Wednesday, April 13, 2011

When Banks Get Lax, Fraud Is to be Expected

Lax lending standards are a giant, neon, gold-ribboned, engraved invitation to commit fraud. The very nature of basing valuations on recent sales, rather than on the underlying economic value of the house based on rents, ensures that banks will lend into the teeth of a bubble. By doing so they leave the door wide open to fraud and money laundering.

To cash out significant money from the bank all one needs is a buyer claiming a house is worth more than the last sale in a neighborhood. The bank is ready and willing with cash. Then you turn around and three months later sell it again (inside your ring of associates) for even more money. Why is the house worth any of these sales amounts? Well, it isn't, really. In these cases it's not an arms-length transaction, but these transactions turn out to be indistinguishable from one inspired by raging house hormones. (In California, real estate agents sold properties within their own offices to inflate local prices and to generate cash flow.) How does the bank tell the difference? Well, turns out, they can't. And moral hazard helps make this sort of fraud a cakewalk. In the U.S. the moral hazard was securitization; Wall Street was screaming for any paper they could securitize and they paid cash without verifying a thing. In Canada it's partly securitizers (in the last three years), but mostly it's CMHC.

Defendants in massive mortgage lawsuit blame BMO for letting fraud happen
Hundreds of Albertans stand accused by BMO of being tied to 14 interconnected groups that allegedly inflated the value of homes and recruited "straw buyers" to assume liability for mortgages in exchange for payments between $3,000 and $8,000.
"The plaintiff was eager to loan money in a heated real estate market. As high ratio mortgage loans were fully insured, the plaintiff took no care whatsoever in approving loans or supervising those who had the authority to approve mortgage loans," reads a joint statement of defence submitted by Suneet Sharma, Rajesh Sharma, Anjna Sharma and several numbered companies.

"The plaintiff was wilfully blind in respect of the following: the fact that mortgage applicants were overstating the value of their assets; the fact that applicants were overstating their income; the fact that applicants were not intending to live in the properties being purchased."
The first is from the accusations in the suit. The second is from the defendants statement of defense. Neither have been verified, nor have charges been filed, but notice how they form perfectly matching puzzle pieces.

"Until then, the plaintiff's employees were praised for their high volume of mortgage loans," it reads. "The plaintiff knowingly participated in a conspiracy or scheme to make as much money as possible in a rising real estate market."
Plus ça change, plus c’est la même chose, which I'll translate as: Welcome to the next bubble level, Canada.


jesse said...

The other angle on this is the general back-end "efficiencies" that have occurred. BMO has often resorted to automated appraisals based on comparable sales data in the neighbourhood as a way of avoiding paying those expensive and old-school real-life appraisers that, you know, tend to find reasons why appraisal values don't fit some bin in a database query.

Heaven forbid that it's better to have a human look over a multi-hundred-thousand-dollar asset to determine if, say, there are any obvious attempts to game some algorithm. Because we did a test regression on that algorithm and it passed so there should be no problems.

Too bad that "appraisers" had their own line item on someone's budget.

Probably the good old stodgy "income verification department" was next on the budget Pareto, followed closely by the expensive and "client 3 month fact checking verification" step, both that could be e-assignerd to task IDs on the central servers.

GG said...

Having human appraisers didn't help in the U.S. I'm afraid.

If the banks want high valuations (because for some crazy reason, one random buyer gets to set the price) they will get them. The only thing that will work is appraisals based on rents (that are then audited by someone, say some central interested authority like CMHC.) This insurance setup could be working for the good of housing, it just isn't because there's not enough profit to be made that way. But it's a government authority. It COULD be working for the good of housing.

The banks in Canada (I'm willing to lay good money on) bet big that homeowners will slave to cover the mortgage payments, no matter what. They believed this in their black little hearts in the U.S., which is far more friendly to debtors.

The Chief Commercial Appraiser at Indy Mac Discusses its Rampant Fraud, Corruption, Criminality
Let me hasten to add that many appraisers were offended by the corruption of colleagues in their industry, especially those greased by the worst elements among mortgage brokers and real estate agents. In 2005, more than 8,000 appraisers -- roughly 10 percent of the industry -- signed a petition asking the federal government to take action; the White House and Federal agencies demurred, and appraisal fraud continued unabated.

I need to have a post about fall out. The more debtor friendly atmosphere in the U.S. is working to repair household balance sheets. This debt debacle in Canada is going to be haunting the economy for more than a decade if bankruptcy dings future paychecks. (It does, right?)

jesse said...

Good points on appraisers. Countrywide was notorious for using computers to complete appraisals.

Private appraisers often gave the values that lenders wanted to hear, and with everyone making money you're without a paycheque if you don't play along.

I've talked to some mortgage brokers in Canada that have adversarial relationships with appraisers because they will kill previously-negotiated mortgage deals. Despite the horrible conflict-of-interest stories we hear about many appraisers do their jobs based on a code of ethics. Of course if you use comparable sales as a major input into your calculation...