by William K. Black February 4, 2016 Bloomington, MN This is the fourth part of my series on the lies about “liar’s” loans that suffuse the Wall Street Journal article reporting that “big money managers” want to bring back “liar’s loans.” This part focuses on the fact, which the WSJ treated as so obviously reasonable that it was unworthy of analysis, that: Money managers want to bankroll the loans while relying on the mortgage firms to handle the process with borrowers, basically acting as a lender, “one step removed from the process,” one of these people said. When the real lender taking the risk of making the home loan employs an agent from a separate for-profit firm to actually recruit the borrowers in return for receiving a sales commission from the real lender (the “big money managers”) we call that agent a loan broker. The “big money manager’s” plan is (a) to make loans that are endemically fraudulent, (b) by incentivizing de facto loan brokers to find the buyers and handle the loan applications. The “big money managers” in the most recent crisis used loan brokers extensively and designed their incentives in an exceptionally perverse manner. This ended badly. Critics argued that with this much money at stake, mortgage brokers had every incentive to seek “the highest combination of fees and mortgage interest rates the market will bear.
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William K. Black
February 4, 2016 Bloomington, MN
This is the fourth part of my series on the lies about “liar’s” loans that suffuse the Wall Street Journal article reporting that “big money managers” want to bring back “liar’s loans.” This part focuses on the fact, which the WSJ treated as so obviously reasonable that it was unworthy of analysis, that:
Money managers want to bankroll the loans while relying on the mortgage firms to handle the process with borrowers, basically acting as a lender, “one step removed from the process,” one of these people said.
When the real lender taking the risk of making the home loan employs an agent from a separate for-profit firm to actually recruit the borrowers in return for receiving a sales commission from the real lender (the “big money managers”) we call that agent a loan broker. The “big money manager’s” plan is (a) to make loans that are endemically fraudulent, (b) by incentivizing de facto loan brokers to find the buyers and handle the loan applications.
The “big money managers” in the most recent crisis used loan brokers extensively and designed their incentives in an exceptionally perverse manner. This ended badly.
Critics argued that with this much money at stake, mortgage brokers had every incentive to seek “the highest combination of fees and mortgage interest rates the market will bear.” Herb Sandler, the founder and CEO of the thrift Golden West Financial Corporation, told the FCIC that brokers were the “whores of the world.” As the housing and mortgage market boomed, so did the brokers. Wholesale Access, which tracks the mortgage industry, reported that from 2000 to 2003, the number of brokerage firms rose from about 30,000 to 50,000. In 2000, brokers originated 55% of loans; in
2003, they peaked at 68%. JP Morgan CEO Jamie Dimon testified to the FCIC that his firm eventually ended its broker-originated business in 2009 after discovering the loans had more than twice the losses of the loans that JP Morgan itself originated (FCIC Report 2011: 91).
Given that the secondary market collapsed in mid-2007, it is hilarious that FCIC thought that Dimon only “discovered” in 2009 that broker-originated loans were massively toxic. Recall that in an earlier installment I noted that the overall 90+ delinquency rate on liar’s loans had reached the catastrophic level of 26% by February 2010. That suggests that if JPMorgan’s experience was typical the 90+ day delinquency rate for broker-originated liar’s loans was above 30 percent – over six times higher than the 5% delinquency rate at which regulators believe a home lender is at a severe risk of failure.
The officers that run home lenders have known for many decades that lending through brokers dramatically increases the risk to the lender. George Akerlof (Nobel Laureate in Economics) and Paul Romer emphasized this point in their classic 1993 article entitled “Looting: The Economic Underworld of Bankruptcy for Profit.”
“Loan brokers, who match borrowers and lenders in exchange for a commission, have a deservedly bad reputation. The incentive to match bad credits with gullible lenders and to walk away with the initial fees is very high. It can also take several years for this kind of scheme to be detected because even a bad creditor can set aside some of the initial proceeds from a loan to make several coupon or interest payments” (Akerlof & Romer 1993: 46).
Note that they are talking about a “deservedly bad reputation” that was known to everyone in lending back in the 1980s when the savings and loan debacle began. Even a former president of the professional association of loan brokers damned his field.
“Marc S. Savitt, a past president of the National Association of Mortgage Brokers, told the Commission that while most mortgage brokers looked out for borrowers’ best interests and steered them away from risky loans, about 50,000 of the newcomers to the field nation-wide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were ‘absolutely’ corrupt” (FCIC 2011: 14).
What harm could 50,000 corrupt loan brokers do? The CEOs of home lenders have known for at least 35 years that loan brokers make massive amounts of bad loans. The CEOs have seen the brokers help produce fraud that is so endemic that it drove two financial crises. The CEOs have seen that liar’s loans created large losses in the S&L debacle before we drove them out of the industry and catastrophic losses in the more recent crisis. The reaction of the CEOs of the “big money managers” to this is to bring back, and combine, the two most perverse incentives to commit endemic fraud. It is almost as if the CEOs know that doing so will make them wealthy through the “sure thing” of the “fraud recipe” for a lender. It is almost as if they know that the Department of Justice (DOJ) will never prosecute them for this tried-and-true fraud scheme.
The WSJ is so clueless that it appears to think the return of fraudulent liar’s loans via fraudulent loan brokers is an obviously sensible example of von Hayek’s “spontaneous order.” Why would their reporters listen to what a Nobel Laureate, criminologists, regulators, or the successful prosecution of over 1,000 S&L officials and co-conspirators in cases designated as “major” by the DOJ found and documented?
A note to those who study economics: Ronald Coase and Oliver Williamson repeatedly claimed that private market institutions like loan brokers emerged to minimize transaction costs and ensure that the agent would act loyally towards the principal. They argued that this meant we need not worry about fraud in the private sector. Theoclassical economists pose a grave risk to our world.
My next column will explore how the lenders’ CEOs crafted intensely perverse incentives to recruit and induce fraudulent brokers to use liar’s loans in combination with brokers to predate upon borrowers. I will explain how this predation optimized the CEOs’ wealth from employing the “fraud recipe” while increasing deniability
