Fraud and frothy markets: Lessons from Letitia James

Start with the federal indictment last week of New York Attorney General Letitia James for bank fraud. The government alleges that Ms. James misrepresented a home she bought in Norfolk, Va., in 2020 as a secondary residence when in fact she rented it out. Investment properties typically carry higher interest rates because they are riskier.

According to the sparse indictment, Ms. James’s alleged misrepresentation allowed her to save $18,933 over the life of the loan. She has said “these charges are baseless." There’s no question they were politically motivated, and mortgage fraud is rarely prosecuted.

But maybe it should be punished more often to discourage it. Even if lenders don’t lose money on individual loans, widespread fraud can contribute to inflated housing prices and increase risks for taxpayers.

A Philadelphia Federal Reserve Bank study in 2023 found that investors falsely claiming homes as their residences accounted for about 6% of mortgage borrowers during the housing bubble and between 2% and 3% in subsequent years. Fraud was more common in places with greater price appreciation like California, the District of Columbia, Florida and Nevada.

Borrowers who misrepresented their occupancy to lenders notably had lower credit scores than honest investors. Such misrepresentations allowed dishonest borrowers “to circumvent tighter underwriting guidelines imposed by lenders" and obtain lower interest rates. This enabled them to take on more mortgage debt, which fueled higher housing prices.

When the housing bubble collapsed, fraudulent investors defaulted at more than double the rate of honest ones. This resulted in a bigger crash. Could mortgage fraud also have fueled the runup in housing prices in recent years? Who knows, but a borrower who takes out a mortgage at 3%—as Ms. James allegedly did—can turn a nice profit renting out the property.

Low interest rates can be an inducement for fraud. The bigger problem, however, is that lenders have little incentive to guard against fraud when mortgages are ultimately guaranteed by taxpayers. Even if lenders suspect fraud, they might choose to ignore it because they make more money by originating more loans, regardless of quality.

This is the definition of moral hazard. But fraud and hazards often don’t become apparent until the economy heads south. That may be why reports of fraud are now capturing more attention in the financial press.

Bankruptcies last month by the subprime auto dealer Tricolor Holdings and auto-parts supplier First Brands Group have rattled credit markets. Not so much because they were unexpected, which they were, but because sophisticated investors including some of the nation’s biggest banks and asset managers overlooked blazing red flags.

Both companies took on excessive debt and engaged in questionable financial practices. The Justice Department is reportedly investigating their dealings with creditors, including whether collateral was double-pledged or commingled. But it’s hard to feel much sympathy for the victims who didn’t look under the hood before financing the companies.

Tricolor specialized in making loans to undocumented immigrants. Barron’s reported in 2022 that Tricolor’s environmental-social-governance credentials helped it “raise money from some of the nation’s highest-profile banks and accelerated the growth of its business."

More than two-thirds of its customers lacked a credit score, according to a Tricolor bond issuance this year. For those with credit scores, the average was 614. More than half didn’t have a driver’s license. President Trump’s deportations raised the risk of defaults—not that its financiers seemed to care until the company filed for bankruptcy.

Does Tricolor’s crash reflect a broader breakdown in due diligence? The Charlie Javice fraud case certainly suggests that may be the case. The 33-year-old fintech entrepreneur last month was sentenced to seven years in prison for swindling JPMorganChase, which purchased her student financial-aid startup in 2021 for $175 million.

The bank later discovered she had inflated her user count more than tenfold. Why didn’t bankers detect this deception earlier? Because they rushed the review.

“Ms. Javice’s case is not the prototypical type of fraud case," her defense attorney argued. “This case was a 28-year-old versus 300 investment bankers from the largest bank in the world that did due diligence in 22 business days." He added that “part of the rush was what they called a defensive play, that they didn’t want another bank to get this product."

Other red flags: The Education Department and Federal Trade Commission had rebuked Ms. Javice’s startup in 2017 and 2020 for misleading customers. JPMorganChase has “a lot to blame themselves" for, the judge said at Ms. Javice’s sentencing hearing. But his job in sentencing her is “punishing her conduct and not JPMorgan’s stupidity."

In these heady times, stupidity isn’t getting punished by markets any more than fraud.