Systemic Fraud in the Mortgage Securitization Industry

One way to see how this played out among the largest banks is to consider the settlements that the banks made with the government over mortgage fraud, predatory lending, and securities fraud.

Credit Crisis-Related Settlement Amounts by Year: 2007-July 2017

both origination and securitization were more likely to settle lawsuits than banks who were participants in only one or the other.

The cases of Bear Stearns and WaMu illustrate how the pressure to continue originating mortgages after 2003 in order to be able to create MBSs and CDOs worked. Both firms went aggressively into the nonconventional mortgage market and in particular dramatically increased their origination of option ARMs and subprime mortgages. The pressure to continue originating mortgages in order to have them as inputs into securities never decreased, even as the number of potential customers for new mortgages began to decline.

They sold those mortgage securities as AAA rated and held many of them on their own accounts. They borrowed money to originate and securitize mort­gages. They also borrowed money in the ABCP and repo markets in order to support their own purchases of those securities. In the end, many people, partic­ularly those who committed fraud or were the victims of predatory lending, were foreclosed on at a historically high rate. That put more pressure on other home­owners who saw the value of their homes decline and caused the housing market to crash. It also meant that many securities that were built on these mortgages, particularly those built in 2006-2007, were susceptible to default.

My analysis shows that the nature of the whole system was in fact at fault. The demand for MBSs and CDOs pushed banks to take on riskier and riskier mortgages. Their activities kept house prices rising for a while as they focused their attention on zip codes where there had already been a high level of house price appreciation. But eventually, to keep going, they had to cut corners and engage in mortgage fraud and predatory lending. The banks that were the most susceptible to these pressures were those who were involved in both origina­tion and securitization.

The narrative that no one was punished for their role in creating the crisis is only half true. Banks did pay huge fines for their illegal activities. But those activities were not the main thing driving the banks over the cliff. Their reli­ance on procuring mortgages to create securities meant that as the conventional and then the nonconventional mortgage markets dried up, vertically integrat­ed banks became desperate to keep their securitization machines going to keep their high profits intact. They realized the only way this could work was to cut corners by engaging in mortgage fraud and predatory lending. This worked for a short time, but eventually many of those bad mortgages faced foreclosure be­cause the people who bought them simply could not afford the payments.

What the American public did not realize is that just because all of this ended badly, it did not have to be because someone committed a crime. The crimes of mortgage fraud, predatory lending, and securities fraud were oddly the collateral damage at the end of the whole mortgage cycle centered on the vertical integra­tion of the banks and their focus on securitization. The market for MBSs and CDOs was kept going by the mortgages that were obtained fraudulently. But the bad end is inevitably what happens in capitalism when all of the easy profits get made and the market is saturated. It pushed banks to do whatever they could to keep their vertically integrated structures going. Without regulators watching to ensure that firms don't cross the line from aggressive to illegal, things tend to end badly. But of course, such regulators would have had to understand what was going on. I finally turn to how the regulators missed this whole thing.