NPR’s Robert Siegel Interviews William K. Black on the Investigation of S&P

Listen to William Black explain how investigations into the recent financial crisis differ from inquiries into previous disasters. Also, you’ll find Professor Black’s review of Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance below the fold.

http://www.npr.org/v2/?i=139763198&m=139763179&t=audio

Fannie and Freddie, like all U.S. systemically dangerous institutions (SDIs) were privately-owned and their liabilities were not guaranteed by the Treasury. Nevertheless, all SDIs have an implicit Treasury guarantee of their debts because any SDI failure could cause a global systemic crisis. The SDIs obtain the implicit guarantee by implicitly hold our economy hostage. The perverse incentives arising from this guarantee are the authors’ core concept.

The authors are finance professors at NYU’s Stern School. Their logic makes this a revolutionary book. The book is a case study of the perverse behavior of the managers controlling two SDIs, but the authors generalize the perverse incentives as controlling all SDIs.

The authors’ findings support James Galbraith’s thesis in The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too. Our financial leaders are the SDIs’ CEOs who make “free” markets impossible. The authors found that SDIs cause “a highly distorted market with two types of institutions – LCFI King Kongs and GSE Godzillas – both implicitly backed by the government….” (p. 55). (LCFI: “large complex financial institutions” – the authors’ polite euphemism for SDIs.) Their conclusion that “there was nothing free about these [housing finance] markets” applies to all the SDIs (p. 21).

“[T]he failure of the LCFIs and the GSEs is quite similar – a highly leveraged bet on the mortgage markets by firms that were implicitly backed by the government with artificially low funding rates only to differing degrees” (p. 49).

They adopt the CBO’s simile: living with Fannie and Freddie is like sharing a canoe with a bear.
“Because the GSEs are currently under the conservatorship of the government, it would be crazy not to kill off the “bear” and move forward with a model that did not again create a too-big-to-fail – and, more likely, a too-big-to-reform – monster” (p. 74).

The authors’ revolutionary logic is that it would “be crazy not to kill off the bear[s]” – the SDIs are inherently “monster[s]” that hold our economy hostage and block real markets and real democracy.
The authors argue that it is impossible even for massive SDIs to compete with the largest SDIs. Their simile is that the largest SDIs’ advantages are so great that it is “like bringing a gun to a knife fight” (p. 22).

In 1993, George Akerlof and Paul Romer authored Looting: the Economic Underworld of Bankruptcy for Profit. Akerlof & Romer explained how financial CEOs used accounting fraud to make record reported profits a “sure thing” (p. 5). The record, albeit fictional, reported profits were certain to make the CEO wealthy, while the bank was guaranteed to fail.

The authors confirmed Akerlof & Romer’s thesis. The CEOs’ perverse incentive creates three concurrent guarantees: the bank will report high (albeit fictional) short-term profits, the controlling officers will extract large increases in wealth, and the bank will suffer large losses. The bank fails, but the controlling officers walks away rich. “Control frauds” represent the ultimate form of “rent-seeking.” The SEC charged Fannie’s controlling officers with accounting and securities fraud to inflate its reported income so that they could extract greater bonuses.

The Authors Related Tenets: “Tail Risk” and the “Race to the Bottom”

The authors do not explain their concept of an extreme tail gamble, but they say that Fannie and Freddie’s tail gamble was purchasing nonprime loans. Those purchases were not honest “bets” and they were not subject to loss only in “rare” circumstances. Pervasively fraudulent “liar’s” loans sank the SDIs, hyper-inflated the bubble, and caused the great recession. Liar’s loans were certain to default catastrophically as soon as the housing bubble stalled. The housing bubble was certain to stall.

I believe that the authors’ logic chain is as follows:

1. SDI executives caused “their” banks to make investments that had a negative expected value, but a high nominal yield

2. In violation of generally accepted accounting principles (GAAP), the SDIs did not provide remotely adequate allowances for those future losses (ALLL)

3. This created a “sure thing” – SDIs were guaranteed to report high (fictional) short-term

4. This guaranteed fictional income led to the guaranteed massive executive bonuses

5. The officers controlling the SDIs used professional compensation (e.g., of auditors, appraisers, and rating agencies) to create a “race to the bottom” that led to widespread “echo” fraud epidemics among appraisers and credit rating agencies

6. The SDIs did the same thing to produce echo epidemics by loan officers and brokers

7. The accounting control frauds created a “race to the bottom” that drove the officers controlling other SDIs to mimic their frauds

8. This hyper-inflated the housing bubble

9. The hyper-inflation of the bubble allowed the SDIs to hide losses The SDIs’ creditors did not provide (expensive) market discipline because of the implicit government guarantee protected them from loss

10. The SDIs’ regulators did not act as the regulatory “cops on the beat” to break this private sector “race to the bottom” because the SDIs’ used their political power and ideological “capture” to create a regulatory “race to the bottom” (p. 191, n. 3)

11. SDIs following this fraud strategy were guaranteed to suffer massive loan losses and fail

12. These fraud epidemics and SDI failures triggered the Great Recession

The Authors’ Proposed Reforms are Criminogenic

Any analysis that ignores control fraud is certain to distract us from the reforms essential to prevent our recurrent, intensifying financial crises. Ignoring fraud led the authors to propose reforms that are criminogenic.

The authors’ suggestion that the Treasury charge the SDIs a fee equivalent to the value of their implicit Treasury subsidy would encourage accounting control fraud. Frauds use deceit to hide the risks the lender or purchaser is taking. The result would be an intensified Gresham’s dynamic because the accounting frauds would have an even greater advantage (due to the grossly inadequate charge for their implicit Treasury subsidy) over their honest competitors. Under the authors’ own logic and simile we must kill all of the bears.