Subprime Failure Was Not Fraud But “Willful Blindness”

I’ve written many posts regarding subprime lending, many under the title Stripped Bare - Beneath the Feel Good Veneer of Subprime Lending.  In one of those posts, dated April 15, 2008, subtitled Self Inflicted, I stated the following.

The stage was set for the collapse of the subprime lending industry with the origination of the individual subprime loan underwritten to foolish; one could say incompetent; underwriting guidelines.  As more and more of these structurally deficient loans piled up in lenders’ servicing portfolios, to be mined again and again for any remaining equity subprime borrowers may have retained in their homes, the swiftness of the final collapse lacks any astonishment.  The subprime lending business model was fundamentally flawed and myopic.

I’ve also commented, on a number of occasions, regarding the allegations that fraud was the cause of the subprime lending failure, and stated the following in regards to this allegation.

While the FBI may find a few prosecutable mortgage lending fraud cases, what will mostly be brought to light by their investigations will be the foolishness of the underwriting guidelines utilized by the subprime lending industry, and the unethical, but not illegal, methods which were utilized to suck subprime borrowers in.

I once again take up this subject, after reading a piece at The Huffington Post written by William K. Black, Associate Professor, University of Missouri - Kansas City which is titled The Two Documents Everyone Should Read to Better Understand the Crisis.

The two documents Mr. Black refers to, and conveniently does not provide links to, are an S&P document of unknown title, and the other is a Fitch document, also of unknown title.

The gist of Mr. Black’s piece, arguing that fraud is the cause of the world wide financial market meltdown, is that individually originated subprime mortgage fraud was the catalyst for “widespread accounting fraud” in mortgage derivative markets, which were constructed around those individually originated, allegedly fraudulent, subprime mortgages.

To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud.

Let’s review some of what Mr. Black states to bolster his incorrect analysis.  First, Mr. Black’s preamble regarding the S&P document.

The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages “underlying” the derivative. A senior manager sends a blistering reply with this forceful punctuation:

The “blistering reply.”

Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.

Mr. Black then immediately follows the “blistering reply” with this statement.

Fraud is the principal credit risk of nonprime mortgage lending.

This is blatantly incorrect.  The principal credit risk(s) of subprime (nonprime) mortgage lending are twofold.  First, does the borrower have the ability to repay the debt?  Second, what is the borrower’s history of credit use?  Does the borrower repay his debts, or does the borrower’s credit history consistently show that the borrower ignores his debt payments, of all types?  These are the principal risks of subprime lending, not fraud.

Mr. Black then states, to bolster his fraud argument, the following.

Unfortunately, “most investors” (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The “AAA” rating is supposed to indicate that there is virtually no credit risk—the risk is equivalent to U.S. government bonds, which finance refers to as “risk-free.”

Were the credit agencies implicitly practicing fraud in not reviewing the subprime mortgage paper loan files (when pooling mortgages for sale into the secondary market, typically between 5% and 10% of the mortgages in the pool are audited) and assigning the derivatives derived therefrom “AAA” ratings?  No, they were not.  They were practicing, as Mr. Black himself alludes to, “willful blindness.”

Mr. Black’s argument for fraud as the cause of the financial market collapse then references the Fitch document, which is quoted as follows.

Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.


[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.

Note that this Fitch document initially states that “there was the appearance of fraud or misrepresentation” and then implicity states that “fraud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control, and fraud prevention tools…”

Once again, I state that fraud is not the culprit.  Fitch refers to the culprit, though, when it mentions “inadequate underwriting controls,” which simply means foolish underwriting guidelines, or lending to individuals who have a long history of not paying their debts and credit over extension, but lending them money anyways, and then crossing your fingers and hoping they make the new subprime mortgage payment when it comes due.

There is no doubt the collapse of the financial markets is the result of the collapse of the subprime lending industry, but the collapse of the subprime lending industry is not because of fraud.  The collapse of the subprime lending industry was the direct result of lending too much money to borrowers who could not afford to repay, even though the underwriting guidelines projected they could, and who had a long and detailed history of not repaying the debts they had contracted in the past.  The failure was not fraud, but “willful blindness” to the reality of the risk of lending to crappy borrowers.

Posted by .(JavaScript must be enabled to view this email address) on 02/26 at 11:06 AM

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