[Vnbiz] Fraud and the subprime bubble

[Tai Phan]

*Fraud and the subprime bubble*
By George Pugh

Asia Times - July 24, 2008

The subprime crisis is ending in massive losses, bare balance sheets and
wilted capitalizations: a true rite of spring. Early theories blamed the
crash on corporate greed, bad product design, poor analytics, rating agency
failures, and fraud, in various combinations.

The US Federal Reserve Board is now asking for tighter regulation of the
brokerage industry, while in truth fraud started with the mortgage
originators, which helped cause the collapse of the market, while the firms
that are now being blamed are actually the victims rather than the
perpetrators of the fraud.

The Sarbanes Oxley Act of 2002, with its supporting regulations, was
supposed to curb fraud at the company level by improving


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internal controls and emphasizing management responsibility for accurate
financial reporting: in that aspect it is a signal failure.

*The subprime mortgage-based CDO*
Germany's President Horst Koehler has blamed the subprime crisis on highly
leveraged investments in complex financial instruments. Actually the
subprime instruments were the result of increased investor sophistication.
The firms held product inventories not for speculation but rather as a
service to their customers for collateralized debt obligations (CDOs) and to
provide general liquidity in a counter-party market.

CDOs were first issued in the late 1980s by the now defunct Drexel Burnham
Lambert of junk-bond fame. The CDO is an entity that holds collateral and
sells cash flows, with varying seniorities organized into tranches broken
down by asset-quality risk. They are popular because they can be large, meet
the demand for cash-flow only products and are more profitable for the
issuer than traditional debt instruments: they are a legitimate product
filling an actual demand rather than being a speculative tool.

Banks have long issued CDOs collateralized by mortgage-backed securities
(MBS) containing prime mortgages, that is, in the US, ones eligible for
Fannie Mae, Freddie Mac and Ginnie Mae guarantees. Subprime mortgages have
no such protection, so for that lack alone they are at once more risky
because of the range of borrower credit quality.

Many have terms that give the borrower the ability to pick a payment size -
full (principle and interest), interest only or some mix of the two. In
addition, many are adjustable-rate mortgages (ARMs) that switch from a fixed
to variable rate after the first two years, called the "2-28" option. The
variable rate is set at say 5% over the 12-month London interbank offered
rate after the initial fixed period. There is generally a very high cap, say
15% on the rate. Developing the common risk profile needed to create CDOs is
both expensive and difficult for these assets because of the wide range of
terms and uninsured asset risk (mortgages).

CDOs are designed to provide separate cash flows, risk defined by the
tranche from which each is drawn. The complicating factor is that the
underlying instruments, MBSs funded by subprime mortgages, do not have
easily estimated cash flows. [1]

*Doing the math*
Despite initial reactions in the news, the firms in question managed their
risks extremely well, considering the unanticipated element of fraud, which
thanks to the Sarbanes Oxley reforms they had no rational expectation of
encountering. The best single assessment of the firms' response quality is
found in "Observations on Risk Management Practices during the Recent Market
Turbulence" by the Senior Supervisors Group of the Bank of International
Settlements, dated March 6, 2008. Though the study did not include the whole
universe of firms involved, it covered 11 of the largest banking and
security firms, along with an additional five present at the round table
discussion, which were all there to the end.

This report outlines supervisors' observations on the risk-management
practices that may have enabled some firms to weather the financial market
turmoil better than others from summer 2007 through year-end 2007.
Specifically, supervisors focused on practices related to the following:
The role of senior management oversight in assessing and responding to the
changing risk landscape;
The effectiveness of market- and credit-risk management practices in
understanding and managing the risks in retained or traded exposures, and
The effectiveness of each firm's liquidity-risk management practices in
assessing its vulnerability to that risk in a stressed environment and
taking appropriate action. [2]

The key was management quality, which in this case turned on the ability to
properly allocate capital and a solid understanding of market conditions.

Firms that managed their funding liquidity needs more successfully through
year-end 2007 encouraged individual business lines to assess and communicate
their likely needs for funding to the treasury function and to price those
internal claims on liquidity appropriately in light of actual market
conditions. [3]

These efforts were strongly related to intellectual flexibility and timely
decisions. The more-successful firms were willing to revisit their
assumptions and sometimes revert to simpler, risk-reducing measures.

In light of some firms' uncertainty about the accuracy of assumptions
underlying their risk measures during the current period of turbulence,
several firms cited the usefulness of revisiting simple notional limits to
highlight potential concentrations of risk. [4]

These firms faired better than those that relied on assumptions that might
not have been true. Some, by holding to their initial assumptions, finally
lost sight of their total risk and did not do as well as others for that
reason.

There were other problems that required adjustment, which related to the
tools used. One of the more important was related to value at risk (VaR):

Nevertheless, firms indicated that VaR, as a backward-looking measure of
risk dependent on historical data, may never fully capture severe shocks
that exceed recent or historical norms. ... Most of these exceptions were
generated by much higher market volatility and realized asset price
correlation than the historical data series implied. [5]

Data quality and an over-reliance on historical activity are always
problematic. The data may have been smoothed by removing outliers, or not
have taken in enough data to include extremes. Put another way, VaR data
does not necessary reflect the current situation because of the number of
prior periods used (generally five years) hiding the true level of
volatility at the time.

The firms also had to cope with the fact there was a confusion between the
risk of CDOs and those of debt instruments, which were assumed to be
equivalent and weren't.

In general, the construction of CDOs tends to make them more sensitive to
systematic shocks. In contrast, highly rated corporate debt issuances tend
to be more sensitive to "idiosyncratic" risk, or risks associated with
characteristics specific to the corporation that issued the debt. [6]

The second problem is more profound: firms made assumptions about their CDOs
that simply were not true. The only thing they have in common is the rating.
Corporate debt is unique, being tied to one set of unique assets. The CDOs
use fungible collateral, making them risky as a class. That is, if a
corporation has problems, its debt value and rating may fall, but others in
the class may not: it is company specific. For CDOs, if anything happens to
the perception of the collateral, the shock will be universal. Management
simply could not or would not see this simple difference and acted as if it
didn't exist because their models did not take the difference into account
or did not recognize it.

Though firms varied in how effectively the used their risk-management tools,
good management simply used very similar ones better. In fact, considering
that the tools handled the fraudulent collateral (mortgages) which was in no
way anticipated, it can be said that any additional regulation at this level
would be nugatory, except as political display. Mortgage fraud at this level
was the sign of serious problems not of their making.

*The subprime mortgage as an asset*
The subprime CDO was a remarkable new instrument. It was not until 2001 that
any CDO pricing became cost effective, thanks to the adoption of Gaussian
cupola models developed by David Xi. The models are simpler and cheaper to
use than the Monte Carlo simulation method. The math was by no means suspect
and it will be of note that the tool itself came under no criticism. [7]

What made subprime-backed MBSs more problematic was the lack of guarantees
concerning the underlying mortgage obligations by the US government. In this
instance, the firms decided to purchase ratings for these instruments from
the rating agencies. It must be noted that Moody's and the other rating
companies were doing their risk assessment on the originator documents, and
not on the underlying facts represented. Moody's structured-finance group
grew to account for about 43% of Moody's revenue in 2006, up from 28% in
1998. By 2006, the firm had more revenue from structured finance - US$881
million - than its entire revenue had been in 2001. [8]

More to the point, Moody's in particular was way overcommitted to the line
of business and was subject to customer pressure very early on.

Consider a Bank of America mortgage deal in early 2001. As in most such
deals, the vast majority of the securities based on the pool of mortgages
would be rated triple-A. The question was how big a chunk would be rated
lower - paying a higher interest rate and bearing the brunt of any defaults
that occurred.

A rating committee at Moody's voted to require that the issuer put about
4.25% of the deal's value in the lower-rated section, to provide extra
protection for buyers of the top-rated section. But after Bank of America
complained and said it might go with a different rating firm, Moody's
reduced the size of the lower-rated chunk slightly, saving the issuer some
interest costs, according to people with knowledge of the matter. [9]

The problem was twofold: first, Moody's regularized its business before the
subprime market in all its forms really began to grow, and they were rating
the terms and more importantly the component tranches rather than the
mortgages that backed the MBSs. Lastly, there was fraud, and Brian Clarkson,
the architect of Moody's role in this market, offers the following:

We knew that there was fraud. We may have thought it was X; [it turns out]
it was X to the 10th power. We knew the risks were increasing, so we
increased the protection. It was completely dwarfed. We were preparing for a
rainstorm and it was a tsunami. We saw the increased risk, but we didn't see
what appears to be an 18-month period where anything went. I hate going
through this because it sounds defensive, but the fact is that there were
people who were supposed to be doing due diligence on this who just didn't
do it. [10]

The problem was that they were simply not there to find fraud nor were they
looking for it, simply because that was not what theywere hired to do, which
was to review the tranches and the associated originator-provided credit
scores.

The first tremor that rattled Merrill's profitable business of underwriting
mortgage securities came at the end of 2005. As it repackaged mortgage bonds
into securities called CDOs, Merrill had a key partner in insurer American
International Group Inc. An AIG unit bore the default risk of the CDOs'
largest and highest-rated chunk, known as the "super-senior" tranche,
normally sold to big investors such as foreign banks.

But AIG was keeping a close eye on the housing boom because it had another
unit that made subprime loans, those to home buyers with weak credit. AIG
did a review of the market. Concerned that home-lending standards were
getting too lax, AIG at the end of 2005 stopped insuring mortgage
securities. [11]

The problem or question about getting timely information alone

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might have discouraged entry and certainly became a problem during the
crisis. Not only were there questions about performance but actual fraud
became much more of a concern, or should have.

In calendar year 2006, financial institutions filed 37,313 SARs citing
suspected mortgage loan fraud, a 44% increase from the preceding year,
compared to a 7% overall increase of depository institution SAR filings. One
reason for this increase may be that lenders are increasingly identifying
suspected fraud prior to loan approval and reporting this activity.
Suspected fraud was detected prior to loan disbursements in 31% of the
mortgage loan fraud SARs filed between April 1, 2006, and March 31, 2007,
compared to 21% during the preceding ten years. Total SAR filings in 2006 on
suspected mortgage loan fraud, when divided by the subject's state address,2
showed the greatest increases in Illinois (75.80%), California (71.29%),
Florida (53.04%), Michigan (51.50%), and Arizona (48.73%). [3]

Mortgage brokers initiated the loans reported on 58% of the SARs sampled for
this report. SAR reporting includes examples of brokers acting both as
active participants in the reported fraudulent activity, and as
intermediaries that did not verify information submitted on the loan
application, according to the Financial Crimes Enforcement Network (FinCEN).
[12]

Put another way, mortgage fraud "suspicious activity reports" (SARs)
increased from 3,515 in 2000 to 25,898 in 2005 and in 2006 to 37,313. [13]
Thus mortgage fraud was growing very rapidly during the period, and most
firms took no action, with the exception of AIG and that was probably
because AIG had special knowledge coming from another subsidiary that wrote
subprime mortgages.

The firms that collateralized CDOs were about the last to appreciate the
fraud risks in the MBSs they used. Nonetheless they reacted to them as yet
another unanticipated risk and in the majority of cases brought it under
some control. Checking for fraud was not in their mandate, though it was in
their interest to do so.

Despite all the information available and the amount of money in play it is
clear that any efforts at the originator level were meaningless, and that no
one had thought about the issues even though it is clear that mortgage fraud
was not a new issue.

*Who's to blame?*
Clearly fraud played a very important role in this bubble, and that fraud
began with the originators. The last time fraud was an issue, we later found
that not all "cures" stand the test of time. The demand for preventative
action always comes in the wake of a costly financial crisis like this one
and the last one that had fraud in the mix. Retired Congressman Michael
Oxley told of his dissatisfactions in an interview, highlighting also the
role of the Public Company Accounting Oversight Board (PCAOB) which the
Sarbanes Oxley Act established to oversee and discipline accounting firms in
their roles as auditors of public companies:

The main thing is the enormous cost that was driven by the outside audit. It
was Auditing Standard No 2 [the standard for auditing internal controls over
financial reporting], promulgated by the PCAOB that started all the
problems. Of the complaints you hear [about Sarbanes Oxley], 99.9% are about
404 [the section requiring management and an external auditor to report on
the adequacy of a company's internal control over financial reporting]. It
was two paragraphs long, but by the time the PCAOB was done, it was 330
pages of regulations. It was far too prescriptive and [more] expensive than
anyone anticipated. [14]

The author of Sarbox thought that it was poorly designed, costly and in need
of change after its full effects could be seen, so there is a need for any
new rules to be well thought out to prevent similar problems in the future.
Fraud was a major factor in this bubble and collapse, and Sarbox provided no
amelioration or warning. It seems that Mr Oxley's misgivings were well
placed. In this case, all the new rules and regulations which were in effect
and evidenced in the SEC filings simply did not work as promised.
There is reason to doubt how seriously the SEC has taken the PCAOB. All the
members of the predecessor Public Accounting Board and industry groups
resigned in the face of then SEC chairman Harvey Pitt's plans for a new
regulatory body which evolved into PCAOB.

William Webster was appointed as first PCAOB chairman in 2002 and a few
weeks later newspapers reported that he had served on the audit committee of
US Technologies, which was being investigated for accounting irregularities.
One of the SEC members, Harvey Goldschmid, had already claimed that the
PCAOB candidates were not properly vetted and with that both Pitt and
Webster resigned in November 2002. It is clear that the whole enterprise was
ill-omened and had the elements of putting on a proper show rather than
doing anything to lessen the opportunities for fraud:
Both the SEC and the American Institute of Certified Public Accountants,
before the PCAOB took over the rule-making function, had incorporated the
Treadway Commission Report (into fraudulent financing reporting) into their
work. A critical rule is that the auditors make a revenue fraud and
rebuttable presumption. That rule didn't seem to make any difference, based
on the FinCEN figures quoted above.
The subprime loan instruments are only subject to limited recourse based on
the retention of residual interest, and the recourse is limited to that
interest. Absent demonstrable fraud, the originators gave only limited
recourse to the buyers.

Was there really fraud involved or are we just seeing name calling? First
the firms themselves took definitive action to control the situation: Such
actions show genuine surprise and a desire to solve the problem and in no
way demonstrate *mens rea*, which ignoring the problem might.

... rigorous internal processes requiring critical judgment and discipline
in the valuation of holdings of complex or potentially illiquid securities.
These firms were skeptical of rating agencies' assessments of complex
structured credit securities and consequently had developed in-house
expertise to conduct independent assessments of the credit quality of assets
underlying the complex securities to help value their exposures
appropriately. [15]

This is probably the best proof that fraud caused the problem at the lowest
level and that the people who received them were as much victims as others.

The US Attorney General Michael Mukasey has issued a statement on the
subject:

Yesterday, AG Mukasey rejected the idea of a national task force to combat
the national mortgage crisis, leaving it to local prosecutors to oversee
separate FBI investigations. According to this report in the New York Times,
Mukasey called the problem a localized one akin to 'white-collar street
crimes' and distinguished it from the Enron collapse, for which a task force
was created. [16]