Page 2 of 2 Fraud and the subprime bubble
By George Pugh
were hired to do, which was to review the tranches and the associated
originator-provided credit scores.
The first tremor that rattled
Merrill's profitable business of underwriting mortgage securities came at the
end of 2005. As it repackaged mortgage bonds into securities called CDOs,
Merrill had a key partner in insurer American International Group Inc. An AIG
unit bore the default risk of the CDOs' largest and highest-rated chunk, known
as the "super-senior" tranche, normally sold to big investors such as foreign
banks.
But AIG was keeping a close eye on the housing boom because it had another unit
that made subprime loans, those to home buyers with weak credit. AIG did a
review of the market. Concerned that home-lending standards were getting too
lax, AIG at the end of 2005 stopped insuring mortgage securities. [11]
The problem or question about getting timely information alone
might have discouraged entry and certainly became a problem during the crisis.
Not only were there questions about performance but actual fraud became much
more of a concern, or should have.
In calendar year 2006, financial
institutions filed 37,313 SARs citing suspected mortgage loan fraud, a 44%
increase from the preceding year, compared to a 7% overall increase of
depository institution SAR filings. One reason for this increase may be that
lenders are increasingly identifying suspected fraud prior to loan approval and
reporting this activity. Suspected fraud was detected prior to loan
disbursements in 31% of the mortgage loan fraud SARs filed between April 1,
2006, and March 31, 2007, compared to 21% during the preceding ten years. Total
SAR filings in 2006 on suspected mortgage loan fraud, when divided by the
subject’s state address,2 showed the greatest increases in Illinois (75.80%),
California (71.29%), Florida (53.04%), Michigan (51.50%), and Arizona (48.73%).
[3]
Mortgage brokers initiated the loans reported on 58% of the SARs sampled for
this report. SAR reporting includes examples of brokers acting both as active
participants in the reported fraudulent activity, and as intermediaries that
did not verify information submitted on the loan application, according to the
Financial Crimes Enforcement Network (FinCEN). [12]
Put
another way, mortgage fraud "suspicious activity reports" (SARs) increased from
3,515 in 2000 to 25,898 in 2005 and in 2006 to 37,313. [13] Thus mortgage fraud
was growing very rapidly during the period, and most firms took no action, with
the exception of AIG and that was probably because AIG had special knowledge
coming from another subsidiary that wrote subprime mortgages.
The firms that collateralized CDOs were about the last to appreciate the fraud
risks in the MBSs they used. Nonetheless they reacted to them as yet another
unanticipated risk and in the majority of cases brought it under some control.
Checking for fraud was not in their mandate, though it was in their interest to
do so.
Despite all the information available and the amount of money in play it is
clear that any efforts at the originator level were meaningless, and that no
one had thought about the issues even though it is clear that mortgage fraud
was not a new issue.
Who's to blame?
Clearly fraud played a very important role in this bubble, and that fraud began
with the originators. The last time fraud was an issue, we later found that not
all "cures" stand the test of time. The demand for preventative action always
comes in the wake of a costly financial crisis like this one and the last one
that had fraud in the mix. Retired Congressman Michael Oxley told of his
dissatisfactions in an interview, highlighting also the role of the Public
Company Accounting Oversight Board (PCAOB) which the Sarbanes Oxley Act
established to oversee and discipline accounting firms in their roles as
auditors of public companies:
The main thing is the enormous cost that
was driven by the outside audit. It was Auditing Standard No 2 [the standard
for auditing internal controls over financial reporting], promulgated by the
PCAOB that started all the problems. Of the complaints you hear [about Sarbanes
Oxley], 99.9% are about 404 [the section requiring management and an external
auditor to report on the adequacy of a company's internal control over
financial reporting]. It was two paragraphs long, but by the time the PCAOB was
done, it was 330 pages of regulations. It was far too prescriptive and [more]
expensive than anyone anticipated. [14]
The author of Sarbox
thought that it was poorly designed, costly and in need of change after its
full effects could be seen, so there is a need for any new rules to be well
thought out to prevent similar problems in the future. Fraud was a major factor
in this bubble and collapse, and Sarbox provided no amelioration or warning. It
seems that Mr Oxley's misgivings were well placed. In this case, all the new
rules and regulations which were in effect and evidenced in the SEC filings
simply did not work as promised.
There is reason to doubt how seriously the SEC has taken the PCAOB. All the
members of the predecessor Public Accounting Board and industry groups resigned
in the face of then SEC chairman Harvey Pitt's plans for a new regulatory body
which evolved into PCAOB.
William Webster was appointed as first PCAOB chairman in 2002 and a few weeks
later newspapers reported that he had served on the audit committee of US
Technologies, which was being investigated for accounting irregularities. One
of the SEC members, Harvey Goldschmid, had already claimed that the PCAOB
candidates were not properly vetted and with that both Pitt and Webster
resigned in November 2002. It is clear that the whole enterprise was ill-omened
and had the elements of putting on a proper show rather than doing anything to
lessen the opportunities for fraud:
Both the SEC and the American Institute of Certified Public Accountants, before
the PCAOB took over the rule-making function, had incorporated the Treadway
Commission Report (into fraudulent financing reporting) into their work. A
critical rule is that the auditors make a revenue fraud and rebuttable
presumption. That rule didn't seem to make any difference, based on the FinCEN
figures quoted above.
The subprime loan instruments are only subject to limited recourse based on the
retention of residual interest, and the recourse is limited to that interest.
Absent demonstrable fraud, the originators gave only limited recourse to the
buyers.
Was there really fraud involved or are we just seeing name calling? First the
firms themselves took definitive action to control the situation: Such actions
show genuine surprise and a desire to solve the problem and in no way
demonstrate mens rea, which ignoring the problem might.
...
rigorous internal processes requiring critical judgment and discipline in the
valuation of holdings of complex or potentially illiquid securities. These
firms were skeptical of rating agencies' assessments of complex structured
credit securities and consequently had developed in-house expertise to conduct
independent assessments of the credit quality of assets underlying the complex
securities to help value their exposures appropriately. [15]
This
is probably the best proof that fraud caused the problem at the lowest level
and that the people who received them were as much victims as others.
The US Attorney General Michael Mukasey has issued a statement on the subject:
Yesterday,
AG Mukasey rejected the idea of a national task force to combat the national
mortgage crisis, leaving it to local prosecutors to oversee separate FBI
investigations. According to this report in the New York Times, Mukasey called
the problem a localized one akin to 'white-collar street crimes' and
distinguished it from the Enron collapse, for which a task force was created.
[16]
From both items it is clear that the frauds started with
the people making fraudulent mortgage applications which were not caught by the
people issuing the mortgages. The second conclusion is that the firms were only
later involved and did not try to hide the problems in a meaningful way; though
there may have been instances in some firms, it was by no means generalized.
Fraud and bubbles
It seems proper to make a brief detour and discuss how fraud plays an intimate
roll in the creation of bubbles. Fraud distorts market signals for demand and
more importantly growth in demand and price. In this instance, increased
mortgage financing bid up existing stock and created a multiplier effect among
existing home owners, who sought to reinvest their gains in larger properties.
These price increases encouraged builders to build for the increased demand
which was debt financed. Mortgage lenders were eager to keep up, and lowered
their standards, even if no fraud was involved, to keep their competitive
position. The risks were passed on to the purchasers, so the mortgage
originators and their auditors simply did not see the contingent risk as large.
It really doesn't take a lot of increase in demand to increase the growth in
prices, feeding building and speculation.
Up to this point, it is clear that mortgage fraud fed the bubble and that
subprime loans were in the center ring. There is strong evidence that the firms
that stayed in the market behaved well when contending with the fraud involved
in the underlying instruments. It is also clear that SEC regulations,
especially Sarbanes Oxley, are totally worthless in preventing or detecting
fraud. It appears that the politicians want to further regulate the firms
rather than look to their own regulatory failures.
George Pugh is president of George Pugh & Co, a New Jersey-based
consulting firm. He is a Certified Public Accountant, has an MA from The Paul H
Nitze School of Advanced International Studies (SAIS ) of The Johns Hopkins
University, and an MBA from Rutgers University. Prior to that, he was a naval
intelligence officer, brokerage auditor at PricewaterhouseCoopers, and lending
officer at HSBC and NatWest.
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