Politico has joined Deal Book in a “competition in sycophancy.” The contestants are competing to see which can author the most extreme version of a fantasy meme in which heroic Wall Street “banks” are oppressed by “Washington.” I had not believed that any “serious” journalist could compete with Andrew Ross Sorkin’s Deal Book in pounding this meme. Ben White, Politico’s economics reporter, has become my dark horse favorite in the race to the bottom of the “serious” business press with his whitewash entitled “How Washington beat Wall Street.”
In fairness to Sorkin and White I am focusing on them as a matter of (almost) respect. There are vastly worse business reporters than Sorkin and White. The point is that we rightly expect a great deal from the New York Times and Politico wants to compete in that league. It is fair to expect them to strive every day to be a national asset rather than a national embarrassment that harms the public. They are worth trying to save from the dark side, so I have tried to hold Deal Book’s feet to the fire by pointing out their failings in great detail. We need to redirect their efforts into a competition in rigor to root out the rot that causes our recurrent, intensifying financial crises. Sorkin should be tired of writing his endless stream of “DC done JPMorgan wrong” songs. This column is the first in a series designed to try to enlist White and Sorkin in a competition for rigor.
We have long understood the regulatory policies that create control fraud epidemics
Effective financial regulators have known for at least 30 years, and top economists for 20 years, what produces a “criminogenic environment” in finance. The environment creates such perverse incentives that it causes crime to become epidemic. Akerlof and Romer explained the concept in their famous 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”).
“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations 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).
Accounting is finance’s “weapon of choice” because it is a “sure thing”
Accounting control fraud produces three “sure things. The bank is guaranteed to report high (fictional) profits in the near term, the officers are sure to be made promptly wealthy by the bank’s compensation system, and the bank is sure to suffer catastrophic losses. George Akerlof and Paul Romer drove this point home as forcefully as they could in their famous 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”).
“[M]any economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4-5).
The key implication of accounting fraud’s three “sure things” is that from the perspective of the CEO running such a fraud the terms “risk” and “return” are lies and deliberate means of deceit. The CEO deliberately makes (or purchases) crappy loans with high nominal yields that will produce net losses.
The three, record, fraud epidemics that drove the crisis
Consider the three fraud epidemics that drove the current crisis. No honest lender would extort appraisers to inflate the appraised value of the home because the adequacy of the true market value of the home is the lender’s great protection against loss if the borrower defaults (it also makes default far less common).
Similarly, no honest home lender would make “liar’s” loans because they knew that it invariably led to endemic, severe inflation of the borrower’s income (typically prompted by the lenders and their agents). The borrower’s true income is the lender’s great protection against default. The industry called them “liar’s” loans when they were talking behind closed doors. That lacks a certain subtlety.
Liar’s loans also have a history. They began, as do all good U.S. financial frauds, in Orange County, California. We were the regional regulators with jurisdiction over the S&Ls making the liar’s loans. This was a new product and the loans were not called “liars” loans in our era. We were also dealing with the S&L debacle, an immense task for which we had inadequate resources to respond fully to the existing epidemic of accounting control fraud. Nevertheless, as Akerlof and Romer aptly observed, “the regulators in the field … understood what was happening from the beginning.” Our regional leader, Michael Patriarca, listened to what our examiners “in the field” found and concurred with their warning that no honest home lender would make loans that did not verify the borrower’s income. Mike also made it a high priority, despite our inadequate resources, to shift resources to stamping out this new fraud scheme before it became epidemic. We drove liar’s loans out of the S&L industry in 1990-1991. We viewed ending liar’s loans by S&Ls as one of the easiest supervisory calls we ever made during the S&L debacle.
Liar’s loans caused hundreds of millions of dollars of losses to S&Ls in our era, but we ended these fraudulent loans before they caused expensive S&L failures. They were not able to hyper-inflate a financial bubble and they did not cause any crisis or recession.
As future columns will discuss in greater detail, the regulators dealing with the current crisis should have had a far easier time than us in ending such loans. They had the advantage of our experience. The industry had developed the term “liar’s” loan to describe the loans – and the regulators knew they had done so. The liar’s loans in the current crisis were vastly worse loans than the loans we forced out of the industry. For example, by 2006 half of all the loans called “subprime” were also liar’s loans (the two categories are not mutually exclusive). Consider for a moment what this indicates. These loans were overwhelmingly made contrary to regulators’ and the mortgage industry’s own anti-fraud experts’ warnings. Indeed, the industry dramatically increased the quantity and radically decreased the loan quality of the liar’s loans in response to those warnings.
In 1994, Congress provided the Fed with the express statutory authority to ban liar’s loans by any lender – even if they were not federally insured. We had no such power in our era. Congress mandated Fed hearings on predatory lending that produced urgent pleas by a host of housing advocates (including ACORN!) plus state attorney generals and prosecutors alerting the Fed to the endemic abuses and risk of terrible losses and begging the Fed to ban liar’s loans.
Alan Greenspan did not simply refuse to act. He refused his colleague (Board Member Gramlich’s) plea that the Fed use its examiners to find the facts. Much of the senior leadership of the Fed attacked the Fed’s supervisors when they provided data on the largest banks enormous origination of liar’s loans.
Ben Bernanke continued to refuse to use the Fed’s unique authority to ban liar’s loans. Finally, in 2008, in response to acute Congressional pressure, Bernanke finally used his HOEPA authority to ban liar’s loans. Even then he delayed the effective date of the rule by over a year because he did not want to inconvenience the CEOs of fraudulent lenders. These non-responses demonstrate how complete and destructive the desupervision of finance were and why three fraud epidemics were allowed to grow to world record size without any serious regulatory response. More subtly, as I will explore in future columns, the desupervision is a major part of the explanation for the fact that the criminal justice response to the bank CEOs who led these record fraud epidemics that drove the crisis has been virtually non-existent.
Fraudulent “reps and warranties” are essential to sell fraudulent mortgages
There is no fraud exorcist. Fraudulently originated loans can only be sold through fraudulent “reps and warranties.” The fraudulent sale of fraudulently originated mortgages was the third fraud epidemic. No honest purchaser of loans would continue to purchase loans from a seller when the purchaser knew that the loans being sold were frequently fraudulently originated in the manner I’ve described and that the lender was attempting to sell the loans through fraudulent “reps and warranties.”
Note these are not close questions. Each of the three fraud epidemics was driven by behavior that is unambiguously consistent with accounting control fraud and falsifies any claim that the bankers were engaged in high risk but honest “gambles.” These analytics are neither difficult nor controversial. Future columns will provide data on the frequency of each of these fraud epidemics. The data are neither difficult to understand nor controversial. Any discussion of the crisis premised on the (always untested) assumption that it was caused by “risky” lending seeking “high yields” must be erroneous because it is contrary to the facts. It would also be a complete departure from the S&L debacle and the Enron-era frauds, both of which were driven by epidemics of accounting control fraud. Any competent business reporter can understand the relevant analytics, history, and data.
A few major control frauds can create a “Gresham’s dynamic” producing endemic fraud
George Akerlof was the first economist to explain, in his classic 1970 article on markets for “lemons,” why individual “control frauds” can cause fraud to become epidemic.
[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence (Akerlof 1970).
Akerlof called this a “Gresham’s” dynamic because bad ethics tends to drive good ethics out of the markets and professions. Akerlof was far from the first person to recognize this dynamic. Over two centuries earlier, a writer observed:
The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage (Swift, J., Gulliver’s Travels).
These factors explain why fraudulent CEOs make weakening regulation their top priority
The regulators must serve as effective “cops on the beat” to prevent “the knave” from gaining “the advantage” through fraud. Only the regulator can ensure that “the honest” banker is not “undone” by the CEOs running the control fraud. We are so dangerous to the fraudulent CEO because we are the only “control” that the CEO cannot fire and cannot suborn by controlling compensation and the opportunity for promotion.
Fraudulent CEOs choose the board of directors – not the other way around. Fraudulent CEOs decide which people will be nominated as directors and vote the proxies that elect the directors. Fraudulent CEOs almost always chose well (which is to say badly). Boards rarely stop CEOs leading control frauds.
Because of our unique ability to sanction CEOs running control frauds, competent regulators are their prime target. CEOs can, and do, launch wide ranging efforts to neutralize their regulators. As I will develop in future columns, the formal rules are often the least important aspect of these efforts. I will explain the three “de’s” in detail (deregulation, desupervision, and de facto decriminalization) and the three primary strategies fraudulent CEOs use against effective regulators – “buy, bully, and bamboozle.”
Ronald Reagan’s signature joke slandered regulators while he aided the S&L “knaves”
Reagan: “The nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’”
There are several vital implications of the fact that the crises were driven by frauds led by CEOs that typically caused massive losses to “their” corporations. Effective financial regulation protects “banks” – and their shareholders (unless the CEO is the paramount shareholder) and creditors – from their gravest threat, their CEO. Indeed, only effective financial regulation can protect banks, (honest) shareholders, and creditors from the CEO because CEOs leading control frauds have demonstrated the consistent ability to suborn internal and external “controls” and pervert them into fraud allies. “Private market discipline” is an oxymoron when it comes to accounting control frauds – and the Enron-era frauds and the current crisis demonstrate that this is not the result of deposit insurance. Private creditors eagerly fund the rapid growth of accounting control frauds because the fraud makes them appear to have record profits.
These facts mean that, contrary to President Reagan’s smear of government workers, effective regulators are the indispensable friends of honestly-led banks and banks’ shareholders and creditors because we are the worst nightmare of bank CEOs that loot. The ten most terrifying words in the English language are “I’m from Goldman Sachs, and I’m here to help you.”
Reagan was aware of our reregulation of the S&L industry, our crackdown on the looters, and the furious attacks on us by the looters’ political allies. Reagan and his administration repeatedly sided with the looters and attacked us. He never ceased his sneering smears of the regulators even as we exposed the lie at the core of his signature joke. (I’m not arguing that financial regulators are unique or even special in this regard. Many “government” workers such as firefighters regularly “help” people by risking their lives to save complete strangers.)
Reagan continued to ally with the worst financial frauds, including Charles Keating, against us even when we were the targets of Democratic politicians who were acting in a shameful fashion to try to prevent us from closing the worst frauds. Four of the five Senators who became known as the “Keating Five” and Speaker Wright were Democrats. Each of these five prominent Democrats allied with Keating to attack us, but so did the Reagan administration in myriad ways.
To give but one example, in late 1986, Reagan tried to appoint two “Members” chosen by Keating to the three-Member Federal Home Loan Bank Board. This would have given Keating majority-control over the regulatory agency – and it would have caused trillions of dollars in losses and produced the worst political-financial scandal in U.S. history and rendered Reagan the Republican Party’s most embarrassing official. Fortunately for the Nation, and Reagan’s reputation, one of the nominees was blocked by random politics. The second served as Keating’s “mole” at the agency until I was able to blow the whistle on his surreptitious effort to aid Keating. He made a deal with the prosecutors to resign to end the criminal investigation.
Politico’s framing of the issues misses each of these analytical points
White admirably places his thesis and framing in the first sentence of his January 16, 2014 article entitled “How Washington beat Wall Street.”
“In 2009, Washington went to war against big Wall Street banks hoping to blow up the kind of high-risk, high reward strategies that helped spark the financial crisis.”
This column will address only White’s first sentence and his framing. First, “Washington” is too vague a term to allow analysis and it falsely implies that there is some singular entity with a singular policy. “In 2009,” as at every year of its existence, different actors that work in Washington, D.C. had markedly different view about “banks” and bankers and those views often depended on the particular issue being discussed rather than some overall view about “banks.”
I will expand on this point in future columns, but here are a few of the major ways in which White’s thesis collapses as soon as we disaggregate “Washington” and examine the facts of “Washington’s” Phony War on “banks.”
- The Financial Crisis Inquiry Commission (FCIC) described an example of the deliberate creation by fraudulent CEOs of the Gresham’s dynamic that caused the epidemic of appraisal fraud.
“From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011:18).
By 2000, after two years of organizing the coalition and agreeing upon the text of the petition, the appraisers warned “Washington” that the banksters had declared war on America (to adopt White’s martial metaphors simply for the purpose of revealing how he stacked his rhetoric). No honest lender would ever extort appraisers to inflate appraisals, so this was the perfect “signal” of the presence of an epidemic of accounting control fraud – which means that the bankster/looters were making war on “their own” banks. “Washington” did nothing material in response – even when surveys demonstrated that 90% of all appraisers had personally been subjected to such extortion in the prior 12 months. So, if “Washington went to war” only in 2009 in response to the banksters’ assault on the banks – which was large enough for the honest appraisers to identify it as a crisis by 1998 – we have demonstrated that “Washington” is astoundingly slow to anger (11 years) when the banksters make war on our Nation, the banks and their customers.
Oh, and as is characteristic of Dodd-Frank, it has provisions dealing with appraisers and appraisals – none of which would prevent a recurrence of the fraud epidemic.
- In 2009, “Washington” saw to it that AIG officers got new bonuses while Treasury bailed it out and that the officers who grew wealthy by looting AIG to the point it was insolvent, thereby creating a global, systemic crisis, were able to keep that wealth.
- In 2009, Treasury Secretary Timothy Geithner intervened to prevent AIG from negotiating a settlement reducing its debt to the huge banks that were its credit default swap (CDS) counterparties. Geithner insisted that AIG pay the banks in full – at the expense of the Treasury.
- In 2009, “Washington” made large explicit bailouts to the banks through TARP and far more massive implicit bailouts to the banks through a series of Fed credit facilities.
- In 2009 (and before and after that year) “Washington” brought zero criminal prosecutions, and less than a handful of civil cases, against any of the elite Wall Street banksters who grew wealthy by leading the three fraud epidemics that caused the crisis.
- Throughout the crisis, “Washington,” including President Obama and Attorney General Holder consistently downplayed any role of insider fraud.
- Larry Summers and Geithner spent much of 2009 trying to kill the Volcker rule
- “Washington” never seriously thought of repealing the two laws that had proved harmful – the act repealing Glass-Steagall and the Commodities Futures Modernization Act of 2000.
- “Washington” blocked the appointment of regulators who were considered likely to be vigorous, such as Elizabeth Warren.
- Republicans are promising to destroy the Volcker rule and gut Dodd-Frank should they regain control of the Senate.
Second, any “war” metaphor applied to financial regulation is sure to mislead. I know because I’ve used them. This particular metaphor is false for the reasons I’ve explained above.
Third, “Washington” reformers aren’t opponents of “banks.” They are opponents of fraudulent bankers. Effective regulation is essential to “banks.” More precisely, it is essential to protect their shareholders, creditors, and customers and honest bank CEOs. Why would members of Congress or regulators want to destroy “banks?” Banks are major sources of political contributions and banks are what financial regulators seek to protect from their gravest enemy – fraudulent CEOs. “Banks” aren’t human. Fraudulent CEOs are the ones who seek to harm “their” banks.
Fourth, for the reasons I’ve explained, many “Washington” actors are the fraudulent CEOs’ most valuable allies and the “bank’s” most dangerous foe. These actors include prominent members of Congress and senior officials in the Obama administration. Recall that a decade before “2009” the Clinton administration, Alan Greenspan, Senator Phil Gramm, and the “13 bankers” (the CEOs of the largest banks) allied to crush Brooksley Born (Chair of the CFTC) when she thought to study whether financial derivatives (including CDS) should be regulated. The result was the deliberate creation of a “regulatory black hole.”
Fifth, for the reasons I’ve explained, the crisis has little or nothing to do with “high-risk, high reward strategies.” The “strategies that helped spark the financial crisis” were not “high-risk in the sense White uses the term. The strategy that drove this financial crisis, like the S&L debacle and the Enron-era scandals, was the traditional “sure thing” of accounting control fraud. Indeed, one of the fraud mechanisms, making liar’s loans, reprised the fraud strategy of the non-crisis of 1990-1991. In those years, because we understood fraud schemes and why making liar’s loans only made sense for fraudulent CEOs, the regulatory response was so rapid and vigorous that the incipient fraud epidemic was ended before it could cause a “Gresham’s” dynamic and produce a crisis.
Dodd-Frank has a provision banning liar’s loans. Does White assert that such loans were honest “high-risk” “gambles” rather than endemically fraudulent? Why does he think that bank CEOs dramatically increased the quantity, and decreased the quality, of liar’s loans in response to their own anti-fraud experts’ and the regulators’ warnings?
Sixth, White is logically inconsistent and tries to hide it with his marital rhetoric. If Congress had sought to end the banking strategy that caused the crisis, that would refute White’s claim that they were waging a “war” against “big Wall Street banks.” Readers remember, even if White does not, that the banking strategies that caused the crisis rendered most of the world’s largest banks insolvent and in deadly liquidity crises. If White were correct that Congress, President Obama, and the federal financial regulators sought to end the banking “strategies” that devastated the “big Wall Street banks then it would follow logically that they were seeking to protect rather than wage “war” against those banks. “Blow up” is nicely martial, but one does not “blow up” a “strategy.” If White had claimed that “Washington” was “hoping to blow up” banks his readers would have realized that he was seeking to mislead them.
The first sentence of White’s attempted whitewash states (and refutes) his thesis and demonstrates his failure to understand the causes of the crisis, the nature of accounting control fraud, and the nature and purpose of financial regulation. It turns out that the 2009 “war” on “big Wall Street banks” primarily consisted of sending them trillions of dollars to save them from collapse, secret interventions by Geithner designed to secretly use AIG as a means of funneling even more money from Treasury to Goldman Sachs and friends, and the development of a new (not so) legal doctrine of “too big to prosecute” designed to ensure that the Wall Street CEOs’ could loot with impunity.
“Phony War” is too kind a phrase to describe a “war” in which the Treasury and the Fed carpet bombed “the big Wall Street banks” and their CEOs for over a year with trillions of dollars in cash and cheap loans in Operation “Rolling Plunder.” It is deeply offensive to call Bernanke “Helicopter Ben.” Ben used the equivalent of our entire fleet of B-2 stealth bombers to shower the industry with the Fed’s cash.
To paraphrase Tevye in Fiddler on the Roof: “May the Lord smite me with [such a “war”]. And may I never recover!”