Information’s starting to trickle out about Operation Malicious Mortgage (good name!) and the 67 locals who have been charged in the FBI’s sweep. And it’s really confusing. I’m here to help! Let’s learn together, I’m pretty foggy on it myself.
How does mortgage fraud work? The Seattle Times has a brief article about some folks up there that gives a sense of how an elaborate mortgage scam works. It takes teamwork. This 2006 article from the SF Chronicle is also good.
Actually, just inflating your income to get better terms or more money on a loan is mortgage fraud, but a mortgage ring usually involves some combination of (1) an appraiser who inflates the asking price of a property (2) a dealer who sells it at the inflated price (3) a straw buyer who takes out a loan for the inflated price and 4) a mortgage broker who packages the scheme to a lender. There might also be a crooked loan officer to grease the wheels. Then everyone splits up the loan and leaves the lender with a market-value property.
That’s one way of doing it, anyway; there’s a rich number of variations. One of the more straightforward ones is to set up a foreclosure prevention company, refinance a bunch of at-risk homes, and then just not give the homeowners the money, eg. But generally speaking it’s just asking lenders for money under false pretenses and then not paying it back.
Why’s this a big thing now? House prices skyrocketed over the past decade, and a lot of very smart professionals, much less regular folk, had no idea when they would stop going up (or at least fooled themselves into thinking they would steadily increase for a long time), and this meant a couple things: (1) Inflated appraisals seemed much more plausible. (2) Lenders were making so much money on solid business that they sometimes didn’t even report getting screwed, because no one wants to play the fool, especially in front of shareholders.
What went wrong? Straight-up mortgage fraud is just a part of the picture. The housing bubble inspired lenders to loan lots and lots of money: some to frauds (made easier by liar loans); some to people who took out “subprime loans,” i.e. loans with bad terms to people with bad credit or no money; some to people who bought like five houses as investments and couldn’t meet payments when the market, um, corrected itself.
Of course, it couldn’t be as simple as the banks giving money to people that they didn’t get back. Banks spread the risk by creating complicated investments that used the mortgages as collateral, and then those investments were used to make other, even more complicated investments to spread the risk further. Obviously, when people invest, they expect a certain amount of the risk to pay off, which is supposed to make up for the part that doesn’t. But the risks were much worse than the banks and the investors thought. So spreading out the risk (1) didn’t work (2) screwed a lot more people than it might have otherwise.
All of this created Big Shitpile, a term coined by the economist-turned-blogger Duncan Black (if you don’t have bad manners, he also suggests “Jenga”).
What is Big Shitpile? Paul Krugman explains in an absolutely invaluable column (emphasis mine):
And the numbers are huge. The financial blog Calculated Risk, using data from First American CoreLogic, estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.
That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.
How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.
How big is Big Shitpile? I just started a history of the crisis, The Trillion Dollar Meltdown by Charles R. Morris, a lawyer, former banker, and financial historian (The Tycoons), a book he had the idea to write in early 2007 when he saw Big Shitpile building. During the 1990s, he ran a software company that made tools to analyze the complex investment pools that now make up so much of Big Shitpile. He writes:
“Here is a crude gauge of the credit bubble. Not long ago, the sum of all financial assets–stocks, bonds, loans, mortgages, and the like, which are claims on real things–were about equal to global GDP. Now they are approaching four times global GDP. Financial derivatives, a form of claim upon financial assets, now have notional values of more than ten times global GDP.”
“In this book, I lay out, on quite moderate assumptions, the likely course of writedowns and defaults on the whole asset gamut–residential mortgages, commercial mortgages, high-yield bonds, leveraged loans, credit cards, and the complex bond structures that sit atop them. It comes out to about $1 trillion.”
Where’d the money go? Um, that depends on what you mean by “money.” I wish I was kidding. I don’t really grasp it myself. Obviously some smart hedge fund managers came out way in the black–I’m talking in the motherfucking billions, although John Paulson is clearly an outlier–betting against the bubble. Apparently Warren Buffett has some of it? But it’s way more complicated than that. I’m in over my head, but this comment is intriguing. That person’s observation at least agrees with Morris’s belief that Nixon unhooking the dollar from gold for short-term political gain was a terrible mistake.
Then again, it’s over the heads of people who actually studied economics. When the wave started to break, Morris writes, “the CFO of Citigroup did not know how to value his holdings.” The best I can do is to say that a lot of people made agreements with each other to exchange stuff in the future and there turned out to be a lot less stuff than everyone figured there’d be. In other words, “the potential claims for payment vastly exceed what the economy itself can actually produce.”
What do the Bear Stearns guys have to do with it? That part of the initial news articles confused me. They don’t have anything to do with mortgage fraud. They were the guys convincing people to invest in the funds that included the Big Shitpile investment pools that were surely based on some fraudulent mortgages, but also on legal, stupid mortgages and heaven knows what else. The government alleges that they strung along investors well after they knew Big Shitpile would swamp the funds. That’s a totally different kind of fraud.
Why’d you waste my time explaining Big Shitpile? Because it’s worth noting that mortgage fraud is only a piece of a much greater crisis, and a seemingly small part at that. The housing market freakout encouraged mortgage fraud and made it easier, but it also encouraged a lot of very stupid but lawful financial moves.
Why should I care? When a major financial institution like Bear Stearns goes ass over teakettle, it can destabilize the national or world economy. If the institution is small enough, a bunch of rich guys can get together and clean up the mess, but beyond a certain point, the U.S. government has to do it with our money. And there’s so much bad scary debt out there you better get used to it.
Whose fault is all this? People who committed mortgage fraud, people who bought lots of houses and then defaulted on them, Richard Nixon, Alan Greenspan, Bear Stearns, the gasbags on TV who said housing prices would go up forever–I dunno, man.
The point is that even though it’s fun to see rich balding guys in suits getting frogmarched, the actual problem was systemic and a ton of it was on the up-and-up, strictly speaking, and we’ve only begun to put together the pieces, or figure out what the pieces actually look like.