Capitalism’s Defender Unknowingly Indicts the Banksters

By William K. Black
Quito: April 13, 2015

Johan Norberg, of Cato, wrote a book in 2009 entitled Financial Fiasco.  Norberg is an Austrian School economist and the author of In Defense of Global Capitalism (2001).  As his 2009 book demonstrates, however, the quintessential global capitalists were preparing to blow up the global capitalist system in an orgy of “accounting control fraud” at the time he wrote his “Defense.”

He agrees that Fannie and Freddie were used by their controlling officers as accounting control frauds in order to enrich themselves through lush executive compensation.  He aptly explains President Bush’s hypocrisy about Fannie and Freddie.

“The White House put out a talking point entitled “GSEs – We Told You So” memo when Fannie and Freddie failed citing Armando Falcon Jr.’s 2003 memo warning that Fannie and Freddie could go bankrupt if their bad underwriting continued.

There was just one small detail Bush’s aides left out of their talking-points memo:  The same day that Falcon published his report, he received a call from the White House personnel department informing him that he was fired” (p. 36).“

Norberg then turns to the broader frauds by the lenders and the credit rating agencies that aided and abetted those frauds.

“And the rating agencies also ignored the fact that mortgages singled out for securitization were not just any mortgages.  The mortgages put in packages were the most toxic ones, the ones that lenders preferred to get rid of quickly.  One study show that a set of mortgages that had been securitized ran about a 20 percent higher risk of failure than a set of mortgages with the same risk profile that had not been securitized.

To this should be added and even more fateful circumstance:  As the housing bubble inflated, the mortgage amounts became higher and the demands made of borrowers became laxer.  James Grant had a look at a representative sample and found that, in 2000, 0 percent of subprime loans were interest only, just 1 percent were second mortgages to exploit prices rises, and just 25 percent lacked proper documentation of income or the like.  In 2006, the corresponding shares were 22, 31, and 44 percent, respectively.”

But why would credit rating agencies ignore such critical facts?  From an Austrian economic perspective that should never happen because the rating agencies should have valued their reputation for candor and expertise (must keep a straight face as I write this).  Why would the purchasers – typically the most elite investment banks in the world – buy mortgages that were securitized given the obvious perverse incentive for the originator/seller to defraud the secondary market purchaser?

Norberg tells us that by 2006, liar’s loans represented 44% of all the loans originated.  Now add a few key facts that Norberg does not tell the reader.

  • By 2006, roughly half of all the loans the industry called “subprime” were also liar’s loans – the categories are not mutually exclusive
  • The massive increase in fraudulently originated liar’s loans between 2003 and 2006 hyper-inflated the bubble – conventional loans fell while liar’s loans surged
  • By September 2004, the FBI had publicly warned the industry that there was a mortgage fraud “crisis” and predicted that it would cause a financial “crisis” if it were not stopped
  • The Bush regulators – none too vigorous – repeatedly warned the lenders against making liar’s loans, as MARI noted in Spring 2006
  • By Spring 2006, MARI/MBA had informed every Mortgage Bankers Association member in writing that MARI had found that 90% of liar’s loans were fraudulent – so why would any lender make such loans – and why would anyone purchase such loans in the secondary market?
  • That means that in 2006 alone the lenders made over 2 million fraudulent liar’s loans
  • The secondary market for non-prime loans collapsed in mid-2007
  • Hundreds of non-prime mortgage lenders had failed by late 2007

Then consider two key analytical errors in Norberg’s second paragraph about James Grant’s “look at a representative sample” of home loans in 2000 and 2006.  First, while the phrase “just 1 percent were second mortgages” is sensible, the phrase “just 25 percent lacked proper documentation” is insane.  As early as 2000 – eight years before Lehman collapses – one-quarter of the loans in what Norberg assures us were “a representative sample” were “liar’s” loans.  That means that at the beginning of the decade the first of the three great epidemics of accounting control fraud that caused the financial crisis was already an enormous share of the total mortgage market – one-quarter of it.

Second, no honest lender would make liar’s loans.  The failure to underwrite creates severe “adverse selection,” which means that the lender will lose money.  Norberg recognized (p. 66) that such losses would be greatly delayed however if lenders simply refinanced the bad loans.  The saying in the trade is that “a rolling loan gathers no loss.”

Now add the second great epidemic of loan origination fraud by lenders – appraisal fraud – which was also enormous by 2000.  The Financial Crisis Inquiry Commission (FCIC) described an example of the deliberate creation of an “echo” epidemic of fraud in the ongoing crisis by inducing a Gresham’s dynamic among appraisers.

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).

An appraisal survey in 2003 found that 55% of appraisers had personally been subjected to pressure to inflate appraisals – which no honest lender would ever do.  By 2006, the survey found that 90% of appraisers had been subjected to such pressures.

These two great epidemics of mortgage origination fraud ensured that if there were secondary market sales there had to be a third great epidemic of accounting control fraud – fraudulent reps and warranties.  The loan originators/sellers to the secondary market could only sell their fraudulently originated loans by making fraudulent reps and warranties.

Norberg does not inform his readers about the criminology literature or George Akerlof and Paul Romer’s 1993 economic explanation of “looting.”  But he does show that the lenders and the secondary market loan purchasers followed the classic accounting control fraud “recipe.”

  1. Grow extremely rapidly
  2. By making (purchasing) huge amounts of bad loans at a premium nominal yield while
  3. Employing extreme leverage, and
  4. Providing only trivial allowances for loan and lease losses (ALLL)

This produces the famous three “sure things.”

  1. The bank will promptly report record profitability
  2. The controlling officers will promptly be made wealthy by modern executive pay, and
  3. The firm will suffer catastrophic losses

To follow this recipe, the lenders and the secondary market purchasers must gut their underwriting and their internal controls.  Sound underwriting and internal controls are essential to a bank’s profitability and soundness, so honest bankers would never take either action.  Norberg notes that the controlling bank officers ensured the perverse incentives that would produce the origination and purchase of vast amounts of fraudulent loans.

“One persons who was in the bond business and worked for one of the world’s biggest banks tells me that they were under constant pressure from management to cram as many risky mortgages as possible into their packages” (p. 66).

Norberg does not use the term, and may not be familiar with the concept, but he describes the resultant “Gresham’s” dynamic in which modern executive compensation caused bad ethics to drive good ethics from the banks.

“They were constantly comparing themselves with other banks, and whenever someone else upped their level of risk slightly they felt they could do the same.  In other words, more and more junk bas being put in the packages to be sold” (p. 66).

Norberg does not explain the banksters’ creation of a Gresham’s dynamic to suborn the credit rating agencies, but he describes the results.

“And yet the rating agencies guaranteed that they were of the same high quality as before” (p. 66)

Norberg notes that economic theory claims that these fraud epidemics could not occur – but reality falsified (again) those theories.  Note that Norberg explicitly admits that the pattern was “fraud.”

“Some people were attentive to the fraud that was going on, such as Pimco, the manager of the world’s largest bond fund, which abandoned the mortgage market as far back as the end of 2004, when it saw the packages being filled with riskier and riskier loans to less and less creditworthy households.  In fact, distrust should have been a very lucrative niche.  It was obvious that the prices of derivatives were built on wishful thinking by all parties involved, speculators should have been able to exploit it.”

Yes, it was “obvious” that the values of nonprime mortgage product were massively inflated.  This was not built on “wishful thinking,” but as Norberg admitted two sentences earlier, “fraud.

Norberg admits some of the key implications of his admissions about the lack of any true financial market for trillions of dollars of nonprime mortgage product, but tries to excuse that failure as growing pains.

“The trade in [MBS] was so new that there was no liquid and open market where different investors had strong incentives to assess real risk at all times, thus pushing prices down.  A large share of trades took place behind closed doors between two people who were often more interested in achieving a large volume of sales than in making good deals since sales volume was what earned them their bonuses.  There was no real market price” (p. 67).

Note that Norberg had admitted a fatal “agency” problem – yet failed to analyze who created it – and why.  He says that senior officers at our most elite investment and commercial banks conspired with senior officers of the sleaziest loan originators to ignore “real risk” (which inherently inflates the supposed values of financial assets) and bought “toxic” assets that would cause the purchaser and whoever bought the toxic MBS or CDOs created by the secondary market purchaser enormous losses.  Norberg also admits that the officers did so not because they were optimists but because they preferred high volume deals to good deals “since sales volume was what earned them their bonuses.”  The fraud recipe explains why officers on both sides of the fraudulent secondary market transactions could simultaneously be made rich by overstating nonprime asset values.  This was the financial version of “don’t ask; don’t tell.”

But no honest CEO would create – and maintain in the face of warnings from the appraisers, MARI, the FBI, and the regulators such a perverse pay system that they knew was leading to the origination, purchase, and repackaging for sale as MBS or CDOs of fraudulently originated mortgages sold through fraudulent reps and warranties.

Trade in MBS was not “new” in 2006.  Liar’s loans were not new in 2006.  Even if they had been new, that was no reason to create perverse incentives based on volume, which were not new.  The perverse incentives that bonuses based on volume invariably created in lending were well known.

Norberg’s admissions constitute a devastating indictment of Austrian economics’ dogmas, but he tried to rally with a classic Austrian tale – the market always answers any need through “spontaneous order.”  In this case, Norberg seeks to make the ABX.HE index an Austrian hero.

“Toward the end of 2007, the big indexes of mortgage-backed securities had fallen by 80 percent, and everybody had to reconsider his or her view of the housing market.  The ABX.HE was too late to prevent the bubble, but it was just in time to pop it.

At the same time, the analysts at Moody’s who were constantly monitoring ratings to see if they needed to be changed discovered  that something was very wrong with Subprime XYZ/  Many borrowers had fallen behind with their payments right from the start, and 6 percent of the loans were in default after only six months – a record level.  Concern spread, and the people at Moody’s contacted the lenders to find out what was going on.  What they were told made them realize that the U.S. housing market was on the edge of the abyss” (p. 67).

Well, no.  First, ABX. He did not “pop” the bubble.  The real estate bubble already popped in 2006.  As I have explained, there were many warnings, far earlier and more reliable than the ABX that nonprime asset value were enormously inflated by fraud.  The most obvious warning by 2006 was that the industry itself referred to the fraudulent loans as “liar’s” loans.  The earliest and best warning, reiterated in MARI’s Spring 2006 warning to the industry, was our experience as S&L regulators in 1991 – fifteen years earlier.  Our examiners correctly identified liar’s loans (that term had not yet developed, they were called “low documentation” loans in our era) as inherently fraudulent for the reasons I explained above.  We agreed with our examiners and drove them out of the S&L industry beginning in 1991.  As MARI notes, the liar’s loans from this era caused hundreds of millions of dollars of losses, which was significant because such loans were in their infancy and the total magnitude of liar’s loans was small.  The percentage losses, however, were very high.  The industry knew that liar’s loans were substantial by 2000 – and rapidly expanded them.  The industry knew that appraisal fraud was rampant by 2000 – and greatly increased the incidence of that fraud.

The idea that Moody’s had analysts “constantly monitoring” nonprime ratings “to see if they needed to be changed” is hilarious.  Moody actively avoided learning that its ratings were massively inflated by refusing to conduct any underwriting of the loans.  Even in Norberg’s tale Moody waits until the “end of 2007” – six months after the secondary market in nonprime loans had collapsed, after hundreds of nonprime lenders had failed beginning in 2006, three years after the FBI warning, seven years after the appraisers’ public warnings, and 16 years after our warnings and actions against liar’s loans before it acted.

Note that Moody’s and Norberg share the analytical flaw of treating “subprime” as distinct from liar’s loans even though by time he discussing over half of the loans called subprime were also liar’s loans.  Consider this portion of Norberg’s description of Moody’s work.

“[Moody’s] discovered that something was very wrong with Subprime XYZ/  Many borrowers had fallen behind with their payments right from the start, and 6 percent of the loans were in default after only six months – a record level….”

“Discovered” is clearly not the correct word.  It’s not like Moody’s actually engaged in underwriting to check the quality of the XYZ Subprime and Liar’s loan pools.  They simply looked at a routine print out on early payment defaults (EPDs).  With house prices no longer rising, the loans were no longer “rolling” to avoid loss recognition.  Norberg’s own data show that the true depths of the loan origination fraud were increasingly revealed.

“Six months later, 13 percent of the mortgages included in Subprime XYZ were in default, and the percentage kept rising each month.  Tranche after tranche of securities based on those mortgages lost all its value.  This was alchemy in reverse.  The losses first hit the riskiest securities but soon found their way up to the Aaa-rated tranches like a flooding river that has invaded the basement, starts to submerge the lower stories, and is now slowly rising toward the highest floors” (p. 68).

Norberg doesn’t tell the reader that EPDs are universally viewed as a powerful indicator of loan origination fraud.  (Nor does he tell the reader that investigations have found that lenders and their agents primarily drove these frauds.)

“[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.

Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007” (Tom Miller, AG, Iowa, 2007 testimony to Fed.)

A 6% EPD portfolio rate will kill any specialty home lender.

We also know what would have happened had Moody’s actually sampled the loan quality – you know, actually check the credit quality.  We know from Fitch’s study – which they carefully did not conduct until the secondary market in nonprime loans collapsed and they would not lose any business as result of the study.

“The result of the [Fitch loan file] analysis was disconcerting…as there was the appearance of fraud or misrepresentation in almost every file.

[T]he files indicated that fraud was not only present, but, in most cases, could have been identified with adequate underwriting …prior to the loan funding” (Fitch 11.07).

Fitch did not conduct an investigation.  It simply conducted a review of the loan and servicing file and found endemic fraud obvious on the face of the files. Fitch’s results were no surprise – the fraud was so common and so obvious that the rating agencies knew they dared not look at loan credit quality lest they lose their lucrative stream of revenue from calling toxic waste “AAA.”

Norberg’s Parting Slander

We can all agree that Bush’s Wrecking Crew (Tom Frank) of anti-regulators represents what happens when you care enough to (largely) send the very worst.  Bush was following the dictates of places like Cato in selecting officials who would create a self-fulfilling policy of regulatory failure.  The key takeaway is that as bad as Bush’s appointees were, there were pockets of resistance that were far better than the industry.  Norberg misrepresents the regulatory situation – reversing reality.

“And considering all that this financial crisis has taught us about the shortcomings of risk models and credit-rating agencies, what else is there to say about the fact that the brightest international bureaucratic brains have arrived at a Basel II, which increases the regulatory importance of mathematical models and credit rating?” (p. 146)

Actually, there is a great deal to say.  “The brightest international bureaucratic brains” did not create Basel II.  Basel II was a product of the largest banks – who were allowed at the behest of entities like Cato “inside the tent” to create the rules.  The largest banks’ supposed “brightest … brains” created Basel II.  They did so with the active aid of anti-regulators, particularly the Fed’s economists who shared Cato’s disdain for regulation.  It is true that the Fed’s anti-regulatory economists consider themselves the “brightest … brains” and have high IQs, but in the context of effective supervision and regulation that is a vain pretense by a group that, collectively, is best known for its regulatory hostility and incompetence.

The “brightest brains” under Bush were at the FDIC, who fought a successful rearguard action against the Fed’s anti-regulatory economists.  The FDIC regulators showed that the big banks’ risk models (that the Fed economists shamelessly shilled for) were absurd.  A bank could be “critically undercapitalized” under U.S. law, but would have substantial “excess” capital under the biggest banks’ fantasy “risk models.”  Richard Spillenkothen, the Fed’s long-time head of supervision, strongly supported the FDIC.  He termed the search for reliable internal risk models an “ignis fatuus” (p. 15 of his memorandum to the FCIC).

In his memorandum to the FCIC, Spillenkothen also explained that the anti-regulatory Fed Governor leading the charge for Basel II (someone with the ego to believe he qualified as the “brightest international bureaucratic brains”) ordered the Fed supervisors to end their efforts to insist on adequate capital for the largest banks.

“Quantitative impact studies in the middle of this decade suggested that Basel II, even after five years of development, would still allow a huge decline in regulatory capital. This sobering reality, together with actual experience and lessons learned during the financial crisis, further highlighted Basel II’s fundamental, deep-seated, and systemic flaws. In the years preceding the crisis, efforts to establish limits on how much regulatory capital would be allowed to decline under Basel II, some proposed by the FDIC, were initially denigrated and dismissed by Basel II advocates within the Federal Reserve. Some senior career supervisors, myself included, supported such limits and many supported retention of the leverage ratio, which would maintain a meaningful floor below which capital could not fall.

Senior career supervisors, especially those who had worked directly with problem banks in the past, should have done more earlier to highlight the proposal’s obvious shortcomings and offer meaningful alternatives, but they were strongly advised in early 2002 by the Board member leading the Fed’s Basel II effort, who also played a leadership role in international regulatory forums, to stop exploring options or fallback positions to Basel II. Basel II was viewed by its most ardent Fed devotees with a quasi-theological reverence and as a sine qua non for assuring financial stability in an increasingly complex global financial system. The Basel II development process did provide regulators with insights and information on evolving risk management practices in the industry, as well as on widespread weaknesses in industry risk metrics, analytics, and information systems – insights that seemed to come at a high price and that were not always heeded” (p. 16).

The FDIC succeeded in creating in the U.S. a minimum (“leverage”) capital requirement – regardless of the “risk models.”  Europe, as part of the City of London’s “winning” the regulatory “race to the bottom,” imposed no such requirement.  As a result, leverage in European banks was roughly twice that of U.S. banks.

Conclusion

It takes enormous chutzpah for an entity like Cato that works incessantly to eviscerate regulation through the appointment of anti-regulatory leaders and economists to claim that the resultant insane policies prove that regulation cannot work.

4 responses to “Capitalism’s Defender Unknowingly Indicts the Banksters

  1. Pingback: How the “Super Crunchers” Became the “Super Torturers” of Finance Data - New Economic PerspectivesNew Economic Perspectives