginning in or around the 1970s, originators like BOA-Bank began offloading the risk that mortgage borrowers would default to third parties by securitizing the mortgages and selling the resulting securities to investors. The securitization process shifted the originators’ focus from ensuring the ability of borrowers to repay their mortgages to ensuring that the originators could process (and obtain fees from) an ever-larger volume of mortgages for distribution as RMBS. This practice was commonly referred to as the ‘originate-to-distribute’ model. The originate-to-distribute model drastically changed the economic incentives of originators like BOA-Bank and encouraged originators to focus on the quantity of mortgages originated rather than the quality of those mortgages. It also allowed originators to receive revenues up front, rather than receiving them slowly over the life of each mortgage.”
It is true that mortgages were overwhelmingly held in portfolio historically and that they held the risk of owning such loans. It is also true that a portfolio lender should have an incentive to underwrite, though DOJ does not explain why this is true. Markets do not reward “risk.” They reward a small subset of risks that can be prudently undertaken. Credit risk is one of those potential areas of positive expected value if the lender has special expertise in evaluating and pricing credit risk. A residential or commercial mortgage lender that fails to underwrite prudently creates severe “adverse selection” – it will make loans to very poor credit risks and it will inherently charge an inadequate price. The result is that such loans have a negative expected value – in plainer language, the lender will suffer severe losses.
The fact that the firm that makes the loans has strong incentives to underwrite prudently does not mean that the lender’s controlling officer has such incentives. The accounting control fraud recipe works for portfolio lenders and “originate to sell” lenders. The Irish crisis involved minimal secondary market involvement as did the S&L debacle. A lender controlled by a fraudulent CEO will report record profits in the near term and be able to borrow exceptional amounts of money even if it lacks deposit insurance. It is the controlling officer’s incentives, not the incentives fictionally assigned by neoclassical economists to inanimate firms that are critical. This is why the National Commission that investigated the causes of the S&L debacle reported that at the “typical” large failure fraud was “invariably” present, why we (the federal S&L regulators) made tens of thousands of criminal referrals, and why we secured over 1,000 felony convictions in cases designated as “major” by DOJ.
Note that paragraph 33 of the complaint states that securitization began in “the 1970s.” It was an important activity throughout the S&L debacle but did not lead to sale of “toxic waste” mortgages to the secondary market. That should have warned DOJ that its analytics had failed.
DOJ is focused on a false assumption that the secondary market is the key rather than the ability to borrow and grow by reporting record (albeit fictional) profits in the near term by following the fraud recipe. DOJ also fails to ask the obvious question – if the secondary market caused such a drastic and perverse change in home lenders’ economic incentives why didn’t the secondary market purchasers realize that fact and take steps to protect themselves from the lenders’ perverse incentives? Nobody had a gun to Wachovia and the FHLBSF’s heads and required them to buy B of A’s fraudulent MBS.
The first answer to the question is that the secondary market purchasers’ controlling officers used contract law to limit “offloading the risk that mortgage borrowers would default to third parties by securitizing the mortgages and selling the resulting securities to investors.” DOJ knows this is true for its complaint emphasizes the extensive reps and warranties that industry practice required the lenders to make about the credit risks of the underlying mortgages. The reps and warranties required, as the DOJ complaint also emphasizes, are required precisely they are the best predictors of “the risk mortgage borrowers would default.” This means that if a lender acts openly and honestly in the manner DOJ claims a loan-to-sell lender would act: “to focus on the quantity of mortgages originated rather than the quality of those mortgages” it would have to disclose in its reps and warranties that it was selling crappy loans with an exceptionally high risk that the “mortgage borrowers would default.” Under the (disastrous) neoclassical economic theories that the Bush and Obama administration DOJ’s have trumpeted the ultra-sophisticated secondary market purchasers are supposed to provide the most ideal form of “private market discipline.” They would either refuse to buy the crappy loans or buy them only at such a large discount from their original (inflated) values that the lender would have to recognize an immediate loss upon sale (because the loans would have a negative expected value). Under either scenario the secondary market would, under neoclassical dogma, immediately crush any fraudulent or even imprudent lender.
DOJ’s complaint implicitly assumes that the fraudulent lender will have to engage in further fraud to induce secondary market purchasers to buy the loans. But that requires one to ask again – under neoclassical theory why would the purchasers allow them to engage in such an easily discoverable fraud? Wachovia and the FHLBSF’s central competence is underwriting credit risk. Why don’t they underwrite the credit risk of B of A’s loans before purchasing them (and charge B of A for doing so if the reps and warranties are false)?
(If your answer is “the government made Fannie and Freddie” buy B of A’s fraudulent loans then you need a new answer. First, DOJ is suing about loans sold to Wachovia and the FHLBSF. Second, most of the toxic waste B of A was selling was liar’s loans that Fannie and Freddie could not count toward “affordable housing.” Third, the smallest loan B of A sold in this package was $400,000.)
An excerpt from paragraph 50 of the complaint illustrates DOJ’s factual and analytical incoherence and indicates why its incoherence has been fatal to any prosecution of the credit rating agencies for their role in aiding and abetting fraud in the secondary market.
“The rating agencies did not have access to the underlying mortgage files.”
“Because investors did not have access to the original loan files for the mortgages collateralizing the BOAMS 2008-A securitization, they had to rely solely on Defendants for information concerning the likelihood of borrowers repaying their mortgages in a timely manner and the value of the collateral supporting the mortgages.”
These statements are, at best, disingenuous. The credit rating agencies could have required that they be provided with the loan types on all the underlying mortgage files. The investors could have refused to purchase the MBS unless B of A gave them the right to review a sample of the loan files. The credit rating agencies and the purchaser deliberately refused to review even a sample of the files of the loans sold in the secondary market. Had they reviewed a sample of the B of A’s loan files (and been honest) they would have never have purchased the loans because the quality of B of A’s portfolio was awful – and rapidly falling. The Complaint alleges:
“115. Underwriters, such as BOA-Securities, conducted Loan Level Due Diligence and obtained AVM’s to ensure that representations concerning the quality of the mortgages and statistics concerning the characteristics of the mortgages in offering documents and other marketing materials were correct. Prior to the BOAMS 2008-A securitization, BOA-Securities conducted Loan Level Due Diligence on a sample of at least 10% of the mortgages collateralizing a BOAMS securitization.
116. The Loan Level Due Diligence conducted for those three securitizations found significant problems with the quality of the mortgages in the collateral pools and numerous errors where the data in the mortgage files did not match the statistics in the offering documents and marketing materials. For instance, the Loan Level Due Diligence revealed that over 40% of the mortgages sampled did not materially conform to BOA-Bank’s underwriting standards. Of those, BOA-Bank purportedly found compensating factors that offset the defects for many of the mortgages, but for as many as 7.3% of each sample, it could not find sufficient compensating factors and the mortgages were slated to be removed from the collateral pools.
117. The Loan Level Due Diligence also revealed that a significant amount of the statistics concerning the mortgages in the offering documents and other marketing materials did not accurately reflect the information in the underlying mortgage files. In other words, the Loan Level Due Diligence showed that statistics concerning the mortgages contained in the offering documents and other marketing materials regarding such material characteristics as the occupancy status, DTI ratio, LTV ratio, CLTV ratio, and credit score associated with the mortgages were materially false. Further, the AVM’s obtained by BOA-Securities showed that the appraisals used in originating the mortgages in the collateral pools were often inflated. For example, the AVM’s BOA-Securities obtained for the BOAMs 2007-3 securitization showed that as much as 50% of the appraisals used to originate the mortgages in the collateral pool were inflated. Had the appraisals not been inflated, several of the mortgages would not have appeared to comply with BOA-Bank’s underwriting standards. Upon information and belief, the BOA-Securities Managing Director received or had access to the results of the previous Loan Level Due Diligence and AVM’s prior to the closing of the BOAMs 2008-A securitization.”
Again, these three paragraphs display DOJ’s failure to understand basic fraud mechanisms. First, it is absurd (and harmful to the government’s case) for DOJ to allege that:
“Underwriters, such as BOA-Securities, conducted Loan Level Due Diligence and obtained AVM’s to ensure that representations concerning the quality of the mortgages and statistics concerning the characteristics of the mortgages in offering documents and other marketing materials were correct.”
BOA-Securities did not act to ensure “correct” “representations” and DOJ knows they did not do so.
“The Loan Level Due Diligence also revealed that a significant amount of the statistics concerning the mortgages in the offering documents and other marketing materials did not accurately reflect the information in the underlying mortgage files. In other words, the Loan Level Due Diligence showed that statistics concerning the mortgages contained in the offering documents and other marketing materials regarding such material characteristics as the occupancy status, DTI ratio, LTV ratio, CLTV ratio, and credit score associated with the mortgages were materially false.”
The sample size of this (not really) “due diligence review is described in the Complaint only as over 10% but we know that one cannot use such a sample to locate the bad loans in the remainder of the MBS (which is up to 90% of the total MBS tranche being sold).
B of A covered up gaping falsehoods by falsely declaring “compensating factors.” I have explained in prior articles that there is no reliable “compensating factor” for mortgage fraud. I have shown that the most commonly described “purportedly” compensating factors (Complaint, paragraph 116) (low debt-to-income ratios and low loan-to-value (LTV) ratios) were themselves the product of immense of the two most common and destructive forms of mortgage fraud by lenders and their agents. The chutzpah of using fraud as “purportedly” compensating for the fraud is immense.
Note that B of A’s “purported” “underwriting” consistently made the great bulk of the false representations it had made disappear through the magic of “compensating factors.” The Complaint alleges that B of A’s underwriting reviews found that “over 40% of the mortgages sampled” did not meet B of A’s loan standards. As appalling as that number is, it must be read in conjunction with three other aspects of the Complaint. The sample size was small (“over 10%”) and the Complaint implies that B of A did not expand the sample size even when they found over a 40% rate of non-compliance in their small sample. This is unacceptable. Note that it makes it impossible for the “underwriting” to “kick out” the terrible, non-conforming loans in the un-sampled portion of the MBS, which can be up to 90% of the total loans. DOJ has to take the position that this is unacceptable or create a safe haven for control fraud.
Second, “compensating factors” “purportedly” resurrected the overwhelming bulk (roughly 80%) of the failed loans. At most, “only” 7.3% of the loans ended up not being resurrected by such (unspecified, unsupported, and perverse) compensating factors. If DOJ allows “compensating factors” to be used in this fashion it will encourage massive fraud.
Third, B of A found strong indications of endemic appraisal fraud – and refused to treat it as appraisal fraud. Instead, the Complaint implies that B of A treated it solely as a (typically minor) adjustment to value.
“[A]s much as 50% of the appraisals used to originate the mortgages in the collateral pool were inflated. Had the appraisals not been inflated, several of the mortgages would not have appeared to comply with BOA-Bank’s underwriting standards.”
A strong indicator of endemic appraisal fraud got perverted and minimized by B of A into a trivial adjustment that only put “several” mortgage loans out of compliance with B of A’s grossly imprudent “underwriting standards.” Again, DOJ cannot allow B of A’s trivialization of flags of likely endemic mortgage fraud without creating a field day for felons.