And Some with a Fountain Pen: Mortgage Fraud, Securitization and the Subprime Bubble

Abstract

Fraudulent subprime loans are a thread that runs through the collapse of the subprime bubble. Starting with a subprime loan to finance a foreclosure rescue scheme, the paper traces the thread of mortgage fraud from origination by lender MILA through securitization by Goldman Sachs. The thread in this account ends with the creation of the collateralized debt obligations (CDO) that facilitated bets against mortgage backed securities (MBS) and the housing market. Mortgage fraud is defined to include predatory lending, predatory borrowing and loans that could reasonably be expected to be unsustainable at origination. Minsky’s model of financial instability provides the link between unsustainable/fraudulent loans and the subprime bubble. MILA and New Century, the second largest subprime originator and a source of greater depth, both adopted the industry standard originate-to-distribute model. Their emphasis on speed of approval versus verification for no down payment, stated income loans contributed to the exponential growth in misrepresentation and fraud associated with 2006 vintage subprime loans, the proximate cause of the subprime bubble collapse in 2007. Both lenders continued to originate unsustainable loans for Goldman Sachs in the face of mounting investor demands that they repurchase these loans and both were bankrupt in early 2007. Goldman Sachs warned investors of increased risk as subprime lending standards deteriorated at these and other originators but allowed this fact to be obscured with the imprimatur of triple-A ratings. The loan pools that Goldman Sachs securitized in 2005-2007 and sold to investors lost 35 percent of their value by 2010. Losses from unsustainable/fraudulent subprime loan defaults were magnified by the synthetic collateralized debt obligations used to bet against the housing market. The magnitude of fraudulent loss was sufficient to collapse the subprime bubble and initiate the subsequent financial meltdown.