Hundreds of American citizens are sitting in federal prison convicted of “mortgage fraud.” They all should be set free. Here’s why.
The alleged victim banks, including global behemoths such as J.P. Morgan and Credit Suisse, willfully and purposefully created — and ultimately carried out — the policies, practices and actions that resulted in the loans made to the mortgage fraud defendants. The banks approved of and sanctioned these loans. As such, the lending banks were not defrauded. Instead, the government’s use of the wire fraud statute (18 U.S.C. 1343) against defendants was the true fraud in these unfortunate cases.
To demonstrate, let’s take a look at the mortgage lending environment at the time.
The Pre-Crash Lending Environment
By 2004, the dominant feature of the mortgage lending business model had evolved to securitization. The mortgage-backed security represented the central element of the business model. No longer did banks earn revenue by paying interest on deposits, while lending those deposits at higher rates. A major boost to the dominance of securitization came in the 1980s when volatile interest rates forced many savings and loans into insolvency. No longer could the banks successfully manage their interest rate risk, especially with competition from money market funds that paid higher rates. The savings and loan institutions could no longer keep fixed-rate mortgages on their books and continue to make a profit.
The answer was securitization. And by 2004 the model had evolved so that banks such as J.P. Morgan Chase Bank typically longer kept very few, if any, loans on their books. Their entire profit in this business came from selling and servicing mortgage-backed securities.
Following the refinancing boom of the early 2000s, the business evolved further. Prior to 2000, the government-sponsored entities, Freddie Mac and Fannie Mae, had dominated the mortgage securitization business. The two entities faced little competition from the private market, and they generated huge profits by maintaining high underwriting standards and limiting their portfolios to sound mortgages.
By 2004, however, Wall Street had created a significantly large private-label securitization market to rival the government-sponsored entities. But with it came risk. To generate the fees that the banks had been accustomed to during the refinancing boom of 2000-03, and to generate the profits demanded by shareholders, the private-label banks needed significantly more volume. The requisite number of high-quality mortgages simply could not be found to meet this demand. And volume could only be generated by lowering lending and underwriting standards.
This approach toward diminishing underwriting standard and increased risk reached a fever pitch from 2003-2007. During this time, private-label securitizers (such as J.P. Morgan Chase Bank and Credit Suisse), had reduced underwriting standards to dangerous levels. Yet, during that time, profits increased in this business. Why? Because the business model had evolved completely away from collecting principal and interest to one that profited from selling and servicing loans. The lending banks sold these loans at huge margins, often upwards of 30 percent. Thus, volume increased profits. The more loans that could be sold, the more money was made. Underwriting standards continued to plummet, as no longer did the banks have any motivation to investigate and verify the ability of the borrowers to pay back the loans.
Yet, most importantly, and perhaps counterintuitively, the private-label banks actually made more money and generated more revenue when borrowers actually did NOT pay on time.
Is This Really True?
This notion seems implausible, but it runs to the core of the mortgage fraud cases. After selling the loans, the banks often maintained servicing rights which included fees for collecting interest and principal for the investors holding the mortgage-backed securities. However, fees increased when borrowers missed payments and ultimately defaulted. Again, the banks had no incentive to maintain underwriting standards. And finally, the banks profited during foreclosure when they reported and wrote off losses based on these bad loans, although they often did not own the loans and never truly lost revenue at all.
This leads us to the environment that was intentionally and willfully created by J.P. Morgan Chase Bank and Credit Suisse and other banks that led to the loans to defendants.
The Real Fraud
Given the environment and the particular lending practices during that time, the individual mortgage fraud defendants could not have deceived or defrauded the lending banks, including J.P. Morgan Chase and Credit Suisse. The so-called victim banks had every incentive to entice unqualified borrowers to take bad loans. They had no incentive to verify a borrower’s ability to pay back the loans, nor did they care. The desire of the banks was actually the opposite of the traditional model. The lending banks actively and purposefully designed their loans to fail. They wanted loans to fail to generate more servicing fees, and they wanted as many borrowers as could be found, so as to generate huge profits from selling the securities via mortgage-backed trusts to unwitting investors.
Industry standards dictated that once a borrower had made three payments on a loan, that loan could be sold into a mortgage-backed trust. Indeed, the defendants were typically told by originating banks that only three payments need be made on their loans. Why would a bank advise a borrower to make only three payments? This runs counter to any and all common notions of how banks function. Because profits were elsewhere – in the selling and servicing of large numbers of mortgages.
Given that this was the business model during the time that many defendants obtained loans, evidence outlining the practices of the banks should be allowed at mortgage fraud trials. This evidence would show that the requisite criminal intent was not formed nor were the elements of materiality and reliance present. But too often, this evidence was inexplicably excluded by judges.
The Law of Wire Fraud
The elements of wire fraud are: (1) devising or intending to devise a scheme or artifice to defraud another by means of a material misrepresentation, with (2) the intent to defraud through (3) the use of mail or interstate wires. See White Collar Crime § 8:2 (2d ed.). “[M]ateriality of falsehood is an element of the federal mail fraud, wire fraud, and bank fraud statutes.” Neder v. United States, 527 U.S. 1, 25, 119 S.Ct. 1827, 1841, 144 L.Ed.2d 35 (1999). See also United States v. Starr, 816 F.2d 94, 98 (2d Cir.1987).
Essential to a scheme to defraud is fraudulent intent. See Durland v. United States, 161 U.S. 306, 313–14, 16 S.Ct. 508, 511, 40 L.Ed. 709 (1896) (“The significant fact is the intent and purpose.”); Starr, 816 F.2d at 98 (fraudulent intent “critical” to a scheme to defraud).
Because the defendant must intend to harm the fraud's victims, misrepresentations “amounting only to a deceit are insufficient to maintain a mail or wire fraud prosecution.” Starr, 816 F.2d at 98. “Instead, the deceit must be coupled with a contemplated harm to the victim.”
If the alleged victim receives what it bargains for, establishing intent to defraud is problematic.
The Mortgage Fraud Cases
In the mortgage fraud cases, the banks, J.P. Morgan and Credit Suisse and others, continued their participation knowing full well that the defendants made misrepresentations. The so-called victim banks continued their dealings even when they knew that borrower representations were false. As such, none of the statements or actions of the borrowers (the mortgage fraud defendants) were material to the lending banks decisions to approve the loans.
Thus, if the banks authorized the loans to defendants, knowing that foreclosure was possible, even likely, and did so because the market was profitable, then criminal intent could not have been formed by the mortgage fraud defendants. Given that the mortgage brokers were acting with authority, on behalf of the lending banks, such as J.P. Morgan Chase and Credit Suisse, defendants could not have deceived the banks or contemplated harm.
In fact, the lending banks never relied on anything that the defendants (or anyone else) said or did. The so-called victim banks were driven by a business model that required volume and the attendant lessening of underwriting and lending standards. The banks needed numerous borrowers to absorb the massive amount of mortgage finance that had become available from investors. Investors were pouring money into the market and demanded mortgage-backed securities. The lending banks fulfilled this need by originating and selling mortgages in large volumes, while completely ignoring the ability of borrowers to pay.
The statements and actions of defendants therefore were not material to the transactions. The banks completely ignored those statements and could have easily verified that defendants were unqualified for the loans. But the lending banks willfully and purposefully chose not to, in part through their agent mortgage brokers. Profits were to be made by selling these loans, servicing these loans and foreclosing on these loans. The banks willingly and knowingly created the business model that demanded volume and then knowingly profited from borrowers who would never be able to pay back these loans – and were often instructed not to.
At no point did any borrowers, any mortgage fraud defendant, ever deceive or defraud the banks.