Eyes Wide Open

How Outrageous Risks and Endless Greed Led to the Current Recession

By Amy Logan

Fraud in the News  

Every day the media report grim stories about the economy. The news is about spiking unemployment statistics; an unstable, weakening stock market; and rampant fraud.

Many people are now saving their spare change instead of spending it, and some are desperate to find new jobs. Meanwhile, economists venture to explain the causes of this latest recession. Could fraud have been partly to blame? News headlines of corporate corruption innuendo certainly seem to suggest it. But Joseph Koletar, CFE, DPA, a retired FBI senior executive, said fraud was more symptomatic of a larger problem: bad business decisions and poor oversight.

"There is a fine line here," Koletar said. "The issue is intent - the only difference between murder and manslaughter is intent; you have a dead body either way. Unless intent or deception is proved, poor or overly aggressive business decisions may cause significant harm, but they are not fraud."

"Whether businesses are guilty of fraud, people simply don't trust them with their investments anymore," said Alton Sizemore Jr., CFE, CPA, director of investigations at Forensic/Strategic Solutions. "If one were to list all the factors causing our current economic condition, in my opinion, fraud is a major factor in each one. Fraud is like cancer - once it starts, it grows, spreads, and if left untreated, destroys its host. Because of the way mortgages and bonds are securitized, once the cancer of those frauds began spreading throughout the banking, mortgage, and home-building sectors, those frauds affected us the most."


More than two decades after the savings and loan crisis of the 1980s, Americans are suffering yet another mortgage debacle. This crisis apparently led to banks and investment firms going belly-up, which eventually led to the stock market crash of October 2008, which then culminated in a worldwide financial downturn. Can we then blame fraud for the subprime mortgage crisis?

According to Matt Merlone, director of fraud investigations for Interthinx - a provider of fraud prevention, compliance, and decision-support tools for the mortgage industry - much of the crisis started with old-fashioned greed that led to fraud.

"Mortgage fraud represents the ‘perfection' of a cycle of institutionalized greed," he said. "Banks and mortgage lenders relaxed credit policies to seize market share, and this sparked something akin to the Oklahoma Land Rush."

Merlone said once subprime lending roadblocks like quality control and training were relaxed, lenders scrambled to exploit the weaknesses and maintain their competitive edge in the market. He said eventually brokers, loan officers, real estate agents, settlement agents and appraisers - among others - followed suit.

"As this cycle matured, fraud was legitimized by the levels of misrepresentation required to close more and more loans," Merlone said. "A cadre of well-paid insiders was formed by this culture, incented to create deals regardless of borrower capacity or intent to repay the obligation. At this point, the crisis became inevitable."

The problems could've been averted if the industry had learned its lesson from the 1980s' savings and loan crisis, said Connie Wilson, CFE, CMB, executive vice president of Interthinx.

"The exuberance in the marketplace to produce volume was so contagious that lenders did not follow what policies they had in place," Wilson said. "There were very few regulations and minimal guidelines for lending during the 1980s. The market was good, the economy was growing, and lenders were making loans betting on the market and economy increasing."

But those bets didn't pay off in the end, said Ann Fulmer, vice president of industry relations for Interthinx.

"That was the whole problem with the subprime fraud for housing," Fulmer said. "The markets just got insanely high. California, for example, at the height was experiencing 30 percent increases year after year in housing prices. But that's part of the reason the subprime collapsed: people really could not afford to sustain such a loan over time."

Fulmer said when the default rate started to climb in the subprime without compelling economic reasons to do so, Wall Street investors got nervous "and the whole thing fell apart."

"The rest, as they say, is history," she said.

Wilson, who wrote a red-flag fraud manual for Interthinx, said "lenders must use technology to help identify higher-risk transactions" to avoid repeating history.

"I have recently heard that some lenders feel they will have no fraud issues going forward because they are only doing full-doc loans [loans that require the borrower to present all necessary documents, including income verification, in order to be considered]," she said. "While full-doc loans do offer the lender more insight into the borrower, [they] will not prevent fraud.

"There is not a single loan document that cannot be created using Microsoft Office. I have personally recreated every document in a loan file using Word and Excel. Advances in technology have made it easier to create fraudulent documents. Therefore, lenders must also use technology to identify a potentially fraudulent loan file."

The best way to avoid mortgage fraud, Wilson said, is to train underwriters, processors, and loan officers on the telltale signs that point toward risky ventures.

"Understanding the red flags of fraud are imperative to prevention," she said. "Training is essential - not just [in identifying] the red flags, but for explaining what they mean and how they should be addressed."


So it seems mortgage fraud was a leading cause of the subprime crisis, which led to massive foreclosures. Banks and mortgage lenders couldn't recoup their losses from homeowners who'd been bled dry in the subprime meltdown and simply had no money left to give. That, in turn, staunched the once-fluid cash flow into the economy.

Soon, large corporations like Lehman Brothers and Bear Stearns were filing for bankruptcy or selling shares dirt cheap and transferring ownership. Emotions soared and the stock market took a nosedive right into the hardest crash the United States has experienced in nearly 80 years.

When the U.S. Bureau of Labor Statistics (BLS) announced on Feb. 6 that the U.S. unemployment rate had shot from a 16-year high of 7.2 percent in December 2008 to 7.6 percent in January, we could almost hear the groans of despair around the world.

The BLS reported that 598,000 American jobs were lost in January - the worst month for job losses in 35 years. Overall, a total of 11.6 million Americans were unemployed in January, and about 3.6 million of those have been unemployed since the recession began in December 2007. Consumer spending has declined in the world's largest economy, which has decreased demand for imports and thrown global markets into deep financial crises.

When the flow of money circulating around the world began to slow severely in late 2008, long-term frauds were left exposed for all to see. This led to high-profile global fraud examinations.

"The revelations of significant frauds in trusted companies has shattered the public's confidence and trust in the market, fostering a perception of gambling with cheaters and causing investors to wonder why they should play," Sizemore said. "Consequently, they bail out of the market at the first sign of trouble."

In a Jan. 27 New York Times article, "Troubled Times Bring Mini-Madoffs to Light," staff writer Leslie Wayne reports that "the deteriorating economy and heightened skepticism about outsize returns" has contributed to the unveiling of several smaller "mini-Madoff" Ponzi schemes.

In Wayne's interview with Stephen J. Obie, the head of enforcement at the Commodity Futures Trading Commission, Obie said "there is no way for a Ponzi to survive given the large number of redemptions and a lack of new investors."

When investors bail, the economy dives further into recession. Recession only leads to more fraud, Sizemore says.

"When financial difficulty strikes, businesses tend to cut back on the fundamentals of fraud prevention - internal audits, internal controls, and other checks and balances," he said. "With tremendous pressure to maintain a positive image to customers and investors, executives are forced to make tough decisions. Unfortunately, some will choose to fraudulently alter their financial statements.

"Of course, fraud isn't all about executives. Employees are also feeling the economic crunch, many of which will take advantage of their employers to improve their own economic situation. The end result is increased fraud during the economic recession."


Deloitte recently asked more than 1,250 executives in an online poll whether they expected accounting fraud to continue in the next two years. Nearly two-thirds (63.3 percent) of respondents said they did. Despite that number, both Sizemore and Koletar are skeptical that those same executives will bother to take the proactive measures they should to prevent fraud in their organizations.

"Businesses tend to underestimate the importance of fraud prevention and consequently fail to make it a priority even in the best of times," Sizemore said. "I once had an executive describe his involvement in the audit process as ‘another weed in my garden that I don't need.' In hard economic times, executives start to jettison everything that does not add to the bottom line, including fraud prevention and training. The effect is a welcome sign for fraudsters."

Koletar's opinion on the matter is just as grim.

"Will more resources be devoted to fraud? Doubtful," he said. "Executives still see fraud prevention as a bottom-line expense that only detracts from net revenue. I have been on this soap box for 20 years. Until, as a profession, we can make an ROI [return on investment] argument as to the worth of our work, we will always be an afterthought."

Afterthought or not, Sizemore said it's imperative for businesses to seek the expertise of a Certified Fraud Examiner (CFE) during this economic downturn. A story published Jan. 9 in The Economic Times said multinational companies located in New Delhi, India, have been seeking expert advice from their area CFEs in an effort to assess possible fraud and plug any existing loopholes. This phenomenon began to occur right after fraud charges were filed against Satyam Computer, India's fourth largest IT firm. India-based companies understand the benefits of seeking CFE expertise, and Sizemore and Koletar can only hope U.S. companies follow suit.

"The services provided by CFEs are invaluable to businesses in the prevention and investigation of fraud, waste, and abuse," Sizemore said. "Looking for fraud can be like looking for a needle in a haystack. Fraud examiners understand that all investigations are commenced in the anticipation of litigation. [We] are trained to look for the anomalies and red flags, and to know what a fraud looks like when we find it."

All fraud fighters can agree - it's better to prevent fraud in the first place, than to try to track it down, recoup the losses, and bring the culprits to justice after the fact. While Sizemore said he believes current U.S. laws meant to prevent or help prosecute fraud are sufficient, "there are not enough investigators, prosecutors, judges and jails to handle the volume of wrongful activity.

"People are not being held accountable for their actions and too many crimes are falling through the cracks due to a lack of resources," he said. "We not only need to teach our children, students, and employees the importance of honesty and integrity, but we need to walk the walk and not just talk the talk.

This periodic column, written by various authors, highlights developing fraud-related topics and stories. This issue's columnist is Amy Logan, Fraud Magazine's assistant editor.  

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