Fraud in the Markets E-Book

Peter Goldmann

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 335

Veröffentlichungsjahr: 2010

Beschreibung

A dramatic look at fraud's role in our financial markets-and how you can protect yourself Fraud In the Markets reveals the critical role fraud played in the global financial crisis-even as many of the perpetrators continue to go unpunished. Shedding light on the reckless conduct of the former senior executives at major Wall Street firms such as Lehman Brothers, Bear Stearns, Merrill Lynch and others just before their collapse, this timely book shows how the culture of "anything goes" on Wall Street fueled the innovation of exotic but deadly asset-backed securities. A frank insider look at the most dramatic economic and business headlines in recent memory, you will find revealing discussion of * The egregiously fraudulent lending practices that engulfed the entire US mortgage industry * The brazenly deceptive marketing of asset-backed securities * A road map to prevent similar disasters from recurring Fraud in the Markets offers forward-looking advice, with practical guidelines for protecting yourself and your company from various forms of fraud that were found to have played a role in the current economic and financial crisis.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Preface

Acknowledgements

Introduction

Banking Fraud in the Early Days

Market-Building by Morgan

Flim Flam Finance

Savings and Loan Fraud Follies

Beginning of the End

Off to the Races

Notes

CHAPTER 1 - The Fraud Culture

I Wanna Be Rich

The Spread of Ethical Erosion

What It All Means

How We Got Here

The Evolving Shapes of Fraud

Pressure, Opportunity, and Rationalization on Wall Street

A Triangle or a Diamond?

A Fraud Pentagon?

Notes

CHAPTER 2 - The Politics of Banking Fraud

Politics and Regulation

Antebellum Banking

Early Due Diligence

Central Banking : The Drive Is Revived

Enter the ABA

The Warburg Factor

Financial Regulation Today

What If?

Is Regulation Here to Stay?

Notes

CHAPTER 3 - Modern Day Financial Services Fraud (1980-2010)

The Fraud Culture and Today’s Frauds

The “Milken/Boesky” Era

Fancy Financing Foments More Fraud

The Ignominious Birth of “Pay for Performance”

Risky . . . Riskier . . .

A Deluge of Derivatives

The Good Side of CDSs

Shortening Memories

Enron et al.

Notes

CHAPTER 4 - Reform, Re-Regulation, and the Persistence of Fraud

Better Antifraud Controls

Beyond Financial Reporting Fraud

Regulation and Legislation

More Aggressive Action Needed

Notes

CHAPTER 5 - Real Estate Bubble and Bust: The Fraud Factor

How Did It Get So Bad?

Subprime Mortgages: Licenses to Steal

Who Is Subprime?

Going for Broke(r)

Notes

CHAPTER 6 - The Makings of a Meltdown

Other Fraud-for-Profit Schemes

Greed Grows and Fraud Follows

Fraud-for-Prop erty Schemes

The Role (or Not) of Predatory Lending

Notes

CHAPTER 7 - Beginning of the End: Death by Derivatives

Playing with Fire

Chaos out of Order

Anatomy of a Subprime Deal

The Fine Art of Business Deception

Bankers Go with the Flow—Into the Tank

Hard Money

And Then There Is AIG

How “Toxic” Securities Ended Up in So Many Investor Portfolios

Rating Agency Deception Redux

And So, The End Begins

Notes

CHAPTER 8 - Can the Circle Be Broken?

So What Now?

Critical Reform Issues

Policing, Policy, and Propriety

Notes

About the Author

Index

Copyright © 2010 by Peter Goldmann. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Goldmann, Peter, 1953-

Fraud in the markets: why it happens and how to fight it/Peter Goldmann.

p. cm.

Includes index.

eISBN : 978-0-470-60838-8

1. Capital market. 2. Corporations—Corrupt practices. I. Title.

HG4523.G65 2010 364.16’3—dc222009046298

To Barbara and Leah

Preface

All men are frauds. The only difference between them is that some admit it. I myself deny it.

—H. L. Mencken

This book will examine a wide range of often complex factors that played key roles in bringing the U.S. financial system to the brink of collapse in 2007 and 2008.

Inevitably, the discussion will often have at its core or within its subtext issues related to the subprime mortgage issue.

The reason for this is paradoxically simple: Had there been no subprime mortgage industry—which didn’t even get its start until the mid-1980s—there is a good chance that there would have been no financial and economic meltdown.

Some would argue that this is an oversimplified view of the meltdown. They would suggest that because of the culture of greed, hubris, and invincibility on Wall Street, together with a conspicuous absence of government and industry oversight, the rise of the subprime “industry” was inevitable. They would further point out that the subprime problem proved to be only one of many financial factors that collectively brought about the worst crisis since the 1930s.

All true. Unfortunately, it is impossible to quantify the exact degree to which each contributing factor catalyzed the financial markets’ precipitous demise.

In the end, what really matters is the subprime crisis’s related financial failures and how the perfect storm that brought the entire U.S. financial system to its knees came together. Thus, this book will address such issues as:

• The history of the financial markets and the origins of the cultures of greed, financial omnipotence, and hubris that gave rise to a fatal redefinition of risk in the late 1990s and early 2000s.

• The related culture of “anything goes” on Wall Street which fueled the innovation of super-high-risk asset-backed securities whose excessive use went either unaddressed or underestimated to the devastating disadvantage of institutions that invested in them.

• The egregiously fraudulent lending practices that engulfed virtually the entire U.S. mortgage industry, leading to the fatal deterioration of balance sheets and ultimate collapse of major players such as Washington Mutual, Wachovia, Countrywide, as well as untold thousands of unscrupulous mortgage brokers, appraisers, and independent lenders.

• The wildly irresponsible decisions on the part of Wall Street’s top honchos that cost them their firms, their jobs and the livelihoods of tens of thousands of their employees and clients.

• The widespread fraudulent marketing of asset-backed securities, based on exaggerated or completely fictitious representations of risk levels, including the stunning indictments of two highly regarded Bear Stearns traders.

The latter part of the book will address options for preventing similar disasters from recurring and will provide readers with practical guidelines for protecting themselves and their companies from various forms of fraud that were found to have played a role in the current economic and financial crisis.

Let it be noted at the outset that American economic and financial history is blemished with numerous catastrophic events, the most devastating of which was, of course, the Great Depression. The history lesson that needs to be kept in mind however, is that as much as our political leaders may try, they will never be able to safeguard America’s financial institutions from future crises. It can only be hoped that with a thorough understanding of the factors and forces that triggered the crisis of 2007-2008, there is at least a chance that those who lead our nation will have the wisdom and foresight to render these future events far less painful than those the country endured beginning in the summer of 2007.

A note on terminology: Unlike the Great Depression, the financial crisis that is the subject of this book has not as yet been blessed with a colloquial household name. In the interest of simplicity and consistency, the crisis will generally be referred to in these pages as “the financial crisis of 2007-2008” or “the meltdown of 2007-2008” (the two years during which most of the damage and panic occurred).

Acknowledgments

Many of the people who offered valuable insight and perspective on key topics in this book insisted on anonymity in exchange for doing so. As part of the deal, they also required exclusion from this segment of the book. However, they know who they are and for their assistance I am indeed sincerely appreciative.

Thomas Scanlon, CPA, CFP, a seasoned accountant at Connecticut-based Borgida & Company, provided essential feedback throughout the book.

Stephen Pedneault, CFE, CPA, another Connecticut CPA and a razor-sharp antifraud expert, also helped by sharing his experiences and detailed knowledge of key types of fraud that played direct or indirect roles in the period leading up to the Great Crash.

Chris Doxey of Business Strategy, Inc. in Grand Rapids, Michigan was a great sounding board for many of the ideas that went into putting this book together. Chris has a unique view of the world of corporate crime, having been directly involved in developing antifraud controls at companies after they fell victim to financial trickery similar to that which came into play leading up to the 2007-2008 crisis.

Thanks also to Tim Burgard of John Wiley & Sons, along with his team of editors, whose efforts in forcing adherence to tight deadline schedules ensured that this volume appeared much earlier than it otherwise might have.

INTRODUCTION

A Brief History of Fraud in Financial Markets

The subprime mania that swept the home mortgage and securities markets, starting around 2002-2003, was the last straw for the U.S. financial system as we knew it since the early years of the twentieth century. Since the establishment of central banking in 1913, the American economy has toughed out several recessions. But never before 2007—including the devastating years of the Great Depression—has the economy and financial system come as close to utter obliteration.

It is no coincidence though that the financial services industry was the breeding ground for the deadly forces that brought on the Great Crash of 2008 and its aftershocks.

It is also no surprise that fraud played a starring role in the emergence of these dark chapters in American financial history. But it is important to understand the dynamics of earlier economic and financial crises in order to fully appreciate the genesis of the 2008-2009 meltdown and the key role that criminal activity played in it.

Banking Fraud in the Early Days

Before the Civil War, the United States had a banking and financial system that could be described as “sketchy” at best. Prior to the advent of the railroad, barons like Jay Gould and Cornelius Vanderbilt who exploited the underdeveloped and woefully misregulated businesses of borrowing and lending, made several failed attempts to create a central bank.

One of the federal government’s efforts to establish a national bank resulted in what is believed to be the largest management-level bank fraud in post-Revolutionary history.

The target bank was the Second Bank of the United States (SBUS), an institution that was two years in the making thanks to intractable political divisiveness between supporters of state banking and those who favored national banking. When the SBUS was finally opened in early 1816, there were 19 branches, of which the Baltimore and Philadelphia branches were among the largest. Another nine were opened between 1817 and 1830.

The heads of these branches, along with other directors and executives, exploited the country’s new frenzy over bank stocks and proceeded to purchase controlling shares in the SBUS. They used their power to establish their own financial firm whose sole mandate apparently was to manipulate SBUS stock. Specifically, one ploy used to drive up the price of SBUS shares was to pledge their previously purchased SBUS shares as collateral for loans from the SBUS in order to buy more of the bank’s own shares. Though such unscrupulous activity would today be viewed as the worst possible form of insider trading, it went unpunished for several years within the SBUS. Worse, the bank executives cooked the bank’s books to conceal these internal sham loans. But the scheme went unnoticed due to a “see-no-evil” mindset among the bank’s directors that sounds disturbingly similar to the mindset of the top bosses at Countrywide, Washington Mutual, and other major players in the subprime lending business of the early 2000s who chose to turn a blind eye to the rampant mortgage fraud that was making them mountains of money. (More on this in Chapter 5.)

Ultimately the SBUS conspirators were caught, but, curiously enough, a Congressional investigation into the fraud resulted in no recommendations for punitive action against the perpetrators, despite the findings of blatant violations of bank operating rules and laws.1

Following the failure of the SBUS, Washington made further efforts to stabilize the economy and monetary system. It did so by issuing currencies of numerous varieties from gold and silver coins to demand notes to United States Notes affectionately dubbed “greenbacks.” Federal efforts to bring stability to the monetary system continued to be undermined by the cycle of issuance and retraction of state-issued currencies that continued over the decades leading up to the Civil War.

These were the products of “free banking” which is best described as minimally regulated state banking in which anyone could open a bank with next to no capital and issue its own banknotes (currency) as loans to customers. Unfortunately for most holders of these notes, the limited geographical usefulness of the currency inevitably resulted in drastic depreciation and ultimate losses.

While these monetary systems were loosely regulated by state governments and as such were not fraudulent in and of themselves, they did enable bank owners to exploit the system to illegal ends. They would purchase goods with the notes immediately after issuance and get out of Dodge. Due to inadequate backing by shareholder equity, the notes would quickly become worthless, the bank would fail, and the note holders would be left with nothing.2

On a more brazenly fraudulent level, free banking gave rise to what was aptly called wildcat banking. It took hold in numerous states, initially in Michigan and then in New York and several other states. According to one top economic historian, this is how it worked:

If the bond security [of the bank] was valued at more than its market value, individuals had an incentive to buy bonds, issue notes, and abscond with the proceeds.

For example, if someone could buy $80,000 worth of bonds at current market prices and the bonds were valued as security at their face value of, say, $100,000, and the notes could be passed for more than $80,000, say $90,000, there is a one-time gain of $10,000 in starting the bank. If the owner could avoid being sued for noteholders’ losses, for example by leaving the court’s jurisdiction, this difference between the amount received for the notes and the market value of the bonds created an incentive to start a bank and let it fail quickly.3

Along with wildcat banking came rampant counterfeiting and other swindles. Fortunately for the average American, the free banking system was shut down by the federal government through a levying of debilitating taxes. The banking industry then became a federally-run system, with a whole new set of flaws and regulatory loopholes.

This ongoing state of financial dysfunction brought with it some relatively complex financial frauds, highlighted in 1867 by the landmark collapse of Credit Mobilier, a construction company-turned-financial institution indirectly owned by the financial promoters of the Union Pacific Railroad, which was itself controlled by the federal government at the time.

The bank, originally organized by the aptly named George Francis Train, existed for the prime purpose of financing the railroad’s construction in exchange for ample “returns” generated by drawing down substantial loans that the government had earlier provided to the railroad. But shortly after Congress-man Oake Ames took over the “bank,” it was learned that Ames had generously spread Credit Mobilier shares among numerous Congressional colleagues to secure votes on additional federal funding that was purportedly needed to complete the railroad’s construction. The first major incident of pre-nineteenth century financial fraud made the history books when the loan’s proceeds, to the tune of $23 million, ended up in the Credit Mobilier owners’ pockets.

The subsequent collapse of Credit Mobilier thus also earned the dubious distinction as the first major American financial institution failure. The event shed light on America’s woefully underdeveloped financial and regulatory structure.

Paradoxically, this period—the latter half of the nineteenth century, which Mark Twain dubbed “The Gilded Age” in an 1873 eponymous novel he co-authored with Charles Warner—was a time of unprecedented industrial advancement and rapid population growth. It was the period during which the oil empire of John D. Rockefeller was built; when Andrew Carnegie joined the elite ranks of the super-rich by master-crafting the largest steel company in America; and when modern industrial infrastructure including railroads, steel, and utilities took root.

Market-Building by Morgan

During this period, in 1892-1893, the first “real” stock market crash occurred, as well as the era of the “Money Trust” of the early 1890s—a term that came to be synonymous with John Pierpont Morgan.4

Through the turn of the century and into the 1920s, Morgan built his father Junius’s London-based business partnership with American banker extraordinaire, George Peabody into the United States’ first major investment banking firm. During those years, Morgan managed to earn a reputation of what former banking executive and financial historian, Charles Morris defined as “absolute integrity and straight dealing.”5

Morgan was the builder of modern securities markets, replacing the one-stop pseudo-monopolistic financing approach of Jay Gould. Under Morgan, shareholders actually became living, breathing investors to be respected and reckoned with.

He accomplished this by recapitalizing the railroads with fresh cash, much of it originating in Europe where, in part thanks to his father’s accomplishments, Morgan commanded enormous admiration and respect. He simplified the capital structure of the railroads into no more than two layers of debt with interest rates that the railroads’ cash flows could comfortably manage. Equity meanwhile was sold to a broad market of investors.

And then came The Great War, which sparked a massive appetite for credit on the part of the Allies. Almost overnight the dollar became the “modernized” world’s leading currency. To raise funds for their war efforts, France and Britain turned to JP Morgan for help. In what was at the time the largest bond issuance ever, the Morgan dynasty orchestrated a $500 million debt offer, cleverly selling them as “trade finance” bonds instead of what they really were—“war bonds.”6

By the time the United States entered the war—in 1917—demand for U.S.-issued bonds was so great that the U.S. Treasury was able to successfully market some $17 billion of its own debt in the final year or so of the war.

By war’s end, so many “average” Americans had bought government debt that demand for consumer investment services was more than adequate to fuel the rapid emergence of the country’s retail securities industry.

Flim Flam Finance

Unsurprisingly, with the rapid growth of Western capitalism in the late-nineteenth and early-twentieth centuries came great temptation for employees and outsiders to steal from the country’s rapidly increasing number of banks and investment houses. But in the end it was naive individual would-be investors who suffered most at the hands of swindlers peddling bogus securities to a public delirious with visions of overnight riches.

Things got progressively more precarious throughout the “Roaring 1920s” which saw the frenzy over government debt spread to equities and residential real estate. And while only about two million Americans actually owned stock by the time the market crashed in October 1929, the spread of securities holdings among American investors was substantial enough to give rise to a greatly exaggerated appreciation of the impact of the market dive than was actually justified. In fact, as many historians have written, the market crash was not the cause of the Great Depression. Rather, it was a by-product of misguided monetary policy and colossally misconceived foreign trade policy in the form of the Smoot-Hawley Act of 1930 which effectively choked off imports through astronomical tariffs, thus triggering inflation and sluggish economic growth in Europe which had been the source of large amounts of needed investment capital in the fast-growing U.S. manufacturing base.

It is nonetheless undeniable that the spirit of speculation that gripped the U.S. stock market beginning in the mid-1920s had “imminent disaster” written all over it. And, not entirely unlike the events of 2007-2008, fraud played a major role in bringing on the inevitable bursting of the bubble. Huge amounts of bogus stock were sold to investors, rich and poor, while legitimate issues of equities experienced stupendous price growth within very short periods of time.

One of the more colorful examples of this financial chaos is the story of Ivar Kreuger, a Swedish entrepreneur who built his father’s tiny match manufacturing business into the world’s dominant supplier of “safety matches.”

Kreuger arrived in the United States in 1922 having realized that the poverty of many European governments after World War I provided an opportunity for capitalists with cash. He arranged for large loans—up to $125 million—to governments in return for official match monopolies. The scheme worked so well that, by 1930, Krueger controlled 90 percent of the world’s match production.

But Kreuger was a fraud, a Bernard Madoff-type Ponzi schemer. His was by some accounts the largest financial fraud to date in U.S. history. He told prospective American investors that the foreign loans whose bonds he was peddling were risk-free since they were secured by an excise tax on match sales—the proceeds of which went into a trust account at a Kreuger-owned bank until the loan and interest were paid.

According to one account:

The source of Kreuger’s capital was the American public. Since his company’s securities were often issued in small denominations, many of Kreuger’s stocks and bonds ended up in the hands of small investors. For instance, Kreuger issued $5 bonds, whereas the minimum at other corporations was $1,000. Kreuger’s securities, both bonds and the stocks of his many subsidiaries, paid high returns to investors, yielding up to 20% annually on both stocks and (participating) bonds. Unfortunately, those dividends were largely paid out of capital, not profits. Because profits weren’t substantial enough to pay the promised double-digit returns to bond investors, Kreuger’s pyramid scheme ultimately collapsed.

The Depression accelerated the collapse of the Kreuger pyramid. Investors had little money to invest, and when there were no new investors there could be no dividend payments. Seeing the end of his empire and being hounded by an Ernst & Ernst auditor working for a legitimate subsidiary, Kreuger took his own life in Paris on March 12, 1932.

Initially, the world mourned his loss, but the truth was uncovered by Price Waterhouse auditors who were hired to unravel his affairs. Nearly a quarter of a billion dollars in assets apparently never existed. On the Monday following Kreuger’s death, his securities accounted for 1/3 of the New York Stock Exchange volume, and lost 2/3 of their value. Within weeks the securities were worthless.7

Significantly, Kreuger’s U.S. company had neither external nor internal auditors. Kreuger evidently saw no need for accurate financial records and hence there was no need for auditors. He insisted on strict secrecy about the financial condition of his company. This turned out to have been essential to the perpetration of his financial scheme since as noted above, once he was no longer in the picture, auditors discovered that he had been perpetrating a massive pyramid scheme, paying dividends to investors with capital from the company and investment income from new investors (sounds of Madoff?).

The generally unknown result of the Kreuger scandal was that it led to new federal laws, including perhaps most importantly, mandatory audits for listed companies, and other changes at the New York Stock Exchange.

As with the 2007-2008 bubble burst, in the crash of 1929 a panoply of egregious frauds helped to accelerate the country’s slide toward disaster.

According to the records of an aggressive investigation into the stock market crash and its aftermath by a subcommittee of the Senate Committee on Banking and Currency, led by a Senate staffer, Ferdinand Pecora between 1932 and 1934, major banks, investments houses, and even law firms had peddled hundreds of millions of dollars of worthless stock leading up to the fateful day in October of 1929.

The Pecora Commission methodically dissected—and exposed—the malodorous actions of virtually every “big-name” Wall Street firm, including Chase National Bank, J.P. Morgan & Co., Kuhn Loeb and Co., National City Bank, and its so-called “securities affiliate,” National City Co.

The latter two names are of particular interest in that according to the Pecora Commission, one of the most brazen frauds of the 1920s was perpetrated by the large New York banks flogging off massive amounts of worthless securities to their securities “affiliates,” thereby applying copious layers of financial cosmetics to their own balance sheets.

And in yet another incident eerily similar to the self-enriching conduct of the captains of Lehman Brothers, Merrill Lynch, and other sinking Wall Street super ships in late 2008, Ferdinand Pecora uncovered the fact that while the market was crashing in 1929, Chase’s then-boss, Albert Wiggin, made a $4 million profit as his bank’s stock price rapidly tanked.8

In the end, the important but little-known fact is that the Pecora Commission’s work to expose the criminal activities of financial institutions in the late 1920s led directly to the drafting and ultimate passage of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Glass-Steagall Act of 1933.

Savings and Loan Fraud Follies

Beginning in the early 1980s, Congress lifted a number of key regulations that were stifling savings and loan institutions’s ability to attract deposits and make profitable home loans. But within a few short years, the pendulum had swung to a climate of virtually complete deregulation which immediately attracted a band of non-banker investors who smelled an opportunity for easy riches with minimum financial risk. So unfettered were these new S&L owners in how they managed their operations, that they ended up with billions of dollars worth of ultra-high risk real estate loans on their books—many designed to benefit the owners themselves through arrangements that would today be characterized as unadulterated self-dealing. Simultaneously they feasted on the inflow of depositors’ savings to pay for lavish lifestyles—often with brazen disregard for criminal laws prohibiting the misuse of depositor funds.

Of course as their Wild West banking practices ultimately produced wave after wave of defaults, the entire industry imploded and the federal government was left to clean up the mess and prosecute some of the most offensive scoundrels such as Charles Keating, Don Dixon, and others who ultimately did hard time for looting hundreds of millions of depositor dollars, brazen book cooking, and other serious financial felonies.

Beginning of the End

As the S&L crisis was winding down, the subprime mortgage industry was just shedding its training wheels. In 1990, there was effectively no secondary market for loans that were not “conforming”—that is, loans that didn’t meet the credit standards of Fannie Mae and its companion government sponsored enterprise (GSE), Freddie Mac. These were mortgage loans up to $417,000 for a single family home whose borrower(s) had specified credit scores and income levels considered by the GSEs’ policymakers to be “adequate” to make the loan affordable.

In 1999, a total of $2.9 trillion in mortgage-backed securities (MBS) and collateralized debt obligations (CDO) were on the books of the government “agencies”—mainly Fannie Mae and Freddie Mac. By the end of 2007, that amount had ballooned to $6 trillion.9

The modern-day makings of the worst crisis since the Great Depression started taking root in 1983 when the Federal National Mortgage Association Fannie Mae—the federal home mortgage giant—issued the first-ever collateralized mortgage obligation (CMO). These were securities that “elaborated” on the first securitized products—MBSs, which were the brainchild of a Salomon Brothers’ trader named Lew Ranieri.10

One of the clearest descriptions of these financial “products”—which in subsequent years gave rise to mind-numbingly complex offshoots—was offered by Cameron L. Cowen, a partner at the New York City law firm, Orrick, Herrington, and Sutcliffe, in testimony given in late 2003 to the House Subcommittee on Housing and Community Opportunity and the House Subcommittee on Financial Institutions and Consumer Credit:

CMOs redirect the cash flows of trusts to create securities with several different payment features. The central goal with CMOs was to address prepayment risk—the main obstacle to expanding demand for mortgage backed securities, (MBS). Prepayment risk for [basic] MBS investors is the unexpected return of principal stemming from consumers who refinance the mortgages that back the securities. Homeowners are more likely to refinance mortgages when interest rates are falling. As this translates into prepayment of MBS principal, investors are often forced to reinvest the returned principal at a lower return. CMOs accommodate the preference of investors to lower prepayment risk with classes of securities that offer principal repayment at varying speeds. The different bond classes are also called tranches (a French word meaning slice). Some tranches—CMOs can include 50 or more—can also be subordinate to other tranches. In the event loans in the underlying securitization pool default, investors in the subordinate tranche would have to absorb the loss first.

As part of the Tax Reform Act of 1986, Congress created the Real Estate Mortgage Investment Conduit (REMIC) to facilitate the issuance of CMOs. Today almost all CMOs are issued in the form of REMICs. In addition to varying maturities, REMICs can be issued with different risk characteristics. REMIC investors—in exchange for a higher coupon payment—can choose to take on greater credit risk. Along with a simplified tax treatment, these changes made the REMIC structure an indispensable feature of the MBS market. [In 2003,] Fannie Mae and Freddie Mac [were] the largest issuers of this security.

Asset-Backed Securities

The first asset-backed securities (ABS) date to 1985 when the Sperry Lease Finance Corporation created securities backed by its computer equipment leases. Leases, similar to loans, involve predictable cash flows. In the case of Sperry, the cash flow comes from payments made by the lessee. Sperry sold its rights to the lease payments to an off-book legal entity called a Special Purpose Vehicle (SPV). Interests in the SPV were, in turn, sold to investors through an underwriter.11

As Cowen went on to explain to the Subcommittees, the ABS market quickly grew as Wall Street started securitizing and marketing debt related to and including auto loans, credit card receivables, home equity loans, manufactured housing loans, student loans, and even future entertainment royalties.

According to Paul Muolo and Mathew Padilla, in their co-authored book, Chain of Blame, the initial motor behind CMOs was Larry Fink, head of mortgage trading at the investment firm, First Boston (absorbed in 1988 by Credit Suisse), who came up with the idea of creating a trust that guaranteed payments to the bondholders.12

There was nothing unethical, illegal, or even particularly risky about these securities in their early years. But, as upcoming chapters will reveal, these and their offspring which came to be defined by the catch-all term, “derivatives,” spawned trading and sales tactics that in many cases were anything but above-board.

Off to the Races

The subprime mortgage industry, which originated a paltry $35 billion in 1995 swelled to $190 billion in 2001 and to $600 billion in 2006.

Similarly, between 2001 and 2006, the number of mortgage brokers exploded from an estimated 37,000 to some 53,000.

The beginning of the end for the subprime mortgage business—and for financial stability as we knew it—came when in the mid-1990s, Lehman Brothers became the first major investment bank to, in the words of former subprime mortgage lender Richard Bitner, “aggressively enter the business.”13

Given the circumstances of its 2008 demise, it is in retrospect unsurprising that Lehman’s 1990’s foray into subprime territory proved disastrous. The event represents what is believed to be the first instance of Wall Street-related subprime mortgage fraud. In Bitner’s words:

In 1995, when [Lehman] provided financing for First Alliance Mortgage Co. and underwrote the securities, Lehman’s own internal memos questioned whether some borrowers had the capacity for repayment. As other investment banks backed away from First Alliance, federal and state regulators started to investigate their practices. Throughout the turmoil, Lehman continued to support First Alliance, keeping the operation in business....

In 1993 a California jury awarded over $50 million in damages against First Alliance and attributed 10 percent of the responsibility to Lehman’s involvement. It was eventually discovered that many of the sales tactics used by loan officers at First Alliance confused and misled borrowers.14

Lehman also settled a lawsuit filed in Broward County Circuit Court by Florida authorities who charged Lehman with being an “accomplice” in First Alliance’s frauds. While admitting no wrongdoing, Lehman agreed to pay $400,000 and “review its practices.”15

In true super-aggressive Lehman form, the firm also entered into a joint venture with Amresco, Inc., a struggling Dallas-based publicly traded subprime firm that thus became the first Wall Street firm to operate an actual subprime lending unit. It was called Finance America.

Chapters 5 and 6 will address the morbid details of how this rather inelegant birth of the subprime mortgage industry progressed to a period of relative financial sanity to one of questionable activity and ultimately to one effectively defined by one direct player as an “industry” of “fraud factories” which ultimately brought it crashing down.

It is important to keep in mind that the subprime crisis, besmirched as it was by rampant fraud, was not solely responsible for bringing the U.S. financial system to the brink.

Other critical factors include:

• Misguided or nonexistent regulation of banking and investment firm activity

• The unprecedented intensity of global competition in financial markets

• A partial failure to remedy the wounds to America’s reputation as the financial standard bearer of the world after the rash of mega-corporate scandals of the early 2000s

• A management culture in financial services firms of indifference and denial with regard to the growing problem of fraud within their ranks

From the preceding pages, it is clear that the meltdown of 2007-2008 was not an isolated incident. However, it will ultimately be recorded as one of the worst financial crises in the country’s colorful history of financial calamities, each of which is to varying degrees attributable to what over the decades has arguably become a culturally ingrained propensity for fraud throughout the financial industry.

Each of these powerful forces will be addressed in detail in upcoming chapters, with the objective of creating a complete perspective of the sometimes complex but invariably sobering impact of fraud on pushing the world’s preeminent financial system to disaster on more than just a few occasions.

Notes

1 Edward S. Kaplan, The Bank of the United States and the American Economy (Santa Barbara, CA: Greenwood Publishing Group, 1999), 63.

2 Federal Reserve Bank of Atlanta, Gerald P. Dwyer Jr., “Wildcat Banking, Banking Panics, and Free Banking in the United States,” Economic Review, December (1996): 6-7.

3 Federal Reserve Bank of Atlanta, Gerald P. Dwyer Jr., research by Hugh Rockoff, economist, cited in “Wildcat Banking, Banking Panics, and Free Banking in the United States,” Economic Review, December (1996): 11.

4 Charles R. Morris, Money, Greed, and Risk: Why Financial Crises and Crashes Happen (New York: Times Books, 1999), 53.

5 Ibid., 53.

6 Ibid., 62.

7 Gaurav Kumar, Dale L. Flesher, and Tonya Flesher, Ivar Kreuger Reborn: A Swedish/American Accounting Fraud Resurfaces in Italy and India, available at SSRN: http://ssrn.com/abstract=1025525.

8 Jerry W. Markham, A Financial History of the United States, (Armonk, NY: M.E. Sharpe Inc., 2002), 1:146.

9 Securities Industry and Financial Markets Association (SIFMA). www.sifma.org.

10 Paul Muolo and Mathew Padilla, Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis (Hoboken, NJ: John Wiley & Sons, 2008), 56.

11 Statement of Cameron L. Cowan, Partner at Orrick, Herrington, and Sutcliffe LLP, on behalf of the American Securitization Forum before the Subcommittee on Housing and Community Opportunity, Subcommittee on Financial Institutions and Consumer Credit United States House of Representatives, Hearing on Protecting Homeowners, “Preventing Abusive Lending While Preserving Access to Credit,” November 5, 2003.

12 Muolo and Padilla, Chain of Blame, 57.

13 Richard Bitner, Confessions of a Subprime Mortgage Lender: An Insider’s Tale of Greed, Fraud, and Ignorance (Hoboken, NJ: John Wiley & Sons, 2008), 110.

14 Ibid.

15 Michael Hudson, “How Wall Street Stocked the Mortgage Meltdown,” Wall Street Journal Online, June 28, 2007.

CHAPTER 1

The Fraud Culture

American organizations lose approximately 7 percent of gross revenue to fraud every year, according to the Association of Certified Fraud Examiners (ACFE).1

In 2006 (the last year for which data are available), of 21 industries studied by the ACFE, banking/financial services topped the list in terms of number of internal fraud incidents reported. A fairly distant second was the government and public administration, followed by healthcare.2

What does this tell us about fraud in the financial services industry? Other than the obvious fact that 7 percent of gross revenue of any bank or financial services firm represents a large sum of money, the industry’s dubious distinction as having the most incidents of internal fraud speaks to the disturbing reality that fraudulent behavior has become integral to the culture of this sector.

The reasons for this are complex but it is hoped that understanding them will help political, industry, and social leaders come up with new laws and regulations to control the fraud problem in financial services.

As for professionals whose duties include fraud detection and prevention, understanding the mentality of this “fraud culture” is essential to developing deterrents, incentives, regulations, laws, and any other potential weapons for effectively stopping the growth of this cancer.

Without knowing how and why the basic values and ethics of large swathes of the financial industry became egregiously compromised, there is little chance of restoring the integrity, fairness, and respect for others that—reassuringly—represent the ethical guidelines by which many financial executives and professionals still conduct their affairs.

I Wanna Be Rich

As the “Land of Opportunity,” America has for over 200 years provided better odds of success than any economic system in history to individuals seeking to become materially wealthy. It is thus not surprising that America has always been the country with the largest number of ultra-wealthy individuals. In Forbes magazine’s latest tally, 11 of the world’s 25 richest people reside in the United States.

This is surely not a bad thing. Together with constitutionally guaranteed political, economic, and civil freedoms and a unique cultural spirit of optimism, ingenuity, and excellence, this “golden promise” has made America the most successful free market nation in history.

Similarly, the successes of America’s first generation of true business icons like Morgan, Carnegie, and Rockefeller, and most recently, Gates, Buffett, Jobs, and Trump, have reinforced the inspiration of millions who choose to devote themselves to the pursuit of financial happiness.

Historically, for most entrepreneurs, getting rich has been a healthy obsession—one that has pushed them to strive for perfection, work as hard as it takes, and commit to never giving up despite the risks. Many possessing these personality traits have built successful businesses that collectively employ millions, generate billions in tax revenue, and comprise the 20 million-plus small businesses responsible for the lion’s share of U.S. economic growth.