Big Fraud Theory

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There are a few books or movies like "The Big Short", Liar's Poker, or William Black who float this Big-Fraud theory (BFT), It is loved by Hollywood, the Media, Progressives (Elizabeth Warren, Bernie Sanders), and those who know better but want to distract and enrage the gullible. It's becoming the most widely spread theory because simply hate and ignorance spread faster than information, complexity, and introspection. It is really just a variant of GST and "Too Little Government".

The idea is:

  1. Massive greed encouraged massive over-leverage, and while everyone (or a few) knew better, they did it because they were dumb, greedy and corrupt.
  2. They screwed the public knowing that the entire system would collapse, but as long as they were making money and bonus's, they didn't care.
  3. Greed and over-leveraging caused everything.

The problem is no one credible has really offered this as a "theory", because it's not economics, it's politics. And it doesn't explain anything, if you think it through.

NOTE: No one doubts there were a few unsavory actors, or that Countrywide wasn't and aggressively selling LIAR/NINJA loans (preying on consumers that couldn't afford to pay them back). They were doing exactly what Fannie/Freddie and the CRA had demanded, and paid them for (by buying all those loans up, and putting them into MBS's in the first place). But these characters weren't the fundamental cause of the crash (all markets cycle), or the credit crunch caused by over-regulation, and it has nothing to do with Glass-Steagall which couldn't have done anything to stop it. So yes, there were over-aggressive players, taking advantage of the Democrat created credit traps -- and they slightly magnified the problem. But had they not existed, the same exact thing would have happened. And those that try to pin THE blame on these guys, are ignorant or dishonest. These were bad actors, but it's like blaming a pickpocket in the back of the plane for 9/11.

The reality is:

  1. If Fannie/Freddie weren't buying these loans, it wouldn't have been possible: so it's still a failure of Government Sponsored Entity and thus government.
  2. The leverage was lower in the 2007 than it was in 1998 -- so their increase in leverage was not the trigger (or it would have gone off in 1998).
  3. Leverage doesn't cause crashes or markets seizing up -- it can only magnify it (or mitigate / hedge against it, if leverage was being used as a hedge). Whether you have 10% or 20% equity in your home, or if you owe $5K or $20K on your credit card doesn't change whether you're going bankrupt or not. The underlying problem is one of cashflow: money in versus money you have to put out.
  4. Either Fraud was the cause, and there was no underlying value to the assets being written against, and the market couldn't recover something that didn't exist (the correction would have to have been permanent). Or fraud was a very minor part of the issue, and once the bigger issues were worked out, the market/housing would rebound (as happened). Pick one. The facts that the markets recovered so quickly (a few years), shows that most assets did have underlying value, and it wasn't just smoke-and-mirrors (all leverage), and the Big Fraud Theory is flim-flam.
  5. This theory doesn't explain is why the credit markets seized. Why do people stop loaning, and why did TARP fix it if it was fraud? So it's saying that fraud helped with the bubble, slightly - but everything else in CRAFFT theory was still at play. So it's not an explanation of anything, it's just an excuse to point fingers somewhere else and hate.
  6. Why didn't government go after them? To believe the Big Fraud Theory, you have to also believe in a huge conspiracy between Government and Wall Street, that bankers and investors have colluded with Congress to deceive the public and that's why no one went to prison in massive investigations of widespread abuse. But CRAFFT theory explains why, much better.

Easier Explanation

The far easier explanation is that while this might have happened in small scale (that TV shows and or sensationalist authors exaggerated for self promotion), that it wasn't that widespread, and they were complying with Fannie & Freddies standards (as demonstrated by Fannie/Freddie trafficking in 60-80% of these loans) -- which is how those loans got in the system. Yes, leverage can injected some risk in the system, but the only reason it could have, is because Fannie/Freddie and regulations allowed it. That's not fraud, that's complying with really badly written rules/regulations by a government sponsored entity. Slimy, but legal. (E.g. not Fraud).

So the real theories posited in the article are the economic explanations. This BFT is just a political agenda masquerading as an explanation for what happened: but doesn't really explain anything.

To me, the fraud theory is the chewbacca defense: it could have happened, it could not have happened, but it's an unsavory side note to what caused the majority of the bubble, or the credit markets to seize afterwards (FAS-157), and what TARP and the other loans did to get credit moving again.


Financial crisis of 2007-2008 : CRA, Fannie/Freddie TheoryBig Fraud TheoryGlass-SteagallFinancial Terms