By William K. Black
(Cross posted at Benzinga.com)
I have often written and spoken of my frustration that economists refuse to read George Akerlof and Paul Romer’s classic 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”) and apply it to an analysis of the current financial crisis. Note that their title expresses the paradox they were reporting – the best way to loot the bank is for its controlling officer to cause it to make extraordinary amounts of terrible loans that will typically cause the bank to fail.
In my fantasy world I am even frustrated that they refuse to read the white-collar criminology literature that my colleagues and I have spent decades developing about “accounting control fraud” (what Akerlof and Romer called “looting”). Economists do not study fraud and in my flights of fantasy I imagine a world in which they would read the work of those who specialize in that field. Silly, I know, though that is exactly what Akerlof and Romer did, see their beginning note*, because they wanted to get the facts correct. If you think that is the obvious approach that any scientist examining an issue would take – congratulations – you just might be a scientist, but you’re almost certainly not an economist.
Economists, even in a non-fantasy world, might actually read the work of a Nobel Laureate in economics (and Paul Romer is one of the economists rumored to be under consideration for a Nobel). Even economists do not doubt that the Enron-era accounting control frauds were run by the CEOs and CFOs. In addition to Akerlof and Romer’s article that explains the strong evidence of looting during the S&L debacle there is the corroborating finding written by James Pierce, their colleague, working independently as the Executive Director of the National Commission on Financial Institution Reform, Recovery and Enforcement.
“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to ‘milk’ the organization” (NCFIRRE 1993).
There was also the corroboration, going up against the best criminal defense lawyers in the world, of securing over 1,000 felony convictions in S&L cases that the Department of Justice classified as “major.” And, of course, there was the corroboration of the detailed findings of the regulators, including thousands of enforcement actions, and white-collar criminologists about the dominant role that control fraud played in driving the second (far costlier) phase of the S&L debacle.
The two antecedent scandals were driven by epidemics of accounting control fraud. The growing fraud scheme that we (the OTS regional regulators based in San Francisco) prevented from becoming a scandal in 1990-1991 when we cracked down on the Orange County, California S&Ls that were “innovating” by beginning to issue what the industry now (not then) called “liar’s” loans would have become an epidemic of accounting control fraud.
Let’s be serious – even economists who have never read Akerlof and Romer or the NCFIRRE report, were raised in cloistered religious communities where the word “fraud” was never spoken, and studied at U. Chicago where they never learned anything about fraud, should be able to figure out that an industry issuing well over two million mortgage loans in 2006 alone that they called “liar’s” loans should be able to figure out that there was a catastrophic fraud problem both in the origination and the subsequent fraudulent sale of those fraudulently originated mortgages to the secondary market, which propagated into MBS and CDOs. And just for spice, recall that sentient economists know that by 2006 half of all the loans the industry called “subprime” were also liar’s loans and had “layered” on top of those terrible loan characteristics were a host of other loan features that made the loans even more toxic. Again, the paradox is that it that making really bad loans optimizes looting.
With this track record, and Akerlof and Romer’s pleas to their profession that they made this the last paragraph of their article in order to emphasize their central findings, you might think economists would have reacted to this crisis by inquiring first whether it was produced by new epidemics of accounting control fraud. After Akerlof and Romer’s 1993 warnings, economists unquestionably “knew better” than their embarrassing role in the 1980s. Economists created the criminogenic environment that led to the fraud epidemic that drove the S&L debacle.
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).
Surely, economists would not repeat their terrible mistake in pushing three “de’s” (deregulation, desupervision, and de facto decriminalization) again after these three scandals they helped create and after Akerlof and Romer’s warnings? Even if they couldn’t figure out the import of the regulators’, prosecutors’, and criminologists’ findings confirming those fraud epidemics, no scientist would fail to heed the warning of a Nobel Laureate in his discipline.
The reality is that economists almost entirely ignored Akerlof and Romer and all the rest of us (effective regulators, public administration scholars, prosecutors, and criminologists – which I’ll refer to as “the other literatures”) as well as the reality staring them in the face. Fewer than one economics journal article in a hundred allegedly discussing the current crisis even cites their1993 article. Virtually no economist, other than those who work with me, notes the other literatures. No economist outside the small circle that work with me alerted his or her readers to the compelling data establishing the three accounting control fraud epidemics.
But the craziest economists are the ones who cite Akerlof and Romer – and ignore them
I posted a column on January 14, 2014 (“The Icelandic Chutzpah Prize is Retired: Portes and Baldursson Win by Losing”) about two famous and disastrous economists who exemplified this point. Portes and Baldursson cited Akerlof and Romer in their article advancing the claim that the officers controlling the Icelandic bank (who looted the banks) were engaged in honest, but failed “gambling for resurrection.”
Akerlof and Romer’s article, over the course of 40 pages of analysis, explains why CEOs would rarely engage in “gambling for resurrection” in circumstances where the three “de’s” were present because “looting” is a “sure thing” whereas gambling is very likely to fail. Akerlof and Romer also explained in detail, citing my analysis, why the bankers controlling the S&Ls did not operate in a manner that made any sense if they were trying to win an honest, high-risk gamble. Note that Portes and Baldursson did not cite Akerlof and Romer in order to explain why they thought that the “sure thing” point or to try to counter the points Akerlof, Romer, and I made about the total irrationality of the controlling officers’ conduct were they engaged in trying to win a high-risk gamble were not applicable in the Icelandic context. They failed completely to engage with any aspect of our analysis even though they cited the Akerlof and Romer’s article.
A “Fingerprint” plan designed by professors who don’t understand, Akerlof & Romer
I came across today another example of this approach. The 2009 article by Helmut Gründl and Thomas Post is entitled “Transparency through Financial Claims with ‘Fingerprints’: A Mechanism for Preventing Financial Crises.”
I won’t provide an exhaustive take down of this article. Here is the authors’ premise:
“MBSs and especially CDOs exhibit a large degree of opaqueness (i.e., market participants often have limited information about the true nature of the risks of the underlying mortgages). Every additional repackaging has the potential for even more information loss. In the run-up to the crisis, this situation caused the market for these securities to dry up. Furthermore, banks that held these opaque securities faced major refinancing problems.
The apparent collapse of the market for MBSs has led many policymakers and commentators to demand stricter regulation of transactions and compulsory trading of asset-backed securities at stock exchanges. Some have even called for a complete ban on MBSs.
We propose an incentive-compatible mechanism that takes ‘fingerprints’ of the original mortgages and of MBS and CDO transactions. By fingerprints, we mean a complete record of information concerning the original mortgage transactions and all subsequent securitizations of those mortgages. This mechanism would solve many of the markets’ problems without stricter regulation and without impeding the potential for innovation in the securitization markets. We believe that our proposed mechanism would offer advantages at all stages of the securitization process, albeit with some possibly minor transaction costs.”
Akerlof and Romer warned that the three “de’s” “were bound to produce looting.” The authors cite Akerlof and Romer in a footnote for no apparent purpose, ignore completely their analysis and warnings, and write an article devoted entirely to preventing any effective regulation of the secondary market and housing derivative products even though they had just blown up the global financial system. The authors are not serious about their use of the phrase “apparent collapse.” The authors admit that there was a real collapse and promise that their plan will prevent any future collapse – and promise that “we don’t need no stinkin’ badges!” They promise that their system will ensure:
“that the information be used to solve some of the more severe problems of the current crisis – no confidence in financial institutions that hold securitized assets and no trade in ‘toxic assets.’ Under our proposal, a systematic collection of securitization transaction data could become the cornerstone of an incentive-compatible mechanism in securitization transactions and thus foster a revival of securitization markets without new regulation.”
I first encountered this pathology when I read the bizarre Agenda for Reform produced by Federal Home Loan Bank Board Chairman Richard Pratt in 1983. The published report put three quotations on the cover. Two of the quotations made the point that it was vital that Pratt’s deregulation of the S&L industry (he was the principal drafter of the Garn-St Germain Act of 1982 that deregulated the S&L industry) succeed. Pratt was an academic economist. Here was the kicker – the quotations on the report’s covers revealed that Pratt’s true fear was that the failure of S&L deregulation would discredit the concept of deregulation. His concern was not how much damage a failure of S&L deregulation would do to the Nation. This is a classic example how economists unintentionally reveal that the policies they push are driven by dogma, not science.
Academics who do not understand accounting control fraud, incentives, or crises
The authors of the “fingerprint” proposal stressed that there were numerous similar proposals being made – each of them designed to prevent regulation. That is their paramount priority, not preventing the looting that drives our recurrent, intensifying financial crises. If the authors had actually understood Akerlof and Romer’s discussion of why banking officers have perverse incentives, the causes of the crisis, and the other literatures it would have been obvious to them that the accounting control frauds would easily defeat their “fingerprint” proposal. Here are the key components of that proposal.
“The [mortgage loan] originator gathers this information during credit scoring and subsequent credit monitoring activities. Entries include such information as loan characteristics (principal debt, fixed or variable interest rate, duration, currency denomination), borrower characteristics (income, employment status, financial assets and liabilities, FICO score, delinquency and foreclosure status), collateral characteristics (ZIP code, type, size, age, and value of house), and, possibly, information on the originator or on the mortgage broker.”
I will not detail the smaller things that are easy to scam such as the FICO score. (Hayek ignored the fact that one of the forms of “spontaneous order” that arise due to the desire to make a buck is a maze of businesses devoted to aiding and abetting frauds.) Similarly, there use of the word “possibly” in the final clause indicates that they lack even the most basic understanding of mortgage origination.
I discuss three fatal flaws in the fingerprint proposal. I will not provide the supporting data and sources. They can be found in my book and in scores of articles. First, the proposal would rely on the lender’s report as to the borrower’s “income.” I explained above that by 2006 the controlling officers of lenders knowingly chose to make over two million liar’s loans, many of them to borrowers they knew to have poor credit scores (very low FICO scores). The lenders’ officers knew that the fraud incidence in liar’s loans was 90% and that nearly 60% of the time the borrower’s income was inflated by at least 50%. Liar’s loans constituted the first epidemic of mortgage origination fraud. The information lenders would have provided under the fingerprint plan on the borrower’s income would have been massively fraudulent.
The two most critical pieces of information about the credit quality of a home loan are the borrower’s income (central to the probability of default) and the appraised value of the home (central to the risk of loss upon default). The fingerprint proposal requires the lender to provide the “value of house.” The second epidemic of loan origination fraud consisted of lenders’ controlling officers inflating massive numbers of appraisals. The controlling officers of the lenders and their agents extorted appraisers by “blacklisting” honest appraisers who refused to inflate appraised values. No honest lender would inflate an appraisal or permit an appraisal to be inflated. By 2006, surveys of appraisers revealed that 90% of all appraisers had been personally subjected to such extortion in the last calendar year. Once again, the data provided under the fingerprint plan would have been massively fraudulent.
The third point is both more subtle and more fundamental. The fingerprint proposal, despite citing Akerlof and Romer about looting never takes the possibility of looting seriously. It, implicitly, assumes that the officers who control the lenders and the purchasers in the secondary market are not acting fraudulently. I have shown that this assumption is false about officers controlling a huge group of the lenders. But my same showing has implicitly demonstrated that the officers controlling the financial institutions that purchased the endemically fraudulent loans were also engaged in fraud. All the information I have referenced was public and was known throughout financial industry. That means that the officers directing the purchases of the endemically fraudulent loans knew they were endemically fraudulent (the phrase “liar’s loans” was also a strong hint).
There are other proofs of this point that I have explained in detail in previous articles and will only list here. The purchasers typically hired a “due diligence” firm (Clayton was the largest) to review a tiny sample of the loans. Clayton’s reviews, and the purchasers’ response to those findings demonstrates that the purchasers’ officers knew they could best loot their firms by deliberately purchasing bad loans (another variant of the paradox that Akerlof and Romer’s title reflects – bad loans, at a premium nominal yield, are the best fraud “ammunition”). The average incidence of false “reps and warranties” by the lenders that Clayton found was 46%. The response of the purchasers’ officers to this endemic compound fraud was:
- They did not refuse to deal with sellers who constantly lied to them
- They did not increase the sample size to be able to reject the fraudulent loans
- They allowed Clayton to use fraudulently inflated reports of the borrower’s income to “compensate” for fraudulently inflated appraisals (and the reverse) and for the resultant false “reps and warranties” by the lender
- They frequently used the high reported incidence of fraudulent reps and warranties to negotiate a cheaper purchase price (they then turned around and called the toxic waste “AAA”)
- They even “waived” fraudulent reps and warranties about fraudulently originated loans and purchased them despite Clayton’s warnings
The fingerprint system would be an open invitation to accounting control fraud. It would not have stopped any of the three most destructive epidemics of accounting control fraud in history. The officers controlling the purchasers of the endemically fraudulent loans from the lenders that knowingly originated the endemically fraudulent mortgages knew that they were buying toxic waste and that the lenders were lying to them about the quality of those loans. They bought the fraudulent loans, knowing that the reps and warranties were fraudulent, because doing so created a “sure thing” that made the officers wealthy but caused grave, often fatal, losses to their companies. Again, it is that paradox that caused Akerlof and Romer to choose the title (“Looting: The Economic Underworld of Bankruptcy for Profit”). The officers’ incentives are so perverse that they are the opposite of what the authors’ assumed (“incentive compatible”). Had the authors understood Akerlof and Romer’s warnings (or our warnings) they would not have designed a plan that was an open invitation to continue the three fraud epidemics that drove the U.S. financial crisis.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @williamkblack