Tag Archives: regulation

What Banks Should Expect in the Future

By William K. Black

Bill talks with CCTV America about the future expectations for Banks.

Debt Obligations and the Need for Regulation

By Dan Kervick

Brad DeLong says he often wondered why Milton Friedman was willing to accept the need for government regulation in the world of money and banking, but not elsewhere:

In my rare coffees and phone calls with Milton Friedman, I found I could distract him whenever I was losing an argument by saying: “Why is it that the government needs to intervene and keep the flow of liquidity services provided to the economy growing along a smooth path? Why must there be a quantitative target achieved by government for the path of the liquidity services industry–commercial banking–when there must not be a quantitative target for kilowatt hours or freight-car loadings?”

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Discrediting Regulation: from George Stigler to Tyson’s Fraud-Free Carbon Tax Fantasy

By William K. Black
(Cross posted at Benzinga.com)

Laura D’Andrea Tyson (President Clinton’s principal economist) has written an ode to a “carbon tax” that does not acknowledge a single disadvantage or substantive (as opposed to political) concern with such a tax.  A carbon tax can have advantages, but her article oversells the idea and ignores the severe concerns about such a tax.  Her article demonstrates why the Clinton administration’s anti-regulatory and fiscal policies helped sow the seeds of ongoing financial disaster.  (The Bush administration watered and fertilized those seeds and we all reaped the whirlwind.)

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NEP’s Bill Black Appears on Tell Somebody

Bill Black appeared on the June 11, 2013 pledge drive edition of Tell Somebody. The topics of discussion were economics and regulation. You can listen here.

Ideology trumps science and blocks regulation

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.

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Time to Take off the Blinders about Obama Taking off the Gloves

By William K. Black

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.”

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Embedded Examiners always married the Natives, but now their Bosses Do Hook Ups

By William K. Black
(Cross-posted from Benzinga.com)

Jessica Silver-Greenberg and Ben Protess have written an extraordinarily important column for the New York Times about embedded examiners at JPMorgan.

Embedded examiners’ are federal regulators whose normal work station is a desk at the bank.  We only embed examiners for systemically dangerous institutions (SDIs) – banks so large that they pose a systemic risk to global economy.

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“The only winning move is not to play”—the insanity of the regulatory race to the bottom

By William K. Black

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).

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Bluto: Please Smash the Guitar and End the Bipartisan Deregulatory Kumbaya Chorus

By William K. Black
(Cross-posted from Benzinga)

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.

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

By William K. Black 

(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.

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.