Green Slime Drives Our Financial Crises

By William K. Black

“Pink slime” just had its fifteen minutes of fame.  BPI, the producer of pink slime, calls it “Lean Finely Textured Beef.”  BPI’s slogan is “expect a higher standard.” Pink slime starts with fatty tissues that are inherently more likely to be repositories of salmonella and e coli infections.  The tissues are shredded and rendered and most of the fat drained off.  The pink slime, however, is still more likely to be infected after this processing and that makes it dangerous and can make it smell spoiled.  BPI’s “innovation” was to gas the pink slime in Mr. Clean (ammonia) to try to kill bacteria and reduce the stink.  The resultant pink slime is then frozen into bricks and shipped in bulk.

Pink slime was originally limited to dog food, but it has secretly been fed to Americans for a decade.  Major hamburger chains, grocery stores, and school lunch programs added it to make up 15% of our burgers.  The government didn’t require disclosure of pink slime or ammonia.  Tests have established that pink slime remains more likely to harbor dangerous bacteria and that the only way to reduce that problem is to add so much Mr. Clean that the pink slime stinks and tastes awful.  Because BPI could not sell the product if it continued to stink and taste awful they reduced the amount of Mr. Clean they used in processing and the risk of the pink slime harboring dangerous bacteria rose.

The New York Times revealed the pink slime scandal in a story that ran on December 31, 2009.  Unfortunately, it buried the lead.  The story broke the news that Gerald Zirnstein, a government microbiologist, had dubbed the product “pink slime” in 2002, but it did so around the 25th paragraph and the story did not generate a demand for reform.     

A few weeks ago, Kit Foshee, a former BPI employee fired for blowing the whistle on pink slime, helped make the secret adulteration of hamburgers with pink slime a scandal.  Once the public focused on pink slime they decided that they did indeed “expect a higher standard” for their burgers and BPI lost so much business that it closed three of its four plants producing pink slime.

The infected, odiferous, and bad tasting pink slime (aka, the “higher standard”) secretly added to our burgers for over a decade would be embarrassing to any system that pretends to the label “free enterprise,” but it has special resonance amongst economists.  Adam Smith’s most famous saying, which captures his central vision of markets, is a seemingly paradoxical tale about butchers.  He wrote that we could rely on the butcher providing us with wholesome meat not because of his altruism, but because of his far more reliable devotion to self-interest.  Our butcher may not care about us, but he cares about whether he gets our business.  This causes him to act reliably as if he cared for our well-being.  He knows that if he sells us unfit meat we will cease buying meat from him and his business will fail.  Pink slime is inconceivable in Adam Smith’s ode to the self-interested butcher.

Relying on corporate butchers’ self-interest (greed) has been proven to be unreliable by the pink slime deception.  Greedy corporate butchers taught that they should not really care about the customer’s well-being realized that they could maximize their self-interest by selling us pink slime as long as they could do so secretly.

Modern finance theory extended Smith’s paradoxical tale about the butcher to the financial world.  Theorists assured us that financial markets were, absent regulation, reliably “efficient” because they were “self-correcting.”  Any pricing error created a profit opportunity for trades and those trades removed the pricing error.  “Accounting control fraud” is impossible because it would create a consistent pricing bias by overstating the value of the securities issued by the frauds.  The markets exclude fraud so effectively that “a rule against fraud is not an essential or … an important ingredient of securities markets” (Easterbrook & Fischel 1991).

“Private market discipline” adds to the impossibility of accounting control fraud.  Creditors suffer severe losses and fail if they make imprudent loans.  They have an incentive to develop the experience, expertise, and systems to ensure that they underwrite superbly prior to making large, risky loans.  A lender’s central expertise should be underwriting and an investment bank’s central expertise should be “due diligence.”  The biggest banks and investment banks, which pay starting compensation of well over $100,000 should have incomparable skills in conducting, respectively, underwriting and due diligence.

It is, therefore, inconceivable under modern financial and economic theory that the financial crisis we continue to suffer from could occur.  As with the perversion of Adam Smith’s reliable butcher into a corporate butcher specializing in aiding the secret adulteration of our burgers with pink slime, however, the CEOs of our leading financial firms have adulterated our financial system with green slime (the color of our money.)  Pink slime was limited to 15% of our burgers and it generally does not makes purchasers sick.  Green slime became one-third of the mortgages made in 2006 and close to 100% of our collateralized debt obligations (CDOs).  Green slime typically caused severe financial losses.  The financial CEOs did not add Mr. Clean to their green slime to reduce its endemic infestation by pathogens.  They did, however, tell us to “expect a higher standard.”  Indeed, they ensured that the rating agencies would rate the green slime “AAA” and the outside auditors would give clean financial opinions to financial statements claiming that green slime was “prime” and free of adulteration.  The meat butchers and the financial butchers called their slimed products “prime” – prime meat and prime loans.

Green slime drove the current crisis, just as it did the Enron era frauds and the second phase of the S&L debacle.  Studies of “liar’s” loans have shown their fraud incidence to be 90% — they are virtually all fraudulent.  The Orwellian term that BPI used to disguise the nature of pink slime was “Lean Finely Textured Beef.”  The Orwellian term the industry favored to disguise the nature of green slime was “Alt-A.”  “A” signifies that the mortgage is of the lowest credit risk – it is “prime.”  “Alt” is short for “alternative” and, falsely, implies that the loans were underwritten by an alternative process.  Failing to underwrite, e.g., by verifying the borrower’s income, is not an “alternative” means of underwriting.  Honest mortgage lenders do not make liar’s loans (the term that the lenders used in private to describe their green slime) because they create severe “adverse selection” and encourage endemic fraud.  Both results mean that the expected value of making such loans is negative.  In plain English, that means that the lender will suffer catastrophic losses and fail.

Liar’s loans became the most common form of non-prime mortgage loans.  Many commentators make the fundamental mistake of assuming that liar’s loans and subprime loans are mutually exclusive.  “Subprime” refers to borrowers known to have serious credit defects.  “Liar’s loans” refers to the lender’s failure to verify essential information such as the borrower’s income.  Mortgage lenders created the most toxic form of green slime by making liar’s loans to subprime borrowers.  By 2006, roughly one-half of the loans called “subprime” by the lenders were also liar’s loans.  That means that by 2006 roughly one-third of all mortgage loans made that year were liar’s loans.  Liar’s loans grew massively between 2003 and 2006.  The growth rate appears in that period appears to be over 500%.  Liar’s loans hyper-inflated the housing bubble.

The rapid growth in liar’s loans continued after the mortgage industry’s own anti-fraud experts and federal and state regulators warned that loans were endemically fraudulent – green slime.  Lenders and their agents were responsible for putting the lies in liar’s loans by creating perverse compensation systems and encouraging liar’s loans despite the fact that they knew such policies were the perfect growth medium for green slime.  (Criminologists call environments that create the perverse incentives for crime “criminogenic” – a direct steal from microbiology’s concept of a “pathogenic” environment.)

Liar’s loans constitute the ideal “natural experiment” that allows us to test why lenders made millions of liar’s loans and  why the largest commercial and investment banks purchased the green slime to create the even slimier CDOs.  No government official, law, or rule required any mortgage lender to make liar’s loans or any entity (and that includes Fannie and Freddie) to purchase liar’s loans or CDOs.  To the contrary, federal regulators – even under the Bush administration – warned against making liar’s loans and Fannie and Freddie did not get credit toward their “affordable housing” goals for making liar’s loans.  Lenders made, and the largest investment banks and Fannie and Freddie purchased, vastly more liar’s loans after being warned that such loans were overwhelmingly fraudulent and likely to cause enormous losses.

Why did lenders make, and investment banks purchase, over a trillion dollars in liar’s loans and sell roughly a trillion dollars in CDOs in which the “underlying” was overwhelmingly liar’s loans?   Contrary to many commentators’ claims, it was the norm for sales of green slime to be made “with recourse” so lenders typically had enormous “skin in the game” even if they sold their liar’s loans to the secondary market.  Indeed, the sales of liar’s loans inherently required that the fraudulent lenders engage in further frauds when they made false “reps and warranties” as to the quality of the green slime they were selling.  Making, selling (with recourse), and purchasing liar’s loans and CDOs was certain to produce massive losses.

All of modern finance theory predicted that green slime would immediately be driven out of the marketplace.  Instead, green slime spread rapidly for many years and became dominant in some massive financial sectors (CDOs), common in one of the world’s largest financial spheres (U.S. residential housing), and the norm at most of the world’s most prestigious commercial and investment banks.  Three of America’s five largest investment banks were destroyed by their embrace of green slime.  Green slime grew so rapidly that it caused financial bubbles in several nations to hyper-inflate.

Modern finance theory was falsified by research findings in criminology two decades before modern finance theory was created.  Control frauds cause greater financial losses than all other forms of property crime – combined.  The “weapon of choice” for financial control frauds is accounting.  The optimal “recipe” for a lender or purchaser of loans engaged in accounting control fraud calls for the creation of vast amounts of green slime.  The recipe has four ingredients.

  1. Grow extremely rapidly by
  2. Making or purchasing crappy loans or derivatives (green slime) at a premium yield while
  3. Employing extreme leverage and
  4. Providing only trivial allowances for the inevitable eventual losses

The title of George Akerlof and Paul Romer’s classic 1993 article explaining why green slime can become epidemic explains why it is rational for CEOs to cause “their” firms to make and purchase green slime (“Looting: the Economic Underworld of Bankruptcy for Profit”).  Akerlof & Romer emphasized that the fraud recipe produces a “sure thing.”  Indeed, it produces three sure things.  It guarantees that the firm that follows the recipe will report enormous (albeit fictional) income in the near term.  (If many firms in the same industry follow the same recipe and use the same ingredients they will hyper-inflate financial bubbles.  This can greatly extend the life of the fraud because losses on the bad loans will be hidden by refinancing.  The saying in the trade is that “a rolling loan gathers no loss.”)  Modern executive compensation, which the CEO typically determines, guarantees that the record reported income will promptly make the CEO wealthy.  The fraud recipe also guarantees that the firms will suffer massive losses, particularly if the frauds hyper-inflate a financial bubble.  As Akerlof and Romer’s title makes clear, the firm fails (“bankruptcy”), but the CEO looting the firm walks away with a huge “profit.”

It should, of course, be impossible for lenders making liar’s loans to sell such endemically fraudulent loans to the world’s (allegedly) most sophisticated sources of private market discipline.  In fact, roughly 90% of the endemically fraudulent liar’s loans were sold to the world’s most prestigious commercial and investment banks and, eventually, Fannie and Freddie.  Those commercial and investment banks pooled the green slime mortgage loans to create the ultimate in cynicism and fraud – the greater green slime known as CDOs.  The underlying instruments for CDOs were commonly liar’s loans.  The “AAA” tranche of the typical CDO represented 80% of the overall CDO.  Think of what that means.  The investment banks took loans they knew to be endemically fraudulent – the slimiest of green slime available – and called the vast bulk of the slime “AAA” – the credit rating that is supposed to be granted only to the investments posing the absolutely lowest degree of credit risk.  Calling green slime “AAA” is the ultimate in financial chutzpah.

The key function of regulators in food or finance is to prevent the spread of pink and green slime.  If cheaters gain a competitive advantage over honest firms it creates a “Gresham’s” dynamic – bad ethics drives good ethics out of the markets.  Market forces become perverse.  The Federal Home Loan Bank of San Francisco understood this in 1990-1991 when we used normal supervisory powers to put an end to the making of liar’s loans, which were becoming common among Southern California savings and loan.  We were veterans of the regulatory struggle to identify, close, and prosecute the accounting control frauds that drove the second phase of the S&L debacle so we recognized that liar’s loans were certain to be open invitations to fraud and disastrous.  Unfortunately, the fraudulent lenders that made liar’s loans moved overwhelmingly to ensure that they were not subject to federal regulation, e.g., by becoming mortgage banks.

Congress responded to this regulatory black hole by passing the Home Ownership and Equity Protection Act of 1994 (HOEPA).  HOEPA gave the Federal Reserve the exclusive authority to ban any unsafe mortgage lending practice by any lender, even those not normally subject to federal banking regulation.  Sheila Bair, originally a senior Treasury official appointed by President Bush, worked with Federal Reserve Board Governor Gramlich to urge the Fed to ban liar’s loans.  Liberal consumer groups, including ACORN, and state regulators asked the Fed to use its HOEPA authority to crack down on liar’s loans.

Fed Chairman Alan Greenspan and his successor Ben Bernanke, however, were devout believers in the dogma that held that securities markets automatically excluded fraud.  They refused to ban liar’s loans.  (Bernanke, under intense Congressional pressure, finally adopted a rule on July 14, 2008, under HOEPA banning liar’s loans.  Even then, he delayed the effective date of the rule until 2009.)  Greenspan and Bernanke were so gripped by anti-regulatory dogma that they refused to even send examiners into bank holding company affiliates making liar’s loans to get the facts.

The Fed had at all relevant times during the crisis complete statutory authority under HOEPA to ban green slime.  Its leaders’ refusal to do so was what allowed fraudulent loans to become endemic and drive the crisis.  The nation and much of the globe continue to pay a terrible price for Greenspan and Bernanke’s anti-regulatory dogma, which ascribed miraculous abilities to markets to eliminate green slime – abilities that had no basis in reality.  The markets did the opposite, massively expanding the origination and sale of green slime.  Adam Smith’s reliable butcher had become a mass purveyor of green slime.  The financial markets’ embrace of green slime was so complete that they collapsed and could only be rescued by extraordinary governmental aid.  Green slime is the great killer of jobs and the mass destroyer of wealth, particularly working class wealth.  The recent passage of the fraud-friendly JOBS Act will produce increased green slime.  The Bush and Obama administrations’ failure to hold the elite CEOs who led the massive control frauds that spread the green slime accountable for their crimes is as pusillanimous and reprehensible as it is dangerous.  In the financial sphere, our top priority should be ensuring that we end the frauds that produce the green slime that causes our recurrent, intensifying financial crises.


16 responses to “Green Slime Drives Our Financial Crises

  1. Bravo.

    Adam Smith did not contemplate an environment like the large corporations of today. BPI can get away with pink slime because it is fundamentally different from your local butcher. Likewise the TBTF banks are not your local lender. Both operate in a world that is fundamentally different from the one in which Adam Smith lived.

    Today we depend on government to police our large institutions, food producers and banks alike, because we cannot do it ourselves. They are big enough to ignore us as individuals, and far enough away that even if they would pay attention, we cannot visit them in enough numbers to make a difference in the market.

    If the USDA was not policing the pink slime, then what, pray tell, useful function did they do to protect us? How do they justify their existence after allowing pink slime to be labeled as fresh-ground hamburger?

    You have well documented the failures of our financial regulators. My question is why they allowed these things when they knew them to be harmful? Were they sharing, under the table, the CEO bonuses?

    Still, without government intervention, the green slime operators would have failed, just as Adam Smith predicted. Clearly fraud is not impossible, but in a free market it is not “sustainable”. Enron and Bernie Madoff and every other crook eventually failed. Only government saved the perpetrators of the green slime frauds. The free market would have had them failing, too.

  2. This post really rocks.

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  4. “The Bush and Obama administrations’ failure to hold the elite CEOs who led the massive control frauds that spread the green slime accountable for their crimes is as pusillanimous and reprehensible as it is dangerous.” – Professor Black

    Boom. Awesome. That sentence alone draws me closer to supporting Jill Stein’s candidacy.

  5. Pingback: Green Slime In The Financial Markets Is Much Worse Than The Pink Slime In Your Ground Beef

  6. William K. Black for President 2012. Slimers to Sheol, whether pink or green. Deadenders down. High Noon.

  7. Isn’t making pink and green slime creating value outside of normal market discovery processes? Sounds like the typical ambivalent human nature (love to dominate others – hate being dominated by others) society has to design against.

  8. Graham Paterson

    I find it incomprehensible that you can blame any individual, in this case Bush and Obama, for not prosecuting the CEO’s responsible for “green slime”. Surely, there is some mechanism that applies when blatant fraud and dishonesty becomes an integral part of the system. No single person can have the level of responsibility for every decision made in the name of the US – from all accounts, the Presidency seems to be more a compliant tool of the people who really do make the decisions. Maybe it is worthwhile bearing in mind the words of Sun Yatsen, “reforms are not the answer to tyranny and tyranny cannot be cured with words” because, tyranny seems to be the current political, military and financial status of the US in this day and age.

    • No, there is no single individual responsible for every decision. Senator Dodd and Congressman Frank bear a large responsibility for urging (and threatening) the banks to make loans they knew would have high default rates. One could make a case that CMOs were a response to that pressure, trying to lay off the risk they were forced to take.

      As for regulation, though, the President is the captain of the ship. All the regulators work for him. He is responsible for their failures, and takes credit for their successes. He directs their strategy, if not their individual decisions. He hires and fires them, according to how well they carry out his wishes. If a President were paying attention, and wanted it to stop, it would have stopped. If nothing else, he could have brought it up at every press conference and every campaign speech, instead of or in addition to the other issues that he brought up at every press conference and campaign speech.

  9. Ding, dong, free markets shred;
    Corruption and control fraud spreads.
    Ding, dong, democracy is dead.
    High ho’s and quid pro quos;
    Sell us out for donors’ dough.
    DC insider tip sales grow!
    We’ve gone where the plutos go
    Behold their money flows!
    Yo-ho! Deregulation works (not for us, so sing it):
    Ding, dong, we’re overthrown, sing it high, sing it low
    Yes we know democracy is dead!

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  12. Corban Wells

    Your argument is incomplete.

    You are assuming that previous enabling policies enacted by the Federal Government are of no import.

    The FDIC Insurance is just one of many such enabling policies.

    The big banks have no need to worry about what is right anymore. That responsibility was usurped by the Federal Government. The bank’s only job is to make money as fast as they can. And if they fail in the attempt, the Federal Government will bail out all the grannies and kids with college funds. So nobody really gets hurt.

    Your oversimplification of the problems with our financial markets exposes your pro-government agenda.

    You are a hammer looking only for nails.

    No objectivity.

    No economic science.

    All is not lost. I see that what you really want is for people to be protected, and for people not to suffer needlessly, and you think you have found a way to prevent pain.

    Adam Smith was right. You are wrong.

    The fact that our country and other similarly free countries have produced the modern age is proof enough.

    The problem that needed fixing in the late 1920’s was greed. There was greed at all levels of society. One cannot legislate or regulate away greed. The best that can be done by regulators is to outlaw activities that are usually born out of greed.

    Prior to the great depression, one could purchase $100 worth of common stock with $5. A 20-1 margin. Then the government decided that it should be illegal to take such a risk. (For those unaware, if you purchase $100 worth of stock with $5, and the stock drops $20 in value, the ‘investor’ loses his $5 AND he must pay an additional $15 just to stop the losses from continuing. So it is possible to loose 300, 500, 1000% of one’s investment in an attempt to earn 100, 200, 500% gains.)

    The 1930’s fixed that pretty well.

    Very similar situation here.

    Big banks got greedy, (unconcerned with the repercussions of their activities IF things went bad) and so did all the idiots who did ‘liars loans’. Why in the world would you buy a home you had no ability to pay for? Because you were hoping that with no money down, you could pocket a cool 20K after a couple months of appreciation, and you had a great rentor who was willing to pay the mortgage for you for a while.

    Idiots all.

    But you can’t regulate away idiots or greed. There are infinite ways of being greedy and trying to outlaw greed is a fools errand.

    The answer is simpler and harder than that.

    A republic will only stand so long as there are honest, educated, and good people. But when the country is full of people who feel entitled to other’s money and services, and when they feel no responsibility for their own successes or failures, perhaps a hammer is in need afterall.

    Not because it will fix the problem and bring about an end to the business cycle, but because it will punish the idiots the most. More regulation equals less opportunity and less affluence for the lowly ignorants who thought through greed they may get ahead.

    Keep chasing your nail.



  13. Unfortunately the ‘green slime’ problem can not be solved the same way as the ‘pink slime’ problem.

    Pink slime was exposed and almost immediately people voted with their feet and stopped buying hamburger from the establishments that purchased (supported) the Pink Slime market. There was an immediate economic impact ONCE the information was made broadly available (Thanks to the internet and youTube).

    Green slime is much more insidious, the people have very little direct impact on the perpetrators. Green slime is like a cancer, spreading the unethical (and what should be illegal) behaviors throughout the FIRE sector and metastasizing across our capitalistic system morphing it into crony-capitalism. The very people that would shun Pink Slime are infected by and spreading the Green Slime. Adam Smith describes capitalism, he would have been slain by crony-capitalism. We need an equivalent of Adam Smiths “invisible hand” for the plutocracy and crony-capitalist to SLAP them to hell and allow Competitive Free Market Capitalism to recover.

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