Fraud and the Wall Street Financial Bailout

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The question I have been asked more over the last few weeks than any other question is: “How big of a role has fraud played in this Wall Street bailout?”

I wish that was an easy question to answer. It’s not, because fraud has played a role in many aspects of the whole financial drama the United States is in.

The start of the financial mess can be traced to the frenzied buying of real estate. Everyone wanted to get into the game, which pushed up prices and potential profits, which made others want to get into the game, which pushed prices and profits up more, and so on.

Real estate prices in many markets may have been pushed artificially high because of the volume of buying and selling. It’s true that the value of an asset is whatever a party is willing to pay for it, but real estate prices got out of control because of excessive buying and selling.

As consumers were trying to get into the real estate market, both with owner-occupied real estate and investment properties, there came a point when the math no longer worked.

People simply couldn’t afford the properties they wanted to buy. The solution? Lie about income, lie about whether this was an investment property, lie about the appraised value to create instant equity, and the like.

Banks and mortgage companies were all too happy to play the game and hand out mortgages based upon flimsy documentation. They got their fees and the interest on the mortgages, so there was no real incentive to verify information. The government was all too happy to participate in this game by backing mortgages in the name of expanding home ownership.

But the entire financial crisis can’t be laid in the laps of those who were giving and getting mortgages. That’s simply one part of the equation in which fraud occurred. We then had companies packaging and selling these mortgages as investments.

The due diligence on some of the mortgages was substandard or completely ignored.

Risky mortgages were marketed as nearly riskless. Buyers for these investments were defrauded when they were misled about the quality of the investments.

It’s possible that many purchasers of the investments weren’t sufficiently educated about what they were buying. But it also looks like they were led to believe they were buying something with a much different level of risk than they were told they were buying.

The buying and selling of these sketchy assets became a substantial part of Wall Street.

Companies were generating profits from these investments, so the incentive to push more and more of these investments on investors is clear.

Investors were also buying shares of stock in the companies participating in these investments and turning profits from them. As more investors were buying and selling shares of stock, those share prices were generally rising just like the real estate prices had been rising.

Then the real estate market slowed, which meant that the mortgage industry slowed too.

A higher-than-normal default rate on mortgages throws a wrench into things. Mortgages no longer seem to be such good investments, so the companies buying and selling them slow down as well.

Everything slows until we get to a figurative financial gridlock. Money is not flowing between entities, which means profits aren’t being generated. Values of investments and companies fall quickly, many of them now with artificially low values.

It’s easy to see how this is a case of a bad problem related to real estate and mortgages snowballing and creating many unintended consequences. Even companies that had no real connection to the mortgage-based investments became participants in the whole problem. They were relying on banks and investment companies to lend them money as a normal part of their operations.

Our government steps in to remedy the problem, rather than letting the markets work things out. The lawmakers are attempting to inject some liquidity back into the markets, but no one is sure if this will really be achieved or how long it will take.

The government’s plan will have hundreds of billions of dollars doled out with relatively little oversight. Yes, there will be people assigned to oversee things, but initially it looks as if the oversight will be far less than what is needed. That creates a situation which is ripe for fraud.

Seemingly insignificant frauds at each stage of the process have created a massive train wreck. The problem is part bad business and part irresponsibility in the trading of real estate, mortgages and investments. There is a component of fraud before, during, and after this bailout.

How can I be so certain that fraud will occur when the bailout is being carried out? Because wherever money is at stake and greed exists as a common human trait, there will be fraud. Indeed, fraud is a recurring theme in today’s financial mess.

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