Mankiw Whiffs on “Learning the Right Lessons from the Financial Crisis”

By William K. Black
July 31, 2018     Bloomington, MN

I am writing a major article on myths about the causes of the financial crisis, so I read with special interest N. Gregory Mankiw’s column “Learning the Right Lessons From the Financial Crisis.”  (HT: DCJ.)  The context of Mankiw’s article, as he appropriately discloses, is to do a favor for a friend by plugging the friend’s new book in Mankiw’s column in the New York Times.  I have no criticism of that purpose and applaud him for alerting readers to it.  The problem is substance, both the book’s and his column.

Mankiw is the leading author of economic textbooks in the world, so his views and his ideology are enormously influential.  The first sentence of his book review asks the right question:  “What caused the financial crisis of 2008?”  The remarkable thing is that he never attempts to answer the question and does not explain how the book he is reviewing attempts to do so.

Here is how Mankiw discusses the question of causality.

In the past decade, a conventional wisdom has developed about the answers.

Yet a new book questions that orthodoxy, offering a more disturbing perspective on the past and a less sanguine prognosis for the future.

In a nutshell, the conventional wisdom goes like this:

In the mid-2000s, the nation experienced a housing bubble. A combination of stupidity, negligence and malfeasance led a bunch of Wall Street firms to make excessively risky bets that the bubble would go on forever. Through mortgage-backed securities and related instruments, they extended credit to home buyers of dubious credit quality.

For a while, this credit expansion fueled the bubble. But when the bubble burst, these new homeowners defaulted in record numbers, and the Wall Street firms headed toward insolvency. The whole financial system teetered on the edge of collapse, leading to a deep recession.

Fortunately, policymakers came to the rescue.


Their bold steps saved us from another Great Depression.

I agree that there is a “conventional wisdom” and that Mankiw’s “nutshell” description of causality and Bernanke’s claim to be a noble savior sums it up.  As readers know, I think the conventional claims of causality and saviors are largely false.  I, therefore, am disposed favorably to listen to explanations that reject the conventional wisdom and aid us in “Learning the Right Lessons From the Financial Crisis.”

So how does Mankiw answer the question he raises in his first sentence:  “What caused the financial crisis of 2008?”  He does not answer it.  He not even explain why he does not answer his own question.

Why did bank CEOs deliberately originate, purchase, and sell nearly $2 trillion in toxic mortgage product that they knew were frequently fraudulently originated and sold through false “reps and warranties?”  Why did the collapse of those markets, which the vastly larger general economy dwarves, stop trading in a vast numbers of financial products so suddenly, resulting in hundreds of market trading failures?  Why did the federal financial regulators refuse to prosecute the fraudulent bankers?  Why did the federal financial regulators refuse to remove those fraudulent bankers from control?  These are not questions that Mankiw has any expertise in answering.

What about Mankiw’s friend and his book that “questions” the “conventional wisdom” about the causes of the crisis and the bailout?  Does he have expertise in elite frauds and federal financial bailouts?  Here is how Mankiw introduces his friend’s book.

 [A] new book, “The Fed and Lehman Brothers,” by Laurence M. Ball, an economist at Johns Hopkins University, casts doubt on this narrative. Mr. Ball (who is a friend of mine) does not excuse the financiers from starting the trouble. But he draws attention to the policymakers who, in his view, failed to do their jobs at a crucial moment.

Ball chairs JHU’s economics department and is a well-known macroeconomist.  He has no clear expertise relevant to evaluating the conventional wisdom about the causes of the 2008 financial crisis that Mankiw set out.  Ball’s description of his “research topics” is “unemployment, inflation, and fiscal and monetary policy.”  The subtitle of his book is Setting the Record Straight on a Financial Disaster.What is he setting “straight” about the causes of the 2008 financial crises?  Does Mankiw agree with Ball’s thesis that the Fed should have made very large loans to Lehman?

I start with the second question because it has a short answer.  Mankiw does not say whether he agrees with Ball’s thesis.  Given the fact that Ball is a friend, Mankiw’s lack of agreement is telling.

Ball has made an earlier version of what became his book available on the web.  It is telling that the 210-page manuscript does not contain the word “fraud.”  (It has five references to “fraudulent conveyances” as part of a discussion of the Fed’s excuses for not bailing out Lehman.)  Lehman was a “control fraud” and one of the largest fraud “vectors” in the world pumping out enormous amounts of toxic mortgages to the world through fraudulent “reps and warranties.”  Those fraudulent sales, had Lehman been bailed out by the Fed, should have still rendered Lehman deeply insolvent when purchasers brought claims based on Lehman’s knowingly false reps and warranties.  Ball appears oblivious to all this despite my detailed congressional testimony about the scope of Lehman’s fraudulent sales.   

Ball’s 210-page manuscript also does not contain the acronym “HOEPA” or the full name: Home Ownership and Equity Protection Act of 1994.  That is an indefensible omission when the topic he purports to be addressing is what the Fed should have done to prevent the financial crisis.  As my congressional testimony and writings – and many other home lending advocates’ work – has emphasized for decades, HOEPA gave the Fed the unique authority to ban the most toxic fraudulent form of lending – the liar’s loan.  (The lending industry called them “liar’s” loans because it knew that the failure to verify the borrower’s income led to massively inflated income in loan applications.)  HOEPA gave the Fed the unique authority to ban even “shadow” sector lenders like Lehman from making such loans.  Lehman was one of the world’s largest sellers of liar’s loans.  Worse, Lehman specialized in purchasing and selling the most toxic form of liar’s loan – subprime liar’s loans.

It should be obvious to macroeconomists such as Mankiw and Ball that the first “lesson” we should draw from Lehman’s failure is it is vastly better to prevent the massive fraudulent issuance and resale of toxic mortgages that will hyper-inflate the bubble and cause catastrophic losses.  Greenspan and Bernanke’s decision to allow Lehman (and scores of other fraudulent lenders) to continue to operate as a fraud vector for over a decade was catastrophic.  Ball’s claim that the public should have bailed out Lehman and allow it to continue to be one of the world’s largest fraud vectors is appalling.

One of Mankiw’s vague sentences in his book review comes into sharp relief once we know that Ball ignored HOEPA and the Fed’s failure to use it to ban liar’s loans.

Central banks like the Fed have two tasks. The first is to adjust the money supply and interest rates as economic conditions change. The second is to help ensure the safety and soundness of the financial system. As part of this second task, central banks sometimes need to act as a lender of last resort.

I understand that Mankiw described the “lender of last resort” function as only “part” of its “safety and soundness” functions.  If we focus on any “part” of the Fed’s “safety and soundness” mission in seeking to understand the right lessons we need to learn to minimize the frequency and severity of future crises, we would never start with “lender of last resort.”  We would start with the three “de’s” – deregulation, desupervision, and de facto decriminalization.  We would begin with HOEPA, but the Fed also had conventional regulatory authority over banks and bank holding companies.  The Fed and the OCC brag that fewer of their banks died, but that is because the frauds cluster in the fields with weakest supervision (the Shadow) and because we bailed out many of the largest control frauds such as Citigroup.  The Fed and OCC, however, could have used their examination, supervision, and research powers to find the critical facts that – a decade later – would hyper-inflate the housing bubble and cause the financial crisis.  For example, the Fed should have documented the vast rise in the origination, sale, and purchase of liar’s loans by its regulatees.  The Fed had (limited) examination authority that would have allowed it to learn these facts even about otherwise unregulated members of the Shadow sector that were owned by bank holding companies.  The Fed could have documented how many of these loans were fraudulent.  Siddique’s testimony to the Financial Crisis Inquiry Commission (FCIC) explained that when he got even preliminary information from the largest banks on their liar’s loans the result was a personal attack on him by senior Fed leaders – for providing them with the industry’s own alarming facts.  The FCIC report also notes ‘Ned’ Gramlich’s famous pleas to his Fed colleague Alan Greenspan urging him to use the Fed’s power to get these critical facts and Gramlich’s warnings about surging nonprime lending.

Similarly, the Fed could have reacted to Enron’s fraudulent use of off-balance sheet SIVs by adopting a powerful, mandatory rule preventing the abuses.  Spillenkothen’s long memo to the FCIC about Greenspan and the regional Fed presidents’ war on effective Fed regulation and supervision provided Ball with the critical facts to make this point.  Ball’s lengthy manuscript shows that he is familiar with the congressional hearings and relevant portions of the FCIC report discussing the Fed and Lehman, but he never mentions Gramlich, Siddique, Spillenkothen, or me.

The word “regulation” appears only four times in Ball’s manuscript.  The word appears in his bibliography in the title of a journal and the title on an article.  He cites the Fed’s liquidity requirement rule once and a rule about the Freedom of Information Act.  Ball does not discuss “deregulation,” safety and soundness regulation, or the Fed’s “examination” authority.  His thesis seems to be that Lehman’s failure “caused” the global financial crisis.

Ball’s lengthy manuscript uses the word “subprime” once, even though Lehman was a massive vector for sales of subprime liar’s loans under false reps and warranties.  Lehman owned BNC, which originally purchased and resold subprime loans and Aurora, which originally specialized in buying and reselling liar’s loans.  Over time, however, both subsidiaries morphed into entities that largely purchased subprime liar’s loans and resold them through fraudulent reps and warranties.  (By 2006, half of all the loans the industry called ‘subprime’ were also liar’s loans – the two types of nonprime loans are not mutually exclusive.)  It is, of course, disastrous for the firms to combine both of these features, but I have often explained why it optimizes the “fraud recipe” and creates the “sure thing” of enriching the officers.

Ball’s manuscript never uses the words “warranties,” “reps,” or “representations” even though he published it after the papers will filled with discussions of tens of billions of dollars in civil recoveries by the Department of Justice based on claims that banks had fraudulently sold toxic mortgages through false reps and warranties, particularly to Fannie and Freddie.

Ball’s lengthy manuscript does not mention “contingent liabilities” – even though Ball’s goal is to ‘prove’ that Lehman was (barely) solvent and that the Fed could have provided it with liquidity by making it tens of billions of dollars in loans.  Ball does not discuss or analyze Lehman’s grossly inadequate allowances for losses on the sale of toxic loans with early payment defaults (EPDs) and false reps and warranties.  The firms that purchased toxic mortgages from Lehman would have sued it for fraud had the Fed bailed out Lehman.  The courts could have been awarded the firms very large punitive damages.  Lehman sold hundreds of billions of dollars in toxic mortgage loans to other financial firms through false reps and warranties.  Ball’s analysis ignores these liabilities and the liquidity needs to repay these liabilities.

Lehman’s frauds and grossly inadequate loss reserves inflated its reported income and net worth and understated its liabilities.  This exposed Lehman to securities fraud lawsuits by its investors, lenders (which would include the Fed under Ball’s proposal), and the SEC.  The Department of Justice could have prosecuted Lehman and its controlling officers for those frauds.  Ball implicitly assumes that DOJ would never prosecute Lehman and its controlling officers for such frauds.  That implicit assumption, if correct, is actually a telling admission as to the true causes of the financial crisis and the policy lessons we should learn from it.

These suits and prosecutions, in addition to increasing costs, could require Lehman to restate its financial statements and spark refusals to roll Lehman’s short-term loans, causing a sudden liquidity crisis even if the Fed loaned tens of billions of dollars to Lehman under Ball’s proposal.  Lehman would have had to make reps and warranties to the Fed that its balance sheet and income statement were accurate and that it had correctly identified and estimated its liabilities and provided adequate loss reserves for its fraudulent sales of toxic mortgages and its fraudulent accounting disclosures to lenders and investors.  Those reps and warranties from Lehman to the Fed would have been false for the reasons I have explained here and in my House testimony and the scam REPO accounting Valukas stressed in his report and House testimony.  Lehman would have been defrauding the Fed to induce it to make tens of billions of dollars of loans to Lehman.  Again, Ball is implicitly assuming that the Fed, the SEC, and the DOJ would never sanction Lehman for such frauds.  Again, that is unintentionally revealing as to the reasons the 2008 financial crisis was so severe and why we failed to learn the proper lessons of the need to hold the most powerful CEOs personally accountable through prosecutions and civil and administrative sanctions.

Ball also fails to consider the untenable financial condition of Lehman even if it did not have these massive liabilities for its fraudulent sales of toxic mortgages.  Ball claims Lehman might have been barely solvent based on a computation that ignores its fraud and contract liabilities.  A barely solvent, massive financial firm poses a grave danger under even neoclassical economic analysis.  It would have extraordinary leverage (debt-to-equity ratio) and be subject to off-the-charts ‘moral hazard’ that would create perverse, dangerous incentives.  The neoclassical economic policy was that regulators must close such firms long before they approached insolvency.  Neoclassical economists convinced Congress and the President to adopt, in 1991, “prompt corrective action” mandating such closures in the case of federally insured institutions.  Under the neoclassical economic views that Ball and Mankiw have long espoused, it would have been grotesquely irresponsible to keep Lehman open as a vampire firm kept ‘undead’ through constant Fed loan transfusions.  Liquidity is the life’s blood of financial firms.

Ball also seems to assume, implicitly, that if the Fed had delayed Lehman’s failure by making tens of billions of dollars in loans to Lehman there would have been no financial crisis.  Ball cannot demonstrate the truth of such a claim.  The fraudulent liar’s loans and extorted inflated appraisals that hyper-inflated the bubble were going to cause massive defaults and losses upon default.  The larger the fraudulent loans grew, the larger the losses were likely to grow.  The massive frauds dominated lending in Ireland and Iceland more than they did in the United States.  The growth rate of fraudulent lending in Ireland and Iceland was even larger than in the U.S.

Losses do not tend to grow linearly during a severe crisis.  Losses generally grow exponentially in severe crises as fraud eventually causes trust to break down and financial markets fail.  If Lehman had not failed in fall 2008, it would have failed, and likely more spectacularly, in some later year, when it was sued for fraud by its loan purchasers and investors.  Other large fraudulent lenders plus AIG and Merrill Lynch would have failed unless the federal government bailed them out.  By 2007, hundreds of uninsured and overwhelmingly fraudulent nonprime lenders had failed.  Federally insured fraudulent nonprime lenders such as WaMu, Countrywide, Wachovia, and IndyMac lasted longer than their shadow sector rivals because they could raise funds via deposit insurance, but those insured failures would have occurred by 2009-2010.  If even larger banks acquired them and continued to make fraudulent loans, it would have endangered the survival of their acquirers.

Even if the Fed had kept Lehman on life support, international and domestic failures of enormous non-shadow insured banks would have become common by 2009 and would have sent financial shock waves even larger than Lehman’s failure did.  Those shock waves would have caused liquidity crises in hundreds of financial markets and sparked a financial crisis.  Those shock waves would have taken down Lehman absent a far larger Treasury bailout or federally assisted sale.

My House testimony in 2010 explained several aspects about Lehman’s failure that support a portion of Ball’s analysis.  I think that allowing Lehman to collapse in an unstructured fashion added unnecessary resolution costs.  I testified that the Fed never undertook the collateral review essential to provide Lehman a temporary, secured loan to aid a structured resolution of the failed investment bank.  This is something that I know a fair bit about because the Federal Home Loan Banks were secured lenders to financial institutions.  Dirk Adams, my predecessor as General Counsel of the Federal Home Loan Bank of San Francisco successfully supported the FHLBSF’s fabulous credit review team in stemming a $6 billion run on what was then the Nation’s largest savings and loan.  Lehman was suffering a far larger run and required, on an emergency basis, intense credit reviews by Fed specialists of tens of billions of dollars in assets.  The Fed, however, never sent enough staff to conduct any meaningful credit review to prepare for emergency, secured lending to Lehman.  I agree with Ball that the Fed never sought a prudent means to loan on a secured basis to Lehman.

The reason the Fed never even prepared to lend on a secured basis to Lehman appears to be personal and ideological.  The right attacked Treasury Secretary Paulson on ideological grounds for arranging a government-supported sale of Bear Stearns.  This criticism from their ideological allies in business and economics for allegedly going wobbly on laissez faire mortified Paulson (and perhaps Bernanke).

Ball, and Mankiw, however, have failed to present an honest account of the lessons we need to learn from the crisis.  The reason they have failed is the same that Ball attributes to former Treasury Secretary Paulson – doing the right thing would require Ball and Mankiw to admit that their neoclassical ideologies led them to teach bad economics and terrible economic policies that helped produce the criminogenic environment that caused the 2008 financial crisis.  They would have to admit that they actually had no relevant expertise or experience in understanding or preventing such criminogenic environments.  They would have to admit that they ignored George Akerlof and Paul Romer’s warnings about “looting” in their famous 1993 article.  Recall that Mankiw was the official discussant when Akerlof and Romer presented their paper and that his classic example of unintentional self-parody of neoclassical nostrums was his infamous remark as discussant that “it would be irrational for savings and loans [CEOs] not to loot.”  Like Paulson, Mankiw and Ball know that if they embraced and taught the real lessons of the 2008 financial crisis about elite fraud and predation, their neoclassical peers’ would pillory them for their heresy.

Lehman deserved to fail.  It died because its CEO killed it by running a control fraud.  Neoclassical economists love to tell us of the glory of “creative destruction.”  There is no more creative destruction than putting a fraudulent financial firm into receivership and bringing in new honest managers.  The Fed and Treasury could have placed Lehman in receivership by first granting it a bank charter on an emergency basis.  The FDIC receivership can create a “good bank” and a bad bank.  The ‘bad bank’s’ new, honest, management team liquidates the assets.  The ‘good bank’s’ new, honest management team readies it for an acquisition.  Lehman’s shareholders suffer the fate of risk capital – as they should.

A receivership with new honest managers also allows those managers to ferret out and document the illegal acts of prior management.  This allows them to fire the culpable and make superb criminal referrals vital to the prosecution of the managers that led the frauds that killed Lehman and contributed greatly to causing the financial crisis.  One of the important reasons we were able to convict over 1,000 of the most serious savings and loan frauds was our use of such receiverships.  The skill of FSLIC personnel in choosing competent and honest CEOs to serve as receivers and the skill and integrity of those CEOs in working with our investigators to discover and document the frauds and prepare superb criminal referrals (SARs) were critical to the prosecutorial success.  Ball’s lengthy manuscript does not mention the words “receiver” or “receivership.”

Ball failed to set “the record straight” about the “lessons” we should draw from the 2008 financial crisis.  Any regulator that accepts his thesis will adopt policies that make future crises more likely and severe.

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