William K. Black
There are many forms of control fraud. I have written primarily about accounting control frauds because they drive our recurrent, intensifying financial crises and we are in the midst of the worst such crisis in modern history. I wrote recently about the intersection of anti-purchaser and anti-employee control fraud in Bangladesh that killed 1,127 employees (and injured roughly twice that number) and made the point that control frauds kill and maim more people than traditional blue collar crimes and cause greater financial losses than all other forms of property crime combined. Control frauds also cause a greater number of crimes than do traditional blue collar crimes. Think for example of the number of victims of the Libor scams, measuring in the hundreds of thousands and the foreclosure frauds.
According to theoclassical economists none of this is supposed to happen because the officers who control firms are supposed to so value their reputations for probity that they do no wrong. This “reputational trump” was theorized to be so powerful that it overcame any criminogenic incentive such as a conflict of interest. In particular, accounting control fraud is supposed to be impossible because private market discipline must prevent them or markets wouldn’t be “efficient.” Since theoclassical economists “knew” markets were efficient it followed that accounting control fraud must be trivial.
The reality is that accounting control fraud recurrently occurs in “epidemics” and that control fraud is itself criminogenic – fraud begets fraud. One of the ways it does so is by creating a “Gresham’s dynamic” in which the officers controlling firms that cheat gain an advantage over their counterparts who remain honest. The widespread existence of most forms of control fraud inherently tends to create a Gresham’s dynamic in which “bad ethics drives good ethics out of the marketplace.” The officers who control “control frauds” also deliberately generate Gresham’s dynamics to suborn internal and external “controls” into becoming valuable allies that will aid and abet their frauds.
This article contrasts the recent reaction of the State of New Jersey to anti-purchaser control frauds – 29 bars and restaurants that the State says defrauded their customers about the quality of the booze they were selling – and the federal criminal justice response to the epidemic of accounting control fraud that drove the ongoing financial crisis. The New Jersey frauds took three forms: selling lower quality/price booze as purported higher quality/price booze, watering the booze they sold (in one case with dirty water), and selling fake “scotch” (rubbing alcohol plus caramel coloring). Each of these forms of fraud creates a competitive advantage in favor of the frauds unless consumers can generally detect the fraud.
I contrast the N.J. reaction by the state (“Operation Swill”) and the producers of booze with the reaction of the Bush administration and business to the FBI warnings in 2004 that an “epidemic” of mortgage fraud would cause a financial “crisis” if it were not contained.
The Prosecutorial Resources and Methods of “Operation Swill”
The investigation began as a result of consumer complaints and a whistleblower.
“The investigation started after the state began receiving more complaints than usual about possibly mislabeled drinks, said the director of the Division of Alcoholic Beverage Control, Michael Halfacre. An informant with knowledge of the industry contacted the agency in the fall to help in the investigation, he said.
The second thing to understand is the scale of the resources used in Operation Swill and the nature of the investigation. The investigation took over a year, it involved the seizure of roughly 1000 samples of booze during a final raid and 150 surreptitious samples during the investigation taken by a combination of State, industry, and citizen volunteers. At peak it involved over 100 regulators from the Alcoholic Beverage Control Division and investigators N.J.’s Criminal Justice Division and the personal involvement of the State’s Attorney General.
Third, these State resources were supplemented by staff provided by the sellers of premium booze who brought additional expertise to the investigation.
“They then took samples of the alcohol covertly, tested them with the True Spirit Authenticator, and then sent the samples to the brand manufacturers to confirm their findings, the Star-Ledger reported. Halfacre said the device examines alcohol using light-emitting technology and is similar to field sobriety tests.”
Fourth, the investigation documented a high frequency of fraud, indicating that a substantial Gresham’s dynamic was developing.
“In January and February, investigators went to 63 establishments they suspected were scamming liquor customers. They ordered drinks neat — that is, without ice or mixers — and then covertly took samples for testing.
Of 150 samples collected, 30 were not the brand as which they were being sold.”
Fifth, the control frauds were not randomly distributed. When the controlling officers of a large entity create a criminogenic environment they can produce widespread fraud.
“TGI Friday’s Inc. said it was conducting its own investigation, working with the franchisee that owns the 13 restaurants cited, The Briad Group.
Briad operates 70 TGI Fridays across the country, including Arizona, California, Connecticut, Nevada, New Jersey, New Mexico, and New York, the Star-Ledger reported. It also runs 42 Wendy’s in New Jersey, New York and Pennsylvania, as well as Marriott and Hilton hotels, the Corner Bakery shops, Cups yogurt stores, Zinburger locations, and the Promenade Shops at Clifton.”
Briad is reportedly the largest TGI Friday’s (TGIF) franchisee. One obvious question is whether other states will make investigating Briad and TGIF a priority. Given the high frequency of fraud reported among Briad’s restaurants in New Jersey there is every reason to suspect that the problem comes from the top of Briad and is not limited to New Jersey.
Sixth, in the grand scheme of things this anti-purchaser control fraud is middling. It is large in scope and it can create significant profit for the fraudsters because the price of premium liquor is far higher than non-premium brands, but the harm to any individual consumer is relatively small and the State of New Jersey says that none of these frauds (even the dirty water) endangered the consumers’ health. (This is in contrast to many nations where drinking the local hooch poses a major risk of being killed or maimed.) The weak penalties for such frauds exemplify one of the recurrent weaknesses in combatting elite frauds.
“Penalties range from a 5-day suspension for the first offense to a 15-day suspension for the third offense, though multiple violations could ensue. ABC regulations could also allow for a 30-day suspension for any illegal activity, as well as a 30-day suspension for not cooperating in the investigation.”
It is all the more extraordinary that the State of New Jersey made such a huge commitment of resources given the fact that so little is likely to come of the findings even if they lead to formal enforcement actions. Note that the listing of penalties ignores criminal sanctions against the individuals leading the control frauds who are the principal beneficiaries of the fraud.
A Telling Comparison with Immunity for Elite Bankers
The FBI warnings in 2004 that should have prevented the crisis
Whistleblowers existed during the early stages of the current banking crisis. There was also a great deal of public information about the “epidemic” of mortgage fraud that the FBI identified publicly in September 2004 and predicted would cause a financial “crisis” if it were not contained.
“At the Washington, D.C., headquarters of the FBI, Chris Swecker, an assistant director, was also trying to get people to pay attention to mortgage fraud. “It has the potential to be an epidemic,” he said at a news conference in Washington in 2004. “We think we can prevent a problem that could have as much impact as the S&L crisis.”
The FBI’s double warning in September 2004 was followed by Steven Krystofiak’s warning. Krystofiak, an honest loan broker, testified before the Federal Reserve’s field hearings in which he reported the results of a study demonstrating a 90% fraud incidence rate in “liar’s” loans and explained to the Fed that it was typically the lenders and their agents who put the lies in liar’s loans.
The mortgage industry’s own anti-fraud specialists, MARI, reported five warnings in writing to the industry in 2006.
“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.”
These are extraordinarily important facts. A 90 percent fraud incidence is incredible. It demonstrates how powerful the criminogenic environment was and how what a superb marker liar’s loans are for accounting control fraud. The finding also confirmed the FBI’s twin warnings in 2004.
The Troika’s Shameful Excuse for ignoring its Own Warnings and Allowing the Fraud Epidemic
The failure of Attorney Generals Alberto Gonzales and Michael Mukasey and FBI Director Robert Mueller (the troika) to respond effectively to the FBI’s 2004 warnings and MARI’s 2006 warnings to contain the fraud epidemic and prevent the Great Recession is tragic. Their excuse for their failure is shameful.
“Alberto Gonzales, the nation’s attorney general from February 2005 to September
2007, told the Commission that while he might have done more on mortgage fraud, in hindsight he believed that other issues were more pressing: “I don’t think anyone can credibly argue that [mortgage fraud] is more important than the war on terror. Mortgage fraud doesn’t involve taking loss of life so it doesn’t rank above the priority of protecting neighborhoods from dangerous gangs or predators attacking our children’” (FCIC 2011: 163).
The same page of the FCIC report shows that Mueller and Mukasey made the same claim that the “War against Terror” excuses their failures to even attempt to prevent the epidemic of accounting control fraud from causing the Great Recession. Gonzales’ statement demonstrates the troika’s incompetence, their efforts to reinvent history to excuse their incompetence, and their disingenuousness.
I’ll begin with his the troika’s claim that because preventing the mass murder of Americans is the Department of Justice’s (DOJ’s) top priority the troika cannot be criticized for failing to deal effectively with any lower priority crime. Under this theory mass terrorism becomes a “get out of jail free” card for the DOJ and the FBI on every lesser crime. This is nonsensical. If a police chief announced that he couldn’t be held accountable for a rape epidemic because his top priority was prosecuting murder we would all have two reactions: the chief was substantively incompetent and a terrible defender of his incompetent policy.
No one in the criminal justice system believes that that the system should be run like the tranches of a collateralized debt obligation (CDO). All resources get applied first to the top tranche and only when that tranche’s needs are filled entirely do any funds flow to the next tranche (and so on). The obvious reason a police chief, FBI director, or Attorney General would never apply a CDO model to law enforcement is that doing so would create intensely criminogenic environments that would produce dozens of crime epidemics.
The less obvious reason is that in criminal justice one would always put 100% of one’s resources into the single, top priority because unlike CDOs the top priority in law enforcement could always claim a need for additional resources. The demand for resources in law enforcement against something like terrorism is insatiable. We could devote every dollar available currently to U.S. law enforcement solely to anti-terrorism efforts and not eliminate terrorism against U.S. targets. We could increase total law enforcement spending one-hundred times and devote every dollar solely to anti-terrorism efforts and not eliminate terrorism against U.S. targets. The even less obvious reason to reject the CDO model is that we could increase total law enforcement spending ten-thousand times and devote it solely to anti-terrorism efforts and we could increase terrorism against U.S. targets and harm our economy and democracy by adopting policies that would increase anti-American hate.
Swecker’s strategy: fight for the resources essential to prevent crises
Swecker understood that law enforcement resources are limited but not fixed. They can be expanded and their allocation is critical – and it is vital to fight to make the prevention of a coming crisis a much higher priority. Swecker understood the need to “prevent” the fraud epidemics that drive financial crises such as the S&L debacle and the Enron-era scandals – not simply to prosecute after a crisis. While it is not clear that the Financial Crisis Inquiry Commission (FCIC) understood the sophistication of Swecker’s strategy to secure the necessary resources to contain the fraud epidemic and prevent the financial crisis. Swecker was not a whistleblower. He was the senior FBI agent with official responsibility for dealing with mortgage fraud and his warnings were all made in his official leadership capacity.
Swecker understood how we prioritize resources. The fundamental thing he understood is that one has to fight for resources. In the passages quoted from the FCIC report he is constantly fighting for increased resources. He needs allies pushing DOJ and the FBI to provide more resources so he recruits the USPS, IRS, and HUD.
“Swecker called another news conference … to say the same thing, this time adding that mortgage fraud was a ‘pervasive problem’ that was ‘on the rise.’ He was joined by officials from HUD, the U.S. Postal Service, and the Internal Revenue Service” (FCIC 2011: 15).
Swecker needs to get Congress and the public as allies so he testifies before Congress and calls press conferences. He is blunt, not bureaucratic in his language and he makes strong predictions instead of the usual Washington namby-pamby.
Swecker knows that he needs data to justify his requests for greater resources. He begins by emphasizing the huge and rapidly growing number of criminal referrals. The official jargon for a criminal referral is a Suspicious Activity Report (SAR).
“Despite the underreporting, the jump in mortgage fraud drew attention. FinCEN in November 2006 reported a 20-fold increase in SARs related to mortgage fraud between 1996 and 2005” (FCIC 2011: 162).
As impressive as the number and increase in criminal referrals was, Swecker understood that the criminal referrals substantially underrepresented the incidence of mortgage fraud. Swecker asked Congress to mandate that all mortgage lenders make criminal referrals when they discovered evidence that created a reasonable suspicion of fraud.
“In that [2004 congressional] testimony, Swecker pointed out the inadequacies of data regarding fraud and recommended that Congress mandate a reporting system and other remedies and require all lenders to participate, whether federally regulated or not.
Swecker unsuccessfully asked legislators to compel all lenders to forward information about criminal fraud to regulators and law enforcement agencies” (FCIC 2011: 161,162).
Banking regulations require federally insured banks and S&Ls to make criminal referrals. There should have been no need to require non-FDIC insured lenders to make criminal referrals. Any honest lender or loan broker would have been eager to make criminal referrals. But mortgage brokers and lenders consistently and successfully fought to avoid any such obligation. More importantly, they refused to make criminal referrals. The brokers and non-FDIC insured lenders always had the ability to make referrals. The Mortgage Bankers Association created and continues to maintain a mortgage fraud reporting system that was explicitly designed not to provide criminal referrals to the FBI and DOJ that they could use to institute investigations and prosecutions of mortgage fraud.
The refusal of the loan brokers and non-insured lenders to make referrals was an enormously big deal because they made such a large percentage of the endemically fraudulent liar’s loans.
“[FinCEN] noted that two-thirds of the loans being created were originated by mortgage brokers who were not subject to any federal standard or oversight. Swecker unsuccessfully asked legislators to compel all lenders to forward information about criminal fraud to regulators and law enforcement agencies” (FCIC 2011: 162).
The obvious advantage of requiring criminal referrals for mortgage fraud would be to learn about far more frauds so that one could prosecute more cases. That obvious advantage was, however, fictional in this case because the number of criminal referrals already vastly exceeded the FBI’s ability to investigate and DOJ’s ability to prosecute mortgage fraud.
Swecker understood that there were far greater advantages to requiring loan brokers and non-insured lenders to make criminal referrals than simply learning about additional frauds. A big advantage was that the reported number of frauds would grow dramatically and provide an even stronger basis for greatly expanding the FBI resources devoted to investigating mortgage fraud.
The greatest advantages of compelling criminal referrals however are still more subtle. The general advantage is superior intelligence. We could identify with much greater precision the fraud hotspots, even better, the likely fraud networks. Identifying the networks is critical to successfully investigating and prosecuting accounting control frauds. The most important advantage of a mandate to file criminal referrals comes from monitoring the lenders that should be making large numbers of criminal referrals but fail to do so. These are among the lenders that should be the top priorities for investigation. Fraudulent lenders tend not to want the FBI in their premises examining their loan files and questioning their employees. Fraudulent lenders have too much to hide and will frequently opt not to make criminal referrals. The FCIC report has a specific example of this pattern.
“Darcy Parmer, a former quality assurance and fraud analyst at Wells Fargo, the second largest mortgage lender from 2004 through 2007 and the largest in 2008, told the Commission that “hundreds and hundreds and hundreds of fraud cases” that she knew were identified within Wells Fargo’s home equity loan division were not reported to FinCEN. And, she added, at least half the loans she flagged for fraud were nevertheless funded, over her objections” (FCIC 2011: 162).
An honest lender, of course, would never behave in this fashion. They would not make loans flagged as likely to be fraudulent and they would make criminal referrals. I testified before FCIC about a broad range of matters but one of the specific things I pointed out was how few insured-lenders filed any material number of criminal referrals and how we would have used this information to prioritize investigations.
The failure of insured-lenders to make criminal referrals, the fact that lenders likely spot a small percentage of mortgage frauds, and the failure of uninsured lenders to make referrals combine to demonstrate that the number of criminal referrals made to FinCEN for mortgage fraud represent only a small percentage of the actual incidence of mortgage fraud during the crisis. FinCEN estimated the frequency of the latter two causes of underreporting. They estimate that 15% of the frauds were spotted and that two-thirds of loans were made by uninsured lenders. Uninsured lenders were more likely than insured lenders to make liar’s loans, so using the two-thirds figure is highly conservative. Correcting only for the latter two causes of underreporting would lead to the conclusion that the official figure represents roughly five percent of the true incidence of fraud. That means that as a first approximation of the true incidence of mortgage fraud one would multiply the reported number of referrals by 20.
We have no good data on the percentage of underreporting of known frauds by insured-lenders. As I have explained, the pattern of reporting by insured-lenders is so heavily distributed among a mere 25 lenders that it indicates strong support for the complaints of whistleblowers that many insured-lenders refused to make criminal referrals even when they discovered mortgage fraud and followed policies that were exceptionally criminogenic for mortgage fraud even when the officers knew those policies were producing widespread mortgage fraud. I explained above (and to the FCIC) why the insured-lenders controlled by fraudulent officers had the strongest incentive to fail to make criminal referrals. It is immensely revealing about the leadership of the banking regulatory agencies that we do not know even roughly the incidence of failure to make criminal referrals at each significant insured-lender. I explained why the entities that made large numbers of fraudulent loans and made relatively few criminal referrals should be the top agency priority for examination. It is a violation of rules for an insured-lender to fail to make criminal referrals, but the far more important point is that a widespread failure demonstrates the collapse of internal and external controls and proper underwriting and it demonstrates that the controlling officers lack integrity. We could introduce the failure to make criminal referrals in a criminal case against the accounting control frauds as evidence of a cover up and of the original intent to make fraudulent loans.
If the insured-lenders failed to make criminal referrals half the time the corrective multiplier would become 40. I believe that if the agencies were to do what they should have done no later than 2004 and investigate the failure to make criminal referrals they would find the industry failed to make referrals well over half the time. These corrections are vital to understand the true extent of the raging fraud epidemic Swecker was trying to contain in order to “prevent” a crisis.
“In 2005, 25,988 SARs related to mortgage fraud were filed; in 2006 there were 37,457. The number kept climbing, to 52,862 in 2007, 65,004 in 2008, and 67,507 in 2009” (FCIC 2011: 162).
Using a corrective figure of 40 would produce an estimated incidence of mortgage fraud in 2007 of over two million. That is the same rough estimate that arises from a different metric. If we take the 90% fraud incidence figure for liar’s loans and apply it to the number of liar’s loans made in 2006 we also produce an estimated incidence of mortgage fraud among liar’s loans of over two million.
Swecker used the data on criminal referrals, pushed to improve that data, and enlisted allies among the anti-fraud community in the IRS, HUD, and USPS in order to increase the chances that the FBI and the DOJ would increase the resources devoted to containing the epidemic of mortgage fraud. Swecker’s sophisticated strategy for increasing FBI and DOJ resources failed to move the troika to act to contain the fraud epidemic.
“Swecker attempted to gain more funding to combat mortgage fraud but was resisted.
Swecker told the FCIC his funding requests were cut at either the director level at the FBI, at the Justice Department, or at the Office of Management and Budget. He called his struggle for more resources an “uphill slog’” (FCIC 2011: 162).
Swecker did not seek additional resources only for DOJ and the FBI. At the press conference he arranged with officials from HUD, IRS, and USPS Swecker and his colleagues sought to convince lenders to make anti-fraud efforts a far higher priority.
The officials told reporters that real estate and banking executives were not doing enough to root out mortgage fraud and that lenders needed to do more to “police their own organizations” (FCIC 2011: 15).
The Two Key Points that Swecker Missed
The 2004 press conference that Swecker arranged was a very good idea, but it also evidences the key points that he missed. First, consider the “officials” who “joined” Swecker – and those who did not join him. HUD, the U.S.P.S., and the IRS joined him in warning about the “epidemic” of mortgage fraud. The banking regulatory agencies – the agencies with the expertise, resources, and unique regulatory authority essential to any successful effort to contain the fraud epidemic – were not present at the meeting. Their absence was not an unfortunate one-time affair.
“Swecker, the former FBI official, told the Commission he had no contact with banking regulators during his tenure” (FCIC 2011: 164).
Please think hard about that sentence. Swecker’s strategy was to go public and to go bold in his warnings to ensure widespread publicity. His words were broadly reported in the general and trade press. He was the senior FBI official with direct responsibility for developing the effort to investigate mortgage fraud. He warned of an “epidemic” of mortgage fraud and predicted that it would cause a financial “crisis” if it were not stopped. There were four major banking regulatory agencies (the Fed, OCC, OTS, and the FDIC) at the time he issued his twin warnings. Those four agencies, collectively, had over 100 senior officials who should have taken an immediate interest in the FBI’s warnings. Fraud has long been the primary cause of catastrophic banking failures. It is simple to find out how to contact a senior FBI official and banking regulators did not have to seek permission from their bosses to email or phone Swecker. Every senior federal banking regulator in office from 2004-2008 failed the most basic test of competence by failing to contact Swecker and work with him to contain the fraud epidemic.
The banking regulatory agencies were in a position to act immediately on Swecker’s warning and end the fraud epidemic before it could hyper-inflate the bubble and cause the financial crisis and the Great Recession. The Federal Reserve had the unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to ban liar’s loans by all mortgage lenders – including those not insured by the FDIC. Switzer’s focus was on getting the private sector to add its resources to contain the fraud epidemic, but the key was not resources. The key was to stop a particular form of lending that had no positive social utility and was endemically fraudulent – the liar’s loan. The Fed had the authority to issue such an order (which it finally did in 2008 – four years after the FBI’s twin warnings). Swecker had the correct concept – the key was to act to “prevent” the crisis, but he was unaware of the Fed’s unique regulatory authority under HOEPA to prevent the crisis.
Second, Swecker made a disabling assumption. He assumed that the real estate brokers and bank executives were the solution rather than the problem. He was repeatedly mystified why they were not committed to stopping mortgage fraud. The banking regulators should have been able to explain to the FBI why making millions of bad loans optimized the accounting control fraud “recipe” for a lender and created several “sure things” that included making the controlling officers wealthy. Without the banking agencies help, the FBI relied instead for its expertise on the mortgage lending industry. Swecker and his colleagues at the IRS, USPS, and HUD were mystified as to why the mortgage lending industry pervasively opposed effective anti-fraud efforts. They simply could not conceive of the existence of accounting control fraud.
The troika’s inability to identify accounting control fraud as the central problem meant that it did not take any of the criminal justice actions essential to contain the relevant fraud epidemic that was producing the epidemic of mortgage fraud. The adoption of an emergency rule by the Fed banning liar’s loans was by far the best means to contain the various “echo” fraud epidemics produced by the underlying epidemics of accounting control fraud by mortgage lenders and purchasers. These echo epidemics happened among appraisers, auditors, loan brokers, and credit rating agencies. The controlling officers of the underlying fraud deliberately generate Gresham’s dynamics to suborn other market participants who can be useful in aiding their frauds. One classic example is the widespread practice of dishonest lenders blacklisting honest appraisers.
How the Troika Could have Contained the Fraud Epidemics and Prevented a Crisis
“Operation Swill” shows us how the troika could have successfully contained the epidemic of mortgage fraud even if the Fed refused to use its HOEPA authority to ban liar’s loans. Fed Chairmen Greenspan and Bernanke refused to use HOEPA in response to the FBI’s twin warnings in 2004. If the troika had publicly pushed the Fed to use HOEPA Greenspan and Bernanke it would have been impossible for them to fail to act against loans they knew to be endemically fraudulent.
New Jersey’s investigation was driven by the intelligence provided by a “confidential informer” (a whistleblower). New Jersey conducted a successful investigation by using undercover investigators as customers to document the true nature of the alcoholic beverages they were served. New Jersey supplemented the whistleblower’s expertise with industry expertise and the expertise of the regulators. The troika could have called upon the services of hundreds of whistleblowers if the troika had asked citizens to come forward to help them stop the fraud epidemics. The troika could have used the extraordinary intelligence it would have gained from the whistleblowers to figure out the problem was an epidemic of accounting control fraud. That understanding would have transformed everything in the federal criminal justice response.
I explain below why the mortgage lending and purchasing industries would provide no help to the effort to investigate and prosecute frauds analogous to the manufacturers of top shelf alcohol beverages. I also explain the importance of the federal banking regulatory agencies’ destruction of their criminal referral units and their total failure to support criminal investigations and prosecutions. Again, they could not have followed these policies had the troika demanded publicly their cooperation. Again, this would have transformed the federal response to raging fraud epidemics.
There were a series of criminal justice steps that the FBI and DOJ, with the aid of the banking agencies, could have taken to contain the crisis – even with very limited FBI resources. Again, New Jersey’s Operation Swill offers useful clues. They could have placed undercover FBI agents in the lenders making the great bulk of the fraudulent liar’s loans. FBI agents would not have even have had to adopt a false name or resume to take such jobs. Their cover story would be that they had retired. They could also have drawn on the work of hundreds of confidential informants. The agents and the informants could have been wired when they had the key conversations. The same loan brokers often worked for dozens of lenders so the FBI could have easily gathered information on large numbers of fraudulent lenders by placing agents or using confidential informants in perhaps a dozen major loan brokerages.
FBI agents and testers (who could be hired as short-term contractors) could have gotten loans approved by the major lenders and brokers and documented how the lenders and brokers falsified information on loan applications and forged the borrower’s signatures. DOJ could have prosecuted the senior officers of two of the largest loan brokers specializing in fraudulent liar’s loans and two of the largest lenders specializing in making fraudulent liar’s loans – and announced that it would work down the list to prosecute the senior officers of every lender that followed the fraud recipe. Alternatively, the DOJ could have prosecuted the pinch points where there were only a few key participants – the senior officers controlling the three major credit rating agencies or the five major investment banks plus Fannie and Freddie. Shutting down the secondary market purchases of fraudulent loans would not have prevented the crisis but it would have dramatically reduced it.
The Troika’s Response to the FBI’s Warnings Was Unconscionable
The amount of resources they provided to contain the epidemic of mortgage fraud
The FCIC details the preposterously inadequate response of the troika to the FBI’s twin warnings in 2004.
“At the same time, top FBI officials, focusing on terrorist threats, reduced the agents assigned to white-collar crime from 2,342 in the 2004 fiscal year to fewer than 2,000 by 2007. That year, its mortgage fraud program had only 120 agents at any one time to review more than 50,000 SARs filed with FinCEN” (FCIC 2011: 162-63).
We can all understand transferring FBI white-collar specialists to anti-terrorism in response to the 9/11 attacks, but that is no excuse for not providing FBI resources in 2004-2008. The FBI requested authority to replace the capacity lost through the transfers through new hires and the administration refused to do so. The result was that the prosecution of elite white-collar criminals fell and their crimes grew massively. Mueller’s request for additional resources means that is less culpable, but it is also true that Mueller did not go to the mat and did not issue strong warnings to the administration and Congress that the lack of FBI white-collar resources was crippling our ability to prevent the mortgage fraud epidemic and the financial crisis that such an epidemic would inevitably cause if it were not contained.
The truth is that even if Mueller had fought for, and won, the ability to bring the FBI’s white-collar specialists back to their staffing levels before 2011 and even if Swecker had succeeded in say doubling the number of FBI agents assigned to mortgage fraud in 2007 nothing significant would have changed. A few hundred more small time frauds would have been prosecuted and convicted. The fundamental problem was the troika’s misidentification of the cause of the mortgage fraud epidemic and the resultant misallocation of FBI resources.
With a mortgage annual fraud incidence measured in the millions, 120 FBI agents could not possibly “prevent” a financial crisis. They did not represent even a speed bump to the epidemic of mortgage fraud. The troika got everything wrong about mortgage fraud despite Swecker’s prescient warnings. Providing 120 FBI agents to prevent the financial crisis that a fraud epidemic will inevitably produce is a useless farce. A House bill’s “finding” section provides a useful perspective on the issue of FBI resources.
A House Bill contrasts the DOJ/FBI response to the S&L debacle and the ongoing crisis.
1ST SESSION H. R. 1350
To provide additional resources for Federal investigations and prosecutions of crimes related to the 2008 Financial Crisis, and for other purposes.
IN THE HOUSE OF REPRESENTATIVES
APRIL 4, 2011
Ms. KAPTUR (for herself, Ms. WATERS, Ms. SCHAKOWSKY, Ms. WOOLSEY, Mr.
JACKSON of Illinois, Ms. TSONGAS, and Ms. NORTON)
To provide additional resources for Federal investigations and prosecutions of crimes related to the 2008 Financial Crisis, and for other purposes.
SECTION 1. SHORT TITLE.
This Act may be cited as the ‘‘Financial Crisis Criminal Investigation Act’’.
SEC. 2. FINDINGS.
Congress finds the following:
(1) The Federal Bureau of Investigation (FBI) has testified that ‘‘today’s financial crisis dwarves the S&L crisis….”
(2) The FBI has testified that mortgage fraud was such a major contributor to the current global financial crisis that: ‘‘it would be irresponsible to neglect mortgage fraud’s impact on the U.S. housing and financial markets’’.
(3) In the late 1980s and early 1990s, the United States experienced a similar financial crisis with the collapse of the Savings and Loan institutions. Again, according to Deputy Director Pistole, ‘‘the Department of Justice (DOJ), [and more specifically the FBI], were provided a number of tools through the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) and Crime Control Act of 1990 (CCA) to combat the aforementioned crisis. As stated in Senate Bill 331 dated January 27, 2009, ‘in the wake of the Savings and Loan crisis of the 1980s, a series of strike forces based in 27 cities was staffed with 1,000 FBI agents and forensic experts and dozens of Federal prosecutors’.’’.
(4) Fraud also played a decisive role in the Savings and Loan crisis. The FBI and Justice Department made prosecuting those elite frauds among its highest priorities. This took a massive commitment of FBI resources, but it produced the most successful prosecution of an epidemic of elite fraud in history—over 1,000 ‘‘priority’’ felony convictions of senior insiders, according to Professor William K. Black in his book ‘‘The Best Way to Rob a Bank is to Own One’’.
(5) However, the FBI, because of its crippling personnel limitations, has been unable to assign sufficient FBI agents assigned to investigate the current global financial crisis. The FBI identified the mortgage fraud ‘‘epidemic’’ in congressional testimony in September 2004. It had so few white-collar crime specialists available, however, that it was able to assign only 120 special agents to mortgage fraud cases—less than one-eighth the agents it found essential to respond adequately to the huge, but far smaller, Savings and Loan crisis.
(6) Given the magnitude of the financial crisis of 2008 and the resulting losses and billions of taxpayer dollars spent to keep the financial system from collapsing, the FBI should have no less than 1,000 agents to address corporate, securities, and mortgage fraud located across the country, and, in addition, more forensic experts and Federal prosecutors to uncover the crimes committed and bring the perpetrators to justice.
In 2007, three years after Swecker’s twin warnings, the troika decided that preventing a financial crisis warranted a total allocation of 120 FBI agents to investigate millions of mortgage frauds – roughly the same amount of investigators that the State of New Jersey allocated to “Operation Swill” to investigate 63 establishments.
The troika assigned its handful of FBI agents to investigate low priority cases
The 120 FBI agents were not part of a national or regional task force assigned to the highest priority fraud cases. During the S&L debacle the Dallas Task Force had over 100 professionals assigned to it (and that does not include our examiners “detailed” to serve as the FBI’s internal experts. (By “detailing” our examiners to the FBI they were able to access grand jury materials under Rule (6) (e) that cannot normally be provided to the regulators.) The 120 agents assigned to investigate mortgage fraud were spread among the FBI’s many district offices in what the military calls “penny packets.” No FBI office had sufficient agents investigating mortgage fraud to mount a serious investigation of any of the large fraudulent lenders.
The FBI got some episodic whistleblower complaints, but it got virtually no criminal referrals from the banking regulator agencies. The OTS and the OCC did zero criminal referrals after Swecker’s twin warnings. The Fed made three referrals to DOJ about discriminatory lending. The FDIC was smart enough to refuse to answer reporters’ questions on how many referrals it did after Swecker’s warnings. The uninsured portion of the lending industry refused to make criminal referrals. The result is that the 120 FBI agents were assigned to investigate a tiny portion of the 52,862 criminal referrals received from the subset of FDIC-insured lenders that made referrals and made referrals about cases of local mortgage fraud. This is a formula for failure. It is a “retail” strategy of investigating and prosecuting in response to a “wholesale” strategy of accounting control fraud in which the fraudulent officers controlling massive, seemingly legitimate lenders made hundreds of thousands of fraudulent loans to optimize accounting control fraud. Every year, the FBI was certain to tens of thousands of referrals farther behind as its inventory of uninvestigated referrals grew by over 50,000 annually.
The FBI later proudly announced that over half the mortgage fraud cases it was investigating exceeded $1 million in losses, but that figure represents two California homes. The FBI did not investigate any major fraudulent lender. To its credit, the FBI eventually realized that this retail strategy had to fail and it recommended a complete restructuring of the FBI’s effort against the mortgage fraud epidemic. Attorney General Mukasey famously killed the FBI’s recommendation to create a task force against mortgage fraud in 2007, claiming that the epidemic of mortgage fraud was trivial – his analogy was that it constituted “white collar street crime.” One can almost feel sympathy for Mukasey. It is true that the FBI investigations of mortgage fraud led entirely to the prosecution of relatively smaller frauds, but what Mukasey failed to realize is that it was the troika’s allocation of FBI resources against mortgage fraud exclusively to relatively minor cases that ensured that they would find evidence only of relatively minor fraud cases. Mukasey’s blindness to his own circular reasoning and the troika’s key role in preventing the investigation of any major bank is telling.
(Parenthetically, we should step back and recognize the import of the fact that mortgage frauds in the $1 million range are “relatively minor.” Plainly, that is an enormously important crime relative to blue-collar property crimes. There is a hidden story here of how absurdly low our prioritization of white-collar crimes remains.)
The Obama administration proves, however, that even the creation of a national task force against mortgage fraud (which Attorney General Holder did in 2009) does not insure proper resource allocation. Without any support for the FBI from the banking regulatory agencies in the form of criminal referrals, training of FBI agents and AUSAs by the regulators on how to detect, investigate, and prosecute control fraud, detailing of examiners to the FBI, or pushing for greater FBI and DOJ resources devoted to mortgage fraud the FBI had only one place it felt it could turn to gain the necessary industry expertise – the mortgage lending industry. The FBI, therefore, “partnered” with the Mortgage Bankers Association (MBA) in 2007.
The MBA is the trade association of the “perps,” so the FBI’s choice of a partner proved catastrophic. The MBA was the group that confirmed the accuracy of the FBI’s twin warnings in 2004. The MBA knew that there was a raging epidemic of mortgage fraud and that such fraud was endemic among liar’s loans (recall MARI’s five warnings in early 2006). But it was also the MBA that led the industry resistance to any meaningful restrictions on liar’s loans by the federal banking regulators of the banks and S&Ls they regulated or the Fed’s use of HOEPA. The MBA also created the parallel data base on mortgage fraud designed not to provide criminal referrals to the DOJ and the FBI. The MBA did not push non-insured mortgage lenders to make criminal referrals. Worst, the MBA created a faux “definition” of “mortgage fraud” under which the lender and its controlling officers were always the victims rather than the perpetrator of the mortgage fraud. The FBI and the DOJ have repeated this fake definition endlessly – without any critical thought even though it implicitly defines control fraud out of existence and even though the FBI still has a few old-timers who know that the frauds that drove the S&L debacle and the Enron-era scandals were accounting control frauds. If you are not a grizzled veteran, however, then you “know” that accounting control fraud does not exist because it is illogical.
“Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. ‘It doesn’t make any sense to me that they would be deliberately defrauding themselves,’ Wagner said.”
Sacramento is one of the epicenters of the accounting control fraud that drove the financial crisis,
But the U.S. Attorney there has been so bewitched by the MBA’s fake definition of mortgage fraud that Wagner cannot even keep his pronouns straight. The “they” in his sentence refers to the controlling officers while the “themselves” he is referencing is the bank. It is not “sense[less]” for a controlling officer to loot the bank in order to become wealthier. The title of George Akerlof and Paul Romer’s famous 1993 article says it all (“Looting: The Economic Underworld of Bankruptcy for Profit”). Because Wagner has made it clear that he would view as “sense[less]” any FBI agent who asked to create a major team together to investigate a huge lender for accounting control fraud we can be sure that the accounting control frauds in his district can defraud with impunity.
Why the MBA is the worst anti-fraud partner while premium booze sellers are ideal
Trade associations typically become perverse as soon as material numbers of their members are control frauds. Trade associations overwhelmingly serve the lowest common denominator among their members. When the lowest common denominator is composed of control frauds the depths the trade association’s leaders will plumb become bottomless. The MBA membership included hundreds of accounting control frauds and the frauds were often the largest and most active and demanding of MBA members. Trade association leaders recognize that any effort by them to crack down on the frauds will lead to a civil war within the association and may get them fired.
The makers of premium alcoholic beverages, by contrast, are the quintessential example of a group for whom it is vital to constrain “lemons” markets in their field and the resultant “Gresham’s” dynamic in which bad ethics (and quality) drives good ethics (and quality) out of the market. Maintaining a reputation for “top shelf” quality is essential for a premium brand to succeed because the price premium is very large and consumers will not pay it if the reputation for suffers. The greatest threat to maintaining that reputation is bars that secretly substitute cheaper quality alcohol for the top shelf brands. A customer pays a premium price, particularly in a bar or restaurant, for a premium product to impress a client or loved one or to celebrate an event. He or she is secretly served an inferior brand. The conclusion that the customer reaches is generally that the brand isn’t all that good rather than that the bar most have switched the booze. Bars and restaurants that switch booze buy far less premium booze. There are three major victims of booze switching: the customers, honest bars that have to pay full price to buy premium booze, and the companies that make premium booze. George Akerlof explained this point in his 1970 article on markets for “lemons.”
“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” George Akerlof (1970).
The makers of premium alcoholic beverages understand this point and are strong supporters of government efforts to prevent booze switching and dilution. It is in their economic interest to develop experts and expert technology that can spot and document booze switching. Their expertise and technology proved very helpful to New Jersey’s ability to detect and document booze switching.
No similar positive incentive to assist the FBI in ending the mortgage fraud epidemic existed at the MBA or among individual lenders. The fraud “recipe” for a lender leads to making vast amounts of bad loans and very large losses to the lenders – but all of this best enriches the controlling officers. From the standpoint of an honest competitor, the fraud recipe not only poses no threat, it is a godsend. If one’s competitors are being driven into a suicidal lending strategy by the fraud recipe the honest competitor’s profits increase. The Gresham’s dynamic arises in this context because of modern executive compensation. The CFO who is honest and refuses to follow the fraud recipe will report far lower “profits” in the near term than will the CFOs of fraudulent competitors. Epidemics of accounting control fraud can hyper-inflate financial bubbles and greatly extend the life of the frauds because it makes it simple to refinance bad loans and greatly delay their defaults. The honest CFO not only must report far lower earnings than his fraudulent competitors and explain to his spouse, peers, and boss why the bonuses are far smaller than those paid by the fraudulent competitors. None of this creates any powerful incentive to spend the resources of an honest lender fighting fraud by the controlling officers of rival firms. Where the Gresham’s dynamic is sufficiently powerful the reaction of the formerly honest CEO is to mimic the fraudulent rivals.
In mortgage lending there was no analog to the premium creator of top shelf alcoholic beverages. A firm that makes a major premium brand of alcohol is a wholesaler who custom crafts a product sold to tens or hundreds of thousands of customers. The mortgage lending industry is completely different. It is inherently retail. One could have high quality standards as a loan broker or lender by refusing to make liar’s loans and refusing to exploit unsophisticated customers by charging premium interest rates to those with relatively high credit ratings. That high quality standard, however, would not produce a product that the loan broker could sell to a lender or lender could sell to the secondary market at a large premium price. It would produce the opposite – dishonest lenders and secondary market purchasers preferred bad (fraudulent) loans with high nominal yields even though the actual expected value of such fraudulent loans was negative. Market structures differ greatly and produce radically different incentives. Those incentives can be so perverse that they are criminogenic. The secondary market, rather than being a source of productive market discipline, encouraged lenders to make even more fraudulent loans.
The FBI’s claim that it could substitute systems for agents
Data programs that look for patterns consistent with fraud are desirable. We routinely used them during the S&L debacle to identify lenders that were most likely to have engaged in accounting control fraud. The FBI developed a software application that looked for a relatively minor form of fraud. If anything, this simply pushed the FBI even more towards the investigation of relatively smaller acts of mortgage fraud.
“In response to inquiries from the FCIC, the FBI said that to compensate for a lack of manpower, it had developed ‘new and innovative methods to detect and combat mortgage fraud,’ such as a computer application, created in 2006, to detect property flipping” (FCIC 2011: 163).
Applebee’s also made New Jersey’s List
One postscript: New Jersey identified one of the 29 restaurants at which their investigations detected what they believed was booze fraud as “Applebee’s, Kearny.”
One of Applebee’s top franchisees, Zane Tankel, is famous for his rants about Obamacare. I quoted this passage in one of my prior articles.
“’Somebody has to pay,’ said Apple-Metro Chairman Zane Tankel on Fox Business Network. The Applebee’s chief added that it is unclear what Obamacare taxes, costs and fines will total, but said his restaurants will do whatever is necessary to stay in business.
That last clause is the key. Restaurants that “will do whatever is necessary to stay in business” are precisely the problem when rival control frauds produce a Gresham’s dynamic. Controlling officers who were honest for many years may engage in fraud because when cheaters prosper markets become so perverse that they become criminogenic. It is hard to compete with a bar that can buy its (faux) premium booze at the price of a cheap brand and sell it at the top shelf price. Profits on the sale of alcohol can easily be the difference between success and failure for a restaurant.