The Wall Street Journal Pines for the Return of Liar’s Loans

By William K. Black
(Cross posted at Benzinga.com)

The Wall Street Journal’s editorial staff (WSJ) criticizes the Dodd-Frank Act and the leadership of the financial regulatory agencies. I share many of those criticisms, but I parted company when the WSJ expressed its horror that: “The regulation micromanages bank decisions down to the kind and quality of loan.” The Dodd-Frank Act bans a “kind” of loan based on the inherently fraudulent “quality of [the] loan.” The Act bans liar’s loans. The WSJ considers this ban so appalling, so obvious a violation of the divine right of banks, that it labels it “micromanage[ment]” and assumes that the label proves the absurdity of banning liar’s loans.

As I have been explaining for over two decades, no honest lender would make liar’s loans. Here is George Akerlof and Paul Romer’s explanation of the analytics in their famous 1993 article in which they expressly cited my explanation. Note the eerie manner in which they discuss the specific underwriting failures that characterized liar’s loans a decade later.

“[An officer] 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. ⁵

5. Black (1993b) forcefully makes this point” (1993: 4 & n. 5).

When a lender fails to follow “even the most basic principles of lending” it will suffer massive losses. The controlling officers, however, will be made wealthy by making crappy loans. Indeed, Akerlof and Romer stressed that accounting control fraud is a “sure thing” (1993: 5).

Here are the famous five warnings of the mortgage industry’s anti-fraud unit (MARI) that the Mortgage Bankers Association sent to virtually every significant mortgage lender in early 2006.

Stated income loans “are open invitations to fraudsters”
Study: fraud incidence is “90 percent”
“[T]he stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan.’”
“It appears that many members of the industry have little … appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses….”
“Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans….”

Even Ben Bernanke, the Nation’s anti-regulator in chief, used the Fed’s unique statutory authority under the Home Ownership and Equity Protection Act (HOEPA) of 1994 to ban liar’s loans in mid-2008. Bernanke delayed the effective date of the rule by 15 months because one would not want to inconvenience a fraudulent lender.

Alan Greenspan ignored Fed Member Gramlich’s famous warnings about non-prime loans and his rejected his plea that Greenspan send the Fed’s examiners into the bank holding company affiliates to find the facts. The Fed’s supervisors were reduced to the ability to simply ask the systemically dangerous institutions (SDIs) what kind of loans they were making (a process certain to lead to substantial understatement by the SDIs).

“Sabeth Siddique, [asked] large banks in 2005 …how many of which kinds of loans they were making. Siddique found the information he received “very alarming,” [N]ontraditional loans made up 59 percent of originations at Countrywide, 58 percent at Wells Fargo, 51 at National City, 31% at Washington Mutual, 26.5% at CitiFinancial, and 28.3% at Bank of America.

[T]wo-thirds of the nontraditional loans made by the banks in 2003 had been of the stated-income, minimal documentation variety known as liar loans, which had a particularly great likelihood of going sour.

The reaction to Siddique’s briefing was mixed. Federal Reserve Governor Bies:. ‘Some people on the board and regional presidents . . . just wanted to come to a different answer. So they did ignore it, or the full thrust of it,’ she told the [FCIC].

Within the Fed, the debate grew heated and emotional, Siddique recalled. ‘It got very personal,’ he told the Commission. The ideological turf war lasted more than a year, while the number of nontraditional loans kept growing….” (FCIC 2011: 20-21).

Here’s the bad news. The senior Fed supervisor asked the SDIs in 2005 for data on their lending as of yearend 2003, which was the beginning of the massive rise in making liar’s loans. From 2003-2006, the number of liar’s loans grew by over 500 percent. By 2006, 40% of all mortgage loans originated that year were liar’s loans. By 2006, half of the loans that the mortgage industry called “subprime” were also liar’s loans (the two categories are not mutually exclusive). Consider how insane it would be for an honest lender to make liar’s loans, with a 90% fraud incidence, to borrowers with known, severe credit defects. It was this massive increase in liar’s loans that hyper-inflated the housing bubble from 2003-2006 (and delayed its collapse until mid-2007). It was the combination of liar’s loans and subprime that guaranteed catastrophic losses to lenders (but huge gains to their controlling officers through the accounting control fraud recipe). By 2006, the fraudulent lenders made over two million fraudulent liar’s loans annually – and sold roughly that amount of fraudulent loans through fraudulent “reps and warranties.”

By 2003 – the start of the critical massive expansion of liar’s loans – the SDIs were already exceptionally likely (67%) to combine liar’s loans with other “nontraditional” lending characteristics known to increase the probability of default and loss upon default. This practice grew dramatically through mid-2007 despite copious warnings of an “epidemic” of mortgage origination fraud and federal regulators discouraging such loans. The best known “nontraditional” lending characteristic was subprime lending, but lenders often “layered” liar’s loans with no-downpayment and negative amortization characteristics. The latter two loan provisions had the effect of substantially delaying defaults on fraudulent liar’s loans. Home lenders who make liar’s loans, by themselves, are certain to suffer grievous losses, but adding any of these non-traditional characteristics to liar’s loan – much less several of them – is certain to cause catastrophic losses to the lender.

It is important to recall that the officers leading the control frauds also frequently “layered” appraisal fraud to these other fraud-friendly characteristics. The appraisal fraud was designed both to increase the reported (fictional) income (the larger the loan amount, the larger the fictional income) and to provide an excuse for the (not very) “due diligence” firms to declare that the (fictional) low loan-to-value (LTV) ratio that resulted from appraisal fraud to provide a “compensating factor” for other fraudulent “reps and warranties.”

I know that the concept that any loan characteristic makes it safe to buy a product from a lender that has deliberately lied to you for the purpose of disguising the product’s defects is facially absurd. I know that that it took unbelievable chutzpah for the “due diligence” firms (even their name was ironic) claim that the lower LTVs manufactured by endemic appraisal fraud “compensated” for fraudulent reps and warranties about liar’s loans made by loan originators and I know that the officers controlling the secondary market purchasers welcomed the chutzpah of the “due diligence” firms. The twin epidemics of accounting control fraud (appraisal and liar’s loan fraud) by loan originators ensured that their endemically fraudulent loans could only be sold through fraudulent “reps and warranties.” I know that their pervasively fraudulent reps and warranties were easily spotted – and ignored – by the fraudulent purchasers of fraudulent loans who employed the financial version of “don’t ask; don’t tell. When control fraud became endemic the financial industry became nonsensical to observers who do not understand the fraud recipe for lenders and purchasers. Once one understands the “sure things” that the officers attain by making and buying crappy loans the industry’s practices become understandable.

No federal entity ever urged, much less required, lenders to make or purchase (and, yes, that includes Fannie and Freddie) liar’s loans. Even the Bush administration anti-regulators like Greenspan who “ignored” the data on liar’s loans and launched personal attacks on anyone at the Fed who dared to criticize the SDIs’ endemically fraudulent lending, discouraged banks from making liar’s loans. The WSJ, in a passage in which they decry purported “fiction” and “spin,” spreads the myth that: “politicians and regulators … pulled every lever they could to force capital into mortgage finance….” No politician or regulator ever forced any entity to make or buy a liar’s loan or to inflate an appraisal. The fraudulent bank officers are the ones that “forced” the banks they controlled to make and buy millions of liar’s loans and extorted appraisers to inflate home values because doing so made them wealthy pursuant to the fraud recipe. The WSJ knows this to be true, which is why it studiously refuses to discuss the reality of how liar’s loans became the dominant source of loan growth driving the hyper-inflation of the housing bubble and why it refuses to discuss the twin epidemic of appraisal fraud.

I have previously explained in detail why we know that it was overwhelmingly lenders and their agents (the loan brokers) who put the lies in liar’s loans. The lenders chose the compensation system to use with loan brokers and the type of loans they were willing to fund. The lenders not only allowed liar’s loans, they designed their compensation system for loan brokers to maximize the number of liar’s loans and to incent the brokers to dramatically inflate the borrower’s income so that the lender would be provided the pretext of approving the liar’s loan based on its purportedly “low risk” nature as demonstrated by the borrower’s (fictionally) low reported debt-to-income ratio. The officers leading the fraudulent lenders and the brokers they carefully incented to put the lies in liar’s loans and inflate appraisals knew that the entire lending process was a charade pumping out millions of fraudulent loans and hyper-inflating the bubble.

The Nation’s leading trainer of loan officers explained the fraudulent charade.

“His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs ‘flipping burgers,’ he told the FCIC. Given the right training, however, the best of them could ‘easily’ earn millions.

He taught them the new playbook: ‘You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.’ He added, ‘I knew that the risk was being shunted off. I knew that we could be writing crap. But … we were not going to be hurt’” (FCIC 2011: 8).

When he refers to the “best” loan officers who moved from “flipping burgers” to “flipping homes” he means, of course, the worst.

“[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.” Tom Miller, Iowa’s Attorney General, 2007 Fed testimony

Let’s recall the exact language of the WSJ’s cry of outrage: “The regulation micromanages bank decisions down to the kind and quality of loan.” The “kind and quality of loan” is precisely what must be regulated to prevent epidemics of accounting control fraud – the frauds that drove our three modern financial crises (the S&L debacle, the Enron-era, and the mortgage fraud crisis from which we are still recovering). The traditional home mortgage underwriting rule that the regulators used before the Clinton and Gore administration’s disastrous “Reinventing Government” (ReGo) crusade repealed it in 1993 had three requirements:

The lender had to underwrite the proposed loan before it was made
The lender had to document that the borrower had the capacity to repay the loan and that the collateral was adequate to repay the loan
The lender had to maintain a written record of this underwriting

The traditional rule was an example of the perfect rule. It imposed no cost on an honest lender. It acted to forbid loans that would only benefit the officers leading accounting control frauds and it required lenders controlled by fraudulent officers to create a “paper trail” demonstrating that they knew they were making a bad loan. That paper trail allowed our examiners to identify likely frauds and our enforcers and prosecutors to demonstrate the existence of accounting control frauds and take legal action against the senior officers leading the frauds. The rule had the incidental benefit of ensuring that the bank kept clear evidence of title and the mortgage interest and any transfers. The rule was, deliberately, not a “best practices” standard. It was the minimum standard any honest lender would follow. Honest controlling officers of banks imposed mortgage underwriting requirements far in excess of our minimum requirements.

The traditional underwriting rule is also what we used in 1990-1991 to stop an incipient “second front” in the control frauds assault on the American people during the S&L debacle. “Low documentation” (such loans were not yet called “liar’s loans”) loans began to become common in Orange County S&Ls. We were regional regulator (OTS-West Region) with jurisdiction over Orange County. We heeded our examiners’ warnings that no honest lender would make such loans and largely drove the lenders who made liar’s loans out of the industry by 1991. This is what MARI was referring to in its fourth bullet point above.

ReGo substituted a deliberately unenforceable “guideline” that allowed lenders to adopt any underwriting standard they chose, even when the underwriting standard was not to underwrite. ReGo’s rationale for destroying the underwriting rule that had proven spectacularly effective in (1) stopping the accounting control fraud epidemics that were driving the S&L debacle, (2) holding the elite officers leading those frauds accountable for their crimes and abuses, and (3) preventing the 1990-1991 outbreak of liar’s loans from becoming a crisis had two parts. First, it ignored the three successes. ReGo only presented stories of alleged regulatory successes arising from deregulation. It routinely excluded evidence of success arising from vigorous regulation.

Second, ReGo ignored control fraud and the officers who control banks. It, like the WSJ, implicitly assumed that the officers who run “banks” act in the interest of the bank rather than in the interest of the officers. When they make explicit assumptions, the WSJ and ReGo’s leaders typically assume that corporate officers act to further their self-interest. If they had explicitly assumed that fraudulent bank officers did not exist, then the ReGo officials and the WSJ would be forced to defend the validity of that (obviously false) assumption. That is why implicit assumptions are so dangerous. Once the implicit (but false) assumption is made that bank officers invariably act contrary to their self-interest to aid the best interests of the banks, it becomes seemingly obvious that any loan underwriting rule exemplifies the absurd “micromanage[ment]” that the WSJ seeks to ridicule. The lenders’ officers will adopt the underwriting standards that best serve the bank. The bank officers will know the bank and the prospective borrowers better than any regulator could possibly know. As best, the regulatory underwriting rule will be unnecessary. At worst, it will prevent the lender from making loans that would aid the bank and its customers. In a typical market transaction the neoclassical economic assumption is that both parties to the transaction (here, the lender and the borrower) will be made better off, so whenever the underwriting rule prevents a loan from being made the world is made worse off.

All of this falls apart, however, as soon as one acknowledges the existence of accounting control fraud and predatory lending and foreclosure fraud. The fraud “recipe” for the officers controlling a lender explains why the first point is true.

Grow like crazy by
Making crappy loans at a premium yield while
Employing extreme leverage and
Providing only trivial allowances for loan and lease losses (ALLL)

The recipe provides the famous three “sure things.” The bank is guaranteed to report record income in the near term. The controlling officers will promptly be made wealthy through modern executive compensation. The bank will suffer severe loan losses vastly in excess of its ALLL. These “sure things” explain George Akerlof and Paul Romer’s famous title for their article – “Looting: The Economic Underworld of Bankruptcy for Profit” (1993). The lender may be bankrupted, but the controlling officers can walk away wealthy.

The borrower will be placed into a loan he cannot afford at the peak of the bubble when the home is most overvalued. The honest borrower will be placed into a liar’s loan that is more expensive and exposes him to a possible criminal prosecution. A liar’s loan typically had an interest rate about 100 basis points more expensive than a conventional loan. It was commonly the lenders and their agents (the loan brokers) who instructed the borrower what income figure to state on the application or even directly wrote the income figure on the loan application (and sometimes forged the borrower’s signature on the application). Each of these actions by the lenders exposed the borrower to being prosecuted.

Lenders such as Ameriquest engaged in endemic predation aimed at blacks and Latinos. The lenders typically created intense, perverse interests through their compensation system for loan brokers. The broker and lender got richer by misleading borrowers into paying an interest rate that was higher than that available in the market to similar borrowers. Brokers targeted the groups they considered to have the least financial sophistication and financial experience.

Once fraudulent mortgages were made they were typically sold to the secondary market. Fraudulent loans can only be sold through fraudulent “reps and warranties.” Conservative finance scholars describe the fraudulent sales as “pervasive” by our “most reputable” banks. (Their irony is unintentional.)

It should now be clear why adopting loan underwriting rules that ban liar’s loans is the single most important thing a banking regulator can do. At no cost to honest lenders, the regulatory agency’s underwriting rule can make accounting control fraud far more difficult to commit and far easier to detect and prove. The rule has many collateral benefits. The fraud recipe is a superb device for hyper-inflating a bubble. Liar’s loans degrade loan documentation and create a criminogenic environment that encourages a culture of deliberately degrading loan and mortgage documentation. Widespread fraudulent lending and the collapse of hyper-inflated bubble lead to the bankruptcy of hundreds of lenders specializing in making fraudulent liar’s loans. It can also lead to multiple sales of the fraudulent loans to other control frauds, many of which will also fail.

As the hundreds of fraudulent lenders and secondary market purchasers fail they go into Chapter 7 liquidations rather than Chapter 11 reorganizations. Indeed, they will often fail so quickly and decisively that they will not even file for bankruptcy because they have virtually no assets to pay the lawyers and their controlling officers simply leave. The result can be hundreds of thousands, perhaps millions, of original mortgage notes being thrown in dumpsters. When one adds the mortgage industry’s self-inflicted disaster of MERS, what was one of America’s crown jewels, our public recordation system for property, has been dealt a terrible blow. The famous (and conservative) economist who is most famous for explaining this crown jewel is Hernando de Soto. I explained this point in a recent column that quote him.

“The unforgivable sins of this great success – our public system of record of title and property descriptions – are that the system is successful, efficient, and public. That is unforgivable because it falsifies their ideologies. You can feel de Soto’s pain as he is staggered by the stupidity of the [capitalist] cannibals.

‘The result was the invention of the first massive ‘public memory systems’ to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, ledgers, contracts, patents, companies, and promissory notes), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: ‘economic facts.’

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don’t know and can’t prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.’”

The combination of MERS, the large number of secondary sales, the deliberate degrading of documentation, the mass failure of the fraudulent lenders, lending to millions of borrowers that the officers controlling the fraudulent lenders knew were unlikely to repay their loans, and the enormous loss of housing value once the bubble burst made it certain that there would be millions of loan defaults – and that the entity foreclosing would frequently lack the documentation required to foreclose. The fraudulent lenders compounded their loan origination and secondary market frauds by engaging in extraordinary levels of foreclosure frauds.

It is only with the terrible experience of the current crisis that we can appreciate how massive the direct and indirect collateral benefits were of the traditional regulatory mortgage loan underwriting rule that was so disgracefully eliminated in 1993. The direct effect, had the rule remained law and been enforced, would have been to eliminate the largest and most destructive epidemic of financial fraud in history. There would have been no crisis and no Great Recession. The indirect effects are also proving extraordinarily harmful. The WSJ’s attempted analytics are internally contradictory. It bemoans the (non) fact that: “The government roots of the crisis are unreformed, especially easy credit and the bias for housing.” The cardinal example of “the government” permitting (not requiring) the fraudulent officers leading the banking control frauds to provide “easy credit … for housing” was the deregulation that killed the traditional mortgage lending underwriting rule. This allowed the banks’ controlling officers – contrary to the regulators’ efforts to discourage liar’s loans – to eventually make millions of liar’s loans. There is no worse form of providing “easy credit” than liar’s loans.

Similarly, it was the refusal of Greenspan and Bernanke – who shared the current disdain of the WSJ and the prior disdain of the ReGonauts for any mandatory loan underwriting rules, particularly rules that would ban the endemically fraudulent liar’s loans – to use HOEPA to ban liar’s loans that ensured that the banks’ fraudulent controlling officers could continue to provide the easiest conceivable credit, liar’s loans. Note that even Greenspan and Bernanke discouraged banks from making liar’s loans and that liar’s loans were not prompted by affordable housing goals but by the bank officers’ fraud goals. Recall that liar’s loans dramatically inflated the borrower’s actual income, which meant they were the worst possible means of purportedly making loans to lower-income borrowers. In sum, it is precisely what the WSJ is complaining about – banning liar’s loans through rules that “micromanaged” the “kind and quality of loan” that produced an enormous (and desirable) reduction in the fraudulent supply of the “easy credit” that the WSJ claims caused the crisis.

The WSJ ignores all of the points I have made, but that understates how detached from reality they are. The WSJ brings up the foreclosure frauds – which consisted of hundreds of thousands of felonies by the banks for which no senior banker will be punished due to a scandalous dereliction of duty by the Department of Justice (DOJ) – in order to complain that “the government” abused the poor, virginal banks.

“Regulators have ordered a top-to-bottom overhaul of foreclosure processes even after extorting more than $25 billion in payouts for exaggerated past offenses.”

First, everyone honest (which excludes DOJ and the WSJ) knows that the banks are not making anything remotely like “$25 billion in payouts” under the settlement in which they (1) got the investigations of their endemic frauds halted and (2) got a complete pass against prosecution of any senior officer or any bank. The vast bulk of the $25 billion is not a “payout.” It is actually a figure for reduced payments in negotiated loan workouts (which involve no “payouts” by the lenders) that the lenders would have entered into anyway to minimize their losses.

Second, it isn’t “extortion” when the WSJ talks about litigated settlements it favors. All litigation settlements are the product of “extortion” under the WSJ’s definition of the word.

Third, the number of felonies committed by representatives of the banks in the course of the epidemic of foreclosure fraud is eclipsed only by the loan origination and secondary market sale frauds. Collectively, these are three largest epidemics of elite fraud in history. The WSJ is so in the tank for the fraudulent officers leading our SDIs that it cites one of the largest epidemics of elite fraud by banksters with explicit immunity for those elite fraudulent bankers as the purported strongest “evidence” that “the government” is abusing the SDIs.

I have spent the better part of a month trying to explain why Larry Summers’ view of financial regulation remains an invitation to producing the epidemics of accounting control fraud that drive our recurrent, intensifying financial crises. The WSJ has, unintentionally, proven my point by adopting Summers’ proposed regulatory approach whole hog. It loves Summers’ idea of basing financial regulation on (unspecified) increases in bank capital requirements with minimal reliance on examination, supervision, and without the essential loan underwriting rules.

The WSJ also believes that “the [American] government” is the enemy. This explains the title of their article: “The Government Won on Financial Reform.” A normal reader might interpret that title as meaning that the United States won on financial reform and view that as a very good thing. The WSJ knows that “the government” is not a legitimate representative of the American people. Many progressives share that belief because of the dominance of the SDIs over American politics. The WSJ, however, views crony capitalism in which “the government” does the SDI’s bidding as desirable and is outraged whenever America (episodically) responds to the SDIs’ endemic frauds and the resultant financial crises by adopting rules restricting (even modestly) the SDIs’ powers. Under the WSJ’s worldview the SDIs rule by divine right and should be immune from any detailed regulatory limitations.

Like Summers, the WSJ’s simplistic answer rests on a myth that I have worked to discredit.

“A sensible reform would have been to require more capital as a bumper against losses, and to use a basic definition of capital that can’t be gamed.”

First, Dodd-Frank did increase capital requirements. Second, capital requirements were reduced dramatically because of lobbying by the SDIs and the theoclassical economic dogmas worshipped by the Fed’s economists. Third, there is no “basic definition of capital that can’t be gamed.” Capital is merely an accounting residual: A – L = K (assets minus liabilities = capital). As long as accounting control fraud exists the bank’s officers can game “capital” by overstating assets and understating liabilities. The accounting control fraud recipe’s four ingredients explain how to massively overstate assets, understate liabilities, and overstate capital (and income).

There is one way to make a bank capital requirement dramatically harder to game – and it requires severe regulatory restrictions on assets and liabilities that would be anathema to the WSJ and Summers’ anti-regulatory proposals. The one way to make it much harder to game a bank’s capital requirement is to adopt “narrow banks.” Narrow banks would be allowed to invest in only short-term U.S. government securities that (1) have minimal credit risk (it is easy to game the asset valuation of loans with substantial risk by providing a grossly inadequate ALLL – the fourth ingredient of the fraud recipe), (2) are routinely traded in “deep” markets that make it harder to inflate “market” values, and (3) are very short term (which tends to reduce interest rate risk). Narrow banks need rules preventing them from taking currency risks and requiring that they maintain adequate liquidity (the three credit requirements I discussed substantially reduce liquidity crises). Narrow banks also need requirements to minimize interest rate risk (again, this is greatly eased by the requirement that the assets have very short maturities). A narrow bank as I have described it is essentially a (well-run) money market mutual fund with deposit insurance. As Lehman’s failure demonstrated, money market mutual funds were allowed to take excessive credit risk by purchasing short-term corporate debt (commercial paper). When Lehman’s commercial paper lost most of its value as a result of its bankruptcy major money market mutual funds that invested in commercial paper experienced losses that “broke the buck” and triggered a multi-billion dollar run on most money market mutual funds that was only stemmed by the emergency provision of federal guarantees and aid.

The key analytical point, which Summers and the WSJ missed, is that the only banking capital requirement that is highly resistant to gaming requires draconian restrictions on bank investment powers. Narrow banks would not make loans to individuals or firms. Summers and the WSJ assumed that the opposite was true – that one can declare a higher capital requirement and make it real while allowing exceptionally broad bank investment powers. Summers and the WSJ did not even understand that restoring critical loan underwriting requirements, fully adequate loss reserves (ALLL), and prompt, complete loss recognition enforced vigorously by competent regulators who make their priority the prevention, detection, countering, and sanctioning of control frauds and the elite officers who lead the frauds would be absolutely essential even if Glass-Steagall were restored and the Commodities Futures Modernization Act of 2000 were repealed. The lower the underwriting requirements and the greater the number and variety of assets a bank can invest in the more critical vigorous regulators who understand accounting control fraud and are vigilant in countering it are if we are to prevent future epidemics of control fraud and the resultant financial crises.

Note that increasing the capital requirement does not remove the gaming problem and can intensify it. Accounting control frauds have routinely demonstrated their ability to get clean audit opinions for financial statements that make deeply insolvent and unprofitable banks appear to have record profits and excess capital. S&Ls and the Icleandic banks used fraud schemes that directly inflated reported capital. Neither Summers nor the WSJ would support the U.S. adopting far higher capital requirements than the EU because both have taken the position that the U.S. must not have tougher regulations than the City of London lest our SDIs relocate to the UK. It is also not credible that a regulator would actually close a bank that failed to meet a 20 percent capital requirement. The WSJ and Summers have long been virulent opponents of restricting the compensation of senior officers even of failed entities bailed out by the Treasury and the Fed – they cannot credibly claim that they support slashing the compensation of senior bank officers and “clawing back” prior bonuses as soon as the bank fails to meet, e.g., a 20% capital requirement. I would be delighted to be proven wrong by them proposing specific capital requirements and specific, mandatory compensation sanctions of the kind I have outlined that automatically come into effect for any bank that fails its capital requirement. Note, however, that this will increase the CEO’s incentive to game the capital requirement.

Even if we created a capital requirement of 100 percent, which one reader recently suggested would end gaming; it would do no such thing. Indeed, it would encourage gaming because even tiny loan losses could cause the bank to be placed into receivership. Fraudulent controlling officers could still use the fraud recipe to create fictional income and capital and escape receivership. Note that a 100% capital requirement for a bank would mean, effectively, that it could not have depositors. A bank subject to a 100% capital requirement would not be allowed to borrow unless it obtained a new equity infusion at least equal to any deposit it accepted. That is not workable. Depositors are bank creditors – we loan money to the bank. If banks cannot have depositors then why bother to have banks? The WSJ, of course, does not want to impose far higher capital requirements on banks.

Competent financial regulators understand that their paramount task is to prevent epidemics of accounting control fraud and ferret out individual frauds. Such regulators understand that the single most effective means of making it harder to inflate asset values is to have loan underwriting rules that ban loans that optimize the fraud recipe. The WSJ is so blind to the lessons of the three modern crises driven by epidemics of accounting control fraud that it demands an end to the most important rule (banning liar’s loans) that makes it harder to “game” reported income and capital.

The WSJ is disingenuous about regulators.

“The Dodd-Frank Act’s great reform conceit is that the same regulators who missed the last crisis, and who tolerated Citigroup’s off-balance-sheet vehicles hiding in plain sight, will somehow prevent the next crisis. It won’t happen. Regulators somehow missed J.P. Morgan’s “London whale” trades even after they were reported in this newspaper.”

The WSJ is correct that it would be absurd to trust “the same regulators who missed the last crisis [to] prevent the next crisis.” But it was the WSJ that applauded the Reagan, Clinton (via ReGo) and Bush II administrations’ anti-regulators who inflicted the three “de’s” on America (deregulation, desupervision, and de facto decriminalization) that produced the criminogenic environments that drove our three modern crises. We must, indeed, appoint leaders of financial regulatory agencies because they have a track record of success against epidemics of accounting control fraud. Instead, we appointed anti-regulators as leaders because they had a track record of failing to spot and prevent such frauds – and a track record of opposing efforts by others to stop such frauds. To conclude that regulation cannot succeed because a series of anti-regulators failed to regulate is the ultimate in self-fulfilling prophecies. Greenspan and many Fed leaders were so vehemently opposed to regulation that they eagerly created the regulatory black hole for derivatives, repealed Glass-Steagall (and turned it into Swiss cheese before the repeal by regulation, interpretation, and refusals to enforce it), sought to eviscerate bank capital requirements through Basel II (the FDIC’s heroic rear guard stand against the Fed’s economists reduced the catastrophe), attacked the Fed’s supervisors when they dared to criticize the SDIs for aiding and abetting Enron’s frauds, refused to use HOEPA to stop the mortgage fraud epidemic that drove the crisis, and attacked the Fed’s supervisors – personally – for daring to provide industry data to the Fed’s leadership because it demonstrated the epidemic of fraudulent liar’s loans. It takes chutzpah for the WSJ to claim that leaders who refused to regulate because they shared the WSJ’s anti-regulatory dogmas prove that regulation cannot succeed.

I know of several hundred financial regulators with superb track records against the epidemics of accounting control fraud. I eagerly await the WSJ editorial urging the Obama administration to appoint these financial regulators to leadership roles, but I am not holding my breath. It is not a rosy hypothetical that these successful regulators would have prevented the mortgage fraud crisis had they been appointed to run the Fed. They prevented a “second front” liar’s loan crisis in 1990-1991 even though they were fighting successfully to contain the S&L debacle and they did so with vastly less information and resources than the Fed had available in 2000-2006. (The lenders didn’t call them “liar’s loans” in 1990-1991. A product that the industry calls a “liar’s loans” is a flashing neon signal of accounting control fraud. As the language I quoted from Akerlof & Romer’s 1993 article demonstrates, we understood the concept of “adverse selection” and used it to identify fraudulent practices and S&Ls that were control frauds. We first used these analytics in 1984. By 2004, when liar’s loans were becoming the dominant means of hyper-inflating the bubble, we had known for two decades why honest lenders would not make liar’s loans and why dishonest controlling officers would make liar’s loans.

The epidemic of mortgage fraud that drove the crisis caused over $11 trillion in wealth losses to U.S. households and over 10 million American jobs. If Mike Patriarca had run the Fed the developing epidemic of liar’s loans would have been stopped in its tracks in 2000 or 2001 because we would have used HOEPA to ban liar’s loans. It’s not too late to hire him to prevent the next crisis.

The WSJ is partly right, but again disingenuous about the SDIs. It is true that Dodd-Frank failed to demand that the SDIs shrink to the point that they no longer pose a systemic risk, but the WSJ has refused to support that essential policy. It is true that the “living wills” are expensive farces. The WSJ is also correct that the Fed will bail out the SDIs rather than allow another global meltdown. The WSJ seems to understand that the Fed and the Treasury can make no credible promise not to bail out an SDI given that the Fed and the Treasury believe that the alternative is a global financial disaster.

Unfortunately, the WSJ’s answer to the problem that the SDIs pose a global systemic risk and will be bailed out by the Fed (even when Ayn Rand’s executor was running the Fed) is to assume the problem out of existence through the fantasy that there is such a thing as a capital requirement that “can’t be gamed.” This fantasy demonstrates that the WSJ is clueless about accounting control fraud, capital, and financial regulation. As I have repeatedly emphasized, Basel II’s capital rules are obscenely low and urgently need to be increased substantially and should never be tied to credit ratings. But it is a dangerous illusion to believe that increased capital requirements will make SDIs (or any non-narrow bank) reliably safe. Capital requirements are inherently susceptible to being gamed by accounting control fraud. That is precisely why our paramount task as financial regulators is to create environments in which the perverse incentives to engage in control fraud are minimized and then to make the detection and elimination of control frauds our top priority. This is also why the most effective work in limiting “systemic risk” is always done by bank examiners. The least effective, indeed, typically counterproductive work on systemic risk is done by economists.

As effective as regulation can be when led by those with a track record of success against control fraud, we would never urge the retention of the SDIs. They are ticking time bombs that must be eliminated. The good news is that eliminating them (by requiring them to shrink within five years to the point that they no longer pose a systemic risk) presents a win-win-win-win opportunity. The SDIs are too big to manage, so shrinking them will make them more efficient.
Shrinking them will remove both the systemic risk and their implicit federal subsidy that even conservative finance experts warn makes “free markets” impossible. The SDIs are the American version of crony capitalism and often exert dominant political power over both major parties – they are a clear and present danger to our democracy. So I also eagerly await the WSJ joining in my call to get rid of the SDIs by forcing them to shrink.