Monthly Archives: January 2011

‘An Economic Philosophy That Has Completely Failed’

By William K. Black

(via the Huffington Post)

I get President Obama’s “regulatory review” plan, I really do. His game plan is a straight steal from President Clinton’s strategy after the Republican’s 1994 congressional triumph. Clinton’s strategy was to steal the Republican Party’s play book. I know that Clinton’s strategy was considered brilliant politics (particularly by the Clintonites), but the Republican financial playbook produces recurrent, intensifying fraud epidemics and financial crises. Rubin and Summers were Clinton’s offensive coordinators. They planned and implemented the Republican game plan on finance. Rubin and Summers were good choices for this role because they were, and remain, reflexively anti-regulatory. They led the deregulation and attack on supervision that began to create the criminogenic environment that produced the financial crisis.

The zeal, crude threats, and arrogance they displayed in leading the attacks on SEC Chair Levitt and CFTC Chair Born’s efforts to adopt regulations that would have reduced the risks of fraud and financial crises were exceptional. Just one problem — they were wrong and Levitt and Born were right. Rubin and Summers weren’t slightly wrong; they put us on the path to the Great Recession. Obama knows that Clinton’s brilliant political strategy, stealing the Republican play book, was a disaster for the nation, but he has picked politics over substance.

I explained in a prior column how the anti-regulators made the crisis possible and caused the loss of over 10 million jobs. 

Anti-regulation proved to be a profoundly negative sum “game” in the financial sphere. Both principals — the home borrower and the lender — lost (negative Pareto optimality). The unfaithful “agents,” however, made out like bandits. 

Effective financial regulation is essential to protect honest firms and consumers from the frauds — it is distinctly positive sum. The primary purpose of financial regulation is to limit fraud. President Obama, Summers, and OMB do not understand this fundamental aspect of financial regulation — limiting fraud. Consider this portion of the President’s letter:

This is the lesson of our history: Our economy is not a zero-sum game. Regulations do have costs; often, as a country, we have to make tough decisions about whether those costs are necessary.
Voluntary transactions should be positive sum — both parties are typically made better off. Fraud causes negative sum transactions. Regulators are the “cops on the beat” in finance. If cheaters prosper, then “private market discipline” drives honest firms and officers out of the marketplace. Vigorous financial regulation is essential to the effective prosecution of elite criminals. Many of the best financial regulations impose virtually no cost. The traditional underwriting rules, for example, would have been exceeded by any honest, competent bank. Indeed, the rules reduced costs to honest firms. The rules imposed material costs only on dishonest managers — and that reduces costs to hones firms and managers. Net, underwriting rules produce enormous net-benefits. That is equivalent to saying that they have a negative cost. The underwriting rules designed primarily to reduce fraud also reduce losses from incompetence, unrecognized risk, and mistake. This means that financial rules designed primarily to reduce fraud are essential to convert the negative sum (fraudulent) transactions that would prevail absent regulation into positive sum (honest) transactions. Because fraud can impose severe “negative externalities,” this transaction-based analysis dramatically understates the net cost savings of effective safety and soundness regulation.

Obama’s proposal and the accompanying OMB releases do not mention the word or the concept of fraud. Despite an “epidemic” of fraud led by the bank CEOs (which caused the greatest crisis of his life), Obama cannot bring itself to use the “f” word. The administration wants the banks’ senior officers to fund its reelection campaign. I’ve never raised political contributions, but I’m certain that pointing out that a large number of senior bank officers were frauds would make fundraising from them awkward.

President Obama’s explanation for his regulatory review program warrants detailed analysis in multiple columns. He decided to place it in the Wall Street Journal as a symbol of his efforts to placate Wall Street (only two sentence of his letter refer to small businesses).

My first column discussing his regulatory review program focuses on gaps in financial “safety and soundness” regulation. This is an area I lived, research, write about, and teach. (If you look at my bio you will see that public administration experts write about my experiences as a regulator.) Obama entitled his letter: “Toward a 21st-Century Regulatory System.” Where have we heard that mantra before? When President Clinton signed the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 Larry Summers proclaimed that the GLB Act was “a major step forward to the 21st century.”

Clinton’s two great deregulatory failures were the GLB Act and the Commodities Futures Modernization Act of 2000 (CFMA). The CFMA deliberately created a regulatory “black hole” for credit default swaps (CDS) by removing the CFTC’s authority to regulate CDS and a regulatory black hole in the trading of energy derivatives that helped Enron’s cartel produce the California energy crisis of 2001. The titles of both of these deregulatory acts included the word “modernization” and the great lie was that the acts they were repealing were archaic. The claim was that we needed a regulatory system designed for the 21st-Century. Summers, Obama’s principal economic advisor, framed Obama’s latest deregulatory foray.

Summers and Rubin remain unwilling to admit that their anti-regulatory financial policies were disastrous. Here’s what Obama said in late 2008 about the decisive role that anti-regulatory dogma played in causing the ongoing financial crisis.

“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.”

Obama’s subtitle is designed to illustrate stupid regulation: “If the FDA deems saccharin safe enough for coffee, then the EPA should not treat it as hazardous waste.” The example is supposed to be self-evident, clearly only regulators could do something so stupid. But the facts are inconvenient to Obama’s scorn — and this is his shining example, the best that the scores of OMB staff that review thousands of regulations could come up with to support this major administration initiative. This is the dumbest rule they found. Obama’s statement about saccharin may seem logical, but it is not. Animal studies originally showed that saccharine was carcinogenic in doses that a heavy consumer might experience. The EPA, therefore, classified the disposal of large amounts of saccharine as toxic. Subsequent studies are now interpreted as showing that saccharine is unlikely to be carcinogenic at such dosage levels. The EPA’s classification of saccharine as a hazardous substance for waste disposal purposes based on its carcinogenic effects in small doses was logical. The logic does not work automatically in reverse. An ingredient can be safe to consume by an individual consumer in extremely low doses yet hazardous in far larger doses. To sum it up, the supposedly dumb rule Obama chose as his lead example did not kill any meaningful number of jobs, was based on the best science then available, and wasn’t dumb.

Consider the overall logic of Obama’s approach to regulation. Under his logic during the campaign, the imperative need was to end the anti-regulatory dogma that was the disastrous product of “an economic philosophy that has completely failed.” When he became President, however, Obama placed Summers and Rubin, the leading Democratic Party purveyors of that completely failed philosophy, in charge of the administration’s financial regulatory policies. The administration’s policies are largely anti-regulatory. The most important indicators of this point are the things not in the President’s regulatory review program. Obama says that the lack of financial regulation made possible the financial crisis, but his regulatory review program does not require the administration to search out areas of inadequate regulation. Here is the closest Obama comes: “Where necessary, we won’t shy away from addressing obvious gaps….” Huh? The vital task is to find the non-obvious gaps. Why, two years into his presidency, has the administration failed to address “obvious gaps”? The administration does not need Republican approval to fill obvious gaps in regulation. Even when Obama finds “obvious gaps” in regulatory protection he does not promise to act. He will act only “where necessary.” We know that Summers, Rubin, and Geithner rarely believe that financial regulation is “necessary.” Even if Obama decides it is “necessary” to act he only promises to “address” “obvious gaps” — not “end” or “fill” them.

In the financial sphere, Obama has allowed “obvious gaps” to persist and, by listening to Summers’ continued embrace of an “economic philosophy that has completely failed” he has even made the gaps worse. Obama’s regulatory review program does not promise to fix any of the anti-regulatory actions taken or allowed to fester and grow under his administration. I provide twelve specific examples of these obvious gaps in financial regulation which have persisted and grown during this Obama’s first two years in office. (There are more than a dozen gaps, but it is premature to address some of them, e.g., Basel III, the Volcker rule, and the new consumer financial protection agency, because there is so much uncertainty about the rules that will emerge.) The gaps addressed here are those where Obama has not even proposed to take an action that could prove effective.

The “Dirty Dozen”

  1. Executive compensation is so profoundly perverse that it is intensely criminogenic, but the administration has opposed the FDIC’s modest efforts to reduce the problem. (Both Treasury officials on the FDIC Board voted against the FDIC proposed rule to limit the perverse incentives of modern executive compensation.
  2. Professional compensation is equally perverse. Bank CEOs created the perverse incentives that produced “echo” epidemics of fraud by appraisers, loan brokers, and mortgage bankers. Bank CEOs deliberately create a “Gresham’s” dynamic in order to create the perverse incentives that have routinely allowed them to suborn successfully “independent” professionals and turn them into fraud allies. As long as the CEO can hire and fire the independent professional he can succeed in suborning some of the professionals — and “some” is ample. Then Attorney General Cuomo’s investigation, for example, found that Washington Mutual kept a black list of appraisers — but appraisers were black listed if they refused to inflate the appraisals. (It is critical that the reader understand the significance of this finding. Only the lender and its agents can extort the appraiser in order to secure an inflated value. No honest lender would inflate, or permit the inflation of, appraised values. Appraisal fraud is a superb “marker” of accounting control fraud.) Dodd-Frank has some provisions seeking to improve appraisals and credit rating agencies, but the essential “gap” that must be closed now is the ability of the CEO to pick the independent professionals.
  3. Honest accounting is the prerequisite effective financial regulation. The administration stood by while Bernanke, the Chamber of Commerce, and the specialized bank lobbyists used Congress to extort the Financial Accounting Standards Board (FASB) to pervert the accounting rules so that banks would not have to recognize their losses. The administration knows that perverting the accounting rules in this manner harms the public in many ways. Not recognizing losses creates fictional bank income and capital. Banks that are deeply insolvent and unprofitable are able to claim to be solvent and profitable. This allows the banks to evade the Prompt Corrective Action law and makes it more difficult for regulators to prevent expensive bank failures. It also allows the controlling officers to pay the officers tens of billions of dollars in bonuses that the officers have not earned. The same accounting scam makes the administration’s (self) vaunted “stress tests” a sham. Obama can end the banks’ accounting scams and end these anti-regulatory disasters at any time because banking regulators have the power to impose regulatory accounting principles that would restore honest accounting and restore effective bank regulation. I shouldn’t have to keep emphasizing this, but honesty in accounting is also essential to integrity – and integrity is essential to everything.
  4. The accounting scams combined with the Fed’s secret bailouts of insolvent U.S. and foreign banks also allowed the administration to enter into a cynical gambit on TARP. The continuing Fed’s subsidies are far larger than TARP. Bank CEOs were eager to get out of the TARP restrictions on executive compensation. The administration was eager to claim (A) that it had resolved the banking crisis, and (B) that it did so for a pittance. The accounting cover up of bank losses combined with the Fed subsidies were the perfect (political) answer that met the banks’ and the administration’s greatest desires. The combination allowed the banks to repay TARP. The banks got to hide their losses, receive large subsidies and cheap liquidity from the Fed, and report fictional profits that allowed them to repay the TARP funds and pay large bonuses to their officers. The administration got to make the absurd claim that it had resolved the largest banking crisis in U.S. (measured in absolute dollars) for a pittance (roughly20 billion). (The real economy and real estate losses in the many trillions of dollars produced20 billion in bank losses. “Too good to be true” hardly does justice to the absurdity of Geithner’s claims that he “resolved” the failures virtually without cost.) The combination of covering up and secretly subsidizing the SDI’s losses also explains the SDIs’ unwillingness to lend to the real economy. It’s safer to borrow funds from the Fed at next to nothing, buy bonds, and clip coupons. This perverse dynamic is one of the important factors, along with fraud, that has made the economic recovery so weak. We are following the failed Japanese strategy.
  5. The Fed is an “obvious gap” in regulation. The Fed has consistently sought to prevent the Congress and the public from learning the disgraceful facts of its bailouts and subsidies of the most undeserving rich in modern history. TARP did not resolve failures. The failures have been covered up and subsidized by the Fed. There is an urgent need to regulate the Fed. The Fed has a consistent record of regulatory failure and is actively hostile to transparency. During Obama’s term in office, Bernanke appointed as the head of all Fed examination and supervision an economist with no experience as an examiner or regulator. The economist is a strong proponent of the anti-regulatory economic philosophy that completely failed. Greenspan used him as the agency spokesman before Congress supporting the passage of the Commodities Futures Modernization Act of 2000 – the Act that created the multiple regulatory black holes that allowed the frauds that caused the California energy crisis of 2001 and contributed to the frauds that drove the ongoing financial crisis.
  6. The Fed’s regional banks have private directors with untenable conflicts of interest. The U.S. has already reached the policy decision in 1989 that such conflicts pose an unacceptable danger of producing ineffective regulation when it enacted FIRREA, which removed any conceivable authority of the private directors over the regulatory process.
  7. The administration could end the obvious gap in regulation known as the “too big to fail” doctrine at any time by adopting regulations that would stop the systemically dangerous institutions (SDIs) from growing and shrink them to the scale they would no longer pose a systemic risk within five years. (These regulatory gaps interact – many of the SDIs are insolvent yet are paying extraordinary bonuses to the officers that caused their massive, unrecognized, losses.) Instead, of shrinking the SDIs, the administration encouraged the SDIs to grow even larger and pose greater systemic risk. The administration opposed efforts to amend the Dodd-Frank bill to require the end of the SDIs. Remember, it is the administration that is telling us that there are 20 U.S. banks so large that as soon as the next one fails it is likely to trigger a systemic crisis. It is insane to roll the dice twenty times a day waiting for the next world crisis. The SDIs are one of those “obvious gaps” that the administration doesn’t find it politically correct to “address.” Effectively regulating the SDIs would be the antithesis of the administration’s campaign to ingratiate themselves with the SDIs.
  8. The administration could end the scandal of the lack of prosecution of the accounting control frauds that created the epidemic of mortgage fraud that hyper-inflated the largest bubble in history and drove the financial crisis and the Great Recession. Effective prosecutions against elite bank frauds are possible only with effective regulation and supervision. We know that the banking regulatory agencies – which made well over 10,000 criminal referrals in response to the far smaller S&L debacle (producing over 1000 felony convictions in “major” cases against elites – made no, or a handful of criminal referrals in response to this crisis. The Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) made zero criminal referrals during the crisis. The FDIC apparently made a very small number of criminal referrals, probably not against elites. It is unknown whether the Fed made any criminal referrals. There is no evidence it made any significant criminal referrals. The banking regulators’ dereliction of their duties to make criminal referrals is so complete that the FBI formed a “partnership” with the Mortgage Bankers Association (MBA) – the trade association of the perps – rather than with the banking regulators. Unsurprisingly, the MBA claimed that the banks were the victims of borrowers and junior officers rather than the CEOs who knowingly created the perverse incentives that drove the epidemic of mortgage fraud.
  9. Only 25 banks – during an “epidemic” of mortgage fraud – made any significant number of criminal referrals, and none of those referrals appear to have been made against the senior bank officers that caused those frauds. Federal rules mandate that the banks file criminal referrals against suspected mortgage fraud, so the data demonstrate endemic regulatory violations by banks. The data also demonstrate that the banks overwhelmingly did not want the FBI to prosecute the mortgage frauds. There is one obvious reason why the banks’ CEOs would be willing to violate a legal mandate to file criminal referrals. I have not found any evidence that the banking regulatory actions have brought enforcement actions against the banks committing these obvious, endemic violations of the law. The mortgage bankers and brokers were not federally insured and therefore were not subject to the rules mandating that they file criminal referrals when they found suspicious activities likely indicating mortgage fraud. The mortgage bankers and brokers, however, were permitted to file criminal referrals. Their nearly universal failure to do so was irrational for honest lenders and brokers – but optimal for control frauds. The administration has allowed the collapse of the criminal referral system within the regulatory agencies, and almost all lenders to continue on its watch. It could fix the scandal of elite bankers being able to loot with impunity without adopting any rules. Each collapse constitutes an “obvious gap” that urgently requires Obama’s attention.
  10. The Mortgage Electronic Registration Service (MERS) is unregulated. MERS, at best, was a system designed to evade county recorder fees. No one – and that includes MERS’ controlling officials – knows the true condition of the mortgage instruments that MERS is supposed to be registering. At best, it is a scandal that threatens the stability of homeowners and holders of instruments that are supposed to be secured by mortgages. MERS is an “obvious gap” in regulatory protections that demonstrates once more the wealth and job destroying consequences of the “completely failed” anti-regulatory philosophy that Obama promised to root out.
  11. The foreclosure scandal revealed an “obvious gap” in regulatory protections – no one regulates the foreclosure process. (The underlying epidemic of accounting control fraud by the nonprime mortgage lenders generated the “echo” epidemic of foreclosure fraud.) Bank of America, the second largest financial institution in America, acquired Countrywide in order to secure its personnel and its mortgage servicing portfolio. Countrywide was notorious for its fraudulent and predatory mortgage lending practices. Placing its employees in charge of servicing – the banking operation that controls the foreclosure process – guaranteed epic abuses. (Bank of America also managed to generate pervasive foreclosure abuses out of the staff it had prior to acquiring Countrywide.) Bank of America personnel, and personnel of other major servicers, eventually confessed that their foreclosure actions relied on massive, universal perjury (a felony). These “robo signing” crimes occurred at a frequency of roughly 10,000 monthly at more than one large servicer. Our most elite banks have confessed to committing hundreds of thousands of felonies.
  12. Fannie and Freddie. These entities are twisting slowly in the wind. Private and regulatory leadership have been ineffective and have lacked courage. I’ll mention only two areas. Fannie and Freddie used some of the most abusive foreclosure law firms in existence. Citicorp’s key mortgage credit guy testified many months ago before the Financial Crisis Inquiry Commission (FCIC) that 80% of Citi’s mortgages sold to Fannie and Freddie were sold under false “reps and warranties.” The Citicorp official’s warnings to his superiors about this extreme incidence of fraud did not lead to corrective action, so the official cc’d Rubin on key correspondence. Naturally, Citi responded by firing the whistleblower rather than the frauds. If Fannie and Freddie put the bad paper back to Citi, then Citi would be insolvent and Rubin would face serious risks. Fannie and Freddie have put only relatively small amounts of Citi’s paper back to Citi. (Note that the extreme incidence of fraud, and a similar incidence has been shown in Countrwide mortgage paper, again demonstrates how completely failed the anti-regulatory model is.) I have explained previously why Fannie and Freddie, because of their large holdings of nonprime paper from many originators and their dealings with credit rating agencies, offer unique data bases and opportunities for research to document exactly what wrong and how the fraud epidemic, bubble, and financial crisis grew and spread. This is a more subtle, but enormously important and dangerous regulatory gap.

L. Randall Wray and William Black interviewed for NPR report

L. Randall Wray and William K. Black were interviewed for NPR’s report, “Faulty Paperwork May Slow Millions of Foreclosures.”

The Anti-Regulators Are the ‘Job Killers’

By William K. Black

(via Huffington Post)

The new mantra of the Republican Party is the old mantra — regulation is a “job killer.” It is certainly possible to have regulations kill jobs, and when I was a financial regulator I was a leader in cutting away many dumb requirements. But we have just experienced the epic ability of the anti-regulators to kill well over ten million jobs. Why then is there not a single word from the new House leadership about investigations to determine how the anti-regulators did their damage? Why is there no plan to investigate the fields in which inadequate regulation most endangers jobs? While we’re at it, why not investigate the areas in which inadequate regulation allows firms to maim and kill. This column addresses only financial regulation.

Deregulation, desupervision, and de facto decriminalization (the three “des”) created the criminogenic environment that drove the modern U.S. financial crises. The three “des” were essential to create the epidemics of accounting control fraud that hyper-inflated the bubble that triggered the Great Recession. “Job killing” is a combination of two factors — increased job losses and decreased job creation. I’ll focus solely on private sector jobs — but the recession has also been devastating in terms of the loss of state and local governmental jobs.

From 1996-2000, for example, annual private sector gross job increases rose from roughly 14 million to 16 million while annual private sector gross job losses increased from 12 to 13 million. The annual net job increases in those years, therefore, rose from two million to three million. Over that five year period, the net increase in private sector jobs was over 10 million. One common rule of thumb is that the economy needs to produce an annual net increase of about 1.5 million jobs to employ new entrants to our workforce, so the growth rate in this era was large enough to make the unemployment and poverty rates fall significantly.

The Great Recession (which officially began in the third quarter of 2007) shows why the anti-regulators are the premier job killers in America. Annual private sector gross job losses rose from roughly 12.5 to a peak of 16 million and gross private sector job gains fell from approximately 13 to 10 million. As late as March 2010, after the official end of the Great Recession, the annualized net job loss in the private sector was approximately three million (that job loss has now turned around, but the increases are far too small).

Again, we need net gains of roughly 1.5 million jobs to accommodate new workers, so the total net job losses plus the loss of essential job growth was well over 10 million during the Great Recession. These numbers, again, do not include the large job losses of state and local government workers, the dramatic rise in underemployment, the sharp rise in far longer-term unemployment, and the salary/wage (and job satisfaction) losses that many workers had to take to find a new, typically inferior, job after they lost their job. It also ignores the rise in poverty, particularly the scandalous increase in children living in poverty.

The Great Recession was triggered by the collapse of the real estate bubble epidemic of mortgage fraud by lenders that hyper-inflated that bubble. That epidemic could not have happened without the appointment of anti-regulators to key leadership positions. The epidemic of mortgage fraud was centered on loans that the lending industry (behind closed doors) referred to as “liar’s” loans — so any regulatory leader who was not an anti-regulatory ideologue would (as we did in the early 1990s during the first wave of liar’s loans in California) have ordered banks not to make these pervasively fraudulent loans.

One of the problems was the existence of a “regulatory black hole” — most of the nonprime loans were made by lenders not regulated by the federal government. That black hole, however, conceals two broader federal anti-regulatory problems. The federal regulators actively made the black hole more severe by preempting state efforts to protect the public from predatory and fraudulent loans. Greenspan and Bernanke are particularly culpable. In addition to joining the jihad state regulation, the Fed had unique federal regulatory authority under HOEPA (enacted in 1994) to fill the black hole and regulate any housing lender (authority that Bernanke finally used, after liar’s loans had ended, in response to Congressional criticism). The Fed also had direct evidence of the frauds and abuses in nonprime lending because Congress mandated that the Fed hold hearings on predatory lending.

The S&L debacle, the Enron era frauds, and the current crisis were all driven by accounting control fraud. The three “des” are critical factors in creating the criminogenic environments that drive these epidemics of accounting control fraud. The regulators are the “cops on the beat” when it comes to stopping accounting control fraud. If they are made ineffective by the three “des” then cheaters gain a competitive advantage over honest firms. This makes markets perverse and causes recurrent crises.

From roughly 1999 to the present, three administrations have displayed hostility to vigorous regulation and have appointed regulatory leaders largely on the basis of their opposition to vigorous regulation. When these administrations occasionally blundered and appointed, or inherited, regulatory leaders that believed in regulating the administration attacked the regulators. In the financial regulatory sphere, recent examples include Arthur Levitt and William Donaldson (SEC), Brooksley Born (CFTC), and Sheila Bair (FDIC).

Similarly, the bankers used Congress to extort the Financial Accounting Standards Board (FASB) into trashing the accounting rules so that the banks no longer had to recognize their losses. The twin purposes of that bit of successful thuggery were to evade the mandate of the Prompt Corrective Action (PCA) law and to allow banks to pretend that they were solvent and profitable so that they could continue to pay enormous bonuses to their senior officials based on the fictional “income” and “net worth” produced by the scam accounting. (Not recognizing one’s losses increases dollar-for-dollar reported, but fictional, net worth and gross income.)

When members of Congress (mostly Democrats) sought to intimidate us into not taking enforcement actions against the fraudulent S&Ls we blew the whistle. Congress investigated Speaker Wright and the “Keating Five” in response. I testified in both investigations. Why is the new House leadership announcing its intent to give a free pass to the accounting control frauds, their political patrons, and the anti-regulators that created the criminogenic environment that hyper-inflated the financial bubble that triggered the Great Recession and caused such a loss of integrity?

The anti-regulators subverted the rule of law and allowed elite frauds to loot with impunity. Why isn’t the new House leadership investigating that disgrace as one of their top priorities? Why is the new House leadership so eager to repeat the job killing mistakes of taking the regulatory cops off their beat?

Fannie and Freddie’s Managers bought Nonprime Paper for the same Reason Merrill Did

(via Benzinga)
The Republican members of the Financial Crisis Inquiry Commission have conducted a preemptive strike.  They issued a report arguing that the problem with Fannie and Freddie was regulation and politics and that Fannie and Freddie are responsible for the U.S. financial crisis – so regulation is the great evil.  This subdivides into four arguments: the Community Reinvestment Act (CRA), Congress’ rejection of an administration proposal to give OFHEO greater supervisory powers, specifically, the power to place Fannie and Freddie in receivership, the ability of Fannie and Freddie to borrow due to their status as Government-Sponsored Enterprises (GSEs), and the rules on Fannie and Freddie making a rising percentage of their loans to those with below median income.
The CRA argument fails on multiple levels.  The CRA became law in 1977 so it is a poor candidate to explain the rise of a crisis a quarter-century later.  Its enforcement did become slightly stronger under the Clinton administration, but it became far weaker under the Bush administration.  If the CRA caused banks to make more bad home loans, then bad loans should have fallen this decade as enforcement efforts fell.  Most nonprime loans were made by entities that are not federally insured – and not subject to the CRA.  The uninsured lenders made nonprime loans for the same reason that insured banks made the loans – doing so guaranteed the creation of record short-term income and executive compensation.  When, for example, we (OTS’ West Region) used our supervisory powers in the early 1990s to stop a sharp rise in the issuance of liar’s loans by a number of S&Ls based in California, Long Beach Savings responded by giving up its charter and federal deposit insurance so that it could become a mortgage banking firm.  Long Beach changed its name to Ameriquest and became the nation’s most infamous predatory lender specializing in making nonprime loans.  Ameriquest changed its charter so that it was not subject to the CRA – as part of a deliberate strategy to expand massively its nonprime lending.  The CRA does not require a lender to make a bad loan.  The nonprime lenders made liar’s loans which inflated the borrower’s purported income, which could make a loan that could have received credit under the CRA appear not to do so.   If the CRA drove increased liar’s loans then lenders and their agents should have falsified the income disclosures on liar’s loans’ applications by reporting reduced income.  In reality, lenders and their agents used liar’s loans to inflate substantially the borrower’s income.

President Bush did propose legislation to strengthen OFHEO’s supervisory powers and Congress declined to pass the bill.  The defeat of the bill, however, played no role in the crisis.  Moreover, while more Congressional Democrats than Republicans opposed the bill, it was a bipartisan coalition that killed the bill.  (I would have voted for the bill and I am a critic of Fannie and Freddie.)  The bill proved to be irrelevant because (1) OFHEO already had ample statutory authority to prevent Fannie and Freddie from purchasing liar’s loans’ paper and uncreditworthy subprime loans, and (2) the Bush administration did not foresee the nonprime loan crisis or the housing bubble and it did not rein in Fannie and Freddie’s purchase of nonprime mortgage paper.  The Bush administration, the Fed, and Peter Wallison did not identify, warn against, and seek to pop the housing bubble.  They did not identify and warn against nonprime lending.  Instead, they encouraged nonprime loans and ignored the warnings of the State attorneys general, consumer advocates, the FBI, and the mortgage industry’s own anti-fraud experts of the growing epidemic of fraud brought on by liar’s loans.  They did not warn against the dangers of Fannie and Freddie purchasing nonprime paper.  Instead, they encouraged them to do so.  OFHEO and Lockhart did not identify nonprime paper as a serious risk.  The bill proposed by President Bush would not have limited Fannie and Freddie’s purchase of nonprime paper.  If the bill had become law Lockhart would not have used it to restrain Fannie and Freddie’s purchase of nonprime paper – a restraint he already had authority to impose. 
The systemic risk that Wallison, the Fed, and Lockhart focused on arose from Fannie and Freddie purporting to use “dynamic hedging” to hedge their interest rate risk created by their rapid portfolio growth.  The critics’ concerns about interest rate risk and dynamic hedging were valid.  Very large dynamic hedging can cause systemic risks – but that particular concern did not contribute to this crisis.  (Moreover, OFHEO already had the authority to prevent Fannie and Freddie from engaging in purported dynamic hedging.  OFHEO used that existing authority to order extensive changes to Fannie and Freddie’s conventional purported hedging practices.  I use the word “purported” because Fannie and Freddie were recurrent accounting control frauds.  One of the ways in which they committed accounting fraud was to make misrepresentations about their hedging operations.)          
Fannie and Freddie did not have explicit federal guarantees.  They were privately-owned corporations.  The markets, however, considered them to be “too big to fail.”  The markets assumed that it was highly likely that the Treasury would prevent defaults on MBS issued by Fannie and Freddie.  Fannie and Freddie did have unique features, but the “too big to fail” aspect was, as we have seen, far from unique.  Some critics argue that if Fannie and Freddie were never created then the current crisis could not have occurred or at least would have been far smaller.  The argument is that Fannie and Freddie had the unique ability to borrow large amounts of funds while being insolvent due to their holdings of uncreditworthy nonprime paper.  The problem with this assertion is that most of the “too big to fail” banks (investment and commercial) were major purchasers of nonprime paper and they too were in reality insolvent because of their (unrecognized) losses on that nonprime paper.  Fannie and Freddie came later to the nonprime paper party than many of its peers.
Fannie and Freddie did have unique rules ratcheting up the proportion of their loans that should be made to lenders with below median incomes.  Americans are relatively wealthy, so it is not sound to conflate “below median” with “poor” or “low income.”  Fannie and Freddie could comply with some of the goals by purchasing prime mortgage loans made primarily to middle-income Americans.  There were no penalties if Fannie or Freddie failed to meet the affordable housing goals.  The goals were complex (there were three subsets) and they increased over time.  Fannie and Freddie did not always meet the goals.  They often purchased a lower percentage of “affordable” loans than the mortgage industry originated.  As to some of the goals, however, Fannie and Freddie often exceeded the goal.  The overall numbers, therefore, do not establish that the affordable housing goals drove Fannie and Freddie’s mortgage purchase decisions. 
There are excellent ways of teasing out whether Fannie and Freddie’s mortgage purchase decisions were driven by a search for yield in order to maximize their controlling officers’ compensation (which is what the SEC investigators had found earlier in the decade) or by the goals.  Liar’s loans are the best way to determine the controlling officers’ motivations.  The lenders and their agents used the absence of underwriting that is the defining element of a “liar’s loan” to substantially inflate the borrowers’ income without leaving a clear paper trail of their fraud.  In 2006, the Mortgage Asset Research Institute (MARI) explained in its Eighth Annual report to industry about mortgage fraud:      
“Stated income and reduced documentation loans speed up the approval process, but they are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.”
“One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.””
It was also common for liar’s loans to have seriously inflated appraisals.  This lowered the reported loan-to-value (LTV) ratio and increased the loan’s sales value.  Appraisal fraud also leads to unusually severe losses upon default.  It was lenders and their agents who deliberately created the perverse incentives (Gresham’s dynamic) that produced the “echo” epidemic of appraisal fraud.  (The borrower can rarely induce the appraiser to inflate the valuation.)  An honest secured lender would never cause, or permit, appraised values to be inflated.  Widespread appraisal fraud is a superb “marker” for identifying lenders engaged in accounting control fraud.  Note that a similar point applied to Fannie and Freddie.  They were exposed to severe losses if appraisals were inflated – and published reports had established that there was an epidemic of appraisal fraud.  Fannie and Freddie, if they were run by honest managers, would have reviewed a sample of the appraisals prior to purchasing mortgage paper.  Had they done so, however, they would have found that fraud was so pervasive in nonprime lending that they could not purchase the product.  The result was that financial participants dealing in nonprime paper adopted the financial version of “don’t ask; don’t tell.”  That approach would allow Fannie and Freddie’s officers to report high income and obtain large bonuses in the short-term, but it would also doom Fannie and Freddie.
Fannie and Freddie’s attainment of the affordable housing goals was measured, in the context of liar’s loans, by “stated income.”  Lenders and their agents engaged in pervasive, large inflation of those incomes because that deceit would increase the price the lender could obtain when he sold the loan.  Buying liar’s loans would simultaneously (1) massively increase Fannie and Freddie’s losses and, (2) reduce their reported compliance with the affordability guidelines by making it appear that Fannie and Freddie were buying mortgages made to those with higher incomes.  That would be a significantly insane strategy for Fannie and Freddie’s senior officers to follow if they were honest and making their business decisions based on a felt need to comply with the affordability guidelines. 
We don’t know the total dollar amount of liar’s loan paper that Fannie and Freddie purchased, but we know that it is enormous.  (The fact that we do not know tells us a great deal about the continuing weakness in the regulation of Fannie and Freddie).  In the Fannie report I reviewed they falsely reported that their liar’s loans were “prime” loans.  Fannie and Freddie’s huge purchases of liar’s loans and the efforts to mislead their investors and OFHEO about the extent of their purchases of liar’s loans only make sense if their controlling officers were following their recurrent strategy, the one laid out in the title of Akerlof & Romer’s 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.”  Fannie and Freddie’s controlling officers repeatedly wanted a “sure thing.”  Purchasing high yield liar’s loan paper maximized their compensation and let them walk away rich. 
If Fannie and Freddie had purchased only subprime mortgage paper to lower income borrowers we would have had more difficulty discerning whether they did so because of the guidelines or the yield.  The huge portfolio of liar’s loan paper, however, makes no sense if they were running an honest financial institution subject to affordable housing guidelines.  No honest CEO would purchase vast amounts of loans that were “an open invitation to fraudsters” and were sure to produce losses so catastrophic that they would cause Fannie and Freddie to fail.  Fannie and Freddie’s CEOs had been warned by the FBI, MARI, and their own staff about the epidemic of mortgage fraud.  Making liar’s loans made it harder for Fannie and Freddie to meet the affordable housing goals.  Why would an honest CEO overpay massively to acquire pervasively fraudulent assets that frequently did not count towards the affordable housing goals?  
Fannie and Freddie caused such horrific losses because they were private institutions run by officers who obtained a “sure thing” – great wealth through booking high yield in the near term without establishing meaningful loss reserves.  OFHEO and the SEC had blocked Fannie and Freddie’s prior accounting scam (abusive hedge accounting) and limited Fannie and Freddie’s growth.  Fannie and Freddie’s officers’ optimal remaining strategy, given OFHEO’s imposition of a constraint on growth, was to maximize reported short-term accounting income by purchasing very high (nominal) yield mortgage paper and not provide adequate loss reserves.  Liar’s loans offered the best nominal yield (many subprime loans are also liar’s loans).  Fannie and Freddie’s officers profited through the quintessentially private sector method of looting a corporation – executive compensation based on short-term, fictional, reported income followed by catastrophic losses and insolvency.     

Round Table: Economics 101 for Politicians and Policy Makers

L. Randall Wray and Warren Mosler participated in a round table discussion for George Jarkesy’s “New Captains of Industry” show on The complete broadcast can be heard here.

Pressures on the Paradigm: The Fall of the New Monetary Consensus

By L. Randall Wray

The following is a paper given at the ASSA conference in Denver this past week for a panel organized by James Galbraith, titled Pressures on the Paradigm, sponsored by Economists for Peace & Security.

The Queen famously asked her economists why none had seen the global crisis coming. Obviously the answer is complex, but it must include the evolution of economic theory over the postwar period—from the “Age of Keynes”, through the Friedmanian era and the return of virulent Neoclassical economics, and finally on to the New Monetary Consensus with a New anti-Keynesian version of fine-tuning by an unaccountable (“independent”) central bank

We cannot leave out the parallel developments in finance theory—with its efficient markets hypothesis—and the subsequent deregulation and de-supervision that led to the financialization of everything.

But to make a long story short: if your theory says that a global collapse is impossible, you won’t see one coming. In truth, as Jamie has argued in his great book, the Predator State, no one outside Chicago and other institutes of the higher learning ever took the free market mantra seriously—outside the ivory towers it was nothing but a slogan, a justification for enrichment of the powerful few.

Like Jamie, I believe orthodox macroeconomics is finished—although not all the zombie practitioners of that dismal religion recognize they are dead. After the crisis hit, Jamie, Duncan Foley and I were invited to appear on panels at the University of Chicago along with a dozen or so of the Chicago boys.

Not surprisingly, none of them was budging from his dogma of free and efficient markets: the crisis was caused by too much government interference; the solution is more deregulation. Three years into this crisis those who never saw it coming proclaim signs of recovery everywhere they look.

And, still, it is only academia that is clueless. Everyone in financial markets saw it coming—indeed, they planned on it and worked fastidiously to create it. They would profit on the way up, and then profit more in the collapse whilst collecting on their credit default swap bets and stealing all the homes.

It is Bush’s ownership society and the goal all along was to transfer all ownership to the top through the creation of serial bubbles—what Michael Hudson calls Bubbleonia. The biggest land grab since the enclosure movement.

So, no, there is no recovery. The banks are more massively insolvent than they were 2 years ago. They are cooking their books so they can pay executive bonuses and reward the traders and the foreclosers who are successfully transferring all wealth to the elite.

But Jamie asked me to address the state of theory—not the economy.

I want to focus on one particular Zombie that needs a stake through its heart or a bullet through its head: the New Monetary Consensus. This is an updated New Keynesian version of the old Bastard ISLM model.

The idea is that inflation slows growth so it must be diligently fought. The Fed will keep inflation expectations low, inflation will be low, and growth will be robust.

Every link in that sentence is a delicious illusion.

The Fed supposedly manages expectations by convincing markets that it controls inflation, and so long as it controls expectations it can control inflation.

But if it cannot control expectations it cannot manage inflation and all bets are off. What a flimsy reed upon which to hang public policy!

And in any case, why should low inflation generate robust growth? Because—well, because the Fed says it will, contrary to all evidence.

Out in the real world, expectations alone cannot govern any economic phenomena: inflation expectations will determine actual inflation only if those with ability to influence prices act on those expectations. And inflation below the high double digits has never proven to be a barrier to economic growth.

Let us take the current experience as an example. We have moved on to QE2, an application of the NMC.

Helicopter Ben is supposedly injecting trillions of dollars of money into the economy to create expectations of inflation—to counter the deflationary real world forces. And many wingnuts actually ARE expecting inflation—running around like Chicken-Littles, buying gold and screaming about hyperinflation and collapse of the dollar. And, yet, no inflation. Why?

Because those who might have pricing power—corporations and organized labor—cannot create inflation. Workers cannot increase their wages given massive global unemployment, and firms cannot increase prices in the face of competitive pressures. So no matter how strong is the will to believe, it has no purchase against the facts.

The wingnuts will be proven wrong. The Fed cannot create inflation. It is within the power of the central bank to lower the price of reserves—the overnight rate–as close to zero as it wants. It can also lower longer term rates on assets it is willing to buy, but there is a nonzero practical limit to that based on what Keynes called the square rule.

Quantitative easing supposedly pumps money into the economy to generate spending in order to create expectations of inflation. But all it really amounts to is substituting reserves for treasuries on bank balance sheets—lowering their interest earnings. QE won’t work because:

• (1) additional bank reserves do not enable or encourage greater bank lending;

• (2) the interest rate effects are small at best, and are swamped by private sector attempts to deleverage;

– The best estimate based on NYFed work: 18 basis points

• (3) purchases of Treasuries are simply an asset swap that reduce the maturity of private sector assets, but do not raise private sector incomes; and

• (4) given the reduced maturity of private sector portfolios, reduced interest income could actually be deflationary.

But we knew all that—Japan has been doing QE for 20 years, trying to create expectations of inflation in the face of deflationary headwinds, thus, it is interesting to compare Japanese and US experience (so far) by looking at a series of three graphs.

As they say, history doesn’t repeat itself but in this case it rhymes nicely. Only insanity would lead us to follow Japan’s path while expecting different results.

Let me finish my critique of the NMC with an observation of a Galbraith—John Kenneth this time:

To limit unemployment and recession in the US and the risk of inflation, the remedial entity is the Fed… For many years (with more to come) this has been under the direction from Washington of a greatly respected chairman… The institution and its leader are the ordained answer to both boom and inflation and recession or depression… Quiet measures enforced by the Fed are thought to be the best approved, best accepted of economic actions. They are also manifestly ineffective. They do not accomplish what they are presumed to accomplish. Recession and unemployment or boom and inflation continue. Here is our most cherished and, on examination, most evident form of fraud.

Even if the early postwar “Keynesian” economics had little to do with Keynes at least it had some connection to the real world. What passed for macroeconomics on the precipice of the global collapse had nothing to do with reality—it is as relevant to our economy as flat earth theory is to natural science.

In short, expecting the Queen’s economists to foresee the crisis would be like putting flat- earthers in charge of navigation for NASA and expecting them to accurately predict points of re-entry and landing of the space shuttle. Of course, the economic advisors to Presidents Bush and Obama could do no better.

Referring to the work of the best known economists over the past thirty years, Lord Robert Skidelsky argues “Rarely in history can such powerful minds have devoted themselves to such strange ideas.” Not only were they strange, but the ideas of the Larry Summers’, Bob Rubins, Mankiws, Marty Feldsteins, Bernankes and John Taylors of the world were, predictably, dangerous.

But one economist got it right, and did see it coming. And that is Hyman Minsky. His theory said it can happen again: market forces are destabilizing.

The economy emerged from WWII with a robust financial system—hardly any private debt and lots of safe and liquid government debt. Various New Deal and postwar reforms also made the economy stable: a safety net that stabilized consumption; strict financial regulation; minimum wage laws and support of unions; low cost mortgages and student loans, and so on. And memories of the Great Depression discouraged risky behavior.

Gradually all that changed—memories faded, self-regulation replaced financial regulations, unions lost power and government support, globalization brought low-wage competition, and the safety net was shredded. Further, profit-seeking firms and financial institutions took on greater risks with ever more precarious finance. Thus, fragility grew on trend. This made “it” possible again.

While most who invoke Minsky focus on the crash, he believed that the main instability is a tendency toward explosive euphoria. High aggregate demand and profits associated with high employment raise expectations and encourage increasingly risky ventures based on commitments of future revenues that will not be realized.

A snowball of defaults then leads to a debt deflation and high unemployment unless there are “circuit breakers” that intervene to stop the market forces. The main circuit breakers, are the Big Bank (central bank as lender of last resort) and Big Government (countercyclical budget deficits).

And, boy-oh-boy have we got a Big Bank and a Big Government! Together, the Benny and Timmy tag team have spent, lent, or guaranteed $25 trillion in the name of Uncle Sam. And that still is not enough. “It” is still happening.

The problem is that most of this was done by the Big Bank Fed, aimed at helping financial institutions—trying to prop up their worthless assets. In short, it was based on the theory that we need Money Manager capitalism and that the only hope is to generate another bubble.

It won’t work. Financialization is the problem, not a sustainable economic strategy. We need to turn instead to an updated Keynesian-Minskian New Deal based on jobs, growing wages, consumption—especially public consumption, constrained and downsized finance, and greater equality. Monetary policy also has to be downsized, while fiscal policy has to play a bigger role. Not fine-tuning but a positive and permanent presence to counter and guide and supplement the private purpose.

More importantly we’ve got to formulate theory applicable to the world in which we actually live—not one in which imaginary representative agents allocate resources along an optimal consumption path.

To that end, we stand on the shoulders of the giants like Minsky in the heterodox tradition.