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Sat Jul 19 08:26:03 PDT 2008
fraudulent mortgage applications which were not caught by the people issuing
the mortgages. The second conclusion is that the firms were only later
involved and did not try to hide the problems in a meaningful way; though
there may have been instances in some firms, it was by no means generalized.
*Fraud and bubbles*
It seems proper to make a brief detour and discuss how fraud plays an
intimate roll in the creation of bubbles. Fraud distorts market signals for
demand and more importantly growth in demand and price. In this instance,
increased mortgage financing bid up existing stock and created a multiplier
effect among existing home owners, who sought to reinvest their gains in
larger properties. These price increases encouraged builders to build for
the increased demand which was debt financed. Mortgage lenders were eager to
keep up, and lowered their standards, even if no fraud was involved, to keep
their competitive position. The risks were passed on to the purchasers, so
the mortgage originators and their auditors simply did not see the
contingent risk as large. It really doesn't take a lot of increase in demand
to increase the growth in prices, feeding building and speculation.
Up to this point, it is clear that mortgage fraud fed the bubble and that
subprime loans were in the center ring. There is strong evidence that the
firms that stayed in the market behaved well when contending with the fraud
involved in the underlying instruments. It is also clear that SEC
regulations, especially Sarbanes Oxley, are totally worthless in preventing
or detecting fraud. It appears that the politicians want to further regulate
the firms rather than look to their own regulatory failures.
*Notes*
1. This section was derived and condensed from Wikipedia, Collateralized
debt obligation<http://en.wikipedia.org/wiki/Collateralized_debt_obligation>.
> 2. Senior Supervisors Group of the Bank of International Settlements
Observations on Risk Management Practices during the Recent Market
Turbulence March 6, 2008.
> 3. ibid p10
> 4. ibid p14
5. ibid p14
6. ibid p15
7. Mark S Joshi: Applying Importance Sampling to Pricing Single Tranches of
CDOs in a one-factor Li Model<http://www.quarchome.org/tranchedimportance.pdf>.
> 8. Lucchetti, Aaron. "Rating Game: As Housing Boomed, Moody's Opened Up"<http://online.wsj.com/article/SB120783282351804761.html>,
The Wall Street Journal, April 11, 2008, pA1.
9. ibid
10. "Interview Excerpts: Moody's Executives Ratings Agency's Clarkson,
McDaniel: 'We Make Assumptions With
Losses'"<http://online.wsj.com/article/SB120783282351804761.html>,
Wall Street Journal, April 11, 2008.
11. Pulliam, Susan; Ng, Serena; Smith, Randall. "Merrill Upped Ante as Boom
In Mortgage Bonds Fizzled Fresh $6 Billion Hit Is Expected as
Toll"<http://online.wsj.com/article/SB120830730844618031.html>,
The Wall Street Journal, April 16, 2008; pA1.
12. FinCEN <http://fincen.gov/MortgageLoanFraudSARAssessment.pdf> (Financial
Crimes Enforcement Network), Mortgage Loan Fraud April 2008.
13. FinCEN <http://www.fincen.gov/MortgageLoanFraud.pdf> (Financial Crimes
Enforcement Network) Mortgage Loan Fraud November 2006.
14. Taub, Stephen, CFO Magazine. "Oxley: I'm Not Happy with
Sarbox"<http://www.cfo.com/article.cfm/8985156/1/c_4314618?f=alerts>April
6,2007.
15. Senior Supervisors
Group<http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf%20%20p3>of
the Bank of International Settlements Observations on Risk Management
Practices during the Recent Market Turbulence March 6, 2008.
16. Law Blog, "Mukasey Sums Up Mortgage Crisis: Enron or No
Enron?"<http://blogs.wsj.com/law/2008/06/06/mukasey-sums-up-mortgage-crisis-enron-or-no-enron>The
Wall Street Journal, June 6, 2008; pA1.
*George Pugh is president of George Pugh & Co, a New Jersey-based consulting
firm. He is a Certified Public Accountant, has an MA from The Paul H Nitze
School of Advanced International Studies (SAIS ) of The Johns Hopkins
University, and an MBA from Rutgers University. Prior to that, he was a
naval intelligence officer, brokerage auditor at PricewaterhouseCoopers, and
lending officer at HSBC and NatWest.*
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<div><strong>Fraud and the subprime bubble</strong> <br>By George Pugh </div>
<div> </div>
<div>Asia Times - July 24, 2008<br><br>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. <br>
<br>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. <br>
<br>The Sarbanes Oxley Act of 2002, with its supporting regulations, was supposed to curb fraud at the company level by improving<br><br> </div><span></span><span></span><span></span>
<div id="beacon_27" style="LEFT: 0px; VISIBILITY: hidden; POSITION: absolute; TOP: 0px"><img style="WIDTH: 0px; HEIGHT: 0px" height="0" alt="" src="http://asianmedia.com/GAAN/www/delivery/lg.php?bannerid=27&campaignid=23&zoneid=36&loc=http%3A%2F%2Fwww.atimes.com%2Fatimes%2FGlobal_Economy%2FJG24Dj03.html&referer=http%3A%2F%2Fwww.atimes.com%2F&cb=3f8baf4de7" width="0"></div>
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<img alt="" src="http://asianmedia.com/GAAN/www/delivery/avw.php?zoneid=36&cb=INSERT_RANDOM_NUMBER_HERE&n=a53e495a" border="0"></a></noscript> <br><br>internal controls and emphasizing management responsibility for accurate financial reporting: in that aspect it is a signal failure. <br>
<br><b>The subprime mortgage-based CDO</b><br>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. <br>
<br>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. <br>
<br>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. <br>
<br>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). <br>
<br>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] <br>
<br><b>Doing the math</b><br>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.
<blockquote>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:<br>
<li>The role of senior management oversight in assessing and responding to the changing risk landscape;
<li>The effectiveness of market- and credit-risk management practices in understanding and managing the risks in retained or traded exposures, and
<li>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] </li></li></li></blockquote>The key was management quality, which in this case turned on the ability to properly allocate capital and a solid understanding of market conditions.
<blockquote>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] </blockquote>
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.
<blockquote>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] </blockquote>
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. <br>
<br>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):
<blockquote>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] </blockquote>
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. <br>
<br>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.
<blockquote>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] </blockquote>
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. <br>
<br>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. <br>
<br><b>The subprime mortgage as an asset</b><br>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] <br>
<br>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] <br>
<br>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.
<blockquote>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. <br>
<br>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] </blockquote>
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:
<blockquote>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]</blockquote>
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.
<blockquote>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. <br>
<br>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] </blockquote>
The problem or question about getting timely information alone<br><br><span></span><span></span><span></span>
<div id="beacon_27" style="LEFT: 0px; VISIBILITY: hidden; POSITION: absolute; TOP: 0px"><img style="WIDTH: 0px; HEIGHT: 0px" height="0" alt="" src="http://asianmedia.com/GAAN/www/delivery/lg.php?bannerid=27&campaignid=23&zoneid=36&loc=http%3A%2F%2Fwww.atimes.com%2Fatimes%2FGlobal_Economy%2FJG24Dj04.html&referer=http%3A%2F%2Fwww.atimes.com%2Fatimes%2FGlobal_Economy%2FJG24Dj03.html&cb=942d00cb01" width="0"></div>
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<img alt="" src="http://asianmedia.com/GAAN/www/delivery/avw.php?zoneid=36&cb=INSERT_RANDOM_NUMBER_HERE&n=a53e495a" border="0"></a></noscript> <br><br>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.
<blockquote>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] <br>
<br>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] </blockquote>
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. <br>
<br>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. <br>
<br>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. <br>
<br><b>Who's to blame?</b><br>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:
<blockquote>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] </blockquote>
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. <br>
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. <br>
<br>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:<br>
<li>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.
<li>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. <br>
<br>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 <i>mens rea</i>, which ignoring the problem might.
<blockquote>... 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] </blockquote>
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. <br><br>The US Attorney General Michael Mukasey has issued a statement on the subject:
<blockquote>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] </blockquote>
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