I was peacefully researching a book I am co-authoring with Wesley Marshall on the pathologies of theoclassical and neoclassical economics as exemplified by “Nobel” laureates in economics (the economics prize is actually a creature of the Swedish Central Bank), when I read a column in the Economist about financial regulation and the crisis that provided an exemplar of how much is wrong about modern economics. The May 1, 2009 column is entitled “WWMFD” (What Would Milton Friedman Do?).
The Economist’s column is a gift to our book project. The idea that one should seek to act like a medium and communicate with the spirit of any deceased writer is wonderfully loopy. The magazine’s motif: treating Friedman as if he were divine – is inspired (pun intended). The title of the article is a riff on WWJD (“What Would Jesus Do?”) – WWMFD (“What Would Milton Friedman Do?”) Treating Friedman as divine makes it “appropriate” to ask his inspired disciples in Chicago to preach his “Gospel of Greed” and to treat their recitation of Friedman’s parables as divinely inspired and infallible. Friedman’s gospel is the “good (no, make that “great”) news” for plutocrats who rightly feared their inability, and the camel they road in on, to pass through the eye of the needle. The disciples’ “Road to Serfdom” conversion to the Gospel of Greed has them transforming their ethics from Paul to Saul rather than the opposite direction. But what makes the Economist’s treatment of Friedman as God and his disciples as those entrusted by God to spread his gospel of greed and parable of the (invariably) “good (no, make that “perfect”) plutocrat” such an epic satire is that Friedman and his disciples were the leading architects of the dogmas that led to the policies that cause our recurrent, intensifying financial crises. And what suspense the Economist’s title creates in the reader. What will Friedman’s disciples say about the crisis? Perhaps they will say – “sorry, we spread a dogma posing as economic theory that proved again the wisdom of FDR’s warning: ‘We have always known that heedless self-interest was bad morals, we now know that it is bad economics.’”?
The Economist’s column is a target-rich environment illustrating the multiple pathologies of economics and Chicago School economists. I will address three passages in a series of articles built around quotations in the Economist’s column from two recipients of the Central Banks’ prize and the third from the patron saint of deregulation. This first column in my series about the Economist’s article I discuss their quotation from Gary Becker. Becker is the Central Bank prize winner who has the distinction of being wrong in more fields than any other winner.
“Becker … believes that simple rules work best because ‘regulators get caught up in the same type of optimism that market participants get caught up in’ and ‘[w]hen you give a lot of discretion to regulators, they don’t use the tools that are given to them.’”
The first point to keep in mind is that these economists make things up – and places like the Economist treat their crisis creation myths as revealed truth. Do regulators “get caught up in the same type of optimism that market participants get caught up in?” Becker makes three factual claims about financial crises in that clause, each of which is typically false. First, he asserts that “market participants” get caught up in “optimism.” Second, he implicitly asserts that these participants’ “optimism” was excessive. Third, he claims that the regulators got “caught up” in the “same” “optimism.”
Becker is implicitly asserting that U.S. financial crises are not driven by epidemics of accounting control fraud. The problem with the CEOs of failed banks is that they are optimists – a generally favorable trait for CEOs. This optimism meme would give the CEOs a complete pass. They could not be criminally prosecuted, but they also should not be the subjects of civil lawsuits or administrative enforcement actions. Indeed, their only “fault” is being human.
While his claims might be true of some “market participants,” Becker presents no evidence supporting his assertion and I know of no evidence supporting his claims. There is, however, overwhelming evidence that the critical market participants were not caught up in “optimism,” much less excessive optimism. Similarly, there is strong evidence that professional regulators were not caught up in the same optimism.
Key market participants demonstrated repeatedly that they were not “optimistic” about the quality of the loans and derivatives they were making, buying, and selling. I have documented these points in many prior posts at length so I will simply list the many forms of data refuting Becker’s global “optimism” assertion.
- The officers controlling the fraudulent lenders extorted appraisers to inflate appraisals by threatening, and making good on those threats, to black list honest appraisers. Bank officers do not gratuitously commit appraisal fraud – they do so to cover up known defects in their loans. By 2006, surveys of appraisers showed that 90% of them had been the subject of attempted extortion in the prior 12 months.
- The officers controlling the fraudulent lenders caused them to increase substantially the number of fraudulent liar’s loans they originated after MARI’s famous five warnings about these loans in early 2006. The officers knowingly and dramatically expanded fraudulent liar’s loans because such loans maximized their compensation.
- Liar’s loans were the “ammunition” that optimized the “sure thing” of accounting control fraud in the U.S. The “sure thing” guaranteed that the officers would promptly be made wealthy through modern executive compensation.
- The officers were well aware that the loans were endemically fraudulent. They deliberately created the incentives to ensure that loan brokers and loan officers would produce massive amounts of fraudulent loans at a higher nominal yield. They deliberately made false “reps and warranties” to secondary market purchasers in order to cover up the endemic fraud in the loans they were selling. Again, bank officers do not gratuitously risk prosecution by making false reps and warranties unless they know that the loans are bad.
- The officers controlling the entities buying the fraudulent loans in the secondary market knew from Clayton’s “due diligence” (laughter!) reviews that the reps and warranties were false (the national average was 46% of the reps and warranties were false). How long would you continue to buy from Amazon if 46% of the time they lied to you and sold you a pamphlet rather than the book you ordered? The officers of the banks purchasing bad loans in the secondary market knew that the higher (albeit fictional) nominal yield on bad loans would create a “sure thing” of making them promptly wealthy.
- The secret emailed jokes from the industry’s officers repeatedly convey their knowledge that the loans and derivatives were toxic. (The industry term: “liar’s loan also makes clear that they knew what was going on.)
Similarly, the professional regulators typically found severe problems with loan quality. The banking regulators – under President Bush – warned about liar’s loans. Indeed, MARI’s fifth warning to the industry was that the regulators were discouraging liar’s loans. The record also demonstrates that it was the anti-regulatory leaders that Bush appointed who refused to act on the professional regulators’ warnings. The Fed’s long-time supervisory leader, Richard Spillenkothen, and the Financial Crisis Inquiry Commission (FCIC) report reveal two shocking examples in which the Fed’s supervisors asked to brief the Fed’s senior leadership on likely illegality by most of the Nation’s largest banks – and the Fed’s leadership responded primarily by becoming enraged at their supervisory staff for having the effrontery to criticize the elite bankers for aiding and abetting Enron’s frauds and making enormous amounts of endemically fraudulent liar’s loans and then selling those fraudulent loans to the secondary market through fraudulent reps and warranties.
The record shows that the controlling officers of the banks helped create a self-fulfilling prophecy of regulatory failure by ensuring that the agencies were run by dogmatic believers in the Chicago School’s unholy war against regulation. In the current crisis, the OTS leadership went so far as secretly approving three S&Ls’ backdating of transactions to make it appear that the failed S&Ls were healthy. This is not “optimism” – it is people who hate government trying to destroy it from within.
Becker also asserts that: “when you give a lot of discretion to regulators, they don’t use the tools that are given to them.” Let’s bring some reality to the discussion – the Chicago School has done everything in its power to (1) prevent regulators from being given “a lot of discretion,” (2) to minimize the ability and willingness of regulators to exercise any remaining discretion, (3) to assure that the political-appointees that run the regulatory agency believe that regulation is illegitimate and will block effective professional regulators from using “the tools” essential to serve as the regulatory “cops on the beat,” (4) to ensure that the (anti) regulatory leaders believe that elite frauds by bankers are impossible (which also means that the financial regulatory leaders should be ignorant of accounting control fraud and the relevant literature on such frauds), and (5) to ensure that the courts will strike down any effort by the professional regulators to use “the tools” to remove and sanction the controlling officers leading the frauds.
Collectively, the Chicago School’s dogmas maximize the three “de’s” – deregulation, desupervision, and de facto decriminalization. The three “de’s” and other perverse polices championed by the Chicago School such as modern executive and professional compensation, optimize the criminogenic environments in the finance industry that drive our recurrent, intensifying financial crises.
In the interests of brevity, because I have literally written the book on the subject, I will simply say that professional regulators with supportive leaders have used the “tools” effectively. Indeed, we identified the real problem, reshaped the tools to new designs best suited to dealing with the epidemic of S&L accounting control fraud and the surge in “liar’s” loan that we stopped in 1990-1991 to prevent an incipient epidemic of those frauds. We did so over the combined, and often coordinated, opposition of the Reagan administration, most of Democratic Party’s congressional leadership, Speaker Wright, the five Senators who became known as the “Keating Five,” the control frauds, the exceptionally powerful S& trade association, economists, and the business press. That opposition was virulent and destroyed or crippled the careers of a number of regulators.
One of Becker’s co-winners of the Central Bank Prize, George Akerlof, co-authored the classic article (“Looting: The Economic Underworld of Bankruptcy for Profit”) about the S&L debacle. They made this passage their concluding paragraph in order to emphasize to their peers the grievous errors economists had made and the need to stop making false statements about the regulators. Unlike virtually all their peers, Akerlof and Romer studied the actual record of S&L regulators carefully. They read thousands of pages of documents and talked extensively with a senior regulator (me) and reached this conclusion.
“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the [deregulation] of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (Akerlof & Romer 1993: 60).
Public administration scholars have also praised the regulators who reregulated and re-supervised the S&L industry under the leadership of Federal Home Loan Bank Board Chairman Edwin Gray as exemplars of effective regulation. Those regulators succeeded in multiple dimensions.
- Reregulation began in 1983, the year after the Garn-St Germain Act deregulated federally chartered S&Ls, when Gray shut off providing federal deposit insurance to the tsunami of newly chartered Texas and California S&L
- Our “autopsies” of every failure in 1984-1986 identified the concept of accounting control fraud, the characteristic mechanism (the fraud “recipe” for a lender), and the three “sure things” such frauds produce
- We used the characteristic practices unique to a lender engaged in accounting control fraud to identify the frauds while they were still reporting record profits, we prioritized these S&Ls for takeover, and we began placing such S&Ls in conservatorship even though they reported that they were solvent and highly profitable and top tier audit partners “blessed” those financial statements
- We realized that the fraud recipe was an ideal means of hyper-inflating regional real estate bubbles and was doing so
- We realized the needs to go to an emergency footing and sent hundreds of examiners from other regions (roughly 30% of such examiners) to the Texas district, which was being overwhelmed by the fraud epidemic
- We identified the accounting control frauds’ Achilles’ “heel” – the need for very rapid growth – and adopted a rule restricting growth
- We, over the opposition of OMB and OPM, doubled the number of our examiners and supervisors in 18 months and raised their salaries to make them competitive with the banking regulators
- Chairman Gray personally recruited top regional supervisors with track records of vigorous, competent, and courageous service to bring our worst two regions (Texas and California) under control
- We deliberately burst the Dallas regional bubble in commercial real estate
- We created the criminal referral process and Gray made the removal of the fraudulent controlling officers from “their” S&Ls our top priority and holding those elite officers personally accountable for their frauds our agency’s second highest priority
- The result, which OTS Director Timothy Ryan and his Chief Counsel Harris Weinstein greatly aided, was over 30,000 criminal referrals and the most effective criminal prosecution of elite white-collar criminals in history
- We brought hundreds of successful civil suits and thousands of successful enforcement efforts
- As explained earlier, we, OTS’ regional regulatory office, drove liar’s loans out of the industry in 1990-1991
By 1983 there were roughly 300 S&L control frauds growing at an annual average rate of 50 per cent. Had Gray not begun the prompt reregulation and re-supervision of the industry and made the elimination of the fraudulent officers running these S&Ls our top priority or had he not adopted the rule limiting growth, the Nation would have suffered many trillions of dollars of losses. Rather from studying the cases of exceptional regulatory success and learning and promoting the keys to effective regulation and supervision – and the prosecution of the elite frauds that drive our financial crises – the Chicago School chorus performs readings of “just so” anti-morality plays declaiming the inevitability of regulatory failure. The Chicago School then tries to ensure that those failures occur.