The FBI on the Trail of Accounting Fraud

TO LICINIUS

You'll do better, Licinius, not to spend your life
Venturing too far out on the dangerous waters,
Or else, for fear of storms, staying too close in
To the dangerous rocky shoreline.
That man does best
Who chooses the middle way, so he doesn't end up
Living under a roof that's going to ruin
Or in some gorgeous mansion everyone envies.
The tallest pine shakes most in a wind storm;
The loftiest tower falls down with the loudest crash;
The lightning bolt heads straight for the mountain top.
Always expect reversals; be hopeful in trouble,
Be worried when things go well. That's how it is
For the man whose heart is ready for anything.
It's true that Jupiter brings on the hard winters;
It's also true that Jupiter takes them away.
If things are bad right now, they won't always be.
Apollo isn't always drawing his bow;
There are times when he takes up his lyre and plays,
And awakens the music sleeping upon the strings.
Be resolute when things are going against you,
But shorten sail when the fair wind blows too strong.

--The Roman Poet Horace advising people to chose the golden mean

Last night, President Bush (9-24-08) addressed the nation about the financial crisis our country faces:

I know many Americans have questions tonight: How did we reach this point in our economy? How will the solution I've proposed work? And what does this mean for your financial future? These are good questions, and they deserve clear answers.

First, how did our economy reach this point?

Well, most economists agree that the problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions -- along with low interest rates -- made it easier for Americans to get credit. These developments allowed more families to borrow money for cars and homes and college tuition -- some for the first time. They allowed more entrepreneurs to get loans to start new businesses and create jobs.

Unfortunately, there were also some serious negative consequences, particularly in the housing market. Easy credit -- combined with the faulty assumption that home values would continue to rise -- led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.

Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages who had been planning to sell or refinance their homes at a higher price were stuck with homes worth less than expected -- along with mortgage payments they could not afford. As a result, many mortgage holders began to default.

These widespread defaults had effects far beyond the housing market. See, in today's mortgage industry, home loans are often packaged together, and converted into financial products called "mortgage-backed securities." These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.

The decline in the housing market set off a domino effect across our economy. When home values declined, borrowers defaulted on their mortgages, and investors holding mortgage-backed securities began to incur serious losses. Before long, these securities became so unreliable that they were not being bought or sold. Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled with large amounts of assets they could not sell. They ran out of the money needed to meet their immediate obligations. And they faced imminent collapse. Other banks found themselves in severe financial trouble. These banks began holding on to their money, and lending dried up, and the gears of the American financial system began grinding to a halt.

...The government's top economic experts warn that without immediate action by Congress, America could slip into a financial panic, and a distressing scenario would unfold:

More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. And if you own a business or a farm, you would find it harder and more expensive to get credit. More businesses would close their doors, and millions of Americans could lose their jobs. Even if you have good credit history, it would be more difficult for you to get the loans you need to buy a car or send your children to college. And ultimately, our country could experience a long and painful recession.

Fellow citizens: We must not let this happen. I appreciate the work of leaders from both parties in both houses of Congress to address this problem -- and to make improvements to the proposal my administration sent to them. There is a spirit of cooperation between Democrats and Republicans, and between Congress and this administration. In that spirit, I've invited Senators McCain and Obama to join congressional leaders of both parties at the White House tomorrow to help speed our discussions toward a bipartisan bill.

I know that an economic rescue package will present a tough vote for many members of Congress. It is difficult to pass a bill that commits so much of the taxpayers' hard-earned money. I also understand the frustration of responsible Americans who pay their mortgages on time, file their tax returns every April 15th, and are reluctant to pay the cost of excesses on Wall Street. But given the situation we are facing, not passing a bill now would cost these Americans much more later.

Many Americans are asking: How would a rescue plan work?

After much discussion, there is now widespread agreement on the principles such a plan would include. It would remove the risk posed by the troubled assets -- including mortgage-backed securities -- now clogging the financial system. This would free banks to resume the flow of credit to American families and businesses. Any rescue plan should also be designed to ensure that taxpayers are protected. It should welcome the participation of financial institutions large and small. It should make certain that failed executives do not receive a windfall from your tax dollars. It should establish a bipartisan board to oversee the plan's implementation. And it should be enacted as soon as possible.

In close consultation with Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and SEC Chairman Chris Cox, I announced a plan on Friday. First, the plan is big enough to solve a serious problem. Under our proposal, the federal government would put up to $700 billion taxpayer dollars on the line to purchase troubled assets that are clogging the financial system. In the short term, this will free up banks to resume the flow of credit to American families and businesses. And this will help our economy grow.

Second, as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back. [Full text]

It might be years before financial experts really understand what caused the current financial collapse, but Treasury Secretary Paulson is charged with fixing the problem right now.

The President seems to be saying that Americans were borrowing and lending recklessly because there was too much easy money; and now we can't borrow or end because there is suddenly no money.

Here's how my dad summed up the Great Depression: "There was no money."

I will never understand the complexities of the subprime mortgage crisis, but I do understand that I have to be able to afford my mortgage and that sometimes real estate goes down. Many borrowers, lenders, and lawmakers seem to have forgotten this.

It also seems to me that the people who lend money for mortgages should also have to shoulder the risk of their loans, but mortgage brokers get paid to make a loan and then sell these risky loans to someone else. The way the laws are now, we seem to have privatized the profits and socialized the risk.

One financial expert I spoke with believes that the subprime mortage crisis is the fault of the financial system and the housing bubble. In this view, criminals did not cause this crisis, although they may be taking advantage of the downturn in real estate.

The FBI (April 2008) also explains:

The downward trend in the housing market provides an ideal climate for mortgage fraud perpetrators to employ a myriad of schemes suitable to a down market. [See also the 9-29-08 comments of FBI official Kenneth Kaiser on the mortage crisis]

The subprime mortgage crisis has been brewing for a long time, and now the media coverage of Wall Street's meltdown has politicians on the hunt for criminals to scapegoat; however, the subprime mortage crisis is probably more the result of our laws than our frauds.

Back in January 2008, there were media reports that the FBI was investigating 14 companies suspected of accounting fraud, improperly securing loans, and insider trading. The New York Times (1-30-08) published an article publicizing the FBI investigations as did The Washington Times (1-30-08) and other newspapers.

In January, the FBI (1-31-08) also posted information about financial fraud and subprime mortgages. The FBI has a homepage for Mortgage Fraud. [For background about the FBI's investigations google FBI subprime; seach the FBI site for "subprime"]

Bloomberg (9-24-08) is now reporting:

The FBI is investigating Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc. and American International Group Inc. in its probe of the collapse of the subprime mortgage market, according to a senior law-enforcement official.

Those companies are among 26 being reviewed by the Federal Bureau of Investigation for possible accounting misstatements, said the official, who asked to remain unidentified. The investigations are preliminary, the official said late yesterday.

The FBI has come under pressure to hold companies responsible as the loan crisis rocked Wall Street and led to the biggest housing slump since the Depression. Financial companies worldwide have reported more than $500 billion in losses and writedowns stemming from the subprime collapse.

Housing lenders Freddie Mac and Fannie Mae, as well as insurer AIG, were all taken over by the government earlier this month. Lehman filed for bankruptcy. The crisis has led the Bush administration to ask Congress to approve a $700 billion bailout for the financial industry.

...The investigations of Fannie Mae and Freddie Mac were recently opened, said the law enforcement official. The agency had already been looking into allegations concerning Lehman and AIG.

...People familiar with the matter have said that other companies under FBI investigation include IndyMac Bancorp Inc. and Countrywide Financial Corp., which has since been bought by Bank of America Corp.

Back in January, The Washington Times (1-30-08) reported:

The FBI yesterday said its investigation into the subprime mortgage crisis is focusing on 14 companies suspected of accounting fraud, improperly securing loans and insider trading.

None of the companies involved were identified by the FBI, but Bear Stearns Cos., Goldman Sachs Group Inc. and Morgan Stanley separately acknowledged yesterday that government investigators were asking for information about their subprime lending practices.

Those acknowledgments were contained in annual reports the companies were required to submit yesterday to the U.S. Securities and Exchange Commission, although it was not clear last night if the SEC disclosures were directly related to the FBI probe. All three said they were cooperating with the government requests.

FBI officials said agents were looking into possible fraud during the many stages of mortgage securitization, adding that the ongoing investigation involved subprime lenders, housing developers and the many banks that packaged loans as securities.

"We're looking at the accounting fraud that goes through the securitization of these loans," said Neil Power, chief of the FBI's economic crimes unit. "We're dealing with the people who securitize them and then the people who hold them, such as the investment banks."

...FBI agents are working with officials from the Securities and Exchange Commission (SEC), which is involved in more than 30 investigations in the subprime mortgage business. The bureau usually focuses on mortgage fraud cases involving more than $500,000. It currently has more than 1,200 cases pending, up 50 percent in the past year.

...The "2006 Mortgage Fraud Report" said there was a "strong correlation between mortgage fraud and loans which result in default and foreclosure," adding that escalating foreclosures provided criminals with the opportunity to "exploit and defraud vulnerable homeowners seeking financial guidance."

The FBI said at the time that it was "proactively working with the mortgage industry" in an effort to curb mortgage fraud crimes...[Full text]

It's a good thing that the FBI is investigating mortage fraud, but the subprime mortgage crisis probably wasn't caused by criminals breaking the laws but by what the laws permitted.

Two thousand years ago the Roman poet Horace gave his countrymen good advice that America's borrowerers and lenders have forgotten today:

That man does best
Who chooses the middle way, so he doesn't end up
Living under a roof that's going to ruin
Or in some gorgeous mansion everyone envies.
The tallest pine shakes most in a wind storm;
The loftiest tower falls down with the loudest crash;
The lightning bolt heads straight for the mountain top.
Always expect reversals; be hopeful in trouble,
Be worried when things go well.