Lehman, Aurora, Liar’s Loans and Fraud

Bill Black testified before the House Committee on Financial Services today.  His entire statement is available here but I’m going to excerpt a huge chunk of it because it is astounding:

Lehman’s principal source of (fictional) income and real losses was making (and selling) what the trade accurately called “liar’s loans” through its subsidiary, Aurora. (The bland euphemism for liar’s loans was “Alt-A.”) Liar’s loans are “criminogenic” (they create epidemics of mortgage fraud) because they create strong incentives to provide false information on loan applications. The FBI began warning publicly about the epidemic of mortgage fraud in 2004 (CNN). Liar’s loans also produce intense “adverse selection” – even the borrowers who are not fraudulent will tend to be the least creditworthy. The combination of these two perverse incentives means that liar’s loans, in economics jargon, have a deeply “negative expected value” to the lender. In English, that means that the average dollar lent on a liar’s loan creates a loss ranging from 50 – 85 cents.
The value of Lehman’s Alt-A mortgage holdings fell 60 percent during the past six months to $5.9 billion, the firm reported last week.

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Gambling against the casino creates a negative expected value, but making liar’s loans creates inevitable, catastrophic losses.
That loss, however, may not be recognized for many years – particularly if the liar’s loans become so large that they help hyper-inflate a financial bubble. In the near-term, making massive amounts of liar’s losses loans creates a mathematical guarantee of producing record (albeit fictional) accounting income. (As long as the bubble inflates, the liar’s loans can be refinanced – creating additional fictional income and delaying (but increasing) the eventual loss. The industry saying for this during the S&L debacle was: “a rolling loan gathers no loss.”

Lehman’s underlying problem that doomed it was that it was insolvent because it made so many bad loans and investments. It hid its insolvency through the traditional means – it refused to

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http://www.denverpost.com/headlines/ci_10473057 “Local Lehman arm led in AltA loans.” By Greg Griffin The Denver Post. Posted: 09/16/2008 12:30:00 AM MDT 6

recognize its losses honestly. It could not resolve its liquidity crisis because it was insolvent and its primary source of fictional accounting income collapsed with the collapse of the secondary market in nonprime loans. If Lehman sold its assets to get cash it would have to recognize these massive losses and report that it was insolvent. Investors knew that Lehman was grossly inflating its asset values, so they were generally unwilling buy stock in Lehman or acquire it.

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E-mail from Frank Raiter to Richard Gugliada et al., March 20, 2001 http://oversight.house.gov/story.asp?ID=2250

There is no way to “manage” the “risk” of making massive amounts of liar’s loans. Lehman was the world leader in making liar’s loans. As the name makes clear, Lehman’s top managers knew that their principal source of income was making fraudulent loans. It was necessary, therefore, that Lehman not document that its liar’s loans were frequently fraudulent. Lehman, instead, classified its massively fraudulent liar’s loans as “prime” loans. Its disclosures did not identify how many of the “prime” loans it held were actually liar’s loans. As I will discuss in more detail in response to your final question, Lehman personnel that pointed out the fraudulent liar’s loans were attacked, even fired, by Lehman’s management. Honest managers, of course, would be delighted if employees identified frauds.
That same pattern of conscious managerial indifference to pervasive mortgage and accounting fraud was the norm at other nonprime mortgage participants that have been investigated. I refer to it as the financial “don’t ask; don’t tell” policy. Here is a classic example from Standard & Poors. The context is that the professional credit rating specialist has asked his boss for a copy of the “tapes” which contain the nonprime loan files that are the “underlying” backing a collateralized debt obligation (CDO). The professional plans to review a sample of the lender’s loan files so that he can evaluate their credit quality. Here is the response he receives (the punctuation is from the original).

Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.

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Making liar’s loans is not risky – it is suicidal. That is why every significant lender specializing in liar’s loans failed. The pervasive fraud cannot be admitted – for Lehman’s entire business model was premised on massive sales of liar’s loans to others. If Lehman admitted that its liar’s loans were often fraudulent it could not sell them – cutting off one of its largest sources of income. Worse, it would be stuck with a portfolio full of fraudulent loans and have to recognize (or hide through further accounting fraud) that it was insolvent. Worse still, if it admitted its liar’s loans were often fraudulent it would risk having to repay past purchasers of its liar’s loans and risk SEC suits and criminal prosecutions. This is why “risk management” is always a sham at firms holding liar’s loans. Risk management is premised on honest operations, honest data,
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and honest managers. Honesty is fatal to entities making, or purchasing, large amounts of liar’s loans.
Second, the right “tone at the top” is essential to effective corporate governance. Lehman’s managers too often created an unethical tone. The Valukus Report contains an example of this problem. When SVP Lee blew the whistle on accounting abuses, as he was required to do under Lehman’s employee policies, management responded by firing him.

Lehman is alleged to have treated another whistleblower in a similar fashion.

The HR lady pulled Michael Walker into a room and told him he was fired.

The reason: Talking to the FBI. It was a violation of the company’s privacy policy.

“I was stunned,” Walker told me. “I couldn’t believe it. But that’s what she said.”

Walker, a “high-risk specialist,” was then walked out of the building as if he were the risk. His job at Aurora Loan Services LLC, Littleton, Colo., ended on Sept. 4, 2008.

Aurora was a subsidiary of Lehman Brothers, the big, failing Wall Street investment bank that didn’t get a bailout. A week after Walker was fired, Lehman filed history’s biggest bankruptcy.

His job was to uncover mortgage fraud. But he claims he was fired for doing it. In a lawsuit recently filed in Denver District Court, he claims Lehman’s mortgage subsidiary wanted to remain profitably unaware of fraud.

Aurora made its loans through independent mortgage brokers, who often didn’t have to meet any criteria to be brokers, not even criminal background checks in some cases. Inevitably, some percentage of the mortgage applications they took would be laced with fraud. But like everyone else, they got paid by loan volume, not by loan quality.

Consequently, Walker and his fraud-seeking colleagues were always busy.

“They just absolutely flooded us with work,” he said. “There was no way we could possibly keep up with it. And that’s what they wanted.

“They were putting the loans into an investment trust,” he explained. “When they became aware of fraud, they had to buy those loans back out of the trust. So it ended up costing them money.”

What were the chances that Bob’s Fly-By-Night Mortgage Co. Would be able to return the funds it got from Aurora? What were the chances that the losses could be recovered through foreclosure? Better to let it ride.

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But Walker couldn’t play this game. A “Suspicious Activity Report” that he filed in 2006 led to interviews with the FBI and the IRS in 2008, and then ultimately to his bizarre dismissal.
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Walker endangered the fraud scheme that lay at the heart of Lehman’s (fictional) profitability because he violated the “don’t ask; don’t tell” rule and brought the FBI to Aurora’s offices. Control fraud turns everything that is normally good about private markets perverse. It creates a “Gresham’s dynamic” in which bad ethics drives good ethics from the marketplace.
The Walker case is stunning, but it is important to step back and see the contours of the forest. Any firm that specializes in making liar’s loans that it purchases from others (who are paid on the basis of volume and conducted no meaningful underwriting prior to lending) and sells to others without any meaningful underwriting will have a pervasive corrupt tone.

Lehman’s senior managers consciously chose to take the unethical path because they viewed it as extraordinarily profitable.

Mr. Hibbert was a vice-president at Lehman Brothers and he’d been sent to meet First Alliance founder Brian Chisick to see if Lehman could form some kind of relationship with the mortgage lender.

“This is a weird place,” he wrote later in an internal memo. While he noted the company’s “efficient use of their tools to create their own niche,” he also pointed out that “there is something really unethical about the type of business in which [First Alliance] is engaged.”

Mr. Chisick had become one of the biggest players in subprime loans. First Alliance’s annual revenue had doubled in four years to nearly $60-million (U.S.) and its profit had increased threefold to $30-million.

In his detailed report, he described the marketing operation as a “work of art” and marvelled at the profit margin, cash flow, collection practices and growth prospects of First Alliance.

But Mr. Hibbert also had some concerns. The company targeted too many elderly customers; he had seen several 30-year loans given to people in their 70s. “It is a sweat shop,” he wrote. “High pressure sales for people who are in a weak state.” First Alliance is “the used car salesperson of [subprime] lending. It is a requirement to leave your ethics at the door. … So far there has been little official intervention into this market sector, but if one firm was to be singled out for governmental action, this may be it.”

At this juncture, various state Attorneys General began to sue First Alliance for consumer fraud. Prudential terminated its ties with the lender.

But Lehman jumped at the opportunity to move in. Senior vice-president Frank Gihool asked Mr. Hibbert to pull together a review of First Alliance for Lehman’s credit risk management team. Mr. Hibbert once again marvelled at the company’s operations and financial outlook. But he also said the lawsuits posed a serious problem. The allegation about deceptive practices “is now more than a legal one, it has become political, with public relations headaches to come,” he wrote.

Nonetheless, on Feb. 11, 1999, Lehman approved a $150-million line of credit, and became the company’s sole manager of asset-backed securities offerings. The bottom line for Lehman was made clear in another internal report: The firm expected to earn at least $4.5-million in fees.

But within a year, the weight of the lawsuits crippled First Alliance. On March 23, 2000, the company filed for bankruptcy protection. Mr. Chisick managed to walk away with more than $100-million in total compensation and stock sales over four years. Lehman, owed $77-million, collected the full amount, plus interest.

First Alliance eventually settled the lawsuits filed by the state attorneys, agreeing to pay $60-million. In the California class-action case, a jury found Lehman partially responsible for First Alliance’s conduct and ordered the firm to pay roughly $5-million.

Lehman acquired Aurora to be its liar’s loan specialist. Aurora, which was inherently in the business of buying and selling often fraudulent loans, set its ethical tone at subterranean levels.

Mark Golan was getting frustrated as he met with a group of auditors from Lehman Brothers.

It was spring, 2006, and Mr. Golan was a manager at Colorado-based Aurora Loan Service LLC, which specialized in “Alt A” loans, considered a step above subprime lending. Aurora had become one of the largest players in that market, originating $25-billion worth of loans in 2006. It was also the biggest supplier of loans to Lehman for securitization.

Lehman senior management, however, responded to problems of fraud and unethical behaviour by cranking up the volume of liar’s loans by Aurora and BNC Mortgage (which specialized in subprime loans).

Lehman had become the only vertically integrated player in the industry, doing everything from making loans to securitizing them for sale to investors.

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Lehman was a dominant player on all sides of the business. Through its subsidiaries – Aurora, BNC Mortgage LLC and Finance America – it was one of the 10 largest mortgage lenders in the U.S. The subsidiaries fed nearly all their loans to Lehman, making it one of the largest issuers of mortgage-backed securities. In 2007, Lehman securitized more than $100-billion worth of residential mortgages.

These demands posed a much larger problem: contagion. Because these CDOs were thinly traded, many of them did not yet reflect the loss in value implied by their crumbling mortgage holdings. If Bear Stearns or its lenders began auctioning these CDOs off, and nobody wanted to buy them, prices would plummet, requiring all banks with mortgage exposure to begin adjusting their books with massive writedowns.

Lehman, despite its huge mortgage exposure, appeared less scathed than some. Mr. Fuld was awarded $35-million in total compensation at the end of the year.

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Despite the warning, Lehman officials recommended a $100-million loan facility for First Alliance. Mr. Chisick turned it down, but he agreed to take a $25-million line of credit and hire Lehman to work with Prudential on several securitizations.
First Alliance was now set. It went public a year later on Nasdaq at $17 a share, with Mr. Chisick keeping 75-per-cent control. The stock hit $27 by year end and peaked at $36.25 shortly afterward. Mr. Chisick opened two dozen offices across the U.S., and made other expansion plans. By 1997, First Alliance was on track to arrange more than $500-million worth of loans, up from $324-million a year earlier.

 

Lehman had acquired a stake in Aurora in 1998 and had taken control in 2003. By May, 2006, some people inside Lehman were becoming worried about Aurora’s lending practices. The mortgage industry was facing scrutiny about billions of dollars worth of Alt-A mortgages, also known as “liar loans”– because they were given to people with little or no documentation. In some cases, borrowers demonstrated nothing more than “pride of ownership” to get a mortgage.
That spring, according to court filings, a group of internal Lehman auditors analyzed some Aurora loans and discovered that up to half contained material misrepresentations. But the mortgage market was growing too fast and Lehman’s appetite for loans was insatiable. Mr. Golan stormed out of the meeting, allegedly yelling at the lead auditor: “Your people find too much fraud.”

Volume of liar’s loans and subprime was everything – as long as Lehman could sell the liar’s loans to other parties. Volume created immense real losses, but it also maximized Mr. Fuld’s compensation.
Aurora was originating more than $3 billion a month of such loans in the first half of 2007.

 

Lehman’s real estate businesses helped sales in the capital markets unit jump 56 percent from 2004 to 2006, faster than from investment banking or asset management, the company said in a filing. Lehman reported record earnings in 2005, 2006 and 2007.

The role of the SEC as Lehman’s primary regulator in oversight, examination and enforcement in advance of Lehman’s bankruptcy filing, and the role of the other government agencies, including the Federal Reserve Bank of New York (FRBNY), that were monitoring Lehman during the crisis.
Consolidated Supervised Entities (CSE) program never made the SEC a real “primary regulator.” The SEC is incapable, as constituted, staffed, and led to be a primary regulator of anything – and that includes the rating agencies. “Safety and soundness” regulation is a completely different concept than a “disclosure” regime. The SEC’s expertise, which it has allowed to rust away for a decade, is in enforcing disclosure requirements. The SEC did not have the mindset, rules, or appropriate personnel to make the CSE program a success even if the agency had been a “junk yard dog.” Given the fact that the SEC was self-neutered by its leadership during the period Lehman was in crisis in 2001-2008, there was no chance that it would succeed. Its only hope was to form an effective partnership with the Fed. The Fed had unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to regulate all mortgage lenders and had unprecedented practical leverage during the crisis because of its ability to lend and convert investment banks to commercial bank holding companies. The Fed is supposed to be an experienced “safety and soundness” regulator (though I will express doubts that it is effective). An SEC/Fed partnership would at least have some chance. The Valukas report reveals that the FRBNY staff at Lehman recognized that the SEC staff at Lehman’s offices were not capable of understanding its financial condition.

The relationship and means of communication, especially formal and informal information sharing, between the SEC and FRBNY as Lehman’s financial condition deteriorated as well as between Lehman, the SEC, the Treasury Department, the Board of Governors Federal Reserve, and the FRBNY.

It was a painful, as a former regulator, to read the Valukas report’s discussion of the FRBNY staff’s open disdain for working cooperatively with the SEC to protect the public. The Valuka
report exposes the sick relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing. The FRBNY, led by President Geithner, had a clear statutory mission — promote the safety and soundness of the banking system and compliance with the law – stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a “three card monte routine” (p. 1470).

 

The FRBNY discounted the value of Lehman’s pool to account for these collateral transfers. However, the FRBNY did not request that Lehman exclude this collateral from its reported liquidity pool. In the words of one of the FRBNY’s on
site monitors: “how Lehman reports its liquidity is between Lehman, the SEC, and the world” (p. 1472).

Translation: The FRBNY knew that Lehman was engaged in fraud designed to overstate its liquidity and, therefore, was unwilling to loan as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS (which regulated an S&L that Lehman owned) of the fraud. The Fed official doesn’t even make a pretense that the Fed believes it is supposed to protect the public. The FRBNY remained willing to lend to a fraudulent systemically dangerous institution (SDI). This is an egregious violation of the public trust, and the regulatory perpetrators must be held accountable. The Fed wanted to maintain a fiction that toxic mortgage product were simply misunderstood assets, so it allowed Lehman to keep dealing the three card monte scam. We now know from Valukas and from former Treasury Secretary Paulson that the Treasury and the Fed knew that Lehman was massively overstating its on-book asset values: “According to Paulson, Lehman had liquidity problems and no hard assets against which to lend” (p. 1530). We know from Valukas’ interview of Geithner (p. 1502):

The challenge for the Government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in “collateral damage” by demonstrating weakness and exposing “air” in the marks.

Or, in plain English, the Fed didn’t want Lehman and other SDIs to sell their toxic assets because the sales prices would reveal that the values Lehman (and all the other SDIs) placed on their toxic assets (the “marks”) were inflated with worthless hot air. Lehman claimed its toxic assets were worth “par” (no losses) (p. 1159), but Citicorp called them “bottom of the barrel” and “junk” (p. 1218). JPMorgan concluded: “the emperor had no clothes” (p. 1140). The FRBNY acted shamefully in covering up Lehman’s inflated asset values and liquidity. It constructed three, progressively weaker, stress tests – Lehman failed even the weakest test. The FRBNY then allowed Lehman to administer its own stress test. Surprise, it passed.
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Criminologists refer to entities that spread fraud epidemics as “vectors” (continuing the public health metaphor, the anopheles mosquito is a “vector” that spreads malaria and can create epidemics). Lehman was one of the largest vectors that spread the fraud epidemic. We must not focus only on what bad assets it held in portfolio at a particular time. If Lehman, for example, had sold more of its “alt a” loans earlier its losses would, of course, have been reduced but system losses on liar’s loans would be unchanged. If Lehman had sold large amounts of “alt a” loans at an earlier date to Fannie and Freddie, for example, it might have caused them to collapse at an earlier date with even greater losses. This might have set off an even worse global crisis. The Fed, due to its unique HOEPA authority, and the SEC, because it has jurisdiction over every publicly traded company, were the only entities that could have shut down the vectors spreading the fraud epidemic. This should have been there most important priority. They had ample warnings of the epidemic of liar’s loans and the fact that it was spreading rapidly. Lehman, Citi, WaMu, Indymac, and Bear Stearns were on everyone’s list of the worst vectors, yet the Fed and the SEC took no effective action until after virtually every major originator of liar’s loans had failed. It would be as if the Public Health Service waited to start killing mosquitoes until 2.5 million Americans had died of malaria over the course of a decade.
It is critical to understand that making liar’s loans required multiple frauds by multiple parties. Because liar’s loans create an intensely criminogenic environment, they produce fraud epidemics. Because liar’s loans also create severe adverse selection, they inherently have a negative expected value. It’s easy to put that in English. When Aurora (Lehman’s firm that specialized in making liar’s loans) made a $400,000 liar’s loans they created annual (fictional) accounting income of perhaps $50,000. They also created a real loss of $200,000 – $300,000. If Lehman sold the $400,000 liar’s loan to another company for $410,000, Lehman created a (real — but likely fraudulent) gain of $10,000. This, however, simply increased the purchaser’s eventual loss to $210,000 – $310,000. Whatever entity purchased the liar’s loan (directly or via a CDO) owned an asset with massive real losses (50% – 85%). Assume a realistic hypothetical. Fannie purchases $60 billion in liar’s loan paper from Lehman. The liar’s loans are really worth $20 billion, so Fannie has just suffered a real $40 billion loss. Ask yourself: will Fannie’s senior officers recognize this loss? If they do, Fannie will report that it is massively unprofitable and insolvent. The senior officers will not get their bonuses and will almost certainly be fired. Not a hard decision for Fannie’s senior leadership.

 

 

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4 thoughts on “Lehman, Aurora, Liar’s Loans and Fraud

  1. My Loan was funded by Lehman Brothers and my loan never even made it to the trust they sold my loan so many times each time they did this no one did what they were supposed to do the servicer of the loan JP CHASE was collecting money from me every month that they never had a right to even collect then even though I never found out about the fraud until 2014 the law firm for the bank when trying to foreclose is a third party debt collection firm who I believe only get paid in the event anxiety that my house sells this way which I will not stop proving my case I have went from a heathy mother of four to someone who has severe anxiety depression from them putting me threw this they should all be punished for doing this to someone where is a lawyer out there in this world who helps people who are not of any means to pay a lawyer thousands of dollars but has a case that is worth millions because they all are doing this to my family I think seven years of this is worth a lot I don’t even care about the money I care about my home and justice for the people who are put threw this just because nobody wants to admit that they have committed fraud on the court fraud paperwork and robo signers there is so much fraud it makes me sick. Reading stuff like this makes me even sicker that I am the person who they did this to if I was never supposed to get the loan then why should a broker even get away with this what is wrong with people this world is a horrible place. There has been times I actually feel like not even living anymore because of all this and the way your passed around when your trying to fight is even more horrible who protects these homeowners

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  2. I asked Aurora for a certified copy of my note. They sent me a signed copy but not certified by Notary Public as true copy of the original. They escalated my payments what other recourse do I have? thanks, fadi

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  3. I have two loans with aurora both investment propertys. Each of these propertys are worth 25% and have been waiting for short sale approval for almost 18 months. Let me know if you need more info

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