Mortgage Servicing Fraud
occurs post loan origination when mortgage servicers use false statements and book-keeping entries, fabricated assignments, forged signatures and utter counterfeit intangible Notes to take a homeowner's property and equity.
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NEW YORK/TORONTO - Eric Hibbert felt uneasy when he toured First Alliance's head office in Irvine, Calif., in July, 1995.

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.

Mr. Chisick didn't need Lehman. He already had Prudential Securities buying the company's loans and securitizing them.

The rise and fall of Lehman Brothers

But Mr. Hibbert was on a mission. Lehman had gone public just a few months earlier, after being spun off from American Express Co. New chief executive Richard Fuld, a New Yorker who had been with Lehman since 1966, was determined to diversify and to refashion the firm as a global powerhouse.

“The Gorilla” was known for his relentless style: He told everyone he bled green, the company's colour. The night he was handed the reins, he had a massive panic attack, and stopped breathing for 45 seconds.

Lehman's influence had dissipated in recent years, and it was mostly known as a bond house, reliant on fixed-income trading for much of its business. But Mr. Fuld set out to change that, steering Lehman deeper into investment banking businesses. Thanks to the regulatory changes in the 1980s, and the advent of securitizing loans, the mortgage market looked like another solid source of new revenue for the firm. Even Mr. Fuld, however, could not have imagined just how lucrative that market would become – or how perfect his timing was.

Although subprime lending had begun to take off in the ‘80s, it was still a sliver of the housing market, populated by small consumer-finance companies like First Alliance. But by 1994, when Lehman was preparing to go public, the Federal Reserve Board increased interest rates, and the number of credit-worthy borrowers looking to buy a home – or refinance an existing mortgage – began to plummet. Banks looking to maintain their loan volume began swimming downstream, looking to lend to people with increasingly sketchy credit scores.

At the same time, a handful of changes were percolating in the financial world that would collide with this renewed emphasis on subprime borrowers, creating a mutually reinforcing trend that would completely remake the U.S. housing business over the following decade.

Although some investment banks had dabbled in mortgage-backed securities in the late 1980s, it wasn't until the mid-1990s that they really caught fire. For one thing, the collapse of Drexel Burnham Lambert, the trading empire helmed by junk-bond king Michael Milken, resulted in a deterioration of the high-yield bond market.

That left large investors in search of other ways to generate above-average returns.

Wall Street's answer was the collateralized debt obligation (CDO) – a product which could pool together thousands of assets, including mortgages of varying quality, and then slice these pools into different chunks, the cash flow of which could be sold to investors. At the same time, major brokerages like JPMorgan were pioneering a new kind of complex derivative known as a credit default swap – basically, an insurance policy that would protect investors if the loans in which they invest go into default.

The rise of these two products would revolutionize the securitization market. Soon, rather than filling these CDOs with mortgages, bankers began stuffing them with credit default swaps. Instead of transferring real assets, the banks were merely transferring risk. And they were doing so through a mind-bendingly large and complex network of investors and counterparties spread around the world.

This new form of security, dubbed a synthetic CDO, was viewed as an easier way for lenders to hedge their exposure to potentially troubled borrowers. But more importantly, thanks again to financial wizardry, its structure made it much easier to obtain high ratings from credit rating agencies. This was the final piece of the puzzle in jump starting the subprime market: Even if pension and hedge funds didn't quite understand the product, they were free to buy it because the rating agencies had conferred their blessings.

While the permutations of all these products were complex, the effects were simple enough. In 1995, when Lehman began dipping its toe in the water, total CDO issuance was about $2.5-billion. Within four years, it would reach $120-billion.

The subprime market moved in near perfect lockstep. In 1994, there was $35-billion in subprime mortgages in the United States, about 5 per cent of the market. But by 1999, that figure would swell to $160-billion, or roughly 13 per cent of all home loans.

By packaging loans in these fancy products and selling them to investors, lenders freed up money to make more loans. The increase in loans created more home buyers, or home refinancings, which in turn boosted home prices across the country, creating a destructive circle. As long as housing prices continued to climb, consumers could be induced to take out bigger loans against their rising equity.

With the derivative market beginning to develop, and subprime lending poised to push into the mainstream, Wall Street saw an opportunity to revive its profitability, which had ebbed amid the recessions and financial crises of the 1980s.

So began a feeding frenzy in the mortgage markets, a race to the bottom of the credit heap in which originators like Mr. Chisick were induced to sell as many mortgages as possible, however they could; in which major banks, hungry for fee revenue, passed on mortgages with clear risks of default; and in which investors, blinded by their zeal for better returns, placed their trust in credit rating agencies without understanding the complexity of the securities they were buying.

It was an elaborate game of passing the buck. And it was a game on which Lehman and other banks were about to stake their reputations – and, in some cases, their very existence.

Not long after Lehman went public in 1994, Mr. Fuld, following in the footsteps of some larger rivals, hired a pair of managers from Prudential Securities to help crack this burgeoning business of mortgage-backed securities. One of them was familiar with First Alliance, and dispatched Mr. Hibbert to check it out.

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.”

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.

And then came Tom James. A lawyer in the consumer fraud bureau of the Illinois state attorney general, he was working out of a store-front office in Chicago's South Side when someone walked in with loan documents from First Alliance and asked him to take a look. “It just jumped off my radar screen,” Mr. James recalled.

He was astonished by the fee schedule and various triggers that jacked up the interest rate every six months. He made a few calls, and learned that 35 complaints had been filed against First Alliance across the city. He decided to file a suit.Within months, a co-ordinated action was launched against First Alliance in Illinois, Minnesota and Massachusetts, and several other state regulators were also investigating. A class-action suit by a group of First Alliance customers was filed in California; by the end of the year, the company was facing hundreds of lawsuits.

Mr. Chisick fought back, filing a host of counterclaims. But the lawsuits began to affect the company. On Dec. 23, 1998, Prudential terminated its financial dealings with First Alliance, citing, in part, the “legal issue.”

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.

The demise of First Alliance didn't slow down Lehman's mortgage operations. By the time Mr. Chisick had gone under, Lehman had snapped up several such companies, including BNC Mortgage Inc. and Aurora Loan Services. Other Wall Street players, including JPMorgan, Citigroup and Bear Stearns, also packaged and sold the asset-backed securities, but Lehman had become the only vertically integrated player in the industry, doing everything from making loans to securitizing them for sale to investors.

Although the lending market was buffeted somewhat by the Asian and Latin American financial crises toward the late 1990s, the subprime sector continued to grow, buoying housing prices with it. Indeed, in 1999 it received another boost. On the last day before the Christmas holidays that year, U.S. law makers led by Senator Phil Gramm – a champion of deregulation – proposed an 11th-hour bill known as the Commodities Futures Modernization Act.

The 262-page bill, tucked into an 11,000-page government reauthorization bill, largely escaped the attention of Congress. But it contained a crucial change. Credit default swaps, those complex insurance products that protected investors in CDOs and other securities, would not only be legal under the proposed law – they would be allowed to trade off of exchanges and thus beyond regulatory scrutiny.

Once credit default swaps were legal, anyone could use them to make a bet on the housing market, kind of like gambling on a sporting event in which you have no personal involvement. Thousands of people might make a bet on a CDO issued by a bank to a handful of investors, magnifying the damage of a collapse in the housing market.

Thanks to this 11th-hour bill, default swaps ballooned from $632-billion in 2000 to a staggering $57.3-trillion as of June, 2008, according to the Bank of International Settlements.

Here was ample fuel for the ignition of the “shadow” banking system, whose labyrinthine, unsupervised workings would ultimately bring Wall Street – and much of the global economy – to its knees.

THE CONTAGION SPREADS

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 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.”

By any measure, the housing market had exploded. Sales of newly constructed homes more than doubled from 1995 levels and the value of all residential mortgages sold had risen fivefold to $3.3-trillion. The amount of Alt A lending had jumped from less than $20-billion in 2001 to $300-billion in 2006. And the market for subprime loans had soared to $625-billion from $210-billion.

Buyers and lenders were helped by historically low interest rates. Alan Greenspan, the long-serving chairman of the Federal Reserve, lowered rates after the collapse of the tech bubble, and continued to lower them after the attacks of September 11, 2001. He has since acknowledged that he missed signals of an overheating market.

Competition among lenders ratcheted up. In their drive for market share, lending standards eased and more new mortgage products emerged. Borrowers could put down next to nothing and get a mortgage, or even two. Such “piggy-back loans” became popular in cities like Las Vegas where home prices were particularly high.

Borrowers flocked to mortgages with “teaser” rates. These required no down payment and typically included a low interest rate for two years, but then reset at much higher.

Most mortgage holders understood that payments would shoot up by roughly 40 per cent on the reset date. But they were told that didn't matter; as long as prices continued to rise, they could refinance or sell the property.

Mortgages were available to people with credit scores so low their only hope of buying a house previously had been with the help of a government lending program. As Credit Suisse analyst Ivy Zelman put it: In 2006, “anybody with a pulse that was interested in buying a home was able to get financing.”

All of this buying propelled Wall Street firms to record earnings, as the market for mortgage-backed securities increased to $628-billion from $73-billion in 2000.

Credit rating agencies helped investment firms structure products so they'd secure Triple A ratings, and earned massive fees for their role. Combined annual revenue for the three largest agencies doubled to more than $6-billion between 2002 and 2007.

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.

But cracks began to show. In 2006, mortgage rates ticked upward as the Federal Reserve rate rose above 5 per cent. That put pressure on borrowers facing resets on mortgages they had taken out two years earlier when the housing market peaked.

Lenders, including Aurora, began laying off workers. Countrywide reported payments were late on 19 per cent of its subprime loans, nearly double the number two years before.

The day after Christmas, 2006, the closely-watched S&P/Case-Shiller index of U.S. home prices reported that following years of steady increases, the housing engine upon which so many had staked their future – from ordinary Americans to banks, brokerages, investors, and even government – had suddenly stalled.

Within a month, home values were in freefall, dropping the most in a decade.

For years, Wall Street had turned a deaf ear to warnings that the housing market could collapse, wreaking a path of devastation throughout the economy. Finally, the evidence of that collapse was becoming too big to ignore.

THE MAN WHO RESCUED LEHMAN

On the morning of June 20, 2007, some of the country's most powerful investment banks began to panic. For several months, they had watched home prices fall and foreclosures begin to soar. A month before, Swiss banking giant UBS AG had been forced to close an in-house hedge fund that bet on the mortgage market. Now, rumours flew that two hedge funds managed by Bear Stearns had run into serious trouble.

Both had borrowed huge amounts of money, estimated at around $6-billion, to bet on CDOs backed by mortgages, many of them subprime. Now the funds were tanking, and Bear Stearns' lenders were demanding it put up collateral.

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.

Within a month, both of its troubled funds were forced into bankruptcy protection. But the real damage was much broader. Bankers were so terrified by the swiftness of the implosions at Bear and UBS that no one wanted to lend money. Some were even calling in their loans, forcing borrowers to auction securities at ever-lower prices.

When Wall Street brokerages announced their third-quarter results that fall, Merrill Lynch and Citigroup announced billions in writedowns and the departures of their CEOs. By mid-November, Wall Street investment banks had lost $84-billion in market value. Canadian Imperial Bank of Commerce became the largest domestic casualty, taking $3.5-billion (Canadian) in writedowns early in 2008.

The banks were faced with some of their earlier mistakes. They had relied on credit rating agencies: Anything that was rated Triple A, they had lunged at. Then there were the credit default swaps. There were, by some estimates, more than $50-trillion (U.S.) worth of these contracts floating around. When mortgages began to sour, those who sold this protection had their ratings slashed, requiring them to post more collateral or take punishing charges.

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.

But Lehman's fate turned quickly. In March, the Fed brokered an emergency sale of the spiralling Bear Stearns, sending a renewed wave of fear rippling through global stock markets, and training attention on Lehman: It was another venerable financial house that had made large bets on the mortgage industry, and that, like Bear, lacked a broad capital cushion.

Lehman's stock was halved in a single day, as hedge funds and others bet that the firm was sitting on massive losses. Mr. Fuld quickly went to work, raising $4-billion of capital and assuring investors at the firm's annual meeting that “the worst is behind us.” Little more than a week later, The Economist ran a profile of Mr. Fuld, with the headline: The Man Who Rescued Lehman.

In early June, Standard & Poor's cut the ratings of Lehman, Morgan Stanley, and Merrill Lynch. Only weeks later, Lehman unveiled a $3-billion loss – and announced plans to raise $6-billion through a stock sale. As cracks began to spread throughout Mr. Fuld's empire, the credit crisis kicked into full swing.

In early September, amid the biggest surge in mortgage defaults the U.S. had seen in three decades, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke engineered a takeover of Fannie Mae and Freddie Mac. But even with this unprecedented intervention, Wall Street remained paralyzed. Lehman and Merrill were both getting hammered as investors bet that one or both would fail.

On Friday, September 12, Mr. Paulson and Mr. Bernanke convened an emergency meeting in New York with bank executives and regulators.

Through much of the weekend, it seemed Barclay's Capital or Bank of America might be persuaded to rescue Lehman through a takeover. But by Sunday, both balked; they could not obtain guarantees against the losses they might suffer on the firm's assets. Bank of America, meanwhile, suddenly shifted course and agreed to an eleventh-hour takeover of Merrill Lynch, saving that once-proud brokerage from unravelling.

That left Lehman without a suitor, and ultimately, without a future. Mr. Paulson, who had said he didn't want to pick winners and losers in the crisis – and who was afraid of “moral hazard” if the government rode to the rescue of any financial company that got itself in trouble – decided to let Lehman fail.

On Monday morning, the 15th, Lehman announced it would file for bankruptcy. It was the largest ever: The firm's $630-billion in assets were a full five times larger than those of WorldCom when it cratered during the tech crash.

The reaction in the market was uglier than anything Mr. Paulson and his fellow lawmakers might have imagined, illustrating just how pervasive this unregulated shadow banking system had become.

The cost of insuring against defaults – the credit default swap market – shot to its biggest one-day rise in history. As the CDS market went haywire, it knocked over other dominoes: Banks and others that sold insurance had to post more collateral to guarantee they could make good on the insurance protection. That required more writedowns, and threw huge credit default providers like American International Group into a tailspin.

The collateralized debt obligation market, meanwhile, screeched to a halt as investors attempted to assess their exposure to Lehman holdings – an extremely complex task, given the lack of transparency surrounding these products; it was sometimes impossible to even discern the identity of the ultimate owners.

This freeze quickly extended to the commercial paper market, a vital short-term lending conduit that many businesses use to finance their day-to-day operations. Banks that attempted to auction off Lehman paper discovered they could only get a fraction of what they thought it was worth. Just as worrisome, Lehman's fall stoked fears that even the country's most stable banks, like Goldman and Morgan, would suffer a similar fate, prompting a run on their stocks.

The fallout was not limited to the North America. As the crisis burrowed more deeply into European markets, French Economy Minister Christine Lagarde faulted Mr. Paulson for allowing Lehman to fail. “For the equilibrium of the world financial system, this was a genuine error,” she said.

The day after the bankruptcy announcement, Mr. Paulson reversed his decision not to pick winners and losers, extending a massive $85-billion lifeline to AIG in return for an 80-per-cent stake in the company. U.S. officials believed AIG was too big to fail – its collapse would severely damage banks and other major investors who owned its corporate bonds, never mind the institutions around the world that had purchased credit default insurance from the company. If AIG went down, they would have to take a staggering amount of cumulative writeoffs.

Mr. Paulson was suddenly the equivalent of the little boy with his finger in the dike: No sooner had he plugged one hole than an even larger breach appeared. Two days after the AIG rescue, he capped one of the most dramatic weeks in Wall Street history by proposing a slapdash $700-billion bailout effort that would change shape several times over the ensuing weeks.

The writeoffs for the banking industry are now expected to ultimately top $1-trillion. Economists are forecasting the worst global recession since at least the Second World War, and possibly since the Depression.

The FBI has begun preliminary investigations into Lehman, Fannie and Freddie, and others. Meanwhile, lawsuits are being launched that could take years to resolve, making Enron's collapse seem a fairly straightforward exercise in litigation.

Just weeks after Lehman was interred, it was Mr. Fuld – and Mr. Fuld alone – who sat in his chair before the House Oversight Committee, atoning for the sins of a Wall Street culture that had spiralled out of control.

Lawmakers dredged up damning e-mails, showing how Lehman sought approval for $20-million in compensation for three departing executives just days before its bankruptcy filings.

“I wake up every single night thinking about what I could have done differently,” Mr. Fuld assured them. “This is a pain that will stay with me for the rest of my life. … What has happened is an absolute tragedy. I feel horrible about what happened.”

Although Mr. Fuld insisted he took “full responsibility,” the contrition didn't sit well with his interrogators. They were looking for a head on a pike that they could present to a suffering country.

This was theatre. But even here, amid the posturing and grilling, were the seeds of a broader explanation: A flash of recognition that the rot transcended Wall Street, and that the very system that underpinned America's ascendancy this century was complicit in the bargain.

“[Congress] missed golden opportunities to treat localized problems before they metastasized throughout the economic system,” noted Representative Tom Davis of Virginia in opening remarks that received little in the way of media attention.

“Out of well-intentioned zeal to promote homeownership, members from both parties and both Chambers not only tolerated, but encouraged the steady erosion of mortgage-lending standards.”
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Thanks Nye, Great read !!!!
This is Part 2 of series.  Here's link to Part 1.
http://www.theglobeandmail.com/servlet/story/LAC.20081220.RCOVER20/TPStory/
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