Monthly Archives: January 2011

William Black featured in NY Times Op-Ed Debate – Was the Financial Crisis Avoidable?

William K. Black was featured recently in the New York Times Opinion pages. His portion is re-posted below. For the full debate go here.

We know the financial crisis was avoidable because we avoided a financial crisis in 1990-1991 by properly supervising the savings and loans.

“Liar’s” loans, the same loans that drove the current crisis, surged in California in those years until we in the Office of Thrift Supervision’s West Region killed such loans by normal regulatory means. It didn’t take sophisticated financial analysis to predict that loans made without any meaningful underwriting by the mortgage lender should be prohibited.

We have known for decades that the senior officials of banks making liar’s loans are essentially engaged in what white-collar criminologists call “accounting control fraud” and economists call “looting.” Here’s the recipe that maximizes short-term reported (fictional) income and the C.E.O.’s compensation:

1. Grow massively
2. By making liar’s loans at a premium yield (interest rate)
3. With extreme leverage (debt), while
4. Providing only trivial loss reserves relative to inevitable massive losses.

Liar’s loans are ideal for this fraud scheme because the only way large numbers of lenders can grow massively at premium yields is to lend to borrowers who will often be unable to repay the loans. A liar’s loan, by definition not underwritten, means that nobody checks the loan brokers’ lies about the borrowers’ stated income. There’s no audit trail proving the lender’s officers knew they were making a fraudulent loan. A lender that follows the four-part recipe is guaranteed to report record short-term income and maximize the chief executive’s compensation. The same recipe guarantees record real losses. The lender fails but the C.E.O. walks away from the toxic waste site a wealthy man.

When we cracked down in the early 1990s on fraudulent S&Ls making liar’s loans, they escaped our jurisdiction by starting uninsured mortgage bankers. Congress, however, promptly closed this regulatory black hole by passing the Home Ownership and Equity Protection Act of 1994, which gave the Fed regulatory authority to prevent abuses by any mortgage lender. Alan Greenspan and Ben Bernanke, however, refused to use the act’s authority to stop liar’s loans despite repeated warnings of the coming disaster.

The F.B.I. warned in September 2004 that mortgage fraud was “epidemic” and predicted that it would cause an “economic crisis.” In 2006, the mortgage industry’s own anti-fraud experts warned that liar’s loans had a fraud incidence of 90 percent because they were “an open invitation to fraudsters.” The lenders reacted to the warning by greatly increasing the number of liar’s loans.

Credit Suisse reported in early 2007 that 49 percent of new mortgage originations in 2006 were liar’s loans. That means that more than a million fraudulent loans were being made each year and that liar’s loans were causing the bubble to hyper-inflate. Federal regulators and the Securities and Exchange Commission also could have stopped liar’s loans and toxic derivatives supposedly backed by liar’s loans. But the Bush administration appointed senior anti-regulators who did not believe that fraud could be a serious problem, so the regulators refused to act.

In 2008, after it was useless, the Fed finally, under Congressional pressure, used its Home Ownership and Equity Protection Act authority to ban liar’s loans. If it had used its regulatory authority in a manner similar to how we used our authority in 1991 there would have been no financial crisis in the U.S. and no Great Recession.

How can the Architects of the Crisis Investigate it?

By William K. Black

The Financial Crisis Inquiry Commission (FCIC) issued its report today on the causes of the crisis. The Commissioners were chosen along partisan lines and the Republicans, one-upping the Republicans’ dual responses to President Obama’s State of the Union address, have issued three rebuttals. The rebuttals follow a failed preemptive effort by the Republicans to censor the report – they insisted on banning the use of the terms “shadow banking system” (the virtually unregulated financial sector that conducts most financial transactions), “Wall Street,” and “deregulation.” The Republicans then issued their first rebuttal last month, their “primer.” The primer, following the lead of the censorship effort, ignored the contributions that the shadow banking system, Wall Street, and deregulation made to the crisis. The combination of the demand that the report be censored and the primer’s crude apologia critical role that the unmentionable Wall Street, particularly its back alleys (the unmentionable “shadow banking system”), and the unmentionable deregulators played in causing the crisis was derided by neutrals. The failure of their preemptive primer has now led the Republican commissioners to release two additional rebuttals to the Commission report. Again, they issued their rebuttals before the Commission issued its report in an attempt to discredit it.

The primary Republican rebuttal was issued by Bill Thomas, a former congressman from California and the vice chairman of the commission; Keith Hennessey, who was President George W. Bush’s senior economic advisor, and Douglas Holtz-Eakin, who was an economic advisor to President Bush on the regulation of Fannie and Freddie and principal policy advisor to the Republican nominee for the President, Senator McCain.

Republican Commissioner Peter Wallison felt his Republican colleagues’ dissent was insufficient, so he drafted a separate, far longer dissent. Wallison is an attorney who was one of the leaders of the Reagan administration’s efforts to deregulate financial institutions and later became the leader of the American Enterprise Institute’s (AEI) deregulation initiatives. His bio emphasizes his passion for financial deregulation.

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.

Each of the Republicans commissioners was a proponent of financial deregulation and was appointed to the Commission by the Republican Congressional leadership to champion that view. Three of the Republican commissioners were architects of financial deregulation. For example, the Republican congressional leadership appointed Wallison to the commission because they knew that he was the originator and leading proponent of the claim that Fannie and Freddie were the Great Satans that had caused the current crisis. The fourth member, Representative Thomas, voted for the key deregulatory legislation when he was in Congress and was a strong proponent of deregulation.

The Republican commissioners’ desire to ban the use of the word “deregulation” in the Commission’s report is understandable. There was no chance that they would support a report that explained the decisive role that deregulation and desupervison played in making the crisis possible. Wallison was a major architect of three successful anti-regulatory pogroms (primarily, but not exclusively, led by Republicans) that created the criminogenic environments that led to our three most recent fraud epidemics and financial crises (the S&L debacle, the Enron era frauds, and the current crisis). The Republican congressional leadership appointed Wallison to the Commission in order to place the nation’s leading apologist for deregulation in a position where he could defend it. President Bush appointed Harvey Pitt to be SEC Chairman because he was the leading opponent in America of the SEC Chairman Levitt’s efforts to make the SEC a more effective regulator. In each case, “mission accomplished.”

Each of the Republican commissioners was in the impossible position of having to investigate and judge their own culpability for the crisis. The Republican politicians who selected them for appointment to the Commission knew that they were placing them in an impossible position and ensuring that the Commission would either give deregulation a pass or split along partisan lines and lose some of its credibility. The proverbial bottom line is that the Commission would fail to identify the real causes of the crisis and the control frauds that drove it would continue to be able to loot with impunity.

In contrast, only one of the six Democratic commissioners was involved in financial institution regulation or deregulation. None of the Democrats was known as a strong proponent of any particular view about the causes of the crisis prior to their appointment. Brooksley Born was head of the Commodities Futures Trading Commission (CFTC) under President Clinton. She famously warned of the systemic risks that credit default swaps (CDS) posed. Her efforts to protect the nation were squashed by the Commodities Futures Modernization Act of 2000, which deliberately created regulatory “black holes” by removing the CFTC’s authority to regulate many trades in financial derivatives. Enron exploited one of these black holes to create the California energy crisis of 2001. The largest banks and AIG exploited the black hole to trade CDS. While the squashing of Brooksley Born was a bipartisan effort (Senator Gramm and Alan Greenspan were the most prominent Republicans in the effort), it was led by the Clinton administration – Messrs. Rubin and Summers at their arrogant, anti-regulatory worst.

By appointing Born to the Commission, the Democrats were admitting their error and ensuring that one of the Democratic Party’s great embarrassments – passage of the Commodities Futures Modernization Act – would be exposed. The Democrats were fostering rather than seeking to forbid discussion of their dirty laundry by appointing someone with a proven track record of taking on her own party.

In 1999, Born resigned as CFTC Chair. She retired from her law firm in 2002. She did not influence or seek to influence regulatory policy role during the crisis. She was not active in making comments about the causes of this crisis prior to her appointment to the Commission.

The next, nastier stage in the Republican apologia for Wall Street and the anti-regulators has already begun. Bloomberg reports that House Oversight Committee Chairman Issa claims to be:

“looking into allegations of partisanship, mismanagement and conflict of interest at the commission. The California Republican and two other lawmakers sent a letter yesterday renewing a demand for documents on the panel’s spending, its use of media consultants and its staff turnover.”

Issa is a deeply committed anti-regulator. He will not be investigating the allegations of partisanship and conflicts of interest by the Republican commissioners who have exemplified partisanship and who are in the impossible position of having to examine their own culpability for the crisis. He will seek to discredit any report and any expert who explains why financial deregulation and desupervision are criminogenic.

The most important question we must answer about our financial crises is actually a two-part question: why are we suffering recurrent, intensifying crises? To answer it we must find not only the causes of the crises, but also (and even more importantly) why we fail to learn the correct lessons from the crises and keep making even worse policy mistakes. The answer to the second question is dogma. The definition of dogma is that it cannot be examined or changed – except to become even purer. The ever purer anti-regulatory dogma creates the ever more intensely criminogenic environments that produce intensifying crises. The Commission’s report makes that clear. For example, Alan Greenspan claimed that markets automatically exclude fraud. He did so after the most notorious “accounting control fraud” of the S&L debacle (Charles Keating) used him to praise his fraudulent S&L, leading to the most expensive failure in the entire debacle. Greenspan learned nothing useful from the S&L debacle. He concluded that there was no reason for the Fed to use its unique authority under HOEPA to stop the pervasively fraudulent “liar’s” loans that were hyper-inflating the real estate bubble and leading us to a crisis. Greenspan ignored the FBI’s September 2004 warning that mortgage fraud was becoming “epidemic” and would cause an “economic crisis.” This anti-regulatory dogma that Greenspan exemplified spread through much of the Western world, and the resultant crises have done the same.

We are witnessing in the multiple Republican apologias for their anti-regulatory policies an example of why we fail to learn the correct lessons from the crises. The groups most in the thrall of the dogma appoint true believers in theoclassical economics to the body that is supposed to find the truth. These anti-regulatory architects of the crisis then purport to be impartial judges of the causes of the crisis that they helped create. The Republican House leadership now openly threatens to use aggressively its subpoena authority to bash anyone who dares to oppose the dogma and the Republican effort to censor the decisive role the anti-regulators play in causing our recurrent, intensifying crises.

The Commission is correct. Absent the crisis was avoidable. The scandal of the Republican commissioners’ apologia for their failed anti-regulatory policies was also avoidable. The Republican Congressional leadership should have ensured that it did not appoint individuals who would be in the impossible position of judging themselves. Even if the leadership failed to do so and proposed such appointments, the appointees to the Commission should have recognized the inherent conflict of interest and displayed the integrity to decline appointment. There were many Republicans available with expertise in, for example, investigating elite white-collar criminals regardless of party affiliation. That was the most relevant expertise needed on the Commission. Few commissioners had any investigative expertise and none appears to have had any experience in investigating elite white-collar crimes. These Republicans, former Assistant U.S. Attorneys (AUSAs) and FBI agents would have played no role in the financial regulation or deregulation policies in the lead up to the crisis. They would not have had to judge their own policies and they would have brought the most useful expertise and experience to the Commission – knowledge of financial fraud schemes and experience in leading complex investigative and analytical skills.

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.

President Obama: “We do big things”

By William K. Black

President Obama’s State of the Union address stressed how we should be training future scientists and engineers.

And over the next ten years, with so many Baby Boomers retiring from our classrooms, we want to prepare 100,000 new teachers in the fields of science, technology, engineering, and math.

In fact, to every young person listening tonight who’s contemplating their career choice: If you want to make a difference in the life of our nation; if you want to make a difference in the life of a child – become a teacher. Your country needs you.

Obama correctly identified a critical need and stated that we must make dramatic changes to meet the need. Are we acting to add 100,000 (net) new teachers in those fields? Obama emphasized in his address that we need to respect teachers. So let’s ask the teachers what is happening. On May 27, 2010, the National Education Association warned.

Without $23 billion from Congress to keep public schools running next fall, 300,000 teachers … and support professionals will lose their jobs.

Everyone knew that the Great Recession would cause a disaster at the state and local government level because states and localities cannot run substantial deficits. Recessions cause tax revenues to fall and needs for social services to rise. In a Great Recession both effects are severe. School districts suffer the worst when home prices (and property tax revenues) fall after the collapse of the largest bubble in history. Virtually all economists support automatic stabilizers at the federal level, which reduce the length and severity of recessions and inflation. We want the federal government to spend in a countercyclical fashion, particularly during a serious recession. The federal government should increase its expenditures while tax revenues fall. Substantial federal deficits are vital and desirable to reduce the harm and length of recessions. Indeed, the automatic stabilizers are not large enough on their own against a severe recession. One of the reasons the automatic federal stabilizers are not large enough is that state and local financing is pro-cyclical. States and localities cut their expenditures and employment during a recession. That pro-cyclical pattern seriously reduces the anti-cyclical nature of the federal government’s expenditures. The result is that recessions last longer and are more severe. But another set of results is that state and local governments add to unemployment and reduce vital services.

There was an obvious, elegant answer to this suggested by many of us – revenue sharing. To its credit, the Obama administration proposed that answer as part of its stimulus bill. Revenue sharing was a good old-fashioned Republican idea (President Nixon). It would have prevented the terminations of over 100,000 teachers and hundreds of thousands of other public employees, including police officers. It would have reduced the severity and length of the recession. It was a win-win-win. Naturally, conservative Democrats (Blue Dogs) and Republicans decided to oppose revenue sharing. Had Obama fought for revenue sharing he would have developed tens of thousands of local government allies. He would have had the support of the great bulk of economists. Instead, Obama folded on a winning hand without a fight.

Obama premises our national strategy on education and research. That strategy is premised on hiring 100,000 new teachers. Instead, we are firing up to 300,000 teachers. And Obama’s answer to closing up to a 400,000 teacher gap – essential to the success of his entire strategy – is to encourage students to become teachers. What he doesn’t propose is anything that would give the school districts the money to retain and hire the 400,000 teachers. One of Obama’s applause lines was: “We do big things.” Yes, that is part of what has made America great. Indeed, we do giant things. Obama’s address was his chance to set out the big things he would do. We got instead an aspiration: “we want to prepare 100,000 new teachers….” Budgets are policies made real. If you don’t have a plan to get the money, what you “want” doesn’t happen. Obama isn’t even trying to get the additional money to the states and localities. He’s freezing those kinds of federal expenditures.

Obama also froze federal employees’ salaries, knowing that it will put political pressure on states and localities to freeze their employees’ salaries. How are we going to recruit “100,000 new teachers in the fields of science, technology, engineering, and math” when we’re firing hundreds of thousands of teachers and freezing the salaries and cutting the pensions of those that stay? Those four fields are highly sought after and command premium salaries in the private sector. Under Obama’s proposal to greatly increase research grants in science and engineering those salaries will rise materially. The gap between teacher salaries and private sector salaries in those four fields, already large, will increase sharply. The school districts are in acute financial distress. No one believes they can afford to raise salaries to compete with the private sector in these fields without large increases in federal aid.

Obama’s plan to increase college graduates also fails to live up to the promise that “we do big things.”

Of course, the education race doesn’t end with a high school diploma. To compete, higher education must be within reach of every American. That’s why we’ve ended the unwarranted taxpayer subsidies that went to banks, and used the savings to make college affordable for millions of students. And this year, I ask Congress to go further, and make permanent our tuition tax credit – worth $10,000 for four years of college.

Many students are graduating with over $100,000 in student loans and Obama’s answer is a tax credit “worth $10,000.” Not $10,000 annually – total. It’s a very bad thing when Obama knows he needs to come up with a “big thing”, tries to think of a “big thing”, and the only thing he can come up with is a small thing. Obama’s education plan is far superior to the Republican’s, but it is puny compared to the scale of the problem he sets out. A bold scholarship program would ensure that no student who had the ability to succeed would be denied a collegiate education.

Why our Fundamental Approach to Banking Regulation is Inherently Unsound

By William K. Black

(cross-posted with

Greetings from the North American Securities Administrators Association (NASAA) annual enforcement conference in Charleston, S.C.  I’m giving the keynote address Monday.  I’ll discuss the NASAA members’ exceptionally important and often effective role against securities fraud in future columns.  This column, however, deals with “safety and soundness” banking regulation.   
Our current approach to banking regulation exposes us to recurrent, intensifying financial crises.  The good news is that because we reached an all time low in Basel II, Basel III almost has to be an improvement. The bad news is that Basel III has not reexamined the fundamental assumptions underlying the Basel process.  As a result, Basel III will be a variant on the common ineffective theme of banking regulation designed by economists and the industry.  

The Basel process is built upon three flawed assumptions. 
1.      Capital requirements are the ideal form of banking regulation.
2.      Capital requirements can be set without establishing sound accounting.
3.      Accounting control fraud is not a serious concern.
Capital requirements are the ideal form of banking regulation under conventional economic wisdom.  The attraction of capital requirements to neoclassical economists is elegance.  Their theory is that while private market discipline ensures that normal corporations are inherently safe, private market discipline poses an inherent dilemma for banks.  A bank run is a form of form of private market discipline.  Banks have very short-term liabilities and longer-term assets.  This exposes them to interest rate risk and liquidity risk.  A run is the ultimate liquidity nightmare for a bank.  The conventional economic wisdom is that runs are not a desirable form of market discipline.  Economists tend to use the word “panic” when they describe runs.  Economists fear that depositors are likely to be financially unsophisticated and to start runs on banks on the basis of false rumors that the banks are unsound.
Deposit insurance is designed to prevent depositors from engaging in private market discipline.  The insurance limit is often set at a sufficiently high amount that the overwhelming bulk of depositors’ accounts are fully insured – minimizing private market discipline.  Central banks often provide a “lender of last resort” facility to allow the central bank to trump any run.  Many nations with advanced economies are so opposed to runs that they provide both deposit insurance and a lender of last resort facility through the central bank.   
The conventional economic wisdom is that deposit insurance renders private market discipline ineffective because banks’ principal creditors are fully insured depositors.  It is expensive for creditors to undertake the monitoring and analyses required to impose effective private market discipline, so fully insured depositors should not discipline banks.  The conventional economic wisdom has a further prediction:  the absence of private market discipline will increase the risk of moral hazard.  The conventional theory gets quite fuzzy at this point about how moral hazard works, a point I return to below, but it predicts that moral hazard can lead banks to take excessive risks.  The conventional economic wisdom further predicts that imposing adequate capital requirements will successfully constrain moral hazard.  As long as the shareholders’ have material capital at risk of loss should the bank fail they will not cause the bank to take excessive risks.  The shareholders’ incentives will be aligned with that of the public and the banks’ creditors as long as the bank meets its capital requirement.  The conventional wisdom, therefore, requires that the regulators force the bank to be promptly recapitalized or closed if it fails to meets its minimum capital requirement.     
The above analysis begins to explain why the conventional economic wisdom is that capital regulation is the optimal form of bank regulation.  The key is the alignment of shareholder’s interests with the public interest, but capital also provides a buffer against loss to the insurance fund and the taxpayers.  When the incentives are right there is little or no need for additional regulation.  Any rules that constrained bank decision-making (when the incentives were correct) would constitute the regulators substituting their business judgments for those of the banks’ officers.  The conventional economic wisdom asserts that private sector business judgments are vastly superior to regulatory decision (Easterbrook & Fischel 1991).  It follows that the conventional economic wisdom was that the banking regulators that regulated the least produced the best banking results.  Increased regulation did not simply increase cost; it increased the risk of banking failures and crises.  Less banking regulation allowed financial intermediaries to be more efficient and increased economic growth. 
James R. Barth, Gerard Caprio Jr., and Ross LevineBank regulation and supervision: what works best?  Journal of Financial Intermediation 13 (2004) 205–248; Barth, J.R., Caprio Jr., G., Levine, R., 2001a. Banking systems around the globe: Do regulations and ownership affect performance and stability? In: Mishkin, F.S. (Ed.), Prudential Supervision: What Works and What Doesn’t. Univ. of Chicago Press, pp. 31–88.
(Barth and his colleagues eventually differed from the conventional economic wisdom in being skeptical even of capital regulation of banks and urging greater reliance on private market discipline of banks.)
The conventional economic wisdom also claimed that small levels of reported capital were sufficient to create the desired incentives among shareholders.  In a bubble, bank loan losses are normally greatly reduced.  Economists began to argue that the lower the banks’ capital requirement the greater the amount of productive loans that would be made and the faster the economy would grow.  Basel II substantially reduced capital requirements.  
The fundamental disconnect with making capital requirements the pillar of banking regulation is that “capital”, “net worth”, and “equity” are accounting concepts.  They have no meaning outside of accounting.  Worse, they are all residual accounting concepts.  Accountants do not, and cannot, count a modern bank’s “capital.”  They determine assets and subtract liabilities to determine capital.  The implication of that is that the accuracy of reported “capital” depends on the accuracy of the valuation of every asset and liability.  That means that capital is not only an accounting concept, but the accounting concept most subject to error.  For a large bank, there are literally tens of thousands of ways to use accounting to distort reported capital by enormous amounts.  Beyond the obvious – understate liabilities and overstate asset values – banks are the perfect vehicles to self-fund “capital.”  Accountants do purport to count “capital” when there is a purchase of newly issued stock or a capital contribution.  Savings and loans and the Big Three Icelandic banks self-funded the purchase of newly issued stock by insiders, cronies, and shills.  Anglo-Irish Bank self-funded the purchase of shares from a distressed shareholder to prevent the sale of a large block of shares in the market.     
Banks can self-fund purported “capital contributions.”  The person controlling the bank, for example, can purport to contribute $10 million in capital to the bank by contributing real estate (improperly) valued at $25 million to the bank and receiving $15 in cash from the bank.  If the real estate actually has a market value of $10 million he will make a profit of $5 million.  The bank will suffer a real loss of $5 million but will falsely report that its capital has increased by $10 million.   Its capital will be overstated by $15 million.
Banks also self-fund reported “income,” which can flow through to capital.  I discuss this in more detail below, but the overall result that needs to be understood is that self-funding can be used to report guaranteed, record income and capital.
All of this means that accurate accounting is essential for banking regulation premised on capital requirements to succeed.  The Basel process relies primarily on capital regulation, but ignores the accounting games that allow banks to create their reported capital.  Bank examination and supervision, globally, puts only minimal emphasis on accounting in the era leading up to the crisis.     
The failure of Basel and the regulators to make accurate bank accounting their central priority would be dangerous even if accounting control fraud did not exist.  In the world of modern finance where accounting is the “weapon of choice” for control frauds, the failure to take accounting seriously was catastrophic.  The four-part recipe that bank control frauds use to produce guaranteed, record fictional short-term income turns regulatory regimes based on capital regulation profoundly perverse.  
1.      Grow extremely rapidly
2.      By making loans to the uncreditworthy at premium yields
3.      While employing extreme leverage
4.      While providing only trivial loss reserves (ALLL)
Akerlof & Romer (1993) emphasize that accounting fraud is a “sure thing.”  If a bank can produce guaranteed, record income then it can appear to be healthy.  Regulators are taught to worry about banks showing losses – not record gains.  A bank reporting record income can pay its controlling officers huge compensation and still have plenty of fictional net income to flow through to fictional capital.  Regulators are taught to believe that firms reporting adequate capital have the correct incentives and have a buffer that will protect the FDIC against losses. 
The fictional increase in income and capital makes it easy for the bank to meet the first ingredient – extremely rapid growth.   It also makes the regulators feel comfortable about the bank employing extreme leverage.  The fourth ingredient is an essential ingredient of accounting control fraud.  The first three ingredients maximize real losses.  The expected value to the bank, for example, of making liar’s loans is sharply negative.  That means that the loss reserves (ALLL) that the bank should establish under GAAP should exceed the net income from the loan (i.e., the loss reserves should be large enough that the lender recognizes a loss on the liar’s loans when they are originated).  That would have meant ALLL provisions in the 20% range for liar’s loans.  Instead, ALLL fell each year in the peak of liar’s loan originations to roughly one percent.
Basel III is premised on the assumption that raising capital requirements will greatly reduce the risk of future failures and crises.  One can understand the logic.  Basel II reduced capital requirements and failed banks followed extreme leverage.  Special investment vehicles (SIVs) employed exceptional leverage and many SIVs failed.  The regulators are correct that leverage matters – it is the third ingredient in the lenders’ accounting fraud recipe.  What the regulators have not taken into account is a series of means of gaming reported capital that render capital requirements malleable.  Instead of correcting these accounting abuses they have stood by, or in the case of Ben Bernanke encouraged, the destruction of the remaining integrity of accounting standards.  Bernanke encouraged the Chamber of Commerce and the banking lobbyists to use their political allies to extort the Financial Accounting Standards Board (FASB) to junk the rules requiring banks to recognize their losses.  This massively overstates asset valuations, which massively overstates reported capital – evading the requirements of the Prompt Corrective Action law.  It also overstates income, allowing bank officers to enrich themselves through bonuses they had not earned.  Having just gimmicked the accounting rules to achieve their goals of covering up the scale of the crisis (and claiming to have “resolved” the crisis for a pittance), it is bizarre that the banking regulatory agencies treat capital requirements as if they had meaning independent of accounting.  A sound system of banking regulation cannot be based on capital regulation as it is conceived in the Basel process.

How to Regulate Mortgage Lending, Part 3

By William K. Black

(cross-posted with

Honest accounting is essential for effective regulation – and for integrity. It is also very helpful to prosecuting accounting fraud. The banking industry lobbyists, including the Chamber of Commerce, with Bernanke’s support, induced the House to extort successfully the Financial Accounting Standards Board (FASB) to gimmick the accounting rules so that banks would not have to report their losses. This accounting scam was implemented in order to gut the Prompt Corrective Action law (which the Bush and Obama regulators wished to evade) and allow the banks controlling officers to pay themselves and their officers billions of dollars of bonuses to which they were not entitled. This shameful act makes it far more difficult for regulators to take effective action against fraudulent and incompetent bankers. It is essential that we restore honest accounting. Indeed, it is vital that the SEC, the PCAOB, and FASB clean up existing accounting defects, such as the endemic failures to provide remotely adequate loss reserves (ALLL) for mortgage loans, CDOs, and CDS. (The international accounting rules are being interpreted even worse – abusive accounting is an open invitation to accounting control frauds.)

The only effective way to implement such a sea change in regulatory mindset is with new leadership. The Obama administration has largely left in place Bush’s failed regulators like Dugan (OCC), reappointed failed regulators like Bernanke (Fed), appointed failed regulators like Shapiro (SEC), and promoted failed regulators like Geithner (Treasury). There are financial regulators with a track record of success, regulators who public administration scholars use as exemplars in their writings of effective regulatory leadership. To my knowledge, the Obama administration has appointed none of them and consulted none of them as to the lessons they learned about what worked and what failed. The exception is Paul Volcker, who was never an “in the trenches” regulator, but who is certainly brilliant. He prompted passage of the Volcker Rule in the Dodd-Frank Act. Larry Summers, according to published accounts, deliberately marginalized and excluded Volcker in order to minimize his ability to influence President Obama. Rubin and his protégés fear a real regulator investigating the banks whose nonprime loans and CDOs drove the crisis. Rubin’s personal nightmare is a vigorous investigation of Citicorp. Any real regulator would make that nightmare a reality within a week. The chances that the administration will appoint a senior banking regulator with a track record of success remain small.

How to Regulate Mortgage Lending, Part 2

By William K. Black

(cross-posted with

When Reputation becomes Ineffective or even Perverse

Control fraud also makes reputation perverse. Theoclassical economists predict that reputation trumps everything, even auditors’ conflicts of interest. This prediction has repeatedly been falsified by reality. The asserted reputational trump ignores crippling errors. Several theoclassical assumptions about reputation and fraud are implicit and interrelated. Implicit assumptions pose the greatest risk of error because the people making the assumption never had to defend the unstated assumptions. Reputation and fraud turn out to have an important, and complex, relationship. One cannot understand reputation without understanding fraud techniques. Common theoclassical assumptions, most of them implicit, about fraud and reputation include:

• An individual has a consistent set of behaviors that drive his reputation

• The public’s perception of an individual’s reputation is accurate

• Members of the public have a consistent perception of an individual’s reputation at any given time

• A good reputation can only be achieved through consistent good deeds

• Fraud is discovered because of its very nature

• Fraud is discovered because of “private market discipline”

• The people who lead frauds are discovered

• The people who lead frauds are sanctioned so that fraud does not “pay”

• All other market participants that might deal with the entity will learn promptly that it has engaged in fraud

• Other market participants will not aid or permit fraud by another party

• Other market participants will not deal with an entity with a reputation for acting fraudulently even if the entity has not (yet) defrauded those market participants

• The people who lead frauds suffer disabling damage to their reputation that makes it impossible for them to commit future frauds even if they are not sanctioned

• Elite financial firms and independent experts will not commit, aid, or permit frauds because of their interest in their reputations

• Elite financial firms and independent experts would lose their valuable reputations if they committed, aided, or permitted frauds

• The least likely persons to commit frauds in elite institutions are their senior leaders

• When CEOs set a “tone at the top” that tone emphasizes integrity and reputation

White-collar criminologists have found that each of these assumptions is unreliable. Economists rarely study fraud or read the criminology literature, yet they often have powerful ideological “priors” about fraud. Easterbrook & Fischel (1991), the deans of applying law and economics to the study of corporate law, exemplify each of these characteristics. They assert that “a rule against fraud is not an essential or … an important ingredient of securities markets.” That assertion is remarkable for its certainty, lack of exceptions, and certitude. It would be wonderful if the assertion were true. Fraud, one of history’s great scourges, would (like polio) be eradicated. Financial markets would be efficient. Bubbles would be much rarer and far less severe. Unfortunately, the assertion is also unsupported and unsupportable. Fischel was an expert for three notorious control frauds during the S&L debacle, where he employed the theories he and Easterbrook would soon write about in their 1991 treatise containing their remarkable assertion.

Individuals, entities, society, and market participants are all far more complex than theoclassical economists assume. It is normal that the same person is perceived differently by every person with a perception, and those differences can be polar. “Fraud” is one of the most variegated of activities. One common characteristic, however, is that fraudsters do not rely on fooling everyone. Many successful frauds, such as the Nigerian “419 frauds”, are obvious to nearly everyone, but “nearly” universal detection of the 419 frauds is not sufficient to prevent them from being profitable. Fraud detection is rarely universal because people vary in their susceptibility and because detection by one person typically fails to spread to most people.

When most people, including economists, think of “fraud” they generalize from what they know from personal life. Nigerian 419 scams, most things advertised on cable television after 10:00 p.m., and con jobs shown on television dramas are what the general public thinks of when they consider “fraud.” The nature of these frauds typically leads the victim to discover (albeit too late) that he has been defrauded. Victims of 419 frauds send “fees” or make “deposits” and do not get the $40 million in funds that the late oil minister allegedly stole from the Nigerian government. The “debt counseling” service charges its victims fees, falsely claims that one need no longer pay one’s creditors and leaves its victims even more insolvent.

These frauds, if they succeed, almost certainly will be discovered by the victim. (There are important exceptions – many fraudsters prey on victims suffering from the earlier stages of Alzheimer’s, those who are functionally illiterate in English, or are incapable of understanding financial matters. Fraudsters profit from their selective reputation with their peers as criminals by selling their mailing lists of vulnerable victims to other fraudsters.) The fraudsters who run the 419 and debt counseling scams know that most of their victims will become aware that they were defrauded. The fraudsters also know that they can continue to defraud others even though the victims learn that they were defrauded and even if the government closes their business. Entry is exceptionally easy for each of these common frauds. If the government shuts down a debt counseling scam it can create a new name and be in operation again within a week. If the fraudulent CEO were banned from the industry he would recruit someone to serve as his “straw” and be back in operation within a week.

Victims of some common, unsophisticated frauds typically do not discover that they have been defrauded. The classic example is the scam drug that promises to enlarge the penis. The victim buys the drug. He is desperate for the drug to work. It is easy for the victim to believe that the drug is working. The alternative is to feel inadequate, hopeless, and made a fool of by a con. This fraud illustrates a key point; an “unsophisticated” fraud can be highly successful because it rests on an insightful understanding of human nature and vulnerabilities.

Accounting control frauds closely approximate the perfect crime. To be a nearly perfect crime a control fraud must reduce the risks of regulatory and prosecutorial sanctions. They are normally not identified as frauds. Even when they are identified as frauds they are normally not sanctioned. Instead of destroying the CEO’s reputation, accounting control fraud normally creates the CEO’s undeserved reputation as a “genius.” This is a subject deserving of extended treatment in future columns, so I will only summarize the key points here in the context of mortgage lending.

• Everyone is reluctant to view a seemingly legitimate lender as a criminal enterprise

• The fraudulent CEO increases this reluctance by mimicking many corporate mechanisms

• No overt conspiracy is required – the CEO creates the perverse incentives and uses his ability to hire, promote, compensate, discipline, and fire to ensure that the recipe will be implemented at the firm and by its loan brokers and that the independent experts will bless the fraudulent valuations and loss reserves

• The CEO can quickly convert large amounts of firm assets to his personal benefit –sufficient to make him wealthy – through seemingly normal corporate compensation mechanisms driven by the record (fictional) income generated in the short-term by employing the recipe

• If there is a bubble, particularly one hyper-inflated by an epidemic of accounting control fraud, then the lender’s bad loans can be refinanced and the record income created by the recipe can be continued beyond the short-term

• The firm fails eventually, but a CEO can always offer a non-fraudulent explanation for a bank failure. This is particularly true when an epidemic of accounting control fraud hyper-inflates a bubble and triggers a severe recession.

Control frauds exploit “agency” problems in order to turn reputation perverse. The Big Four audit firms do have a substantial financial interest in their reputations. The Big Four audit firms are able to charge far more for their audits than can second tier firms. Unfortunately, the more valuable the audit firm’s reputation the more value the audit partner can extract by “selling” that reputation by blessing an accounting control fraud’s financial statements. White-collar criminologists have found that the theoclassical assumptions about top tier audit firms are false.

The most elegant frauds typically signal multiple, conflicting reputations to different actors. The reason a control fraud is so dangerous is that it is a criminal enterprise that appears to be a legitimate enterprise. Indeed, the fraud recipe makes it appear to be an “alpha” bank – exceptionally profitable while suffering few losses despite making highly risky transactions. The CEO who can pull off that impossible trifecta quickly develops a reputation as a “genius.” (He, of course, controls a PR department with essentially unlimited funds that is dedicated to feeding his ego – fraudulent CEOs are human and do not live by yachts alone.)

Obtaining a stellar reputation is one of the greatest attractions of fraud to the C-suite. The portion of C-suite officers who are actually geniuses is vanishingly small. But any C suite officer should have the competence to engage in accounting control fraud. The recipe is straightforward and making huge numbers of bad loans is vastly easier than making huge numbers of good loans. Accounting fraud is a sure thing for a lender. It is a strategy guaranteed to make you wealthy and create a reputation that you are a genius. The desire to attain and retain a highly positive reputation is one of the major contributors to fraud. The best way to become a CEO is to find an industry optimal for control fraud. One of the factors that makes an industry more criminogenic is ease of entry. Anyone with modest net worth could start a mortgage brokerage and become its CEO. States like Florida did not even check if the new CEO had a criminal record. The newly minted CEO could transform himself from a crook to CEO and by following the recipe he could make himself wealthy and gain a positive reputation.

Consider how reputation works when the fraudulent CEO interviews a potential CFO. The CEO wants the CFO to appear to most outside actors to be honest and competent. He wants the CFO to actively assist the accounting fraud by implementing the four-part recipe enthusiastically. The CEO will not hire the applicant unless the CFO-wannabe signals that he is actually a person deserving of a poor reputation for integrity. Once the CFO is hired he may interview the partner at the Big Four audit firm who is seeking to be selected as the audit partner. The CFO of an accounting control fraud and the prospective audit partner will send contradictory signals during the same interview. On one level, they play roles that seem to epitomize professionalism. On another level they carefully send coded signals. The result is effective communication. The control frauds rarely fail to receive clean opinions for fraudulent financial statements even when the bank is massively insolvent, makes hundreds of thousands of fraudulent loans, and violates scores of accounting principles. The control frauds rarely have to fire the audit firm or audit partner. The control frauds do not have to bribe the audit partner, appraiser, or credit rating agency to get them to bless their frauds.

CEOs have their wealth, income, and reputation invested in “their” company. When it is about to fail they may adopt accounting control fraud as a tactic to delay the failure. This is known as “reactive” control fraud.

A fraud I’ve discussed, the Nigerian 419 scam, illustrates another aspect of how frauds manipulate reputation. Consider the multiple levels of reputation involved in this unsophisticated scam. The perps are frauds and deserve a reputation for fraud. To their neighbors, however, they may appear to be honest and have a positive reputation. The perps create a fake identity (e.g., I am the daughter of the late oil minister of Nigeria). The fake identity they construct is that of a corrupt individual of terrible reputation. The paradoxical reason that they construct this terrible reputation is to convey trustworthiness to the victim. You can trust them because they are desperate for your help. They cannot proceed lawfully because they are trying to rip off the Nigerian government. Their message is that there is honor among thieves as long as they need each other. The perps, in turn, are trying to defraud Americans who signal by their responses that they are devoid of integrity and clueless about fraud schemes. If poorly educated, only partially literate Nigerians can understand a subset of Americans that well, think how sophisticated a fraud scheme our elite business school graduates can devise with the aid of a vastly superior weapon of fraud – control of a seemingly legitimate bank.

The CEOs that controlled the fraudulent banks burnished their reputations both to stoke their (and their spouses’) egos and to make it harder for anyone to perceive them as criminals. There are three sure means for CEOs to enhance their reputations. Reporting that your bank earned large profits is certain to prompt praise by business reporters. Causing the bank to make large charitable contributions, which the CEO is credited with providing, is sure to improve one’s social standing. Causing the firm, and its senior officers to make large political contributions is likely to improve the fraudulent CEO’s social standing and political power.

Epidemics of Accounting Control Fraud Hyper-inflate Bubbles

Epidemics of accounting control fraud are not rare. White-collar criminologists use the metaphor that accounting is the “weapon of choice” among financial control frauds. The “ammunition of choice” varies depending on the industry and time period, but it has common characteristics. The ideal asset with which to “load” a lender’s accounting control fraud weapon:

• Lacks a readily verifiable market value

• Has a higher nominal yield

• Can be structured to delay delinquencies and defaults

• Can be sold or retained in portfolio

• Can be refinanced to further delay delinquencies and defaults

• Can be made without documenting that the borrower is uncreditworthy

These characteristics mean that accounting control frauds’ investments are likely to be “lumpy” instead of evenly distributed in many loan categories. Fraudulent lenders are likely to grow overwhelmingly through a few forms of lending that make the most destructive “ammunition.”

When control frauds cluster in a particular asset category they inherently threaten to inflate a bubble. The recipe ensures this for it both requires extreme growth and makes the extreme growth possible – there are tens of millions of potential borrowers who lack the clear capacity to repay the loan.

Lending is often lumpy geographically and scale matters for bubbles. If fraudulent lenders are more active initially in some communities the local bubble becomes self-reinforcing. As the local bubble inflates it becomes easier to attract uncreditworthy borrowers who can hope that rapidly inflating home prices and non-existent underwriting mean that they can qualify for a loan to purchase a house; “flip” the home, and use the profit to be able to afford to purchase a home. Speculators will enter the market and buy multiple homes. They also plan to “flip” the homes, but their goal is profit. Other nonprime lenders will enter the market and mimic the initial frauds’ operations in order to obtain the record “profits” and bonuses. Large numbers of mortgage brokers will start operations and grow rapidly to feed the mortgages to the fraudulent lenders. The greater the fraudulent lenders’ growth rates relative to the size of the local housing market, the faster and greater the local bubble inflates. The bad loans are easily refinanced to minimize reported losses. The result is record reported income and the creation of hyper-inflated local bubbles.

Hyper-inflated bubbles pose systemic risks. They misallocate extraordinary amounts of assets for up to a decade. Markets are intensely inefficient and move ever farther from efficiency. The fraud recipe for maximizing a lender’s reported income actually maximizes losses. This causes massive bank failures and serious losses of employment – producing severe recessions. From a regulatory perspective, hyper-inflated bubbles are particularly dangerous because they can destroy honest banks that had large residential real estate loan portfolios before the bubbles hyper-inflated. If housing market prices drop by 50% in a metropolitan area every portfolio lender is likely to fail. (The frauds, of course, are the villains, but they claim to be victims of the bubble’s collapse.)

Regulating to Counter Accounting Control Fraud Epidemics by Mortgage Lenders

Reducing Crime v. Redirecting Criminals

One of the good news/bad news aspects of criminology is that it is far easier to redirect crime than to reduce it. When I lock my car I don’t make it very difficult to steal. A professional can steal it in roughly 15 seconds. Nevertheless, locking my car materially reduces the risk that my car will be stolen. Defeating my lock requires a tool and some suspicious behavior on the part of a professional and many cars are stolen by amateurs. When I lock my car I redirect potential thieves towards easier prospects but I don’t reduce overall car theft.

The good news arising from this discussion of redirecting crime, from the perspective of any particular regulatory agency’s leaders’ reputation, is that he doesn’t have to do all that much to reduce dramatically the risk of an epidemic of accounting control fraud among banks regulated by his agency. If he is materially tougher than other banking regulators he may still face some reactive control frauds among failing banks, but most opportunistic control frauds should choose to have their banks regulated by weaker supervisors.

The supervisory steps that the stronger regulator could take that would best redirect control frauds are not esoteric – they are precisely the measures that a competent banking regulator would put in place. We can determine the steps that would be most effective in preventing a criminogenic environment by considering the implications of the four-part accounting control fraud recipe. Preventing extremely rapid growth, preventing the making of very large amounts of bad loans, preventing extreme leverage, and requiring appropriate loss reserves would all reduce greatly the fictional income reported by and the real bonuses paid to the bank’s controlling officers. (Directly restricting large bonuses to long-term income would be even more effective, but no American banking regulator was willing to even consider doing so prior to 2010.)

Making entry into the industry more difficult would be particularly effective in redirecting control fraud epidemics. The regulatory agency could also make its industry far less criminogenic by being more vigorous in examining and supervising, bringing administrative enforcement actions and civil suits, and by making criminal referrals and working with law enforcement to make prosecutions of senior bank officials engaged in fraud a priority.

Two classic examples of redirection (and the importance of regulatory black holes and ease of entry) arose when I was an S&L regulator. FDIC savings banks suffered lesser losses than S&Ls during the mid-1980s in substantial part because the FDIC’s tougher regulation and supervision meant that the opportunistic frauds entered the S&L industry in 1982-84 rather than the FDIC-regulated savings bank industry.

In 1990-91 the West Region of the Office of Thrift Supervision cracked down on liar’s loans, which were becoming significant among a number of California S&Ls. We recognized that such loans were often fraudulent and inherently unsafe and unsound. Long Beach Savings responded to this supervisory crack down by giving up its S&L charter and becoming a morgage banker to escape our jurisdiction. It changed its name to Ameriquest and became an infamous predatory lender specializing in nonprime lending. One of its leading nonprime competitors was owned and managed by a family that we had forced out of the S&L industry.

Redirection may be part of the explanation of why Canada had fewer problems with its mortgage lenders than the U.S. did during the recent crisis. Mortgage fraud became endemic in the United States due to the operation of the accounting control frauds, but mortgage fraud and accounting control fraud among Canadian banks are reported to be unusual. Two cautions are in order. First, supervision can be so weak that the regulators routinely cover up the control frauds. I do not think that is the case in Canada. Second, Canada did not engage in the radical deregulation and desupervision that the U.S. did. A Canadian of poor integrity and modest wealth could found a loan brokerage firm in Canada or 50 miles away in the United States. Canada may have redirected many of its wannabe banking frauds to the United States.

Our challenge as regulators should be to reduce the frequency and severity of epidemics of accounting control fraud rather than merely redirecting them to another industry or region. In the context of residential mortgage lending, that means that all residential mortgage lenders should be subject to federal regulation for safety and soundness.

A Recipe for Regulatory and Industry Success

Liar’s loans were bad for mortgage lenders, borrowers, and the nation. Effective regulation would have been aided all three groups. Fortunately, we have known for at least a century how to make safe residential home loans. The following rules and laws should be mandatory for residential home lenders:

• Home loans must be fully underwritten

• The minimum requirements of full underwriting – verification of income, employment, credit history, down payment, etc are specified

• The verified underwriting must be contemporaneously documented and the lender must maintain that documentation

• Home loans must be made on the basis of full appraisals

• It is unlawful for any person to inform the appraiser of the loan amount prior to finalizing the appraisal

• It is unlawful for any person to intimidate or bribe or attempt to intimidate or bribe an appraiser in the regard to a real estate appraisal

• It is unlawful to for any private entity to base any aspect of a loan officer or agent’s compensation on the basis of the volume of loans presented, originated, or approved rather than on the quality of the loans

• All residential home lenders are made subject to the regulations that currently mandate that federally-insured institutions file criminal referrals (Suspicious Activity Reports (SARs)) in the circumstances described in those regulations

• The residential home lender must review each outside appraisal for compliance with appraisal standards

• Teaser rates are prohibited

• All borrowers must be underwritten to establish their ability to repay the loan fully at the fully indexed rate without refinancing the loan and without assuming any appreciation of the home

• All home lenders will take steps to check, prior to lending, whether the borrower owns multiple homes and is representing that more than one home will be his principal dwelling

• I will address in future columns documentation maintenance necessary to end the pervasive problems with fraudulent foreclosures and lost or non-existent documents

In addition to these underwriting and documentation reforms, the regulators need to take broader approaches to be effective. First, the staff and leadership need to be trained in accounting control fraud techniques. For example, only fraudulent lenders deliberately inflate appraised values (or permit them to be inflated). Regulators need to understand that when they identify that practice they have identified a fraud that must be stopped urgently. I asked the question years ago in an academic article – why doesn’t the SEC have a “Chief Criminologist”? I made clear that I was only using the SEC as an example of the many agencies whose duties include civil law enforcement. We have seen the catastrophic cost of regulatory ignorance of fraud techniques.

Second, the entire regulatory and law enforcement partnership that proved so successful in responding to the S&L debacle must be reestablished and it must replace the FBI’s “partnership” with the Mortgage Bankers Association – the trade association of the perps. The regulators need to play a critical role in training the FBI agents and Assistant U.S. Attorneys (AUSAs) to identify and investigate accounting control frauds (a capacity that as I’ve just described the agencies will have to rebuild). I’ve described in prior articles how only the regulators can fill the vital role as “Sherpas”, the virtual cessation of the regulators making criminal referrals, and the failure to create any analog to the “Top 100” prioritization effort, so I will not repeat the details in this column.

Third, the agencies must end the “Reinventing Government” mantra that the industry is the regulators’ “customer.” Our only customer is the people of the United States of America. We provide unique benefits to honest banks precisely because our function is not to make bankers happy. Our function is to be skeptical, to speak truth to power, and to be courageous and vigorous against the frauds. To be successful the regulators must think of themselves as the regulatory cops on the beat whose primary function is to see that cheaters don’t prosper. By cracking down on the cheaters we make it possible for the honest bankers to prosper.

Fourth, the regulators need to understand what makes an environment criminogenic and make the prevention of such environments their top priority. This requires a very different way of thinking, particularly for regulators who have drunk deeply of the anti-regulatory ideologies. Executive compensation is typically perversely weighted heavily towards short-term reported income. This not only prompts fraud, but also provides the means of looting. Since the crisis, executive compensation has become even more perverse. Size matters. If the executive compensation for meeting extreme short-term income targets is very large, one year’s compensation can make the CEO wealthy. The fraud recipe makes attaining even extreme short-term income targets a “sure thing.” Every bank CEO can be a genius – for two-to-eight years depending on the size of the bubble.

Compensation for professionals is also perverse and criminogenic. As long as the CEOs get to hire the “independent” professionals they will not be independent. When the bank CEO is a fraud the professionals will be the CEO’s most valuable allies.

Creating a credible regulator/law enforcement partnership makes an industry far less criminogenic (though one must remember the risk of simply displacing crime). I have discussed above how limiting growth and making entry even modestly more difficult materially reduce the risk of epidemics of accounting control fraud.

How to Regulate Mortgage Lending, Part 1

By William K. Black

(cross-posted with

“Regulating” and “deregulating” are terms that often mislead. My next three columns discuss how to regulate two diverse activities that are critical to our economy – residential mortgage lending and starting small businesses. This column explains the most regulatory approaches essential to regulate residential mortgage lending effectively. Next week’s column will discuss why the regulatory approach we have taken and the modifications to that approach contained in Basel III do not provide an inherently unsound regulatory structure. The third column will deal with regulatory structures that aid small business formation.

Regulating Residential Mortgage Lending: Introduction

Effective regulation must begin with the rationales for regulating the activity. The failure to take this approach was critical to the crisis we have just experienced. One of the great failures was assuming that if the lender was not federally insured there was no need for federal regulation. That assumption, in turn, was based on assumptions about the type of institution requiring deposit insurance. Both of those assumptions are large topics with voluminous literatures that will be the subject of future columns. For purposes of this column I assume that we have decided that the federal government should regulate residential mortgage lenders. Most of the principles I discuss also apply to commercial real estate (CRE) lending (which includes loans to build more than four residential units), but CRE has some unique characteristics that warrant a separate column.

This column focuses on safety and soundness regulation as opposed to compliance, but I emphasize that effective enforcement of rules to protect borrowers would have prevented trillions in dollars in losses to lenders. Indeed, that example exemplifies my central point – effective regulation is essential and desirable to protect honest lenders. That does not mean that all regulation is desirable or that more regulation is better than less regulation.

Our central function as financial regulators is to reduce criminogenic environments and prevent epidemics of accounting control fraud. Home mortgage lending is an industry that we know how to do well. Historically, credit losses on home loans – from all sources – have been under one percent. That means that residential mortgage lenders have long understood how to limit fraud losses to well under one percent. The good news is that the same rules that dramatically limit losses from imprudent loans are exceptionally effective in preventing fraud.

U.S. home lenders suffer severe losses in three circumstances: due to sharp, sustained increases in interest rates, accounting control fraud, or the collapse of hyper-inflated residential real estate bubbles. Foreign banks can also suffer severe losses due to currency risk. U.S. mortgage loans are made in U.S. dollars and borrowers’ salaries are overwhelmingly paid in dollars, so this column does not address how regulators should respond to currency risk.

Uncompetitive Lenders

Home lenders can also fail due to poor cost controls relative to their competitors, but these failures do not cause serious losses and do not pose systemic risks. These failures also typically require several years to occur and are simple for the regulators to spot through routine reviews of the banks’ “call reports.” We send examiners in to confirm the reasons the lender’s general and administrative expenses make it uncompetitive, but the problem is almost always weak managerial skills. We try to convince the bank to hire new managers or find an acquirer before the failure. Our great advantage as regulators over other entities that are supposed to correct such problems, e.g., the board of directors or the outside auditor, is that we can be truly independent. The board of directors was picked by the CEO and signed off on the business strategy that is leading the bank toward failure. The audit partner fears that he will lose the client if he gives a negative audit opinion. It is not the auditor’s function to serve as a business consultant. Good regulators can help in this sphere, but this is not the sphere in which we must show great courage and it is not the sphere in which we can prevent hundreds of billions of dollars in losses, Great Recessions, and the loss of over 10 million jobs.

Systemically Dangerous Institutions (SDIs)

The important exception to this conclusion is that courageous regulatory intervention is essential where the banks’ failures to be competitive is caused by market power and implicit federal subsidies to banks deemed “too big to fail.” Systemically dangerous institutions (SDIs) are far less efficient than their competitors, but they can obtain decisive advantages over smaller competitors because of their ability to borrow more cheaply. That competitive advantage arises in some regions from their market power, which allows them to raise deposits at lower interest rates. Because they are perceived as “too big to fail” they, SDIs are the beneficiaries of an implicit federal subsidy that allows them to borrow other funds more cheaply than smaller competitors. I’ll deal with the necessary regulatory steps to rid us of the SDIs, which are inefficient and dangerous, in future columns. The Bush and Obama administration policies toward the SDIs have made them far larger, substantially increased their market power, and increased the systemic risks they pose.

Interest Rate Risk

Interest rate risk can also pose systemic risks. There is no reason for a home mortgage lender to take large interest rate risks in the modern era. They can transfer the risk either by selling the home loans (and hedging the pipeline) or keeping the home loans in portfolio and hedging the risk. There is no societal advantage to mortgage lenders taking substantial interest rate risk (the expected value of taking interest rate risk should be zero). The Special Investment Vehicles (SIVs) that the huge investment and commercial banks created to hide their sister banks’ true debts added exceptional interest rate risk to their overwhelming operational (control fraud) risk. The Regulators, therefore, should not allow lenders or their affiliates to take substantial interest rate risk and should not allow bank holding companies to create SIVs. SIVs create substantial systemic risk and make finance opaque. From society’s standpoint, SIVs are unambiguously harmful.

Identifying, measuring, and controlling the interest rate risk of a portfolio of American mortgages is a particularly complex process because of the embedded prepayment option and the lack of prepayment penalties. Hedge accounting is notorious for its abuses. The SEC charged that Fannie’s controlling officer abused hedge accounting to inflate reported earnings to maximize their bonuses and that Freddie’s controlling officer manipulated hedge accounting to create “cookie jar” reserves that they could draw on whenever desirable to maximize their future bonuses. Many purported “hedges” are actually designed to prevent loss recognition and involve speculative investments that increase interest rate risk. The banking regulators and the SEC can improve their chances of detecting these scams by having the examiners (with appropriate accounting support) check to ensure that the lender is keeping contemporaneous records documenting that the purported hedging instrument was actually purchased to hedge a specific position and that the bank had demonstrated and documented that the instrument would function as an effective hedge. This discussion illustrates one of the essential facts about effective financial regulation – enforcing honest accounting is a prerequisite.

“Dynamic hedging” is an oxymoron that is subject to even worse abuses than conventional hedges. Dynamic hedging cannot protect against large changes in interest rates (which are the changes we most need to worry about as regulators) and can cause a severe systemic risk that can drive market crashes. Regulators, therefore, should prohibit “dynamic hedging.”

The good news about regulating interest rate risk is that if the regulators do ban dynamic hedging, ensure accurate records of real hedges, and forbid banks from taking substantial interest rate risk then it is very difficult for a bank to take large gambles on interest rates. There is no societal benefit to banks taking substantial interest rate risk in the modern era. An honest, competent bank would not take serious interest rate risk and purport to use dynamic hedging to neutralize that risk. An honest, competent bank would test and document its hedges. Honest, competent banks would do all these things even if there were no regulators. Bankers, not regulators, devised these business practices because they are essential to running a prudent bank that can prosper and survive.

This discussion of the procedures that competent banks would follow in the absence of banking regulation also illustrates why studies purporting to show immense compliance costs to banking regulators are false. Most of these costs falsely classified as costs of regulation would be borne by banks regardless of whether the regulator existed. Other costs, such as creating the call reports, are costs of regulation, but they are of great value to the banks. Absent the regulatory requirement to provide the data and the role of government examiners and data specialists in keeping the data more comprehensive, comparable, and accurate the banks would have to pay a private sector entity to create an inferior industry data system, likely at greater cost.

Banks that are exposed only to modest interest rate risk take a long time to fail even if interest rates increase sharply. America, relative to other nations, has had low interest rate volatility. This means that American banking regulators have typically had ample forewarning of problems arising from interest rate risk. Losses due to interest rate changes have not driven modern American bank failures.

Regulating to Prevent and Limit Accounting Control Fraud Epidemics

Epidemics of accounting control fraud have driven our two most recent U.S. financial crises (the S&L debacle and the current crisis as well as the Enron era frauds). The national commission that investigated the causes of the S&L debacle reported that at “the typical large failure” “fraud” was “invariably present.” (The S&L debacle was a tragedy in two acts. The first act was driven by interest rate risk and it caused serious losses. The second act, which proved roughly five times more expensive than ultimate losses from interest rate volatility, was driven by the accounting control frauds.)

The current U.S. crisis was driven by far more extensive mortgage fraud led by the large nonprime specialty lenders. The incidence of fraud was so great that it hyper-inflated the largest financial bubble in history.

The Recipe for Fraudulent Lenders Cooking the Books

Accounting control fraud is so dangerous because it simultaneously attacks the greatest weaknesses of the private and public sectors. To see why we have to reprise the four-part recipe for lenders maximizing (fictional) short-term income:

1. Grow extremely rapidly

2. By making high yield loans to those who will often be unable to repay

3. While employing extreme leverage

4. And providing only grossly inadequate loss reserves (ALLL)

As Akerlof & Romer stressed in their 1993 article, accounting control fraud is a “sure thing.” They entitled their article – Looting: the Economic Underworld of Bankruptcy for Profit in order to emphasize that the same fraud scheme that produced huge (fictional) income maximized real losses and was a leading cause of bank failures. The fictional income also made exceptional compensation to the bank’s officers a sure thing. The lender fails (in the era in which Akerlof & Romer wrote – we now often bail out the frauds and leave their managers in charge), but the controlling officers walk away wealthy.

The recipe makes individual control frauds into wealth destroying monsters that cause extraordinarily large losses to banks. That alone makes preventing and closing rapidly accounting control frauds our top regulatory priority. Unfortunately, epidemics of accounting control fraud are not rare, and such epidemics create perverse dynamics that cause vastly greater losses. I discuss the risks of such epidemics in greater detail below.

The central problem is that accounting control frauds look wonderful to the public sector and inexperienced and ideological anti-regulators. Theoclassical economists assured regulators that lenders and shareholders’ “private market discipline” makes accounting control frauds impossible. In reality, many lenders and shareholders rush to lend to and invest in banks reporting record profits – and the accounting control fraud recipe guarantees record (albeit fictional) profits in the near-term. The result is that creditors and shareholders lend and invest the cash that funds the fraudulent banks’ exceptional growth.

Theoclassical economists also assured regulators that independent experts, particularly top tier audit firms, would never give favorable opinions to fraudulent corporations. Law students were taught in their “law and economics” classes that they could safely rely on the auditor’s opinion. In reality, the CEOs leading the largest accounting control frauds routinely hire top tier audit firms and consistently receive clean opinions blessing their fraudulent financial statements. The art of accounting control fraud is to suborn – not defeat – the internal and external “controls” and turn them into the most valuable fraud allies. The frauds use the auditors, appraisers, and rating agencies’ reputation and seeming expertise to assist them in deceiving their investors, lenders, and regulators. Indeed, the CEO uses the initial expert’s opinion, e.g., the appraiser, to assist him in suborning the next expert in the chain, e.g., the auditor.

Regulators that rely on reported income, net worth, and losses are worse than useless against accounting control frauds. Unfortunately, that has become the norm in the financial regulatory world and the basis for the entire Basel process. It is an approach that cannot succeed. Accounting entries are subject to massive manipulation. It is common for the banks reporting the greatest profits to be massively insolvent. Standard econometric studies, during the expansion phase of a bubble or in the presence of accounting control fraud, produce systematically biased results that support the worst possible regulatory policies that optimize the criminogenic environment that attracts and optimizes the frauds.

Control Frauds Epidemics can Cause “Echo” Epidemics of Fraud

Fraud begets fraud. The CEOs who control the lenders engaged in accounting control fraud deliberately create the perverse incentives that generate other frauds to aid their looting. Consider four examples of “echo” epidemics of fraud that produced the current crisis:

• They generate endemic internal and external frauds by employing “liar’s” loans

• They generate endemic internal and external frauds by compensating their loan officers based on loan volume rather than loan quality

• They generate endemic fraud by independent experts by creating a “Gresham’s” dynamic. For example, lenders engaged in accounting control fraud may refuse to use appraisers who refuse to inflate the market value of the house. The lenders engaged in control fraud leak to the appraiser the loan amount so that the appraiser will know how high the market value of the home must be inflated.

• They created a network of fraudulent suppliers of fraudulent mortgage loans by creating the perverse incentives that made fraudulent loan brokers the eager suppliers of fraudulent mortgage applications. The CEOs controlling the fraudulent lenders frequently optimized this echo epidemic by employing liar’s loans and degrading their underwriting process so that it would approve tens of thousands of fraudulent loans.

Echo fraud epidemics occur because the private sector is so responsive to financial incentives – including perverse financial incentives. A Gresham’s dynamic does not have to corrupt everyone to be fully effective in the contexts discussed above. The CEO of the fraudulent lender or fraudulent loan broker only needs to suborn a small percentage of the appraisers and loan brokers to implement the first two ingredients in the accounting control fraud recipe. Private market discipline is exceptionally effective – in funding control frauds and generating echo fraud epidemics. The CEOs that controlled the lenders that created these perverse incentives knew full well that they would create endemic echo frauds. Their creation of an intensely criminogenic environment is sufficient to cause the echo epidemics of fraud.

The Real Job Killers? State Budget Crises

By June Carbone

I sit on the Faculty Senate of a large Midwestern university. Every meeting for the past year has been consumed with planning for this year’s budget crisis. For those insulated from Washington politics, the timing is curious. The economy is improving. State revenues are increasing. Yet this year will be the worst in over a decade for cuts to higher education, school teachers in the suburbs, police in crime-ridden cities, and bridge and infrastructure repair everywhere. Virtually every state will be affected. The cumulative impact will worsen unemployment and may be enough to trigger the feared double dip recession, touching off a new round of economic misery.

In this context, Congressional debate of the misnamed “Repealing the Job Killing Health Care Act” is a tragic distraction from the immediate source of job losses — the rejection of the economic lessons that have kept the economy on track since the Great Depression. As Paul Krugman explained in his critique of the euro in this week’s New York Times Magazine, national fiscal policy and state spending are fundamentally different, whether in Europe or the U.S. Spending at the national level includes automatic correctives. Run federal deficits too high for too long, the dollar falls, imports become more expensive and the demand for American goods increases.

States, however, cannot print money and they are rightly subject to balanced budget provisions that require that they slash expenses when revenues fall. Economists have accordingly maintained since the New Deal that federal spending should be counter-cyclical — a recession is the time to spend money to create jobs. Policy makers since Richard Nixon have further argued that much of the counter-cyclical spending should go to the states; they are closer to people’s needs and more directly hurt by falling revenues. So if the concern is jobs, counter-cyclical federal spending implemented through a Republican idea — revenue sharing — should be the new Congress’ first priority. It would forestall the job slashing taking place in statehouses throughout the country and do more to reduce unemployment than any proposal currently on the table.

Yet no one is talking about revenue sharing. President Obama proposed some aid to the states as part of his original stimulus package, but Republicans pared those measures back in favor of tax cuts that contributed less to job preservation. When the Republicans insisted on running up the deficit through tax cuts for the wealthy, the president responded with more tax cuts for everyone else — but not the spending most directly tied to jobs. The bailout of financial fat cats lasted long enough to bring back high corporate profits and rising stock market prices. Yet assistance to the states is being cut off at a time likely to forestall economic recovery.

The results reject the conventional economic wisdom of the last half century and inflict needless misery on the teachers, policemen, and construction workers who form the backbone of the country. While China undertakes massive public investment in schools, universities, technology, roads and a 21st century infrastructure, we are dismantling the institutions essential to our ability to compete. The token fight to repeal health care is a distraction from the job demolition derby underway in the states as a direct result of federal cutbacks. Yet the connection between ideologically driven federal policy and state layoffs does not even seem to merit notice in the scores of stories about layoffs, tuition increases and reduced crime protection. It is time to focus attention on the real job killers and hold them accountable.

June Carbone is the Edward A. Smith/Missouri Chair of Law, the Constitution and Society at the University of Missouri – Kansas City.

Cross-posted from New Deal 2.0 and the Huffington Post.

Obama Embraces the “Economic Philosophy That Has Completely Failed”

By William K. Black
(via the Huffington Post)

President Obama’s Executive Order on regulatory review was originally set in motion by his February 3, 2009 direction to OMB to create an improved regulatory review process.

The fundamental principles and structures governing contemporary regulatory review were set out in Executive Order 12866 of September 30, 1993. A great deal has been learned since that time. Far more is now known about regulation — not only about when it is justified, but also about what works and what does not. Far more is also known about the uses of a variety of regulatory tools such as warnings, disclosure requirements, public education, and economic incentives. Years of experience have also provided lessons about how to improve the process of regulatory review. In this time of fundamental transformation, that process–and the principles governing regulation in general — should be revisited.

September 30, 1993 is an interesting date. I was the deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE). We issued our report in July 1993 on the causes of the S&L debacle. Our report was based on an extensive investigation of what worked and what failed in regulation.

In particular, we found that the deregulation and desupervision created an environment in which at “the typical large failure” “fraud” was “invariably present.” By fall 1993, the Office of Thrift Supervision had learned the lessons and developed extremely effective rules, supervision, enforcement, and support for the criminal justice system. Congress passed the Prompt Corrective Action (PCA) law in 1991. The regulators had removed the abusive regulatory accounting rules designed to cover up the scale of the debacle. Administration officials had falsely used this cover up of losses through accounting gimmickry to claim that the S&L crisis had been “resolved” at no cost to the taxpayers. The PCA was based on the finding that such accounting cover ups and “forbearance” greatly increased the eventual cost to the taxpayers.

By fall 1993, a well-functioning partnership of the OTS and the Justice Department had produced over 1,000 felony convictions of “major” S&L frauds — it remains to this day the greatest success against elite criminals in history. The Justice Department and the OTS ensured that the prosecutions were prioritized properly by creating the “Top 100” list. The OTS (which was created in 1989) had brought over 1,000 serious enforcement actions. The OTS secured over $1 billion in settlements from top tier auditors and brought hundreds of successful civil actions against the elite frauds. The reregulatory effort was so successful that for the next 15 years every U.S. Treasury Secretary flew to Tokyo and urged Japan’s leaders to stop relying on dishonest accounting to cover up their main banks’ losses and to instead adopt the regulatory policies that prevented the S&L debacle from becoming a catastrophe.

By September 1993, the S&L regulators had written extensively of our research findings about the role of accounting control fraud in driving the crisis and the regulatory and accounting lessons we had learned. My papers, collectively roughly 500 pages, had been circulated among many finance economists. Our work explained why econometric studies produced exceptionally erroneous findings in the presence of accounting control fraud and financial bubbles. Three of the nation’s leading white-collar criminologists, Henry Pontell, Kitty Calavita, and Robert Tillman had published several journal articles on these same topics. George Akerlof and Paul Romer formally presented their paper on accounting control fraud — “Looting: the Economic Underworld of Bankruptcy for Profit” at the Brookings Conference on September 9, 1993 before many of the nation’s most prominent finance specialists.

The NCFIRRE report notes that key elements of the Reagan administration — particularly Treasury and OMB, actively opposed our vital reregulation of the S&L industry. That reregulation was essential to containing a raging epidemic of accounting control fraud in the mid-1980s. Only the fact that the Federal Home Loan Bank Board was an independent regulatory agency prevented OMB from blocking S&L reregulation.

President Obama is correct that white-collar criminologists and a few non-theoclassical economists have continued to add to the useful understanding of regulation since 1993. However, his 2009 direction to OMB is not candid. By September 1993, we not only knew how to regulate effectively — financial regulation was exceptionally effective — and employment and growth were surging. The perverse (Gresham’s) dynamics that the accounting control frauds had caused that destroyed wealth and jobs had been eliminated or minimized. Even the most elite frauds and their elite political allies were held accountable. Bank Board Chairman Gray led the successful reregulation in late 1983-mid-1987 over the intense opposition of the Reagan administration, a majority of the House of Representatives, Speaker Wright, and the five U.S. Senators that became known as the “Keating Five.” Paul Volcker was Gray’s sole powerful ally. Wright and the Keating Five intervened on behalf of the two worst control frauds in America. S&L regulators had their careers destroyed, but continued to buck the frauds and their political patrons and do their duty to the public.

In 1991-1992, the OTS’ West Region used its supervisory powers to squash a fast-developing trend among a number of California S&Ls to make “liar’s” loans. We recognized that such loans were inherently unsafe and unsound and frequently fraudulent. Our efforts were so effective that Long Beach Savings gave up its federal charter to escape our regulatory authority. It became a mortgage banker and rebranded itself as Ameriquest — the most notorious of the early non-federally regulated lenders specializing fraudulent and predatory nonprime loans.

What happened after September 1993 is that OMB and Treasury, in alliance with Fed Chairman Greenspan and Senator Gramm, lost the accurate understanding of why vigorous financial regulation is essential and how one makes regulation effective. OMB, Treasury, Greenspan, and Gramm adopted anti-regulatory policies that were intensely criminogenic. We had to reregulate without the benefits of the criminology studies by Pontell, Calavita and Tillman and Akerlof & Romer’s economic studies. The Clinton and Bush administrations had the advantage of all our research and our demonstration of which financial regulatory policies succeed and which fail. (They also had the benefit of the public administration scholars’ books and articles that studied used our reregulation and concluded that it was an exemplar of effective regulation.) Unfortunately, the “completely failed” economic dogma that the Clinton and Bush administrations, Greenspan and Bernanke, and Senator Gramm shared led them to ignore our successes and adopt anti-regulatory policies that were so perverse that they were intensely criminogenic.

The recent epidemics of accounting control fraud, the creation of the largest bubble in history, and the Great Recession could not have occurred if the Clinton and Bush administrations had actually learned a great deal about what works and what fails in regulation. The Clinton and Bush anti-regulatory policies created the “three des” — deregulation, desupervision, and de facto decriminalization. In late 2008, however, then-Senator Obama proclaimed that he had learned the correct regulatory “lessons” from the resulting economic collapse. From the Washington Post:

“John McCain has spent decades in Washington supporting financial institutions instead of their customers,” [Obama] told a crowd of about 2,100 at the Colorado School of Mines. “So let’s be clear: What we’ve seen the last few days is nothing less than the final verdict on an economic philosophy that has completely failed.”

Senator Obama was correct — the Clinton and Bush anti-regulatory policies were a catastrophic failure that permitted the epidemics of fraud that drove the Great Recession and the loss of over 10 million jobs. OMB was among the most virulent opponents of vigorous financial regulation because it has long been dominated by anti-regulatory economists embracing the “economic philosophy that has completely failed.” Bush selected financial regulatory leaders on the basis of the strength of their anti-regulatory zeal. President Obama was incorrect, therefore, in his February 3, 2009 directive to the OMB about the improved understanding of regulation. “Years of experience” have not taught the theoclassical economists “far more” “about what works and what does not” in regulation. The theoclassical economists know vastly less about effective regulation now than did OTS in 1993.

The University of Chicago economists that President Obama appointed to senior positions related to regulatory policy scorned financial regulation. Austan Goolsbee, now Chairman of the President’s Council of Economic Advisors poured scorn on those who warned of the urgent need to regulate nonprime loans. In a March 29, 2007 op-ed in the New York Times, Goolsbee derided those warning that nonprime loans were a “time bomb.”

This column shows why the reasoning and methodology that Goolsbee employed “completely failed” because it relied on anti-regulatory dogma rather than sound economics and white-collar criminology. The column also shows that Obama’s regulatory review policy embraces Goolsbee’s “completely failed” anti-regulatory dogma and methodology and ignores the sound findings and methodologies employed by successful regulators, economists, and white-collar criminologists. Obama is correct that white-collar criminologists and non-theoclassical economists have learned “far more” “about what works and what does not” in regulation. He is incorrect that his economic team has learned these “lessons.”

Goolsbee loves financial innovation and “consumer choice.” He began his defense of nonprime loans by decrying the “very old vein of suspicion against innovations in the mortgage market.” Goolsbee premised his argument upon the findings of an econometric study of home lending innovations. He argued:

These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.

[T]he mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects.

Of course, basing loans on future earnings expectations is riskier than lending money to prime borrowers at 30-year fixed interest rates. That is why interest rates are higher for subprime borrowers and for big mortgages that require little money down. Sometimes the risks flop. Sometimes people even have to sell their properties because they cannot make the numbers work.

And do not forget that the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.

When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.

For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage.

It’s hard to get something more wrong than Goolsbee (and the economists that conducted the study he relied upon) got this wrong. Theoclassical economics assumes that market participants are rational, informed, and utility-maximizing. It follows that expanding choices is always the correct policy. Some individuals who find the new option desirable will take it and be better off. Individuals that can expect to be worse off if they select a new option will not select it. Anyone who criticizes relying on consumer choice is paternalistic and is demeaning less-affluent consumers’ decision-making skills. The econometric study he relies and topic he discusses are perfect foils to illustrate Goolsbee’s opposition to regulation.

The problem is that the study Goolsbee relied upon illustrates why fraud makes econometric studies fail. I have explained (and these explanations can be found in my 1993 NCFIRRE papers and Akerlof & Romer’s 1993 article) why accounting control fraud epidemics can hyper-inflate financial bubbles. Bubbles allow accounting control frauds to refinance bad loans and delay delinquencies and defaults. The regional real estate bubbles had begun bursting before Goolsbee wrote his op-ed — the delinquencies, defaults, and foreclosures lag the collapse of the bubble. A 13% delinquency rate would kill most subprime lenders, but the eventual default rate was likely to be far higher. Goolsbee ignores the loss to the consumer of purchasing a home with substantial negative equity.

Goolsbee stresses that many of the subprime borrowers are relatively poorer minorities. The predatory lenders that induced them to take out loans they could not repay created reverse Pareto optimality — both parties to the nonprime loans made in 2006 and 2007 typically suffered a serious financial loss. Nonprime loans in 2003-2007 hyper-inflated the bubble and the markets increasingly less efficient (not ever more “perfect”). When one considers the endemic mortgage fraud by lenders and their agents and resultant negative expected value of the transaction we see that the frauds also cause negative externalities to the public. The nonprime borrowers included some speculators, but the typical borrower was the prey and the typical nonprime borrower lost wealth.

The three key elements that Goolsbee relied upon to give the worst possible policy advice on how regulators should respond to the nonprime loans (do nothing, all is well, the lenders are making the nonprime borrowers friends) are (1) a presumption that financial innovation is good and that financial regulation is bad if it reduces innovation, (2) greater consumer choice is good and financial regulation is bad if it reduces choice (note the innovation increases choice), and (3) the scientific means of choosing between alternative regulatory policies is to rely on econometric studies. Obama’s Executive Order revising regulatory review policy enshrines each of these three elements even though Goolsbee demonstrated that they lead to the most destructive regulatory policies if control fraud or bubbles are present. Obama’s Wall Street Journal letter adopted this Republican talking point about “innovation.”

Sometimes, those rules have gotten out of balance, placing unreasonable burdens on business–burdens that have stifled innovation and have had a chilling effect on growth and jobs.

There are doubtless some contexts where this unsupported assertion could be true, e.g., the various bans on stem cell research, but in the financial context “innovation” frequently poses systemic risks, is devoid of social utility, and has no demonstrated advantage to anyone but the seller. Paul Volcker has made this point forcefully:

I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two — credit-default swaps and collateralized debt obligations — which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?

You want boards of directors to be informed about all of these innovative new products and to understand them, but I do not know what boards of directors you are talking about. I have been on boards of directors, and the chance that they are going to understand these products that you are dishing out, or that you are going to want to explain it to them, quite frankly, is nil.

I mean: Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.

President Obama’s Wall Street Journal letter directed regulators not to interfere with consumer choice.

[C]reating a 21st-century regulatory system … means using disclosure as a tool to inform consumers of their choices, rather than restricting those choices.

We tried this “economic philosophy” and it “completely failed.” Goolsbee’s op-ed was typical of theoclassical dogma: regulations that restrict consumer choice are inherent illegitimate. The predatory lender pushing the loan that the borrower cannot repay is the borrower’s true friend. The regulator is the paternalistic bureaucrat. The FDIC tried to use disclosure plus consumer education to make this anti-regulatory dogma sound more attractive — and disclosure and consumer education failed to protect the nonprime borrowers.
Obama’s directive is a radical, dangerous assault on regulation and consumers. It would require us to get rid of “suitability” requirements — your 85 year old grandmother’s financial advisor could hand her a “disclosure” page explaining the risks investing in the mezzanine tranche of CDOs and proceed to advise her to put her entire savings in the CDOs. We could not ban “liar’s” loans.

We would have to get rid of many of the food and drug safety laws. We cannot “restrict” the consumer’s “choices.” The drug companies can hand out a “disclosure” page about the risks of a drug that has not been FDA approved for safety and efficacy and it’s up to you to decide whether to buy it. We cannot restrict the consumer’s “choice” so there cannot be any limits on usury or default fees. Your friendly payday lender can hand you their disclosure sheet and then when you are delinquent on a $50 loan they can charge you a $500 fee. We cannot restrict choice, so everybody you contract with can take away your right to sue for torts they commit by disclosing that they have a mandatory arbitration clause and you agree that their maximum liability is $10. Under this logic we couldn’t make prostitution unlawful.

The OMB Director (implicitly) explained the import of the new regulatory review standard for econometrics: “Regulations must be guided by objective scientific evidence.” OMB decides whether the rules are guided by “objective scientific evidence.” OMB is dominated by neoclassical economists who believe, in the economic context, that only econometric studies are “objective scientific evidence.” Econometric studies, however, will show that accounting control frauds are reporting record income in the short-term and that whatever asset is used in the frauds has a strong, positive relationship with income. The regulators could not provide the necessary econometric studies to, for example, stop liar’s loans until the true “sign” (negative) of the relationship between making liar’s loans and income emerged — after the fraud and the bubble collapse. Any proposed rule that would restrict the nonprime lenders’ use of liar’s loans would be contradicted by the “objective scientific evidence” (the econometric study).

The administration is adopting the “completely failed” economic philosophies that rendered regulation ineffective and allowed the epidemics of accounting control fraud that caused the Great Recession. Senator Obama knew that it was imperative that we junk that failed philosophy. President Obama is adopting key aspects of the completely failed philosophy that he condemned. Bring back Senator Obama.