In a recent NY Times article, Neil Irwin asks “What Will Cause the Next Recession?” He says, “The economic expansion in the United States celebrated its ninth birthday last month. If it survives another year, it will be the longest on record.” He challenges the status quo with, “But eventually something will kill it. The question is what, and when.”
Mr. Irwin details some likely threats, yet the question uppermost in my mind is this: will the Fed recognize the warning signs soon enough to take proactive actions to prevent another financial crisis and recession?
Based on the Federal Reserve’s past behaviors in ignoring egregious warning signs, I am doubtful they will. One of these historical issues which had multiple warnings I discussed in my last post regarding the two billion dollar fine levied on Wells Fargo for its lying about the quality of sub-prime and Alt-A mortgages that secured residential mortgage-backed securities in the run-up to the 2008 housing crisis.
Wells Fargo had sold at least 73,539 stated income loans that were included in residential-backed securities (RMBS) between 2005 to 2007. Half of these had defaulted. It continued the pattern Countrywide, Citigroup and other Wall Street banks had followed in making, purchasing and selling stated loans. According to the DOJ, “Investors, including federally insured financial institutions, suffered billions of dollars in losses from investing in residential mortgage-backed securities containing loans originated by Wells Fargo.”
In a recent article, Bill Black, author of The Best Way to Rob a Bank is to Own One, associate professor of economics and law at the University of Missouri-Kansas City, and co-founder, along with myself and others, of Bank Whistleblowers United, talked about the history of stated loans, mortgage fraud and the Federal Reserve.
He notes that “liar’s loans (as they were called) began to become material around 1989 during the savings and loan debacle. In that era, they were called “low documentation” (‘low doc’) loans.” Bill Black was with the regulator of the S&L industry at the time, the Office of Thrift Supervision (OTS), with its examiners concluding that “No honest lender would make widespread loans without verifying the borrower’s income because it was certain to produce “adverse selection” and produce serious losses.” And the OTS made it a priority to drive the stated loans out of the S&L industry.
Nobel prize winner George Akerloff and Paul Romer analyzed the savings and loan crisis in their famous 1993 article “Looting: The Economic Underworld of Bankrupcy for Profit,” concluding that the failure to verify the borrower’s income was, indeed, an example of a lending practice that only fraudulent lenders would use on a widespread basis.
Stated loans and their lenders then migrated to the shadow banking world of mortgage banking over which the OTS did not have purview. But Congress responded to the widespread warnings about stated loans and, in 1994, passed the Home Ownership and Equity Protection Act (HOEPA) which gave the Fed the unique authority to ban all stated loans.
But the Fed did nothing, with the stated loans then becoming popular in banking in 2002, growing exponentially.
Even the FBI issued public warnings beginning in 2004 about mortgage fraud and stated loans, warning that the developing “epidemic” of mortgage fraud would cause a financial “crisis” if not stopped.
But the Federal Reserve did nothing.
Mr. Black also notes and applauds the warnings of Steven Krystofiak, president of the Mortgage Brokers Association for Responsible Lending, a professional association dedicated to fighting mortgage fraud and predation. Mr. Krystofiak presented to the Federal Reserve, in a 2006 public hearing, a highly publicized study and public testimony about the growing dangers of stated loans.
Mr. Krystofiak noted in his testimony before the Federal Reserve that 37% of all loans sold in the United States originated without income being proven. In areas where homes are the least affordable (i.e. California and Florida), that number grows to over 50% and some banks reported that close to 80% of loans originated are stated income loans.
His testimony further noted, “a recent sample of 100 stated income loans which were compared to IRS records (which is allowed through IRS forms 4506, but hardly done) found that 90 % of the income on these stated loans were exaggerated by 5% or more. MORE DISTURBINGLY, ALMOST 60% OF THE STATED AMOUNTS WERE EXAGGERATED BY MORE THAN 50%. These results suggest that the stated income loans deserve the nickname used by many in the industry, the “liar’s loan.”
Krystofiak also warned the Fed about stated loans being sold to investors, saying “Banks have already made their profit. Investors will soon realize stated income loans are too risky…”
But, despite the overwhelming evidence of fraud in stated loans, the Mortgage Bankers Association took the position that the Fed should not use its HOEPA authority to ban the growing epidemic of liar’s loans. So the Fed did nothing.
Stated loans were finally eliminated in 2010 with the passage of both the Dodd-Frank Act and the Truth in Lending Act.
So why was the continuance of this fraudulent lending practice so rampant? Let’s face it: profit, the greed factor!
I can attest to that given my experience at Citigroup. These loans are prevalent, as I and others have often, stated because individuals and institutions are incented for making them. So this fraud was encouraged by the banks and enabled by the Federal Reserve?It’s time our government learned to seriously pay attention to warnings and not to take us down another dangerous path. Click To Tweet
As Mr. Irwin strongly suggests, another economic recession is not a matter of if, but when.
The signs for another recession are clear.
Catastrophic? Perhaps not if the Fed and Congress face up to their responsibilities instead of paying them lip service, pay attention to the warning signs and act with integrity.
It’s time our government learned to seriously pay attention to warnings and not to take us down another dangerous path.