By William K. Black
(Cross-posted from Benzinga)
Sixty Minutes’ December 11, 2011interview of President Obama included the following gem:
KROFT: One of the things that surprised me the mostabout this poll is that 42%, when asked who your policies favor the most, 42%said Wall Street. Only 35% said average Americans. My suspicion is some of thatmay have to do with the fact that there’s not been any prosecutions, criminalprosecutions, of people on Wall Street. And that the civil charges that havebeen brought have often resulted in what many people think have been slap onthe wrists, fines. “Cost of doing business,” I think you called it inthe Kansas speech. Are you disappointed by that?
PRESIDENT OBAMA: Well, I think you’re absolutelyright in your interpretation. And, you know, I can’t, as President of theUnited States, comment on the decisions about particular prosecutions. That’sthe job of the Justice Department. And we keep those things separate, so that there’sno political influence on decisions made by professional prosecutors. I cantell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.
That’s exactly why we had to change the laws. Andthat’s why we put in place the toughest financial reform package since F.D.R.and the Great Depression. And that law is not yet fully implemented, butalready what we’re doing is we’ve said to banks, “You know what? You can’ttake wild risks with other people’s money. You can’t expect a taxpayer bailout.
Hallucinations occur at high altitude when you become oxygen deprived. Let’s review the bidding on theBush/Obama record in prosecuting the elite control frauds that drove theongoing crisis. There are noconvictions of the Wall Street elites that made, purchased, packaged, and soldmillions of fraudulent liar’s loans. There are no federal prosecutions of the major banks that committed over100,000 fraudulent foreclosures. There are a few settlements that sound like large dollar amounts, butare merely what even Obama concedes to be the (deeply inadequate) “cost ofdoing (fraudulent) business.” Fraud pays – it pays enormously and our elites now commit it withimpunity as a means of becoming wealthy. We have just witnessed the travesty of Wachovia admitting to criminalconduct in their (grotesquely weak) settlement with the Department of Justice(which has a policy of no longer prosecuting large corporations that commitcrimes) – and having the SEC refuse to require Wachovia to make similaradmissions in its settlement. Allthis, the President implicitly or even explicitly concedes.
But the President asserts: “Ican tell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.” Kroft, sadly, didnot follow up on this incredible and, if true, extraordinarily importantassertion. Obama’s statementsabout fraud and ethics are inaccurate on multiple levels.
Obama’s factual assertions about the failure to prosecute fraud areunresponsive to the question, false, and logically inconsistent. Note the artful manner in which Obamaevaded answering Kroft’s question. Kroft asks why there are no prosecutions of the Wall Street frauds thatdrove the crisis. Obama answersthat “some” unethical Wall Street actions were not illegal. Obama’s answer implicitly admitted thatmost Wall Street actions that causedthe crisis were criminal. Hesimply argues that some highlyunethical behavior by Wall Street that was not illegal contributed to thatcrisis. As David Cay Johnstonemphasized in his column about Obama’s response to Kroft’s question, Obama’s answeris a non-answer. Why has he failedto prosecute any of the criminal conduct by Wall Street that drove thefinancial crisis? The (alleged)fact that “some” destructive Wall Street conduct was highly unethical, but notillegal, obviously provides no basis for not prosecuting what Obama concedeswas primarily criminal conduct.
Obama claims that the purported legality of Wall Street’s (unspecified)“least ethical behavior” is “exactly why we had to change the laws.” He then describes the two specificchanges in the Dodd-Frank law that he asserts make illegal that “least ethical behavior” for the firsttime. Obama claims that Dodd-Frankmakes it illegal to “take wild riskswith other people’s money” and for bankers to “expect a taxpayer bailout.” Obama is a lawyer and former lawprofessor, so these are matters as to which he is capable of precision. Dodd-Frank does not make it illegal for bankers to take “wildrisks.” Banks inherently takerisks “with other people’s money” so that bit of rhetoric issuperfluous.
Dodd-Frank does not make it illegal for a banker to “expect a taxpayerbailout.” Dodd-Frank does not makeit illegal (and could not constitutionally do so) for bankers to lobby for abailout. We have all seen thesuccess of such lobbying with the Bush and Obama administrations. Both administrations have refused toorder an end to the “systemically dangerous institutions” (SDIs) (inaccuratelyreferred to as “too big to fail”). Both administrations asserted that when the next SDI failed it was likelyto cause a global systemic crisis. (It is a matter of “when”, not “if” they will fail, or more precisely,when we will admit that they failed.)
The SDIs are also too big to manage – they are inefficiently large. We can increase efficiency,dramatically reduce global systemic risk, and reduce the SDI’s exceptionalpolitical dominance by ordering them to shrink over the next five years to apoint that they no longer pose a systemic risk. Instead, the Obama administration continues the Bushpractice of referring to the SDIs as “systemically important” (as if theydeserved a gold star for putting the world’s economy at risk). The Bush and Obama administrations haveallowed, even encouraged, the SDIs to grow larger. That policy is insane. It poses a clear and present danger to the U.S. and global economy andto our democracy. The SDIs will be“bailed out” when they fail. Indeed, they are being bailed out continuously by policies the Fed andTreasury follow that are designed to provide massive governmental subsidiesprimarily for the benefit of the zombie SDIs that have already failed in realeconomic terms, e.g., Bank of America and Citi.
“Wild risks” are not remotely Wall Street’s “least ethicalbehavior.” It is impossible, givenObama’s generalities and Kroft’s failure to probe to know what “wild risks”Obama is talking about, but none of the (supposed) risky loans banks made evenapproach lenders’ “least ethical behavior.” The riskiest loans that banks made were liar’s loans toborrowers with bad credit histories. Credit Suisse reported in early 2007 that, by 2006, 49 percent of loansthat lenders called “subprime” (because they were made to borrowers with known,serious credit defects) were also liar’s loans (loans made without prudentunderwriting). I agree with Obamathat making a subprime liar’s loan is exceptionally “damaging.” Such loans damaged the lender, theborrower, the purchaser of such loans, and the purchaser of the collateralizeddebt obligations (CDOs) that were backed by subprime liar’s loans. (Of course, “backed” deserves to be inquotation marks.) Such loans wouldbe dumb, but they wouldn’t be among the banks’ “least ethical” actions if theloans were lawful. Indeed, ifmaking subprime liar’s loans were merely risky, one could argue morepersuasively that the banks were acting altruistically when they made suchloans.
What Obama missed, and Kroft failed to call him on, is that “wildrisk” by banks are typically frauds. I have explained these matters at length in previous posts, so I willprovide the ultra short version here. Honest home lenders do not make liar’s loans. In particular, honest lenders do not make subprime liar’sloans. Honest home lenders do notmake such loans because they create intense “adverse selection” and create a“negative expected value” (in plain English, they will lose money). No government (here or abroad),required any lender or other entity (i.e., Fannie and Freddie) to make oracquire liar’s loans. In fact, thegovernment repeatedly criticized liar’s loans. The FBI warned of an “epidemic” of mortgage fraud inSeptember 2004. The mortgagelending industry’s own anti-fraud body (MARI) warned every member of theMortgage Bankers Association (MBA) in writing in the 2006 that “stated income”loans were “an open invitation to fraudsters,” had a fraud incidence of 90percent, and deserved the term the industry used behind closed doors todescribe them – “liar’s” loans. Despite these warnings, lenders massively increased the number of liar’sloans they made.
Home lenders made subprime liar’s loans because they were“accounting control frauds.” Subprimeliar’s loans were ideal “ammunition” for accounting fraud. They reduced the paper trailestablishing that the lender knew the loan was fraudulent and they optimizedthe four-ingredient “recipe” for a lender engaged in accounting controlfraud. (Grow rapidly by making badloans at a premium yield, while employing extreme leverage and providing onlygrossly inadequate allowances for loan and lease losses (ALLL)). The CEOs of lenders that made subprimeliar’s loans as part of this recipe were not taking risks in the conventionalmanner we discuss in finance (uncertainty). As George Akerlof and Paul Romer explained in their famous1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”),accounting control fraud is a “sure thing.” The lender is guaranteed to report record (albeit fictional)profits in the near term, which makes the CEO wealthy when he uses modernexecutive compensation to loot the lender. Unfortunately, the same recipe that creates extremefictional income produces massive real losses.
Making liar’s home loans inherently requires lenders tocreate perverse incentives for widespread mortgage fraud. It was lenders and their agents thatoverwhelmingly put the lies in liar’s loans. The CEOs of the lenders who made subprime liar’s loanscompounded their initial mortgage origination fraud by making fraudulent repsand warranties to sell the endemically fraudulent mortgages. The growth in liar’s loans (roughlyhalf of them were also subprime loans) was so extreme – over 500% from 2003 to2006 – that it caused the bubble to hyper-inflate). Making fraudulent loans that placed millions of workingclass borrowers in loans that they frequently could not afford to repay andwere deeply underwater caused them a massive loss of wealth and wasdistressingly unethical. Theofficers controlling the lenders that made fraudulent liar’s loans were evenmore unethical because they caused this devastation in order to become exceptionallywealthy. The most morally depravedof the CEOs running accounting control frauds sought out the least financiallysophisticated borrowers, often minorities, as their victims.
Obama has unintentionallyproved the accuracy of the plurality of survey responders who concluded that heserves Wall Street’s interests at the expense of the public. He cynically evaded responding to theprimary reason why the public “gets it” – the abject failure of his administrationto prosecute the elite financial frauds that drove the financial crisis and theGreat Recession. Obama offered thepathetic (and factually inaccurate) non-excuse that “some” unethical conductmight be legal. It is time forObama (and Attorney General Holder) to “man up.” If they refuse to do so and are going to continue to be lapdogs for the elite financial frauds they should at least change the name of theJustice Department.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @WilliamKBlack