Financial fraud during economic recessions

by Saanya Pherwani

Industries worldwide are experiencing massive financial turmoil due to the COVID-19 pandemic. Companies have been forced to shut their doors and seek out loans to fix disrupted supply chains and everyday sales. In response to the crisis, the US government has distributed $5.3 trillion to stimulate the economy, with approximately $1 trillion going directly to businesses.[1] As economists, politicians, and citizens closely examine and respond to the economic crisis, an important consequence that is overlooked is financial fraud. In general, the occurrences of fraud increase during a recession due to greater incentives to commit fraud, as people look for alternate avenues to generate money. There is also an increased likelihood of detecting fraud as companies look for ways to save themselves from an economic downturn and show stable accounting performance to their investors.[2] In addition, the large influx of stimulus money in the economy gives company managers an opportunity to exploit their chances. Existing fraud prevention measures should be reviewed to handle the increased threat of financial fraud that comes from an economic recession to lessen wasteful spending and ensure that needy businesses receive their share. This can be achieved by analyzing and revitalizing past recessions. The most recent recession in 2008 illuminates issues of widespread fraud and negligence to serve as a model for the current economic crisis.

2008 Recession The 2008 recession was unique because the largest financial institutions committed fraud both before and during the financial crisis. In fact, fraud was the primary cause of the recession.[3] Specifically, fraud was most prominent in the mortgage-backed securities market, which consists of mortgage-backed securities (MBS), a type of loan that bundles home loans together. Fraud in the MBS market was a collective effort as multiple participants in such institutions engaged in fraudulent activities.[4] For example, the underwriter, whose role is to rate the quality of the MBS, intentionally overestimated the quality of the loans to clients. Mortgage originators, whose role is to issue high-quality loans, deceived borrowers about eligibility requirements and sold loans they knew were likely to default.[5] Banks acted similarly to originators, deceiving clients of the true quality of the loans they were purchasing. The misrepresentation of the true quality of these loans, along with other factors like the intentional overstatement of borrower income, caused the loans to default, ultimately collapsing the housing market. In the end, the U.S. Treasury issued a $700 billion bailout to large financial institutions to help with their shortage of funds caused due to the large number of loan defaults.[6] Additionally, the Federal Reserve bought $4.5 trillion worth of MBS over a period of years to inject capital into banks as a part of the Troubled Asset Relief Program.[7] The events leading up to and after the 2008 crisis demonstrate important lessons for the current recession. First, a large majority of fraudulent activities in 2008 were clearly collaborative.[8] Borrowers were often encouraged to fill out loan applications by overstating their income or overestimating loan quality.[9] Therefore, the federal government should establish regulations to monitor fraud at large institutions and oversee the work done at each level to detect manipulation. Second, fraud is often only discovered when a financial crisis ensues, rather than at the beginning. Thus, all fraud should be flagged from the start by governmental organizations. Specifically, the Department of Justice agencies that specialize in detecting fraud should be extra vigilant during recessionary times. In 2008, contrary to its responsibility to monitor fraud, the federal government played a key role in exacerbating the crisis as it incentivized banks to engage in high-risk lending, such as MBS lending, in an effort to provide mortgages to poor households.[10] The conflict of interest between encouraging MBS lending to expand the economy and restricting such practices to regulate the financial industry could have caused the lack of fraud detection.[11] At the same time, regulators and central bankers failed to use their considerable power to monitor risks building up to the crisis.[12] A final lesson to be learned from the 2008 crisis is that huge bailouts demonstrate the willingness of governments to make up for corporate mismanagement and malpractice. Even if necessary to prevent an economic depression, the 2008 bailout placed virtually no restrictions on how large banks used the money.[13] The lack of restrictions allowed banks to foreclose on ten million American families’ homes, and the average American experienced great financial loss.[14]

2020 Recession The current economic crisis is primarily caused by the spread of COVID-19, which has reduced spending in numerous industries. However, similar types of fraud are being detected as were in 2008. For example, thousands of commercial mortgage-borrowers are struggling to meet their mortgage obligations as a result of the pandemic. Also, similar to in 2008, banks are now aggressively lending Commercial Mortgage-backed Securities (CMBS) to businesses and overstating borrower income and their ability to repay debts.[15] This type of fraudulent behavior can cause commercial securities to be highly overvalued and loans to default quickly, triggering an even greater economic collapse. Next, only a few months after Congress enacted a $523 billion Paycheck Protection Program (PPP) to offer emergency loans to businesses impacted by COVID-19, the Department of Justice detected fraud schemes worth $569 million.[16] Although a large majority of the funds were used by small businesses in need, millions of dollars of relief funds to keep employees on payroll were blown away on extravagant personal spending sprees by a handful of business executives and managers. Some fraudulent tactics to qualify for loans included using fabricated documents to fake tax returns, bank statements, and employee salaries.[17] Like in 2008, a large amount of PPP funding was wasteful, helping only a few wealthy executives. Yet, investigators and lawmakers have only detected a handful of these types of fraudulent schemes.[18] Although the recession was a result of a public health crisis, the situations leading up to fraud are almost identical to 2008. The government pushed out a huge amount of money in a short period of time with unclear instructions, and companies simply had to attest that their “current economic uncertainty made this loan request necessary.”[19] Additionally, the Treasury Department put undue pressure on banks to turn loans around within hours.[20] This lack of regulatory requirements and sufficient bank approval made it easy for fraudsters to take advantage of funds. The government-sponsored high-risk lending practices created a perfect environment for fraud. Therefore, although triggered by different underlying conditions, both the financial crisis of 2008 and 2020 have experienced similar tactics to commit fraud and highlight important lessons in managing fraud risk. First, fraud is widespread, especially in financial institutions and during economic crises when many financial market participants’ actions go unchecked. Existing fraud prevention measures should evolve to prioritize the investigation of financial markets to prevent fraud. Second, government policies to stimulate the economy often indirectly support fraudulent activities; without clear instructions on how to distribute, use, and monitor the money, fraud is inevitable and distracts from the true focus of governmental help.


 

[1] Robert Berger, 5 Breathtaking Numbers Reveal the Unsettling Cost of Stimulus, Fᴏʀʙᴇs, (Oct. 18, 2020), https://www.forbes.com/sites/robertberger/2020/10/18/5-big-numbers-reveal-the-unsettling-scope-of-stimulus-spending/?sh=543c72fa142b. [2] University of Portsmouth, Economic Recession: Can we Deal with a New High in Cybercrime and Fraud?, Aᴍᴇʀɪᴄᴀɴ Assᴏᴄɪᴀᴛɪᴏɴ ғᴏʀ ᴛʜᴇ Aᴅᴠᴀɴᴄᴇᴍᴇɴᴛ ᴏғ Sᴄɪᴇɴᴄᴇ, (Apr. 17, 2020), https://www.eurekalert.org/pub_releases/2020-04/uop-erc041720.php. [3] Neil Fligstein & Alexander Roehrkasse, The Causes of Fraud in Financial Crises: Evidence from the Mortgage-Backed Securities Industry, Uɴɪᴠᴇʀsɪᴛʏ ᴏғ Cᴀʟɪғᴏʀɴɪᴀ ᴀᴛ Bᴇʀᴋᴇʟᴇʏ Iɴsᴛɪᴛᴜᴛᴇ ᴏғ Rᴇsᴇᴀʀᴄʜ ᴏɴ Lᴀʙᴏʀ ᴀɴᴅ Eᴍᴘʟᴏʏᴍᴇɴᴛ, 2015. [4]John M. Griffin & Gonzalo Maturana, Who Facilitated Misreporting in Securitized Loans?, 29 Tʜᴇ Rᴇᴠɪᴇᴡ ᴏғ Fɪɴᴀɴᴄɪᴀʟ Sᴛᴜᴅɪᴇs, 384, 419 (2016). [5] Fligstein and Roehrkasse, supra note 3, at 4. [6] Mortgage Backed Securities (MBS), https://www.investopedia.com/terms/m/mbs.asp, (last visited Apr. 30, 2021). [7] Id. [8] Binyamin Appelbaum, How Mortgage Fraud Made the Financial Crisis Worse, New York Times, Feb 12. 2015. [9] U.S. Senate Committee on Homeland Security and Government Affairs: Permanent Subcommittee on Investigations, Senate Investigations Subcommittee Releases Levin-Coburn Report On the Financial Crisis, (2011). [10] James Alexander et al, Government Failure Caused the Financial Crisis, Iɴsᴛɪᴛᴜᴛᴇ ᴏғ Eᴄᴏɴᴏᴍɪᴄ Aғғᴀɪʀs: Bʟᴏɢ, (May 12, 2009), https://iea.org.uk/blog/government-failure-caused-the-financial-crisis#:~:text=Government%20failure%20had%20a%20leading,that%20led%20to%20the%20crash.&text=Central%20banks%20created%20a%20monetary,distorted%20the%20pricing%20of%20risk.&text=Much%20existing%20banking%20regulation%20exacerbated,of%20market%20monitoring%20of%20banks. [11] Griffin & Maturana, supra note 4. [12] Id. [13] Damon Silvers, Repeating the Mistakes of the 2008 Bailout, Tʜᴇ Aᴍᴇʀɪᴄᴀɴ Pʀᴏsᴘᴇᴄᴛ, Mar. 24 2020, https://prospect.org/economy/repeating-the-mistakes-of-the-2008-bailout/. [14] Id. [15] Cezary Podkul, Commercial Properties’ Ability to Repay Mortgages Was Overstated, Study Finds, Nᴇᴡ Yᴏʀᴋ Tɪᴍᴇs, (Aug, 11, 2020), https://www.wsj.com/articles/commercial-properties-ability-to-repay-mortgages-was-overstated-study-finds-11597152211. [16] U.S. Department of Justice: Office of Public Affairs, Justice Department Takes Action Against COVID-19 Fraud, (2021). [17] U.S. Department of Justice, supra note 16. [18] Stacy Cowley, How Bad Was Virus Aid Fraud? One Banker Was ‘Frustrated With Humanity’, Nᴇᴡ Yᴏʀᴋ Tɪᴍᴇs, (Dec. 9, 2020), https://www.nytimes.com/2020/12/09/business/ppp-fraud-paycheck-protection-program.html. [19] Stacy Cowley & Emily Flitter, Frenzy and Desperation as Small Businesses Grab for Government Aid, Nᴇᴡ Yᴏʀᴋ Tɪᴍᴇs, (Apr. 3, 2020), https://www.nytimes.com/2020/04/03/business/sba-loans-coronavirus.html. [20] Cowley, supra note 18.

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