Why Was There So Much Fraud?

Fraud was committed across the value chain that sold mortgages to households, took those mortgages and turned them into securities, and bought and sold those securities. Mortgage fraud, predatory lending, and securities fraud all increased as the conventional mortgage market peaked in 2003 and began its decline.

In this section, I want to return to what was going on in the market for mort­gages from 2001 to 2008. My purpose is to offer an account of why fraud moved from being peripheral to the mortgage market to occupying such a central place that by 2008, it could be described as systemic. I want to consider what brought all of the banks that had previously abided by the rules, more or less, to com­mit fraud in the origination of mortgages and their securitizations. While this fraud became ubiquitous across all parts of the production process, it was most concentrated in the largest players in the market, the vertically integrated banks (Fligstein and Roehrkasse, 2016). The vertically integrated banks were not pass­ing on the risks of bad mortgages to other players but instead were taking on those risks in their origination, securitization, and investment businesses. The question of why they were more likely to push for fraudulent mortgages and predatory lending is what I seek to explain in the rest of this chapter.

The story I told in Chapters 5 and 6 helps us understand how the shifting character of mortgage originations pushed the vertically integrated banks at the core of the mortgage securitization industry to rapidly move into the noncon- ventional mortgage market in 2004-2008. The market for mortgage securities remained strong from 2003 to 2007. AAA-rated mortgage-backed securities that paid high yields were one of the most important investments for banks in the United States and western Europe throughout this period. During the growth of nonconventional mortgages from 2004 to 2008, banks of all kinds borrowed money and loaded up on securities made from these mortgages. Recall that for­eign banks bought nearly $1 trillion worth of securities from 2003 to 2008. The securities based on nonconventional mortgages paid higher interest and pro­duced more profit.

After the refinancing boom in conventional mortgages slowed down in 2004, finding a supply of mortgages to continue to feed the securitization market be­came paramount to keeping the highly profitable business of vertically integrat­ed banks going. The downturn in conventional mortgages in 2004 pushed banks to shift their marketing strategy from households with excellent credit to house­holds that had less-than-stellar credit. This pressure to continue to produce se­curities created incentives for all involved to keep originating mortgages even when the supply of mortgagors who could be reasonably expected to be able to pay off those mortgages declined.

As even those mortgages got harder and harder to find, originators began to loosen their standards for mortgage approval to fund almost anyone. This loosening was accompanied by their cutting corners on mortgage applications, which produced increased mortgage fraud. It also encouraged predatory lending because originators could roll the higher fees into the cost of the mortgage. It was this continuous need for mortgages to securitize that brought the increase in fraud and predatory lending.

The shift toward mortgagors with less good credit was originally viewed with some trepidation. But quite quickly, banks realized that such mortgages were more valuable than conventional mortgages. The additional fees to originate such mortgages and the higher interest rates that came with them meant that the securitization machines of the vertically integrated banks not only could contin­ue to prosper but could actually make more money. The rise of the nonconven- tional market became a huge opportunity for investment banks such as Lehman Brothers, Merrill Lynch, Morgan Stanley, and Bear Stearns. They were able to ramp up their securitization businesses because the GSEs were unable to secu­ritize nonconventional mortgages. Even after the housing market began to turn down in 2005, banks had to chase after mortgages. But because mortgages were becoming scarcer, as I showed in Chapter 5, investment banks began to buy orig­inators to insure them with supply. Banks that were already integrated, such as Countrywide, Washington Mutual, and Citibank, were chasing after fewer and fewer loans, and they intensified their efforts to originate and buy more loans.

In Chapter 5, I showed that the opportunity to sell MBS-CDOs and hold on to them for investments caused banks to securitize a higher and higher percentage of the mortgages being originated. By 2007, almost 90 percent of subprime mort­gages were being securitized. It also brought banks into the subprime industry and created more vertical integration as banks sought out more supply of mort­gages. This lack of supply of mortgages got banks that were producing securities to put pressure on their origination department and other mortgage brokers to bring them more and more nonconventional mortgages.

The appetite for MBSs and CDOs based on these mortgages was insatiable. Indeed, the repacking of unsaleable tranches of MBSs into CDOs was stimulated by the size of the market for these products. When the supply of mortgages be­gan to dry up in 2005, banks that were holding on to lower-ranked tranches of securities that had been rated BBB or lower ramped up their CDO production to offer new products to sell and hold as securities. This meant that riskier mortgag­es were being securitized at high rates. The need for new mortgages encouraged originators who were either free standing or employed by vertically integrated banks to offer mortgages to people with impaired credit and little ability to pay back loans.

At a meeting in May 2005 on CDOs and the market for those securities, the main topic of conversation was how the demand for CDOs was driving the mortgage market:

In a panel on the effect of CDOs on the fixed-income market, Bear Stearns traders said mortgage issuers and CDO managers are playing off one an­other. While one group provides the fuel—borrowers induced by new mortgage products to buy a new home or refinance—the other supplies the structure as well as the investors, replenishing liquidity through secu­ritization. All seemed to agree that as long as investors are willing to pay, there will be managers willing to do deals. (Pyburn, 2005: 8)

In particular, there was brisk demand for CDOs based on nonconventional mortgages:

The innovation surge in the mortgage industry, such as subprime IO loans, the 40-year mortgage, and a slew of so-called option ARMs, is needed to create more and more structured finance CDOs. Product innovation will likely continue as the mortgage industry, sated after the refinance boom, prowls for untapped markets—such as borrowers without a social security number—to keep volume high amid rising interest rates. “As long as there are investors willing to purchase the product, the market will continue to grow more and more levered”, said Jeff Zavattero, senior managing direc­tor in the CDO group at Bear.

In this perverse situation, loans that had little or no documentation were ac­tually more valuable because fees and interest rates were higher, making profits sustainable even at lower loan volumes. The line between aggressive and risky lending and fraudulent lending turned out to be a fine one. If investors who bought securities based on low documentation were informed of that, they ex­pected higher rates of return. This was not illegal. But the low-documentation loans were more subject to risk of fraud. So-called “liars' loans” meant that mort­gagors were literally lying about their circumstances. Banks also had huge in­centives to engage in predatory lending to less sophisticated mortgagors. Banks began to court people with impaired credit, and they did so by intentionally misstating information on loan forms and loading those mortgagors up with fees and higher interest payments. They also put many mortgagors into mortgage products that were more lucrative for originators but potentially more problem­atic for mortgagors. It became not just something one or two rogue banks were doing but a systemic feature of how the mortgage market operated from 2004 to 2008.

Note that these pressures existed for all banks no matter where they resided on the value chain. Originators who knew they were going to sell loans to secu- ritizers found themselves able to make more money on fees and selling riskier mortgages to securitizers. They also found that banks that were buying mortgag­es preferred these mortgages, and they came under pressure to produce these mortgages if they wanted to sell them in the secondary market. Some originators were certainly pirates, by which I mean that they enthusiastically took the op­portunity to engage in mortgage fraud to profit. But all faced the same pressure to produce nonconventional mortgages that would yield higher profits for those producing securities.

Vertically integrated producers were more susceptible to committing mort­gage fraud and predatory lending. This was because their entire business de­pended on mortgages as raw materials. Their success at finding mortgages by internalizing the origination function gave them an advantage over nonintegrat­ed producers of securities. It also pushed investment banks who did own non- conventional originators to backwardly integrate into the origination business in order to continue to be able to securitize mortgages.

As the market for mortgages dried up, everyone else felt compelled to do what­ever they needed to in order to ensure a supply of mortgages to secure. Those who were vertically integrated held on to lots of these securities even though they knew they were riskier. Since they paid out higher returns, having some of the riskier MBS-CDOs made a great deal of sense. All of this got worse as finding mortgages in the origination market got harder. This made banks that had taken on risky mortgages more desperate and more likely to commit mortgage fraud and predatory lending to ensure a supply of mortgages for securitization.

In 2005, when house prices stopped rising and foreclosures (particularly of recently lent subprime mortgages) increased, the pressure to continue to origi­nate and securitize mortgages did not let up; if anything, it intensified. Instead of cutting back on their origination and securitization businesses, vertically in­tegrated banks doubled down on doing whatever they had to do to keep going. After all, their businesses had risen on taking advantage of the ability to borrow money, originate millions of mortgages, and turn those mortgages into highly profitable securities. But as those securities came under pressure because they contained riskier and riskier mortgages, vertically integrated banks could do lit­tle but continue to originate and produce securities. In order to keep their busi­ness model going, they had originated many mortgages fraudulently and created securities based on those mortgages. When they fell, they experienced larger losses, and most of them went out of business, were forced to merge with other banks, or, for the lucky few, were bailed out (Goldstein and Fligstein, 2017). The push to keep going meant that committing fraud was baked into their products (Fligstein and Roehrkasse, 2016).