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Sat Jul 19 08:26:03 PDT 2008

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&#39;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, <a href="http://en.wikipedia.org/wiki/Collateralized_debt_obligation">Collateralized debt obligation</a>. &gt; 2. Senior Supervisors Group of the Bank of International Settlements Observations on Risk Management Practices during the Recent Market Turbulence March 6, 2008. 
&gt; 3. ibid p10 &gt; 4. ibid p14 5. ibid p14 6. ibid p15 7. Mark S Joshi: <a href="http://www.quarchome.org/tranchedimportance.pdf">Applying Importance Sampling to Pricing Single Tranches of CDOs in a one-factor Li Model</a>. 
&gt; 8. Lucchetti, Aaron. <a href="http://online.wsj.com/article/SB120783282351804761.html">&quot;Rating Game: As Housing Boomed, Moody&#39;s Opened Up&quot;</a>, The Wall Street Journal, April 11, 2008, pA1. 9. ibid 
10. <a href="http://online.wsj.com/article/SB120783282351804761.html">&quot;Interview Excerpts: Moody&#39;s Executives Ratings Agency&#39;s Clarkson, McDaniel: &#39;We Make Assumptions With Losses&#39;&quot;</a>, Wall Street Journal, April 11, 2008. 
11. Pulliam, Susan; Ng, Serena; Smith, Randall. <a href="http://online.wsj.com/article/SB120830730844618031.html">&quot;Merrill Upped Ante as Boom In Mortgage Bonds Fizzled Fresh $6 Billion Hit Is Expected as Toll&quot;</a>, The Wall Street Journal, April 16, 2008; pA1. 
12. <a href="http://fincen.gov/MortgageLoanFraudSARAssessment.pdf">FinCEN</a> (Financial Crimes Enforcement Network), Mortgage Loan Fraud April 2008. 13. <a href="http://www.fincen.gov/MortgageLoanFraud.pdf">FinCEN</a> (Financial Crimes Enforcement Network) Mortgage Loan Fraud November 2006. 
14. Taub, Stephen, CFO Magazine. <a href="http://www.cfo.com/article.cfm/8985156/1/c_4314618?f=alerts">&quot;Oxley: I&#39;m Not Happy with Sarbox&quot;</a> April 6,2007. 15. <a href="http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf%20%20p3">Senior Supervisors Group</a> of the Bank of International Settlements Observations on Risk Management Practices during the Recent Market Turbulence March 6, 2008. 
16. Law Blog, <a href="http://blogs.wsj.com/law/2008/06/06/mukasey-sums-up-mortgage-crisis-enron-or-no-enron">&quot;Mukasey Sums Up Mortgage Crisis: Enron or No Enron?&quot;</a> The Wall Street Journal, June 6, 2008; pA1. 
 George Pugh is president of George Pugh &amp; 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. </li>
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