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By L. Randall Wray

In a Wall Street Journal article this week three Hoover Institute economists (Gary Becker, George Schultz and John Taylor) endorsed Republican efforts to make large federal government budget cuts.  I will not address all the arguments made in defense of a “Hooverian” approach to economics (we tried that in the early 1930s!). Here I want to focus on the two main points made:

1. “When private investment is high, unemployment is low. In 2006, investment—business fixed investment plus residential investment—as a share of GDP was high, at 17%, and unemployment was low, at 5%. By 2010 private investment as a share of GDP was down to 12%, and unemployment was up to more than 9%. In the year 2000, investment as a share of GDP was 17% while unemployment averaged around 4%. This is a regular pattern.”
2. “In contrast, higher government spending is not associated with lower unemployment. For example, when government purchases of goods and services came down as a share of GDP in the 1990s, unemployment didn’t rise. In fact it fell, and the higher level of government purchases as a share of GDP since 2000 has clearly not been associated with lower unemployment.”

The authors supply a graph showing investment and government spending as a share of GDP to demonstrate these two points. Based on that data, these economists argue that the solution is to cut federal spending and then to hold its growth rate below that of GDP. This will allow the share of government spending to fall—while economic growth will let tax revenues rise a bit faster so that the budget will move toward balance.

By framing their argument in terms of ratios to GDP, the authors provide a misleading characterization of cause and effect. It is true that high investment spending tends to increase GDP while lowering unemployment—that is the Keynesian “multiplier” at work. High growth of GDP, in turn, lowers the ratio of government spending to GDP so that we will observe a correlation between falling unemployment and a falling government share of GDP—but that is a correlation of no causal significance. When an investment boom collapses—as it did in 2006-2007—GDP growth then falls and the government share of a smaller GDP will rise. Our Hooverians interpret that as “proof” that a rising government share does not help to fight unemployment.

In fact, however, relatively stable government spending over a cycle helps to cushion a private sector “bust”. While it is hard to prove the counterfactual—how bad would things have been without sustained government spending—it is hard to believe their argument that a loss of 8% of GDP due to reduction of private spending would not have led to a much deeper recession (or depression) without the stabilizing force of our government spending.

Let us take a look at the components of GDP over the past two decades. Recall from your Econ 101 course that the aggregate measure of a nation’s output of goods and services (GDP) is equal to the sum of consumption, private investment, government purchases, and net exports (for the US that is of course negative). We can further divide investment into residential (housing) and nonresidential (investment by firms). Finally, we can divide government spending between federal government and state and local government. The following chart graphs the domestic components of GDP (net imports are left out), indexing each component to 100 in 1990. (This makes the scale easier to show in the graph, and simplifies comparison of growth by component. For example, if consumption spending doubles between 1990 and 2000, its index increases from 100 to 200.)

What we see in this graph is that the slowest growing component over the two decades was federal government spending—it actually did not grow much until the term of President George W. Bush. (A substantial portion of federal government growth since 2000 can be attributed to our multiple wars, as well as to domestic spending on security.) By 2010, federal government spending was just over 2.3 times bigger (in nominal terms) than its spending in 1990. Private consumption as well as state and local government spending grew steadily, increasing by about 267% before the deep recession led to some retrenchment. By contrast, residential investment boomed in the real estate bubble, growing by 350% until 2005. It then collapsed so that it stood at an index of just 150 in 2010 (fifty percent higher than in 1990). Nonresidential investment shows a clear cyclical nature, and it too collapsed in the aftermath of the global financial collapse. Viewed in this light, it is not at all surprising that when total investment (residential plus nonresidential) is growing rapidly, unemployment tends to fall; but when investment spending collapses we lose jobs at a stupendous pace.

This has long been the concern of Keynesian economists: investment by its very nature is highly cyclical, subject to what J.M. Keynes called “whirlwinds of optimism and pessimism”. That is not all bad. J. Schumpeter referred to the “creative destruction” that makes capitalism dynamic—waves of innovation generate new investment, wiping out firms that get left behind. But if an entire economy is whipped about by unstable investment, we oscillate between the extremes of boom and bust. That is why we need some spending that is more stable—better yet, we need a source of spending that can act in a countercyclical manner to offset the swings of investment.

And that is precisely what we created in the aftermath of the Great Depression. First, we grew the federal government—from about 3% of GDP in 1929 to above 20% after WWII. As the chart above shows, federal government spending is not subject to the wild swings that afflict investment, so it helps to stabilize GDP and jobs. Second, we put in place a variety of federal government programs that help to stabilize household consumption (unemployment benefits, Social Security retirement, and “welfare” for households, firms, and farms). That is, again, reflected in the chart above—even when the financial sector crashed and unemployment exploded, consumption dipped only slightly, thanks in large part to government “transfer” payments like unemployment benefits.

Our modern Hooverians would like to return to the “good old days” of President Hoover, when the government was smaller and both unwilling and unable to offset the swings of private investment spending. Back then, when investment collapsed unemployment did not go to 9 or 10 percent, it went all the way to 25 percent. Hooverian economics would turn back the clock to ring in another Great Depression with the same old pre-Keynesian ideas that failed us in the 1930s.

By William K. Black

(cross-posted with Benzinga.com)

My next columns address three writings by Stephen Moore, the Wall Street Journal’s “senior economics writer.”

White Collar Witch Hunt: Why do Republicans so easily accept Neobolshevism as a cost of doing business? [The article appeared in the American Spectator in September 2005.] “Bullish on Bush: How the Ownership Society Is Making America Richer.” [Madison Books, 2004.] We’ve Become a Nation of Takers, Not Makers. [Wall Street Journal, April 1, 2011.]

Moore’s column deplores the debasement of the American economy by government employees.

“More Americans work for the government than work in construction, farming, fishing, forestry, manufacturing, mining and utilities combined. We have moved decisively from a nation of makers to a nation of takers.”

The claim that employees involved in making physical things that are purchased in the markets are uniquely valorous is an odd argument for someone with his professional career (Moore ran the ultra conservative, “supply side” anti-tax group, the Club for Growth). The trade and tax policies he embraces encouraged U.S. businesses to export their manufacturing plants (and their jobs) to low-wage/low-tax nations and to import food produced in those low-wage/low-tax nations. Moore has praised both states and nations that serve as tax havens. He has singled out the Texas model – low wage, low tax, low government services, and hostile to safety rules. Moore has worked for years to punish the “makers” and produce the condition he deplores in which the number of U.S. “makers” has fallen sharply. His column decries the budgetary crises in states and localities, but it was the Great Recession driven by the criminogenic environment his anti-regulatory policies created together with the anti-tax hysteria generated by his repeatedly falsified fantasy that slashing taxes for the rich increases tax revenues that drove that budgetary crisis. Architects of the crisis like Moore who write primarily to excuse their consistent failures should stop. They have done enough damage to the world for a dozen lifetimes.

Consider the implications of Moore’s assertion that people who do not work in manufacturing and farming are “takers.” Under this dichotomy the world is divided between “makers” and “takers,” the biggest “takers” in the world work on Wall Street, the City of London, and the worst kleptocracies – the Wall Street Journal’s core readership. If “makers” of manufactured goods and crops are uniquely valorous, then Moore’s logic requires that it is the workers in these sectors – not the managers, professionals, and clerical workers – who are the actual “makers” who embody that unique valor. (Again, it is passing strange that Moore has dedicated his life to rewarding these uniquely valorous Americans by exporting their jobs and leaving them unemployed or employed at lower wages.) If one can claim to be a “maker” by performing functions that merely assist the actual “makers” make things, then we are all “makers.”

Moore, however, implicitly makes two assertions about government employees – all government employees are “takers” and only government employees are “takers.” Moore doesn’t attempt to support any of his assertions, and they are logically inconsistent. These truths are apparently self-evident to Mr. Moore – people are not created equal. Americans who choose to be government employees are inferior because they are not endowed by their creator with an adequate taste for risk.

“Surveys of college graduates are finding that more and more of our top minds want to work for the government. Why? Because in recent years only government agencies have been hiring, and because the offer of near lifetime security is highly valued in these times of economic turbulence. When 23-year-olds aren’t willing to take career risks, we have a real problem on our hands. Sadly, we could end up with a generation of Americans who want to work at the Department of Motor Vehicles.”

In Moore’s world, an American who wishes to work as a “maker” and develops the skills to be a “maker” has no inalienable right to a job as a “maker” at a living wage. Why? If (1) there really is something particularly virtuous about working in manufacturing or farming, (2) there are too few Americans working in those industries, and (3) the Americans who wish to work in those industries embrace “tak[ing] career risks” and have prepared themselves by education to be able to be productive “makers” why not commit the U.S. to ensure that these virtuous, risk-loving young people can find jobs in manufacturing and farming in the U.S.

Moore is not strong on nuance. All government employees are “bureaucrats” in his parable of “makers” and “takers.” No corporations are bureaucratic. Moore’s fable is crude propaganda. Let us add some reality. Our largest group of federal employees provides national security (DoD, CIA, NSA, DHS, DOJ/FBI, VA, etc.). Many of these “bureaucrats” are living their parasitical life of ease as “takers” in Iraq and Afghanistan. (The virtuous Taliban are busy being “makers” – cultivating poppies.) I do not recommend telling our troops that they are risk-averse “takers” and bureaucrats. The exact number of federal employees engaged in national security is unknown because many employees in other agencies, e.g., NASA, actually work on national security under various degrees of deliberately misleading information. There are over a million federal military personnel. DoD, Homeland Security (DHS), and the VA have nearly a million civilian employees.

The only other federal sector with very large numbers of employees is the Postal Service (around 600,000 – less than one-third the size of the federal workforce in the national security sector). The Postal Service, of course, provides a productive service – communications. Moore does not even attempt to explain why our federal troops or our federal communications workers are supposedly parasitical “takers.” Moore does not even attempt to prove that Americans choose to work for the nation or their State because they fear taking risks. I took far more risks as a federal employee than as a private sector employee. Charles Keating hired private detectives twice to investigate me. He sued me for $400 million in my individual capacity. Another fraudulent CEO also sued me for millions of dollars. Speaker of the House James Wright sought to get me fired. One of the presidential appointees running my agency conducted what he claimed was an investigation of me with the hope that he would be able to get me fired or sued. Charles Keating gave a “secret file” to senior members of my agency that he purported had adverse information about me. The agency excluded me from meetings with Keating and removed our jurisdiction over Lincoln Savings. The head of my agency attacked me publicly in the press and in congressional testimony. (I returned the favor – he resigned in disgrace.) I was a mere financial regulator.

The overwhelmingly dominant sectors of state and local governmental employment are teaching, police, fire, and prison officers and staff. Each of these jobs would be shunned by those afraid to take risks. Moore views this hypothetical as his nightmare of American decline:

“Sadly, we could end up with a generation of Americans who want to work at the Department of Motor Vehicles.”

I have never met a college graduate (the context of this excerpt from Moore’s column) who aspires to work at DMV. I doubt that Moore has ever met one with that career goal. Moore chooses DMV as his example in order to disparage government and government employees. Moore believes that government workers are mediocre. Too scared and too incompetent to work in real jobs, government workers are parasitical “takers.”

“One way that private companies spur productivity is by firing underperforming employees and rewarding excellence. In government employment, tenure for teachers and near lifetime employment for other civil servants shields workers from this basic system of reward and punishment. It is a system that breeds mediocrity, which is what we’ve gotten.”

Ah, yes, the “rank and yank” system and executive and professional compensation have been a brilliant success in “private companies.” Private systems have worked so brilliantly that they destroyed tens of trillions of dollars of wealth by creating a criminogenic environment in which private incentives became so perverse that they drove the epidemic of accounting control fraud that produced a massive financial crisis and the Great Recession. Moore thinks that failed private system should be our model for the public sector. Moore has been disastrously wrong about nearly every major economic policy issue of importance. He has learned nothing useful from his failures.

Mr. Raines explained in response to a media question what was causing the repeated scandals at elite financial institutions:

We’ve had a terrible scandal on Wall Street. What is your view?

Investment banking is a business that’s so denominated in dollars that the temptations are great, so you have to have very strong rules. My experience is where there is a one-to-one relation between if I do X, money will hit my pocket, you tend to see people doing X a lot. You’ve got to be very careful about that. Don’t just say: “If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.

Mr. Raines was speaking on behalf of the Business Roundtable, which picked him as its spokesperson to explain to the media why the epidemic of Enron-era accounting control frauds was occurring. (You can’t compete with unintended self-parody.) Raines knew what he was talking about – as Fannie’s CEO he employed an executive compensation system that created these perverse incentives. During the crisis, the fraudulent CEOs running the fraudulent liar’s lenders deliberately created intense, perverse incentives among their loan brokers, loan officers, appraisers, auditors, and rating agencies by creating a “Gresham’s” dynamic in which bad ethics drove good ethics out of the marketplace. They were exceptionally effective in achieving the desired results. The CEOs were consistently able to get overstated appraisals, overstated borrower income, clean opinions for financial statements that were not prepared in accordance with GAAP, and “AAA” ratings for toxic waste. CEOs can and do use compensation for good or evil.

Moore’s discussion reveals more about him than about government employees. He can’t imagine employee excellence not based overwhelmingly on fear or quasi-bribery. He can’t imagine anyone wanting to be a teacher, a regulator, a soldier, a firefighter, a CDC scientist, a VA doctor, an FBI special agent, or a police officer. He can’t imagine people who voluntarily accept lower pay than they could get in the private sector because they want to protect people from harm. He can’t even imagine people who want a job in the local prison because they live in rural areas with high unemployment and the prison job is the best way to continue to live and work where they can help a sick mother. People work for the government for myriad reasons. Effective leaders, whether they are in the private or public sector, do not rely on threats or bribes to motivate their teams. They choose good people, train them, praise them, and give them constructive feedback. Effective leaders demonstrate through their actions integrity and dedication to the mission. Accomplishing that mission – teaching a child to read, closing fraudulent banks, putting out fires, arresting rapists, preventing a terrorist attack, or preventing criminals from escaping prison – becomes a matter of the best kind of pride and purpose. Government employees often work far longer hours than required for no additional compensation. This is, for example, overwhelmingly true of teachers.

Why does Moore believe that human capital is so unimportant? His supposed “takers” are the leading “makers” and protectors of the “makers” he claims epitomize valor. It is teachers that help us become productive (and civilized). The police, firefighters, CDC, and the FDA safeguard lives. Does Moore find that unproductive?

The literature on performance pay shows that even when it is not used deliberately by fraudulent leaders to create perverse incentives it can often disrupt work teams and make them less effective by creating divisiveness. It is as if a mother declared that certain of her children were superior to others.

The effort to create performance pay is also perverse because it leads to demands for quantification of performance. Moore errs when he claims the government does not use performance pay. The “Reinventing Government” movement (championed by Vice President Gore and (then) Texas Governor Bush as well as many academics was premised on applying private sector management practices in the public sector. For example, Moore’s column complains about students’ test scores not improving. Student test scores did, infamously, improve dramatically in Houston, as did graduation rates, in response to performance pay tied to test performance and dropout rates. The Houston “miracle” led to Bush’s education program (“No child left behind”). The miracle was actually a fraud. The dropout rates were scammed by the Houston leadership and teachers simply taught to the test.

The SEC and Justice Department use “objective” performance measures to determine bonuses. This increases the perverse incentive to bring cases against minor wrongdoers rather than against the most damaging frauds in which it is far more difficult and time-consuming to obtain convictions.

The other bright idea of Reinventing Government was to order the bank regulators to refer to the banks they were supposed to regulate as their “customers.” That too was a direct steal from private sector management. It is a destructive practice in the regulatory context.

Moore claims that the private sector is always more efficient in providing services.

“Most reasonable steps to restrain public-sector employment costs are smothered by the unions. Study after study has shown that states and cities could shave 20% to 40% off the cost of many services—fire fighting, public transportation, garbage collection, administrative functions, even prison operations—through competitive contracting to private providers. But unions have blocked many of those efforts. Public employees maintain that they are underpaid relative to equally qualified private-sector workers, yet they are deathly afraid of competitive bidding for government services.”

Yes, there are badly designed studies that make these claims, and then there is the reality of privatization. For example, some studies on prison operations find that private prisons are cheaper than public prisons. The problem is that these studies compare average costs of public imprisonment with the costs of private prisons for the lowest risk prisoners. Security drives prison expense, so these studies are meaningless. Privatization can also create perverse incentives. The most notorious example is the CEO of the private prison who bribed judges to sentence innocent juveniles to extensive imprisonment in order to increase the CEO’s compensation.

The private sector can always cream skim some aspects of public services at what appears to the uninformed to be a saving. A private school that does not provide services to special needs students is not more efficient – it is simply taking advantage of a cross subsidy from the public sector.

Privatization does not typically lead to “competitive bidding for government services” by “equally qualified private-sector workers.” The sales of public assets are often not competitive and are not made at market prices. Privatization tends to be a giveaway, making the cronies with the strongest political connections wealthy (think Mexico). I have provided examples of why the “government services” provided under privatization of prisons and schools are often not equivalent because the private sector cream skims the lowest cost aspects of those services, which does nothing to reduce overall costs. The private parties often do not provide “equally qualified private-sector workers.” In college education, for example, GAO studies have found that “for profit” schools have a terrible reputation for endemic fraud. They do not provide equally qualified staff. Private prisons often do the same. Private military contractors are more expensive than government troops and produce recurrent scandals because of their CEOs’ perverse incentives.

American workers do fear the dynamic Moore has long championed. What is the American worker supposed to do if the outsourcing to the private sector is to India and the wages there are one-twentieth of the U.S. wages? That dynamic would lead to the impoverishment of tens of millions of American workers.

In the regulatory world we have just run a real world experiment with applying private sector management theories to the private sector. We privatized many regulatory activities by adopting self-regulation. We used “early outs” to shrink the FDIC (losing many of our most experienced federal employees). We shrank the FDIC by more than three-quarters. The FDIC adopted “MERIT” (non) examination of banks (the “M” and “E” stood for “maximum efficiency). We brought the bank lobbyists “inside the tent” in financial rulemaking, i.e., in creating Basel II. We gave performance bonuses to senior FDIC officials for dramatically reducing FDIC employees. We preempted the State regulators and AGs seeking to protect consumers from predatory nonprime lenders. Each of these actions contributed to the abject regulatory failure.

To sum it up, private sector financial employees, due to the perverse incentives their CEOs put in place and that Moore wishes to spread, were far worse than “mediocre” at hundreds of lenders. The incentives became so perverse that they produced multiple epidemics of fraud and led our most prestigious professionals to aid those frauds. The results were catastrophic. Moore wants to spread those perverse compensation systems and incentives throughout the public sector, where they are even more inappropriate and destructive. We have a catastrophe because the private sector incentives were perverse and the political leaders appointed anti-regulatory leaders to run the agencies. Moore invariably bases his solutions to the problems of the public sector on the private sector approach without examining the problems of the private sector approach or whether that approach makes sense in the public sector. Moore’s theme song is a straight steal from My Fair Lady: “Why can’t a woman be more like a man?” Real men (“makers”) embrace risk and work in the private sector. If only government workers (“takers” – women and men too scared to take those risks) could be made more like the private sector employees all would be solved. In the movie, the song is satire designed to expose male prejudice. Moore doesn’t get the satire.

By William K. Black

(cross-posted with Benzinga.com) 


If you read this column you are familiar with our family rule that one can never compete with unintentional self-parody. The Justice Department is the latest exemplar of this rule. Joe Nocera’s March 25, 2011 column, “In Prison for a Taking a Liar Loan” discusses the case. Spoiler alert: Joe ends his column with a twist that is the thrust of my column so please read his column first.

I have explained in prior columns some of the principal myths about “liar’s” loans. See particularly “How did a Relatively Small Number of Subprime Loans Cause a Record Crisis?” and “Lenders Put the Lies in ‘Liar’s’ Loans.” The answer to the question posed was that nonprime loans were a large portion of the residential housing finance market, roughly half of new mortgage originations by 2006 according to Credit Suisse’s estimate. Other estimates are that nonprime loans were over one-third of all new mortgage originations by 2006. Under either estimate nonprime lending caused an enormous increase in mortgage lending. Nonprime lending caused the “epidemic” of mortgage fraud that the FBI first publicly warned about in September 2004. Nonprime lending led to such a large increase in home purchasers that it hyper-inflated the financial bubble.

Credit Suisse found that by 2006, half of all new residential loan originations in the U.S. called “subprime” were also “liar’s” loans, i.e., they were made without verifying essential financial information about the borrower (typically income and employment). Most people assume that “subprime” and “alt a” (aka, “stated income” and “liar’s loan) were officially defined, mutually exclusive categories of loans. Both assumptions are false. There were multiple, inconsistent definitions of “subprime.” The confusion was deliberate. Nonprime lenders and sellers and purchasers of nonprime paper profited by systematically and dramatically overstating the credit quality of nonprime loans they owned.

Liar’s loans got that name because they were pervasively fraudulent. The fraud incidence in liar’s loans was often 80% or above. I have explained previously why, in the mortgage context, liar’s loans inherently produce intense adverse selection and that adverse selection causes such lending to have a negative expected value. (In plain English, this means that making liar’s loans is guaranteed to cause lenders severe losses.) This explains why honest home lenders do not make “liar’s” loans. For reasons I have explained, lenders that made material amounts of liar’s loans had to engage in accounting (and if they were publicly traded, securities) fraud. Entities that sold or held substantial amounts of liar’s loan paper also had to engage in accounting and securities fraud. Sellers could not disclose to their purchasers that the liar’s loans were pervasively fraudulent and would produce enormous losses. Holders of liar’s loan paper could not establish the loss reserves required by GAAP (and by the SEC) for the losses inherent in liar’s loans because the losses would have been so large that the firm holding the paper would have to report it was unprofitable and likely insolvent. I refer to the lenders that made significant numbers of liar’s loans as “lying lenders.”

Liar’s loans are optimal for only one group of lenders – those engaged in accounting control fraud. The four ingredients of the recipe for fraudulent CEOs of lenders to maximize the bank’s (fictional) short-term reported income and (real) longer-term losses are:

1. Rapid growth
2. Making loans at a premium yield even to the uncreditworthy
3. Extreme leverage
4. With grossly inadequate allowances for loan and lease losses (ALLL)

The officers that control the lenders that follow this recipe achieve what Akerlof & Romer aptly termed a “sure thing.” The recipe is mathematically guaranteed to produce record short-term income (until the bubble collapses) and, with modern executive compensation, make the officers wealthy. The lender fails (or is bailed out), but the controlling officers walk away rich. Akerlof & Romer’s title emphasized that dynamic – “Looting: the Economic Underworld of Bankruptcy for Profit.”

Liar’s loans were ideal ingredients for optimizing this recipe for maximizing fictional income and executive compensation. The two most obvious advantages were that competent underwriting takes time and costs money. Not underwriting, therefore, allowed fraudulent lenders to lend more cheaply (if one ignores the resultant, catastrophic losses) and more quickly. Not underwriting aided the first ingredient – it made rapid growth easier and, by reducing expenses, increased reported short-term income.

Liar’s loans also aided the second ingredient of the fraud recipe. Lending even to those who will often fail to repay the loan requires the bank to subvert normal underwriting and internal controls. Liar’s loans are the most elegant solution to subverting normal underwriting and internal controls. Liar’s loans, by definition, eviscerate essential underwriting and make it difficult for internal controls to operate effectively. (One could, of course, demand verification of income and employment of a sample of the liar’s loans – but lying lenders did not want to document that they knew their loans were pervasively fraudulent.) Lying lenders are able to grow rapidly and charge a premium yield to borrowers. Anyone can qualify for a liar’s loan – all it requires is fraud and the mortgage bankers own anti-fraud specialists (MARI) warned the industry in 2006 that “stated income” loans deserved to be called liar’s loans because they were “an open invitation to fraudsters.” Even a poor credit history could be overcome by enough fictional borrower income and fictional housing value. Millions of liar’s loans were made even to borrowers with credit histories so poor that the loans were considered subprime.

Lying lenders found liar’s loans ideal for predation. Yield and growth are the keys that determine which types of loans maximize fictional accounting income. The fundamental attraction of liar’s loans was the premium yield. The higher yield, of course, was harmful to the borrower and no rational, informed borrower who could qualify for an underwritten loan at a lower interest rate should have taken out a liar’s loan. Liar’s loans were marketed and sold under a series of bright shining lies. The primary lie was that liar’s loans were really prime (“A”) loans that were underwritten under an alternative, equally effective means – hence the term “alt-a.” The alternative to traditional underwriting was to rely instead almost entirely on the borrower’s credit score – without verifying the borrower’s income, employment, etc. This lie implicitly claimed that “alt-a” borrowers were providing the lenders a free, premium yield unrelated to increased risk.

The bright shining lie was premised on four subsidiary lies. One, “alt-a” borrowers really had the same credit quality as other prime borrowers but could not verify their income. Two, the reason borrowers could not verify their incomes did not constitute a credit risk. Three, the borrowers actually had the income stated on the loan application. Four, a borrower’s credit score is an equally effective alternative means of underwriting credit risk to traditional underwriting (which verifies the borrower’s actual income, employment, etc.).

The typical bright shining lie story was the self-employed business person who could not credibly verify his own income. The story was not simply nonsense; it was obvious nonsense. The IRS has long had a form to cover this concern. The borrower signs it to authorize the IRS to release to the lender copies of the borrower’s federal income tax returns. Americans do not deliberately overstate their income on their tax returns because doing so would increase their taxes, so the tax return provides highly reliable information to the banker on the self-employed. The spread between prime and liar’s loans shrank over time (the opposite would have occurred if liar’s loans were not fraudulent and markets were efficient), but a liar’s loan was always substantially more costly to the borrower over the life of the loan. No honest self-employed borrower would opt to pay tens of thousands of dollars in additional interest rather than provide the IRS form and give the bank access to his tax returns. A credit score inherently cannot underwrite a borrower’s ability to repay a mortgage loan and it is an unreliable measure even of a borrower’s willingness to repay a jumbo mortgage loan. It is easy to game a credit score by taking out, and promptly repaying, a series of small loans and a borrower can readily fraudulently “borrow” another person’s higher credit score.

There are four obvious reasons why a borrower would pay the higher interest rate required to obtain a liar’s loan. One, the borrower did not have the income necessary to receive any mortgage loan. The loan officer and the loan broker knew the minimum incomes (though even the minimums were often negotiable). They would falsify the income or direct the borrower to falsify the income stated on the loan application. Normal underwriting easily detects and prevents this fraud – which is why credit losses on traditional residential mortgages were minimal for nearly 50 years. Fraudulent lenders designed liar’s loans to remove these underwriting protections against fraud. Their fraud-friendly design was so successful that their own industry anti-fraud experts (MARI) denounced their product as “an open invitation to fraudsters.” The officers controlling the lying lenders designed and implemented the perverse incentives that produced the intended “echo” fraud epidemics among loan brokers, loan officers, appraisers – and some borrowers. The combination of liar’s loans and the echo epidemics helped the controlling officers produce the first two ingredients of the lender fraud recipe – rapid growth at premium yields. The officers that controlled the lying lenders wanted to be able to make loans to the uncreditworthy – as long as they could do so at a premium yield. Liar’s loans made it easy to do both – and prevented the creation of an incriminating underwriting paper trail documenting that the lender knew the information on the loan application was false when it made the loan. The resultant deniability is implausible to anyone that understands fraud mechanisms, but it does fool the credulous.

Two, the borrowers would pay the higher interest rate if they had the requisite income but were hiding its existence from their current or prior spouse or the IRS. Do not make the mistake of believing that this situation represents minimal credit risk to the lender. A borrower who will lie to loved ones and the government (both of which are typically criminal acts) in order to keep from paying them legal obligations poses an exceptionally great credit risk to the lender. The borrower’s character is one of the most important determinants of credit risk.

Three, the borrowers could receive better loan terms if they inflated their income on the loan application. This could prompt borrowers to engage in fraud. Fraudulent borrowers could get larger loans at a lower interest rate if they made the debt-to-income ratio on the loan appear to be smaller by inflating their incomes. Borrower fraud of this nature obviously posed an enormous credit risk to the lender. The third and fourth categories of borrowers who would be willing to take liar’s loans illustrate the complexity of accounting control fraud. To understand these categories of borrowers one must understand the officers who controlled the lying lenders. The controlling officers wanted to make large loans, in enormous, growing volumes, at premium yields because doing so produced a “sure thing” of record (albeit fictional) short-term income and high bonuses.

The controlling officers, of course, have preferred to maximize the yield on liar’s loans but they did not have the power to do so. The controlling officers faced several tradeoffs. If they got honest information on the uncreditworthy lenders they could not grow rapidly by making loans at a premium yield to that group – and lending to that group was essential to their fraud strategy. In a reasonably competitive, mature industry like home lending a bank cannot grow rapidly and achieve premium yields by making enormous numbers of high quality loans. High quality borrowers typically can borrow from any bank at a low yield. A lender that tried to grow rapidly by making high quality residential loans would have to “buy market share” by lowering its yield. Its competitors would match the lower yields and the result would be that the home lenders active in that regional market would suffer materially lower reported income (reducing executive compensation). The implication of this first tradeoff (among growth, yield, and credit quality) was that the only sure way to grow rapidly and charge premium yields in a reasonably competitive, mature home loan market (ingredients one and two in the fraud recipe) is to make large numbers of loans to the uncreditworthy.

The other major tradeoff arose from the need to loan to the uncreditworthy. I have explained why this always requires the lender’s controlling officers to suborn the bank’s underwriting and internal and external controls in order to implement their strategy of accounting control fraud (what Akerlof & Romer aptly termed “looting”). Control frauds are so dangerous in large part because they are routinely able to suborn successfully these systems. Suborning underwriting and controls, however, requires a tradeoff. It inherently leaves the lender exceptionally vulnerable to internal and external frauds by parties other than the controlling officers. Fraud begets fraud. Eviscerating underwriting and controls makes the bank environment highly criminogenic and often kicks off an “echo” epidemic of fraud by others.

Strictly speaking, the controlling officers who are looting the bank through accounting fraud neither desire nor necessarily know in advance of the specific acts of secondary fraud by others. The CEO that is looting “his” bank would prefer not to share to the fraud gains with others, but this represents another tradeoff. The fraudulent bank CEO needs to incent large numbers of individuals to act perversely in order to accomplish the primary fraud that he is directing. He must unhinge effective underwriting and controls, so he must expose the bank to secondary internal and external fraud by others. Similarly, fraudulent bank CEOs frequently found it desirable to pay generous bonuses to their agents (i.e., loan officers and loan brokers) in order to incent them to make loans to the uncreditworthy and produce false loan applications and appraisals that would cause the loans to deceptively appear to be far less risky – which translates into far more valuable loans (which are a lender’s assets). Again, they traded much greater growth in loans with premium yields that falsely appeared to be of relatively low credit risk for loans that were, in reality, far more likely to be based on fraudulently inflated borrower income and appraised values and therefore far more likely to default and to cause larger losses upon default. The perverse incentive structures the officers controlling the lying lenders created for their employees and agents made it inevitable that liar’s loans would be pervasively fraudulent. The law allows us to hold the CEO’s who controlled the lying lenders criminally responsible for the predictable consequences of these perverse incentives.
 
Indeed, accounting control fraud is finance’s “weapon of choice” in much of the developed world because it is the superior solution to the tradeoff between the risk of being sanctioned for looting and the rewards from looting. Even the most powerful bank CEO faces a grave risk of being imprisoned if he sticks his hand in the till and steals $10,000. If, instead, he uses accounting control fraud to loot the bank of $50 million he has an excellent chance of never even being prosecuted. All he has to do is limit his means of converting bank assets to his personal benefit to seemingly normal executive compensation received because the bank “earned record profits” in the short-term.

The recipe for accounting fraud is a “sure thing” that will produce those (fictional) record profits and quickly make the CEO exceptionally wealthy. The record income, of course, will be blessed by a top tier audit firm. The recipe fraudulent U.S. bank CEOs use maximize short-term reported income and their compensation is attractive because it is a “sure thing” with minimal risk of prosecution, but it does represent a tradeoff. Fraudulent CEOs can convert a higher proportion of bank assets to their personal benefit (“fraud efficiency”) if they make themselves the direct beneficiary of the fraud. They can do so by stealing money from the vault, causing the bank to lend money to them that they do not repay, or causing the bank to lend money to them through a nominee (also called “straw man” or a “shill”). Indeed, the fact that most fraudulent U.S. bankers overwhelmingly loot “their” banks through accounting control fraud tells us that they still fear prosecution. In nations where the CEOs believe that they can loot directly with impunity they employ cruder frauds that achieve greater fraud efficiency.

I need to emphasize several words of caution about the concept of optimization, particularly when applied to very large corporations. Readers who have lived through conventional microeconomics and then worked in the real world know that the neo-classical claims of firm optimization in perfect competition are, to be gentle, misleading. Neo-classical economists’ assumptions about rationality fail descriptively and often fail to predict behavior. Anyone that has dealt with CEOs knows that ego, a desire for fame, a feeling of exceptionalism – they are not subject to the same rules as govern lesser persons – and a consuming drive for dominance can drive decisions. Criminology arose from sociology and psychology is our cousin. White-collar criminologists have long employed a non-ideological view of rationality. We have long-recognized that from the perspective of the fraudulent CEO, the economic and psychological aspects of their fraud schemes tend to be mutually reinforcing. It is the rare CEO who is exceptional (in a positive manner) relative to his peers. The “sure thing” aspect of accounting control fraud simultaneously makes mediocre or failing CEOs wealthy, famous, and powerful. Criminologists never expect perfect optimization. Perfect optimization never occurs in large organizations. Large organizations have various fiefdoms which may have variant professional cultures. Unfortunately, neither honest nor fraudulent CEOs require perfection to pursue (imperfectly) an overall banking strategy.

Lying lenders that sold their liar’s loans found other aspects of these loans optimal. The best loan originations from the perspective of the secondary market had four characteristics: a premium yield, on a larger loan, loan structures that would postpone as many early defaults as possible (e.g., “teaser” initial interest rates so low that they failed even to pay the interest – producing negative amortization), and the appearance of relatively low credit risk. Liar’s loans were superb devices for obtaining, simultaneously, these four (sometimes inconsistent) objectives. The loan brokers commonly inflated seriously the borrowers’ real income and knew that this would produce very high early period defaults (EPDs) unless the borrowers’ payments were reduced substantially. The loan broker could structure the loan to employ an initial, far lower, “teaser” rate in order to greatly reduce EPDs. The loan brokers and loan officers frequently created a “Gresham’s” dynamic (bad ethics drives good ethics out of the market) to induce an echo epidemic of appraisal fraud. By inflating the appraisal and the borrower’s income, the loan officers and brokers were able to maximize their fees and bring in huge loan volume. Inflating the borrowers’ income lowered the reported debt-to-income ratio and inflating the appraisal lowered the reported loan-to-value (LTV) ratio. The two forms of fraud made it appear to those purchasing liar’s loans that the loans were lower risk. By structuring the loans to delay the inevitable defaults the loan brokers and officers were able to reduce EPDs and allow more time to refinance the liar’s loans. Collectively, these characteristics led to premium prices being paid by those purchasing liar’s loans for the secondary market. The officers controlling the lying lenders structured the perverse financial incentives they paid to the loan brokers and officers – and made it clear to them by approving liar’s loans and paying the brokers and officers large bonuses for making fraudulent loans sure to default frequently – that they would not effectively kick the tires to prevent the endemic fraud the criminogenic incentives were certain to produce. Liar’s loans were the financial variant of “don’t ask; don’t tell.”

Four, some borrowers who took out liar’s loans were relatively low risk, even prime, borrowers. The ideal mortgage loan for an accounting control fraud is a very low risk loan paying a premium yield. (Recall that this was the lying lenders’ bright shining lie about liar’s loans.) Theoclassical economists asserted that it was impossible to make loans having both characteristics. Such loans would not occur in efficient financial markets. They can occur, however, under predation. Predatory lenders take advantage of information asymmetries to induce lower-risk borrowers to borrow at excessive yields. The information asymmetry is greatest when lending to the financially unsophisticated and those that cannot comprehend the loan terms because they are not literate in the language used in the loan documents. Those asymmetries, statistically, are more likely to be large among Latinos and African-Americans. Some borrowers, therefore, could have provided “free” premium yields to the lying lenders. However, one should be cautious about assuming that the premium yield was a “free” premium even in cases of predation. Loan brokers and officers were operating under such perverse incentives (created by the lying lenders), that they are likely to have exploited the information asymmetries by encouraging financially unsophisticated clients to purchase homes they could not afford under the premises/promises that the loan could always be refinanced and home prices always rose. The more expensive the home being purchased, the larger the loan, and the greater the fee the loan brokers and officers would receive. But this also meant that the victims of predation were being abused in multiple ways and put into homes and loans they could not afford – which caused severe credit risk and meant the purported yield premium was not remotely large enough to compensate the bank for the credit risk of making the liar’s loan.

The twist in Joe Nocera’s column is that the borrower on a liar’s loan from Countrywide is in prison for lying on a loan product that Countrywide’s controlling officers structured knowing that it would produce endemic fraudulent applications. Countrywide’s controlling officers structured their liar’s loans in this manner to facilitate their vastly greater looting of Countrywide’s creditors and shareholders. The prosecution of Countrywide borrowers for fraudulent liar’s loan applications is the modern variant of the old joke.

“What does chutzpah mean?”
“A son killed his parents and asked the court for mercy because he was an orphan.”

Nocera’s story is also a wonderful illustration of how insane our lack of prioritization is in prosecuting the lying lenders that drove the “epidemic” of mortgage fraud that hyper-inflated the financial bubble and caused our financial crisis and the Great Recession. No senior officer of the major nonprime lenders that caused the catastrophe has been prosecuted. (One will be, but even he is a special case because the investigation and indictment were triggered by an alleged effort to defraud the TARP program.) The contrast to the S&L debacle, where we obtained over 1000 felony convictions in “major” cases and ensured that the most culpable, most elite frauds would be prosecuted by creating the “Top 100” list of fraudulent S&Ls is stark and should prompt public outrage. The FBI deserves great credit for warning about the “epidemic” of mortgage fraud in its September 2004 testimony – over six-and-a-half years ago – and predicting that it would cause a financial crisis if it were not contained. Countrywide went heavily into liar’s loans after that warning and went even more heavily after MARI denounced the loans in 2006 as “open invitations to fraudsters.” The FBI can place undercover agents in banks without even changing their resumes or names. If it had sent undercover agents into the ten largest lying lenders in 2004 it could have prevented the Great Recession. Banks engaged in accounting control frauds operate in ways designed to superficially mimic honest lenders, but there are clear markers of fraud that a special agent who understands fraud mechanisms would be able to spot within days. Honest lenders do not make liar’s loans, do not inflate appraisals, do not suborn their underwriting staff and internal and external controls, do not create perverse incentives for loan brokers and officers and other corporate officers, do not forge borrowers’ signatures, and do not suggest or provide false information on loan applications. Lying lenders and/or their agents routinely did each of these things. The IRS, in a situation in which we prosecute none of the lying lenders’ controlling officers and only prosecute around 1000 of the roughly one million annual cases of mortgage fraud – a strategy that guarantees failure – used a wired undercover special agent to investigate one of those individual frauds. It did so while giving a pass to Countrywide’s CEO, the exemplar of “bankruptcy for profit.” Countrywide was shocked, shocked to hear that there was lying going on in its liar’s loans. The loan broker (a confessed fraud) suggested the fraudulent statement of income on the loan application and may have forged the borrower’s name on the application. (Both practices were common because lying lenders, including Countrywide, structured their bonuses to loan brokers to ensure that the brokers could make very large amounts of money by fraudulently inflating the borrower’s income and appraised value of the home.

Nocera’s story demonstrates that the Justice Department has mastered the art of unintentional self-parody. Attorney General Holder should resign as a matter of principle and the administration should find a real AG. I suggest a novel choice that the Republicans could not block: Sol Wisenberg. Sol was chief of the Financial Institution and Health Care Fraud Unit in the U.S. Attorney’s Office for the Western District of Texas, where he successfully brought one of the “Top 100” S&L fraud cases. He later became a senior prosecutor in Ken Starr’s Office of Independent Counsel (conducting a famous deposition of President Clinton). Sol left the Federalist Society because it wasn’t conservative enough for his tastes. The point is that prosecuting elite white-collar criminals isn’t a political or ideological act. It is essential to our democracy and our economy.
I’ve seen Sol train FBI agents and prosecutors how to investigate and try sophisticated financial frauds. I’ve seen him prosecute in court. We share the same fundamental attitude. We don’t care about the politics, power, or ideology of the folks we investigate. We don’t scream. We don’t think bankers are crooks by definition. We know that if cheaters prosper markets become perverse. We try to make sure that cheaters don’t prosper. President Obama, please start to use the “f” word – call the frauds “frauds” and demand accountability. Did you read Nocera’s story? What did you order Attorney General Holder to do in response? I urge the next reporters who interview the President to ask both of these questions.