Zachary Karabell and our Flawed “Society of Apologists for Plutocrats (SAPs)”

By William K. Black

Slate has replaced one minor member of the Society of Apologists for Plutocrats (SAPs), Matt Yglesias, with another, Zachary Karabell. The transition has been seamless. As I noted in my prior column, Karabell’s initial columns served up apologias for extraordinary executive compensation and extreme inequality, high youth unemployment, and high frequency trading (HFT) scams. Karabell is the type of Wall Streeter who thinks it reflects well on him that he has been a “regular” on CNBC, rather than an admission of grave defects of character and intellect. Similarly, he thinks it is an honor that he was dubbed a bright young thing (a decade ago) by the denizens of Davos, the club for selfless plutocrats eager to “take up the white man’s burden.”

I decided to look at Karabell’s prior work to see what Slate thought it was getting. The answer is that they were not misled. As the Davos award indicates, Slate’s due diligence revealed that he was a SAP from the beginning. I chose his August 9, 2013 column (“Fannie, Freddie and our flawed ‘Ownership Society’”) and a March 2, 2011 column (“The Insider Trading Scandal: Is It the Crime or the Prosecution?”) as exemplars of his apologias.

An Apologia for Fraudulent CEOs while Blaming the Hairdressers

The thrust of his 2013 column is that the three “de’s” (deregulation, desupervision, and de facto decriminalization) and control fraud are distractions from the true cause of the crisis. Karabell is frustrated that the true causes of the crisis are ignored: poorer families wanted to buy homes and Fannie and Freddie bought their mortgages.

Yes, Karabell is a Peter Wallison wannabe. He wrote over two years after the Financial Crisis Inquiry Commission (FCIC) explained in exhaustive detail why Wallison’s claims were false. (It is revealing that Wallison could not get any of the exceptionally partisan fellow Republican members of the FCIC to sign his dissent.)

Karabell Begins by Largely Endorsing President Obama’s Myths about Fannie & Freddie

Karabell begins by endorsing a statement President Obama made about Fannie and Freddie. The statement evinces the President’s lack of understanding and candor about Fannie and Freddie.

“For too long, these companies were allowed to make big profits buying mortgages, knowing that if their bets went bad, taxpayers would be left holding the bag,” the president said this week. ‘It was ‘heads we win, tails you lose.’’”

The President (and Karabell) missed everything critical about Fannie and Freddie. First, Fannie and Freddie are not human and do not make decisions. The CEOs are the folks who make the decisions and have the perverse incentives. As I have explained many times, the SEC explicitly charged Fannie’s CEO with leading massive accounting and securities frauds for the purpose of maximizing his compensation. Fannie and Freddie were classic control frauds.

Second, Fannie and Freddie had no governmental guarantees and their bonds explicitly stated that they were not backed by the Treasury. Fannie and Freddie were privately owned and privately managed. They were bailed out not because they were governmental, but because they were so massive.

Third, Fannie and Freddie’s CEOs were not making “bets.” They were running accounting control frauds and such frauds are a “sure thing.” They produce three sure things: the firm is guaranteed to report high earnings, the controlling officers are certain to promptly be made wealthy through modern executive compensation, and the firm will suffer catastrophic losses because the fraud “recipe” for an originator (or purchaser) of loans is optimized by making (or buying) exceptionally bad loans. It was “heads or tails we win and you lose.”

Fourth, Fannie and Freddie became disasters for the same reason that Bear Stearns, Lehman, and Merrill Lynch failed. Their officers became wealthy by purchasing huge amounts of bad loans at a (nominal) premium yield. If they had not bought the mortgages other firms would have done so in order to enrich their controlling officers.

Fifth, the secondary market was not necessary for the crisis. Ireland, relative to GDP, had a real estate bubble twice as large as the U.S. bubble with minimal secondary market purchases. Banks can grow massively by holding the bad loans in portfolio, reporting record profits, and borrowing to finance rapid growth. Mortgage lenders that sold to the secondary market did so through “reps and warranties” that left them on the hook for fraudulently originated mortgages.

Sixth, Fannie and Freddie’s purchase of huge amounts of “liar’s” loans proves that their controlling officers were engaged in accounting control fraud. The purposes of liar’s loans were to inflate the borrower’s income dramatically, to charge the borrower a premium (nominal) yield, and to remove the paper trail that we used during the savings and loan debacle to demonstrate that the executives were leading frauds because they deliberately made bad loans likely to have exceptional default rates. Inflating the borrower’s income dramatically (in 60% of the cases by at least 50%) is a nonsensical strategy if one posits a theory that Fannie and Freddie knowingly purchased bad loans because they were trying to meet affordable housing goals (i.e., to loan to poorer borrowers). Further, many liar’s loans did not report the borrower’s income and could not be counted toward affordable housing goals even if the borrower’s income was not inflated beyond that of the median borrower.

“Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not. Alt-A mortgages were not generally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from counting toward affordability goals. Levin told the FCIC that they believed that the purchase of Alt-A securities “did not have a net positive effect on Fannie Mae’s housing goals.” Instead, they had to be offset with more mortgages for low- and moderate income borrowers to meet the goals” (FCIC 2011: 125).

What that means in plain English is that purchasing liar’s loans made it harder to meet Fannie and Freddie’s affordable housing goals – yet Fannie and Freddie’s CEOs eventually caused them to purchase huge amounts of liar’s loans. The only logical explanation for that behavior is that they were leading accounting frauds. Fannie and Freddie’s CEOs caused them to massively increase their purchase of liar’s loans after the mortgage industry’s own anti-fraud experts publicly warned the entire industry that they were an “open invitation” to fraud and reported that the incidence of fraud in liar’s loans was 90 percent.

Note that this means that the logical inference is also that Fannie and Freddie’s CEOs caused them to purchase large amounts of subprime loans for the same reason they purchased so many liar’s loans – it aided their accounting fraud by creating a high (nominal) yield. Recall that by 2006 the best estimates are that 50-60% of the loans the industry called “subprime” were also liar’s loans – the two categories are not mutually exclusive.

Then Karabell Tops Obama’s Myths about Fannie & Freddie

Karabell wrote this paragraph immediately after quoting Obama’s myths.

“Well, not entirely. The U.S. government and taxpayers did rescue these agencies in 2009 (to the tune of nearly $200 billion), and, after injecting them with capital and essentially nationalizing them, these companies started to turn a profit as the housing market slowly recovered. This month, they contributed more than $15 billion to the U.S. Treasury, and have been one factor in sharply reducing government deficits.”

My focus here is on his apologia for the fraudulent financial CEOs, so I leave to the reader the listing of the many crazed aspects of this “analysis.” And, yes, his understanding of the joys of austerity in the context of recovering from the Great Recession reveals fundamental economic incoherence. He is actually so detached from reality that he thinks that if Fannie and Freddie report huge “profits” and “contribute” them to the Treasury America’s economy strengthens. He’ll love the Fed under QE! (Hint: we can easily have Fannie and Freddie engage in derivatives deals with the Fed in which both counterparties report hundreds of billions of dollars in “profits” from the transactions and then “contribute” the “profits” to the Treasury.)

Hang the Hairdressers

In a confusing passage Karabell complains about this “story” about the crisis (which he admits is true).

“Over the past decade, we have collectively spun a story of the financial crisis. It goes something like this: in the 2000s, government regulation of the financial system loosened as large banks, in collusion with free-market ideologues in government, convinced regulators that risk was a thing of the past. They then took advantage of easy money and lax regulation and began to push mortgages to speculators and low-credit individuals, who bought homes they couldn’t afford. Those mortgages were then packaged and used as the fodder for financial derivatives, which turned bad loans into a global crisis. Meanwhile, millions of people lost homes and jobs; the government spent hundreds of billions to bail out the banks, and those millions of citizens were left with shattered credit, no employment, and fractured communities such as Detroit.”

The three “de’s” began well before “the 2000s,” but the “story” would be accurate if Karabell didn’t exclude accounting control fraud from description of what caused the crisis. While admitting that the “story” of the crisis as driven by the three “de’s” and modern executive and professional compensation (which he also ignores) producing the three most destructive epidemics of financial fraud in history is “true,” Karabell complains that we don’t blame the “crucial” culprit – the hairdresser who wanted to own her home.

“What’s missing from the story is crucial, however. Obama alluded to it in his speech, but he buried the details. Often neglected is the degree to which so many felt that they needed to own a home.

That part of the story is sadly, though understandably, overlooked and underplayed. Targeting government ineptitude and Wall Street greed is a far better sell politically, and a better sell for the media, than speaking of collective responsibility for our dreams trumping our means.”

“Collective responsibility” in this context means that we must blame the borrower who fell for the loan broker’s and realtor’s pitch that buying the home with the appraisal demonstrating that it had a $75,000 gain built-in at the purchase price was the best business decision the borrower had ever made. The borrower, of course, did not know that the appraisers had been coerced by the lender’s CEO to deliberately create a “Gresham’s” dynamic among appraisers in order to produce endemically inflated appraisals as an aid to CEO’s accounting control fraud. Karabell ignores Stanley Milgram’s “Obedience to Authority” studies and all modern research on behavioral finance when he pronounces “collective guilt” on borrowers. I guarantee that Karabell has personally witnessed this process in action during his years on Wall Street.

“That story also infantilizes ‘the American people’ by suggesting that so many of us were dupes and rubes, easily manipulated by government and business into making bad choices.”

The “government” warned bankers against making liar’s loans. Alan Greenspan and Ben Bernanke refused to use the Fed’s unique, explicit statutory authority to ban liar’s loans and they did so for purely ideological reasons based on precisely the dogma that Karabell reproduces in the sentence that claims if one is defrauded he must be an “infant” and a “rube.” Indeed, Karabell reproduces the nonsense that Greenspan and Bernanke spread that claimed that “sophisticated” parties could not be defrauded and that having rules against fraud were unnecessary because markets automatically excluded fraud.

“Blaming venal banks and inept government will not transform our system, however satisfying it may feel.”

Karabell has it exactly wrong. “Banks” cannot be “venal” – they are not “persons” whatever the Supreme Court says. Bankers and the humans who are supposed to serve as “controls” can be venal and when a CEO creates a Gresham’s dynamic markets and professions become perverse and tend to drive good ethics out of the markets and professions. Recall that the U.S. government investigation has found that each of the massive banks that set LIBOR conspired to commit fraud and create a cartel. No one sentient thinks that came about because of “rogue traders.” It is essential to transform such perverse incentives by removing that competitive advantage through effective “regulatory cops on the beat” who can ensure that fraud is no longer a “sure thing.”

An Apologia for Elite Frauds: Blaming Prosecutor who Prosecute

Karabell is very disturbed at the tiny number of criminal investigations of the elite financiers – he thinks there are too many.

“I have no opinion about the guilt or lack thereof of [Rajat] Gupta or [Raj] Rajaratnam. Like almost everyone save for a handful involved, I don’t know what happened and likely never will. But the nature of this investigation should raise the eyebrows even of those who believe that there is something rotten at the heart of American business.

In essence, this investigation and its prosecutions raise the question of whether we are criminalizing behavior simply because it is deemed immoral and allowing prosecutors too much latitude to pry into personal relationships. Both the left and the right are wary of the potential abuses of government investigatory power, and the United States has nurtured a long and powerful tradition of wariness of the claims of officials to be on the side of the angels in pursuing wrong-doing.”

The “nature of the investigation” of Rajaratnam’s insider trading ring was not unusual. Yes, we typically criminalize behavior because we reach a societal judgment that it is “immoral” and causes harm. The doubly disturbing claims that Karabell makes are that he’ll never know whether Gupta and Rajaratnam are guilty because he doesn’t trust prosecutors or juries. The fact that Rajaratnam was found guilty on all counts two months later becomes a non-fact. When fellow Wall Streeters are on trial Karabell rejects the entire concept of culpability and accountability. When financiers are the subject of investigations it is illegitimate to “pry” “into personal relationships” even when the nature of that “personal relationship” includes leaking insider information to a very useful contact.
Karabell conceded the obvious – the government had a very strong case against Gupta.

“In the case of Gupta, he made calls to Rajaratnam just after several important meetings of the Goldman Sachs board, and Galleon then made trades of Goldman stock (or options) just after those calls. So it’s hard to deny the appearance that information was exchanged.”

Karbell then repeated Gupta’s the defense lawyer’s incredibly weak defense against this very strong case.

“I have managed money and still do. Stocks today move for all sorts of reasons, are traded globally and electronically often by programs rather than people, and often based on factors having nothing to do with the company per se. Rarely is one data point sufficient. As a result, insider information is neither worth the risk of obtaining it nor usually worth much even if you do. What is perhaps most striking about this case from that perspective is that Galleon is alleged to have made a grand total of $17 million in profit from this inside information. That is a lot of money in the real world, but for Galleon’s bottom line, it hardly rates, and certainly would be worth nowhere near the risk of obtaining it by violating Reg FD.

If the charges are true as alleged, then these individuals destroyed careers and their future not for untold riches but for minimal advantage relative to others who did not flirt with the rules. The narrative may say greed, but in truth, the gain wasn’t enough for the risk. Galleon reaped hundreds of millions annually by legitimate means, and Gupta supposedly reaped nothing for his insider troubles. We like the simple narratives, but human motives, those are often far more complicated.”

Every aspect of these paragraphs demonstrates that Karabell is in willful denial about fraud and insider trading and is a shameless shill for Wall Street. First, he’s wrong about the value of insider information, and there’s a broad literature providing that trading on insider information is common and produces superior returns. Again, fraudulent CEOs love a “sure thing” and fraud and insider trading are common routes to a “sure thing.” Insider traders wait for salient proprietary information (the “single data point” reference is a silly straw man) that is highly likely to move the stock price materially before they act on the insider information by trading. Over the course of a year, however, it is normal that the insider will learn several secrets that when they are revealed will be highly likely to move the stock and create a profitable opportunity for insider trading. Karabell’s claim that much insider information does not lead to trades is a deliberate, disingenuous effort to mislead his readers.

Second, Karabell seems to assume that fraud and insider trading by CEOs will be discovered and sanctioned. Criminologists, regulators, and legal counsel know that this is absurd, but so does Karabell because he’s been at the epicenter of the frauds in history and he’s seen that even the CEOs of small mortgage banks have escaped not simply prosecution but even investigation despite compelling indications of massive frauds led by those CEOs. CEOs are frequently arrogant and believe that they can get away with committing fraud with impunity.

Third, the claim that no one would cheat to make an additional $17 million demonstrates that people on Wall Street are often detached from reality. Gupta was only one of Rajaratnam’s sources of insider information that have been discovered by the government investigation. Many other sources will likely never be discovered. Government investigations and charges frequently represent only a sliver of the overall fraud scheme because of limits on our resources. Karabell’s writes in the article that he does not know either the nature or the scope of Galleon’s crimes, so he logically cannot know that “Galleon reaped hundreds of millions annually by legitimate means.” Galleon’s criminal means may have been the primary source of its growth.

Karabell reflects perfectly Wall Street’s whiny response to the crisis. It is not sufficient that Wall Street elites grew wealthy through leading the most destructive financial frauds in history with complete impunity not simply from prosecution but even from having the proceeds of their looting “clawed back.” Karabell makes clear that Wall Street still feels oppressed – zero prosecutions for the financial frauds that drove the crisis is too many prosecutions! Karabell portrays Wall Street’s elites as the victims of overzealous (non) prosecutors eager to criminalize the elites’ immoral actions.

“[P]rosecutors have extraordinary powers in our society, and it is difficult for them to resist the temptation to use the law to enforce public mores. At any given time, some law on the books can be used to police a wide range of behavior. That’s great if you agree with the morality that they are enforcing (no abortions, for instance, or no emissions by chemical companies). But it’s not so great when that morality is at odds with yours (no abortions, for instance, or no emissions by chemical companies). We live in a system where trials are supposed to afford the accused a chance to clear their name or face penalty, but in a world where reputations are hard to build and easy to lose, prosecutors have undeniable advantages. It is up to them to use that power judiciously.”

We’ve run a real world test of Karabell’s claims in this paragraph and each of them has proven false. Rather than it being “difficult for [prosecutors] to resist the temptation” to prosecute the immoral elite banksters’ frauds that drove the crisis they have managed to resist that temptation in 100% of the cases. Instead, we have been treated to the spectacle of Lanny Breuer, the head of the Criminal Division and Eric Holder, the A.G., announcing that the rule of law does not apply to large banks and their officers and Lanny Breuer’s angst at the prospect of putting a bank that committed massive frauds into receivership, removing its controlling officers who led the frauds, and replacing them with prudent bankers of high integrity. We did that hundreds of times during the savings and loan debacle. Karabell also proved wrong about reputation. Recall that Greenspan claimed that the CEO’s concern for reputation ensured that the markets automatically excluded fraud without regulation or prosecution. White-collar criminologists proved correct about reputation. The surest way for a CEO to develop a top reputation is through the “sure thing” of running an accounting control fraud. The bank’s eventual failure, particularly if it takes place in a crisis (a point that Keynes made) – does not cause a serious loss of the CEO’s reputation. Karabell, of course, is a contributor to this lack of accountability because he claims that even successful prosecutions in which the CEO has the top criminal defense lawyers in the world does not establish the guilt of elite Wall Street officials. No elite banker is shunned by Wall Street. Karabell celebrates them even when he admits that the criminal case against them is exceptionally strong.
While Karabell’s column is about insider trading he generalizes his apologia for financial CEOs to all forms of fraud. He bemoans the investigation (much less, the prosecution) of elite insider trading at Galleon, and denounces it as a sad example of how sick our “culture” must be because there are demands to hold fraudulent bank CEOs culpable for their crimes.

“In part, all of this is the fallout of a culture looking for villains for the financial crisis. As Charles Ferguson, director of the documentary Inside Job said in accepting his Academy Award, no financial executive has gone to jail for their role in the financial meltdown, and in his view, that is wrong. But is it? Generals routinely mess up during war, either from incompetence, vanity, arrogance or simply the unexpected. They are recalled and sacked, we hope, but unless it can be shown that they willfully and purposely screwed up, they are in our society rarely see a court-martial. Financial executives were culpable in myriad decisions that led to the financial crisis, but that in itself does not translate into prosecution and jail time.”

Karabell cannot even bring himself to use the “f” word (fraud) and discuss his purported basis for why he claims that this was the first Virgin Crisis – conceived without sin in the C-suites. After hundreds of successful prosecutions in the Enron era and over a thousand successful prosecutions in the S&L debacle where the same basic fraud mechanism (accounting control fraud) was used in each of the three modern crises Karabell does not even feel it is incumbent on him to explain why fraud ceased. Note that he admits that the rewards to accounting control fraud grew massively, he cannot deny that it is a “sure thing,” and he admits that the three “de’s” made the detection and sanctioning of elite frauds vastly less likely. Logically, that should have led accounting control fraud to grow massively greater than during the prior crises. But Karabell simply goes into his full apologia mode.

Why Does Karabell claim that being a Sycophant makes him “Edgy?”

I know the answer, as do my readers, but we should still ask Slate the question. Why do they hire SAPs as their financial columnists? And what part of “edgy” is Karabell claiming as his self-descriptor – a Wall Street insider who writes apologia for Wall Street elites is simply one of hundreds of thousands of sycophants. When did sycophants become “edgy” instead of puerile?


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