The AEI Takes its Regulatory Advice from Alan Greenspan

By William K. Black
(Cross posted at Benzinga.com)

Mark J. Perry and Robert Dell’s February 24, 2011 article (“More Equity, Less Government: Rethinking Bank Regulation”) claims that the government caused the crisis and that the solution is to increase capital requirements and reduce government regulation.  The authors are at an ultra-conservative “think” tank (AEI) dedicated to protecting elite CEOs from the “regulatory cops on the beat.”

AEI’s Latest Creation Myths about the Crisis

AEI is notorious for the failed effort through Peter Wallison, its long-time head of its financial deregulation campaign, to blame the crisis on lending to minorities.  Wallison was put on the Financial Crisis Inquiry Commission (FCIC) for the purpose of defending the three “de’s” – deregulation, desupervision, and de facto decriminalization – that AEI had championed for so many years. The authors’ first claim as to why the banks suffered catastrophic losses is facially preposterous alternative creation myth.

“The overreliance on credit rating agencies—a legally protected oligopoly—was driven by regulatory policy, which supplanted market discipline.”

No one required the banks that bought the fraudulent mortgages and mortgage products to “rely” much less “over rely” on the credit rating agencies.  The banks had the ability, and the conservatives assured us that they had the proper incentives, to provide effective “market discipline.”  Banks’ paramount expertise is (they tell how repeatedly) is recognizing, understanding, and quantifying credit risk.  Wall Street officers have long disparaged credit rating agency employees as B-School “C” students.

Investigations have also confirmed that the banks were eager to induce the credit rating agencies to rate toxic waste derivatives as pristine “AAA” paper.  The investigations confirm that the banks created a Gresham’s dynamic by threatening to move their business to rival credit rating agencies – or actually moving their business if the threat did not successfully extort a credit rating agency.

AEI’s Chutzpah: Blame the Regulators for AEI’s Destruction of Regulation

Second, the authors blame the regulators for reducing the banks’ capital requirements.

“Why else would bank equity be lower under the 347-page Basel II accord than under the 37-page Basel I agreement?”

There is some truth to this point, but it is deliberately written to mislead.  The difference between the Basel I process and the Basel II process is that in Basel II the banks were allowed into the tent and their officers got to secretly lobby for dramatic reductions in capital requirements.  The fact that the banks were allowed “under the tent” and the fact that the banks’ controlling officers successfully convinced virtually all of the regulators to support the bank officers’ desires for reduced capital requirements is a testament to the fact that Presidents Clinton and Bush maximized the three “de’s” – deregulation, desupervision, and de facto decriminalization.  The three “de’s” were major contributors to the creation of the criminogenic environment.  Those that hate regulation and regulators created a self-fulfilling prophecy of regulatory failure by urging the President to appoint “regulatory” leaders who were the leading opponents of effective regulation.  AEI and its billionaire funders destroy effective regulation.  As I explained, the AEI’s Wallison led that conservative campaign.  One of the means they use it appointing their partners in plunder to run the regulatory agencies.  Here is the iconic image of this aspect of the crisis.   

James Gilleran, the head of the Office of Thrift Supervision (OTS) and the Vice-Chair of the FDIC posed with the three leading bank lobbyists to symbolize their working hand-in-glove with the industry lobbyists to destroy effective regulation.  “Chainsaw” Gilleran holds a chainsaw (not a precision surgical tool) to symbolize his glee about “partnering” with the industry to destroy regulation.

The AEI’s Expert on Regulation is: Alan Greenspan!

The authors managed the almost impossible feat of exceeding the logical absurdity of AEI blaming “regulation” for failing when it was AEI that made destroying effective regulation its paramount priority.  They rely on Alan Greenspan, the exemplar of the anti-regulator, to support their claim that we should increase capital requirements and expand the three “de’s.”

“To quote Alan Greenspan: ‘Adequate capital eliminates the need for an unachievable specificity in regulatory fine tuning.’ Had Bear Sterns and Lehman Brothers been operating with tangible equity capital of 15 percent of total assets, for example, neither would have become insolvent.”

It was Alan Greenspan and his anti-regulatory Fed economists who led the charge to support the elite bank officers’ goal that the Basel II rules adopt exceptionally weak capital requirements and to have the U.S. promptly adopt those weak requirements so that U.S. banks could rush to reduce their capital. We were saved only because the FDIC fought a tenacious rear guard action against Greenspan.  The FDIC’s heroic resistance substantially delayed the U.S. adoption of Basel II.  Better yet, the FDIC succeeded in having the U.S. regulators imposing a minimum capital requirement that “trumped” Basel II’s far lower capital requirements.  Richard Spillenkothen, the Fed’s top supervisor, explained these points in his May 31, 2011 memorandum to the Financial Crisis Inquiry Commission (FCIC).

The authors are as wrong as it is possible to be wrong.  They rely on the most culpable anti-regulator in the world.  It was the real regulators – the ones AEI sought to crush – who acted to prevent Greenspan and the banking CEOs from succeeding fully in their quest to eviscerate capital requirements.  It was AEI and Greenspan who told us in the run-up to the crisis that we should maximize the three “de’s” and rely instead on “private market discipline.”  As I show below, the AEI now tells us that the way to avoid future crises is to maximize the three “de’s” and rely instead on “private market discipline.”

Assuming the (Electric) Can Opener and the Nuclear Generator to Power It

Greenspan’s quotation and the AEI authors’ claims about capital are also embarrassingly false.  Greenspan and the AEI economists have committed the classic blunder for which economists are notorious.  Indeed, economics’ defining joke was created to satirize this blunder.  We all tell our students the joke to try to inoculate them against the blunder.  The punch line to the joke is “assume a can opener.”  The joke is so appropriate because bad economists frequently assume away the problem.  Examine the language they used carefully in light of the joke.

“To quote Alan Greenspan: ‘Adequate capital eliminates the need for an unachievable specificity in regulatory fine tuning.’ Had Bear Sterns and Lehman Brothers been operating with tangible equity capital of 15 percent of total assets, for example, neither would have become insolvent.”

Yes, if I assume that a bank always has adequate capital it will, under that assumption, always have adequate capital.  But imposing an adequate capital requirement does not ensure adequate capital.  “Capital” is simply an accounting residual (Assets – Liabilities = Capital).  This means that if the banks’ officers overstate the bank’s assets and/or understate the bank’s liabilities the bank’s reported capital will be larger than its actual capital.  This is no pot of cash in a bank vault representing “capital.”  The fraud schemes that Bear Stearns and Lehman Brothers’ controlling officers ran massively overstated asset values and massively understated liabilities which meant that both investment banks   that they exceeded their capital requirements when they were in fact massively insolvent.  (Readers who would like greater detail can read my congressional testimony on Lehman’s frauds and view the video of my oral statement.)

(For accounting wonks – requiring that their capital be “tangible” would not have prevented these frauds.  The assets and liabilities whose values were inflated and understated were overwhelmingly tangible – and fraudulent.)

Bear and Lehman’s controlling managers could have used accounting fraud to report tangible capital in excess of 15 percent when the investment banks were actually insolvent.  Accounting control frauds frequently suffer losses of 60% of total (reported) assets.  Fifteen percent capital represents at most a speed bump to accounting control fraud.

Greenspan and the AEI have managed to get financial regulation completely wrong (again).  Here is the key sentence that shows their incoherence:  “Adequate capital eliminates the need for an unachievable specificity in regulatory fine tuning.”  How do we know that a bank has “adequate capital?”  We cannot assume that any particular bank, or the industry as a whole, have “adequate” capital simply because we adopt a rule or law with a higher capital requirement.  We cannot assume that a bank has adequate capital because it reports that it has adequate capital – the controlling officers’ incentives to inflate reported capital are powerful.  We cannot rely on “private market discipline” to ensure that banks have adequate capital because creditors and shareholders typically fund, not restrain, the exceptional growth of banks engaged in accounting control fraud.

We can only have a reasonable basis for believing that a bank’s capital is adequate if the examiners and their regulatory leaders are skilled, vigorous, and courageous and engage in timely reviews of the quality of the bank’s assets and the true amount of its liabilities.  Those reviews must be conducted with “specificity” and “fine tuning” that address the circumstances of the individual bank.  Examiners are, of course, “fallible,” but everyone else has is not only fallible but can be readily suborned by the officers leading the accounting control frauds.  Only the examiners can bring the essential independence that makes it possible to identify control frauds and take effective action to against their controlling officers.  George Akerlof and Paul Romer (who the AEI authors ignore), explained this point to their fellow economists in 1993.

The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the [deregulation] of the 1980s were 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 (Akerlof & Romer 1993: 60).

Even in this crisis, with terrible leaders appointed to prevent effective regulation, the examiners often identified and warned of severe problems years before the triple epidemics of accounting control fraud brought down the global financial system.  Spillenkothen’s paper and the FCIC report document these points.  It is apparent from their rhetoric that the AEI authors are implicitly claiming that capital requirements are infallible even though under their logic the “fallible” examiners must make their proposed capital system fallible.  The only alternative would be a howler – the authors would have to be claiming that “private market discipline” is infallible.

Conservative Odes to “Private Market Discipline” Intensify as it Consistently Fails”

“Private market discipline” routinely fails against accounting control fraud because such frauds report record (albeit fictional) profits and as much capital as they need to optimize their fraud.  Private market discipline is supposed to come primarily from lenders – elite banks.  But bankers love to lend to other banks reporting record profits and compliance with their capital requirements.  Bankers are figuratively trying to break down the doors of the CFOs of banks reporting record profits so that they can beg the CFO to borrow from them.  We just ran a real world experiment with “relying more on market discipline” – and it produced the most destructive financial crisis in 75 years.

Here are the arguments that the AEI authors made that demonstrate further that they do not understand capital, accounting control fraud, or financial regulation.

“Relying more on market discipline and required minimum equity would allow for less reliance on short-sighted politicians and fallible regulators to develop, implement, and continually update complex and uncertain systems of regulation.

The possibility of a contagion of fear arising from defaults on their debt obligations would have been greatly reduced, as their losses would have been contained within their common shareholders. And higher equity would have reduced the incentives to take excessive risk in the first place.”

“Risk” isn’t the issue.  Accounting control fraud, as criminologists, competent regulators, and competent economists understand, produces three “sure things.”  The bank will report exceptional (albeit fictional) profits, the controlling officers will promptly be made wealthy by modern executive compensation, and the bank will suffer catastrophic losses (which will be covered up for years by accounting fraud).  Losses would not have been “contained within their common shareholders” had Bear and Lehman had 15% tangible capital requirements.  Losses would have far exceeded 15% of reported total assets because Bear and Lehman’s assets were overstated by far more than 15% and its liabilities were substantially understated.  The common denominator was accounting fraud.  The fact that accounting control fraud produces the three “sure things” and the fact that the controlling officers of Bear and Lehman could make vastly more money through fraud than they stood to lose on their firm investments meant that higher capital requirements do not in fact materially reduce the risk that the controlling officers will engage in fraud.

Only bank examiners have shown the ability, particularly when their leaders were not selected for the purpose of making real AEI’s unholy war against effective regulation, to spot the losses on assets and the understatement of liabilities and take action against fraudulent bank CEOs while the bank is still reporting record profits.

Like Jupiter Eating His Children?

The difference in the regulatory response can be made concrete by considering the significance of a memorandum singled-out by Charles Keating for emergency intervention.  On July 1, 1986, Charles H. Keating, Jr. sent a letter to Donald T. Regan, President Ronald Reagan’s Chief of Staff.  Here is the full text:

The enclosed memorandum from the law firm of the Chairman of the Federal Home Loan Bank Board is confirmation of a horrible episode in American Government, namely:

The Federal Home Loan Bank Board under Edwin Gray is Nazi and diametrically opposed to everything your administration stands for.

The Federal Home Loan Bank Board is a prime factor in the current economic stagnation of the United States which will lose the U.S. Senate to the Democrats in November.

Can you read the enclosed memorandum and not be horrified at the police state Edwin Gray has created?

Like Jupiter eating his children.

The enclosed memorandum was not written by the “law firm of the Chairman” of the federal regulatory agency, but it was written by the Nation’s preeminent law firm specializing in the representation of savings and loans (S&Ls).  The memorandum alerted S&L managers that the agency was targeting the types of S&Ls that the agency had found were most likely to be fraudulent.  The alert (accurately) stated that we were prioritizing S&Ls reporting extreme profits, rapid growth, heavy concentration in commercial real estate lending and investments, and those controlled by new entrants to the S&L industry who were real estate developers.  Keating considered our prioritization to be obviously outrageous.  Calling us Nazis or terrorists was his normal practice.  What we were doing, of course, was using our understanding of the accounting control fraud “recipe” to identify the worst control frauds at a far earlier point while they were still reporting record (fictional) profits.

The Contrast with Our Successors’ Regulation of Banks Reporting High Profits

“Senior supervisors told the FCIC it was difficult to express their concerns forcefully when financial institutions were generating record-level profits. The Fed’s Roger Cole: ‘a lot of that pushback was given credence — Citigroup was earning $4 to $5 billion a quarter. And that is really hard for a supervisor to successfully challenge’” (FCIC 2010: 307).

The reality was that Citigroup was losing vast amounts of money on its fraudulent mortgage loans – but reporting profits through deceit.

Richard Bowen Citi SVP, underwriting: “supervise[d] the purchase of roughly $50 billion annually in prime loan pools [for resale to Fannie & Freddie]. The [weak] sampling provided to Bowen’s staff for quality control … showed extremely high rates of noncompliance. [In 2006] we identified that 40 to 60 percent of the files either had a ‘disagree’ decision, or they were missing critical documents” (FCIC 2010: 168).

In the S&L debacle, our standard operating procedure would have made Citi a top priority.  Citi was not “earning” that amount of income – it was reporting “record” income as a result of the fraudulent sale of tens of thousands of mortgages to the secondary market.  In the ongoing crisis, the largest bank frauds became effectively immune because the anti-regulators that Bush made the agency leaders feared it would be “really hard” to challenge a bank reporting high profits.

The Things AEI Conveniently Ignored in Order to Assume the Can Opener

The AEI authors assumed away the central driver of the crisis – the three epidemics of accounting control fraud.  That type of complacency, combined with their call to further weaken already desperately weak regulation, would optimize finance as a criminogenic environment.  Note that the authors do not even consider the possibility of fraud and looting by elite bank CEOs.  They never use any of these words:  “fraud,” “crime,” “sure thing,” “looting,” “prosecute” “accounting,” “deregulate,” “desupervise,” or “decriminalize.”  They ignore the relevant criminology, regulatory, and economics literature on these critical concepts that drove not only this crisis but also the S&L debacle and the Enron-era frauds. They not only assume the can opener; they assume away the very existence of the elite corporate thieves stealing the cans.  They aim to surpass Wallison is becoming the architects of the next great financial fraud epidemics and resultant crises.

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