Dawn of the Gargoyles: Romney Proves He’s Learned Nothing from the Crisis

Aurora sealed Lehman’s fate by serving as a “vector” that spread an epidemic of mortgage fraud throughout the financial system and caused catastrophic losses far greater than Lehman’s entire purported capital.  Aurora epitomizes what happens when we demonize the regulators and create regulatory “black holes.”  Romney literally demonized banking regulators as “gargoyles” and claimed that banking regulations and regulators were the cause of the economy’s weak recovery.

On April 20, 2010, I testified before the Committee on Financial Services of the United States House of Representatives regarding Lehman’s failure.  I was the witness chosen by the (then) Republican minority because they wished to have testimony from an experienced and successful financial regulator who would pull no punches in critiquing the failures of the Federal Reserve Bank of New York (FRBNY), the Board of Governors of the Federal Reserve (the Fed), and the Securities and Exchange Commission (SEC) with regard to Lehman.  The Republicans’ target was the former President of the FRBNY, Timothy Geithner. 

My House testimony explained why Aurora was the key to understanding Lehman’s failure and the causes of the financial crisis. 

Lehman was a “control fraud.”  That is a criminology term that refers to situation in which the persons controlling a seemingly legitimate entity use it as a “weapon” (Wheeler & Rothman 1982) of fraud (Black 2005).   Financial control frauds’ “weapon of choice” for looting is accounting.

Lehman’s nominal corporate governance structure was a sham.  Lehman was deliberately out of control with regard to “risk” in its dominant operation – making “liar’s loans.”  Lehman did not “manage” the risk of making liar’s loans.  It engaged in massive, fraudulent transactions that were “sure things” (Akerlof & Romer 1993).  The Valukas Report … provides further evidence of the accuracy of George Akerlof and Paul Romer’s famous article – “Looting: Bankruptcy for Profit.”  The “looting” that Akerlof & Romer identified is a “sure thing” in both directions – firms that loot through accounting scams will report superb (fictional) income in the short-term and catastrophic losses in the long-term. 

The value of Lehman’s Alt-A mortgage holdings fell 60 percent during the past six months to $5.9 billion, the firm reported last week.[1]

     

This roughly $9 billion loss, in 2008, was an important factor in destroying Lehman, but it represents only losses on liar’s loans still held in portfolio.  Aurora specialized in making liar’s loans and Aurora’s loans caused massive losses because they were pervasively fraudulent.    Lehman sold tens of billions of dollars of liar’s loans through Aurora and a subsidiary (BNC Mortgage) that specialized in making subprime loans – roughly half of which were liar’s loans by 2006.  The purchasers of these fraudulent loans had the legal right and economic incentive to require Lehman to repurchase the loans, which would have far exceeded Lehman’s reported capital.  Making and selling fraudulent liar’s loans doomed Lehman.  Lehman was one of the largest vectors that spread fraudulent mortgage paper throughout much of Europe and the United States.

The volume of liar’s loans and subprime loans was everything – as long as Lehman could sell the liar’s loans to other parties.  Volume created immense real losses, but it also maximized Dick Fuld’s compensation.  Nonprime loans drove Lehman’s (fictional) gains in income and capital under Fuld.

BNC was Lehman’s subsidiary that specialized in subprime loans.  By 2006, roughly half of its loans were liar’s loans to borrowers with poor credit records.

 

Lehman’s pattern of conduct seems bizarre because no honest firm would make liar’s loans.  The pattern, however, is optimal for an accounting control fraud.  The people who control fraudulent lenders optimize their compensation by maximizing the bank’s short-term reported income.  The “recipe” for maximizing fictional income (and real losses) has four ingredients:

The officers controlling a fraudulent lender find it necessary to eviscerate the bank’s underwriting in order to be able to make large amounts of bad loans.  The managers deliberately create a fraud-friendly culture, and Aurora demonstrated how extreme the embrace of fraud could become.   

Lehman’s senior managers consciously chose to take the unethical path because they knew it generate extraordinary reported income in the short-term, which would maximize their compensation.  Prior to becoming one of the world’s largest purchasers and sellers of nonprime loans through Aurora and BNC, Lehman had eagerly embraced fraudulent and predatory lending.  The officers who controlled Lehman also showed in this earlier episode that they would choose that short-term reported income that maximized their compensation even when they were warned that it was produced by fraud and abuse of the customers and knew that the loans would produce large losses,

Aurora and BNC Mortgage were regulatory “black holes.”  The Fed had unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to regulate all mortgage lenders and had unprecedented practical leverage during the crisis because of its ability to lend to investment banks and convert them to commercial bank holding companies.  Fed Chairmen Greenspan and Bernanke, despite pleas from Dr. Gramlich, refused to use this authority to close the regulatory black hole.  Bernanke finally, under repeated pressure from Congressional Democrats, used the Fed’s HOEPA authority in August 2008 – over a year too late to even minimize losses.  Greenspan and Bernanke were chosen to lead the Fed because of their intense, anti-regulatory dogma.  Greenspan was notorious for his assertion that fraud provided no basis for regulation.  He believed that financial markets automatically excluded fraud.   

The SEC was equally notorious for its anti-regulatory policies.  It created the disgraceful non-regulation regulation of Lehman and its four sister investment banks.  The Consolidated Supervised Entities (CSE) program never made the SEC a real “primary regulator.”  The SEC is incapable, as constituted, staffed, and led to be a primary regulator of anything – and that includes the rating agencies.  “Safety and soundness” regulation is a completely different concept than a “disclosure” regime.  The SEC’s expertise, which it has allowed to rust away for a decade, is in enforcing disclosure requirements.  The SEC did not have the mindset, rules, or appropriate personnel to make the CSE program a success even if the agency had been a “junk yard dog.”  Given the fact that the SEC was self-neutered by its leadership during the period Lehman was in crisis in 2001-2008, there was no chance that it would succeed even if the CSE been a real program.

The primary cause of severe bank failures has long been senior insider fraud (James Pierce, The Future of Banking (2001).  We know the characteristics that cause the criminogenic environments that produce the epidemics of accounting control fraud that cause our recurrent, intensifying crises.  Two of the most important factors are the “three de’s” – deregulation, desupervision, and de facto decriminalization – and perverse executive, professional, and employee compensation.  These two factors were principally responsible for creating the epidemic of mortgage fraud that drove our crisis.  Financial regulation was effectively destroyed in the U.S. 

The primary function of financial regulators is to serve as the “regulatory cops on the beat.”  “Private market discipline” was an oxymoron – financial firms are supposed to provide the discipline by denying credit to poorly managed and overly risky firms.  They are supposed to be impervious to fraud.  The reality is that they fund the frauds’ rapid growth.  Fraud begets fraud.  George Akerlof warned of this perverse “Gresham’s” dynamic in his famous 1970 article about “lemon’s” markets.  When fraud provides a competitive advantage market forces become perverse and drive ethical firms from the marketplace.  Effective, vigorous financial regulation is essential to break this Gresham’s dynamic.  The regulatory cops on the beat must take the profit out of fraud.

There are several reasons why the economic recovery is weak and there is a great danger of recurrent recessions.  My colleagues on this blog have explained the macroeconomic reasons so I will concentrate on the regulatory barriers to recovery.  Suffice it to say that my colleagues have shown that the recovery is not weak primarily due to credit restraints by banks on lending to corporations.  The regulatory barriers to recovery are the opposite of what Romney asserts.  Financial regulation in the U.S. remains extraordinarily weak.  President Obama has largely kept in power and even promoted Bush’s financial wrecking crew.  Larry Summers and Timothy Geithner are fierce anti-regulators.  The Republicans have blocked vital appointments to the Fed – under the claim that a Nobel Prize winner in economics lacks sufficient expertise to serve on the Fed.  The Republicans, while claiming that Fannie and Freddie pose a critical risk to the nation; have blocked the appointment of a superbly qualified head of the agency that is supposed to regulate Fannie and Freddie.  The Republicans have blocked the appointment of Elizabeth Warren to head the Consumer Finance Protection Bureau.  Warren (a) warned of the coming nonprime disaster, (b) is superbly qualified to lead the bureau, and (c) is a remarkably pleasant and unassuming Midwesterner.  The head of the SEC was named based on her experience as a failed leader of self-regulation.  Bernanke named as the Fed’s top supervisor an anti-regulatory economist with no experience in examination or supervision.  Bernanke then, absurdly, claimed that his appointment made the agency more inter-disciplinary.  The reality is that it simply made theoclassical economists dominant in the one senior professional post that previously provided the Fed with an alternative policy perspective and real expertise.  Attorney General Holder has largely continued the Bush administration’s policy of allowing the elite bank frauds to proceed with impunity. 

The Republicans are trying to force severe cuts in the already inadequate budgets of the financial regulatory agencies.  The flash clash revealed that the SEC does not have the internal capacity to monitor or even study retrospectively hyper-trading, which has become increasingly dominate.  The SEC will not be provided with sufficient budget to even develop a system to monitor and study hyper-trading.  The commodity markets are being subjected to exceptional manipulation.  The Commodities Futures Trading Commission (CFTC) has announced that it cannot afford to develop the systems essential to detect and track commodity speculation.  Instead of demanding that the CFTC develop such an essential system the Republicans are seeking to slash the CFTC’s already grossly inadequate budget. 

      

Romney’s claim that this group of understaffed and funded regulators led by senior anti-regulators constitutes “gargoyles” that have terrified the systemically dangerous institutions (SDIs) that dominate our finance system is ludicrous.  There isn’t an SDI in the U.S. that fears its regulators.  The regulators are like gargoyles – they may scare children but one soon learns that they are immobile stones that do not see, bite, or even growl.  They are perches and canvasses for pigeons and their droppings.

Epidemics of accounting control fraud cause severe economic crises and harm recoveries in myriad ways.  First, fraud causes far more severe losses.  Second, fraud erodes trust because the essence of fraud is the creation and betrayal of trust.  Trust can take many years to recover.  The number of middle class Americans willing to invest in the stock market has still not recovered from the Enron era frauds.  Third, as Akerlof & Romer (1993) warned, accounting control fraud epidemics can cause bubbles to hyper-inflate.  Severe bubbles make markets grossly inefficient.  Japan demonstrates that it can take over a decade for the prices to fall to levels where the markets will “clear.”  The catastrophic nature of the losses and their concentration in financial institutions leads to the temptation to change the accounting rules to cover up the banks’ losses.  We refused to do so during the S&L debacle and the result was a prompt recovery.  We, like Japan, gave in to the banks’ demands during this crisis and the result is an impaired recovery.  Fourth, the endemic mortgage fraud by lenders led to endemic foreclosure fraud because fraudulent lenders (a) keep extremely poor records and (b) a number of the largest servicers are staffed with personnel from the firms that made the fraudulent loans.  The foreclosure fraud is harmful both because it defrauds the innocent and because it shields the most abusive borrowers from prompt foreclosures.  Fifth, the fraud and the hyper-inflated bubble lead to a severe drop in private wealth and demand and household pessimism.  The household sector has not been able to provide the demand to produce a strong recovery.  Sixth, because we pretend that insolvent banks are healthy and keep them under the leadership of the inept and even fraudulent managers who caused them to become insolvent we end up with Japanese-style crippled banks that prefer to clip coupons rather than make commercial loans.         

Romney is replaying the absurd and harmful propaganda of 1986-1987.  S&L regulation was critically weak, which is what made the S&L industry so criminogenic.  The industry trade association, however, claimed that regulation was oppressive.  We, the S&L Federal Home Loan Bank Board Chairman Edwin Gray with any funds and any additional regulatory powers to counter the accounting control frauds that were running wild.  Instead, in the Competitive Equality in Banking Act of 1987 (CEBA), Congress mandated “forbearance” designed to gut our power to close the frauds.  This was not Congress’ intent – they did not consciously seek to aid the frauds.  The worst S&L frauds, however, formed what a prominent CEO called a “Faustian bargain” with the S&L trade association to counter our proposed legislation.  The result of that Faustian bargain was that language was inserted in our proposed bill that was framed by the frauds’ lobbyists for the express purpose of making it far more difficult for us to close the frauds.  Until we took on their political patrons and spent months explaining to members of Congress, their staffs, and the media how the proposed amendments would damage our ability to act effectively against the frauds these claims that the regulators were ogres were taken as true by most politicians.  All their political contributors said it was true.  The reality was, of course, the opposite as virtually everyone now agrees.  S&L regulation had been nearly non-existent.  With the aid of Representatives Gonzalez, Leach, Carper, and Roemer and Senator Gramm (yes, that Senator Gramm!) we were able to make subtle changes in the CEBA bill that undid the worst of the frauds’ amendments. 

Will the Obama administration be willing to fight like we did to save the effort to put the fraudulent S&Ls in receivership, remove the scam accounting rules, toughen regulation, and prosecute the fraudulent senior officers?  Or will it give in to Romney’s propaganda and its desire to raise vast sums in political contributions from finance executives by weakening the already criminally weak Dodd-Frank Act?  The administration’s most recent action has been to delay adoption of the rules implementing the Act.  It wants banks to be able to continue the disastrous practices that made the crisis worse and that the Dodd-Frank Act sought to prohibit. 

Here are the key passage and question arising from Romney’s speech: