http://neweconomicperspectives.org/2015/08/the-worst-of-the-worst-of-the-worst-new-century-and-its-economics-shills.html
I have often noted the existence of a primitive tribal taboo shared by virtually all economists against using the “f” word – “fraud.” I have found a new example that sums up many of the pathologies of economics and economists. It is an article entitled “Going for Broke: New Century Financial Corporation, 2004-2006.” Given that New Century was a classic accounting control fraud, the use of the long-discredited gambling metaphor (our “autopsies” of S&L failures refuted it in 1984) demonstrates the crippling power of the taboo. The three economists who authored the September 2010 article are Augustin Landier (Toulouse School of Economics) David Sraer (Princeton University) David Thesmar (HEC & CEPR) (collectively, “LST”).
The Office of the Comptroller of the Currency (OCC) has published a list of the “worst of the worst” – the ten worst lenders in the ten worst markets for nonprime mortgage foreclosures. The absolute worst lender on that list is New Century. That makes it the worst of the worst of the worst. It also makes LST the worst of the worst of the worst economists writing about the fraud epidemics that drove the financial crisis. The LST article is remarkably and inexcusably awful. At the time it was written it was representative of the lack of quality of orthodox economic “scholarship” about elite financial frauds. That has changed. As Mian and Sufi explained in their recent study demonstrating pervasive fraud in liar’s loans:
We know from a large body of research that both non-agency securitized mortgages and low-doc mortgages were associated with a high incidence of fraud (e.g., Ben-David (2011); Jiang, Nelson, and Vytlacil (2014), Griffin and Maturana (2014); Piskorski, Seru, and Witkin (2015)).
The most recent studies by very conservative financial scholars that actually study elite financial frauds have confirmed what we have been explaining for decades. While LST did not have access to these two recent studies, one of the studies (Piskorski, Seru, and Witkinl) was done on the basis of a New Century data set that the authors shared with other scholars who requested access, including the Jiang study that LST cite. Piskorski, Seru, and Witkin and Mian and Sufi exemplify how economists can conduct a real “forensic” investigation of fraud. The press picked up both the Piskorski, Seru, and Witkin and the Mian and studies’ findings. Here is the key passage from a story in which Piskorski was interviewed.
The authors specifically studied two types of mortgage misrepresentations: mortgages taken for primary residences that were not, in fact, primary residences, and mortgages taken for one property, while the second mortgage on the same property was concealed.
They compared loan-level mortgage data with credit reports and used New Century, a now-bankrupt subprime lender, as a case study. By comparing the loans with the credit profiles of their borrowers, they found that the loans New Century sold did not accurately reflect what the bank knew in their credit files.
While the data cannot establish how blatant the fraud was or how it was motivated, other research and insider accounts show that
fraud was endemic among mortgage lenders in the years leading up the housing crash. And it wasn’t a case of a single bad company — the authors studied major companies and found similar results for all originators across the board.
“We didn’t find out this is the only the problem of a few bad apples. That would be kind of good news,” Piskorski said. “This is a really pervasive problem, and every single institution in the data misrepresented mortgages.”
This wasn’t a few cases of fraud, either. According to the study, 27 percent of loans obtained by non-owner occupants misreported their true purpose, and 15 percent of loans with second liens incorrectly reported that such loans were not present.
LST got New Century wrong despite an extensive, publicly available record that refuted their claims. LST ignored that record, failed to conduct any forensic examination of New Century, failed to conduct an effective hypothesis testing, and failed to alert their readers to any of these facts. They produced a travesty that exposes many of the pathologies of theoclassical economics. LST have no excuse because their citations include George Akerlof and Paul Romer’s classic 1993 article – “Looting: The Economic Underworld of Bankruptcy for Profit.” LST, however, simply assumed that New Century could not be a control fraud. Here is the sole basis they provide for this assumption (with its accompanying footnote). LST use the acronym “NC” to refer to New Century.
Before going in detail over NC’s strategy following the 2004 monetary shock, it is interesting to note that the managerial team at NC had significant ownership stakes in the company. In 2001, Robert Cole, Brad Morrice and Edward Gotschall owned, according to EXECUCOMP, namely 15% of the company. With a market capitalization of around $277 Millions, this represented a $42 Million stake for the founding team. In 2005, because of multiple equity offerings, the ownership stake of the three founders went down to 7%. However, thanks to a striking increase in market capitalization (from $277M to $2B), their dollar stake did actually go up from $42M to $147M. As a consequence, we remark that during the entire period our sample covers, the top executives of New Century had significant incentives to maximize shareholder value. This evidence brings strong support to the risk-shifting view we develop in the remaining of the paper relative to explanations that would be based on “looting”.20
20 Besides, we have checked the insider filings on the SEC’s EDGAR website. Between 2003 and the default of NC, the founder-managers have sold less stocks than they were granted, in particular through stock-option exercise.
“This evidence” (A) is not “evidence” and (B) provides zero logical support for their assumption that it would demonstrate that the NC was not an accounting control fraud. It is not “evidence” because the LST authors assumed their conclusion – they assumed that NC’s “market capitalization” was not the product of accounting fraud.
The reality, which LST studiously ignored in order to mislead the reader and policy makers, was that NC’s reported “profits” that drove the “striking increase in market capitalization” were fictional. They were produced by the accounting control fraud “recipe” for a lender. LST know this to be true from a raft of publicly available information from multiple sources. LST, however, provide none of that information to their readers.
The information destroys their assumption that bankers who own stock in a company will never loot the company (an assumption also disproved by the relevant literature and history). The LST authors fail to engage Akerlof and Romer, the criminologists, the financial regulators, the secondary market participants, investigative, and judicial findings that had falsified their claim about stock ownership decades earlier. Indeed, Akerlof and Romer, the National Commission on Financial Institution Reform, Recovery and Enforcement, and the criminologists confirmed that we (the financial regulators) were correct that
dominant (often 100%) ownership of an S&L by its controlling officers was a factor that greatly increased the risk of looting. LST hide all these findings from the reader. There are many reasons why a fraudulent CEO faces restraints in stock sales or simply waits too long to sell.
The first question is whether NC followed the accounting control fraud “recipe” for a lender. The answer, indisputably, is “yes.” (I provide details below.) The recipe for a fraudulent lender (purchaser) of loans has four “ingredients.”
Grow like crazy by
Making (or buying) really crappy loans at a premium nominal yield while
Employing extreme leverage and
Providing only grossly inadequate allowances for loan and lease losses (ALLL)
In NC’s case, in addition to the (deliberately and pathetically inadequate) ALLL on loans it held in portfolio (allowances that its controlling officers reduced as fraud, defaults, and losses surged in its massively expanding liar’s loans) the most relevant loss allowances were for repurchases of loans that it (A) fraudulently originated and (B) fraudulently sold to the secondary market through fraudulent “reps and warranties.”
Lenders led by honest bankers, of course, would never follow this recipe because it produces the classic three “sure things” – (1) the bank is guaranteed to report record (albeit fictional) profits in the near term, (2) the controlling officers will promptly be made wealthy through modern executive compensation, and (3) the firm will suffer catastrophic losses.
There is a literature on how to distinguish between accounting control fraud, incompetence, and “gambling for resurrection.” The beginning of that literature is cited by Akerlof and Romer.
In contrast to popular accounts, economists’ work is typically weak on details because the incentives economists emphasize cannot explain much of the behavior that took place. The typical economic analysis is based on moral hazard, excessive risk-taking, and the absence of risk sensitivity in the premiums charged for deposit insurance. This strategy has many colorful descriptions: “heads I win, tails I break even”; “gambling on resurrection”; and “fourth-quarter football”; to name just a few. Using an analogy with options pricing, economists developed a nice theoretical analysis of such excessive risk-takings strategies.4 The problem with this explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.5 Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem. They were right (Akerlof & Romer 1993: 5).
4. See Merton (1978).
5. Black (1993b) forcefully makes this point.
The research paper I authored in 1993 for the National Commission on Financial Institution Reform, Recovery and Enforcement that Akerlof and Romer cited was not the genesis of this analysis. Our “autopsies” of every S&L failure in 1984 disclosed the fraud “recipe” and the fact that it was essential to gut underwriting in a manner that no honest lender would ever do in order to produce the first two “ingredients” of the recipe. We used that insight beginning in 1984 to identify the accounting control frauds while they were still reporting record (albeit fictional and fraudulent) profits (like NC’s reported “profits” that LST implicitly assume must be real). Indeed, to Charles Keating’s horror, we targeted the S&Ls reporting the highest profits as our examination and enforcement priorities, while economists praised the frauds on the basis of their record reported (albeit fictional and fraudulent) profits. Three decades, and tens of thousands of frauds later, economists shilling for the CEOs leading these frauds still accept reported income and capital as if it were obviously accurate.
In 1995, I supplemented that “point” about how one can distinguish accounting control frauds from (hypothetical) honest “gamblers for resurrection” even more “forcefully” in an article I co-authored with two top white-collar criminologists – Kitty Calavita and Henry Pontell. “The Savings and Loan Debacle of the 1980s: White-Collar Crime or Risky Business” Law and Policy Volume 17, Issue 1, pages 23–55, January 1995. LST ignore the relevant literature. As financial regulators we found, in all the S&L failures, not a single case of “gambling for resurrection” that accorded with the theoclassical economic model on which LST rely. This is not surprising, as Akerlof and Romer explained in the next paragraph of their article.
Some economists’ accounts acknowledge that something besides excessive risk-taking might have been taking place during the 1980s. Edward Kane’s comparison of the behavior at savings and loans (S&Ls) to a Ponzi scheme comes close to capturing some of the points that we emphasize. Nevertheless, many economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution? (Akerlof & Romer 1993: 4-5).
In the current crisis, the “risk of prosecution” of banksters leading accounting control fraud has become nonexistent.
New Century Was a Classic Accounting Control Fraud
At the time the LST authors wrote the version of the paper I found on the web there was a wealth of information available about NC’s frauds and the fact that it followed the fraud “recipe.” Two of the sources were the bankruptcy examiners massive report on NC and securities litigation against NC.
Warning: I went really wonky on this article because I am so outraged at LSTs’ conduct in not revealing these facts to their readers. I want to give the reader an understanding of how detailed the forensic evidence of NC’s accounting control fraud is and how pervasive, large, and blatant NC’s controlling officers’ frauds were. My secondary purpose in providing such extensive, arcane quotations is to give my readers a real world sample of the kind of understanding of accounting fraud schemes that is essential to be an effective financial regulator, investigator, and prosecutor – or economist or white-collar criminologist. None of these roles is for the faint at heart or those unwilling to make a huge investment of time to understand how fraud schemes actually work.
The first ingredient in the fraud recipe is extreme growth.
Indeed, an investigation conducted into New Century’s business practices by the court-appointed Bankruptcy Examiner assigned to investigate the causes of New Century’s collapse concluded that “New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy."
That finding establishes the first ingredient and (if you know the industry) the second. The LST authors concede this point, referring to NC’s “amazing growth.” The SEC’s securities fraud complaint against NC’s three controlling officers was also available to the LST authors, but none of its relevant findings from the SEC investigation were disclosed to the reader. The SEC’s investigation confirmed the “phenomenal” growth of NC loans (and the effect on reported earnings).
From 2001 to 2005, New Century’s loan production increased more than nine-fold, and in 2005 it originated over $50 billion in mortgage loans in that year alone and, at its peak, had over 7,000 13 employees. New Century’s earnings per share grew commensurate with its phenomenal growth. The Company’s reported earnings per share grew from $0.13 in 1996 to $7.17 in 2005. In a May 4, 2006 news release, under New Century’s trademarked byline, “A New Shade of Blue ChipTM,” Morrice publicly reported that the Company’s wholesale business “ranked as the #1 non-prime wholesale lender and #4 wholesale lender in the overall mortgage market in 2005.”
The fact that NC’s controlling officers bragged about being the largest non-prime wholesale lender in the world also demonstrates the second ingredient. The SEC complaint explains that making poor credit quality loans was NC’s strategic plan.
According to its periodic filings, New Century focused on “lending to individuals whose borrowing needs are generally not fulfilled by traditional financing institutions because they do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers.”
Even LST concede, albeit in one of history’s great understatements, that “Over the full period, there is some evidence that NC’s lending standards have worsened….” But they ignore the fact that to speak of NC’s “lending standards” is to discuss an oxymoron, for NC’s lending standards were not followed. They were simply a key element
in the fraud scheme – the false representation that NC actually (1) had prudent underwriting standards and (2) actually followed them. This deception was essential to NC’s ability to sell tens of billions of dollars in fraudulently originated mortgages through fraudulent “reps and warranties” to secondary market purchasers. The fraudulent “reps and warranties” were that NC actually had, and followed, prudent underwriting standards. One of the publicly available securities law suits alleges the following about NC’s underwriting practices – and backs the allegations up with compelling evidence. (“CW” refers to “confidential witness” – whistleblowers from NC.)
New Century systematically disregarded its own underwriting guidelines and wholly disregarded a borrower’s ability to pay when originating loans….
As noted in the New Century’s Bankruptcy Examiner’s investigation (the “Bankruptcy Examiner’s Report”), which included a review of a large number of documents and 110 interviews of 85 fact witnesses, numerous members of New Century’s board of directors and senior management stated that the predominant standard for loan quality was whether the loan could be sold in the secondary market to investors like Deutsche Bank, not—as stated in the ACE 2006-SL1 RMBS prospectus supplement—whether a borrower could meet the obligations under the terms of a loan. Indeed, according to the Bankruptcy Examiner’s Report, New Century’s Chief Credit Officer said that in 2004 New Century had “no standard for loan quality.”
As reported by the Bankruptcy Examiner, reckless origination and underwriting of New Century loans was rampant. For example:
Certain senior managers at New Century in 2004 were told by a New Century employee that when underwriting stated income loans, “we are unable to actually determine the borrowers’ ability to afford a loan.”
In early 2006, one senior manager at New Century described the performance of a certain loan product as “horrendous.”
In 2004, the number and severity of the exceptions to underwriting standards employed by New Century to originate greater volume was 67 described by one Senior Officer as the “number one issue” facing New Century.
By 2004, New Century Senior Management became aware of spiking increases in Early Payment Default (“EPD”) rates—where a borrower fails to make even the first several payments on a loan—suggesting that the loan should never have been originated in the first place. In every month following March 2006, the EPD rate exceeded 10%, reaching to as high as 14.95% by year end.
Up until 2005 New Century used a DOS-based underwriting system which, according to a New Century manager interviewed by the Bankruptcy Examiner, enabled employees to “finagle anything.”
In December 2009, the SEC filed civil fraud charges against New Century’s former CEO, CFO and controller, alleging that despite New Century’s representations as a prudent lender, it “soon became evident that its lending practices, far from being ‘responsible,’ were the recipe for financial disaster.” The executives settled the SEC’s civil fraud charged in July 2010 for approximately $1.5 million.
Numerous former New Century employees interviewed by TIAA’s counsel confirmed the conclusions of the New Century Bankruptcy Examiner and the SEC’s complaint against New Century’s executives explaining that loans were not originated according to New Century’s stated underwriting guidelines, but were instead originated without regard to a borrower’s ability to repay the loan. For example, according to CW 26, a former New Century fraud investigator and senior loan underwriter who examined numerous New Century mortgage loans from January 1999 until April 2007, New Century “started to abandon prudent underwriting guidelines” at the end of 2003 in order to “push more loans through.” According to 68 CW 26, New Century essentially “stopped underwriting.”12 CW 29, a former New Century Vice President and Regional Manager, employed by New Century from September 1996 until May 2007 explained that New Century made very low quality and extremely risky loans, even for a sub-prime lender, noting that: “If you had a heartbeat, we would give you a loan.”
CW 30, another former New Century underwriter and risk manager employed at New Century from December 2001 until April 2007, explained that exceptions to underwriting guidelines were endemic and it was “more about quantity than quality,” with the attitude being “get the volume on; get the volume on.” Indeed, CW 30 reported that nine out of ten loans that CW 30 recommended denying were nevertheless approved by management.13
Facts such as these led the New Century Bankruptcy Examiner to conclude that statements in New Century’s SEC filings declaring that “regardless of document type, New Century designed its underwriting standards and quality assurance standards to make sure that loan quality was consistent and met its guidelines” were “not supportable.” Rather, the Bankruptcy Examiner concluded that “New Century did not produce ‘high quality’ loans or have ‘high origination standards.’” Moreover, claims asserted against New Century for making false 12 CW 27, a former New Century Vice President, Corporate Finance, agreed that New Century began to lower credit standards beginning in 2003. At that time, New Century changed its practice with respect to stated income loans, which became to be known in the industry as “liar’s loans.” CW 28, a former New Century senior training development manager employed by New Century from March 2003 until March 2006 explained that underwriters often allowed borrowers to resubmit a rejected full-documentation loan (which had been rejected because the borrower’s income was too low) as a “stated loan” with a new and higher income, which was then approved. CW 28 stated that this practice was “taboo” in the mortgage industry but routinely occurred and was a “running joke” at New Century. 13 CW 31, a former New Century Vice President, Regional Manager, employed by New Century from October 1999 until March 2007, stated that starting in 2003 and 2004, roughly half of New Century’s loans contained exceptions. CW 32, a former New Century underwriter employed by New Century from May 2005 to March 2006 in Itasca, Illinois and, previously, from 2000 until 2003 in Cincinnati, Ohio, explained that he could not recall the last loan that he looked at that did not have an exception. 69 or misleading statements of material fact regarding New Century’s purported prudent underwriting guidelines have already been sustained under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, and Section 11 of the Securities Act of 1933. See In re New Century, No. CV 07-00931 DDP (JTLx), ECF No. 333, at 34 (C.D. Cal. Dec. 3, 2008) (“This Court likewise agrees…that Plaintiffs’ Complaint alleges sufficient facts that the statements were material misrepresentations of New Century’s loan quality and underwriting practices.”).
Statements in the Offering Materials representing that New Century ensured proper appraisals when issuing loans to borrowers were also false and misleading when made. In order to increase loan origination volume, New Century routinely hired biased appraisers and used inflated appraisals as a matter of course to issue loans to borrowers who would not otherwise qualify for the mortgage.
As described in the Bankruptcy Examiner’s Report, in New Century’s wholesale division—which accounted for the vast majority (approximately 85%) of New Century’s loan originations—the regional managers who had lending authority could override the internal appraisers’ decisions. Moreover, the regional managers’ compensation was not tied to loan quality, but was rather based on the volume of loans originated, providing incentive to inflate appraisal values in order to increase origination of New Century loans.
As revealed in a 2005 internal New Century audit disclosed in the Bankruptcy Examiner’s Report, 18 of 77 (or 23%) of the loans reviewed at one Sacramento fulfillment center had “exceptions with either the appraisal conducted or the review of the appraisal submitted with broker-provided loans or the review appraisal conducted by New Century’s Appraisal Department.” The results of that audit were not an anomaly. According to the Bankruptcy Examiner, the results of New Century’s own loan quality audits of underwriting procedures, account manager review/approval, appraisals and funding “were dismal.” As reported by the 70 Bankruptcy Examiner, of nine branches audited by New Century in 2005, none were rated satisfactory, seven were rated unsatisfactory and two were rated as needs improvement.
Former New Century employees interviewed by TIAA’s counsel confirmed that loans were routinely originated using improperly inflated appraisals. For example, CW 33, a senior vice president enterprise program manager for New Century in Irvine, California from July 2005 to April 2006, stated that he could “guarantee” that large appraisers used by New Century gave New Century “the benefit of the doubt,” i.e., provided an overly optimistic appraisal, in order to maintain New Century’s business. As but one example, CW 33 stated that an appraiser might photograph only one side of the house but not the side that was run down and falling apart in order to justify the inflated valuation. According to CW 33, these appraisal companies did not “want to piss off New Century” because they were compensated on volume.
New Century’s statements regarding its “improved underwriting controls and appraisal review process” have already been held by one court to be false or misleading statements of material fact.14 Indeed, the poor quality of New Century loans were cited in a action brought by the Massachusetts Attorney General, which led to Morgan Stanley’s payment of $102 million to resolve charges that the Morgan Stanley funded loans to target lower-income borrowers and lure them into loans that they predictably could not afford to pay. See Assurance of Discontinuance, In re Morgan Stanley & Co. Inc., Civ. A. No. 10-2538 (Mass. Super. Ct. June 24, 2010) (the “Morgan Stanley Settlement”). 14 See In re New Century, No. CV 07-00931, at 33-34 (C.D. Cal. Dec. 3, 2008), ECF No. 333 (“The pleadings adequately support a finding that these statements were false when made.”).
All of this was publicly available to the LST authors through a simple web search.
NC’s controlling officers knew that making massive amounts of liar’s loans would inherently produce far greater losses – and proceeded to dramatically increase the number of liar’s loans it made and combine them with features that were certain to increase the default rate (and loss upon default) but which would also produce non-cash “income” for the bank and delay those defaults. The two primary features that had these characteristics were making zero down payment loans and “exploding rate” adjustable rate mortgage (ARM) loans. By “qualifying” borrowers at the “teaser” “ARM” rate the bankers also sought to (falsely) make it appear that the borrowers had adequate income to repay the loan. As I have explained on many occasions, liar’s loans are ideal “ammunition” for accounting control fraud because they remove the paper trail that we used to produce many of the S&L fraud convictions. LST ignore each of these points.
No one serious disputes NC’s massive leverage. LST admit that the controlling officers developed a strategy designed to create a “sharp increase” in leverage.
The SEC complaint spends considerable time documenting the inadequacy of NC’s loss reserves and related accounting fraud, the resultant inflation of “profits” that were actually losses, and how this enriched the controlling officers that were looting NC. Again, all of this was publicly available to the LST authors, who ignored it. Why would the findings of SEC investigators about fraud and looting by NC’s controlling officers be relevant to an economic article that assumes without any meaningful analysis that NC’s controlling officers must not have engaged in fraud and looting? Plainly, the direct and overwhelming forensic evidence of numerous brazen frauds by NC’s officers that the SEC (and bankruptcy and civil plaintiffs’ investigations) documented was irrelevant because LST knew that those officers would never loot or engage in fraud because they owned stock in NC. LST were simply protecting their readers from the facts that proved that LST’s thesis was false.
38. The February 2006 Capital Markets Report, which Morrice, Dodge and Kenneally received on March 17,2006, contained a special report on loan losses and borrower age. The report confirmed that losses were greater for stated income loans than for full documentation loans and for second-lien loans than for first-lien loans. The report concluded by stating: “As New Century continues to fund a greater percentage of 80/20 stated documentation purchase [loans] for younger borrowers … you can expect losses to increase as well.”
39. After first payment defaults jumped from a low of 0.6% in March 2005 to a then historical high of 2% in April 2006, New Century conducted a study to determine the cause of the increase. The “First Payment Default Report,” which Morrice, Dodge and Kenneally received on July 26, 2006, noted that the increase in FPDs occurred after New Century had changed the “credit mix” of its loans, including higher overall loan-to-value ratio loans (i.e., mo
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