Category Archives: Regulation

FHFA Complaints: Can Control Frauds Recover for Being Defrauded by other Control Frauds?

By William K. Black 

(Cross-posted from

Reading the FHFA complaints against many of the world’s largest banks is a fascinating and troubling process for anyone that understands “accounting control fraud.” The FHFA, a federal regulatory agency, sued in its capacity as conservator for Fannie and Freddie. Its complaints are primarily based on fraud. The FHFA alleges that the fraud came from the top, i.e., it alleges that many of the world’s largest banks were control frauds and that they committed hundreds of thousands of fraudulent acts. The FHFA complaints emphasize that other governmental investigations have repeatedly confirmed that the defendant banks were engaged in endemic fraud. The failure of the Department of Justice to convict any senior official of a major bank, and the almost total failure to indict any senior official of a major bank has moved from scandal to farce.

The FHFA complaints are distressing, however, intheir failure to explain why the frauds occurred and how an accounting controlfraud works.  The FHFA complaint againstCountrywide is particularly disappointing because it accepts hook line andsinker Countrywide’s internal claim that it acted improperly for the purpose ofattaining a larger market share. Executive compensation drops entirely out of the story even though it isthe reason the frauds occur and the means by which controlling officers loot“their” banks.  The FHFA complaintagainst Countrywide ignores executive compensation.  The FHFA complaint against J.P. Morgan(purchaser of WaMu) mentions only that loan officers’ compensation was based onloan volume rather than loan quality. 

The complaints fail to explain the extraordinarysignificance of widespread appraisal fraud – something that only the lender andits agents can produce and a “marker” of accounting control fraud.  No honest lender would inflate, or permit tobe inflated, appraisals.

The complaints also fail to explain why no honestmortgage lender would make “liar’s” loans. The FHFA complaint against Countrywide notes that Countrywide loanofficers would use undocumented loans to aid their creation of fraudulent loanapplications.

Even neoclassical economists – the weakest of allfields in understanding fraud – understand that this crisis was driven byexecutive compensation.  Consider theadmirably short piece entitled
Fake alpha or Heads I win, Tails you lose” by Raghuram Rajan.  Rajan’spiece is badly flawed, but it at least understands the importance ofcompensation, accounting, and risk. 

“Whatthe shareholder will really pay for is if the manager beats the S&P 500index regularly, that is, generates excess returns while not taking more risk.Hence pay for alpha.”
Rajan is correct that the neoclassicaltheory of CEO compensation is that the CEO should only be compensated for high (“excess”)returns if they were not generated by“taking more risks.”  Modern bonus plans oftenpurport to provide exceptional compensation to CEOs who achieve extreme short-term“excess” returns that are not generated by “taking more risks.”  Rajan gets the next point analytical pointcorrect as well:  “In reality, there areonly a few sources of alpha for investment managers.  [S]pecial ability is by definition rare.”  It is the “rare” CEO who can achieve massivebonuses through exceptional performance, but all CEOs desire massive bonuses.  
Rajan gets the next step in theanalytics correct – the answer to the CEO’s dilemma is to create “fake alpha,”but he falls off the rails in the last clause.
“Alphais quite hard to generate since most ways of doing so depend on the investment managerpossessing unique abilities – to pick stock, identify weaknesses in managementand remedy them, or undertake financial innovation. Unique ability is rare. Howthen can untalented investment managers justify their pay? Unfortunately, alltoo often it is by creating fake alpha – appearing to create excess returns butactually taking on hidden tail risk.” 
In his recent book, Rajan explainsthat by “hidden tail risk” he means taking risks that will only cause losses inhighly unusual circumstances.  I willreturn to why this aspect of Rajan’s reasoning is false. 
Rajan gets the next part correct– generating fake alpha will cause the bank to fail when the risks blow up.  Rajan’s “tail risk” theory, however, predictsthat these risks will only blow up rarely.
Rajan then stresses, correctly,that executive compensation based largely on short-term reported income willcreate perverse incentives to generate fake alpha.  He also        
“Truealpha can only be measured in the long run ….  Compensation structures that reward managersannually for profits, but do not claw these rewards back when lossesmaterialize, encourage the creation of fake alpha.”
Rajan, being a good neo-classicaleconomist, recognizes the vital need to change compensation, but has no urgencyabout doing so. 
“[U]nlesswe fix incentives in the financial system, we will get more risk than webargain for. And the enormous pay of financial sector managers, which has hithertobeen thought of as just reward for performance, will deservedly come underscrutiny.”
Corporations have changedexecutive compensation in response to the crisis – by making it even moredependent on short-term reported income. Rajan does not ask why corporations base executive compensation onshort-term reported income without clawbacks. Rajan is correct that such compensation systems create intenselyperverse incentives that cause managers to loot the shareholders and creditorsand cause the bank to fail. 
Rajan’s extreme tail risk theorydescribes an accounting control fraud. Rajan does not understand that he is describing conduct that wouldconstitute accounting fraud.  Rajan alsodoes not understand that his hypothetical has nothing to do with what actuallyhappened in the crisis.  The extreme tailrisk scheme he hypothesizes would be a terrible fraud scheme.  He does not understand accounting controlfraud.
The real investments that drovethe financial crisis were not assets that would suffer losses only in rarecircumstances.  They were nonprimeloans.  Roughly 30% of total loansoriginated by 2006 were “liar’s” loans – with a 90% fraud incidence.  Liar’s loans and subprime are not mutuallyexclusive categories.  By 2006, half ofall loans called subprime were also liar’s loans.  Appraisal fraud was also epidemic.  The probability of endemically fraudulentloans causing losses (instead of fictional “excess return”) was certainty.  The loss recognition could only be delayedthrough a combination of accounting fraud (failing to provide remotely adequateallowances for loan and lease losses (ALLL)) and hyper-inflating thebubble.  Hyper-inflating the bubbleincreases the ultimate losses.
Making extreme tail riskinvestments is a deeply inferior fraud scheme. Rare risks produce tiny risk premiums and the entire game is to createsubstantial risk premiums.  Making liar’sloans allows exceptional growth (part one of the fraud “recipe” for a lender)and booking a premium yield (if one engages in accounting fraud on theALLL).  The key is found in GeorgeAkerlof and Paul Romer’s article title – “Looting: the Economic Underworld ofBankruptcy for Profit” (1993).  As theycorrectly observed, the fraud recipe is a “sure thing” – it maximizes(fictional) short-term reported income, executive bonuses, and real losses.
Rajan got many things correct andmany things wrong about generating fake alpha, but at least he sought toexplain the perverse dynamic.  The FHFAcomplaints lose explanatory power and persuasiveness because they ignorecompensation and accounting.  It pays tounderstand accounting control fraud.       

Mr. Greenspan takes it all back. His Old Time Religion was right after all.

By Michael Hudson

It all seems so long ago! On October 23, 2008, Alan Greenspan choked up a mea culpa for his deregulatory policy as Federal Reserve Chairman. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform. “The whole intellectual edifice, however, collapsed in the summer of last year.”
For a moment he seemed to be rethinking his lifelong assumption that the financial sector would seek to protect its reputation by behaving so honestly that its customers would gain from dealing with it. “I had been going for 40 years with considerable evidence that it was working exceptionally well” – the idea that regulation was not needed because bankers would seek to protect their reputations and their “counter-parties” would look to their own interest.
“Were you wrong?” Congressman Henry Waxman prompted him to elaborate.
“Partially,” the Maestro replied. “I made a mistake in presuming that the self-interest of organizations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms.” The fact that they simply sought predatory gains for themselves – in the form of losses for their customers and clients (and it turns out, taxpayers”) was “a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”
But the past two or three years evidently have given Mr. Greenspan enough time for a re-think. In Wednesday’s Financial Times (March 30, 2011) he returns to his old job proselytizing for deregulation. His op-ed, “Dodd-Frank fails to meet test of our times,” is a mea culpa to his co-religionists for his apostate 2008 mea culpa. “The US regulatory agencies will in the coming months be bedevilled by unanticipated adverse outcomes,” he warns, “as they translate the Dodd-Frank Act’s broad set of principles into a couple of hundred detailed regulations.” The Act “may create … regulatory-induced market distortion,” because neither lawmakers nor “most regulators” understand how “complex” the financial system is.
But Mr. Greenspan refused to acknowledge the obvious: If Wall Street’s collateralized debt obligations (CDOs) and other derivatives are too complex for regulators to understand, they also must be too complex for buyers and other counterparties to evaluate. This negates a key free market assumption. How can one make an informed choice without understanding the market and the consequences of one’s action? On this logic regulators would follow free market orthodoxy in rejecting derivatives and other such “complex” products.

Many critics would say that CEOs of the banks that went bust don’t understand the complexity that led to their negative equity either. Or, they know all too clearly that they can take a gamble and be bailed out by the government, simply by threatening that the alternative would be monetary anarchy that would drag down consumer banking along with casino banking. The problem is not so much complexity, but gambling – increasingly with computer models and fast mega-trading of swaps and derivatives. This is how investment bankers have made (and often lost) their money.
But they want the game to continue. That is the bottom line. On balance, even if they lose, they will be bailed out. So of course they are all for “complexity” that enables them to make gains at the economy’s expense (Mr. Greenspan’s “flaw” in the system).
But alas, he does not acknowledge the fact that Wall Street blackballs regulators who do understand how the financial system works. An ideological blind spot free-market style is a precondition for deregulators such as Mr. Greenspan. It’s as if he still doesn’t understand that this is precisely why he was hired for his job at the Fed! After rejecting Brooksley Born’s attempt to regulate credit-default swaps at the Commodity Futures Trading Commission in 1998, he served his banking benefactors by passionately supporting Robert Rubin and Larry Summers in pressing the Clinton Administration to repeal Glass-Steagall, opening the door to make consumer banking dependent on wild financial gambling by the likes of Citibank and what has become Bank of America. This self-imposed blindness cost to the economy trillions of dollars and has left a dysfunctional commercial banking system. (At least former S.E.C. Chairman Arthur Levitt has apologized to Ms. Born.)
Mr. Greenspan’s euphemism for dysfunctional is “complex.” His op-ed says what priests or nuns tell parochial school pupils who ask about how God can let so many bad things happen here on earth. The answer is simply to say: “God is too complex for you to understand. Just have faith.” Nobody has sufficient skills to be “entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are importantly altered.” Just look at how Bush Administration happy-face appointees at the FDIC and IMF expressed faith that risks were declining in 2007-08. “Regulators were caught ‘flat-footed’ by a breakdown we had erroneously thought was more than adequately reserved against.” Who could have seen that fraud was going on? Certainly nobody that was let into the Fed’s policy meetings.
Federal Reserve Board Governor Ed Gramlich’s warning about subprime mortgage fraud is ignored as an anomaly here. When Mr. Greenspan says “we” in the above quote he means the useful idiots that Wall Street insists that the government hire – true believers in the deregulatory kool-aid being doled out on behalf of their financial god too complex for mortals to know. “The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems.” But the “regulators who never got more than glimpse” were co-religionists headed by Bubblemeister Greenspan himself. He bears his failure to “more than glimpse” like a badge of honor.
It seems that only bankers really understand what they’re selling, but you must trust Wall Street to do the right thing. (If Mr. Greenspan mouthed such a claim in Wisconsin, where five school districts were suckered into borrowing $200 million in addition to their original investment in CDOs, he would meet with considerable ridicule.) If bankers do not make money for their customers, they will lose their trust. Why would bankers and financial institutions act in such a way as to profiteer at their customers’ expense (and that of the overall economy for that matter)?
The reason, of course, is that the financial sector notoriously lives in the short run. Countrywide Financial, Lehman Brothers, WaMu, Bear Stearns, A.I.G. et al. gave their managers enormous salaries and even more enormous bonuses to turn themselves into a new power elite with fortunes large and “complex” enough to endow their heirs for a century.
The Federal Reserve Bank of Minneapolis has just published statistics showing that the wealthiest 1% of America’s population doubled its share of wealth over the decade ending in 2007 as the bubble reached its peak. No doubt this polarization is widening as the economy shrinks under the weight of its debt overhead. Mr. Greenspan acknowledges criticisms that Wall Street has used TARP and other bailout money simply to maintain “the outsized (to some, egregious) bankers’ pay packages.” But he points out that “small differences in the skill level of senior bankers tend to translate into large differences in the bank’s bottom line.” Skill is expensive.
What amazes me about mismanagers like Countrywide’s chairman Angelo Mozilo and his counterparts is that when the S.E.C., F.B.I. and state attorneys general open a investigation to see whether to charge them with criminal felonies, the bankers always insist that they were out of the loop, had no idea of what was going on, and are shocked, shocked, to find out that there’s gambling going on in this place.
If they are so unknowledgeable to be even more blind than the regulators and economists who warned about what was happening that has required a $13 trillion government bailout, how can they insist that they are worth whatever they can grab? For that matter, how did they manage to avoid jail terms? This is the real question that “free market” economists should be asking.
Most Wall Street firms have paid substantial settlements, and Mr. Mozilo recently paid the Securities and Exchange Commission $67.5 million to avoid going to trial for civil fraud and insider dealing. But only Martha Stewart became an insider jailbird. For Wall Street, paying a civil fine “without acknowledging wrongdoing” blocks victims from recovering civil damages in the event that they try to sue to get their money back. Evidently the Obama Administration believes that to make the banks pay would simply require yet further bailouts of “taxpayer money.” By refraining from prosecuting, Mr. Geithner at the Treasury and other regulators thus can claim to be saving taxpayers – while permitting the large banks to have grown 20 percent larger today than they were when the bailouts began, by extorting high credit card fees and penalties, and using tax breaks and almost free Fed credit such as the $600 billion QE2 to make money by fleeing the dollar to speculate in foreign currencies and make casino capitalist bets.
Mr. Greenspan insists that the economy would be even poorer under financial regulation. “One of the [Dodd-Frank] law’s provisions,” he criticizes, “made credit-rating organisations legally liable for their opinions about risks.” To avoid killing business with such regulation, “the Securities and Exchange Commission in effect suspended the need for a credit rating.” The idea was to save the ratings agencies from having to take responsibility for the tens of billions of dollars lost as a result of their pasting AAA ratings on junk mortgages.
It is as if fraud is simply part of the free market. In this respect, I find his Financial Times op-ed more damning than his evidently temporary burst of candor in his October 2008 Congressional testimony. Mr. Greenspan has rejoined his flock. And to show how thoroughly he has been cured from his temporary apostasy from free market religion, he belittles the fact that: “In December, the Federal Reserve … proposed to reduce banks’ share of debit card fees associated with retail transactions, leading many lenders to contend they would no longer be able to afford to issue debit cards.”
But can there be a better logic to promote the “public option” and have the Treasury issue credit cards as well as debt cards? The rake-off charged by banks from sellers and buyers alike (not to mention late fees that yield the card companies even more than their interest charges these days) has been a major factor eating into retail profits and personal incomes.
The banks are arguing, in effect: “If we can’t earn back enough profits to cover the losses we’ve made on our junk loans, we’ll organize our own lockout of customers – to force you to pay whatever we demand to cover our costs, pay our salaries and bonuses.” This has been their threat ever since the Lehman Brothers meltdown. They threaten to create financial anarchy if the government does not save them from loss, by shifting it onto taxpayers!
The problem is that the bankers’ solution – the inevitable result of Mr. Greenspan’s policy of shifting central planning onto Wall Street – is that it will culminate in the anarchy of debt deflation, deepening unemployment, more real estate foreclosures, and capital flight out of the dollar. So why not let the government say, “OK, we’ll provide a public-option alternative. And if this works, we’ll use it as a model for our public health insurance option. And then we will look to public banking options, and perhaps to Dennis Kucinich’s American Monetary Act to turn you commercial banks back into savings banks to stem your wild speculation at the economy’s expense.” (Just a modest proposal here for argument’s sake to quiet down the bankers’ threats.)
Mr. Greenspan argues that if banks are regulated to reduce the risk they pose to the economy, they may pack up and take their dealings to London: “concerns are growing that without immediate exemption from Dodd-Frank, a significant proportion of the foreign exchange derivatives market would leave the US.” My own response is to say fine, let them leave. Let Britain’s Serious Fraud Office and bank regulators pick up the pieces from their next opaque gamble “too complex” to understand.
Most slippery is Mr. Greenspan’s attempt to divert attention away from the instability that financial deregulation causes – the extreme and rapid polarization of wealth, the mushrooming of bad debt beyond the ability to pay, and the impoverishment of the economy as a result of its debt overhead. Don’t look there, he says; look at how “the global ‘invisible hand’ has created relatively stable exchange rates, interest rates, prices, and wage rates.” But real estate prices have not been stable – they have been inflated with debt, and then crashed the net worth of hapless borrowers. Employment is not stable, wealth distribution is not stable, nor are commodity prices, especially not the price of Mr. Greenspan’s beloved gold bullion.
Nevertheless, Mr. Greenspan concludes, there can be no such thing as a science of regulation. “Financial market behaviour is subject to so wide a variety of ‘explanations,’ especially in contrast to the physical sciences where cause and effect is much more soundly grounded.” But what sets the physical sciences apart from junk economics is the fact that it is not directly self-interested. There are no huge financial rewards for having a blind spot (except of course for scientists denying global warming or that nuclear power might be dangerous or deep-water oil drilling a risky proposition). There is method in the madness of today’s free market orthodoxy opting for GIGO (garbage in, garbage out) financial models that sing along with maestro Greenspan that Wall Street wealth will all trickle down.
“Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago?” he asks rhetorically. By “simpler” banking practices of days of yore, he really means more honest practices, subject to knowledgeable public regulation. It was a world where banks held onto the mortgages they made rather than flipping them to third parties without any responsibility for truth in lending – or in selling, for that matter. “That may not be possible if we wish to maintain today’s levels of productivity and standards of living.” So regulation will make us poorer, not save us from financial fraud and $13 trillion bailouts.
Postulating an admittedly “as yet unproved tie between the degree of financial complexity and higher standards of living,” Mr. Greenspan suggests that wealth at the top is the price to be paid for rising living standards. But they are not rising; they are falling! have Instead of being job creators, bankers are debt creators – and debt deflation is pushing the economy into depression, raising unemployment and driving housing prices further down.
So it sounds like Mr. Greenspan today would do just what he did years ago, and reject warnings that the Fed should regulate reckless bank lending and outright fraud. His mantra is still that the invisible hand is too complex to regulate. It sounds like Willy Sutton bemoaning the fact that policemen keep interfering with his business!
For further commentary on Mr. G’s remarkable “I take it all back” op-ed, I recommend the excellent column of Yves Smith, “OMG, Greenspan Claims Financial Rent Seeking Promotes Prosperity!” Naked Capitalism, March 30, 2011. And if you still believe that Mr. Greenspan can be trusted to provide objective help to today’s financial policy makers, Google the name Brooksley Born and watch the Frontline show “The Warning.” Describing how ferociously Mr. Greenspan and his deregulatory Rubinomics colleagues fought against her attempts to provide information about derivatives so that they might be regulated (saving the U.S. government trillions of dollars), Ms. Born told her interviewer: “They were totally opposed to it. That puzzled me. What was it that was in this market that had to be hidden?”
We now know the answer. Investment bankers were making fortunes at what turned out to be public expense. And that is the real flaw in today’s financial system: most fortunes today, as in past centuries, are made by privatizing wealth from the public domain. To the grabbers, nothing must be allowed to stop that. They insist that is too complex for the regulators to cope with.

Wallison: Leader of the Financial Wrecking Crew

By William K. Black

The most theoclassical economists are often non-economists like Peter Wallison. His bio emphasizes the passion that has consumed his adult life.

From June 1981 to January 1985, he was general counsel of the United States Treasury Department, where he had a significant role in the development of the Reagan administration’s proposals for deregulation in the financial services industry….

[He] is co-director of American Enterprise Institute’s (“AEI”) program on financial market deregulation.

Wallison is back in the media because the Republican Congressional leadership appointed him to the Financial Crisis Inquiry Commission. The Commission has four Republicans and six Democrats. Three of the Republicans were architects of the financial deregulation policies that made possible the current crisis. The fourth, Bill Thomas, was an ardent Congressional supporter of those policies that helped make those policies law. Unsurprisingly, none of the Republicans is willing to support the findings of the Commission’s staff’s investigations of the causes of the crisis because deregulation, desupervison, and de facto deregulation (the three “des”) played a decisive role in making the crisis possible. Each of the Republican members of the Commission is in the impossible position of being asked to investigate his own policies, which the Commission’s investigations have shown to have had disastrous consequences.

Even within the Republicans, however, Wallison stands out for the zeal of his efforts to blame everything on the government and working class Americans. He decided that his Republican colleagues had been too weak in condemning the staff’s findings and wrote a separate, lengthy dissent to make his case. Wallison’s actions were predictable. He was famous prior to his appointment for creating the narrative that the government’s desire to help working class Americans purchase homes twisted Fannie and Freddie into the Great Satans that caused the crisis. He believes in complete deregulation – banks deposits should not be insured by the public and banks should not be regulated.

I have critiqued Wallison’s claims about the current crisis and explained why I think he errs. I will return to this task in future columns now that he has written a lengthy dissent. In this column I will discuss a portion of a shorter, even more revealing article that he wrote that exemplifies what I will argue are the consistent defects introduced by his anti-regulatory dogma in each of his apologies for a series of financial deregulatory disasters over the last 30 years.

Wallison wrote an article in Spring 2007 (“Banking Regulation’s Illusive Quest”) criticizing a conservative law and economics scholar, Jonathan Macey, who had written an article about financial regulation. Wallison was disappointed that Macey, who typically opposes regulation, concluded that banking regulation was necessary. Wallison wrote the article to rebut Macey. I’ll discuss only the portion of Wallison’s article that seeks to defend S&L deregulation.

Wallison begins his critique of Macey by asserting:

If the business of banking is inherently unstable, it would long ago have been supplanted by a stable structure that performs the same functions without instability.

Why? That assumes that there are banking systems that are inherently stable and that the market will inherently establish such systems. There is nothing in logic or economic history that requires either conclusion. Economic theory predicts the opposite. Indeed, the paradox of stability producing instability was Hyman Minsky’s central finding.

Wallison does not support his assertion. The accuracy of the assertion is critical to Wallison’s embrace of financial deregulation. If banks are inherently stable, then financial regulation is unnecessary. He assumes that which is essential to his conclusion. His closest approach to reasoning is circular and unsupported.

In the absence of regulation or deposit insurance, one would expect to see banks hold sufficient capital for this purpose, simply because instability would result without it and instability would make it difficult for banks to acquire deposits.

So, absent regulation and deposit insurance, bank instability cannot exist because instability would make banks unstable. Banks would want to be stable, so Wallison “expects” that they would hold “sufficient capital.” His “expectation” is his conclusion. One does not prove one’s conclusions by “expect[ing]” that they are true.

Wallison cited his (then) co-director of AEI’s deregulatory program, Charles Calomiris, who argued that early U.S. banks with broad branching authority had low failure rates. The study design could not prove Wallison’s argument about private market discipline. Mr. Calomiris’ attempt to employ his theories in the real world led to the failure in 2009 of the S&L he controlled. His brother, George, tried unsuccessfully to get Charles removed from his control of the S&L:

In 2004, after the company posted large losses, George Calomiris asked the board to replace Charles Calomiris and Amos with “qualified, experienced management,” he said in a letter to the board.

That request fell on deaf ears, George Calomiris said in an interview. “Since that time, I and everyone else who protested my brother’s total incapacity to do anything in the real world have seen the truth. … It’s been a total disaster.”

He said he has lost more than $1 million he invested in the bank. “This is not sour grapes. I’m not the only guy who has lost a fortune here.”

While calling his brother an esteemed professor, George Calomiris said “he hasn’t any idea how to run a bank.”

Several local banking experts and investors shared that sentiment, but declined to go on the record.

And that really is the central point of why Wallison, Calomiris, and AEI’s financial deregulatory efforts have caused so much harm to America. AEI’s financial deregulation efforts have been immensely influential even though they were run by individuals who had a “total incapacity to do anything” successful “in the real world.” Accounting and fraud happen in the real world and they turn these anti-regulatory dogmas into “a total disaster.” Indeed, they turn them into recurrent, intensifying disasters. That is why Tom Frank’s famous book title: “The Wrecking Crew” describes Wallison so well. He has led the financial wrecking crew. As his track record of failure has increased, so has his refusal to accept personal responsibility for those failures.

The dynamic Wallison relies upon, private market discipline, cannot be “expect[ed]” to be reliable. Even if we assumed that creditor and shareholders act in accordance with the rational actor model that Wallison implicitly relies upon (and economists and psychologists have proven that assumption is unreliable) it would not follow that private market discipline would be effective to make banks stable.

Private market discipline becomes harmful – not simply ineffective – in four common circumstances even if actors are purely rational. First, if creditors and shareholders believe they can rely on the bank having “sufficient capital” then control frauds will use accounting fraud to create fictional bank capital so that they can defraud the creditors and shareholders.

Second, given the risks of accounting control fraud to creditors and shareholders, creditors and shareholders will realize that reported net worth may be a lie. That uncertainty means that the creditors and shareholders may not be willing to lend to and invest in banks that are actually solvent. Indeed, the depositors may stage a run on a healthy bank. Capital does not save banks from serious runs.

Third, when the bank is an accounting control fraud its senior officers will use their ability to hire, fire, promote, and compensate to create perverse incentives that suborn its employees and internal and external controls (the appraisers, auditors, and credit rating agencies) and turn them into fraud allies. The perverse incentives create a “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace. This produces what white-collar criminologists refer to as “echo” epidemics of fraud.

Fourth, banks engaged in accounting control fraud can generate Gresham’s dynamics and produce “echo” epidemics of fraud in “upstream” providers of loans. Bank control frauds create pay systems for loan brokers, and loan products, i.e., “liar’s” loans, that produce such intensely perverse financial incentives that they are intensely criminogenic. This produced endemic fraud in liar’s loans obtained by loan brokers.

Note that these failures demonstrate that deposit insurance does not end private market discipline. Fraudulent CEOs systematically pervert market incentives and use their power as purchasers and their ability to massively inflate reported income and capital to exert discipline and produce perverse behavior. Indeed, they create an environment so perverse that it becomes criminogenic.

Famous economists, Akerlof & Romer 1993 (“Looting: the Economic Underworld of Bankruptcy for Profit), the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) 1993 (which investigated the causes of the S&L debacle) and many of the nation’s top white-collar criminologists, Calavita, Pontell & Tillman 1997 (Big Money Crime), and a number of my works had explained how accounting fraud worked many years before Wallison wrote this article.

Wallison relies on the same circularity when he turns explicitly to the S&L debacle.

Because they were backed by the government, the s&ls were not required to hold capital that was commensurate with the risk they were taking, and depositors and other creditors were not concerned about this risk for the same reason.

His first clause merely asserts that the S&Ls would have been required to hold more capital absent deposit insurance. His second clause is even weaker. Why do “other creditors” – uninsured creditors at risk of suffering severe losses upon the failure of the S&L – should have exercised effective market discipline against the S&Ls. They never did so. Many S&Ls had subordinated debt. Anti-regulatory proponents like Wallison assert that subordinated debt provides superb private market discipline against banks. The purchasers of sub debt are not insured, they are supposed to be financially sophisticated, and they often buy large amounts of sub debt – all factors that are supposed to optimize private market discipline. The problem is that they have consistently failed to do so in reality. Deeply insolvent S&Ls were able to issue sub debt.

Neither Macey nor Wallison address the consistent failure of uninsured S&L creditors and shareholders – a failure that destroys their underlying assumption that deposit insurance is the cause of market discipline failures. But recall that Macey and Wallison were writing well after the S&L debacle. They were writing after the failure of the Enron-era accounting control frauds – frauds at firms that had no deposit insurance. Market discipline becomes an oxymoron in the presence of accounting control fraud. As Akerlof & Romer (1993) stressed, fraud is a “sure thing.” Creditors rush to lend to uninsured non-financial firms that report record (albeit fictional) income. The control frauds loot the creditors and shareholders. Despite having seen “private market discipline” fund rather than discipline hundreds of huge frauds, Macey and Wallison simply assumed that private market discipline would succeed absent deposit insurance.

Macey writes, “Without government regulation to substitute for the market discipline typically supplied by contractual fixed claimants, disaster ensued.” True enough, but regulation was clearly the underlying cause of the problem.

Wallison’s description of S&L deregulation is remarkably selective and disingenuous.

The deregulation that occurred was an effort to compensate for the earlier regulatory mistakes, but it was too late. Many in the industry were already hopelessly insolvent.

Deregulation was an expedient that came too late to halt the slide of the s&l industry toward insolvency.

And allowing undercapitalized or insolvent s&ls to continue to function — attracting deposits through use of their government insurance — guaranteed a financial catastrophe.

Only the last assertion is sound, but Wallison misinterprets even it, for it was a product of the deregulation that his department (Treasury) imposed on the Federal Home Loan Bank Board. Relatively few S&L were “hopelessly insolvent” as a result of the interest rate increases of 1979-82. NCFIRRE’s estimate is that $25 billion (of the $150 billion in total, present value cost ($1993) of resolving the debacle) was caused by interest rate increases. Interest rates began to fall later in 1982 and generally continued to fall. The great bulk of S&L failures – and the overwhelming bulk of the cost of resolving those failures – was caused by credit losses. Accounting control fraud was a major cause of those costs.

Wallison, understandably, focuses on the most benign aspects of S&L deregulation. Federally chartered S&L were permitted to issue adjustable rate mortgages (ARMs) and S&Ls were permitted to pay depositors higher interest rates. (S&L regulators had long supported both of those changes. Congress was the problem.) I quoted above from Wallison’s bio to show his emphasis on his leadership role in framing the Reagan administration’s financial deregulation.

The deregulation, desupervision, and de facto decriminalization of the S&L industry that the Reagan administration initiated (including the “competition in laxity” that federal deregulation triggered at the State level) was far broader than Wallison discusses and was a dominant contributor to the cost of resolving the debacle. The “three des” created an exceptionally criminogenic environment. Absent reregulation, which we implemented over Wallison’s virulent opposition, it would have caused catastrophic losses. Here are only the most destructive of the “three des” that the administration initiated.

• Reducing the number of Federal Home Loan Bank Board examiners and froze hiring

• Sought to prevent the agency’s decision to double the number of examiners

• Perverting the accounting rules to hide losses and cover up the industry’s mass insolvency – which created fake capital and income that made it far harder to act against the frauds. Covering up the mass insolvency of the industry was at all time the Reagan administration’s dominant S&L industry priority.

• Reducing capital requirements

• Increasing the permissible loan-to-value (LTV) and loan-to-one-borrower (LTOB) ratios to the point where a single large, bad loan could render the S&L insolvent

• Allowed acquirers to create massive fictional assets – goodwill via mergers that made real losses disappear from accounting recognition and created large, fictional income from mergers of two insolvent S&Ls

• Allowed acquirers to have intense conflicts of interest

• Allowed single acquirers, overwhelmingly real estate developers, to take complete control of S&Ls

• Ceased placing insolvent S&Ls in receivership

• Created hundreds of new S&Ls (de novos), overwhelmingly controlled by real estate developers

• Attempted to appoint (on a recess basis without the Senate’s advice and consent) two members to run our federal agency selected by Charles Keating – the most infamous S&L control fraud. The agency was run by three members, so this would have given Charles Keating effective control of the agency.

• Testified before Congress and in a deposition taken in support of a lawsuit by the owners of an S&L challenging the Carter administration’s appointment of a receiver for the S&L based on its acknowledged insolvency. A senior Reagan administration Treasury official testified that insolvency

• The OMB threatened to file a criminal referral against the head of the agency, Ed Gray, who was reregulating the industry, on the purported grounds that he was closing too many failed S&Ls

• Treasury Secretary Baker met secretly with House Speaker James Wright and struck a deal under which the administration would not re-nominate Ed Gray,

The overall effect of the “three des” was that the S&L control frauds were originally able to loot with impunity. Roughly 300 fraudulent “high fliers” grew at an average rate of 50% in 1983. Gray began reregulating the industry in 1983, roughly six months after he became Chairman. The S&L frauds were able to hyper-inflate a regional real estate bubble in the Southwest. Reregulation contained the crisis by promptly and substantially reducing the growth of the fraudulent portion of the industry. Had deregulation continued an additional three years the costs of resolving the crisis would have risen to over $1 trillion. Note that Gray reregulated over the opposition of the Reagan administration (including Wallison), a majority of the members of the House, the Speaker of the House, the “Keating Five”, the industry trade association, and (at first) the media.

Wallison consistently refuses to even discuss the failures of private market discipline caused by accounting control fraud. His lengthy Financial Crisis Inquiry Commission rebuttal, for example, mentions the word fraud once. That reference ignores the evidence before the Commission on the endemic fraud by nonprime lenders and their agents that and mentions only fraud by borrowers. Accounting control fraud is the Achilles’ heel of private market discipline. Effective private market discipline is the sole pillar underlying Wallison’s anti-regulatory policies. He is one of the principal architects of the criminogenic environments that were principal causes of the second phase of the S&L debacle, the Enron-era frauds, and the current crisis. The recurrent, intensifying crises his policies generate have left him with a full time job as apologist-in-chief for his deregulatory disasters.

Investment Banking by Blood Sucking Vampire Squids

By L. Randall Wray

While investment banking today is often compared to a casino, that is not really fair. A casino is heavily regulated and while probabilities favor the house, gamblers can win abut 48% of the time. Casinos are regulated—by the state and presumably by the mob. Top executives who steal funds end up wearing very heavy shoes at the bottom of the ocean.

By contrast, the investment bank always wins, and its customers always lose. Investment banks are “self-regulated” (meaning, of course, they do whatever they want—sort of like leaving your 15 year old at home alone all summer with the admonition to “behave yourself” and keys to the liquor cabinet and the Porsche). Top management rakes off all the funds it wants with impunity. And then the CEOs go run the Treasury to bailout the investment banks should anything go wrong.

This summer I was lunching with a trader who works for one of these investment banks (hint: there are not many left, and he was not with Goldman). Speaking of Goldman he said “those guys are good”. Indeed they are so good, he said, “I don’t know why anyone would do business with them.”

He explained: When a firm approaches an investment bank to arrange for finance, the modern investment bank immediately puts together two teams. The first team arranges finance on the most favorable terms for the bank that they can manage to push onto their client—maximizing fees and penalties. The second team puts together bets that the client will not be able to service its debt. Since the debt cannot be serviced, it will not be serviced. Heads and tails, the investment bank wins.

Note that this is also true of hedge funds and the half dozen biggest banks that are bank holding companies providing a full range of financial “services”.

In the latest revelations, JPMorgan Chase suckered the Denver public school system into an exotic $750 million transaction that has gone horribly bad. In the spring of 2008, struggling with an underfunded pension system and the need to refinance some loans, it issued floating rate debt with a complicated derivative. Effectively, when rates rose, that derivative locked the school system into a high fixed rate. Morgan had put a huge “greenmail” clause into the deal—the school district is locked into a 30 year contract with a termination fee of $81 million. That, of course, is on top of the high fees Morgan had charged up-front because of the complexity of the deal.

To add insult to injury, the whole fiasco began because the pension fund was short $400 million, and subsequent losses due to bad performance of its portfolio since 2008 wiped out almost $800 million—so even with the financing arranged by Morgan the pension fund is back in the hole where it began but the school district is levered with costly debt that it cannot afford but probably cannot afford to refinance on better terms because of the termination penalties. This experience is repeated all across America—the Service Employees International Union estimates that over the past two years state and local governments have paid $28 billion in termination fees to get out of bad deals sold to them by Wall Street. (See Morgenson

Repeat that story thousands of times. Only the names of the cities and counties need to be changed. Analysts say that deals like that pushed onto Denver would never be accepted by for-profit firms. Investment banks preserve such shenanigans to screw the public. Michael Bennet, who was the head of the school district pushing for the deal had worked for the Anschutz Investment Company—so he knew what he was doing. He was rewarded for his efforts—he is now a US senator from Colorado.

Magnetar, a hedge fund, actually sought the very worst tranches of mortgage-backed securities, almost single-handedly propping up the market for toxic waste that it could put into CDOs sold on to “investors” (I use that term loosely because these were suckers to the “nth” degree). It then bought credit default insurance (from, of course, AIG) to bet on failure. By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find. In other words, the financial institution bets against households, firms, and governments—and loads the dice against them—with the bank winning when its customers fail.

In a case recently prosecuted by the SEC, Goldman created synthetic CDOs that placed bets on toxic waste MBSs. Goldman agreed to pay a fine of $550 million, without admitting guilt, although it did admit to a “mistake”. The deal was proposed by John Paulson, who approached Goldman to create toxic synthetic CDOs that he could bet against. Of course, that would require that Goldman could find clients willing to buy junk CDOs. According to the SEC, Goldman let Paulson suggest particularly risky securities to include in the CDOs. Goldman arranged 25 such deals, named Abacus, totaling about $11 billion. Out of 500 CDOs analyzed by UBS, only two did worse than Goldman’s Abacus. Just how toxic were these CDOs? Only 5 months after creating one of these Abacus CDOs, the ratings of 84% of the underlying mortgages had been downgraded. By betting against them, Goldman and Paulson won—Paulson pocketed $1 billion on the Abacus deals; he made a total of $5.7 billion shorting mortgage-based instruments in a span of two years. This is not genius work—an extraordinarily high percent of CDOs that are designed to fail will fail.

Previously, Goldman helped Greece to hide its government debt, then bet against the debt—another fairly certain bet since debt ratings would likely fall if the hidden debt was discovered. Goldman took on US states as clients (including California and New Jersey and 9 other states), earning fees for placing their debts, and then encouraged other clients to bet against state debt—using its knowledge of the precariousness of state finances to market the instruments that facilitated the shorts.

To be fair, Goldman is not alone — all of this appears to be common business procedure.

There is a theory that an invisible hand will guide unfettered markets to perform the public interest. In truth, unregulated Wall Street bets against the public and operates to ensure the public loses. Investment banks are now all corporations (and all have bank charters). Corporations and banks are chartered to further the public purpose. Why do we allow them the screw the public?

What Do Our Nation’s Biggest Banks Owe Us Now?

By William K. Black

This week, ABC News World News with Diane Sawyer is airing a series about the struggling middle class. The show’s producers posed the following question to a few of the nation’s leading economic and financial analysts, including UMKC’s own William K. Black.

QUESTION: As the nation’s largest banks have regained their footing, what, if anything, can or should they do to help Americans still struggling as a result of the financial crisis and recession?  Are there specific solutions or actions the banks should take or HAVE they already done enough?  Do the banks have an “ethical obligation” to help those average American families still struggling?
ANSWER: First, banks have not recovered.  It is essential to remember that the banks used their political clout last year to induce Congress to extort the Financial Accounting Standards Board (FASB) to change the accounting rules such that banks no longer have to recognize losses on their bad assets unless and until they sell them.  Absent this massive accounting abuse, hiding over a trillion dollars in losses, banks would (overall) not be reporting these fictional “profits” and would not be permitted to award the exceptional executive bonuses that they have paid out.

Second, banks have, in reality (as opposed to their fictional accounting ala Lehman) been suffering large losses for at least five years.  They only appeared to be profitable in 2005-2007 because they provided only trivial loss reserves (slightly over 1%) while making nonprime loans that, on average, suffer roughly 50% losses.  Loss reserves fell for five straight years as bank risks exploded during those same five years.  Had they reserved properly for their losses the industry would have reported large losses no later than 2005. 
Third, banks have performed dismally when they were supposedly profitable.  They funded the nonprime and the commercial real estate (CRE) bubbles that not only cause trillions of dollars of losses and the Great Recession, but also misallocated assets (physical and human) during those bubbles.  Far too few societal resources went to productive investments that would increase productivity and employment.  Our nation has critical shortages of workers with expertise in physics, engineering, and mathematics — precisely the categories that we misallocated to finance instead of science and production.  In finance, they (net) destroyed wealth by creating “mark to myth” financial models that maximized executive bonuses by inflating asset values and understating risk. 

Fourth, when finance seems to be working well in the modern era it is working badly.  Finance is a “middleman.”  Its sole function is to allocate capital to the most useful and productive purposes in the real economy.  As with any middleman, the goal is to have the middleman be as small and take as little profit as possible.  Finance has not functioned that way.  It has gone from roughly 5% of total profits to roughly 40% of total profits.  That means that finance has, increasingly, become wildly inefficient.  It is a morbidly obese parasite (in economics terms) that drains capital from the productive sectors of the economy.   
Fifth, the things that finance is good at are harmful to our nation.  Finance is very good at exporting U.S. jobs to other nations.  Finance is very good at fostering immense speculation.  When banks “win” their speculative bets Americans suffer, e.g., when their speculation increases gas and food prices.  When they lose their bets the American people bail them out.  (The least they could do would be to support the proposed Volcker rules.  In reality, of course, they will gut them.)  For the overwhelmingly majority of Americans, increased speculation simply causes economic injury.  In very poor countries, however, “successful” speculation by hedge funds that runs up the price of basic food kills people.  Speculation has also become intensely political.  The right wing Greek parties engaged in accounting fraud to allow Greece to issue the Euro.  When a left wing Greek party defeated the right at the polls the banks and hedge funds decided to engage in a speculative frenzy designed to cripple the nation’s recovery from recession.  Finance is also superb at increasing inequality. 
Sixth, the rise of “systemically dangerous institutions” (SDIs) that the government will not allow to fail optimizes moral hazard (fraud and speculation) and means that future crises will be common and unusually severe. 
Seventh, while lending by smaller banks is flat, funding by SDIs fell by over $1/2 trillion.   
Eighth, banking theory is horribly flawed.  Financial markets are normally not “efficient”, markets do not inevitably “clear,” and banks fund “accounting control frauds” rather than providing effective “private market discipline.”  

To sum it up, whether I’m wearing my economics, law, regulatory, or white-collar criminologist hat the situation in banking demands prompt, fundamental reform so that banking will stop being so harmful.  Then we have to keep working to make it helpful. 

Banks cannot do many of the things that need to be done to fix our economy.  In the interest of limiting space, I’ll talk about only five economic priorities.  I think banks can be helpful in only a few of these priorities.  The most important thing we can do with financial institutions is reduce the damage they cause. 
1)  It is nuts that we think it is OK for 8 million Americans to lose their jobs (and far more lose their ability to work full time) and that we think that it makes sense to pay people not to work but is “socialism” to pay them to work during a Great Recession.  We need a government-funded jobs program. 

2) It is a disgrace that well over 20% of American children grow up in poverty.  It is a greater moral failing that ending this is not a national priority.  The banks have done a terrible job in this sphere.  They caused the greatest loss of working class wealth since the Great Depression and have made tens of thousands homeless.  This is overwhelmingly the product of what the FBI began warning of in 2004 — and “epidemic” of mortgage fraud.  The FBI states that 80% of the fraud is driven by finance industry insiders. 

3) It is insanity to the nth to run our state and local governments into massive cutbacks during a Great Recession when that undercuts the need for stimulus.  The obvious answer is a public policy with impeccable Republican origins — revenue sharing.  It passes all understanding that the Republicans and blue dog Democrats targeted revenue sharing for attack and reduced it to a pittance (relative to the scale of the crisis).  The best things the banks could do in this regard are to stop (a) all participation in “pay to play” corruption involving state & local bond issuances, and (b) stop all sales of unsuitable financial products to governments (and the public).  The opposite is happening:  Goldman fleeces its public sector clients, the SDIs sell toxic derivatives to small Scandinavian cities, the investment bankers are all over public pension funds desperate for higher yields (on their underfunded pension funds) selling them grotesquely unsuitable financial products (typically, the “dogs” they can’t unload on more sophisticated investors), and the inimitable Goldman Sachs helping Greek governments deceive the EU. 
4) Related to points two and three above, the most productive investment we can make is educating superbly the coming generations.  The best thing the banks can do is get out of student lending.  The governmental lending program for college students was administered in a much cheaper fashion.  The privatized lending program is an inefficient scandal that keeps on giving.
5) Banks could put the payday lenders out of business by outcompeting them.  That would be a real public service.
And, on a level of fantasy, banks as a group could tell FASB to restore honesty in accounting.  Individual banks could report their real losses and change their executive compensation systems to accord with the premises that purportedly underlie performance pay.  They could start making criminal referrals against the mortgage frauds (a mere 25 banks and S&Ls make over 80% of the total criminal referrals for mortgage fraud) — most banks refuse to file and help us jail the crooks.  They could stop adding to the glut in commercial real estate.  They could support the Kaptur bill to authorize the FBI to hire an additional 1000 agents so that we can investigate and jail elite financial felons.  They could support a prompt end to the existence of systemically dangerous institutions (SDIs) by supporting rules and regulatory policies to require them to shrink to the point that they no longer endanger the global economic system.  Pinch me if any of these dreams come true.  I’d like to be awake to experience and celebrate the miracle.

Timmy Geithner Must Go

By L. Randall Wray

Breaking News: As reported on Bloomberg here and in NYT here, secret emails show that the NYFed under Geithner’s command prohibited AIG from reporting that it was passing government bail-out funds directly to counterparties, including Goldman Sachs. AIG had been negotiating with the banks, asking them to take as little as 40 cents on the dollar against bad CDOs they held. AIG was the biggest insurer in the country and had provided $62 billion of credit default “insurance” to these banks. The CDOs went bad and AIG could not cover claims. It was forced into insolvency and the government came to the rescue, with $182 billion of bailout funds through last June. By all rights, its counterparties should have lost big on their bad bets. Apparently, Geithner arranged the bailout of AIG with full knowledge that it would pass the bailout funds directly to the banks. Whether or not some protection should have been provided to the banks, it clearly was not good public policy to provide dollar-for-dollar protection to them. If you are a favored Wall Street bank, no bet can go bad!

Note that Geithner worked with then Treasury Secretary Paulson to broker this deal. Paulson, of course, had been the CEO of Goldman. Geithner is the protégé of Clinton’s Treasury Secretary Rubin, also from Goldman.

According to Representative Darrell Issa, Republican of California, “It appears that the New York Fed deliberately pressured AIG to restrict and delay the disclosure of important information to the S.E.C.”. Not only did Geithner want to keep this information from the public, but also from fellow regulators. (Whoops, Geithner admitted he was never a regulator.) This smells fishy because it is. Geithner not only oversaw the operation but his office prohibited AIG from telling the truth about it. Remember, this is the same guy who “forgot” to pay his taxes (see here). He is ethically challenged. Should he be running the Treasury?

As Republican Congressman Brady of Texas put it, “Conservatives agree that, as point person, you’ve failed. Liberals are growing in that consensus as well. Poll after poll shows the public has lost confidence in this president’s ability to handle the economy. For the sake of our jobs, will you step down from your post?” (see here).

“Why is Obama Championing Bush’s Financial Wrecking Crew?”

By William K. Black

“First Published on New Deal 2.0
Tom Frank’s book: The Wrecking Crew explains how the Bush administration destroyed effective government and damaged our social fabric and our economy. The Obama administration has chosen to reward two of the worst leaders of Bush’s crew – Geithner and Bernanke – with promotion and reappointment. Embracing the Wrecking Crew’s most destructive members has further damaged the economy and caused increasing political and moral injury to the administration.

Last week was a bad one for Geithner and Bernanke. Senator Dodd said that Bernanke’s confirmation was no longer a done deal. The House Financial Services Committee revolted against the administration, the Fed, and Chairman Barney Frank. It voted for a strong bill to audit the Fed. Senate Banking Chairman Schumer went to a conference at Columbia University – where a generation of students salivated at the prospects of Wall Street wealth – and was overwhelmed by an audience denouncing the continuing stranglehold of the finance industry over successive administrations and the Congress. Neither Barney’s blarney nor Schumer’s schmooze was any avail before an outraged public.

The administration promptly secured a column in the Washington Post claiming that the effort to fire Geithner “buoy[ed]” him because, as the subtitle to the article explained: “Even ex-Bush aides sympathetic, sources say.” The article didn’t note that Geithner is an “ex-Bush” senior official who, with his fellow “ex-Bush aides” (particularly Bernanke and Paulson) produced a chain of disasters: the bubble, an “epidemic of mortgage fraud” by lenders, the Great Recession, and the scandalous TARP and AIG bailouts. Of course they’re “sympathetic” to a fellow member of the Wrecking Crew that destroyed effective regulation and turned the nation over to Wall Street. The craziest part of the story is that the anonymous Obama administration flack that spread this anecdote believes that we should support Geithner because his fellow members of the Bush Wrecking Crew empathize with him because they too have been criticized for wrecking the economy.

The Washington Post article then offers a metaphor that serves as an apology for the Bush Wrecking Crew. The metaphor is driving over a cliff.

“Secretary Geithner has helped steer the American economy back from the brink, and is now leading the effort on financial reform,” White House spokeswoman Jen Psaki said.

Geithner pushed back against Republicans who questioned his performance, telling them, “you gave this president an economy falling off the cliff.”

“You” – how about “we”? Bush’s financial Wrecking Crew “gave this president an economy falling off the cliff.” Geithner was President of the Federal Reserve Bank of New York from October 23, 2003 until President Obama chose him as his Treasury Secretary. He was supposed to be the lead regulator of many of the largest bank holding companies. His failures as a regulator were a major cause of the “economy falling off the cliff.” Bernanke held prominent positions in the Bush administration from 2002 to the end of the administration and failed as a regulator and as an economist. Geithner and Bernanke failed to regulate even after the FBI publicly warned in September 2004 that (1) there was an “epidemic” of mortgage fraud and (2) it would lead to a financial crisis if it were not contained. Their refusal to take responsibility for the harm they did our nation as leaders of Bush’s financial Wrecking Crew adds to their unsuitability. Rewarding their perennial failures with a promotion and reappointment represents a dereliction of duty by the Obama administration.

The administration apologists praise Geithner and Bernanke for “steer[ing] the American economy back from the brink.” Greenspan, Paulson, Bernanke, and Geithner were the leaders of Bush’s financial Wrecking Crew. They were the guys blinded by their pro Wall Street ideology that drove the car 120 mph down an icy mountain road and lost control of it. They took us to the “brink” of running “off the cliff” and creating the Second Great Depression. The bizarre claim is that we should praise them because they, and Wall Street, only wrecked the economy – they haven’t (yet) utterly destroyed it. Under their metaphor, we’re supposed to cheer Geithner and Bernanke because once they finally figured out that they were careening toward the cliff they decided to sideswipe a row of trees in order to avoid going off the cliff. They wrecked the car but they walked away from the crash without a scratch. If your teenager gets drunk, speeds, crashes into a school bus (injuring dozens of kids), and flips the Ford Focus – but walks away from the crash – you don’t praise him, give him the keys to the family minivan, and have him drive the soccer team to practices. You take all the keys away from him and ground him.

The Obama administration promoted Bush’s architects of the financial disaster and demands that we hail them as heroes. President Bush was ridiculed for saying: “Brownie, you’re doing a heck of a job.” FEMA administrator Michael Brown stood by while Hurricane Katrina reduced a single large city to ruin. Geithner and Bernanke stood by while scores of large cities were devastated.

I suggest that we will build on the momentum we’ve achieved on the Fed audit by making the following issues our near term financial priorities:

1. Fire the senior leaders of Bush’s and Clinton’s financial Wrecking Crews and stop treating them as financial experts. President Obama should not reappoint Bernanke as Fed Chairman. He should dismiss Geithner and Summers and cease to take any advice from Rubin. Replace them with the Reconstruction Crew – people with a track record of getting things right and being effective economists, regulators, and prosecutors. Members of Bush’s financial Wrecking Crew run far too many regulatory agencies, often as “Actings.” They can, and should, be replaced promptly.

2. End “too big to fail.” These banks are “systemically dangerous institutions” (SDIs). They should not be allowed to grow, they should be shrunk to the point that they no longer pose systemic risk, and they should be subject to vigorous regulation while shrinking. They are too big to manage and too big to regulate. They are ticking time bombs that will cause recurrent global crises as long as they are SDIs.

3. Adopt Representative Kaptur’s proposed to provide the FBI with at least 1000 additional white-collar specialists. Senator Durbin and (then) Senator Obama made a similar proposal several years ago.

4. End the perverse executive compensation systems that reward failure and fraud. The private sector has made compensation worse since the crisis. Modern executive compensation creates a virtually perfect crime – “accounting control fraud.” Until we fix the perverse incentives of executive compensation we will have recurrent epidemics of fraud and global financial crises.
5. Kill TARP and PPIP. Use the funds to help honest homeowners that would otherwise lose their homes because of predatory loan terms.

6. Make the Federal Reserve System public. It is a largely private structure that creates intense conflicts of interest and ensures that it is controlled by the systemically dangerous institutions. We have already decided that such a structure is inherently improper. The Federal Home Loan Bank System was set up along the same institutional lines and suffered from the same conflicts of interest. Congress ordered an end to these conflicts in the 1989 FIRREA legislation. It should end private control of the Fed.

7. Defeat any proposal to make the Fed the “Uberregulator.” The Fed, for inherent institutional reasons, is unsuited to be the “systemic risk regulator.” The Fed has never cared about regulation. The Fed cares about monetary policy and (theoclassical) economic theory and research. Regulation is, at best, a tertiary concern. Its economists wrote frequently about systemic risk – but missed the obvious, massive systemic risk of the financial bubble and the epidemic of accounting control fraud. Its policies intensified rather than restricting systemic risk. Theoclassical economists have no effective theories (or policies) to deal with bubbles or epidemics of accounting control fraud. Greenspan, Bernanke, and Geithner epitomize the Fed’s inability to recognize or reduce systemic risk. Their policies consistently increased systemic risk. Greenspan didn’t believe that the Fed should act against fraud. Geithner testified before Congress that he had never been a regulator (a true statement – but one that should have gotten him fired rather than promoted). Bernanke praised the subprime loans that caused the crisis and were so often fraudulent.

8. Sever the Consumer Financial Product Agency portion from the broader (and deeply flawed) regulatory reform bills in the House and Senate and adopt it into law. Revise the broader bill to strip out its many anti-reform provisions.

9. End the waste of long-term unemployment. Anyone able and willing to work should be employed by the government as an employer of last resort and should help repair our crumbling infrastructure. Paying people to do nothing or allowing them to become homeless (the status quo) is an insane system.

10. Adopt a $250 billion revenue sharing program. American state and local governments are in economic crisis. They are slashing spending at the worst possible time when their services are most vital and when cutting spending is pro-cyclical and will delay our recovery from the Great Recession. Revenue sharing was a Republican initiative. Republicans and “Blue Dog” Democrats killed the revenue sharing provisions of the administration’s proposed Stimulus bill. That was an enormous mistake. The federal government is not like a state government (or a household). It is a sovereign government with its own currency and a central bank. It can – and should – run large deficits during deep recessions, but the states and local governments cannot. Revenue sharing is the ideal answer to the crisis and it is an answer with an impeccable conservative pedigree. State and local governments should come together and demand a program to offset the state and local cutbacks – roughly $250 billion. (The Obama administration’s claim that reducing the deficit should be a priority – at a time when unemployment has reached tragic levels – is economically illiterate. It repeats the error that FDR made when he listened to conservative economic advisors and slashed the budget deficit during the Great Depression – causing a surge in unemployment and the extension of the depression. The large federal deficits of World War II reversed the policies of his conservative economic advisors and ended the Great Depression.)

Prof. William K. Black on the Financial Crisis in the United States

Our own Prof. William K. Black delivered a presentation at the Corruption Forum 2009-University of Calgary.

See also the videos below.

The Point of No Return

Our own Bill Black on bank’s equity and nonperforming loans. Black argued on the Bloomberg article that

“While 5 percent can be “fatal” for home lenders, commercial real estate lenders may be able to withstand higher rates…Commercial loans carry higher interest rates because they’re riskier.”

“At the 5 percent range, you’re probably hurting,” said Black, an associate professor of economics and law at the University of Missouri-Kansas City. “Once it gets around 10 percent, you’re likely toast.”

Click here to read the whole article.

The Great American Bank Robbery

(From UCLA’s Hammer Forum) — William K. Black, the former litigation director of the Federal Home Loan Bank Board who investigated the Savings and Loan disaster of the 1980s, discusses the latest scandal in which a single bank, IndyMac, lost more money than was lost during the entire Savings and Loan crisis. He will examine the political failure behind this economic disaster, in which not only massive fraud has taken place, but a vast transfer of wealth from the poor and middle class continues as the federal government bails out the seemingly reckless, if not the criminal. Black teaches economics and law at the University of Missouri, Kansas City and is the author of The Best Way to Rob a Bank Is to Own One. (Run Time: 1 hour, 38 min.)