How Much Fraud Was There?

The issue of measuring how much fraud was perpetrated in 2001-2008 is fraught with difficulties. What is legal and illegal behavior is a difficult question. Our definitions of fraud and our legal standards for proving it reflect how financial businesses have influenced the laws and regulations that are supposed to govern their businesses (Calavita et al., 1997).

A second problem is detecting fraud. Detecting fraud in mortgage documents is not straightforward and requires objective sources of information in order to decide if someone has filled out their paperwork fraudulently. Detecting pred­atory lending is even more difficult. Determining whether a particular mort­gagor was targeted for a worse loan than they qualified for is almost impossible. One must decide whether that targeting was excessive with the goal of predation or whether the mortgagor just could have gotten a better deal somewhere else. Whatever estimates can be generated around these activities require innovative techniques in the face of questionable data quality. Discovering predatory lend­ing can require those who are its victims to recognize what happened and then go public by trying to sue their bankers. A large amount of predatory lending is simply not detected because its victims remain unaware or inactive.

Much of our data on mortgage fraud comes from official sources. That data tries to infer the motives of those committing the fraud.

With those caveats, in the housing bubble that preceded the financial crisis of 2007-2008, there is significant evidence that much financial crime existed in the form of mortgage fraud (Bitner, 2008; Nguyen and Pontell, 2010; Patterson and Koller, 2011; Barnett, 2011, 2013; Fligstein and Roehrkasse, 2016; Baumer et al., 2017; Financial Crimes Enforcement Network, 2008). The mortgage industry can be thought of as consisting of two distinct segments. In the primary mort­gage market, mortgage originators, with the help of brokers, escrow agents, and appraisers, originate and provide loans to borrowers. In the secondary mortgage market, investment banks, government-sponsored enterprises, and credit rating agencies engage in the business enterprise of securitizing and managing loans originated in the primary mortgage market (Nguyen and Pontell, 2010: 597; Col­lins and Nigro, 2010: 634). Fraud was rampant in both segments of the mortgage industry. Vertically integrated banks, of course, committed both kinds of fraud.

Evidence overwhelmingly suggests that mortgage fraud and predatory lend­ing became a systemic problem in the years before the mortgage meltdown (Koller, 2012; Patterson and Koller, 2011; Frieden, 2004). Under US federal law, mortgage fraud is prosecuted criminally as bank fraud, wire fraud, mail fraud, or money laundering. The rapid rise of mortgage fraud in the early twenty-first century has also led states to develop their own penalties for mortgage fraud. According to the FBI, 80 percent of all reported mortgage fraud losses involve collaboration or collusion by industry insiders (FBI, 2008, cited in Smith, 2009: 479; FBI, 2010).

Baumer et al. (2017) have used a unique data set to try to estimate the overall prevalence of mortgage fraud. That data set examines all US mortgages and uses an algorithm to locate suspicious applications. That algorithm is in current use by banks and mortgage companies. They suggest that 24.2 percent of all applica­tions contained some fraudulent information. We have several other estimates of such fraud. At the low end, Piskorski et al. (2015) estimate that about 10 per­cent of all loans in a sample of MBSs created by the GSEs contained fraudulent information. Griffin and Maturana (2016), using different data and techniques, report that around 48.1 percent of all mortgages contained at least one element of fraud. Many of the differences are due to different samples, different data sets, and different methods to estimate fraud. For example, the Piskorski et al. (2015) data set contains only mortgages used by GSEs. These mortgages were likely to have contained less fraud because they were based on more conventional mort­gages. Even if one takes the middle of the range of estimates (about 25 percent), one can conclude that mortgage fraud involved at least a quarter of mortgages and was a large problem.

Richard Bitner, a former president of the subprime mortgage lender Kellner Mortgage, reported that that he was well aware of the fraudulent nature of loan applications coming from mortgage brokers. He says, “At the end, 70 percent of submissions from brokers to the company were deceptive, half of the property values related to loans were over-edged by up to 10 percent, a quarter had prop­erty prices exaggerated by 11 to 20 percent, and the rest were so overvalued, they defied all logic” (Bitner, 2008: 97).

Predatory lending was widespread among mortgage originators (Willis, 2006). Predatory lenders often target potential and current homeowners who are generally not seeking loans (Renuart, 2004). In most cases, predatory lend­ers target subprime borrowers with little prior experience in the credit market (Engel and McCoy, 2001: 1261; Delgadillo et al., 2008). They capitalize on these borrowers' lack of financial literacy and lack of access to unbiased financial ad­vice (Engel and McCoy, 2001). In the prime market, mortgages are extended to borrowers who are deemed to have a high level of creditworthiness and good credit histories. The predatory market has been conceived of as constituting a separate section of the subprime market and has been said to target “people who, because of historical credit rationing, discrimination, the exodus of banks from inner-city neighborhoods, and other social and economic forces, are disconnect­ed from the credit market and hence are vulnerable to predatory lenders' hard­sell tactics” (Engel and McCoy, 2001: 1279).

Estimates of the prevalence of predatory lending, especially those forms that reach the level of illegality, are hard if not impossible to come by. The diversity of practices subsumed under predatory lending, the different credit markets in­volved, and the lack of a common definition of predatory lending make it diffi­cult to quantify its prevalence and costs. Moreover, as already noted, victims of predatory lending rarely understand that they have been wronged, and if they do, they rarely bring lawsuits. Ryder (2014) concludes that “It is impossible to de­termine how many of the subprime loans issued before the start of the financial crisis fell within the definition of predatory lending” (75-76). There is, however, a shared understanding in the literature that, at least in the United States, preda­tory lending practices were widespread during the housing boom that preceded the financial crisis of 2007-2008 and that hundreds of thousands of homeowners have been victimized in the past decade (Willis, 2006; Fligstein and Roehrkasse, 2016; Ryder, 2014).

Fligstein and Roehrkasse (2016) report that each of the top ten mortgage orig­inators, which in 2007 had a 71.7 percent market share, have been implicated in fraudulent or discriminatory lending practices. These lenders have settled law­suits brought by regulators and borrowers alleging predation. In certain cases, banks such as Goldman Sachs and Morgan Stanley that underwrote but did not directly broker mortgages have been found liable for the predatory practices they helped finance.³ Agarwal et al. (2013) estimate that predatory lending practices led to a one-third increase in the probability of subprime mortgagors defaulting on their loans.

Investment banks, acting as issuers and underwriters for securities, have been shown to have made false statements to investors and other market partic­ipants about the quality and character of those securities (Ferguson, 2012; Bar­nett, 2013; Fligstein and Roehrkasse, 2016; Ryder, 2014: 95-103; Piskorski et al., 2015). According to one observer, “almost all prospectuses and sales material on mortgage-backed bonds sold from 2005 through 2007 were a compound of falsehoods” in the United States (Ferguson, 2012: 191). Fligstein and Roehrkasse (2016) show that all of the top ten underwriting firms, which together represent­ed 74.1 percent of the market, have all been implicated in securities fraud cases. All settled with regulators or investors over underwriting-related fraud allega­tions (Fligstein and Roehrkasse, 2016: 28).

In their study, Piskorski et al. (2015) found that about one out of every ten loans in their dataset involved some sort of misrepresentation. The authors of the study emphasize that these results are complicated by the fact that it is diffi­cult to determine where exactly in the supply chain of credit, be it at the level of the borrower, the lender, or the underwriter, the misrepresentation took place (Piskorski et al., 2015: 32). They also found that the delinquency rate of misrepre­sented loans was 60 to 70 percent higher than the delinquency rate of otherwise similar loans, potentially impacting MBSs with a combined outstanding balance of up to $160 billion (Piskorski et al., 2015: 5).

Taken together, there is ample evidence that fraud was built into the mortgage business during 2001-2008. Fraud was being committed by literally everyone in the mortgage business. Mortgagors accepted loans under conditions where they knowingly lied on their applications (Jiang et al., 2014). Originators helped mortgagors obtain loans and frequently took advantage of unsophisticated bor­rowers by locking them into mortgages that paid high fees but were guaranteed to fail. Those who made the securities were knowingly packaging loans that were obtained fraudulently. How the industry became so corrupt is the question we turn to next.