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Repo fraud “happens all the time,” says convicted Farkas

Securitized banking has its first 21st Century big-time crook.

Lee B. Farkas, chairman of one of the largest privately owned mortgage lending companies in the U.S. when it collapsed in 2009, was convicted by a jury April 19 of a $2.9 billion securities and bank fraud. Sentencing is scheduled for July 1.

The conviction stems from Farkas’ role in a seven-year securitized banking scheme that caused hundreds of million of dollars in losses to several large financial institutions and contributed to the failure of 75-year-old Colonial Bank, one of the 25 largest banks in the U.S. when it failed in 2009.

Securitized banking is securitization financed mainly with repurchase agreements.  For a detailed discussion of securitized banking, see the About Repo tab at RepoWatch.org

During his trial, Farkas testified that it’s common for repo borrowers to fake the collateral they use to get repo loans, as prosecutors accused him of doing

“It’s very common in our business to, to sell — because it’s all data, there’s really nothing but data — to sell loans that don’t exist,” he explained, according to business writer Floyd Norris. “It happens all the time.”

RepoWatch suspects he’s right. If one wheeler-dealer did it, others did. This suggests investigators looking for big-time criminal fraud in the financial crisis of 2007-2008, and so far finding none, might find repo collateral a fruitful area to examine. Maybe we’ve been looking for fraud in all the wrong places.

In the best tradition of financial scondrels, Farkas lived big and well while the money spigot flowed freely.

His company, Taylor, Bean & Whitaker Mortgage Corp., was headquartered in Ocala, Fla., in the north-central part of the state. Handily, Colonial Bank of Montgomery, Alabama, put the headquarters of its Mortgage Warehouse Lending Division, which made loans to mortgage lenders, nearby in Orlando.

That nexus was a money machine that supported Farkas’  big-shot Florida lifestyle.

He used fraudulent mortgages and other scams to leech $20 million out of Taylor, Bean for himself, in addition to his multi-million dollar paycheck, according to prosecutors who said he earned about $2 million in salary, wages, and commissions in 2006, nearly $3 million in 2007, and more than $3 million in 2008.

He bought a Dassault Falcon 2000 private jet, a collection of classic cars and several homes and businesses including restaurants and bars, prosecutors said. His oppulent lifestyle attracted a lot of attention around Ocala.

From an editorial in the Ocala Star-Banner:

Back in the middle of the last decade, Ocala/Marion County was awash with housing boom high-rollers — builders and bankers, land speculators and lenders. And none was bigger than Lee Farkas.

When Farkas showed up someplace, people stopped and gawked. The self-made millionaire’s meteoric rise in the mortgage lending industry had elevated him to rock-star status hereabouts. He started a string of businesses. He gave generously to charities. He spent lavishly on his headquarters and his employees.

Then we found out it was all an illusion.

Here’s how Farkas’ scheme worked, according to prosecutors, securities regulators, bank regulators and trial testimony:

In the most basic form of securitized banking, financial institutions borrow money on the repurchase market, use the money to make or buy business and consumer loans, and sell those loans to an off-the-books business they create. The off-the-books business pools the loans and sells asset-backed securities and asset-backed commercial paper, backed by the pools of loans, to investors.

Securitized banking is the banking that blew up in 2008, causing the credit crisis and the federal bailout of some of the nation’s largest financial institutions.

Farkas’ scheme had two phases, the repo phase and the securitization phase.

First, the repo phase.

Originally, starting in 2002, Farkas got the money to make mortgage loans from a mortgage warehouse line of credit with Colonial Bank’s Mortgage Warehouse Lending Division. A warehouse line of credit with a commercial or investment bank is the traditional way that mortgage lenders are funded.

After repeatedly overdrawing his line of credit, and increasingly relying on fake loans to get money out of Colonial Bank, Farkas made a couple of changes in the structure of his borrowing, finally settling on repurchase transactions.

In 2005 Farkas got Colonial Bank to make him a series of repo loans, in which the collateral was interests in pools of non-existent or troubled mortgages that Farkas privately called “crap,” according to prosectors. Farkas told Colonial Bank he would repurchase the bank’s interest in the pools within 30 to 60 days, as soon as he created securities backed by the pools and sold the securities to investors.

The advantage for Farkas of the repurchase transaction over other loan arrangements was that the collateral was the interest in the pools, not individual loans, and Colonial Bank did not review or track the individual loans in the pool. That made it harder for regulators, auditors and others to spot the fraud, according to prosecutors.

These opaque pools were the “data” Farkas was talking about when he said, “It’s very common in our business to, to sell — because it’s all data, there’s really nothing but data — to sell loans that don’t exist. … It happens all the time.”

Prosecutors did not say why Colonial Bank agreed to the repo transactions in 2005, except that the bank wanted Farkas’ business.

It seems possible that Colonial Bank agreed to the repos because in April of that year the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 added repos collateralized with mortgages and interests in mortgages to the list of repurchase agreements that were exempt from the claims of other creditors when a repo borrower like Tayor, Bean went bankrupt.

In fact, in 2005 many lenders like Colonial Bank changed their warehouse lines of credit to repo loans and relaxed their due diligence because the Bankruptcy Act had moved their claim to the head of the line in a bankruptcy.

Some economists say this freeing of repo lenders from having any ‘skin in the game’ played a critical role in the financial crisis of 2007-2008. To this day most repos are exempt from bankruptcy claims.

The second phase of Farkas’ scheme was the securitization phase:

Taylor, Bean & Whitaker created a subsidiary called Ocala Funding LLC, which sold asset-backed commercial paper to investors and used the money to buy Taylor, Bean’s fake loans, which it securitized.  The investors who bought the asset-backed commercial paper and wound up taking the biggest hits were two large European banks, Deutsche Bank and BNP Paribas.

The fake loans included nonexistent loans as well as reused crap loans. Sometimes Taylor, Bean used loans that it had already sold to mortgage giant Freddie Mac and had also used as collateral for Colonial Bank repos and as collateral for the ABCPaper sold to Deutsche Bank and BNP Paribas.

From the Securities and Exchange Commission civil case against Farkas:

Thus, as a result of Defendant Farkas’ fraudulent conduct, Colonial Bank, the collateral agent, the Ocala Investors, and Freddie Mac have competing claims to approximately $1 billion of mortgage loans originated by TBW

“In 2008, Lee Farkas boasted that he ‘could rob a bank with a pencil.’ And he did just that,” U.S. Attorney Neil H. MacBride said in an April 19 press release announcing the conviction. The line harkens to the famous verse in Woodie Guthrie’s song “Pretty Boy Floyd”:

Yes, as through this world I’ve wandered
I’ve seen lots of funny men;
Some will rob you with a six-gun,
And some with a fountain pen.

Survivors of the S&L days will enjoy knowing that Colonial Bank turned to a familiar S&L trick in 2008 when regulators began closing in – Colonial changed regulators, transferring from a federal to an Alabama state charter.

From the FDIC Office of Inspector General’s material loss review on the failure of Colonial Bank:

According to the Office of the Comptroller of the Currency, in response to the examiners’ findings, bank management became argumentative and recalcitrant and, unbeknownst to the OCC, bank management also sought out a charter change.

The state regulators found the same problems that the Office of the Comptroller of the Currency did, and state regulators closed Colonial August 14, 2009, saying it had been mortally wounded by the Farkas fraud and also by its own mismanagement, poor lending decisions and risky investing. By March 31, the estimated loss to the FDIC insurance fund was $3.8 billion.

Six executives at Taylor, Bean or Colonial Bank have pleaded guilty in the scheme.

Media accounts of the trial do not mention securitized banking or repos. Instead they say Farkas sold worthless and fake mortgages to Colonial Bank and Ocala Funding. Or Colonial lent hundreds of millions of dollars on worthless and fake mortgages. Or Ocala Funding sold commercial paper backed by worthless and fake mortgages.

This shorthand denies readers the understanding that this fraud occurred in the wheeling-and-dealing market among giant financial institutions that was responsible for the financial crisis of 2007-2008.

It denies readers the insight of how easy it is to fake collateral on the repo market, and how vulnerable that market was, and still is, to manipulation and runs.

It denies Americans – who ultimately bore the losses in the last crisis, and who will bear them again in the next – a chance to weigh in on what RepoWatch considers to be the most important, and most ignored, issue of the financial crisis: How should securitized banking be reformed?

The case is U.S. v. Farkas, 10-cr-00200, U.S. District Court, Eastern District of Virginia (Alexandria).

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