Reinventing Crony Capitalism: the Context of Geithner’s Obscene Rant against Barofsky

By William K. Black

Neil Barofsky, the former Special Inspector General for the Troubled Asset Relief Program (TARP) (SIGTARP), was one of the officials that made one proud of America.  Naturally, Treasury Secretary Timothy Geithner detested him.  Barofsky discusses Geithner’s antipathy for him in a newly published book: “Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street.”  The juicy parts that have been discussed in the media involve Geithner’s epic “f” word rant against Barofsky in fall 2009 in response to Barofsky’s recommendations for greater transparency about TARP.

The Huffington Post article quotes from the book’s description of the meeting:

“As we parried back and forth, Geithner repeatedly reached a pitch of anger, regaling me with detailed expletive-filled explanations that established my apparent idiocy. He would then calm himself down and give me a forced, almost demonic smile.”

My column, however, expands on the article’s last paragraph:

“[T]he more-damning allegations of the book [are] that Geithner’s Treasury Department repeatedly tried to undermine Barofsky’s authority, ignoring his warnings about the risk of fraud in TARP programs and generally carrying water for the banking industry.”

In his 1996 reinvention report, Gore used a famous adage to express the same unwillingness to tolerate resistance to the administration’s anti-regulatory dogma:  “Government reinventors believe in the adage, “Lead, follow, or get out of the way.”  Speaking truth to power is a career limiting gesture in the dictatorial world designed by Osborne and Gore.  They viewed rival reinventors who sought to explain how criminogenic an environment their anti-regulatory policies were creating as the enemy and their opposition as intolerable.  They did not trust in the persuasiveness of their assertions to carry the debate.  Their opponents were illegitimate and dishonest.  Geithner’s vulgar, unprofessional diatribe against Barofsky flows from this same mindset.  What enraged Geithner is that the statutory protections provided to ensure the inspector generals’ independence allowed Barofsky to speak truth to power by documenting why he thought that Geithner’s policies were contrary to the program’s mission.  That is the real reason that the anti-regulatory reinventors have such a passionate hate for inspector generals.  They cannot be “remove[d]” when they provide “resistance” to the anti-regulatory dogma or document that elite frauds are not a trivial problem that provides no basis for vigorous regulation.  They can make public embarrassing information that falsifies the anti-regulatory dogma.  The IGs can serve as safe havens for those that believe that the government’s mission is to serve the nation’s interests rather than the industry’s interests.  This was the heart of Barofsky’s message as shown in his book title – “Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street.”  Barofsky’s charge was that Geithner was serving the interests of the often fraudulent banking industry that caused the crisis rather than the interests of the public (“Main Street”).  Geithner is a firm believer in the modern version of “what’s good for GM is good for America” – “what’s good for Wall Street is good for America.”

What drove Geithner’s verbal assault on Barofsky was the frustration of recognizing that he lacked the power to fire or silence him because of the IG’s statutory protections.  Geithner’s only recourse was to seek to intimidate Barofsky.  Sadly for Geithner, Barofsky was made of sterner stuff.  Geithner’s other problem is that while the Keating Five were intimidating, Speaker Wright was intimidating, and Congressman Dingell, back in the day, was intimidating – Geithner in full rage is a comical hissy fit that would not intimidate even the weakest IG.  Barofsky’s greatest challenge was to avoid breaking out in hysterical laughter at the absurdity of Geithner’s attempt to intimidate him.

Themes of this article

I do not detail Geithner’s actions against Barofsky in this article.  I write to situate Geithner’s rage against Barofsky in the broader context of how the “reinventing government” movement helped destroy effective financial regulation and was particularly blind to the essential role that regulators must play to restrain the epidemics of fraud that drive our recurrent, intensifying financial crises.  The reinventing government movement’s embrace of the three “de’s” – deregulation, desupervision, and de facto decriminalization, its embrace of modern compensation, and its trivialization of the risks of control fraud contributed greatly to the maximization of the perverse incentives that produce epidemics of accounting control fraud.  The reinventing government’s ideological embrace of neoliberal dogma created an intensely criminogenic environment.  The irony is that it became dominant at the federal level in the same year that its dogmas were confirmed to be false and criminogenic in the savings and loan context.  Indeed, reinventing government did not simply become dominant – in 1983 it became the exclusive acceptable (anti) regulatory philosophy of the Clinton administration.  Vice President Al Gore led the administration’s reinvention movement with an evangelical passion that interpreted all resistance to its dogma as inherently illegitimate.  Behind the scenes, it was led by David Osborne, a journalist who had reinvented himself as a consultant who developed and championed the “reinvention” concept.  (Ted Gaebler was Osborne’s original co-author.  Gaebler used reinvention techniques as City Manager of Visalia, California.  After he left Visalia, reinvention led to severe problems and Visalia dropped it.  Osborne dropped Gaebler, but not the anti-regulatory dogma.)  The irony is that neither Osborne nor Gore had substantial experience as public sector program managers at the time they implemented and purported to study their reinvention effort.

Ideologically, the reinvention dogma was an application of the “Washington Consensus.”  The Washington Consensus embraced an anti-regulatory, anti-governmental dogma that promised to transform Latin America – the primary test bed for the consensus.  If readers have ever wondered why so many Latin American leaders have been elected on platforms that call for a major governmental role in the economy the shortest answer is that the Consensus failed to deliver on its promise of rapid growth and many aspects of the Consensus enraged a majority of the electorates.

President Clinton and Al Gore were Southern politicians who rose to power as “New Democrats.”  The New Democrats created the Democratic Leadership Council (DLC) to move the Democratic Party to the right.  The DLC was explicitly pro-business and allied with many of the largest corporations.  The DLC was anti-regulatory and shared the neo-liberal dogma that government was frequently a bloated failure while the private sector was a raving success.  Gore explicitly endorsed Francis Fukuyama’s “end of history” claim.  Fukuyama has repudiated that claim and seems to understand increasingly that the assault on the legitimacy and competence of democratic governments sowed the seeds for crony capitalism dominated by financial firms so large that they can commit fraud with impunity.  Crony capitalism makes a mockery of “free markets.”

Barofsky’s unpardonable sins: independence and representing the public instead of banks

This article focuses on one aspect of the reinventing movement’s dogma – the hostility to taking the vigorous regulatory, supervisory and enforcement actions that were essential to prevent control fraud and the destruction of the regulatory support essential to prosecute elite corporate criminals.  The reinvention dogma held that the federal officials who most obviously fought to prevent and punish fraud were the central problem.  The greatest villains were the inspector generals.  Geithner’s visceral attacks on Barofsky did not arise randomly – they exemplify the core dogma of the reinvention movement.

“Federal managers complain bitterly about the inspectors general, for example. Part of the auditing system, each IG’s office has hundreds of auditors and inspectors—many of them former law enforcement people—who comb through the organization looking for wrongdoing. Created by Congress in the late 1970s, they are a legacy of the Watergate era. Unfortunately, they operate as an enormous barrier to innovation, because when reinventors try new things they often have to bend a few rules. The IGs typically slap their wrists, regardless of how petty the infraction or how silly the rule. When Vice President Gore held town meetings about reinvention in each department in 1993, he heard more bitter complaints about the IGs than about any other problem. Departmental managers have no authority over their inspectors general.”

Banishing Bureaucracy: The Five Strategies for Reinventing Government, by David Osborne and Peter Plastrik (1997: 62).

Barofsky is a former prosecutor – one of those “former law enforcement people” who government officials “complain bitterly about.”  They have a bad attitude and enforce “petty” and “silly” rules that “operate as an enormous barrier to innovation” by revinventors who “often have to bend a few rules.”  The IGs are “relics” of an outmoded age.  The reinventors were clever in their assault on the IGs.  They sought to reinterpret the IGs’ mission as – ensuring the success of anti-regulatory reinvention.  Paul Licht famously called An End to the War on Waste. Brookings Review; Spring 93, Vol. 11 Issue 2 (1993: 48).  He argued that if the IGs did not abandon their war on fraud they would become as obsolescent as “battleships.”

Sadly, as Barofsky’s book emphasizes, the reinventors succeeded in bending many of the IGs.

Gore’s Creation Myths about Regulation

The foundational, creation myth that defined the anti-regulatory reinventors – the assertion that elite fraud and corruption is a trivial problem regardless of the regulatory environment – drove the movement’s anti-regulatory policies.  Rules were bad.  “Dictated” rules and supervisory orders were terrible.  The industry was the government’s “customer” and “partner” and Clinton and Gore ordered regulators to “negotiate” rules and supervisory orders with their industry customers/partners.  They put their anti-regulatory mandates on cards with check marks:

All Regulators Will:

Cut obsolete regulations

Reward results, not red tape

Get out of Washington—create grass roots partnerships

Negotiate, don’t dictate

ss/ Bill Clinton and Al Gore

February 22, 1995

It was essential that regulators make their customers happy.  It was horrific when regulators sought to function as the regulatory “cops on the beat.”  The regulators should “partner” with the industry.  The naturally and perpetually honest members of the industry (the mythological 99.5% that Gore’s reinventors assumed) would remain honest no matter how many rules and regulators were eliminated and no matter how deeply in bed with their “customers” the regulators became through “partnerships.”  The dogma implicitly assumed that criminogenic environments could not arise in U.S. industries.

Resistance is Futile: One size fits all deregulation, desupervision, and de facto decriminalization (the three “de’s”)

Gore asserted in his 1996 report that the administration’s anti-regulatory dogma had been proven correct and was universally applicable to regulatory agencies.

Regulatory agencies are on orders to make partnership with businesses their standard way of operating. We have tested it long enough to know it increases compliance with the laws of the land. After all, compliance is what we’re after—not meaningless hassles. Now we can move beyond pilot programs for partnership into the mainstream.

Osborne was even more draconian.

Reinventors use a great many tools to implement these approaches; we described many of them in The Reinventor’s Fieldbook. Whichever ones you choose, there are some fundamental lessons about leading cultural change that apply in virtually every organization:

4. Make a clear break with the past: send an unmistakable signal that you are initiating culture change.

5. Unleash—but harness—the pioneers. Channel their energy in constructive directions.

6. Get a quick shot of new blood, by bringing in new managers who already carry the new culture. Then continue the transfusion every time you hire someone new.

7. Drive out fear, but don’t tolerate resistance. Give employees lots of information and rewards. But if someone repeatedly undermines the change process, remove them.

8. Sell success: constantly call attention to the new behavior you’re looking for, and reward it. But don’t make the new culture politically correct.

Osborne wants a clear signal – any past wisdom and hard won successes are inoperative.  Enlist pioneers, but “channel” them to support the new anti-regulatory dogma.  Bring in new managers who embrace that dogma and “every time” you hire someone make sure they embrace the anti-regulatory dogma.  Number 7 is classically Orwellian: “drive out fear” – by firing anyone who continues to have an opposing view.  Give “rewards” to those that embrace your dogma.  Performance pay (where “performance” was judged by the degree of one’s passion in supporting the anti-regulatory dogma) and a greatly expanded ability to fire public employees were central pillars of Osborne and Gore’s vision of reinvention.  This is logical given their belief that it was essential to “reward” (repeated in points 7 and 8 ) and be able to “remove” employees in order to build a “culture” that did not “tolerate resistance” to the pro-industry dogma.

One hopes it is obvious to the reader that Gore and Osborne actual reinvention program did the opposite of what they asserted was its most important strength – granting authority to employees closest to the facts to innovate and follow policies they thought were most sensible in the contexts they knew best.  The Clinton administration “order[ed]” all regulatory agencies to “make partnerships with businesses their standard way of operating.”  Any form of reinvention was permissible as long as it was the anti-regulatory form that Osborne favored and Gore and Clinton parroted.  Henry Ford (you can have any color car you want as long as it is black) would have recognized kindred spirits in the Osborne and the Clinton team.  He too was a reinventor and his name became a management term: Fordism.  One of its propositions was that the guys at the top make the rules and “order” the grunts to follow the rules.  Ford wasn’t as cynical as Gore and Osborne; he didn’t pretend that he was empowering the grunts to make managerial decisions.

The anti-regulators “know” that deregulation designed by our industry “partners” “increases compliance.”  They had tested this claim “long enough.”  The partnerships largely began deregulating in 1994 and Gore’s report was published in September 2006, so this purported “test” selectively ignored the S&L debacle and our successful 1990-1991 regulatory crackdown on nonprime lending by S&Ls, which supported the opposite conclusion.  The “test” period was also far too brief (rather than “long enough”) to actually “know” whether encouraging the regulators to think of the industry as their “customer” and encouraging our industry “partners” to design radical deregulation would “increase compliance.”

Osborne’s anti-regulatory dogma went well beyond his customer/partner ode to industry and his disdain for rules and demands that most of them be repealed.  Osborne embraced “the rule bender” who would violate whatever rules survived his purge.  Rules were bad, so those in the industry and the government who bent the rules might well be good, or even deserving of the highest possible accolade the “reinventors” could bestow: “entrepreneurial.”  The foundational myth led to the assertion that the (assumed) trivial number of frauds should be prosecuted, which would directly address any downside – and allow anti-fraud needs to be ignored as a legitimate basis for regulation.  The reinvention dogma implicitly assumed that vigorous regulators and regulations were unnecessary to detect or prosecute effectively control frauds.  Implicit assumptions are the most dangerous because the proponents do not even recognize that they have assumed away critical problems.

Gore’s reinvention report for 1996 was open about its assumption of inherently honest industry behavior regardless of regulatory restraints on fraud.

Can federal regulators really be partners with industry? We are not naive. We know that not everyone is going to play by the rules. There will still be bad actors who will not comply. For them, we reserve every penalty and sanction that the law allows. And because regulatory time and effort is no longer being wasted on the good guys, agencies can better focus their attention on the few cheaters.

But experience shows that the vast majority do play by the rules—if they can figure them out, that is. In dealing with that majority who want to do the right thing, partnership can achieve very good results. If we agree on the goals, allow room for innovation, and help each other all we can, that will increase compliance.

As Tommy Roland said, some people might think we’re not doing our job because we’re not hassling everybody anymore. Well, hassling never was our job, and corporate America never was the enemy. The enemy is pollution, contaminated food, workplace and product hazards, and the small percentage of people who smuggle drugs, cheat on taxes, and deliberately pollute our environment.  Our job is to stop all of them, and we are doing it better than ever—along with new partners eager to help get the job done.


Control fraud is the Achilles’ heel of the three “de’s”

Control frauds will not “help [the government] all [they] can” to reduce fraud.  The anti-regulatory reinventors assumed away the perverse incentives of fraudulent elites and the resultant Gresham’s dynamic they can create that can lead to a substantial increase in fraud.  They have also assumed that it suffices if the “majority” of industry members do the right thing.  All these assumptions are not only false, but obviously false.  The problem is that the administration’s false assumptions were implicit.  An explicit assumption challenges the entity making it to determine its accuracy.  Implicit assumptions carry no such protection against disastrous error.  The anti-regulatory reinventors were and are spectacularly, dangerously naïve about regulation, fraud, and many industries.  They were either naïve or reprehensible in defining the industry as the regulators’ “customers” and “partners” – and I personally witnessed them do so at an OTS training event attended by hundreds of our staff.  They failed utterly to understand how rules both prevented or reduced criminogenic environments and made it far easier to prosecute the frauds.  For example, the Bank Board’s underwriting rule mandated that S&Ls maintain written records demonstrating how they had determined that the borrower had the capacity to repay the loan.  This allowed us to take supervisory action in 1990-1991 to drive liar’s loans (with a 90% fraud incidence) out of the industry, which greatly reduced fraud.

We used the same underwriting rule during the S&L debacle to convict felons.  The “recipe” that the CEO of  lender causes it to follow in order to optimize accounting control fraud leads to the making of enormous numbers of loans to borrowers who lack the capacity to repay.  Under our underwriting rules, the fraudulent CEO had four choices, and they were all bad once we reinvented the Bank Board and became vigorous regulators.  He could document in writing that he knew he was making many loans to borrowers who could not repay the loans.  He could fail to underwrite the loan.  He could destroy the documentation documenting that the borrowers could not repay their loans.  He could forge documents purporting to show that the borrowers had the capacity to repay the loans.  The Bank Board’s highly successful underwriting rule was one of the casualties of the anti-regulatory reinventors.  It was replaced with a deliberately unenforceable “guideline” that allowed the CEO to adopt grotesquely unsafe and unsound loan underwriting practices.  This set the stage for the epidemic of fraudulent liar’s loans that drove our ongoing financial crisis.

The industry is not the “enemy” and our job as regulators is not to “hassle.”  It is, however, naïve to assume that your “partners” will eagerly take expensive measures to reduce pollution if their competitors are able to pollute with impunity and gain a competitive advantage over their honest rivals that may cause them to fail.  Prompt, vigorous, and effectively enforced regulatory directives to end the illegal pollution are essential to stop the Gresham’s dynamic.  Even a small number of initial frauds can create such a perverse dynamic.

The anti-regulatory reinvention dogma attacked the aspects of government essential to limiting elite frauds.  The anti-regulatory reinvention movement denounced the three “de’s” that were essential to deter and punish elite frauds and corruption as the problem rather than the solution.  The reinvention movement relied on creation myths that they never even attempted to support empirically, i.e., that only a tiny, inconsequential number of individuals would ever engage in fraud or corruption regardless of whether the reinventors embrace of the three “de’s” dramatically reduced the felons’ risk of their crimes being discovered and severely sanctioned.  That myth had been falsified empirically by financial regulators, prosecutors, criminologists, and economists at the time (1993) that the myth became the Clinton administration’s official, incontestable dogma.  Indeed, an authentic reinvention movement by savings and loan regulators had by 1993 demonstrated astonishing success precisely because the regulators rejected (and falsified) the standard reinvention myths about fraud.  The second (implicit) myth is that the regulators could be taught to think of the industry as their “customer” and “partner” and remain vigorous regulators and enforcers against their “customer” and “partner.”

Why did the reinventors ignore the lessons of the S&L debacle?

That contemporary regulatory success by the S&L regulators, which led to dollar savings that easily eclipsed even Gore’s grossly inflated claimed savings for the administration’s entire reinvention program, was ignored by the anti-regulatory reinventors. On one level, this may seem bizarre.  We were authentic reinventors.  We shared many of the techniques that the anti-regulatory reinventors embraced.  We “flattened” our organization, emphasized outcomes rather than processes, and gave dramatically greater power and flexibility to examiners – the people in the field who best knew the facts.  We changed the Federal Home Loan Bank Board’s policies radically.  In 1982, our agency head (Richard “Dick” Pratt) drafted the deregulatory bill that became the Garn-St Germain Act.  The Act passed with only one dissenting vote in each charter.  By 1983, Bank Board Chairman Edwin “Ed” Gray was actively reregulating the industry.  We reregulated, resupervised, and helped create the first effective prosecution effort against an epidemic of elite control frauds in the heart of the Reagan administration over the virulent bipartisan opposition of the administration, the Congress, the industry, and the media.  In doing so, we prevented over a trillion dollar catastrophe.  Our actions are cited by public administration scholars as exemplars of effective regulation.  By the start of the Clinton administration in January 1993, our ending of the three “de’s” was no longer controversial.  We had already helped convict nearly 1000 S&L frauds of felonies in cases designated as “major” by the Justice Department.  We were hailed for our courage in refusing to be intimidated by the S&L frauds’ powerful political allies, their massive lawsuits against us in our personal capacities, or their retention of private investigators trying to find dirt on us.

As 1993 proceeded and Gore began to implement reinvention as the administration’s primary initiative, the praise for our ending the three “de’s” that had created the criminogenic environment that produced the epidemic of accounting control fraud that drove the second phase of the S&L debacle became even more widespread.  We were praised by George Akerlof and Paul Romer in their classic article – Looting: the Economic Underworld of Bankruptcy for Profit.  Criminologists praised our work against the elite frauds in a series of academic articles.  The National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) praised our efforts.  Congress enacted several of our key policy recommendations, e.g., for expanded enforcement authority, an extension of the statute of limitations, and requiring the regulators to take “prompt corrective action” (PCA) against failing banks.  Economists broadly supported PCA and our aggressive clean-up of the S&L industry.  Even Clinton’s economic team recommended to Japanese regulators that they emulate our regulatory policies rather than continue to cover-up their banks’ massive real estate and stock losses.

Our reinvention of S&L regulation embraced most of the specific measures that Gore was promoting in his reinvention.  We adopted transparency, flattened the organization, radically re-envisioned the agency’s structure and programs to accomplish its mission, focused on performance as opposed to procedure, demonstrated total dedication to mission even in the face of vicious, powerful political opposition, transferred power and responsibility to the people in the field who best knew the facts (and actually listening to what the examiners were finding and adjusting policies to accord with those facts), transformed the regional leadership of the agency in its key positions through the appointment of officials selected solely on the basis of their proven performance success – and granted substantial discretion and authority to those regional officials, and kept as our central guiding principle the need to serve solely the interests of the agency’s true stakeholders – the American people.  We privatized and we cut substantially the number of federal employees working for our agency.  We deliberately created competition between the government employees and the privatized employees.

Why then, did Gore and his consultants who shaped the Clinton administration reinvention program not use us as their exemplar of successful reinvention?  We were the obvious example of real world success for many of their ideas and the quantifiable savings from our reinvention of S&L regulation were staggering.  There were two disabling problems.  First, even if many of our efforts were opposed by the Reagan administration, they occurred during the Reagan and (first) Bush administration.  Prominent Democrats had often been the fiercest opponents of our reinvention of the agency.  Speaker of the House James (Jim) Wright was our most notorious opponent in Congress and four of the five Senators who attempted to block our efforts against the most notorious S&L fraud, Charles Keating, were Democrats.  (The “Keating Five” were Senators Cranston, DeConcini, Glenn, McCain, and Riegle.)  Politics, therefore, made us a terrible exemplar for the Clinton administration, and this grew worse as the Whitewater investigation began and morphed.  The original investigation focused on the Clintons’ loan from Madison Guaranty, an Arkansas S&L, to make an investment in a property known as “Whitewater.”  The S&L was a classic accounting control fraud looted by its head.  News broke nationally that a Justice Department investigation was inquiring into their ties with Madison Guaranty’s controlling managers on November 2, 1993.

Mrs. Clinton had been a partner at the prominent Arkansas law firm that had represented some of the worst S&L frauds in Arkansas.  President Clinton made one of her partners Deputy Attorney General.  He had to resign in disgrace when it was revealed that he had defrauded the U.S. in his representation of the government during investigations of the allegedly fraudulent S&Ls.  The Clinton administration wanted nothing to do with any vigorous action against the S&L control frauds.  It promptly reassigned hundreds of FBI agents and prosecutors who had been investigating and prosecuting elite S&L criminals to pursue health care fraud.

The administration left in place, Jonanthan Fiechter, a neo-classical economist appointed by the first President Bush as the acting head of the Office of Thrift Supervision (OTS), which regulated S&Ls.  Fiechter, as I have explained, killed the Bank Board’s underwriting regulation.  Even more remarkably, Clinton left Fiechter – as an “acting” – in charge of OTS for nearly four years.  When Fiechter finally resigned to join the World Bank, Clinton appointed a part-time successor who continued to run an office at HUD.  He did not appoint a full-time head of OTS until October 28, 1997, nearly six years into his terms of office.

In addition to the political and personal reasons why our reinvention of the S&L industry could not be used by Gore as his exemplar of successful reinvention, there was a disabling problem of dogma.  There is little disagreement that there are a series of managerial steps one can take in organizations that empower the people closest to the facts.  In the context of a financial regulator, that means your examiners.  Getting the facts right is essential to making good decisions.  I taught public management (human and financial) for years at the LBJ School of Public Affairs at the University of Texas at Austin before my wife and I joined UMKC.  These empowerment techniques have no inherent ideological baggage.  Gore and his consultants constantly emphasized the need to “get out of Washington” and into the field to find the facts.  We did not have to “get out of Washington.”  We were out of Washington.  Virtually all of our examiners and line supervisors were in the field and we listened to the facts they found.  The facts that the people in the field find are typically the best indication of the true facts.  (Yes, I know that there are innumerable reasons why psychologists find that our ability to identify “facts” can be badly flawed.  You do the best you can by knowing the examiners and employing analytics employing multiple ways to confirm, or refute, what the examiners report is happening.)  The facts are not inherently conservative or liberal or pro- or anti-regulatory.  The same thing is true of most reinvention steps such as emphasizing mission, performance v. process, and pairing responsibility and authority.  A conservative or a progressive can both employ these techniques.

But something subversive lurks below the surface of these techniques.  What do you do when reinvention provides the leaders with facts that are contrary to their ideology?  Dick Pratt, Ed Gray, and M. (“Danny”) Wall faced this problem.  They chaired the Bank Board and its successor agency, the Office of Thrift Supervision (OTS) from 1981-1989.  President Reagan appointed them as Chair of the Bank Board.  Pratt and Wall responded by adopting accounting techniques and economic projections that pretended that the S&L industry was recovering.  They didn’t like the real facts, so they created fiction.  Gray began by doing the same.  Like Pratt and Wall, he was a conservative Republican known as a strong supporter of deregulation.  But Gray listened to the facts found by the examiners and agreed with them that one of the central problems was what we now call “control fraud.”  (The persons controlling a seemingly legitimate entity use it as a “weapon” to defraud.)  He changed the agency’s intense support of deregulation and desupervision one hundred and eighty degrees in order to emphasize the need to make protecting the nation from the control frauds the agency’s top priority.

So, instead of cutting back on regulation, Gray greatly increased it.  Gray didn’t rely on unenforceable guidelines.  He insisted on enforceable rules.  He sought (often unsuccessfully) to make enforcement vastly tougher.  He personally recruited the top supervisors for our two regions where the frauds were most out of control – Texas and California. He picked, respectively, Joe Selby and Mike Patriarca because they had reputations as the toughest financial regulators in America.  He privatized and cut federal staffing levels because he was faced by opposition by OMB and OPM that would have blocked his plan to double the number of examiners and supervisors within 18 months and to improve the quality of both groups.  We did in fact double both staffs within 18 months, going from over 600 federal examiners to over 1200 privatized examiners.  (We “riffed” the federal examiners and had the Federal Home Loan Banks hire them as privatized examiners who functioned as “agents” for our federal agency.)  OMB offered to allow us to hire a tiny number of federal examiners (if memory serves, 34).

OPM refused to allow us to pay federal examiners wages that were competitive with federal banking examiners.  The Federal Home Loan Banks were not subject to OMB or OPM, so we were able to materially increase examiner compensation which helped both with retention of existing examiners and the ability to hire excellent examiners quickly.

None of us involved thought that the riff of federal examiners (roughly one-third of total agency personnel) and use of the Federal Home Loan Banks as the employers for the examiners and supervisors was the best solution to the problem.  There was an obvious conflict of interest in having the Federal Home Loan Banks (whose directorates were dominated by board members selected by the industry the examiners were supposed to regulate) employ the examiners (or the primary supervisors, which the FHLBs had long employed).  Gray found it necessary to take the unprecedented action of firing the President of the FHLB Dallas for perennially weak supervisory responses to the Texas frauds.  This helped reduce the impact of the conflict of interest.  The reduction in force (RIF) and privatization were our “second best” solution given OMB and OPM’s opposition to our effort to develop the staffing capability to identify and close the frauds.  OMB’s number two official explained its refusal to allow us to staff up to contain the fraud epidemic (which was a product of the administration’s deregulation and desupervision of the industry) to Gray by saying in exasperation:  “don’t you understand?  Deregulation means fewer regulators!”  (It actually requires far more in this context.)  OMB was so enraged at Gray that it threatened to make a criminal referral against him to Justice Department on the grounds that he was closing too many insolvent S&Ls.  OPM was equally unhelpful on the issue of examiner compensation, but was not actively hostile to us.

Those of us in the federal agency or the FHLBs (I was in both at different times) who were part of the solution to the fraud epidemic never thought of the industry as our “customer.”  Our mission was always to protect the nation from the worst elements of the industry.  We went to an emergency basis in 1984 to combat the frauds and we kept it up for a decade.

What I have just described is the quintessential domestic success story of federal reinvention.  It saved the nation roughly a trillion dollars and it demonstrated that no one was above the law.  But the reinvention I have just described was anathema to Gore and his consultant because it falsified their central dogmas.  We said that the problem was Pratt’s reinvention of the agency, which was premised on the same anti-regulatory dogmas and creation myths that Pratt and Osborne insisted were the only legitimate means to reinvent government.  George Akerlof and Paul Romer chose the following passage as the last paragraph of their 1993 article on accounting control frauds (“Looting: the Economic Underworld of Bankruptcy for Profit”) in order to emphasize the point they felt it was essential for economists to understand.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself.”

The NCFIRRE report on the causes of the S&L debacle excoriated the three “de’s” and explained how they led to widespread control fraud.   It found:

“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization” (NCFIRRE 1993)

We falsified their creation myths.  We demonstrated that perverse private incentives can produce epidemics of control fraud, hyper-inflate financial bubbles, and cause financial crises.  Osborne and Gore stressed incentives and stressed that public incentives were often perverse, but they asserted that private sector incentives are positive.  That is only true if cheaters do not prosper.  If they do, then markets become perverse and produce a Gresham’s dynamic in which bad ethics drives good ethics out of the marketplace.  The central role of financial regulation is preventing this perverse dynamic.  Regular police officers do not, and cannot, identify and sanction elite white-collar crime.  Only the regulators can serve as the regulatory “cops on the beat” to prevent this perverse dynamic.

Osborn and Gore’s central claim was that business failure disciplined the private sector and creates inherently positive incentives.  The opposite is true when one is discussing fraud.  Akerlof described the Gresham’s dynamic in his famous paper on markets for lemons (which described anti-customer control fraud and led to the award of the Nobel Prize in Economics in 2001).

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence” (Akerlof 1970).

Accounting control fraud does not create a cost advantage, but it too turns markets perverse.  As Akerlof and Romer explained, accounting fraud produces a “sure thing” from the perspective of the individuals controlling the firm.  The title of their article says it all – “Looting the Economic Underworld of Bankruptcy for Profit.”  The market discipline (bankruptcy) is, after years of fraud have enriched the CEO, visited on the firm.  The CEO (absent prosecution) walks away wealthy and, frequently, with his reputation enhanced by the wealth that he obtained through his fraud.

The reinventors ignore contrary facts and embrace conflicts of interest and propaganda

There are innumerable ways to “reinvent” government, and officials have been doing so for centuries.  Gore and Osborne treated anti-regulatory reinvention as if it were the only legitimate way to reinvent.  This was a product of their anti-regulatory dogma.  They presented “just so” stories to support their points – none of which were contrary to their anti-regulatory dogma.  In every example I’ve read success comes from weakening enforcement and sanctions.  I do not believe that the annual reports give any contrary example.  The rival success (and failure) stories were edited out and ignored.  Our successful reinvention of the Bank Board was an inconvenient truth that they refused to even discuss.  I have not found any anti-regulatory reinventer who has written anything substantial about the S&L experience with the three “de’s” and our policies that did the opposite.

Gore’s first report on reinvention was largely written by Osborne.  The key participants in their program and the drafting of the “just so” stories supporting Osborne’s dogma were those who bought into the same anti-regulatory dogma.  The Gore reports were written in a deliberately journalistic style by a journalist.  Osborne reported on Osborne’s dogma and to no one’s surprise, reported that Osborne’s dogma had been proven correct.  The annual reinvention reports are propaganda.  Some of the “just so” stories may be largely true, but there is no way a scholar could rely on them given that they are so obviously crafted by a journalist as just so stories.

The reinventors “deinvented” successful restraints on fraud and created criminogenic environments that produced epidemics of control fraud and crony capitalism

The anti-regulatory reinventors “deinvented” all the vital means we had put in place that produced the success against elite financial frauds.  The systems and even the knowledge of how to prevent, detect, deter, and sanction elite frauds was discarded by the financial regulators and replaced with the anti-governmental reinventors’ myths about fraud.  This helped produce the three “de’s” that shaped the criminogenic environments that drove the Enron-era control frauds and the ongoing epidemic of financial control frauds.  When Clinton administration officials deviated from the creation myth and treated elite corporate fraud as a major problem they were considered to have gone rogue and were crushed by the administration and the Republicans working in coalition against the would-be regulators.  The two anti-fraud rogues during the Clinton administration were and Brooksley Born, Chair of the Commodities Futures Trading Commission (CFTC) and Arthur Levitt, Chair of the Securities and Exchange Commission.  Sadly, and he now says that he regrets both acts, Levitt caved in to the pressure on his agency not to take vigorous action against auditors’ conflicts of interest and joined in the pressure on Born that led to the passage of the Commodities Futures Modernization Act of 1990 – the epitome of Gore’s and Osborne’s anti-regulatory dogma.  The twin rationales for the Act were the twin rationales for Gore’s and Osborne’s anti-regulatory reinvention dogma.  Fraud risks were trivial because the markets automatically prevent serious fraud.  Private market incentives are inherently superior to regulators’ incentives. The “information age” has rendered “bureaucracy” hopelessly outmoded and requires the reinvention of government in a manner that sharply curtails regulation.  The Clinton administration acts that repealed Glass-Steagall and removed the CFTC’s authority to regulate credit default swaps both had the word “modernization” in the title and shared the assertion that regulation was a relic of our primitive past.

President Bush, Clinton’s successor, was an anti-regulatory reinventor as Governor of Texas.  Dick Pratt expressly used Texas’ earlier S&L deregulation as his model when he drafted the federal deregulatory bill that became the Garn-St Germain Act of 1982.  Texas S&Ls caused over 40% of total S&L losses.  Their anti-regulatory scheme was premised on the closest possible partnering with the industry – the Texas S&L Commissioner was repeatedly serviced by prostitutes paid for by Vernon Savings, the most notorious Texas S&L control fraud.  In the federal regulatory ranks we called in “Vermin” – we never took well to the idea that the industry was our “customer” in this era.

Clinton and Bush’s embrace of the three “de’s” created the criminogenic environments that produced the epidemics of control fraud that constituted the Enron-era, the ongoing financial crises, and the military procurement scandals that proved so destructive in Iraq and Afghanistan.  Osborne and Gore emphasized that they were basing their anti-regulatory reinvention on similar steps Europe.  Osborne often praised Prime Minister Thatcher as the key innovator.  Europe was proud of its “light touch” financial regulation right up to the economic crisis it spawned.

The classic case of where Osborne, Gore, Clinton, and Bush’s anti-regulatory reinvention led is described brilliantly by a journalist.  Rajiv Chandrasekaran’s Imperial Life in the Emerald City describes the U.S. led anti-governmental dogma seeking to reinvent Iraq’s government and explains how it produced a series of disasters that imperiled the mission and lives and cost literally untold billions of dollars moved on pallets.  The rule “benders” ran riot.  They demonstrated the inevitable results of selecting government officials on the basis of ideology and not “tolerating resistance” by those who had actual experience, expertise, respect for the rule of law, and integrity.

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