Who is responsible for missing the signs of fraud? (photo: M.V. Jantzen on Flickr)

One of the smart things we did in the aftermath of 9/11 was to step up efforts to choke off funding for terrorist organizations and their affiliates. It takes a lot of money to operate a real terrorist organization, and you pretty much need a bank to move a lot of money. One part of that effort was increased demands on banks to step up their efforts to detect money-laundering, and to report unusual activity on Suspicious Activity Reports.

SARS were introduced in 1996 by regulations under the Anti-Money-Laundering Act, and were extended to brokers, insurance companies, mutual funds and other financial businesses in the wake of 9/11. The original idea was to detect the movement of drug money and grab it, but it was easily extended to detecting terrorist money movement. It also works for mortgage fraud, a point ignored by Treasury Secretary Geithner and Attorney General Eric Holder.

Banks are required to set up units to detect activity that would require the filing of a SAR. These include criminal transactions in excess of $5000 if the suspect is known, and those in excess of $25000 if not, any transaction involving abuse by insiders; each of these would include mortgage fraud.

Financial institutions are required to set up systems to monitor all transactions and filter out those that might require the filing of a SAR. Most of them set up dedicated units and use some kind of vendor supplied software (.pdf). If the financial institution fails to file SARs, it is subject to civil penalties. There are criminal sanctions for failure to comply. 31 USC § 5322.

SARs are filed with FinCEN, a unit of the Treasury Department, which distributes cases to law enforcement agencies, principally the FBI. The Financial Crisis Inquiry Commission looked at bank compliance with these laws and regulations, and found a total collapse in the banking sector when it came to filing SARs reporting on mortgage fraud. The FCIC Final Report says that Countrywide filed SARs in 13% of the cases where there was an internal referral of potentially fraudulent activity. (P. 190) (References are to the .pdf page, not the page number.)

Darcy Parmer, a former quality assurance and fraud analyst at Wells Fargo, the second largest mortgage lender from 2004 through 2007 and the largest in 2008, told the Commission that “hundreds and hundreds and hundreds of fraud cases” that she knew were identified within Wells Fargo’s home equity loan division were not reported to FinCEN. And, she added, at least half the loans she flagged for fraud were nevertheless funded, over her objections.

[cont'd]

Approximately 80% of the loans were originated by institutions not required to file SARs. Even so, the number of SARs for mortgage fraud rose from 23,998 in 2005 to 37,547 to 65,004 to 67,507 in subsequent years. One reason there were no prosecutions is that the FBI reduced the number of agents working the SARs. The FBI knew about the extent of the problem, but refused the requests of Brian Swecker, the Assistant Director for investigations for more resources for work on mortgage fraud. There were prosecutions for fraud, but all at the originator level. (P. 190)

Why did FinCEN, a unit of Treasury under then Secretary Henry Paulson, not connect the dots? If fraud was as rampant as the sketchy SARs filings showed, of course fraudulent loans were getting into real estate-backed mortgage securitizations, and into CDOs and synthetic CDOs. How could they not have noticed this level of fraud? Darcy Parmer saw it. Why didn’t someone from FinCEN talk to her or people in positions like hers?

One obvious area of follow-up from the Final Report is to look closely at FinCEN. If it couldn’t figure out a giant disaster like mortgage fraud, why do we think it can find terrorists or drug cartels?

Most important, there are no excuses for failure to file SARs as appropriate, including what the Final Report says is the consensus view, that markets are self-regulating. It looks like there are grounds to investigate and prosecute the individuals at the banks who failed to file SARs. Who knows what turning over those rocks will produce?

Why hasn’t Treasury Secretary Timothy Geithner put FinCEN forces to work investigating this part of the Great Crash? Why hasn’t Attorney General Eric Holder done anything?

Is it because they desperately cling to the foolish and false consensus view? Or because despite the mountains of evidence, they don’t believe that the financing business is shot through with fraud?