I made a mistake in presuming that the self-interests of organiza­tions, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.

—Alan greenspan (New York Times, October 23, 2008).

One of the great public outcries in the wake of the financial crisis was the issue of why executives of banks did not go to jail for their roles in the financial crisis.

The purpose of this chapter is to explore the link between the massive fraud that was committed and the eventual collapse of the mortgage securitization industry. The drying up of conventional mortgages and the great expansion of nonconventional mortgages after 2003 drove banks to originate worse and worse mortgages over time. Eventually, banks became so desperate for mortgages to securitize that they loosened lending standards and started down the slippery slope to commit mortgage fraud. They also engaged in predatory lending, par­ticularly to minority communities, in order to secure mortgages that attracted higher fees and higher interest rates. Vertically integrated banks were particular­ly susceptible to these pressures and were the most likely to have paid fines for mortgage and securities fraud (Fligstein and Roehrkasse, 2016).

To begin, it is useful to consider the three kinds of fraud that were being com­mitted and who instigated the fraud. Mortgage fraud is the “intentional mis­statement, misrepresentation, or omission by an applicant or other interested parties, relied upon by an underwriter or lender to fund, purchase or insure a loan” (Federal Bureau of Investigation [FBI], 2007).

Mortgage fraud in terms of misinformation in the application process was only one kind of fraud that was being committed. As loans became more im­portant to the securitization process, originators engaged in predatory lending. Predatory lending is a kind of fraud in which loan originators engage in unfair and deceptive practices during the loan origination process (Forrester, 2005). While predatory lending has no consensus legal definition, the Federal Depos­it Insurance Corporation characterizes the behavior as “imposing unfair and abusive loan terms on borrowers, often through aggressive sales tactics; taking advantage of borrowers' lack of understanding of complicated transactions; and outright deception” (Federal Deposit Insurance Corporation, 2006: 1). A vari­ety of laws regulate predatory lending. At the federal level, deceptive lending practices are criminalized under the Truth in Lending Act, most particularly the subsidiary Home Ownership and Equity Protection Act. Discriminatory lending practices are covered under the Fair Housing Act and the Equal Credit Opportunity Act.

Lenders stand to gain and borrowers lose from predatory lending practices in three ways. First, lenders may misrepresent or conceal information about eligi­bility criteria and may offer excessively costly loans to groups that have had dif­ficulty obtaining a mortgage, such as racial or ethnic groups. In this way, lenders can channel borrowers into loans that are more expensive than those to which they are entitled. Second, lenders may misrepresent or conceal information about loan features such as add-ons or balloon payments or about the estimated likelihood that a borrower will default. This practice allows lenders to extract unexpected fees and penalties from borrowers.¹ There is extensive evidence that borrowers who lived in minority or low-income communities were more likely to be taken advantage of in both of these ways (Baumer et al., 2017; Rugh et al., 2015). Finally, such loans were often more attractive for securitizers because they paid higher interest rates that increased the value of mortgage security tranches.

A third kind of fraud is securities fraud. Securities fraud is the situation in which actors misrepresent, withhold, or otherwise misuse information used by investors to make decisions. Securities fraud is regulated by diverse federal and state laws and enforced by an array of federal and state agencies. In this case, however, it is pursued chiefly by the Securities and Exchange Commission, the Department of Justice, and the attorneys general of major states such as New York and California. In the mortgage securitization industry, securities fraud usually takes the form of misleading investors or shareholders about the quality or composition of the mortgage assets underlying MBSs.

Issuers and underwriters stand to gain at these actors' expense in at least two ways. On the one hand, they may inflate securities prices by willfully or negli­gently misrepresenting the characteristics of MBS products to investors.

Why would banks want to give mortgages to people who could not pay them back, and why would they risk their reputations by committing mortgage and securities fraud? One explanation has been that the originators of these mort­gages were not going to hold them and would instead sell them to banks, who would then package them into securities. Those banks would not care about the riskiness of the loans because they intended to sell them to someone else. This was one of the reasons why the originate-to-distribute model was thought to be the main source of the origination and securitization of bad mortgages (Ash­craft et al., 2010). While this was true for some originators and securitizers, there is strong evidence that vertically integrated banks were the most likely to have encouraged their loan originators to commit mortgage fraud and knowingly packaged these mortgages into securities, thereby committing securities fraud (Fligstein and Roehrkasse, 2016). Why was this the case?

The shift to nonconventional mortgages was necessitated by the need to keep finding mortgages to create securities beginning in 2004. The demand for those securities was so high that originators and securitizers had little choice but to obtain such mortgages if they wanted to continue to make high profits. But once that shift began, originators and securitizers realized that such mortgages gen­erated larger fees and had higher interest rates, and thus the securities based on them would appeal to investors who wanted higher returns.

When the market for nonconventional mortgages began to dry up by 2005, finding even these mortgages to produce securities became harder and harder. It was at this moment that the pressure from securitizers on originators to contin­ue to produce new mortgages caused many originators to relax their mortgage standards, and this encouraged them to falsify loan documentation (DellAriccia et al., 2012). This competition over an increasingly shrinking pool of mortgages pushed banks to begin the chain of fraudulent behavior by faking information on loan applications in order to secure those mortgages to keep their securitiza­tion machines up and running (Barnett, 2011, 2013).

This process was particularly acute for vertically integrated banks. Because their business models were predicated on using mortgages as raw materials, they felt particular pressure to keep originating mortgages. Without the mortgages, their entire pipeline would collapse. While there was awareness that these mort­gages were riskier and more likely to be foreclosed on, people in banks that were vertically integrated and who wanted to remain employed had little choice but to do their jobs and respond to the pressures to keep producing.

These pressures resulted in the vertically integrated banks taking on the riskiest of mortgages, which resulted in them eventually having the largest losses and made them more likely to face bankruptcy (Goldstein and Fligstein, 2017). As a result, they were also the ones who were the most likely to engage in mortgage fraud. Indeed, committing mortgage fraud goes hand in hand with originating and securitizing the riskiest mortgages. Vertically integrated banks had the most to lose if their business models collapsed. Banks that were only originators or who produced securities (i.e., pure investment banks) could en­ter other businesses or scale their MBS businesses down (which is what Gold­man Sachs did) as mortgages dried up.

Vertical integration also increased the likelihood that within the bank, no one had any interest in doing due diligence in value chains. When performed by multiple firms, the mortgage securitization process entails several distinct transactions, each of which provides opportunities not only for malfeasance but also for monitoring the quality of loans. When securitization is integrated within firms, originators, issuers, and underwriters share rather than oppose one an­other's interest in misrepresenting the characteristics of mortgages and MBSs. Firms that engaged in fraudulent lending perpetrated securities fraud because they were forced to hide the low quality of the mortgages they had originated.

While fraud was not the cause of the financial crisis, it was a symptom of the in­creasingly problematic business models of banks. Loans given to people who could not afford to make mortgage payments proved to be risky, as these were the first mortgagors to face foreclosures. As house prices stopped rising, those who could not pay their mortgages and could not sell their homes were inclined to walk away from their homes. This put further pressure on house prices. That created a spiral that meant that the securities that were built last in the process were at the greatest risk of failure. The financial debacle that followed exposed the predatory tactics that were being used to keep the mortgage securitization boom going.

This chapter is organized in the following way. First, I present some of what we know about the extent of the three kinds of fraud. Then I tie together the strands of the argument more explicitly about who committed fraud and why, and I consider some evidence for that account. Next, I turn to considering the internal organizational dynamics for how Bear Stearns and Washington Mutual committed fraud from origination to the sale and purchase of securities. It has been very difficult for researchers to get information on what was going on in­side banks through this process. These case studies are based on two sources: court documents including testimony by executives who were involved in cases and public documents, particularly evidence presented at the hearings of the Financial Crisis Investigation Committee (Financial Crisis Investigation Com­mission, 2010a, 2010b). They reveal evidence that the basic outlines of the story I am telling about vertically integrated banks rings true. Finally, I consider the generality of my explanation of the role played in the fraud by vertically integrat­ed banks by examining what we know about the banks that have paid large fines to settle lawsuits regarding various kinds of fraud.