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Elliott Morss | December 18, 2014

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JP Morgan Revisited – When Is Fraud Really Fraud?

JP Morgan Revisited – When Is Fraud Really Fraud?
© Elliott R. Morss, Ph.D.

Introduction

In a previous post on the pending $13 billion JP Morgan (JPM) settlement with the Justice Department, I pointed out that:

  • $13 billion is a lot of money;
  • JPM can afford the best lawyers in the world, and
  • Those lawyers would not tell JPM to settle unless there was “solid evidence” of fraud.

I then questioned whether the buying and selling of mortgage packages could constitute fraud/solid evidence when they buyers and sellers were all quite knowledgeable and “playing the same game”. Fraud is defined as “deceit or trickery perpetrated for profit”. But what if both parties to an alleged fraud know what is up? That is, they all knew there were very risky mortgages in the packages they were buying and selling. That led me to question what evidence the Justice Department has that is so definitive that JPM would settle for $13 billion. In this article, I present some data on evidence and discuss what it means.

Key Players

Before proceeding to the evidence, let’s look at who writes mortgages, and those buying/repackaging mortgages. There are two types of mortgage writers: those with their own money and those that must sell off their mortgages (mortgage companies). Banks have their own money (deposits) as do private equity, hedge, and other funds. In contrast, mortgage companies don’t have their own money and are dependent on their being buyers for the mortgages they write. It turns out the vast majority of mortgages originated in banks  are not held by the banks that originated them but are instead securitized and sold as securities to investors.

So both the banks and the mortgage companies use the same financial model: earn commissions by selling off mortgages they write. One can draw two inferences from such a model:

  • Banks won’t care as much about the quality of the mortgages as they would if they planned to hold them to maturity;
  • A certain amount of misrepresentation can be expected when the banks sell off mortgages and mortgage packages.

So who are the buyers? Back in 2005-2007, the biggest buyers were the Feds – Freddie Mac and Fanny Mae who both work under the Federal Housing Finance Agency (FHFA) umbrella. Under law, they are not allowed to purchase mortgages or mortgage packages that do not have well-documented income with upper limits on mortgage size based on income. So what happened? The Feds ended up buying high-risk packages and according to news reports, are only now are suing for misrepresentation.

An Aside

It is hard to believe the Feds did not know what they were getting at the time. One would hope they were doing some sampling of the packages they were buying to insure they were as represented. Maybe not. But I just cannot imagine working for one of these agencies where all you were doing was buying this stuff and not asking what you were getting. I return to this point later.

Evidence

And there is more evidence of misrepresentation. An astute commenter on my previous JP Morgan piece alerted me to an article by William Black that in turn cited concrete evidence of the only fraud data I have seen. The piece, by Piskorski, Seru, and Witkin[1] (PSW) identifies two types of misrepresentation. I quote from PSW: “More than 6% of mortgage loans reported for owner-occupied properties were given to borrowers with a different primary residence, while more than 7% of loans (13.6% of loans using a broader definition) stating that a junior lien is not present actually had such a second lien. Alternatively put, more than 27% of loans obtained by non-owner occupants misreported their true purpose and more than 15% of loans with closed-end second liens incorrectly reported no presence of such liens.”

Legally I suppose it does not matter whether both sides are aware of the misrepresentation: a misrepresentation is a misrepresentation and will stand up in court. Interestingly, PSW have data on the misrepresentations they turned up for the largest banks (Table 1).

Table 1. – Misrepresentations by Major Banks

Source: “Asset Quality Misrepresentation by Financial Intermediaries: Evidence from the RMBS Market”, February 2013,

Columbia Business School Research Paper No. 13-7. Available at SSRN.

From Table 1, it is clear that Lehman Brothers was in a class by itself on misrepresentations. But when the misrepresentations of the financial firms acquired by Bank of America (BAC) and JPM are included, JPM tops the list. However, the precedents for misrepresentation suits are increasing. That means Barclays (BCS), HSBC (HBC), Citigroup (C), Deutche Bank (DB), UBS (UBS), Nomura (NMR), RBS (RBS), and Morgan Stanley (MS) can also expect misrepresentation lawsuits soon. And it won’t just be the Feds initiating lawsuits. Other levels of government and private firms are watching the growth of precedents with great care.

It should be noted that the misrepresentations that PSW picked up could well be the “tip of the iceberg”. PSW: “Note, however, that because we look only at two types of misrepresentations, this number likely constitutes a conservative, lower-bound estimate of the fraction of misrepresented loans.”

It is quite likely that even greater misrepresentations were made by mortgage writers on borrowers’ income and by assessors on real estate values. And misrepresentations on these items could also constitute grounds for legal actions. And there are real grounds for damages. For example PSW pointed out that on the misrepresentations uncovered, delinquencies were 60% higher “when compared to otherwise similar loans”.

Were Both Parties to These Transactions Aware of the Risks?

PSW: “Lenders seem to be partly aware of this risk, charging a higher interest rate on misrepresented loans relative to otherwise similar loans, but the interest rate markup on misrepresented loans does not fully reflect their higher default risk”.

In a recent piece commenting on PSW, three authors[1] associated with the Federal Reserve Bank in Atlanta contend the misrepresentations had little effect on investors’ decisions and hence had little economic impact. In essence, the Fed authors suggest what I have suggested above: the buyers and sellers of mortgage packages were all in on the “game”. To document their point, the Fed authors obtained forecasts from some of the buyers of the packages and found they turned out to be quite accurate. They offered two reasons for this:

  • The investors were properly skeptical of any information they couldn’t verify, so they rationally assumed that there was some misrepresentation going on.
  • This lack of trust led investors to base their forecasts on the historical performance of the loans.

So most of the players knew or sensed what was happening and they went along with it. However, in a court of law, evidence of misrepresentation usually holds up.

Conclusions

What should be drawn from all of this? My conclusion: focus on incentives: as long as income can be made from misrepresentations, misrepresentations will be made. As long as banks can earn most of their income from selling of loans for commissions, they will worry more about earning commissions than the quality of the loans they make.

The solution: require banks to hold all the loans they make to maturity. Bankers should not be allowed to gamble with depositors’ money.

Black, in the article referenced above, takes the incentive issue a step further. He says: “The key is that the officers who control the banks do not have skin in the game – they can loot the banks they can control and walk away wealthy….” Agreed and there are only two ways to deal with this:

  • Don’t allow the officers to sell off loans;
  • Start prosecuting the officers as criminals.



[1] Paul Willen, Chris Foote, and Kris Gerardi “Asset-Quality Misrepresentation as a Factor in the Financial Crisis”, Federal Reserve Bank of Atlanta, June 2013.




[1] Tomaz Piskorski, Amit Seru, and James Witkin, “Asset Quality Misrepresentation by Financial Intermediaries: Evidence from the RMBS Market”, February 2013, Columbia Business School Research Paper No. 13-7. Available at SSRN.

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