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Lehman’s Liar’s Loans and Other Cons
Prof. William Black submitted a 24-page report on the Lehman bankruptcy to the House Committee on Financial Services on Tuesday. It is the best analysis of the underlying causes of the financial crisis to date. Black, who is a former government regulator and white-collar criminologist, shows that the crisis was not an unavoidable disaster, as Wall Street apologists suggest, but the result of large-scale fraud perpetrated by financial institutions like Lehman Brothers. The incidents of fraud were numerous, blatant, extreme and premeditated. In making his case against Lehman, Black exposes the omissions, failures and negligence of the primary regulators, particularly the Fed. Had the Fed not been derelict in its duties, the cyclical downturn would not have turned into a near-Depression.
"Lehman’s failure is a story in large part of fraud," Black said in his testimony before the House. "Lehman was the leading purveyor of liars’ loans in the world. For most of this decade, studies of liars’ loans show incidence of fraud of 90per cent. … If you want to know why we have a global crisis, in large part it is before you."
As the Litigation Director of the Federal Home Loan Bank Board during the S&L crisis, Black knows what he’s talking about. He was so dogged in his investigation that Charles Keating "directed his chief political fixer that his ‘Highest Priority’ was to ‘Get Black … Kill him Dead.’” But Black didn’t buckle or give ground. He shrugged off the threats and continued to expose unsound practices and illegal activity. His team faced the same challenges that regulators face today, "elite frauds" by powerful institutions that wield tremendous political power.
Black’s statement cuts through much of the ideological claptrap surrounding the crisis and shows that deregulation is really the decriminalization of fraud. The notion that the market can "regulate itself" has been jettisoned altogether and public support for reform is gaining momentum.
"It is insane to withdraw accountability for negligence," says Black. "Doing so encourages negligence."
Financial institutions have used "laisser faire" dogma for their own aims. It’s the mask behind which the voracity and predations remain hidden. To a large extent, that’s the story of Lehman, an institution that paid no attention to rules and regulations. Anything went. It’s a philosophy that was embraced by the nation’s chief regulator, Alan Greenspan, former chairman of the Federal Reserve.
"Lehman’s nominal corporate governance structure was a sham," says Black. "Lehman was deliberately out of control with regard to “risk” in its dominant operation – making “liar’s loans.” Lehman did not “manage” the risk of making liar’s loans. It engaged in massive, fraudulent transactions that were “sure things”.
Black notes that sleight-of-hand accounting assures that institutions will "report superb (fictional) income in the short-term and catastrophic losses in the long-term," which is exactly what happened. The head honchos skimmed off billions in fat bonuses and stock options, while their companies were fed to the dogs.
"Lehman’s principal source of (fictional) income and real losses was making (and selling) what the trade accurately called ‘liar’s loans’ through its subsidiary, Aurora… Liar’s loans are ‘criminogenic’ (they create epidemics of mortgage fraud) because they create strong incentives to provide false information on loan applications. The FBI began warning publicly about the epidemic of mortgage fraud in 2004.” (CNN)
The proof of criminal intent could not be clearer. The FBI reported what they’d found to the regulators, but nothing was done. Bush had filled all the supervisory posts with Wall Street loyalists who simply looked the other way. Thus, lending standards were relaxed, profits exploded, housing prices soared, the bubble mushroomed, and Lehman raked in record profits, knowing full-well that the eventual implosion would inflict massive damage on the system and severe hardship on everyone else.
"Lehman’s underlying problem that doomed it was that it was insolvent because it made so many bad loans and investments. It hid its insolvency through the traditional means – it refused to recognize its losses honestly. It could not resolve its liquidity crisis because it was insolvent and its primary source of fictional accounting income collapsed with the collapse of the secondary market in nonprime loans. If Lehman sold its assets to get cash it would have to recognize these massive losses and report that it was insolvent."
This requires some explanation. Prior to the meltdown, the depository "regulated" banks were mainly funded through repurchase agreements (repo) with institutional investors. (aka—"shadow banks"; investment banks, hedge funds, insurers) The banks would post collateral, in the form of bundled "securitized" bonds, and use the short-term loans to maintain operations. When the banks collateral became suspect — because no one knew which bundles held the subprime mortgages — then intermediaries (primary dealers) demanded more collateral for the loans. Suddenly the banks were losing money hand-over-fist as the value of their assets tumbled. Lehman got trapped in this revolving door and couldn’t roll-over its debt using its shabby collateral, which, by now, everyone knew was garbage. There was a bank-run on the shadow system; the secondary market collapsed. In truth, the market was traumatized by a radical repricing event, where asset prices were revalued overnight. Lehman could not survive in this new tight-credit environment.
"There is no way to ‘manage’ the ‘risk’ of making massive amounts of liar’s loans. Lehman was the world leader in making liar’s loans………If Lehman admitted that its liar’s loans were often fraudulent it could not sell them – cutting off one of its largest sources of income."
Low-documentation "liar’s loans" were Lehman’s bread and butter. Ironically, its own auditors discovered that up to half of them "contained material misrepresentations". It didn’t matter; everyone was making gobs of money and the bonus packages continued to shower wealth on the front office. Lehman responded to the auditors’ findings as expected, by boosting the volume of liar’s loans. "Damn the torpedoes". This increased the likelihood of contagion and systemic risk. Lehman’s activities now threatened the whole system.
The SEC didn’t have the manpower to supervise Lehman, but the same can’t be said of the Fed.
"The Fed had unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to regulate all mortgage lenders and had unprecedented practical leverage during the crisis because of its ability to lend and convert investment banks to commercial bank holding companies. The Fed is supposed to be an experienced ‘safety and soundness’ regulator."
But the Federal Reserve Bank of New York (FRBNY) had no intention of overseeing Lehman or of assisting the SEC in carrying out its mission. In fact, Geithner’s Fed "stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a ‘three card monte routine.’”
Black blasts Geithner and the FRBNY:
"The FRBNY knew that Lehman was engaged in fraud designed to overstate its liquidity and, therefore, was unwilling to loan as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS … of the fraud. The Fed official doesn’t even make a pretense that the Fed believes it is supposed to protect the public. The FRBNY remained willing to lend to a fraudulent systemically dangerous institution (SDI). This is an egregious violation of the public trust, and the regulatory perpetrators must be held accountable."
Geithner (apparently) did everything in his power to assist Lehman in hiding its true financial condition and may have deliberately misled investors by facilitating repo 105 transactions which concealed up to $50 billion off-balance sheet liabilities. In his testimony this week before the House Committee on Financial Services, Lehman CEO Richard Fuld said that the Fed was aware of everything that was going on at the bank. If that’s true, than the case against Geithner should be airtight.
Geithner and Fed chairman Ben Bernanke had good reason to mask Lehman’s financial situation. If Lehman’s mortgage-backed assets were "marked to market", it would have forced a systemwide repricing which would have triggered huge firesales of financial assets and severe deflation. So, instead of demanding fair-value disclosures, Geithner and Bernanke assisted in the ongoing accounting cover-up. The debt-instruments and toxic assets are now hidden in Fannie Mae, Freddie Mac, the Fed’s balance sheet, and financial institutions that use "mark to fantasy" accounting trickery. The debts have not gone away; they’ve merely been removed from public view.
"The FBI warned in Congressional testimony in 2004 of an "epidemic" of mortgage fraud…..The Fed deserves special criticism for its failure to respond to these warnings by taking any effective action to stop liar’s loans. The Fed had unique authority under HOEPA to ban liar’s….loans, which would have prevented the bubble from hyper-inflating and contained the rapidly growing epidemic of mortgage fraud."
As early as 2000, consumer groups were urging the Fed to use its authority under HOEPA to address predatory lending. But the Fed refused to respond.
According to Elizabeth MacDonald, the Fed also brushed off "One of the nation’s biggest mortgage industry players". In an article titled "Housing Red flags Ignored" MacDonald states:
"One of the nation’s biggest mortgage industry players repeatedly warned the Federal Reserve…..that the U.S. faced an imminent housing crash….But bank regulators not only ignored the group’s warnings, top Fed officials also went on the airwaves to say the economy was ‘building on a sturdy foundation’ and a housing crash was ‘unlikely’…”
As it pleaded with bank regulators to stop subprime lending abuses, the Mortgage Insurance Companies of America [MICA] pointed out the red flags in analysis from the bank regulators’ own staffers as well as the likes of Bear Stearns and Lehman Brothers, three years before these two Wall Street giants collapsed under the weight of bad mortgage bets."
Mortgage insurers are “deeply concerned about increased mortgage market fragility, which, combined with growing bank portfolios in high-risk products, pose serious potential problems that could occur with dramatic suddenness."… Failure to adjust bank underwriting, reserves and capital to account for this growing risk “means that downturns from credit and/or interest rate events–let alone shocks–will be far more severe than” if precautions are taken." (Elizabeth MacDonald, "Housing Red flags Ignored", FOX Business News)
There were others, too, like former New York governor Eliot Spitzer who warned of a "predatory lending crisis" and lambasted the Bush administration for blocking the prosecution of mortgage fraudsters. Spitzer’s article appeared in the Washington Post in 2003. Here’s an excerpt:
"But the unanimous opposition of the 50 states (Attorneys General) did not deter, or even slow, the Bush administration in its goal of protecting the banks. In fact, when my office opened an investigation of possible discrimination in mortgage lending by a number of banks, the OCC filed a federal lawsuit to stop the investigation."(Washington Post)
These incidents show that the problem wasn’t "deregulation" as much as "refusal to regulate". But, why? Why did the Fed refuse to respond to the many warnings it had gotten from reliable professionals? And, why did Bush take such a hostile approach to consumer protection? Was it a conspiracy or was there merely a tacit understanding between high-ranking members of the political and financial establishment, that predatory lending and mortgage fraud were an acceptable way to fatten the bottom line, with a wink and a nod.
Either way, it’s clear that the crisis was not "natural disaster" or even a "system malfunction", but the result of widespread corporate larceny engineered and executed by the nation’s largest financial institutions.
Black again: "Criminologists refer to entities that spread fraud epidemics as "vectors"…Lehman was one of the largest vectors that spread the fraud epidemic. ….The Fed, due to its unique HOEPA authority, and the SEC, because it has jurisdiction over every publicly traded company, were the only entities that could have shut down the vectors spreading the fraud epidemic… yet the Fed and the SEC took no effective action until after virtually every major originator of liar’s loans had failed."
Indeed. The Fed and SEC knew exactly what needed to be done and they refused to do their jobs. The S&L crisis established the precedents for dealing with “low doc” loans back in the 1990s. So there was a blueprint for acting preemptively to protect the public from the economic fallout. But nothing was done because all the "right people" were getting rich gaming the system, selling garbage loans to vulnerable applicants, and inflating a enormous credit bubble that would leave the economy in a shambles.
Black’s statement leaves no doubt that the hanky-panky at Lehman was deliberate and that the fraud was abetted by friends in high places. Now it’s up to Congress to appoint an Independent Counsel to follow the evidence and make sure that the criminals are brought to justice.
William Black’s full "must read" statement can be seen here: http://www.house.gov/apps/list/hearing/financialsvcs_dem/black_4.20.10.pdf
MIKE WHITNEY lives in Washington state. He can be reached at firstname.lastname@example.org