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Why Did the Fed Refuse to Heed Warnings About Fraudulent Mortgage Lenders?

Appraisers, prosecutors, and industry tried to tell the Fed about a massive fraud crisis, but no one was listening.

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Real regulators are vital to a nation. They can stop crises in their tracks — or they can let a them explode on an unsuspecting public. The Federal Reserve was warned by many different people, including appraisers, prosecutors, and industry players that the mortgage industry was rife with fraud. Why didn't they listen?

The Appraisers’ Warning of the Lenders’ Fraud Epidemic

A very large number of appraisers have tried to combat home lenders and their agents who were deliberately extorting them to inflate appraisals.  When cheaters prosper, the markets drive honest firms and professionals out of business, something economists call "Gresham's dynamic." Honest appraisers tried to block this dynamic:

“From 2000 to 2007, [appraisers] ultimately delivered to Washington officials a petition; signed by 11,000 appraisers…it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were ‘blacklisting honest appraisers’ and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18). 

There is a “recipe” by which fraudulent mortgage lenders (purchasers) optimize their reported (albeit fictional income); promptly making their controlling officers wealthy through modern executive compensation.  That recipe requires the massive origination (purchase) of bad loans, and inflating appraisals makes bad loans appear to be good loans and helps hyper-inflate bubbles.

The device lenders typically used to ensure the endemic inflation of appraised values was to blacklist honest appraisers. The fraudulent lenders took what had once been a very good practice, refusing to use appraisers who inflated appraisals or were simply incompetent, and perverted it into an instrument of extortion and fraud by blacklisting appraisers who refused to aid their fraud schemes by inflating appraisals.

We worked closely with appraisers and their professional bodies interested in preventing fraud when we regulated the S&L industry.  The Bank Board’s appraisal standard (R-41c) was considered the platinum standard for professional home appraisals.  The appraisers determined to stamp out appraisal fraud were the only professionals that supported our effort to crack down on the roughly 300 S&L control frauds.  The “Big 8” audit firms, the legal profession, and economists were impassioned opponents of our efforts to reregulate the industry and to hold the senior officers running the control frauds accountable.

The FBI’s Warnings of the Fraud Epidemic and the Financial Crisis it Would Create

In September 2004, Chris Swecker, the FBI official charged with responsibility for mortgage fraud, began warning publicly that an “epidemic” of mortgage fraud was developing.  Swecker predicted that it would cause a financial “crisis” if it were not contained.

Representatives of the Borrowers Warned the Fed about Endemic Mortgage Fraud

I will make this topic the subject of an entire article.  My conclusion from reading the transcripts of several hearings on mortgage abuses that Congress mandated the Fed to conduct is that representatives of nonprime borrowers overwhelmingly opposed the loans, typically explaining that they were frequently fraudulent and predatory.  ACORN was one of these groups warning the fed about nonprime loans. 

State Prosecutors Warned the Fed about Endemic Mortgage Fraud

“Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete”

“[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer” Miller, T. J., Iowa Attorney General (August 14, 2007).