By William K. Black
(Cross posted at Benzina.com)
This column was prompted by a story that ran Friday entitled “Congressman Calls Evolution Lie from ‘Pit of Hell.’” Yes, unintentional self-parody continues to reign supreme.
By William K. Black
(Cross posted at Benzina.com)
This column was prompted by a story that ran Friday entitled “Congressman Calls Evolution Lie from ‘Pit of Hell.’” Yes, unintentional self-parody continues to reign supreme.
On June 13, 2011, the New York Times wrote an exasperated editorial entitled “Nearly a Year After Dodd-Frank.” It began by warning that:
Without strong leaders at the top of the nation’s financial regulatory agencies, the Dodd-Frank financial reform doesn’t have a chance. Whether it is protecting consumers against abusive lending, reforming the mortgage market or reining in too-big-to-fail banks, all require tough and experienced regulators.
The editorial ended with this sentence: “It’s past time for President Obama to take off the gloves.”
The plot of the movie WarGames (1983) involves a slacker hacker (played by Matthew Broderick) who starts playing the game “Global Thermonuclear War” with Joshua, a Department of Defense (DoD) supercomputer that has been given partial control by DoD of our nuclear forces. The game prompts Joshua, who has been programmed to win games, to trick DoD into authorizing Joshua to launch an attack on the Soviet Union so that Joshua can win the game. The hacker and the professor that programmed Joshua realize that the only way to prevent Joshua from attacking is to teach “him” that no one can “win” global thermonuclear war. The insanity is that the people who created the game “Global Thermonuclear War” thought it could be won. Joshua races through thousands of scenarios and ends his plan to win the “Global Thermonuclear War” game by attacking the Soviet Union when he realizes that “the only winning move is not to play.”
The JOBS Act is insane on many levels. It creates an extraordinarily criminogenic environment in which securities fraud will become even more out of control. One of the forms of insanity is the belief that one can “win” a regulatory “race to the bottom.” The only winning move is not to play in a regulatory race to the bottom. The primary rationale for the JOBS Act is the claim that we must win a regulatory race to the bottom with the City of London by adopting even weaker protections for investors from securities fraud than does the United Kingdom (UK).
The imminent passage of the fraud-friendly JOBS Act caused me to reflect on the fact that the worst anti-regulatory travesties in the financial sphere have had broad, bipartisan support. The Garn-St Germain Act of 1982, which deregulated savings and loans (S&Ls) and helped drive the debacle, was passed with virtually no opposition. The Texas and California S&L deregulation acts – the two states that “won” the regulatory “race to the bottom” – passed with virtually no opposition. Texas S&L failures caused over 40% of total S&L losses and California failures caused roughly 25% of total losses. In 1984, a majority of the members of the House of Representatives, including Newt Gingrich and most of the leadership of both parties, co-sponsored a resolution calling on us to cease our reregulation of the S&L industry.
(Cross-posted from Benzinga.com)
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.
(Cross-posted with Benzinga.com)
This is the fourth and final article in a series of pieces discussing the claim by a Cato scholar at CIFA’s recent meeting in Monaco that formal benefit-cost tests by economists were essential to prevent regulatory excess. The second column focused on a speech in 2001 by Mitch Daniels, then President Bush’s Office of Management and Budget (OMB) director to the Competitive Enterprise Institute (CEI).
Mitchell E. Daniels, Jr., Competitive Enterprise Institute Speech, 05/22/2002
Daniels is the nation’s leading proponent of benefit-cost tests, and the purpose of his speech was to advance arguments in favor of OMB economists’ use of benefit-cost tests to block the adoption of regulations. The column discussed Daniel’s use of a “mistress metaphor” to explain why economists’ formal benefit-cost tests are vital.
Daniels warmed up his global warming denial audience (pun intended) with this joke, which he said he often shared with his daughter. Many of us who are parents look for these opportunities to mix family meals and an opportunity for moral instruction. This is how Daniels relates his efforts at teaching moral reasoning:
‘If James Carville and Geraldo Rivera were both drowning, and you could only save one [laughter], would you read the paper, or eat lunch [laughter and applause]?’
Altruism is, as Ayn Rand stressed, a grave error. To be a Good Samaritan, particularly to save the life of someone who disagrees with you, is not a mitzvah but an unpardonable sin. It follows that one should teach their children that the correct response to learning that a person is drowning and only they can save a life – is to let them drown – while noshing. The death of those who disagree with us is a cause for celebration [“laughter and applause”].
The substance of Daniels’ talk was an effort to claim the high moral ground for OMB and CEI’s efforts to block new regulations and kill new ones. Daniels began with a premise that illustrates, unintentionally, several classic abuses of benefit-cost tests.
“We know with some degree of precision that, conservatively estimated, regulations on the books of federal government inflict 600 to eight hundred billion dollars in cost to the American economy every year. It’s wrong to put it the way I just did, because such costs are not inflicted on abstractions like economies, but on each of us, on everyday citizens, with ultimately every dollar of that falling on a purchaser of a good or service, either in a direct cost, or the unavailability of that product or the loss of the freedom of our choice consequent to some regulatory restriction.”
No, we don’t know any such thing, much less with “precision” and the people who make these estimates are the most partisan theoclassical economists whose central dogma requires them to believe that regulation is unnecessary, harmful, and an assault on central freedoms.
Consider the glaring flaw that Daniels is oblivious to – what happened to the benefits? They don’t even require discussion – they don’t exist and can’t exist under Daniels’ anti-regulatory ideology. The most basic and inexcusable error in benefit-cost analysis is to ignore either the costs or the benefits while stressing the other. Buying M1A2 tanks and Super Hornets is exceptionally expensive. Such costs are, under Daniels’ reasoning, “inflicted … on each of us.” They are inflicted without our individualized choice. I may not want the U.S. operators of Predator drones to launch Hellfire missiles to attempt to assassinate American citizens in Yemen without trial. The answer is – tough luck. By a democratic process, U.S. representatives voted to procure roughly a trillion dollars annually in military goods and services and to use them as the Commander-in-Chief orders. But Daniels would never discuss only the costs of tanks, carrier-based high performance fighter-bombers, drones, or missiles and ignore the benefits.
Can economists quantify in a rigorous fashion the benefits of the current U.S. military v. one with 80% or 120% of its existing capabilities? No. Usually they’re smart enough not to try. Can economists quantify the net costs and benefits of trying to use Predators to kill Americans in Yemen who we suspect of being terrorists? No.
If you understand the code, Daniels gives away his theoclassical blinders in this clause about the costs that regulation inflicts upon consumers: “the loss of the freedom of our choice consequent to some regulatory restriction.” Consumer regulation is inherently harmful to Daniels – he literally cannot conceive of any other outcome. Most people in the world, rightly, consider this dogma crazed – but neoclassical economists often embrace it. Indeed, many introductory microeconomics textbooks present this claim as if it were indisputable truth – for they present a graph “proving” the point. Here is the logic. Consumers vary in their desires and consumers are the best judges of their desires. Any regulation that changes a consumer’s choice, therefore, must cause him to be worse off (he falls to a lower indifference curve in his utility map).
Except, and even neoclassical economists would have to admit it if you cornered them, the opposite is true in a wide range of situations. The claim that rules harm consumers:
The typical microeconomics course treats these market realities (which, collectively, are the norm) as if they were curious theoretical exceptions to a grand norm of market perfection. The typical microeconomics text ignores many of these market imperfections. It is common for the professor to either not get to or rush through in the last week a small subset of the imperfections that dominate real markets.
Consider the interaction of only a few of these common market failures in a context relevant to the current crisis and Daniels’ April 2002 speech to CEI. Daniels made specific his claim that OMB and CEI captured the high moral ground when they prevented or removed regulation. Because consumer protection regulation inherently harmed consumers, it followed that any actions that OMB and CEI took to prevent consumer regulation protected consumers. Daniels’ lead-in sentence to the paragraph of his speech about the cost of regulation that I quoted above was: “regulatory review is consumer protection in its purest form.” No, it isn’t, particularly as Daniels practiced it. It is not consumer protection in any form to be captured by a dogma that is contrary not only to real life, real markets, and real economics (as I have just detailed). A theoclassical economist whose dogma requires him to believe that rules designed to protect consumers impose only costs will harm consumers. Daniels is not describing “regulatory review” by OMB to protect consumers – he is describing an assault on consumers by ideologues.
Daniels gave one specific example of consumer protection regulation in his speech. The passage in which he describes it provides the fuller context for the clause I have just been discussing.
“Think back with me, if you will, to 1978, when a seven- or eight-year campaign ultimately failed in its bid to create a Consumer Protection Agency for the United States. Well thank goodness it did. Two years later, by Executive Order, the organization we now know as OIRA got full authority to become a central clearinghouse and review agency, a second opinion source on major federal regulations, would-be regulations emanating from the various departments of the federal government. And those two otherwise unrelated events are linked in my mind because I would assert, if done properly, regulatory review is consumer protection in its purest form.”
OIRA is the section within OMB that conducts benefit-cost tests. Remember the time period of Daniels April 2002 speech to the CEI. All hell has broken loose. The FBI had transferred 500 of its agents specializing in white-collar crime investigations to national security in response to the September 11 attacks. Most of the remaining FBI agents, and probably the great bulk of those they considered most effective, had been working since 2001 to investigate the massive accounting control frauds (Enron and its ilk) who had failed in 2001-2002. The FBI requested permission to hire agents to replace the transferred white-collar specialists – the Bush administration, and that means then OMB Director Daniels, refused. The FBI was left with fewer than 100 agents to investigate a developing “epidemic” of mortgage fraud that by the time of Daniels’ CEI speech was still small enough that it could have been stopped by vigorous prosecution of the largest fraudulent lenders. The FBI was unable with that grossly inadequate number of agents to investigate any of the major fraudulent lenders making the hundreds of thousands of fraudulent liar’s loans. Daniels’ response as OMB Director to the FBI’s critical resource limitations to respond to the developing “epidemic” of mortgage fraud and the Enron-era accounting control frauds was to deny the FBI the resources that were essential to prevent the fraud epidemic and the developing financial crisis. It is inconceivable that Daniels’ decision to deny the FBI the resources could have passed any benefit-cost test. Allowing fraud epidemics and financial crises is catastrophically expensive. Bush’s nickname for Daniels was “the blade” because of his role in cutting expenditures in programs and rules designed to protect the public. The concept that an effective OMB director must be to find areas of excessive, ineffective, and inadequate expenditures was foreign to Bush and Daniels except in the context of inadequate expenditures on national security.
OMB’s function is supposed to be to ensure rational budgeting. Given the September 11 attacks and the very large transfers of FBI white-collar specialists to national security, the staggering size of Enron-era accounting control frauds, and the rapidly growing epidemic of mortgage fraud it was certain that the national interest required a substantial increase – not simply restoration – in the number of FBI white-collar specialists.
Focus closely on Daniels’ rhetoric and claims about “consumer protection in its purest form.” He says “thank goodness” that the efforts to create an agency to protect consumers were killed by the financial industry’s lobbyists and he sees this as, while “unrelated,” also “linked” to the decision to make OMB a super-regulator entitled to second-guess and overrule the decisions of agency experts, after analyzing the industry’s comments on the proposed rule, that the adoption of a particular rule is in the public interest. We can agree that the decisions were “linked” – the industry, particularly the financial industry, was eager to prevent the adoption of rules to protect the public and killing the consumer protection agency and using OMB to prevent the adoption of rules to protect the public. Daniels is wrong about both anti-regulatory actions being “unrelated” – they were generated as part of the same anti-regulatory lobbying effort.
History ran a real world test of Daniels’ assertions that blocking rules to protect consumers is the purest form of consumer protection. The genius of free exchange is that it can, in many circumstances, lead to Pareto optimal exchanges – both parties are made better off. I have discussed above a number of the circumstances in which voluntary exchange will not necessarily make consumers better off. The crisis tested the Daniels/Greenspan/Fischel theory that financial consumers are better off if regulations that are designed to protect consumers are removed. Consider only the intersection of accounting control fraud and asymmetrical information. The typical nonprime borrower and lender from 2005 to 2007 suffered large losses. Both principals were made worse off, particularly if the loan was fraudulent. The typical “liar’s” loan was fraudulent and the lenders and their agents typically put the lies in the liar’s loans. Many working class Americans had their limited wealth wiped out by nonprime loans. Virtually all of the nonprime lending specialists failed – they all suffered tremendous losses. The “unfaithful agents” – the lenders’ and loan brokers’ senior officers, the employees placed on compensation systems that created incentives to make fraudulent loans, the appraisers who inflated appraisals, the audit firms and the rating agencies that blessed the massive overvaluation of the assets and the grotesquely inadequate allowances for loss reserves were often made wealthy. The fraudulent lenders created the perverse incentives through their compensation systems that produced these “echo” epidemics of fraud among the agents by deliberately generating “Gresham’s” dynamics in which bad ethics drove good ethics out of the markets and professions. The nonprime mortgage market – well over a trillion dollars – was based on reverse Pareto optimality. Both parties to the transaction were typically made worse off.
The often fraudulent nonprime loans drove the hyper-inflation of the bubble, particularly in 2005 and 2006 and delayed the collapse of the bubble into 2007. This caused millions of prime borrowers and their lenders to suffer enormous losses. Accounting control fraud causes exceptionally large negative externalities.
A consumer protection agency that banned “liar’s” loans would have prevented the bubble from hyper-inflating. Banning liar’s loans would have caused the bubble to collapse far earlier when it would have caused far smaller losses. A consumer protection agency that banned perverse compensation systems that generate Gresham’s dynamics would prevent “echo” fraud epidemics and greatly reduce losses. Note that this would aid not only consumers but also honest businesses. George Akerlof explained this point in his famous 1970 article on markets for “lemons” (which led to the award of the Nobel Prize in Economics). Appropriately designed consumer protection regulation and prosecution of control frauds is essential to ensure that honest businesses, not cheaters, prosper.
“The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”
As OMB director, Daniels got wrong all the important OMB decisions that contributed to the developing financial crisis. He could not conceive of the vital need for the OMB to insist that the federal banking regulatory agencies regulate and enforce the laws effectively to protect consumers. He stood by and cheered while:
Does the fact that most important government and corporate decisions are made without relying on formal benefit-cost analyses conducted by economists mean the military does not think about costs and benefits of different missions, equipment, and doctrine? No. Economists produce one variant of benefit-cost analysis – a variant that is not remotely universally useful for analyzing the most important issues a government faces. Indeed, very few business decisions are made on the basis of formal benefit-cost studies conducted by economists.
There is no logical or experiential basis for making OMB a super-regulator. It lacks substantive competence and, as Daniels’ exemplifies, it is driven by unconscious biases that cause it to make consistent errors that would prevent rules with strong net benefits. Its methodology, benefit-cost analysis, is not universally (or even generally) useful even in theory and in practice OMB uses it in a biased fashion due to politics and ideology.
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.
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 www.nytimes.com/2010/08/06/business/06denver.html)
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?