How the Rocket Scientists Aided the Senior Fraudulent Bank Officers

By William K. Black

In my first column in this two-part series I explained how the Department of Justice’s (DOJ) non-prosecutorial effort against the banksters’ frauds that caused the financial crisis had ended with a pathetic whimper uttered by Deputy Attorney General James Cole during his ritual exit interview with Bloomberg. Cole’s explanation for DOJ’s failure to prosecute a single senior banker for leading the three fraud epidemics that drove the financial crisis was that DOJ was “dealing with financial rocket science.” My first column made the point, which escaped DOJ and Bloomberg that if this were true it would presumably have been modestly important for DOJ to do something about the ability of “rocket scientists” to grow wealthy by leading the frauds that cost the U.S. $21 trillion in lost GDP and 10 million jobs. In my second column I explained why no rocket science was required to prosecute the senior bank officers that led the three most destructive epidemics of financial fraud. In light of a reader’s comment I promised to write this third piece on “rocket science” in the financial context.

The Limited Role Played by Financial “Rocket Scientists”

There are people in finance who could justifiably be called “rocket scientists” because of their extreme skills in mathematics. Indeed, because physics requires such high order mathematics, many of Wall Street’s “rocket scientists” are drawn from the ranks of physics student. I made a stronger statement in the documentary “Capitalism: A Love Story” – we have far too many rocket scientists in finance. As a society, we have a critical shortage of people with advanced mathematics and physics skills. The “opportunity cost” of taking many of our most promising students out of mathematics and physics, where they would do enormous good for society, and having them work in finance instead is extraordinary. In finance, the role of the “rocket scientists” is primarily pernicious. Nevertheless, they played a much smaller role than the officers that controlled the banks played in the growth of the financial crisis and an even smaller role in the three epidemics of control fraud that caused the crisis.

One of the things one must understand about the largest banks and investment banks before the crisis is that none of them was led by a CEO who was a “rocket scientist.” The CFOs of the largest banks were rarely rocket scientists. The most senior position a “rocket scientist” was likely to hold in a large financial institution was “Chief Risk Officer” (CRO). The Financial Crisis Inquiry Commission (FCIC) presents typical examples (Lehman and Freddie Mac) of what happened when CROs raised red flags – they were ignored and punished (FCIC 2011: 18-19, 177, 179). Lehman epitomizes the industry’s hypocrisy, proclaiming that “Risk Management is at the very core of Lehman’s business model,” while actually excluding its risk officers from key decisions (FCIC 2011: 176-177).

Citigroup presented an even worse, but still typical, example in which the CRO, who was paid $7.4 million in 2006 alone, became an active part in the cover up of toxic mortgages being sold to Fannie and Freddie and encouraged more collateralized debt obligation (CDO) purchases as spreads on CDOs were growing rapidly (FCIC 2011: 168, 198, 261). Fannie’s CRO was chosen with the explicit statement from its leader that the CRO wasn’t hired to get in the way of risky purchases. When the CRO complained to Fannie’s CEO that Fannie had no effective risk controls and was taking on far greater risk while his staff was cut substantially he was put in the deep freeze by the CEO (FCIC 2011: 181-183). AIG’s CRO testified that he was unaware of the collateral call aspect of the massive credit default swaps that AIG had sold (FCIC 2011: 243). Those collateral calls caused AIG to collapse and require a federal bailout. Understanding that there can be a collateral call does not require any rocket science skills. Merrill Lynch and Citi’s risk managers claimed that the “super senior” tranches of toxic CDOs bore no credit risk (FCIC 2011: 261).

AIG’s “rocket scientists” exemplified the faux rigor of risk management.

“AIG Financial Products did not have its own model or otherwise try to value the CDO portfolio that it guaranteed through credit default swaps, nor did it hedge its exposure. Gene Park explained that hedging was seen as unnecessary in part because of the mistaken belief that AIG would have to pay counterparties only if holders of the super-senior tranches incurred actual losses. He also said that purchasing a hedge from UBS, the Swiss bank, was considered, but that Andrew Forster, the head of credit trading at AIG Financial Products, rejected the idea because it would cost more than the fees that AIG Financial Products was receiving to write the CDS protection. “We’re not going to pay a dime for this,” Forster told Park.

Therefore, AIG Financial Products relied on an actuarial model that did not provide a tool for monitoring the CDOs’ market value. The model was developed by Gary Gorton, then a finance professor at the University of Pennsylvania’s Wharton School, who began working as a consultant to AIG Financial Products in 1996 and was close to its CEO, Joe Cassano. The Gorton model had determined with 99.85% confidence that the owners of the super-senior tranches of the CDOs insured by AIG Financial Products would never suffer real economic losses, even in an economy as troubled as the worst post–World War II recession. The company’s auditors, PricewaterhouseCoopers (PwC), who were apparently also not aware of the collateral requirements, concluded that “the risk of default on [AIG’s] portfolio has been effectively removed and as a result from a risk management perspective, there are no substantive economic risks in the portfolio and as a result the fair value of the liability stream on these positions from a risk management perspective could reasonably be considered to be zero’” (FCIC 2011: 266-267).

What all of that means is that AIG knew early on, no later than the point where it got bids on hedging its exposure on the CDS protection for CDOs, that the CDS protection it had sold was grossly underpriced because it would, net, lose money if it hedged. AIG then relied on a non-market value model that was worse than useless for risk management purposes because it created false complacency and made incorrect assumptions about the nature of the CDS protection that AIG had sold and false assumptions about CDO losses because it failed to account for the three fraud epidemics in the home mortgages that were supposed to “collateralize” the CDOs. PwC, of course, bought this nonsense hook line and sinker, allowing AIG to provide zero loss reserves to cover a massive loss exposure. PwC eventually came to call AIG’s risk management of its DCS exposure inadequate. It learned, for example, that different units of AIG were taking opposite positions (and not as an intended hedge) on reducing v. increasing their exposure to home mortgages and that AIGs senior managers were incapable of or unwilling to provide effective risk management (FCIC 2011: 271-273).

In its public disclosures, however, AIG pictured its risk management as superb.

“On a conference call, CEO Sullivan assured investors that the insurance company had ‘active and strong risk management.’ He said, ‘AIG continues to believe that it is highly unlikely that AIGFP will be required to make payments with respect to these derivatives.’ Cassano added that AIG had ‘more than enough resources to meet any of the collateral calls that might come in.’ While the company remained adamant that there would be no realized economic losses from the credit default swaps, it used the newly adopted—and adapted—Moody’s model to estimate the $352 million charge. In fact, PwC had questioned the relevance of the model: it hadn’t been validated in advance of the earnings release, it didn’t take into account important structural information about the swap contracts, and there were questions about the quality of the data. AIG didn’t mention those caveats on the call” (FCIC 2011: 270).

The pathetic nature of the “rocket scientists’” performance as risk officers is also exemplified by Citigroup’s evaluation of the risk posed in buying CDOs.

“Duke reflected that she was not overly concerned when the issue came up, saying she and her risk team were ‘seduced by structuring and failed to look at the underlying collateral.’ According to Barnes, the CDO desk didn’t look at the CDOs’ underlying collateral because it lacked the ‘ability’ to see loan performance data, such as delinquencies and early payment defaults” (FCIC 2011: 262).

CDOs are exceptionally complex, but one aspect of them is exceptionally simple. The risk posed by a CDO depends on the intersection of “structuring” and the risk of “the underlying collateral.” That means that you always have to understand the risks of “the underlying collateral.” Citigroup’s risk managers state they “lacked the ability” to evaluate the risks of the underlying collateral. That makes the investment decision simple for any banker – rocket scientist or not. The decision is “no.” We do not buy things if we cannot evaluate the risk.

But the “explanation” by Citigroup’s risk managers about their “seduction” is even more facially ludicrous when one takes into account the fact that Citi was a leading seller of toxic mortgages to the secondary market. Richard Bowen was Citi’s highly competent senior quality control officer on such sales. Bowen’s staff’s studies eventually found an 80% rate of false “reps and warranties” by Citi in connection with secondary market sales primarily to Fannie and Freddie (see Richard Bowen’s statement to the FCIC). If Citi was lying overwhelmingly in its reps and warranties, then there was every reason not to ever buy even the super senior tranche of CDOs.

Further, Clayton or its competitors had reviewed a sample of virtually every secondary market sale of mortgages and those reviews showed a catastrophic level of fraudulent reps and warranties – a 46% national average. Worse, everyone knew that Clayton was a ludicrously weak grader. Citi, before purchasing CDOs, could have required the seller to disclose the Clayton reports on the mortgages “collateralizing” (so inadequately) the debt obligation. When your bonus and promotion opportunities depend on not seeing a risk and calling toxic mortgage product that is at best single “C” “super senior” and “AAA” then the financial industry will pervert rocket scientists that are supposed to serve as “risk managers” into liars – or ex-managers.

The FCIC report discloses that Citi’s risk managers routinely granted exceptions to lending policies designed to limit Citi’s risk. (The last sentence also shows one of the costs of, effectively, repealing Glass-Steagall.)

“Meanwhile, risk managers granted exceptions to limits, and increased exposure limits, instead of keeping business units in check as they had told the regulators. Well after Citigroup sustained large losses on its CDOs, the Fed would criticize the firm for using its commercial bank to support its investment banking activities” (FCIC 2011: 199).

The FCIC report reveals (none too clearly) that Citi’s rocket scientists had no valid model for pricing Citi’s CDO investments and massively underestimated losses on those CDOs (which meant that they massively overstated Citi’s income and net worth). The most infamous example of a “rocket scientist” blessing a massive accounting fraud was at AIG.

“On the call, Cassano maintained that the exposures [CDS protection that AIG sold to guarantee the value of CDOs] were no problem: “It is hard for us, without being flippant, to even see a scenario within any kind of realm or reason that would see us losing $1 in any of those transactions.” He concluded: “We see no issues at all emerging. We see no dollar of loss associated with any of [the CDO] business. Any reasonable scenario that anyone can draw, and when I say reasonable, I mean a severe recession scenario that you can draw out for the life of the securities.” Senior Vice President and Chief Risk Officer Robert Lewis seconded that reassurance: “We believe that it would take declines in housing values to reach depression proportions, along with default frequencies never experienced, before our AAA and AA investments would be impaired” (FCIC 2011: 268).

Given what I have documented about the massive nature of the three fraud epidemics, it was certain that CDOs would suffer record “default frequencies.” It was also certain that this would begin to occur as soon as the housing bubble stalled – before it collapsed. The saying in the trade is that “a rolling loan gathers no loss.” As long as the bubble is inflating the bad loans can be covered up by refinancing. As soon as the bubble stalls the refinancing option begins to disappear and defaults begin to surge. All of this is easily predictable without “rocket science” skills. Rocket scientists, however, ignore fraud (it screws up the models), particularly frauds led by their bank’s senior officers and most particularly frauds that use accounting. Rocket scientists typically cannot be bothered with studying something as primitive as accounting. Consider this clunker when a top risk officer tried to opine about Lehman’s financial condition.

“JP Morgan’s Chief Risk Officer Barry Zubrow testified before the FCIC that ‘from a pure accounting standpoint, [Lehman] was solvent….’” (FCIC 2011: 325).

The use of the word “pure” before “accounting” is a sure indicator that we are dealing with someone who is clueless. Lehman was massively insolvent on a GAAP basis. It simply failed to recognize its losses and contingent liabilities for selling tens of billions of dollars of fraudulent mortgages to the secondary market through fraudulent reps and warranties. Its accounting was debased, not pure.

There was one exception to this disdain for accounting. Risk officers understood enough to know that higher reported asset values led to higher compensation for their bosses and that this was their bosses’ overriding priority. The compensation involved was staggering and contrary to every principle of proper compensation. Bear provides a classic example.

“Cayne told the FCIC he set his own compensation and the compensation for all five members of the Executive Committee. According to Cayne, no one, including the board, questioned his decisions.

For 2007, even with its losses, Bear Stearns paid out 58% of revenues in compensation. Alix, who sat on the Compensation Committee, told FCIC staff the firm typically paid 50% but that the percentage increased in 2007 because revenues fell—if management had lowered compensation proportionately, he said, many employees might have quit. Base salaries for senior managers were capped at $250,000, with the remainder of compensation a discretionary mix of cash, restricted stock, and options.

From 2000 through 2008, the top five executives at Bear Stearns took home over 326.5 million in cash and over $1.1 billion from stock sales, for more than a total of $1.4 billion. This exceeded the annual budget for the SEC. Alan Schwartz, who took over as CEO after Cayne and had been a leading proponent of investing in the mortgage sector, earned more than $87 million from 2004 to 2007. Warren Spector, the co-president responsible for overseeing the two hedge funds that had failed, received more than $98 million during the same period. Although Spector was asked to resign, Bear never asked him to return any money. In 2006, Cayne, Schwartz, and Spector each earned more than 10 times as much as Alix, the chief risk officer” (FCIC 2011: 285).

So, Bear’s top rocket scientist was treated as the poor cousin of the C-Suite. Still, that fact that Alix received (the use of the word “earned” is one of the obscenities in the FCIC report) less than one-tenth the pay of the most senior managers, but that was still ample to leave him a wealthy, abject failure.

Risk management at Bear was farcical.

“In the fall of 2007, Bear’s board had commissioned the consultant Oliver Wyman to review the firm’s risk management. The report, ‘Risk Governance Diagnostic: Recommendations and Case for Economic Capital Development,’ was presented on February 5, 2008, to the management committee. Among its conclusions: risk assessment was ‘infrequent and ad hoc’ and ‘hampered by insufficient and poorly aligned resources,’ ‘risk managers [were] not effectively positioned to challenge front office decisions,’ and risk management was ‘understaffed’ and considered a ‘low priority.’

Schwartz told the FCIC the findings did not indicate substantial deficiencies. He wasn’t looking for positive feedback from the consultants, because the Wyman report was meant to provide a road map of what ‘the gold standard’ in risk management would be.

In January 2008, before the report was completed, Cayne resigned as CEO, after receiving $93.6 million in compensation from 2004 through 2007.He remained as non-executive chairman of the board. Some senior executives sharply criticized him and the board. Thomas Marano told the FCIC that Cayne played a lot of golf and bridge. Speaking of the board, Paul Friedman, a former senior managing director at Bear Stearns, said, ‘I guess because I’d never worked at a firm with a real board, it never dawned on me that at some point somebody would have or should have gotten the board involved in all of this….’” (FCIC 2011: 284-285).

Let me break down this remarkable passage. In Fall 2007, when Bear was already doomed, its board had a consultant review Bear’s risk management. The review found that Bear’s rocket scientists were ignored and not able to function effectively even if they were not ignored. Naturally, that damning verdict was brushed off as not indicating any “substantial deficiencies.”

Bear’s CEO (Cayne) got paid about $25 million annually for bankrupting Bear. Most of that compensation was purportedly based on “performance,” which was oxymoronic. Bear kept him on even after it was clear that he had destroyed the firm. Cayne got this exceptional treatment even though he was despised by members of Bear’s Board of Directors. Imagine what they would have done for Cayne if they liked and respected him.

But the most revealing comment was by Friedman – he was senior enough to be a senior managing director at one of the most prestigious investment banks in the world – and he had “never worked at a firm with a real board.” None of America’s largest commercial or investment banks had “a real board [of directors].” Welcome to the world of the imperial CEO and his oh-so accommodating board that characterizes our systemically dangerous institutions (SDIs).

As with Deputy Attorney General James Cole’s refusal to challenge “rocket scientists,” the SEC failed to deal with Bear’s known defects in risk management. The SEC knew that Bear’s senior managers had designed its “risk management” system to fail so that it would not interfere with Bear’s controlling officers’ accounting control fraud schemes.

“The SEC’s inspector general later criticized the regulators, writing that they did not push Bear to reduce leverage or ‘make any efforts to limit Bear Stearns’ mortgage securities concentration,’ despite ‘aware[ness] that risk management of mortgages at Bear Stearns had numerous shortcomings, including lack of expertise by risk managers in mortgage backed securities’ and ‘persistent understaffing; a proximity of risk managers to traders suggesting a lack of independence; turnover of key personnel during times of crisis; and the inability or unwillingness to update models to reflect changing circumstances’” (FCIC 2011: 283).

FCIC ended a chapter with a formal conclusion emphasizing the failures of risk management at Bear (FCIC 2011: 291).

COMMISSION CONCLUSIONS ON CHAPTER 15

“The Commission concludes the failure of Bear Stearns and its resulting government-assisted rescue were caused by its exposure to risky mortgage assets, its reliance on short-term funding, and its high leverage. These were a result of weak corporate governance and risk management. Its executive and employee compensation system was based largely on return on equity, creating incentives to use excessive leverage and to focus on short-term gains such as annual growth goals.”

Merrill Lynch’s senior managers made false statements about its supposedly superb risk management skills in an effort to deceive investors.

“Merrill’s then-CFO Jeffrey Edwards indicated that the company’s results would not be hurt by the dislocation in the subprime market, because ‘revenues from subprime mortgage-related activities comprise[d] less than 1% of our net revenues’ over the past five quarters, and because Merrill’s ‘risk management capabilities are better than ever, and crucial to our success in navigating turbulent markets.’ Providing further assurances, he stated, ‘We believe the issues in this narrow slice of the market remain contained and have not negatively impacted other sectors.’

However, Edwards did not disclose the large increase in retained super-senior CDO tranches or the difficulty of selling those tranches, even at a loss—though specific questions on the subject were raised.

In July, Merrill followed its strong first-quarter report with another for the second quarter that ‘enabled the company to achieve record net revenues, net earnings and net earnings per diluted share for the first half of 2007.’ During the conference call announcing the results, the analyst Glenn Schorr of UBS, a large Swiss bank, asked the CFO to provide some ‘color around myth versus reality’ on Merrill’s exposure to retained CDO positions. As he had three months earlier, Edwards stressed Merrill’s risk management and the fact that the CDO business was a small part of Merrill’s overall business” (FCIC 2011: 258).

Overall, FCIC concluded: “corporate governance and risk management were breaking down” (FCIC 2011: 18). The anti-regulators, however, sounding just like Cole a decade later, had promised us that the banks’ rocket scientists would protect us all by providing superb risk management because that’s what anyone running an honest bank would strive to do.

“Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that financial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management” (FCIC 2011: 35).

In order to emphasize the point, the FCIC report made this statement as the formal conclusion to a chapter.

COMMISSION CONCLUSIONS ON CHAPTER 14 

“The Commission concludes that some large investment banks, bank holding companies, and insurance companies, including Merrill Lynch, Citigroup, and AIG, experienced massive losses related to the subprime mortgage market because of significant failures of corporate governance, including risk management. Executive and employee compensation systems at these institutions disproportionally rewarded short-term risk taking” (FCIC 2011: 279).

Similarly, FCIC’s formal conclusion to Chapter 16 reads in relevant part:

COMMISSION CONCLUSIONS ON CHAPTER 16

“The Commission concludes that the banking supervisors failed to adequately and proactively identify and police the weaknesses of the banks and thrifts or their poor corporate governance and risk management, often maintaining satisfactory ratings on institutions until just before their collapse. This failure was caused by many factors, including beliefs that regulation was unduly burdensome, that financial institutions were capable of self-regulation, and that regulators should not interfere with activities reported as profitable” (FCIC 2011: 308).

It is striking that six successive chapters (14-19) of the FCIC report have as their common element failed risk management by the rocket scientists. Again, I want to emphasize that many of these failures were deliberately engineered by the banks’ controlling managers.

COMMISSION CONCLUSIONS ON CHAPTER 17

“The Commission concludes that the business model of Fannie Mae and Freddie Mac (the GSEs), as private-sector, publicly traded, profit-making companies with implicit government backing and a public mission, was fundamentally flawed. We find that the risky practices of Fannie Mae—the Commission’s case study in this area—particularly from 2005 on, led to its fall: practices undertaken to meet Wall Street’s expectations for growth, to regain market share, and to ensure generous compensation for its employees. Affordable housing goals imposed by the Department of Housing and Urban Development (HUD) did contribute marginally to these practices. The GSEs justified their activities, in part, on the broad and sustained public policy support for homeownership. Risky lending and securitization resulted in significant losses at Fannie Mae, which, combined with its excessive leverage permitted by law, led to the company’s failure.

Corporate governance, including risk management, failed at the GSEs in part because of skewed compensation methodologies” (FCIC 2011: 323).

COMMISSION CONCLUSIONS ON CHAPTER 18

“The Commission concludes the financial crisis reached cataclysmic proportions with the collapse of Lehman Brothers. Lehman’s collapse demonstrated weaknesses that also contributed to the failures or near failures of the other four large investment banks: inadequate regulatory oversight, risky trading activities (including securitization and over-the-counter (OTC) derivatives dealing), enormous leverage, and reliance on short-term funding.

While investment banks tended to be initially more vulnerable, commercial banks suffered from many of the same weaknesses, including their involvement in the shadow banking system, and ultimately many suffered major losses, requiring government rescue.

Lehman, like other large OTC derivatives dealers, experienced runs on its derivatives operations that played a role in its failure. Its massive derivatives positions greatly complicated its bankruptcy, and the impact of its bankruptcy through interconnections with derivatives counterparties and other financial institutions contributed significantly to the severity and depth of the financial crisis.

Lehman’s failure resulted in part from significant problems in its corporate governance, including risk management, exacerbated by compensation to its executives and traders that was based predominantly on short-term profits” (FCIC 2011: 343).

COMMISSION CONCLUSIONS ON CHAPTER 19

“The Commission concludes AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure—a profound failure in corporate governance, particularly its risk management practices” (FCIC 2011: 352).

Even the primary FCIC dissent agreed with the majority on the centrality of risk management failures to the crisis.

“An essential cause of the financial and economic crisis was appallingly bad risk management by the leaders of some of the largest financial institutions in the United States and Europe. Each failed firm that the Commission examined failed in part because its leaders poorly managed risk” (FCIC Dissent 2011: 428).

Creating Perverse Incentives Designed to Ruin Risk Management as a Control

While the FCIC report takes a while to make this (almost) clear, any analysis premised on the assumption that “financial institutions had strong incentives” is fatally flawed. Banks do not have incentives. Bankers have incentives. I use the shorthand “honest banks” at times for the sake of brevity, but what always matters is the incentives of the bankers. Typically, it is the incentives of the controlling bankers that matters for they establish the incentives that drive everyone else’s behavior. FCIC explicitly tied the perverse financial incentives to the gutting of risk management. Sandy Weill, Citi’s former CEO, told the FCIC:

“The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Commission, ‘I think if you look at the results of what happened on Wall Street, it became, ‘Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are going to leave my place and go someplace else.’ Managing risk ‘became less of an important function in a broad base of companies’” (FCIC 2011: 63-64).

(Weill is describing a “Gresham’s” dynamic in which bad ethics drives good ethics out of the markets.) FCIC later explains that the controlling officers of the largest banks created pervasively perverse compensation systems at every level.

“Tying compensation to earnings also, in some cases, created the temptation to manipulate the numbers. Former Fannie Mae regulator Armando Falcon Jr. told the FCIC, “Fannie began the last decade with an ambitious goal—double earnings in 5 years to $6.46 [per share]. A large part of the executives’ compensation was tied to meeting that goal.” Achieving it brought CEO Franklin Raines $52 million of his $90 million pay from 1998 to 2003. However, Falcon said, the goal ‘turned out to be unachievable without breaking rules and hiding risks. Fannie and Freddie executives worked hard to persuade investors that mortgage-related assets were a riskless investment, while at the same time covering up the volatility and risks of their own mortgage portfolios and balance sheets.’ Fannie’s estimate of how many mortgage holders would pay off was off by $400 million at year-end 1998, which meant no bonuses. So Fannie counted only half the $400 million on its books, enabling Raines and other executives to meet the earnings target and receive 100% of their bonuses.

Compensation structures were skewed all along the mortgage securitization chain, from people who originated mortgages to people on Wall Street who packaged them into securities. Regarding mortgage brokers, often the first link in the process, FDIC Chairman Sheila Bair told the FCIC that their ‘standard compensation practice . . . was based on the volume of loans originated rather than the performance and quality of the loans made.’ She concluded, ‘The crisis has shown that most financial institution compensation systems were not properly linked to risk management. Formula-driven compensation allows high short-term profits to be translated into generous bonus payments, without regard to any longer-term risks.’ SEC Chairman Mary Schapiro told the FCIC, ‘Many major financial institutions created asymmetric compensation packages that paid employees enormous sums for short-term success, even if these same decisions result in significant long-term losses or failure for investors and taxpayers’” (FCIC 2011: 64).

FCIC and the regulators it quoted missed the key point. Compensation was not tied to “earnings” – it was tied to reported earnings and the fraud “recipe” is a “sure thing” that guarantees extreme reported earnings which are guaranteed to produce enormous, prompt increases in compensation. The three fraud epidemics did not produce “short-term profits” – but they did produce enormous “short-term [reported] profits.”

Rocket Scientists Have a Long Record of Failure

The rocket scientists first came to prominence as the developers and promoters of “portfolio insurance.” As the name was deliberately designed to imply, this nostrum was sold as a means of “insuring” the investment portfolio against risk. This is generally believed to have been a primary contributor to the stock market crash known as “Black Monday.”

FCIC noted that the world’s top rocket scientists (including two Nobel Laureates in Economics) failed during the Long-Term Capital Management (LTCM) crisis.

“In a 1999 report, the [President’s Working Group on Financial Markets] noted that LTCM and its counterparties had ‘underestimated the likelihood that liquidity, credit, and volatility spreads would move in a similar fashion in markets across the world at the same time.’ Many financial firms would make essentially the same mistake a decade later. For the Working Group, this miscalculation raised an important issue: ‘As new technology has fostered a major expansion in the volume and, in some cases, the leverage of transactions, some existing risk models have underestimated the probability of severe losses’” (FCIC 2011: 58).

LTCM did not fail due to fraud. It failed because of a combination of complacency (based on the rocket scientists’ bad models that ignored the risk of a “flight to quality” – a well-known market phenomenon that was certain to cause a crisis for LTCM’s investment strategy). It should have been horrific news that the world’s top rocket scientists were so inept that, even without fraud, they erred so badly that they destroyed FCIC and threatened the global economy. When you add accounting control fraud to the mix the rocket scientists’ catastrophic failures become endemic and far larger.

Banks were also making investments that posed far greater credit risk and adding extreme leverage and interest rate risk. This made the need for superb risk management ever more critical. Again, when one adds accounting control fraud to the mix this need become vastly more acute. As FCIC concluded, “The need for risk management grew in the following decade” (FCIC 2011: 58).

LTCM did not shake the anti-regulators’ faith in the rocket scientists, but Enron and the Enron-era accounting control frauds magnified the anti-regulators’ complacency.

“This resilience led many executives and regulators to presume the financial system had achieved unprecedented stability and strong risk management. The Wall Street banks’ pivotal role in the Enron debacle did not seem to trouble senior Fed officials.

In a memorandum to the FCIC, Richard Spillenkothen described a presentation to the Board of Governors in which some Fed governors received details of the banks’ complicity ‘coolly’ and were ‘clearly unimpressed’ by analysts’ findings. ‘The message to some supervisory staff was neither ambiguous nor subtle,’ Spillenkothen wrote. Earlier in the decade, he remembered, senior economists at the Fed had called Enron an example of a derivatives market participant successfully regulated by market discipline without government oversight” (FCIC 2011: 60).

Let me provide some context. Many of the largest banks operating in the U.S. eagerly aided and abetted Enron’s frauds – and were caught red-handed by Enron’s bankruptcy examiner. DOJ, however, failed to prosecute the banks and the senior bankers. This was a failure that proved immensely costly to our Nation for it could have provided vital deterrence. Enron ran its primary frauds (which included tax evasion) through special purpose vehicles (SPVs). This should have led to effective regulation of the SIVs that proved so damaging during the current crisis. Instead, the anti-regulators gutted the rule and made it worthless.

The third chance to deter the current crisis came when the Federal Reserve’s top supervisor, Spillenkothen, used his very limited political capital to brief the agency’s senior leadership about how officers of the top banks conspired with Enron’s CFO to commit one of the largest frauds in history. The reaction of the Fed’s senior leadership, the primary coven of the anti-regulators, to being informed of these crimes was that they became enraged – at their own supervisors for daring to criticize the large banks. The facts were, after all, inconvenient to the Fed’s claims that Enron demonstrated the brilliance of removing regulation. (Note that by the time of Spillenkothen’s briefing it was known that Enron actually traded derivatives as one of two primary devices it used to create an artificial energy crisis in California and the Pacific Northwest. None of this made an impression on the anti-regulators.)

Spillenkothen explicitly blamed the Fed’s rocket scientists for the idiocy of leading the Basel II charge to gut capital requirements. Fortunately, the FDIC fought a tenacious rearguard action that delayed the implementation of Basel II in the U.S. and set a materially higher minimum capital requirement than in Europe. Had the rocket scientists at the Fed gotten their way on Basel II the U.S. financial crisis would have been far more severe.

For reasons of brevity I will simply note that the rocket scientists also devised and conducted the “stress tests” that were “passed” by Fannie, Freddie, AIG, Bear, Lehman, the Big Three Icelandic banks, and many others weeks before they collapsed.

The Anti-Regulators Went Wrong When They Relied on the Bank’s “Risk Experts”

The vocabulary used to describe the anti-regulators’ response to the purported “rocket scientists” is absurd. The phrase they used was “risk-focused.” The reality was that it meant that the anti-regulators nattered endlessly about risk, (implicitly) excluded any consideration of accounting control fraud, concluded that they should rely on the banks to deal with risk, and “focused” exclusively on making excuses for not acting against those risks even as three fraud epidemics raged. And, surprise, they concluded that the banks’ “rocket scientists” couldn’t be beat.

“Supervisors had, since the 1990s, followed a ‘risk-focused’ approach that relied extensively on banks’ own internal risk management systems. ‘As internal systems improve, the basic thrust of the examination process should shift from largely duplicating many activities already conducted within the bank to providing constructive feedback that the bank can use to enhance further the quality of its risk-management systems,’ Chairman Greenspan had said in 1999. Across agencies, there was a ‘historic vision, historic approach, that a lighter hand at regulation was the appropriate way to regulate,’ Eugene Ludwig, comptroller of the currency from 1993 to1998, told the FCIC, referring to the Gramm-Leach-Bliley Act in 1999. The New York Fed, in a ‘lessons-learned” analysis after the crisis, pointed to the mistaken belief that “markets will always self-correct.’ ‘A deference to the self-correcting property of markets inhibited supervisors from imposing prescriptive views on banks,’ the report concluded.

The reliance on banks’ own risk management would extend to capital standards. Banks had complained for years that the original 1998 Basel standards did not allow them sufficient latitude to base their capital on the riskiness of particular assets. After years of negotiations, international regulators, with strong support from the Fed, introduced the Basel II capital regime in June 2004, which would allow banks to lower their capital charges if they could show they had sophisticated internal models for estimating the riskiness of their assets. While no U.S. bank fully implemented the more sophisticated approaches that it allowed, Basel II reflected and reinforced the supervisors’ risk-focused approach. Spillenkothen said that one of the regulators’ biggest mistakes was their ‘acceptance of Basel II premises,’ which he described as displaying ‘an excessive faith in internal bank risk models, an infatuation with the specious accuracy of complex quantitative risk measurement techniques, and a willingness (at least in the early days of Basel II) to tolerate a reduction in regulatory capital in return for the prospect of better risk management and greater risk-sensitivity’” (FCIC 2011: 170-171).

I’ll conclude by addressing two points raised by commenters on my first article in this series.

Yves Smith

Yves noted in “Naked Capitalism” that many experts came forward and volunteered from the beginning to aid, without fees, DOJ to understand the complex aspects of financial markets and instruments. DOJ and the regulatory agencies spurned these offers as it has my offers to assist.

Technical Flaws in Models

I received a detailed email discussing technical problems with financial modeling. I thank the reader for taking the time to discuss these topics which are familiar to quants, e.g., the use of a Gaussian Copula function, but not accessible to normal human beings. There is also the “black swan” theory that argues that the financial models underestimated the probability of unusual, highly negative outcomes in which assets suffer severe losses in value.

I want to emphasize a more fundamental problem with the attempt to use models to measure the risk and infer the market value of financial assets. The problem I will explain requires a basic understanding of one aspect of statistics – the distribution. I know that this means it is a foreign concept to many readers, but it is understandable to far more readers than any discussion of the Gaussian Copula. All the models, including black swan models, assume that there is a fixed (exogenous) distribution of financial events. My message, as a white-collar criminologist and financial regulator, is that is not true. Our policies largely determine the distribution. When we adopt criminogenic policies that produce epidemics of accounting control fraud in our financial institutions we make it vastly more likely that we will hyper-inflate financial bubbles and cause severe financial crises and recessions. Our last three major crises, the savings and loan debacle, the Enron-era scandals, and the most recent crisis were driven by these fraud epidemics. If we continue to fail to learn the lessons and keep doubling down on the same errors that produce criminogenic environments we will continue to have severe crises. One of the important factors that can shape such an environment is the failure to prosecute the senior bankers that become wealthy by leading the fraud epidemics.

In addition to this overarching failure, it is true that the rocket scientists at the failed financial firms created models that made many technical errors and many of the errors count as “basic” in their esoteric world. These errors were biased. The errors, overwhelmingly, led to underestimating risk, which overstates the value of financial assets. That was the result their senior managers desired and that was the result that often enriched the rocket scientists personally through bonuses. Their senior managers deliberately created the perverse incentives for the rocket scientists that produced this bias. That is not, primarily, a failure of theory. It is a failure of integrity on the part of the senior managers and the rocket scientists. Yes, the senior managers are more culpable and often were rewarded with more than ten times the bonus that the CRO received for inflating asset values massively. But a Chief Risk Officer who “only” received a few million dollars in bonuses by employing a model that overstated asset values is not someone we should allow to stay in the financial industry.

Conclusion

Deputy Attorney General Cole is doubtless correct that the world of the financial rocket scientists is far beyond his understanding. Much of that world is beyond my understanding. If Cole consulted any competent white-collar criminologist, however, we could explain to him why that is no barrier to prosecuting the leaders of the fraud epidemics and why it is essential that DOJ prosecute those leaders. Indeed, we would explain that the fact that the senior bank managers so frequently ignored, suborned, or punished the rocket scientists serving as risk officers is one of the many proofs that those managers were running accounting control frauds.

2 responses to “How the Rocket Scientists Aided the Senior Fraudulent Bank Officers

  1. This is a TKO, Dr. Black!

    When combined with the “foamed runways” of TARP and the Illegal robo-signing of MERS documents, we have a very clear picture (not reliant upon complex math) on how to get away with massive fraud.

    For many families in our country, the loss of 10 million job and $21 Trillion of resources is equivalent to a death sentence… yet we do not have a three strike penalty for white collar criminals (appraisal, accounting, and reps and warranty fraud). We need a 21st Century Pecora Investigation!

    Thanks for your tireless work

    Trendisnotdestiny

  2. Macroeconomics

    As a retired aerospace engineer I find that rocket science is really not all that difficult. Even aerodynamics is harder.