Lending fraud: Have investors learned from the financial crisis?

A study soon to be published in the Journal of Economic Literature, authored by John Griffin of the McCombs School of Business at University of Texas - Austin, contends that there has been a consensus error of the role of fraud in the subprime mortgage crisis of 2007 (which of course morphed into the global financial crisis of 2008-09). In this paper, Ten Years of Evidence, Griffin reviews the literature, and considers the 11 legal settlements between banks and the U.S. Department of Justice. “A lot of academics think that conflicts of interest and fraud are things the media like to talk about, but they’re not of major economic importance,” Griffin said in a statement commenting on the formal paper. His research says the contrary. “Checks and balances are supposed to be in place, but a lot of them don’t work,” he added. Furthermore, Griffin concludes, there is a similar dynamic at work today and it may have analogous consequences. The possibility ought to make institutional investors wary of complicated securities with multiple intermediaries. Of course, COVID-19 caused a brief collapse in stock prices (February to March 2020). That was quickly reversed and stock prices are, as the year nears its end, higher than they were when it began. But this does not mean we are out of the woods. Griffin, answering an emailed question about the pertinence of his study in 2020, said, “The Fed is propping up asset prices making a disconnect between many financials and the true fundamentals.” From a fundamental point of view, we may be wandering deeper into the woods than we know. Looking back But let’s look back, with Griffin’s paper, at the first decade of this millennium. He contends that there were four pertinent types of offenders, in the critical bubble years 2003 - 06: loan originators (who misreported key financial information in 48% of the loans securitized by non-government agencies); appraisers (who regularly targeted their appraisals to exactly match loan amounts); investment bank underwriters (who in the settlements have admitted that they knowingly out false figures in prospectuses); and the credit rating agencies (who conveniently adjusted their ratings models to suit the bubble). Griffin observed that without the adjustments of the credit raters, some of the top-rated AAA securities would have fallen to BBB, barely investment grade. Griffin divided California, by zip code, into high-fraud and low-fraud areas. Then he looked at the bubble-ending collapse in realty values with the help of this division. In zip codes where fewer than 3% of the home loans involved fraud, values declined only 5%. But where more than 15% of the home loans involved fraud, average prices fell 45%. Looking forward Griffin believes that grave potential for lending fraud, and for fraud with serious consequences, remains very much with us. The greatest potential for fraud is no longer in the home mortgage market or derivatives based thereon. Now it is more likely to be commercial property mortgages or collateralized loan obligations. But the same conflicts of interest are still at work. As Griffin wrote in the conclusion of the study, “Although all of us had hoped history would not repeat the same mistakes, the conflicts of interest regarding underwriters, rating agencies, originators, and appraisers at the heart of 2003-2007 RMBS and CDO securitizations appear to be of a similar nature and an item of concern in other securitized [and] non-securitized markets even recently.” Pension managers beware A reporter asked Griffin what advice he might give to pension fund managers trying to preserve their value over the years ahead. He replied, “I would be careful of buying complex securities that rely on multiple intermediaries. These have the tendency for more fraud and misrepresentation.” Asked about hedge funds, as well as private equity and venture capital funds, Griffin said they were “not part of the structured finance lending fraud”. They may have been over levered, but “this was not a central feature of the last crisis”. Nor does he believe that they are analogously involved in the ongoing contemporary lending frauds. This might be considered a gold star of sorts for the alternatives space, though a star with a rather back-handed stroke. Meanwhile, Griffin’s message to economists and economic historians is that they should not underestimate the significance of fraud. They tend to treat it, he thinks, as a journalistic matter that averages itself out over long, or even medium-distance, hauls, and thus to neglect it in favor of macro-economic explanations. Yet the total costs of the 2007-09 financial crisis are estimated (by the GAO) at $22 trillion. No small thing on any human scale.

Lending fraud: Have investors learned from the financial crisis?

Continue Reading With a Free Trial

Christopher Faille

Continue Reading With a Free Trial

Christopher Faille

Be an Alts Watcher

Subscribe to our mailing list and know first!

Alternatives Watch Fund Formation survey to track manager trends

Blackstone to buy 2.3 million square foot medical lab near MIT

Related Articles

Marquette’s Kweku Obed on financial literacy and the search for yield that makes a difference

Connecticut taps K2 for HF risk mitigation strategy

Altimeter, Thiel buy SE Asia companies via SPACs

Maverix closes inaugural fund at $500m

Get our daily news digest in your inbox

Get our daily news digest
in your inbox