By William K. Black
Greetings from Quito, Ecuador!
Introduction: The SDIs Pose Systemic Risks
This article makes the policy case that U.S. subsidies to its systemically dangerous institutions (SDIs) violate World Trade Organization (WTO) principles. The WTO describes its central mission as creating “a system of rules dedicated to open, fair and undistorted competition.” There is a broad consensus among economists that the systemically dangerous institutions (SDIs) receive large governmental subsidies that make “open, fair, and undistorted competition” impossible. To date, WTO is infamous for its hostility to efforts by nation states to regulate banks effectively. At best, the result is a classic example of the catastrophic damage cause by the “intended consequences” of the SDIs’ unholy war against regulation.
There is broad agreement among economists that the U.S. provides extremely valuable subsidies to the SDIs and that these subsidies have disastrous consequences. Neither major Party in the U.S., however, is willing to end the SDIs or even subject them to effective regulation. I propose that Latin America take the lead in demanding that the WTO live up to its stated mission and stop the massive governmental subsidies that the rent-seeking SDIs have extorted through their political power and their ability to hold the global economy hostage. It would be a irony of cosmic degree if the WTO, among the SDIs’ most consistent allies were to find the SDI subsidies to violate U.S. treaty obligations. (The same argument can be made against other nations that subsidize their SDIs, but some of the best data on the magnitude of the subsidies and the damage they cause is available now in the United States.
The direct bailout programs to banks were enormous, but the indirect subsidies through massive purchases by the Fed of poor quality mortgage paper are far larger. The Fed continues to hold the paper and to refuse to book losses on the bad loans. The SDIs receive an even more opaque subsidy, however, and it too is massive. The SDIs are able to borrow more cheaply and have greater leverage because they are perceived as “too big to fail.” Because they pose a systemic risk of causing a global crisis SDI creditors believe that the U.S. is likely to bail them out rather than allow an SDI to collapse. In economic essence, the SDIs hold the global economy hostage, daring the U.S. to allow them to collapse and spark a global crisis.
Economists and bank regulators favor a thoroughly dishonest term that should be treated with derision – “systemically important” – as if the SDIs deserved a gold star for putting the global economic system under constant risk of catastrophic failure. The U.S. does not bail out banks because they are well run institutions that provide unique benefits to the economy. It bails out banks because they are so badly run that they have losses so large that the regulators fear could cause cascade failures at dozens of other banks. I urge you to call authors on their use of any euphemism that fails to stress that these banks are systemically dangerous.
The U.S. is in the process of trying to define which banks are SDIs, but there are roughly 20 U.S. financial institutions that the regulators have treated as SDIs during this crisis. That means that the continued existence of the SDIs requires us to roll the dice twenty times every day to see whether one or more of the SDIs have reverted to form and suffered losses so great that they threaten to fail and cause a global systemic crisis. To (cheerfully) mix my metaphors, the SDIs are ticking time bombs.
Treasury implicitly Subsidizes the SDIs
Regulators believe SDIs pose systemic risk whenever they fail. One of the scenarios that the regulators most fear is a “cascade failure” in which the failure of the SDI causes the failure of a series of banks because the creditors of the first bank suffer losses and either fail or suddenly withdraw their loans to other banks to seek to avoid similar losses. Regulators, therefore, typically bail out some or all of the creditors of SDIs – even uninsured creditors – in order to avoid prompting cascade failures. Economists argue that creditors recognize this dynamic and are more willing to lend funds to SDIs than to smaller banks. This greater willingness constitutes a valuable, implicit government guarantee to the SDIs’ creditors.
Economists Estimate that the Value of the Subsidy to the SDIs is Enormous
Economists have estimated that the value of U.S. subsidy to just two SDIs, Fannie and Freddie, was many billions of dollars. Four Stern School finance professor at NYU (Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence J. White) recently authored the book Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance (Princeton 2011) (“Stern 2011”) that discuses these estimates.
In a May 2001 updated study, the CBO estimated that the annual implicit subsidy had risen to $13.6 billion by the year 2000. A few years later, Federal Reserve Board economist Wayne Passmore … estimated that the aggregate value of the subsidy ranged somewhere between $119 billion and $164 billion, of which shareholders received respectively between $50 and $97 billion (p. 29).
Economists now argue that those estimates of the value of the U.S. subsidy to only two of the 20 SDIs proved to be far too low because Fannie and Freddie changed their operations to create even greater systemic risks subsequent to these estimates in manners that greatly increased the value of the subsidy to its creditors (and, therefore, to the SDIs’ controlling managers). From “Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009,” by Viral V. Acharya, Thomas Cooley, Matthew Richardson and Ingo Walter in Foundations and Trends in Finance Vol. 4, No. 4 (2009) 247–325 (“Acharya, et al. 2009”) we find:
Consider the investment function of the GSEs. For every $1 of mortgage-backed securities purchased with equity, there was a large amount of debt issued to purchase additional mortgage-backed securities. Figure 2.2 shows the book and market leverage ratios of the GSEs, measured as assets divided by equity, over the period 1993–2007. The extraordinary point to note is the access to very high leverage, given that the GSEs were investing in risky, relatively illiquid mortgage-backed securities. This provides an idea of the size of the implicit government guarantee. In fact, the literature has quantified the transfer from taxpayers to the GSEs to be in the billions of dollars even before the crisis ignited (see, for example Passmore, 2005; Lucas and McDonald, 2006) (p. 270).
These data indicate that the U.S. subsidy to the SDIs is far larger than total U.S. trade subsidies to agriculture.
While Economists often denounce the GSEs’ Subsidies, all SDIs are de facto GSEs
The Stern 2011 authors concede that the SDIs are all de facto Government Sponsored Enterprises (GSEs). Fannie and Freddie were entirely-privately owned and managed. It was their private managers who exploited the implicit federal subsidy.
But when one scratches below the surface, the failure of the LCFIs and the GSEs is quite similar – a highly leveraged bet on the mortgage markets by firms that were implicitly backed by the government with artificially low funding rates only to differing degrees (p. 49).
(“LCFI” is another euphemism for SDIs. It refers to Large, Complex Financial Institutions.) The Stern authors argue that the massive U.S. investment banks were able to secure extraordinary leverage at extremely low interest rates because they were SDIs.
Economists Argue that the Subsidy Gives the SDIs Decisive Advantages over Competitors
The Stern authors (2011) present this simile to explain the extent of the SDIs’ competitive advantage over non-SDIs: “Opening up mortgage markets without restraining Fannie and Freddie was like bringing a gun to a knife fight” (p. 22). They follow this up with an even more colorful metaphor that shows that they recognize that their logic applies to all SDIs, for the refer to “LCFI King Kongs and GSE Godzillas – both implicitly backed by the government….” (p. 55). Nobody normal – without a huge subsidy from the U.S. – can compete with either King Kong or Godzilla.
The Stern scholars’ recent book quotes with approval from Alan Greenspan’s May 19, 2005 speech denouncing the destruction of competition caused by the Treasury subsidy to U.S. SDIs (pp. 29-30).
[I]nvestors worldwide have concluded that our government will not allow GSEs to default…. Investors have provided Fannie and Freddie with a powerful vehicle for achieving profits are virtually guaranteed through the rapid growth of their balance sheets, and the resultant scale has given them an advantage that their potential private-sector competitors cannot meet. As a result, their annual return on equity, which has often exceeded 30 percent, is far in excess of the average annual return of approximately 15 percent that has been earned by other large financial competitors holding substantially similar assets. Virtually none of the GSE excess return reflects higher yields on assets; it is almost wholly attributable to subsidized borrowing costs…. The Federal Reserve Board has been unable to find any credible purpose for the huge balance sheets built by Fannie and Freddie other than the creation of profit though the exploitation of the market-granted subsidy.
I was an expert witness for the regulatory agency (then, OFHEO) in its administrative enforcement action against the top leaders of Fannie during this era. Greenspan’s analysis is wrong because he ignores accounting control fraud. As the SEC staff investigation found, and the SEC explicitly charged in its suit, Fannie’s controlling officers created its extreme (fictional) returns by engaging in accounting fraud for the purpose of maximizing their incomes, which grew massive if they reported extraordinary profits. Note also that Greenspan’s statement that “virtually none” of Fannie and Freddie’s fraudulently reported income was due to purchasing higher yield mortgage paper was incorrect (indeed, the Stern authors stress this point repeatedly). Fannie and Freddie were far smaller players in liar’s loans in 2005, but they were far from trivial players. Greenspan is internally inconsistent in claiming (1) that no private entity could compete effectively with Fannie and Freddie and (2) that Fannie and Freddie had “virtually no” nonprime loans. In 2005, Fannie and Freddie had lost substantial market share precisely because other SDIs were aggressively purchasing and securitizing nonprime loans.
When the SEC discovered Fannie and Freddie’s accounting and securities frauds, OFHEO substantially limited the growth of Fannie and Freddie’s portfolio (not securitization). Unfortunately, OFHEO did not order an end to Fannie and Freddie’s criminongenic compensation systems. With portfolio growth limited, but massive bonuses still available for reporting high returns, the obvious alternative fraud strategy was to purchase dramatically more nonprime loans at premium yields to hold in portfolio.
These corrections of Greenspan’s analytical errors, however, simply add to the thrust of the logic of the Stern (2011) authors’ argument. The SDIs dominated the securitization and holding in portfolio of nonprime loans, particularly fraudulent “liar’s” loans. The officers controlling the SDIs did so because, under the constraints of OFHEO’s restrictions on portfolio growth, this was the fraud tactic that optimized guaranteed, (fictional) reported income and their compensation.
Economists argue that SDIs remove Effective Private Market Discipline
Because SDIs’ creditors are protected from loss, and because it is expensive for creditors to provide effective private market discipline, the Stern authors state that creditors cease to provide effective market discipline. The Stern (2011) authors found that the collapse of private market discipline with regard to the SDIs was so complete that there was a “lack of any market discipline imposed by creditors” (p. 55).
Economists argue that the Removal of Effective Discipline Maximizes Moral Hazard
The Stern (2011) authors note that SDIs inherently produce moral hazard problems even “in normal times” (p. 56). Under the authors’ logic, the subsidy to the SDIs must remove effective private market discipline against fraudulent and abusive SDI business practices by the SDIs’ controlling officers. This means that the U.S. Treasury subsidy that SDIs inherently receive must make the banking environment substantially more criminogenic for “accounting control fraud.”
Economists & Criminologists Recognize that Accounting Control Frauds Drive Crises
Accounting control fraud refers to a situation in which the officials who control a seemingly legitimate entity use accounting as a “weapon” to defraud the firm’s creditors and shareholders. Accounting control fraud epidemics drove the three recent U.S. financial crises: the savings & loan debacle, the Enron-era frauds, and the epidemic of nonprime mortgage fraud that drove the ongoing crisis. The title of George Akerlof and Paul Romer’s famous 1993 article captures the essence of accounting control fraud – “Looting: the Economic Underworld of Bankruptcy for Profit.” See also, Black, William K. The Best Way to Rob a Bank is to Own One (2005).
The Stern (2011) authors use euphemisms for accounting control fraud (“tail risk”), but their logic and factual descriptions support their recognition that what they are describing is a classic accounting control fraud that followed the standard four-ingredient recipe for simultaneously maximizing (fictional) reported income, real executive compensation, and real losses. That recipe is:
- Grow extremely rapidly
- By making (or purchasing) bad loans with premium yields, while employing
- Extreme leverage, and
- Providing grotesquely inadequate allowances for the inevitable losses.
The Stern authors describe Fannie and Freddie’s strategy as a “Ponzi scheme” (p. 5) – which is, of course, a fraud. Akerlof & Romer made the key analytical point:
The problem with [economists’ conventional description of moral hazard as an] explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications. Examinations of the operation of many such thrifts show that the own ers acted as if future losses were somebody else’s problem. They were right (1993: 4).
Note the business practices that Akerlof & Romer aptly said an honest lender would never engage in – the precise practices that characterized nonprime lenders and investors in this crisis.
Economists Argue that Subsidizing SDIs make Free Markets Impossible
The destruction of competition and the creation of a perfect environment for accounting control fraud inherent with SDI subsidies mean that free markets are impossible. The Stern (2011) authors are blunt on this point: “there was nothing free about these markets” (p. 21). SDIs create extreme market concentration and enormous income inequality.
Akerlof & Romer and financial regulators and criminologists’ discovery of the recipe that the controlling officers use to maximize reported (albeit fictional) reported income concur that the optimal strategy is to make or purchase loans with a negative expected value. This makes “markets” profoundly inefficient. Accounting control frauds are engines of mass financial destruction that destroy wealth at a prodigious rate. Accounting control frauds also cluster in the most criminogenic industries, regions, and products. This, and each of the ingredients of the fraud recipe, makes them the ideal weapon for hyper-inflating financial bubbles. Financial bubbles are damaging as they grow because they systematically misallocate assets and capital, but they can be catastrophic when they collapse if they have been allowed to hyper-inflate.
Accounting Control Frauds Spawn “Echo” Epidemics
George Akerlof’s seminal 1970 article on “lemon” markets presents several examples of anti-customer control frauds in which the seller deceives the buyer about the quality of the good. He added the powerful insight that these frauds could produce a “Gresham’s” dynamic because dishonest sellers would gain a competitive advantage over their honest rivals. At the extreme, the market would become perverse and drive honest sellers out of the marketplace. Criminologists have employed Akerlof’s insights to explain how control frauds deliberately create Gresham’s dynamics suborn “controls” (e.g., appraisers) and agents (e.g., mortgage brokers) into fraud allies in manner that produces limited risk of detection and prosecution. The CEO running a fraudulent nonprime lender simply creates perverse financial incentives that create intense Gresham’s dynamics. It is insane for an honest lender to pay bonuses to loan officers and brokers based on volume with no penalty for making bad loans – but it is optimal for an accounting control fraud to do so. In criminological jargon: control fraud is criminogenic. In plainer English: fraud begets fraud.
Accounting Control Fraud Erodes Trust and Can Cause Market Collapses
Economists and scholars from multiple disciplines have increasingly begun to find how valuable trust is in many contexts. It is essential to finance. The defining element at law of “fraud” is “deceit.” To commit a fraud a perpetrator gains the victim’s trust – and then betrays it. This is why fraud is the most effective acid against trust. Fraud by elites is the most destructive assault on trust. Fraud can cause market collapses long before it becomes endemic because of its ability to harm trust. Consider attending a conference or concert where everyone is given a bottle of water. If the public health authorities announce that one bottle in a hundred is contaminated, how many of us will drink our bottle. Markets collapsed in 2008 because bankers no longer trusted other bankers to tell the truth about the value of the assets they were selling. That lack of trust was rational, for deceit was the norm in the sale of “liar’s” loans.
Vigorous Regulation Can Block SDIs from Causing Crises – but SDIs Destroy Regulation
The Stern (2011) authors stress that the SDIs inherently create a regulatory “race to the bottom” (p. 41). More broadly, they understand that economic domination of this degree not only destroys free markets but free democracies. The SDIs will use political contributions and lobbying power to try to emasculate regulation and criminal justice systems because they recognize that only these public sector bodies can possibly restrain or remove the SDIs. The good news is that economists broadly agree that the SDIs confer no real economic advantages. They are too large to be efficient. Their domination is due solely to their receipt of huge governmental subsidies. That means that shrinking the SDIs in size would simultaneously increase bank efficiency and market efficiency while dramatically reducing fraud and systemic risk and restoring more functional and democratic government.
The revolutionary nature of their logic is all the greater because their logic suffers from a devastating blind spot. Once that blind spot is removed their logic invites the reader to look behind the edifices and see that the modern “free market” economy is a Potemkin prank. The authors provide a superb example of why James Galbraith’s titled his most recent book The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too. The irony of modern “capitalism” is that its leaders are the CEOs running the SDIs and, as the authors demonstrate, SDIs inherently make it impossible for markets to be “free”, efficient, or sound. The SDI CEOs that dominate our economy and government are implacable foes of real markets. Their bleating about the wonders of the markets is a cynical sham designed to block effective regulation. They oppose effective regulation precisely because it would create more competitive markets. They hate free markets. They want rigged markets that ensure they will destroy any honest competitor.
The SDIs’ CEOs are not risk-takers. They seek a sure thing. Risk-taking is supposed to be the essence of capitalism. The Stern authors’ case study provides yet another example supporting Robert Prasch’s insights about risk. His classic 2004 article is entitled “Shifting risk: the divorce of risk from reward in American capitalism.” In 1993, George Akerlof and Paul Romer authored the most important economics paper on financial crises, entitled Looting: the Economic Underworld of Bankruptcy for Profit. Akerlof & Romer explained the ultimate separation of risk and reward – what criminologists now term “accounting control fraud.” Akerlof & Romer explained how financial CEOs used accounting fraud to make record reported profits a “sure thing” (p. 5). The record, albeit fictional, reported profits were certain to make the CEO and his confederates wealthy through modern executive compensation. The bank was guaranteed to fail. The only question was how soon it would fail.
SDIs are Expert at Evading Rules with Impunity
The Stern (2011) authors explain that the SDIs first corrupted the Basel II rules on bank capital requirements (the regulators made them partners in creating the rules) and then used Special Investment Vehicles (SIVs) to evade even the weakened capital requirements. The authors aruge that the SIVs, corrupt credit rating agencies, weakened capital requirements, and the death of private market discipline led to obscene levels of leverage. Leverage, of course, is debt and debt means creditors. Prior to the crisis, Judge Easterbrook & Professor Fischel claimed that extreme leverage guaranteed that accounting control fraud could not occur. SDIs can afford to hire armies of professionals whose task is to create opaqueness and complexity for the express purpose of defeating even vigorous regulators. The SDIs are “too big to regulate.”
The SIVs raise a broader point that I will only mention due to the length of this paper. The entire shadow banking system is another area of implicit governmental subsidy and such subsidies should be prohibited under WTO rules. The subsidies include the avoidance of taxes, another practice that is a defining element of U.S. SDIs. Most disturbingly, the shadow banking system is the source of many efforts to manipulate commodity prices – including food – which imperils hundreds of millions of people in less developed nations. These efforts at manipulation make markets far less efficient, so there is no excuse for the allowing these murderous manipulations to continue. The WTO should act with no bureaucratic delays as a scourge against these subsidies to the shadow banking system.
The Bailouts of SDIs Have Increased the Subsidies
Again, due to concern for length I will simply make the observation that virtually all the U.S. efforts to bail out the SDIs (including quantitative easing) constituted increased subsidization of the SDIs. If the U.S. will only act to make the subsidies worse, then the WTO must act, and for the WTO to act a member nation must bring a complaint against the U.S. subsidies of the SDIs.