I know I have lost the argument that in a mortgage fraud case, calculating the “actual loss” under the federal sentencing guidelines should include a reasonably foreseeable analysis, but it makes me feel better to continue to beat the drum on the argument that there is a better approach.
Generally, “’actual loss’ means the reasonably foreseeable pecuniary harm that resulted from the offense.” USSG § 2B1.1, App. Notes 3(A)(i). Unfortunately, in a mortgage fraud case, the reasonable foreseeably language has been given an unreasonably narrow interpretation. This narrow interpretation results from the use of a two step approach. In step one, the court determines the reasonably foreseeable amount of loss at the time the crime was committed with no consideration for market conditions or other external factors. It appears that that in a mortgage fraud case the reasonably foreseeable amount of the loss will always be the amount of the loan. The second step requires the court to credit the defendant for the market value at the time of sentence of any collateral sold. The value given to this offset amount carries with it no consideration that it be reasonably foreseeable to the defendant. In other words, the credit is whatever the value of the collateral is at the time of sentencing with no further analysis. In essence, this approach, in my opinion, renders the “reasonably foreseeable pecuniary harm” language of USSG § 2B1.1, App. Notes 3(A)(i) completely meaningless; in this analysis the total amount of the unpaid principal is always the “actual loss” – period.
To fully appreciate the unforeseeable nature of the real estate market collapse, it may be helpful to explore what was happening in Wall Street during the last 15 to 20 years and the effect that those events had on real estate prices. Historically, the American public and the institutional investors that manage large retirement instruments have largely relied on the stock market as its principal place for investments. In the mid-to late 1990s, institutional investors began to shift their portfolios to include newly created bond instruments, which promised a reasonable rate of return with the low level of risk usually associated with government bonds. These bonds were largely backed by corporate debt. At its simplest form, these bonds were made up of the obligation instruments of American corporations. As corporations paid their debts, bondholders received the benefit of those returns. Given their safety and attractive rates of return, the appetite for these instruments grew exponentially. The problem was that once the available corporate debt was absorbed and repackaged by these new investment instruments, the availability of new bonds was practically nonexistent.
Wall Street dealt with this dilemma by looking for other historically safe debt whose returns could be packaged into AAA rated bonds and sold to investors in much the same fashion as the corporate debt backed bonds had been. Because the default rate in American home mortgages was historically very low, home mortgage backed bonds became an ideal product to satisfy investors’ desire for this type of investment. However, like the corporate debt backed bonds, there was a finite number of American home mortgages available to be purchased and repackaged.
The seemingly insatiable appetite in Wall Street for purchasing mortgage debt led commercial banks to make more and more loans to an ever-increasing group of less credit worthy debtors, knowing that they would not have to bear the risk for these loans since the debt obligation would be purchased by Wall Street investment banks and sold to investors in the form of bonds. With more and more banks lending money for the purchase of real estate and more and more Americans taking advantage of what seemed like favorable market conditions, real estate prices continued their upward climb.
Of course as the credit worthiness of home purchasers decreased, one would expect the rating of the bonds to likewise decrease. Wall Street investment banks sidestep this problem by creating bonds, which packaged the mortgages of credit worthy homeowners with a sprinkling of riskier mortgages. Eventually the percentage of riskier mortgages packaged with those of credit worthy homeowners shifted radically but the rating of the bonds never did. By this time, the rating agencies and institutional investors were so enamored with these instruments and so convinced of their safety that they failed to carefully scrutinize them. In fact, insurance giants like AIG felt so confident of the soundness of these mortgage-backed bonds that, to their demise, they insured billions of dollars in these ultimately risky instruments.
As we all know now, the day of reckoning came — despite predictions to the contrary by legions of highly trained, well regarded analysts, Americans failed to make mortgage payments in record numbers; this caused billions of dollars in mortgage backed bonds to fail and become worthless. In the process the demand for real estate came to a screeching halt, which sent values tumbling down.
It is difficult to conceive how anyone could reasonably suggest that the collapse of the mortgage backed bond market, and with it the real estate market, was reasonably foreseeable to any real estate investor. That is precisely what the test should be – “whether market factors and the resulting loss were reasonably foreseeable.” United States v. Parish, 565 F.3rd 528, 535 (8th Cir. 2009). How could a real estate investor had foresee this market collapse when in early 2007, the time frame of the loans in question, respected Wall Street giants like “Bear Stearns and Lehman Brothers continued to publish bond market research reaffirming the strength of the market.” Michael Lewis, The Big Short 165 (First Edition, W. W. Norton & Company, Inc., 2010).
A sentencing court should employ a mechanism that “incorporates a causation standard that, at a minimum, requires factual causation (often called `but for’ causation) and provides a rule for legal causation.” United States v. Olis, 429 F.3d 540, 545 (5th Cir. 2005). In other words, a sentencing court should determine those reasonably foreseeable losses caused by the fraud, as opposed to those losses caused by independent factors and therefore not reasonably foreseeable.
The mechanism for determining actual loss — deducting the fair market value of the real estate at the time of sentencing from the amount of the loan would be appropriate except for the unprecedented, unforeseen collapse in real estate values, which occurred in 2007 and thereafter. Because this collapse is unrelated to the vast majority of the garden variety mortgage fraud crimes and not reasonably foreseeable, courts should adopt a more sophisticated approach in order to segregate those losses that are completely unrelated to the defendant’s conduct. As articulated by the Ninth Circuit, this Court, “must take a realistic, economic approach to determine what losses the defendant truly caused or intended to cause.” United States v. West Coast Aluminum Heat Treating Co., 265 F.3d 986, 991 (9th Cir. 2001).
As previously noted, since the end of Great Depression, real estate values in the United States have remained constant or steadily increased. The chart below provides clear evidence of the systematic increase in property values from the 1960s through early 2007.
Given the clear escalation of real estate prices throughout the last 50 years, the current method for calculating the loss would have been appropriate for a sentencing taking place prior to February of 2007 and in fact, in certain cases, may have provide a benefit to the defendant. For example, a defendant who committed bank fraud related to a real estate transaction and sentenced several years after the loan secured by the real estate was obtained would almost certainly have received the benefit of the appreciation of the real estate during those years.
As demonstrated by the chart above, from 1963 until early 2007, any defendant who obtained a loan by fraudulent means, collateralized by real estate, reasonably expected that the value of that collateral would remain the same or increase and as a result would have been able to reasonably foresee the potential pecuniary effect of his crime to the lender.
This necessarily means that the current mechanism for determining loss, if used in a sentencing hearing anytime after the Great Depression but before 2007, would have provided a sentencing court with the type of “a realistic, economic approach” discussed in West Coast Aluminum Heat Treating Co. Id. However, as seen in the chart below, beginning in approximately February of 2007, radical unforeseen depreciation of real estate values across the United States renders this approach inappropriate, in that it fails to account for losses in the value of real estate that are completely unrelated to the crime before the court for sentencing.
As depicted in the chart above, since 2007 average real estate prices across the United States have dropped in value by nearly 40%; in some instances the decline has been even greater with some Sarasota real estate parcels experiencing a loss in value of as much as 90%.
While the drastic drop of real estate value is fairly recent, the issue of determining loss based on instruments that suffer rapid devaluation from conditions unrelated to the criminal conduct involved is not unprecedented. A number of sentencing courts have dealt with this type of issue. This is often seen in securities or commodities cases; the value of these types of instruments is often influenced by a universe of factors, often unrelated to the criminal conduct. The methods used by courts in these types of cases are instructive because they must undertake the process of determining the amount of the loss to the value of the security, which resulted from the fraud as opposed to unrelated market conditions. See generally, Olis, 429 F.3d 540 (5th Cir. 2005), United States v. Ebbers, 458 F3rd 110 (2nd Cir. 2006) and United States v. Rutkoske, 506F.3d 170 (2nd Cir. 2007). In Ebbers, the court insisted that those losses ‘from causes other than the fraud must be excluded from the loss calculation.” Ebbers at 128.
The Ninth Circuit in wrestling with the proper calculation of the loss figure in a securities fraud case stated that a sentencing court “must disentangle the underlying value of the stock inflation of that value due to the fraud and either inflation of deflation of that value due to unrelated causes.” United States v. Zoplin, 479 F3rd 715,719 (9th Cir. 2007). The disentanglement discussed in Zoplin in precisely the type that must be done here since the reason for drop in value was not reasonably foreseeable or related to fraud. Fortunately there are several reliable methods that do just that.
One such method is to rely on an independent appraiser to determine the true market value of the condominiums at the time the loans were obtained (as opposed to the inflated purchase prices used in the transactions) and then deducting the amount of the true market value from the amount of the loans (Appraiser Method).
Another reasonable alternative for determining the loss would be to examine the sale prices of the comparable, unrelated units purchased around the same as the defendat’s purchases. From that, one can determine the average sales price for that type of unit and compare it to the amount financed by the defendant for a comparable unit and the multiply the difference by the number of units financed.
While these two approaches result in different loss figures, they both provide the court with mechanisms, which yield reasonably foreseeable loss figures and which exclude the totally unrelated precipitous real estate market collapse and will necessarily yield a more just sentence.