FOMC: Fraud is funny!

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In February 2007, the subprime meltdown began. Two months before that, members of the Federal Open Market Committee were laughing about borrowers who were having trouble qualifying for mortgages.

Sandra Pianalto, president of the Cleveland Federal Reserve Bank, told her fellow Fedsters during the Dec. 12, 2006, FOMC meeting that she had heard that a homebuilder in Phoenix was giving new buyers Lexuses so the builder wouldn’t have to cut the asking prices of houses.

She added, acccording to the transcript: “Builders in my region report that the ability of potential homebuyers to qualify for home mortgages is becoming an issue. One homebuilder in Columbus told me that he is giving away new cars as well, but his motivation provides a twist to the Lexus story. Some of his customers are struggling to qualify for mortgage loans. So he’s giving them new cars so that they can get rid of their current cars and the payment obligations that go along with them.”

There was laughter in the room, according to the transcript. “He’s not giving them a Lexus; he’s giving them a Kia,” Pianalto continued, to more laughter.

If her story is true, the homebuilders in Phoenix and Columbus, Ohio, probably were committing mortgage fraud. They were selling houses and cars, and probably not telling mortgage lenders about the cars. This is a serious breach, with an implication of appraisal fraud. The experienced bankers of the FOMC had to have known this. Yet they laughed at the story.

If you don’t see why this is a big deal, imagine that you were lending the homebuyer money out of your own bank account. Let’s say the buyer told you that he was buying a $220,000 house, putting 5 percent down, and he wanted to borrow $209,000 from you. But in reality, the house was worth $200,000, and the value was falling every month, and the car’s retail price was $10,000 with the value dropping precipitously as soon as it was driven off the lot.

If you lent the $209,000, and then later you found out that you had lent the money so the borrower could buy a car that you hadn’t been told about and a house that had been overvalued, would you feel like you had been cheated?

In such a case, I think a call to the FBI be appropriate. But I have a hunch that Pianalto didn’t call the FBI, and neither did those laughing bankers at the FOMC meeting.

Fast forward more than five years. Today Elizabeth Duke, a member of the Fed’s Board of Governors, told a gathering of community bankers in Santa Barbara, Calif., that she thinks small banks are overregulated. “I think broader exemptions (to regulations) could be warranted for the thousands of smaller banks that make loans in small metropolitan areas or suburban areas,” she said.

That sounds like what regulators were saying in the early 1980s when they relaxed regulation of savings and loan associations. The savings and loan crisis of the mid-1980s followed. It was the biggest banking scandal in U.S. history — until the banking meltdown of 2008. I wish Duke and the rest of the Fed would recall that history. It wasn’t all that long ago.