The case started as a routine mortgage-fraud prosecution, brought by none other than the aforementioned U.S. Attorney Benjamin Wagner. A group of eastern European immigrants had bought houses in California in 2006, in a real-estate market that was in the early stages of collapse. According to the indictment, filed in 2012, these people’s mortgage applications contained blank spots and wrong information; they were accused of getting the mortgages in order to sell the houses to one another at pumped-up prices in what is called a “straw buyer” scheme. Also, they defaulted on the loans.
However, members of the immigrants’ legal defense team—several of them appointed by the state—had read the newspapers over the years and were aware of the kinds of things that had gone on in real estate during the bubble. They knew, for example, that in the go-go days of the last decade, the mortgage origination industry routinely cranked out “stated income” loans—also known as “liar’s loans”—to people who were obviously unable to make the payments. The bankers back then almost never checked on whether the borrower was telling the truth about their income; they just wanted to make the loan. So the defense team in Sacramento came up with a novel strategy: How can the borrower have committed fraud on a mortgage application if the lender didn’t care whether their answers were truthful?
And lenders so didn’t care back in the bubble days. They invented liar’s loans and blanketed the country with them during the Oughts not because the poors talked them into doing it, or because the liberals in the Bush Administration forced them to do it—on the contrary, the government warned them against issuing these things, just as the government warns us against swallowing arsenic. The reason bankers did it was because liar’s loans were making bankers rich.
This is a difficult thing to understand—indeed, not understanding it is the stated reason Obama Administration officials have made no effort to send financiers to jail—so let us take this slowly. Executives at the mortgage origination companies got huge bonuses in those days for writing lots of loans. OK? They wanted to write more of them, and the only way to really crank out mortgages on a vast scale was by giving one to anyone who wanted one, regardless of their ability to pay, a feat that is only possible by means of the “liar’s loan.” So: Liar’s loans = rich bankers.
Now, it just so happens that liar’s loans are a lousy product, something that is virtually guaranteed to fail when prices stop rising, something that everyone knew at the time would fail when the bubble burst. That’s why you don’t see liar’s loans when banks are honest and regulators are on the job. Because the bank that makes liar’s loans—and the investor who buys a security based on liar’s loans—will eventually lose their money. That’s why they are banned today. So: Liar’s loans = dead banks. Liar’s loans = slow-acting arsenic. But on the other hand, the immediate bonuses that mortgage execs were collecting for making these poisonous loans were so sweet that they didn’t really care about the long-term effects. So while those awful loans they wrote eventually sank all the big subprime houses—and wrecked the global economy to boot, with Europe still in ruins, etc.—the bankers themselves lived to sail away into the sunset, their yachts laden with bullion.
Do you see what I’m saying? Executives do not always share the interests of the corporation that employs them. They weren’t “defrauding themselves,” as our federal protector laughs, they were defrauding the suckers that paid their bonuses, the shareholders that invested in them, the European pension funds that believed their excreta was Grade A Prime.
The name for this kind of scheme is a “control fraud”; it happens when the officers who control a firm use their power over the firm to enrich themselves while driving the firm itself to the boneyard. The country has seen control frauds many times before; indeed, the man who invented the term was a regulator of S&Ls during the S&L meltdown of the 1980s, and he saw the pattern so many times back then that he wrote a book about it. I am referring to my friend Bill Black, a professor of economics and law at the University of Missouri-Kansas City and also a Distinguished Scholar in Residence for Financial Regulation at the University of Minnesota’s School of Law. Control fraud, Black says, always follows the same recipe, with banks growing rapidly by making vast numbers of extremely risky loans, executives immediately getting rich with big bonuses, and the bank eventually collapsing under the weight of those malicious loans.
The last decade’s epidemic of crap financial instruments—liar’s loans, NINJA loans, interest-only ARMs and all the rest—fit the pattern perfectly. “It makes no sense for an honest banker to lend in this fashion,” Black told me. “If you lend in this fashion, you will suffer catastrophic losses. So honest banks don’t make loans without effective underwriting. But dishonest banks find, under the fraud recipe, that it optimizes their fraud scheme. To make not just a few bad loans, but to have a regular practice of making, day in and day out, enormous numbers of bad loans. . . . You’re mathematically guaranteed to make the officers rich and then they can walk away while the place collapses.”
Bill Black worked for many years as a bank regulator and a lawyer for the Federal government, but these days the Federal government has little interest in litigation against bankers. That’s why the mortgage-fraud case in Sacramento saw him appearing as an expert witness for the defense, on whose behalf he testified at great length about the role of control fraud in pumping the real-estate bubble.
The defense wanted the jury to hear Black’s theory because the essence of our government’s law-enforcement work on mortgage fraud is that banks were the victims. Those poor unfortunate financiers were tricked by little people like the “neighbor” that Rick Santelli once ranted against, trying to get an extra bathroom that he didn’t deserve.
What the defense team sought to prove was that this picture was completely upside-down—that the banks didn’t care if people lied on liar’s loans. According to the legal definition of fraud, the lie in question has to be “material,” meaning it has to influence the decision-makers. When a bank is honest, that is an easy thing to show. But it’s different if the decision-makers are themselves trying to crank out lousy (but profitable) loans. Bill Black again, on the control-fraud formula:
“Not only are they not distressed by crappy loans, they must make crappy loans. That’s the fraud recipe. . . . If the decision-makers are running a fraud in which they want this outcome, then they’re going to approve these loans. And they will create a system designed to approve loans that are 90 percent fraudulent.”
What would such a system look like? Well, indiscriminately handing out stated-income loans is part of it. A weak underwriting system is another element. In the case in Sacramento, the court heard testimony from an underwriter at one of the mortgage firms in question and learned that in certain cases she was actually forbidden to ask the borrower’s employer how much the borrower made—in other words, forbidden to check on the income that was stated in the stated-income loan. Here is how Bill Black reacted to that testimony, according to court transcripts:
Q. And do you have an opinion on the quality of the underwriting at GreenPoint [one of the lenders in the case] ?
A. Using the word “quality” in the sentence is an injustice to the word quality.
This was an utter sham in which underwriters were instructed not to underwrite. They were instructed, according to the testimony, that even if they called the employer, had them on the phone, that they were not permitted to ask about the income.
That’s insane.
No honest banker would ever do that.
A mortgage company advertising flier that had been plucked from the sloshing depths of the last decade’s Internet offered further evidence of the bankers’ regard for facts. It is illustrated with a crude computer rendering of the three wise monkeys, next to the words, “Hear No Income, Speak No Asset, See No Employment.” (“Don’t Disclose Your Income, Assets or Employment on this hot new flexible adjustable rate mortgage!”) Look, kids—monkeys! This arsenic must be extra tasty!
The obvious way for the federal prosecutors to head off this argument would have been to describe the lender’s business practices and show that its executives were not, in fact, simply churning out vast numbers of super-high-risk liar’s loans in order to ring some bonus bell. That, in truth, the bankers really cared that facts be represented accurately on loan applications. Unfortunately, the Federal agent who had investigated the case—a man with plenty of experience detecting mortgage fraud—told the court that he had not talked to executives at the firms in question and, indeed, had not interviewed any top mortgage executives, ever.
Q. People in control of a company. So the person who calls the shots at the very top of a company. How many of those have you interviewed in your career?
A. As relates to mortgages?
Q. As to mortgages, yeah.
A. I can’t recall any.
A while later, with a different defense attorney asking questions, here is what the Federal agent had to say about the subprime mortgage lenders:
Q. So you were not concerned at all about the people who were loaning the money and their conduct; is that right?
MR. COPPOLA [the Federal prosecutor]: Objection. Argumentative.
THE COURT: Overruled. You may answer.
THE WITNESS: No. I would consider — they’re the victims in this case. That’s how I consider them.
What kind of snarky remark can I append to that, reader? Sarcasm fails me.
*
This was the first criminal proceeding to examine the basic facts of the mortgage meltdown, and the transcript suggests that some of the people in the courtroom knew it was a historic occasion. After reciting a list of iffy lending practices that were common in the subprime market 10 years ago, the transcript tells us that Bill Black testified as follows:
But for every one of those crazy things that I just described, they’re not crazy for the controlling officers because all of them come with higher fees.
Q. They contribute to the bonuses?
A. They contribute to the phony income that produces the bonuses, but they produce massive increases in losses. That’s why all of the lenders in this case suffered massive losses. Not, you know: Oh, gosh, things got bad. They fell off the table. Disastrous. Billions of dollars of losses in the case of GreenPoint.
But they also pumped out at least 20 billion dollars of this toxic waste. And they are one of the major contributors to the failure of Bear Stearns, one of the largest investment banks in the world.
So you finally have a case in which you are actually looking at the causes of the financial crisis. It’s the first criminal case.
MR. COPPOLA [the Federal prosecutor]: Objection to the relevance of the last remark. Ask it be stricken.
THE COURT: Denied.
The defense put Wall Street’s practices on trial, and the defense won. The jury in Sacramento eventually acquitted all the defendants of all charges.
When I got Bill Black on the phone last week, he talked about the case as a watershed moment. “I came out there to say, ‘Look! there are lions roaming the campsite!’ They took down the global economy!,” he told me. “And jurors can understand this. You say that you can’t get a prosecution. We will come to your back yard and show you how to get a prosecution. Because we’ll do it as a defense. Even though we have no FBI agents, no subpoena authority. . . , we’ll put on a successful prosecution. And we’ll show to you that jurors can understand this.”
U.S. Attorney Benjamin Wagner had this to say, according to the Sacramento Bee: “We respect the criminal process, and accept the jury’s verdict in this case. It will not dissuade us from pressing forward in the many other mortgage fraud cases currently pending in this courthouse.”
Have no fear. The government is on the case. They’re going to track down people who lied on a loan application in the last decade and go after them. Unrelenting pursuit of the people at society’s bottom.
And bailouts for the victims in the C-suites, should some new round of unpleasantness arise.
Of course, the result in the Sacramento case might knock those beautiful plans off the track. Up till now it has been covered as a kind of man-bites-dog story, because “an acquittal in Sacramento federal court is rare,” as the Bee put it. But maybe, in the weeks to come, acquittals like this will become more common. Already, says John Balazs, a member of the defense team, he has been contacted by other attorneys arguing similar cases. Maybe lawyers all over the country will soon be reminding juries that a borrower’s alleged misstatements can’t have been “material” to a lender if the lender was a control fraud dealing in liar’s loans. Maybe one day the courts of this land will acknowledge what the public has known for years: That the fraud that wrecked the world actually happened in the offices of the shadow banks and the Wall Street investment firms.
It all depends, says Toni White, one of the defense attorneys in Sacramento, on “if the judge lets it in.”
“This is what happens when defendants get a fair trial,” she continues. “Where are the CEO’s? Why aren’t they here?”
It’s a good question. The government’s near-complete failure to prosecute the true villains of the Great Recession will surely go down as the Obama administration’s grandest disappointment. It has convinced a generation that the fix is always in, that the government patrols some neighborhoods with a finger on the trigger, showing no mercy ever, but that in other precincts a kinder, gentler law prevails. It gets worse when people realize that the officers who ran the subprime lenders before the disaster are back in the mortgage business today. Taken as a whole, the crisis and its aftermath have given the lie to the president’s oft-repeated faith in meritocracy. The people see what’s happened and they get it: there is no meritocracy without accountability. What we’ve got instead is a society dominated by thieves.
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