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No Mr. President, Larry Summers Did Not Resolve the Financial Crisis for a Pittance, He Just Papered Over the Problem

Posted on October 28, 2010 by | 5 comments

By William K. Black

(via the Huffington Post, where it first appeared)

I passed up the obvious title: “Heckuva Job Larry!” That was the moment of President Obama’s appearance on The Daily Show with Jon Stewart that set all Americans cringing. Yes, he really said that Summers “did a heckuva job.” The candidate that was gifted the opportunity to run against the legacy of one of the worst presidents in U.S. history has, as president, used Bush as his role model to continue many disastrous policies. It was strangely fitting that he would channel Bush’s infamous praise (“Heckuva job Brownie”) for the FEMA chief who failed New Orleans so badly in the hurricane.

President Obama understandably wishes to focus attention on the economic disaster he inherited from President Bush. But Jon Stewart’s question to him, which led to the president’s gaffe, correctly asked about the message that Summers’ appointment sent about the administration’s commitment to fundamental change.

Summers had financial red ink on his hands at the time he was appointed. He was Rubin’s chief minion in the successful effort to defeat effective financial regulation and supervision. (Yes, the effort was bipartisan and the Republican leadership shares in the guilt.) Summers was not simply wrong, but also arrogant and brutal, in blocking effective regulation at the SEC and the Commodity Futures Trading Commission. Summers was made rich by Wall Street in one of those sordid consulting arrangements designed to buy influence and reward past and future favors.

President Obama’s appointment of Summers as his chief economic advisor made the administration’s overall response to the crisis predictable. (Robert Kuttner gives a detailed explanation of the policies that Rubin’s protégés championed in his new book, A Presidency in Peril.) The response would follow the disastrous Japanese model that has harmed their economy and damaged their integrity. The dominant characteristics can be summarized quickly: (1) the government would act for the benefit of the largest financial firms and their CEOs, even when they directed massive frauds, by (2) engineering a cover up of the banks’ losses and the CEO’s misconduct; (3) the administration would use the fictional reports generated to conduct the cover up to declare victory (due to their brilliance); and (4) the same strategy would impair the recovery. (For more on the cover up, see here and here.)

The strategy was also an assault on integrity, the rule of law, and the core precepts of the Obama campaign for president. This is why we warned from the beginning that the cover up could enrage the nation and make him a one-term president.

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President Obama on Wednesday night told Jon Stewart that the administration had resolved the crisis for a pittance — vastly less than their measure of the costs of resolution in early 2009. He also claimed that the administration deserved credit for preventing a second Great Depression.

The first claim is too good to be true. Ask yourself the key analytical question: Does the administration claim that the crisis proved far worse or far better than its original estimates? Look at the administration’s initial estimates about employment or its initial views about how deep the fall in housing values, and how quick their recovery, would be? The administration has repeatedly emphasized that the housing and employment crises are significantly worse than initially forecast. That means that their initial loss estimates should have proven significantly too low. The losses should be much greater than their initial estimates.

Losses on homes are not driven only by employment and housing values. Mortgage fraud causes dramatically greater losses. How much mortgage fraud did the administration initially estimate? That’s almost a trick question, for the administration rarely uses the “F” word (fraud) and gave no evidence at the time of its initial estimates that they took into account fraud losses. Since the time of the administration’s initial loss estimates it has become indisputable that fraud was endemic in liar’s loans and that liar’s loans were not simply enormous, but also far more common than was originally reported. We have discovered since the administration’s initial loss estimates that it was common for the SDIs to lie about the liar’s loans they originated, sold, and purchased. Fannie, Freddie, Lehman and many others falsely called their liar’s loans “prime.”

What else could affect losses on liar’s loans and CDOs backed by liar’s loans? The failure of the secondary market meant that sales of CDOs and packages of liar’s loans had to be individually arranged. Has the secondary market in nonprime mortgages been restored since the administration’s initial cost estimates? No. That is important because the administration initially claimed that the secondary market’s collapse was a temporary liquidity problem. The administration anticipated that the secondary market would soon reemerge. It died more than three years ago. With any luck it will never be resurrected. Once more, the changes since the time of the initial loss estimate should have led to greater losses than the administration’s initial estimate.

This leaves us with two analytical puzzles. First, since the administration’s anti-regulators have spent nearly two years carefully not looking at the liar’s loans and determining their true value and the true incidence of fraud, how is the administration estimating losses without the facts necessary to make estimates? Second, ignoring the first problem for the moment, what miracle made virtually all the losses disappear — at virtually no cost to the public — even though every aspect of the administration’s initial loss estimates proved too optimistic? Logically, the losses should be far greater. For the administration’s claim to have any merit they must have discovered the ultimate “silver bullet” that slays $2 trillion in losses. So what is it — and how did it save $2 trillion? It certainly wasn’t their brilliant negotiation of the TARP terms. Any commercial lender that provided such an unlimited guarantee would have cut a far better deal.

There was no silver bullet. The administration made the losses disappear the old-fashioned way — with fictional accounting. I have already explained how the administration allowed the Chamber of Commerce, American Bankers Association, and the Fed to enlist the Congress to extort FASB to pervert the accounting rules so that most of the SDIs’ losses disappeared. The Fed also took over a trillion dollars in toxic, largely fraudulent collateral — and carefully avoided conducting due diligence to discover either the value or the fraud incidence of the collateral. In essence, the Fed took the toxic stuff off the balance sheets.

Creating fictional numbers and hiding losses at the Fed doesn’t reduce losses. Unfortunately, it increases real losses. First, it leaves the looters in charge, lets them pay themselves enormous bonuses, and lets them cause greater losses. Recall George Akerlof’s and Paul Romer’s title — Looting: the Economic Underworld of Bankruptcy for Profit. They showed that even without a bailout the fraudulent CEO could grow wealthy by destroying “his” bank. With a bailout — and the Bush and Obama administration’s de facto grant of impunity and an unlimited guarantee to the SDIs — the CEOs can loot without it leading inevitably to bankruptcy. This has made banking an even more criminogenic environment for accounting control fraud and will cause recurrent, intensifying crises.

Second, accounting cover ups prevent markets from clearing. That prolongs the recession. Japan shows how severe this problem can become.

Third, integrity is important. I really shouldn’t have to explain this. It depresses me that I have to argue that it is wrong to lie. Our democracy, our economy, our society, and our souls depend on restoring our integrity and the rule of law. Randy Wray and I have proposed a step that would demonstrate the president’s complete repudiation of Summers’ strategy and a return to the rule of law: Place Bank of America in receivership for its tens of billions of dollars in fraudulent loans and its multitude of foreclosure frauds. Don’t talk about doing the right thing — do it — and do it to a major contributor. Don’t do it because it’s a contributor, but because a bank that commits tens of thousands of frauds should immediately be placed in receivership.

The president told Jon Stewart he was hamstrung by tradeoffs. He said he could not place an SDI in receivership because it could cause 100 banks to fail. Randy and I explained the absurdity of this claim in our two-part essay. Receiverships do not cause one hundred banks to fail. The receiver would continue the bank’s operation and pay the checks. Why are 100 banks supposed to fail when their correspondent bank ties remain functional, the checks clear, and the ATMs work? This parade of horribles has never happened.

The administration claimed that it was vital that the Dodd-Frank bill provide it with receivership powers so that it could close a future Lehman without causing cascade failures. Now, the president tells us that he refused to follow the Prompt Corrective Action law and close insolvent SDIs because some official lied to him and told him that operating (not closing) a bank through a receivership would cause 100 banks to fail? That’s why Obama has allowed the SDIs to operate with impunity and provided them with an unlimited federal guarantee? And he, a skilled lawyer, cannot see the contradiction in Treasury — his Treasury — claiming that the Dodd-Frank bill’s grant of receivership powers would prevent such cascade failures?

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Are There Spending Constraints on Governments Sovereign in their Currency?

Posted on October 26, 2010 by | 8 comments

Stephanie Kelton

Video of Dr. Kelton’s lecture at the 1st Fiscal Sustainability Teach-In and Counter-Conference, April 2010, courtesy of NetRootsMass.

Stephanie Kelton
(Session 2 Video – part 1)

Stephanie Kelton
(Session 2 Video – part 2)

For additional content, including audio, slideshow, and transcript click here.

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Specious Arguments Against a Bank Holiday

Posted on October 25, 2010 by | 4 comments

William K. Black and L. Randall Wray

Holding the Fraudulent Lenders, Securities Sellers and Servicers Accountable
In our last piece, we advocated placing Bank of America into receivership as a first step toward resolving the “dirty dozen” biggest banks. This would begin with a Rooseveltian “bank holiday” to give examiners time to identify and then close down the control frauds.
Our call for closing down control frauds and stopping the foreclosure frauds typically meets with three objections. First, it is claimed that while there were some bad apple lenders, much of the fraud was committed by borrowers. Our proposal would let fraudulent borrowers remain in homes to which they are not entitled, punishing the banks that were duped. Second, the biggest banks are too important to foreclose. And third, it is not possible to resolve a “too big to fail” institution.
Who is Guilty?
Let us deal with the “borrower fraud” argument first because it is the area containing the most erroneous assumptions.  There was fraud at every step in the home finance food chain: the appraisers were paid to overvalue real estate; mortgage brokers were paid to induce borrowers to accept loan terms they could not possibly afford; loan applications overstated the borrowers’ incomes; speculators lied when they claimed that six different homes were their principal dwelling; mortgage securitizers made false reps and warranties about the quality of the packaged loans; credit ratings agencies were overpaid to overrate the securities sold on to investors; and investment banks stuffed collateralized debt obligations with toxic securities that were handpicked by hedge fund managers to ensure they would self destruct.
That homeowners would default on the nonprime mortgages was a foregone conclusion throughout the industry—indeed, it was the desired outcome. This was something the lending side knew, but which few on the borrowing side could have realized.
The homeowners were typically fraudulently induced by the lenders and the lenders’ agents (the loan brokers) to enter into nonprime mortgages. The lenders knew the “loan to value” (LTV) ratios and income to debt ratios that they wanted the borrower to (appear to) meet in order to make it possible for the lender to sell the nonprime loan at a premium.  LTV can be gimmicked by inflating the appraisal.  The debt to income ratios can be gimmicked by inflating income. “Liar’s” loan lenders used that loan format because it allowed the lender to simultaneously loan to a vast number of borrowers that could not repay their home loans, at a premium yield, while making it look to the purchaser of the loan that it was relatively low risk. Liar’s loans maximized the lender’s reported income, which maximized the CEO’s compensation.
The problem is that only the most sophisticated nonprime borrowers (the speculators who bought six homes) (1) knew the key ratios they had to appear to meet, (2) had the ability to induce an appraiser to inflate substantially the reported market value of the home, and (3) knew how to create false financial information that was internally consistent and credible. The solution was for the lender and the lender’s agents to (1) instruct the borrower to report a certain income or even to fill out the application with false information, (2) suborn an appraiser to provide the necessary inflated market value, and (3) create fraudulent financial information that had at least minimal coherence.
When the overburdened homeowner began missing payments, late fees and higher interest rates kicked-in, boosting the stated income of mortgage servicers and the value of the securities. Not coincidentally, the biggest banks own the servicers and could maximize claims against the mortgages by running up the late fees. It was quite convenient to “misplace” mortgage payments, so even homeowners who were never delinquent could get hit with fees and higher rates. And when payments were received, the servicers would (illegally) apply them first to the late fees, meaning the homeowners were unknowingly still missing mortgage payments. The foreclosure process itself generates big fees for the SDI banks.
And, miracle of miracles, the banks would end up with the homes and get to restart the whole process again—from resale of the home through the financing, securitizing, and fee-for-servicing juggernaut.
Unfortunately, it did not go quite as smoothly as planned. The SDIs were supposed to act like neutron bombs – killing the homeowners but leaving the homes standing, to be resold. The problem is that wiping out borrowers lowered the value of real estate, crushing not only the real estate market but also construction and through to all associated sectors from furniture and home restoration supplies to big ticket purchases that rely on home equity loans. It also led to questions about the value of the securitized toxic waste manufactured and held directly or indirectly by financial institutions.
Next, a few judges began to question the foreclosures, as they saw case after case in which the banks claimed to have lost the paperwork or submitted amateurishly forged documents. Or, several banks would go after the same homeowner, each claiming to hold the same mortgage (Bear sold the same mortgage over and over). Insiders began to offer depositions exposing fraud and perjury. It became apparent that in many and perhaps most cases, the trusts responsible for the securities (often these are “special purpose” subsidiaries of the banks) never received the “notes” signed by the borrowers—as required by both IRS tax code and by 45 of the US states. Without the notes, billions of dollars of back taxes could be due, and the foreclosures violate state law. Finally, the Attorneys General of all fifty states called for a foreclosure moratorium.
What to do? We suggest an immediate moratorium on foreclosures and a requirement that all notes be produced by purported holders of mortgages within a reasonable length of time. If they cannot be found, the mortgages—as well as the securities that pool them—are no longer valid. That means that the homeowners are not indebted, and that the homes are owned free and clear. And that, dear bankers, is a big, big problem. It is also the law—without evidence of debt, there is no debtor and no creditor.
Commentators are horrified that a foreclosure moratorium would let “deadbeat” borrowers remain in their homes while delinquent in their payments. The speculators that purchased “McMansions” and stated on six separate loan applications that each house was their principal dwelling are frauds. The moratorium would (briefly) reward fraudulent borrowers while (briefly) punishing the fraudulent banks. This is true.
It is not possible to separate “worthy” borrowers who were duped by banks from all “unworthy” borrowers who knew the loan applications were false. Indeed, given the millions of borrowers that received liar’s loans, even if the borrowers were all frauds we could not possibly prosecute all of them due to lack of resources. We currently prosecute roughly 1000 mortgage fraud cases annually at the federal level. If we used all of our resources to investigate and prosecute fraudulent mortgage borrowers exclusively we would be able to prosecute less than one-tenth of one percent of those frauds.
The losses that the fraudulent nonprime lenders caused are vastly greater than the losses caused by fraudulent borrowers, so no rational prosecutor would use his scarce resources to prosecute individual nonprime borrowers. Moreover, prosecutions of individual borrowers for alleged fraud in the applications would be difficult to win against competent defense counsel because it will not be possible to infer the borrower’s intent and knowledge and whether the loan agent instructed him to enter specified information on the application. We are not arguing that the speculator who committed fraud while buying six homes should be allowed to walk free. We are simply arguing that it makes no sense to use limited judicial resources to go after owner-occupier households where it will be almost impossible to prove intent to defraud.
On the other hand, we can infer a lender’s fraudulent intent because it is financially sophisticated and has expertise in lending. An honest mortgage lender would not make “liar’s loans” because absence of proper underwriting inherently produces loans that are expected to default. Yet, in 2006 just about half of all mortgages originated were liar’s loans. Banks happily advertised specialization in “no doc” and NINJA loans. There can be no question about intent—the intent was fraud, plain and simple. Fraud on the part of credit raters is equally easy to infer—we have the internal emails that document intent to defraud securities purchasers by “pay to play” schemes. And the fraud committed by the investment banks that pooled the mortgages is also well documented. These entities committed tens of thousands and even millions of frauds each. For obvious efficiency reasons, that is where our judicial resources ought to be directed.
Macro Effects and Culpability
There is one other consideration that biases the case in favor of borrowers. Many homeowners were sold on the idea that “real estate values only go up”—and quite a few planned to refinance on better terms, or even to flip the house at a price that would allow them to pay-off a mortgage they could not otherwise afford. We realize that it is not easy to shed tears for speculators foiled by the market, and that is not our point.
What is important to understand, however, is that the financial sector is largely culpable for generation of the speculative frenzy, the creation of the “financial weapons of mass destruction”, and the transformation toward financial fragility that finally collapsed in 2007. In the aftermath we lost 10 million jobs and millions of homeowners lost their homes. The “collateral damage” inflicted by the SDIs is now endangering tens of millions of American families—most of whom played no role in the speculative euphoria. Almost half of American homeowners are already underwater or on the verge of going under. In short, it was Wall Street that turned our homes over to a financial casino—and so far virtually all the losses have been suffered on Main Street.
This culpability is at the aggregate scale and of course no individual bank can be held liable in court for the collapse of the financial system. Rather, each bank’s guilt must be assessed according to its own fraud. However, a national moratorium on foreclosures must be evaluated at the macro level, and justified on the basis of the aggregate costs, benefits, and moral implications. And certainly at the aggregate level that must be considered by President Obama, the benefits to the majority of Americans clearly outweigh the costs imposed on the relatively few. And the morality is also on the side of homeowners and clearly against the banks.
Closing the control frauds would actually benefit honest bankers by eliminating the “Gresham dynamics” created by fraudulent institutions—a race to the bottom in underwriting. Since fraudulent banks use accounting fraud to manufacture high profits, they do not actually have to use a viable business model. By eliminating control fraud from the financial sector, it will be much easier for honest banks to succeed.
Further, the financial system has massive excess capacity—as evidenced by the need to create bubble after bubble to find outlets for capacity. Almost all of the innovations in practice and instruments of the past two decades were spurred not by demand but rather by excess capacity. Downsizing the financial sector is critical to restoring it to a size that is commensurate with the needs of the economy.
The cost of not closing control frauds, by contrast, can be staggering. The business practices that maximize the fictional reported income (e.g., making “liar’s” loans to people who cannot repay their loans) maximize real losses and hyper-inflate financial bubbles.  Control frauds destroy wealth at a prodigious rate. The one thing we certainly cannot afford is leaving the control frauds under the control of fraudulent CEOs.
Can the Frauds be Foreclosed?
The assertion that the SDIs cannot be resolved because of their size is unsupported. Very large institutions have already been resolved both in this country and abroad. The “too big to fail” (TBTF) doctrine has always been unproven, dangerous, and counter to the law. An institution that is not permitted to fail faces obvious adverse incentive problems. It also destroys healthy competition with institutions that are not considered TBTF. It encourages risk-taking and fraud. And it subverts the law, which requires that insolvent institutions must be resolved.
As we write this piece, the markets are taking it upon themselves to begin to close down the control frauds—with homeowners fighting the foreclosures and investors demanding that the banks take back the toxic waste. Unfortunately, following the market solution will be a long-drawn-out and costly process—both in terms of tying up the judicial system but also in terms of the uncertainty and despair that will persist. At the end of that process, the banks will have to be resolved. No matter how much the politicians dislike it, they will end up with the banks in their hands—either now or later. Taking them now is the right thing to do.
This post first appeared on Huffington Post.

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William Black Interview on Mortgage Fraud

Posted on October 25, 2010 by | 1 comment

Our own William Black was interviewed on MSNBC’s Dylan Ratigan Show regarding mortgage fraud.

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Marshall Auerback on the G20 Finance Ministers’ Meeting

Posted on October 23, 2010 by | Comments Off on Marshall Auerback on the G20 Finance Ministers’ Meeting

Marshall Auerback was interviewed on BNN’s SqueezePlay Friday regarding the meeting of the G20’s finance ministers and Secretary Geithner’s policy proposals.

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Foreclose the Foreclosure Frauds (Part 1)

Posted on October 22, 2010 by | 5 comments
William K. Black and L. Randall Wray
After a quick review of its procedures, Bank of America announced that it will resume its foreclosures in 23 lucky states. While the evidence is overwhelming that the entire foreclosure process is riddled with fraud, President Obama refuses to support a national moratorium. Indeed, his spokesmen on the issue told the LA Times three key things:
A government review of botched foreclosure paperwork so far has found that the problems do not pose a “systemic” threat to the financial system, a top Obama administration official said Wednesday.

Yes, you heard him correctly. HUD reviewed the “paperwork” problem to see whether it threatened the banks – not the homeowners who were the victims of foreclosure fraud. But it got worse, for the second point was how the government would respond to the epidemic of foreclosure fraud.

The Justice Department is leading an investigation of possible crimes involving mortgage fraud.

That language was carefully chosen to sound reassuring. But the fact is that despite our pleas the FBI has continued its “partnership” with the Mortgage Bankers Association (MBA). The MBA is the trade association of the “perps.” It created a facially ridiculous definition of “mortgage fraud.” Under the definition the lenders – who led the mortgage frauds – are the victims. The FBI still parrots this long discredited “definition.” That is one of the primary reasons why – in complete contrast to prior financial crises – the Justice Department has not convicted a single senior officer of the large nonprime lenders who directed, committed, and profited enormously from the frauds.

Note that the Justice Department was not investigating foreclosure fraud.  HUD Secretary Donovan’s statement shows why:

“We will not tolerate business as usual in the mortgage market,” he said. “Where there have been mistakes made or errors, we will hold those entities, those institutions, accountable to stop those processes, review them and fix them as quickly as possible.”

Note the language: “mistakes”, “errors”, “processes” (following the initial use of “paperwork”). No mention of “fraud”, “felony”, “criminal investigations”, or “prosecutions” for the tens of thousands of felonies that representatives of the entities foreclosing on homes have admitted that they committed. Note that Donovan does not even demand that the felons remedy the harm caused by their past fraudulent foreclosures.  Donovan wants them to “fix” “processes” – not repair the harm their frauds caused to their victims.

The fraudulent CEOs looted with impunity, were left in power, and were granted their fondest wish when Congress, at the behest of the Chamber of Commerce, Chairman Bernanke, and the bankers’ trade associations.  This troika successfully extorted the professional Financial Accounting Standards Board (FASB) to turn the accounting rules into a farce that allowed the banks (and the Fed, which has taken over a trillion dollars in toxic mortgages as wholly inadequate collateral) to refuse to recognize hundreds of billions of dollars of losses. The accounting scam produces enormous fictional “income” and “capital” at the banks. The fictional income produces real bonuses to the CEOs that make them even wealthier. The fictional bank capital allows the regulators to evade their statutory duties under the Prompt Corrective Action (PCA) law to close the insolvent and failing banks.

The inflated asset values allow the Fed and the administration to ignore the Fed’s massive loss exposure and allow Treasury’s propaganda claiming that TARP resolved all the problems – at virtually no cost. Donovan claims that we have held the elite frauds accountable – we have done the opposite.  We have made the CEOs of the largest financial firms – typically already among the 500 wealthiest Americans – even wealthier. We have rewarded fraud, incompetence, and venality by our most powerful elites.

If the government does not hold the fraudulent CEOs responsible, who is supposed to stop the epidemic of elite financial fraud? The Obama administration has the answer – the fraudulent CEOs – at a time of their choosing. You can’t make this stuff up.

But ultimately resolving the problems is not the government’s responsibility, said Michael Barr, assistant Treasury secretary for financial institutions.
“Fundamentally, this is up to the banks and the servicers to fix,” he said. “They can fix it as fast as they feel like.”

So who is Michael Barr and why is saying things on behalf of the Obama administration that make it appear to be a wholly-owned subsidiary of the fraudulent lenders and servicers? He’s a Rubin protégé and he’s the senior Treasury official for banking policy.

We have a different policy view. We believe that only the government can stop fraud from growing to catastrophic levels and that among the government’s highest responsibilities is to provide the regulatory “cops on the beat” with the competence, resources, courage, and integrity to take on our most elite frauds. We believe that anything less is a travesty that causes tens of millions of Americans to be defrauded and poses a grave threat to our economy and democracy.    

Prompt Corrective Action

First, it is time to stop the foreclosures until the banks and servicers adopt corrective steps, certified as adequate by FDIC, that will prevent all future foreclosure fraud. They must also adopt plans to remedy the injuries their foreclosure frauds have already caused, and assist the FBI, Department of Justice, and legal ethics officials investigations of their officers’ and attorneys’ frauds and ethical violations.
Second, it is time to place the financial institutions that committed widespread fraud in receivership. We should remove the senior leadership of the banks and replace them with experienced bankers with a reputation for integrity and competence, i.e., the honest officers that quit or were fired because they refused to engage in fraud. We should prioritize the receiverships to deal with the worst known “control frauds” among the “systemically dangerous institutions” (SDIs). The SDIs’ frauds and fraudulent leaders endanger the global economy.
We propose Bank of America for the first receivership. In the last few weeks, the SEC has obtained a large (albeit grossly inadequate) settlement of its civil fraud charges against the former senior leaders of Countrywide. (Bank of America acquired Countrywide and is responsible for its frauds.) Fannie and Freddie’s investigations (with their findings reviewed by their regulator, the Federal Housing Finance Agency (FHFA)) have identified many billions of dollars of fraudulent loans originated by Countrywide that were sold fraudulently to Fannie and Freddie through false representations and warranties. The Fed, BlackRock, and Pimco’s investigations have identified many billions of dollars of fraudulent loans provided by Countrywide under false reps and warranties. Ambac’s investigation found that 97% of the Countrywide loans reviewed by Ambac were had false reps and warranties. Countrywide also engaged in widespread foreclosure fraud.  This is not surprising, for every aspect of Countrywide’s nonprime mortgage operations that has been examined by a truly independent body has found widespread fraud – in loan origination, loan sales, appraisals, and foreclosures. Fraud begets fraud. Lenders that are control frauds create criminogenic environments that produce “echo” epidemics of control fraud in other professions and industries.
We have been amazed – as one financially sophisticated entity after another found widespread fraud by Countrywide in the entire gamut of its operations – that the administration, the industry, and the financial media act as if this is acceptable. Countrywide made hundreds of thousands of fraudulent loans. It fraudulently sold hundreds of thousands of loans through false reps and warranties. It fraudulently foreclosed on large numbers of loans. It victimized hundreds of thousands of people and hundreds of financial institutions, causing hundreds of billions of dollars of losses.  It has defrauded more people, at a greater cost, than any entity in history.
Bank of America chose to purchase Countrywide at a point when it – and its senior leaders — were infamous. Bank of America made some of these Countrwide leaders its senior leaders. Yet, Bank of America is not treated as a criminal entity. Obama, Holder, Donovan, and Barr cannot even bring themselves to use the “f” word – fraud. They substitute euphemisms designed to trivialize elite criminality. The administration officials do not call for Bank of America to be the subject of a criminal investigation. They do not demand that Fannie, Freddie, Ambac, the FHFA, and Pimco file criminal referrals about Countrywide’s frauds. They do not demand that Fannie, Freddie, and the Fed refuse to purchase or take as collateral any mortgage instrument from Bank of America. No one at the Harvard club in New York moves to kick Bank of America’s officers out of their club! The financial media treats Bank of America as if it were a legitimate bank rather than a “vector” spreading the mortgage fraud epidemic throughout much of the Western world.
For the sake of our (and the global) economy, our democracy, and our souls this willingness to allow elite control frauds to loot with impunity must end immediately. The control frauds must be taken down and their officers removed promptly. Receivership is the way to begin to reclaim our souls, our economy, and our democracy and Bank of America has the track record that makes it a good place to start. It is sufficiently large and powerful that its receivership will send the credible signal that America is restoring the rule of law and that even the most elite frauds will be held accountable.
Next we need to remove the rest of the SDIs to reduce the global systemic risks that they pose. We are rolling the dice with disaster every day. The SDIs are inefficient, so shrinking them will reduce risk and increase efficiency. We need to follow three types of policies with respect to SDIs.
1. They cannot grow larger and compound the systemic risk they pose
2. They must create an enforceable plan to shrink to a level and functions such that they no longer pose a systemic risk within five years
3. Until they shrink to the point that they no longer pose systemic risks they must be regulated with far greater intensity than other banks. In particular, control fraud poses so severe a risk of triggering another global financial crisis that there must be no regulatory tolerance for control frauds at the SDIs. One of the best ways to reduce their risks is to mandate that high levels of executive compensation be paid only after sustained and superior performance (at least five years), and with “claw back” provisions if compensation was obtained by fraudulent reported income or seriously inadequate loss reserves.
Appointing a receiver for an SDI will be a major undertaking for the FDIC, but it is also well within its capabilities. Contrary to the scare mongering about “nationalizing” banks, receivers are used to returning failed banks to private ownership. Receiverships are managed by experienced bankers with records of competence and integrity rather than the dread “bureaucrats.”  We appointed roughly a thousand receivers during the S&L and banking crises of the 1980s and early 1990s under Presidents Reagan and Bush.
Here is how it works. A receiver is appointed on Friday. The bank opens for business as normal (from the bank’s customers’ perspective) on Monday. The checks clear, the ATMs work, and the branches all open. The receiver’s managers direct the business operations, find the true facts about the bank’s operations, senior managers, and financial condition, recognize the real losses, and make the appropriate referrals to the FBI and the SEC so that the frauds can be investigated and prosecuted.
The receiver is also a well proven device for splitting up banks that are too large and incoherent by selling units of the business to different bidders who most value the operations.
Dealing with the “Dirty Dozen” Control Frauds
Simultaneously, we should put in place a system to replace the existing cover up of the condition of other banks with vigorous investigations and honest accounting.  The priority for these investigations should be the “dirty dozen”—the twelve largest banks. The Fed cannot conduct a credible investigation. It has taken so many fraudulent nonprime loans and securities as collateral that it is the leading proponent of covering up these losses.
The FDIC should lead the investigations (it has “backup” regulatory authority over all banks), but it should hire investigative experts to add expertise to its Dirty Dozen examination teams. The priorities of the teams will be identifying existing losses and requiring their immediate recognition (the regulatory authorities have the authority to “classify” assets that can trump the accounting scams that Congress extorted from FASB). The FDIC should prioritize the order of its examinations of the largest SDIs on the basis of known indicia of fraud. For example, Citi’s senior credit manager for mortgages testified under oath that 80% of the loans it sold to Fannie and Freddie were made under false reps and warranties. The Senate investigation has documented endemic fraud at WaMu (acquired by Wells Fargo). The FDIC should sample nonprime loans and securities held by Fannie, Freddie, the Federal Home Loan Banks, and the Fed to determine which nonprime mortgage players originated and sold the most fraudulent loans. This will allow the FDIC to prioritize which SDIs it examines first.
We should also create a strong incentive for financial entities to voluntarily disclose to the regulators, the SEC, and the FBI their frauds, their unrecognized losses, and the officers that led the frauds and to fire any officer (VP level and above) that committed (or knew about and did not report) financial fraud. Any SDI that originated or sold more than $2 billion in fraudulent nonprime loans or securities should be placed in receivership unless it has conducted a thorough investigation and made the voluntary disclosures discussed above prior to the commencement of the FDIC examination, and developed a plan that will promptly recompense fully all victims that suffered losses from mortgages that were fraudulently originated, sold, or serviced.
We make three propositions concerning what we believe to be institutions that are run as “control frauds”. To date, this situation has been ignored in the policy debates about how to respond to the crisis. The propositions rest on a firm (but ignored) empirical and theoretical foundation developed and confirmed by white-collar criminologists, economists, and effective financial regulators. The key facts are that there was massive fraud by nonprime lenders and packagers of fraudulent nonprime loans at the direction of their controlling officers. By “massive” we mean that lenders made millions of fraudulent loans annually and that packagers turned most of these fraudulent loans into fraudulent securities. These fraudulent loans and securities made the senior officers (and corrupted professionals that blessed their frauds) rich, hyper-inflated the bubble, devastated millions of working class borrowers and middle class home owners, and contributed significantly to the Great Recession—by far the worst economic collapse since the 1930s.
Our first proposition is this – the entities that made and securitized large numbers of fraudulent loans must be sanctioned before they produce the next, larger crisis. Second, the officers and professionals that directed, participated in, and profited from the frauds should be sanctioned before they cause the next crisis.  Third, the lenders, officers, and professional that directed, participated in, and profited from the fraudulent loans and securities should be prevented from causing further damage to the victims of their frauds, e.g., through fraudulent foreclosures. Foreclosure fraud is an inevitable consequence of the underlying “epidemic” of mortgage fraud by nonprime lenders, not a new, unrelated epidemic of fraud by mortgage servicers with flawed processes. We propose a policy response designed to achieve these propositions.
S&L regulators, criminologists, and economists recognize that the same recipe that produced guaranteed, record (fictional) accounting income (and executive compensation) until 2007 produced another guarantee – massive (real) losses, particularly if the frauds hyper-inflated a bubble. CEOs that loot “their” banks do so by perverting the bank into a wealth destroying monster—a control fraud. What could be worse than deliberately growing massively by making loans likely to default, converting large amounts of bank assets to the personal benefit of the senior officers looting the bank and to those the CEO suborns to assist his looting (appraisers, auditors, attorneys, economists, rating agencies, and politicians), while simultaneously providing minimal capital (extreme leverage) and only grossly inadequate loss reserves, and causing bubbles to hyper-inflate?
This nation’s most elite bankers originated and packaged fraudulent nonprime loans that destroyed wealth – and working class families’ savings – at a prodigious rate never seen before in the history of white-collar crime. They created the worst bubble in financial history, echo epidemics of fraud among elite professionals, loan brokers, and loan servicers, and would (if left to their own devices) have caused the Second Great Depression.  
Nothing short of removing all senior officers that directed, committed, or acquiesced in fraud can be effective against control fraud. We repeat: foreclosure fraud is the necessary outcome of the epidemic of mortgage fraud that began early this decade. The banks that are foreclosing on fraudulently originated mortgages frequently cannot produce legitimate documents and have committed “fraud in the inducement”—only fraud will let them take the homes. Many of the required documents do not exist, and those that do exist would provide proof of the fraud that was involved in loan origination, securitization, and marketing. This in turn would allow investors to force the banks to buy-back the fraudulent securities. In other words, to keep the investors at bay the foreclosing banks must manufacture fake documents. If the original documents do not exist the securities might be ruled no good. If the original docs do exist they will demonstrate that proper underwriting was not done—so the securities might be no good. Foreclosure fraud is the only thing standing between the banks and Armageddon.
We will deal with objections to our proposal in the next piece.
This article first appeared in the Huffington Post

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Time for a Moratorium on Mortgage Fraud

Posted on October 18, 2010 by | 5 comments

By L. Randall Wray (via Benzinga, where it first appeared)

We have long known that lender fraud was rampant during the real estate boom. The FBI began warning of an “epidemic” of mortgage fraud as early as 2004. We know that mortgage originators invented “low doc” and “no doc” loans, encouraged borrowers to take out “liar loans”, and promoted “NINJA loans” (no income, no job, no assets, no problem!). All of these schemes were fraudulent from the get-go. Property appraisers were involved, paid to overvalue real estate. That is fraud. The securitizers packaged trash into bundles that ratings agencies blessed with the triple A seal of approval. By their own admission, raters worked with securitizers to provide the rating desired, never looking at the loan tapes to see what they were rating. Fraud. Venerable investment banks like Goldman Sachs packaged the trashiest securities into collateralized debt obligations at the behest of hedge fund managers–who were allowed to choose the most toxic of the toxic waste—then sold the CDOs on to their own customers and allowed the hedge funds to bet against them. More fraud.

Indeed, the largest financial institutions were run by their management as what my colleague Bill Black calls “control frauds”. That is, the banks used accounting fraud to manufacture fake profits so that they could pay huge bonuses to top management. The latest data out on Wall Street bonuses show that these institutions are still run as control frauds, with another record year of bonuses paid by cooking the books. The fraud continues unabated.

This is the biggest scandal in human history. Indeed, all previous scandals from around the globe combined cannot even touch this one in terms of scale and scope and stench. This is the mother of all frauds and it will be etched into the history books for all time.

Many have called for a national moratorium on foreclosures. Even some of the banks that have been run as control frauds have voluntarily stopped foreclosing. And yet President Obama, ever the centrist, has taken sides with the Securities Industry and Financial Markets Association, which warns that “it would be catastrophic to impose a system-wide moratorium on all foreclosures and such actions could do damage to the housing market and the economy”.

No, it would expose the securities industry, itself, as the chief architect of the biggest scandal in human history.

Now we know that it was not just the mortgage brokers, and the appraisers, and the ratings agencies, and the accountants, and the investment banks that were behind the fraud. It was the digitization process itself that was fraudulent. Indeed, the securities themselves are fraudulent. Many, perhaps most, maybe all of them.
Some are trying to argue that this is just a matter of some missing paperwork. A moratorium would allow the banks to get all their ducks in a row so that they can supply all the documents needed to foreclose.
However, as reported by Ellen Brown (at Web of Debt) and by Yves Smith (at Naked Capitalism), the paperwork does not exist. Worse, as Yves has discovered, the banks are furiously working to manufacture documents, aided and abetted by companies like DocX that specialize in “document recovery solutions”—for a fee they will create fraudulent documents that banks can use in court.

The banks would like us to believe that in the speculative frenzy of the real estate boom they “forgot” to do some of the required paperwork. That is not likely. The absence of the documents was required to run the scam.

Recall that the banks invented “no doc” mortgages. This was not at the behest of no-account borrowers, high school dropouts with bad credit histories who were duping investment bankers into making mortgage loans they could not repay. No, these mortgages were created and endorsed by originators and securitizers and credit raters to create a patina of “plausible deniability” to be used later in court when they were sued for fraud by investors who bought the securities and by the borrowers who could not possibly service the mortgages. Because if the originators had ever requested the documentation from borrowers it would have demonstrated that the mortgages and the securities were frauds.

Similarly, the paperwork required for the securities was never done because the securities were fraudulent. Yves helps to explains why. The trust that purportedly underlies a mortgage backed security must hold the “note”—the borrower’s IOU (in 45 US states the mortgage that is a lien on the property is an “accessory” to the note, and is not sufficient to do a foreclosure). If the note is not conveyed to the trustee (usually before closing but sometimes up to 90 days after signing) the securities are no good.

This is not just some pesky little rule imposed by a pin-headed regulator. This is IRS code. As reported by Brown, MBSs are typically pooled through a Real Estate Mortgage Investment Conduit (REMIC) that must according to the Internal Revenue Code hold all the paperwork demonstrating a complete chain of title. Done properly, taxes are avoided. Since a number of intermediaries are usually involved from the mortgage originator through to the trustee of the REMIC, there must be endorsements all along the line. However, it now appears that most of the original notes are still held in the loan originator warehouses. There are no endorsements. The trustees do not have the notes. Can anyone say “tax fraud”?

So why weren’t the notes conveyed to the REMICs? There seem to be two possibilities—probably both of them correct. Karl Denninger at MarketTicker believes it was because the REMIC trustees feared an audit by investors in the securities. If the documentation existed, it would show that the mortgage loans were fraudulent. Far better to “lose” the docs, then later manufacture new ones for the foreclosure.

According to Brown (quoting Steve Liesman and Neil Garfield), the other possibility is that the tranching process actually prohibited assignment of the notes to the REMICs. Bundles of mortgages of varying quality would be tranched into a variety of securities, say from AAA to BBB. But no individual mortgage is actually assigned to a particular tranche—until it defaults. When one defaults, it is assigned to a lower tranche security and then the foreclosure process begins. This means that from inception of that BBB security, there was no way to assign a note to the trustee because the trustee did not know in advance which mortgage would default. The REMIC trustees tried to get around that by using a dummy conduit called MERS (Mortgage Electronic Registration System) that would “hold” the mortgages and assign them to the proper tranches later.
 But they do not have the paperwork either, and some courts have rejected their claims as owners.

This is a complete mess. What President Obama must understand is that fraud is endemic at every level of the home finance food chain. We were long told that securitized mortgages cannot be modified because of the complexity involved—modification of most mortgages would require consent of the holders of the securities that each have a piece of the mortgage. But actually it is impossible to tell how many—if any—of these securities holders have a legitimate claim on any of the mortgages. Simply imposing a moratorium will not be enough—it will just give the banks time to manufacture false documents, encouraging even more fraud. Meanwhile, half of all homeowners with mortgages are already underwater or are within spitting distance of being underwater. Many of these are drowning because the epidemic of fraud perpetrated by financial institutions destroyed our economy and caused housing prices to collapse.

The President needs to try a different approach, consisting of the following series of steps:

1. Declare a national bank holiday that would close the biggest financial institutions—say, the top dozen or so. Send in the supervisors to examine their books to uncover fraud. Determine which ones are insolvent and resolve them. While resolving them, net their claims on one another (including derivatives). Do not allow any insolvent institutions to reopen, and do not use the resolution process to merge institutions (we don’t need even bigger “too big to fail” banks). Prosecute the crooks and jail the guilty.

2. Stop all foreclosures. Investigate and prosecute all institutions that have been selling or buying fake documents to be used in foreclosures. Prosecute the crooks and jail the guilty.

3. Announce that all homeowners who occupied their homes on October 1, 2010 will be allowed to remain in their homes indefinitely. Create a national mediation board to adjust all mortgage payments to “owner’s equivalent rent”—the fair value of rent for the home. Establish a fund to provide rental assistance to keep low income homeowners in their homes.

4. Give purported mortgage holders 30 days to produce the original notes; if they cannot find them, hand the homes over to the owner-occupants—free and clear of debt.

5. Create a process to allow securities holders to sue for recovery of value. This must be national—state courts will not be able to handle the case load.

6. Direct the GSEs to refinance mortgages at a low fixed rate. Mortgages would be provided against real estate appraised at fair market value to any borrower for a primary residence. The GSEs would pay holders of existing mortgages only current fair market value. Those holding these mortgages can seek redress through the process outlined in step 5. Only in the case of borrower fraud would the homeowner be held responsible for losses attributed to the refinancing.

7. There will be fall-out from losses. It is better to deal with the collateral damage directly than to prop up the control fraud banks. For example, pension funds hold toxic waste securities as well as equities in the control fraud banks, and by all reasonable accounting the Pension Benefit Guarantee Corporation is already insolvent. But it is better to directly bail-out pensions than to maintain the charade that fraudulently created securities have value.

Bill Black likes to joke that economists are afraid to use the “F” word (fraud). The President must come to realize that there is no other word that can be applied to the US home finance system. Until we deal with the fraud we will never resolve this financial crisis.

(Go to www.nakedcapitalism.com for Yves Smith, “4ClosureFraud posts lender processing services mortgage document fabrication sheet”, October 3, 2010; and to www.webofdebt.com for Ellen Brown, “Foreclosuregate and Obama’s ‘pocket veto’”, October 7, 2010.)

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NEP Blogger William Black Interviewed in NPR Report on Mortgage Fraud

Posted on October 18, 2010 by | Comments Off on NEP Blogger William Black Interviewed in NPR Report on Mortgage Fraud

NEP’s own William Black was recently interviewed by Chris Arnold for a report on mortgage fraud. The full story can be found here.

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While Labor Unions celebrate Anti-Austerity Day in Europe, European Neoliberals raise the ante: Governments must Lower Wages or Suffer Financial Blackmail

Posted on September 30, 2010 by | 7 comments

By Michael Hudson

Most of the press has described Europe’s labor demonstrations and strikes on Wednesday in terms of the familiar exercise by transport employees irritating travelers with work slowdowns, and large throngs letting off steam by setting fires. But the story goes much deeper than merely a reaction against unemployment and economic recession. At issue are proposals to drastically change the laws and structure of how European society will function for the next generation. If the anti-labor forces succeed, they will break up Europe, destroy the internal market, and render that continent a backwater. This is how serious the financial coup d’etat has become. And it is going to get much worse – quickly. As John Monks, head of the European Trade Union Confederation, put it: “This is the start of the fight, not the end.”
Spain has received most of the attention, thanks to its ten-million strong turnout – reportedly half the entire labor force. Holding its first general strike since 2002, Spanish labor protested against its socialist government using the bank crisis (stemming from bad real estate loans and negative mortgage equity, not high labor costs) as an opportunity to change the laws to enable companies and government bodies to fire workers at will, and to scale back their pensions and public social spending in order to pay the banks more. Portugal is doing the same, and it looks like Ireland will follow suit – all this in the countries whose banks have been the most irresponsible lenders. The bankers are demanding that they rebuild their loan reserves at labor’s expense, just as in President Obama’s program here in the United States but without the sanctimonious pretenses.
The problem is Europe-wide and indeed centered in the European Union capital in Brussels, where fifty to a hundred thousand workers gathered to protest the proposed transformation of social rules. Yet on the same day, the European Commission (EC) outlined a full-fledged war against labor. It is the most anti-labor campaign since the 1930s – even more extreme than the Third World austerity plans imposed by the IMF and World Bank in times past.

The EC is using the mortgage banking crisis – and the needless prohibition against central banks monetizing public budget deficits – as an opportunity to fine governments and even drive them bankrupt if they do not agree roll back salaries. Governments are told to borrow at interest from the banks, rather than raising revenue by taxing them as they did for half a century following the end of World War II. Governments unable to raise the money to pay the interest must close down their social programs. And if this shrinks the economy – and hence, government tax revenues – even more, the government must reduce social spending yet further.
From Brussels to Latvia, neoliberal planners have expressed the hope that lower public-sector salaries will spread to the private sector. The aim is to roll back wage levels by 30 percent or more, to depression levels, on the pretense that this will “leave more surplus” available to pay in debt service. It will do no such thing, of course. It is a purely vicious attempt to reverse Europe’s Progressive Era social democratic reforms achieved over the past century. Europe is to be turned into a banana republic by taxing labor – not finance, insurance or real estate (FIRE). Governments are to impose heavier employment and sales taxes while cutting back pensions and other public spending.
“Join the fight against labor, or we will destroy you,” the EC is telling governments. This requires dictatorship, and the European Central Bank (ECB) has taken over this power from elected government. Its “independence” from political control is celebrated as the “hallmark of democracy” by today’s new financial oligarchy. This deceptive newspeak evokes Plato’s view that oligarchy is simply the political stage following democracy. The new power elite’s next step in this eternal political triangle is to make itself hereditary – by abolishing estate taxes, for starters – so as to turn itself into an aristocracy.
It is a very old game indeed. So it is time to put aside the economics of Adam Smith, John Stuart Mill and the Progressive Era, to forget Marx and even Keynes. Europe is ushering in an era of totalitarian neoliberal rule. This is what Wednesday’s strikes and demonstrations were about. Europe’s class war is back in business – with a vengeance!
This is economic suicide, but the EU is demanding that Euro-zone governments keep their budget deficits below 3% of GDP, and their total debt below 60%. On Wednesday the EU passed a law to fine governments up to 0.2% of GDP for not “fixing” their budget deficits by imposing such fiscal austerity. Nations that borrow to engage in countercyclical “Keynesian-style” spending that raises their public debt beyond 60% of GDP will have to reduce the excess by 5% each year, or suffer harsh punishment.[1] The European Commission (EC) will fine euro-area states that do not obey its neoliberal recommendations – ostensibly to “correct” budget imbalances.
The reality is that every neoliberal “cure” only makes matters worse. But rather than seeing rising wage levels and living standards as being a precondition for higher labor productivity, the EU commission will “monitor” labor costs on the assumption that rising wages impair competitiveness rather than raise it. If euro members cannot depreciate their currencies, then they must fight labor – but not tax real estate, finance or other rentier sectors, not regulate monopolies, and not provide public services that can be privatized at much higher costs. Privatization is not deemed to impair competitiveness – only rising wages, regardless of productivity considerations.
The financial privatization and credit-creation monopoly that governments have relinquished to banks is now to really pay off – at the price of breaking up Europe. Unlike central banks elsewhere in the world, the charter of the European Central Bank (ECB, independent from democratic politics, not from control by its commercial bank members) forbids it to monetize government debt. Governments must borrow from banks, which are create interest-bearing debt on their own keyboards rather than having their national bank do it without cost.
The unelected members of the European Central Bank have taken over planning power from elected governments. Beholden to its financial constituency, the ECB has convinced the EU commission to back the new oligarchic power grab. This destructive policy has been tested above all in the Baltics, using them as guinea pigs to see how far labor can be depressed before it fights back. Latvia gave free reign to neoliberal policies by imposing flat taxes of 51% and higher on labor, while real estate is virtually untaxed. Public-sector wages have been reduced by 30%, prompting labor of working age (20 to 35 year-olds) to emigrate in droves. This of course is contributing to the plunge in real estate prices and tax revenue. Lifespans for men are shortening, disease rates are rising, and the internal market is shrinking, and so is Europe’s population – as it did in the 1930s, when the “population problem” was a plunge in fertility and birth rates (above all in France). That is what happens in a depression.
Iceland’s looting by its bankers came first, but the big news was Greece. When that nation entered its current fiscal crisis as a result of not collecting taxes on the wealthy, European Union officials recommended that it emulate Latvia, which remains the poster child for neoliberal devastation. The basic theory is that inasmuch as members of the euro cannot devalue their currency, they must resort to “internal devaluation”: slashing wages, pensions and social spending. So as Europe enters recession it is following precisely the opposite of Keynesian policy. It is reducing wages, ostensibly to “free” more income available to pay the enormous debts that Europeans have taken on to buy their homes and pay for schooling (hitherto provided freely in many countries such as Latvia’s Stockholm School of Economics), transportation and other public services. Manly such services have been privatized and subsequently raised their rates drastically. The privatizers justify this by pointing to the enormously bloated financial fees they had to pay their bankers and underwriters in order to get the credit to buy the infrastructure that was being sold off by governments.
So Europe is committing economic, demographic and fiscal suicide. Trying to “solve” the problem neoliberal style only makes things worse. Latvia’s public-sector workers, for example, have seen their wages cut by 30 percent over the past year, and its central bankers have told me that they are seeking further cuts, in the hope that this will lower wages in the private sector as well, just as neoliberals in other European countries hope, as noted above.
About 10,000 Latvians attended protest meetings in the small town of Daugavilpils alone as part of the “Journey into the Crisis.” In Latvia’s capital city, Riga, yesterday’s Action Day saw the usual stoppage of transportation and an accompanying honk concert for 10 minutes at 1 PM to let the public know that something was happening. Six independent trade unions and the Harmony Center organized a protest meeting in Riga’s Esplanade Park that drew 700 to 800 demonstrators, relatively large for so small a city. Another union protest saw about half that number gather at the Cabinet of Ministers where Latvia’s austerity program has been planned and carried out.
What is happening most importantly is the national parliamentary elections this Saturday (October 2). The leading coalition, Harmony Center, is pledged to enact an alternative tax and economic policy to the neoliberal policies that have reduced labor’s wages and workplace standards so sharply over the past decade. A few days earlier a bus tour drove journalists to the most visible victims – schools and hospitals that had been closed down, government buildings whose employees had seen their salaries slashed and the workforce downsized.
These demonstrations seem to have gained voter sympathy for the more militant unions, headed by the hundred individual unions belonging to the Independent Trade Union Association. The other union group – the Free Trade Unions (LBAS) lost face by acquiescing in June 2009 to the government’s proposed 10% pension cuts (and indeed, 70% for working pensioners). Latvia’s constitutional court was sufficiently independent to overrule these drastic cuts last December. And if the government does indeed change this Saturday, the conflict between the Neoliberal Revolution and the past few centuries of classical progressive reform will be made clear.
In sum, the Neoliberal Revolution seeks to achieve in Europe what the United States has achieved since real wages stopped rising in 1979: doubling the share of wealth enjoyed by the richest 1%. This involves reducing the middle class to poverty, breaking union power, and destroying the internal market as a precondition.
All this is being blamed on “Mr. Market” – presumably inexorable forces beyond politics, purely “objective,” a political power grab. But is not really “the market” that is promoting this destructive economic austerity. Latvia’s Harmony Center program shows that there is a much easier way to cut the cost of labor in half than by reducing its wages: Simply shift the tax burden off labor onto real estate and monopolies (especially privatized infrastructure). This will leave less of the economic surplus to be capitalized into bank loans, lowering the price of housing accordingly (the major factor in labor’s cost of living), as well as the price of public services. (Owners of monopoly utility services would be prevented from factoring interest charges into their cost of doing business. The idea is to encourage them to take returns on equity. Whether or not they borrow is a business decision of theirs, not one that governments should subsidize.) The tax deductibility of interest will be repealed – there is nothing intrinsically “market dictated” by this fiscal subsidy for debt leveraging. This program may be reviewed at rtfl.lv, the Renew Task Force Latvia website.
No doubt many post-Soviet economies will find themselves obliged to withdraw from the euro area rather than see a flight of labor and capital. They remain the most extreme example of the Neoliberal Experiment to see how far a population can have its living standards slashed before it rebels.
But so far the neoliberals are fully in control of the bureaucracy, and they are reviving Margaret Thatcher’s slogan, TINA: There Is No Alternative. But there is an alternative, of course. In the small Baltic economies, pro-labor parties are pressing for the government to shift the tax burden off employees and consumers back onto property and financial wealth. Bad debts beyond the reasonable ability to pay must be scaled back. It may be necessary to let the banks go under (they are mainly Swedish), even if this means withdrawing from the Euro. The choice is between who will be destroyed: the banks, or labor?
European politicians now view this as being truly a fight to the death. This is the ideology that has replaced social democracy.

[1] Matthew Dalton, “EU Proposes Fines for Budget Breaches,” Wall Street Journal, September 29, 2010.

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An Interview with Warren Mosler: Modern Money Theory and the Exonomy

Posted on September 23, 2010 by | 5 comments
Antonio Foglia and Andrea Terzi interview *Warren Mosler*, Distinguished Research Associate of the Center for Full Employment and Price Stability, University of Missouri, Kansas City (participating via videoconferencing)
April 20, 2010
*Antonio Foglia* (AF): I have known Warren from his previous life as an investor, where he definitely proved his skills. Now, he is an economist and, as all economists, he thinks he has a recipe to fix the world. He is also becoming a politician, so he now has another reason for having a recipe to fix the world, and we are definitely most interested in learning what his recipes are today, at a very special conjuncture in the world.
Warren, thanks for being connected with us this evening. I know you are in Connecticut now. We are in Switzerland, so I think a more general point of view of the world is probably more of interest to all of us although I understand that you might be more current on how to fix the U.S., as that is where you hope to have an impact soon.
*Andrea Terzi* (AT): Hello from the Franklin Auditorium, Warren. The floor is yours.
*Warren Mosler* (WM): Thank you. Well, the most obvious observation is that unemployment is evidence of a lack of aggregate demand, so what the world is lacking is sufficient aggregate demand.
*In the United States, my prescription includes 1) what we call a payroll tax holiday, i.e., a tax reduction, 2) a revenue distribution to the states by the federal government and 3) a federally funded $8.00-per-hour job for anyone willing and able to work. *
*For the euro zone, I propose a distribution from the European Central Bank to the national governments of perhaps as much as 20 percent of GDP to be done on a per capita basis so it will be fair to all the member nations*.

The interesting thing is that it would not increase spending, or demand, or inflation, because spending is already constrained by the Stability and Growth Pact (SGP), and so nations would still be required to keep spending down to whatever the EU requires, but what it does do is to eliminate the debt and financing issues, and it takes away the credit risk from the euro zone. The other thing it does is it gives the EU a far more powerful tool for enforcing its requirements. What happens is that anyone who does not comply with the EU’s requirements would risk losing this annual payment.

Right now, anyone who does not comply gets fined, but, as we know, fines are not easy to enforce.

*AF*: I think that after three hours of Keynesian presentations today I didn’t expect anything else than an extra vote for more aggregate demand stimulation, on one side, and the irrelevance of printing more money, on the other side. Somehow, though, I do personally remain concerned, and don’t fully understand how, in the long run, this will not have side effects as people begin to actually expect the fact that more money is going to be printed, more demand is going to be stimulated in less and less productive ways (because it is basically government spending rather than private spending). If I look at history there is little evidence of how you get out from the sort of Keynesian policy that you are proposing, that is certainly very effective in stopping a depression from developing (and we are grateful that policy makers did that), but I don’t understand how you then stop those policies, and how the exit from those policies can happen in the medium and long term.

*WM*: Okay, so you put up a lot of things there. So I’ll start from the beginning. First of all, for the U.S., I’m talking about restoring income for people working for a living which will raise the sales in the private sector right now, so it’s not a question of government. You talk about stimulus, but I’m not talking about adding stimulus. I’m talking about removing drag. You can’t get something for nothing. If you have somebody running and a plastic bag falls over his head that slows him down you can remove that plastic bag. We are still limited by our productive potential, and what we have now are restrictive policies that are keeping us from achieving it. Restrictive policies are demand leakages. In the U.S., there is a powerful incentive not to spend your income as this goes into a pension fund, and in Europe you have the same types of things that reduce aggregate demand. The only way any sector can successfully “net save” is if another sector goes into deficit, so what the government is doing when it lowers taxes or increases spending, depending on what the case may be, is filling the hole in demand created by the demand leakages.

My proposal for the EU doesn’t increase anyone’s spending. All it does is this: As long as countries are in compliance with spending limits set by the EU, they receive the allocation. As soon as they are not in compliance, they risk losing this payment, in which case the market will severely punish them and cut them off. So, to address your questions, I am not advocating any excess spending stimulus beyond just making up for the drags created by what I call “saving desires” and “demand leakages” which are largely a function of the institutional structure.

Let me just say it in one more way. A government like the U.S. has to determine what the right size of government is. For example: what is the right size for the legal system? You don’t want to have to wait two years to get a court date, but you don’t want to have people calling you up asking you come to court because there are a lot of vacancies, so maybe the right waiting period is, say, 60 days. So you then size your legal system and your legal employees for that kind of public service.

Equally, you have to size the military for what the mission is. You have to size the whole government. *Once you’ve sized your government properly, you then have to determine the correct level of taxes that is needed to sustain the level of private-sector activity that you want, and invariably those taxes are going to be less than the size of the government.* So, even if you want a smaller government, which is fine, you then have to have taxes that are even lower. Why? Because that’s the only way you are going to accommodate your private sector on its savings desires.

*AT*: I know where you are coming from, Warren, and I’m sure you realize that your proposal that the ECB distribute money to European governments makes many people here in Europe jump on their seats for two reasons. One: the ECB is prevented by statute from financing national governments; and two: people fear that this is further additional printing money, creating inflation. Would you mind going back to your proposal and explaining to me and the audience, step by step, what this distribution really means, where this money comes from, and where it is going, in this score-keeping exercise that is the true character of a monetary economy?

*WM*: Right, exactly. So, yes, it would require unanimous approval of EU governments. What I’m saying is that European governments have accounts at the ECB. Under my proposal, the ECB would put a credit balance into government accounts. So what will happen is that the balance in their accounts will go up. *Just because a balance on a national bank account goes up, it does not mean there is any additional spending. It is spending that causes inflation, not just the existence of a credit balance on a central bank computer.* But what would then happen is that in the normal course of spending, borrowing and debt management, this balance would be worked down. Not by an increased volume of spending and not by a change in anything else, but it would just be worked down because, for example, when the Greek bonds would mature, the government would be able to continue its normal spending (this would be limited by compliance with the SGP and other international agencies) without having to refinance its bonds. But once the credit balance is used up, then Greece would continue its normal refinancing, but with a level of debt reduced by about 20 percent GDP the first year.

So again this has no effect on the real economy, no effect on real spending. The only effect is that there would be fewer Greek securities outstanding, and that Greek debt levels would be lower and coming down, which would facilitate their continued funding once the credit balance is used up. So it’s purely, as you stated, an operational consideration and not a real economic consideration, and yes, *people would be afraid of things that they don’t understand*. But anyone who understood central banking from the inside at the operational level would realize that this would have absolutely no effect on inflation, employment, and income in a real economy, other than to facilitate the normal funding of national governments.

*AT*: Are you saying that the effect of such annual distribution would be like the effect of the discovery of a new gold mine every year in a country under the gold standard?

*WM*: Well, no, it’s different, because on a gold standard what we call the money supply is constrained in any case, whereas when you get to a currency it’s the opposite: the currency itself is never constrained. So you have a whole different dynamic.

Let me just expose my point from a slightly different point of view. The reason the EU can’t simply guarantee all the nations, and the ECB can’t simply guarantee all the national governments is because if they did, whoever “deficit spends” the most, wins. You would get a race to the bottom of extreme moral hazard that quickly winds up in impossible inflation. So *therehas to be some kind of mechanism to control government deficit spending for the member nations*. They did it through the SGP, that sets the 3 percent limit, and there’s no way around that dilemma. It can’t be done through market forces. It has to be done through the SGP. What they did is to leave the national government on a stand-alone basis, so there would be market discipline, but we’ve seen that that does not work either. They’ve got to get back to a situation where they are not subject to the mercy of market forces but at the same time they don’t want the moral hazard of some unlimited fiscal expansion where anybody can run a 5, 10, 20 percent deficit with inflationary effects.

*My proposal eliminates the credit risk at the national government level, so they are no longer restrained by the markets in their ability to borrow, but it makes them dependent on annual distributions from the ECB in order to maintain this freedom to fund themselves*.

And because they are dependent on the ECB’s annual check, the ECB has a policy to then be able to remove that check to impose discipline on these countries. *By having this policy tool to withhold payments, rather than implement fines, the EU would be in a much stronger position to enforce the deficit limits they need to prevent the race to the bottom of nations*.

*AT*: Your proposed ECB distribution would have the immediate effect of reducing the interest rate spread between German and Greek bonds. However, if the 3-percent deficit constraint remains in place, there is not much hope of prosperity in Europe. Do you agree?

*WM*: Right. The demand management would be based on the SGP: if they decide a 3-percent deficit is not adequate for the level of aggregate demand they may go up to 4, 5, or 6 percent or whatever level they choose. It’s always a political decision for them, and it’s always going to be a political decision. If they choose something too low, then they’re going to have higher unemployment. If they choose something too high, they’re going to have inflation. And so it’s going to be a political choice, no matter how you look at. But the thing is, how do you enforce the political choice? Right now they can’t enforce it. Right now, they’ve been enforcing it through the fining of member nations. But it doesn’t work. So they’ve lost their enforcement tool.

The other problem they have is this: because of the credit sensitivity of the national governments, when countercyclical deficits go up like now, which are needed to restore aggregate demand, output and employment, what happens is that the deficits challenge the creditworthiness of the national governments. *This is an impossible situation with national governments risking default because of the insolvency risk. They are in a completely impossible position to accomplish any of their goals. *

Whereas, reversing the situation, i.e., going from “fines as discipline” to “withholding payments as discipline” puts them in a position that is manageable. It still then requires wise management for the correct level of deficits, for the correct level of aggregate demand, but at least it’s possible. Right now, it’s unstable equilibrium, and what I am proposing switches it to a stable equilibrium, as they used to say in engineering class.

*AF*: If I understand correctly, the essence of the policies that you are suggesting, both in the U.S. and in Europe, involve a certain level of deficit spending and debt accumulation. Then one could expect the dollar/euro exchange rate not to move much because people would probably tend to dislike both currencies the same way. How would you see the interaction of these two areas with emerging markets that are in a totally different economic environment and cycle, and whose currencies are actually currently on the rise?

*WM*: Right, if you look at nations like India and even Brazil, they all have high interest rates and high deficits that help them get through. China, as well, maintains an extremely high deficit offsetting its internal savings desires. China may have overdone it, and it has to face an inflation problem, but this is a different story. *I think that the U.S. is in a far better situation than the euro zone right now, because our budget deficits do not represent the sustainability issues or credit issues*.

The EU has put its member nations in the same position as the U.S. states, as if Germany, or Greece, were like Connecticut, or California. They put all their member nations in the same position as state governments but without the federal government spending that the U.S. uses to help them out. This puts the whole burden of sustaining aggregate demand on European member nations. To get an analogy in the U.S., *if the U.S. had to run a trillion and a half million dollar deficit last year at the federal level, and if the only way that could have happened was at the state level, the U.S. would have been in much the same position as the EU, with all our states right on the edge of default.* So because we have our deficit at the federal level, instead of state level, we are in a much stronger position than the EU right now.

You may have already reviewed the mechanics of how nations like the U.S. or the U.K. do their public spending in the conference, but let me do it very quickly. When the United States spends money that it doesn’t tax, it credits the reserve account of whoever gets that money. Now, a reserve account at the central bank is nothing more than a checking account.

Let me now use the example of China so I can combine the problem of external debt with deficit spending at the same time. China gets its dollars by selling goods and services in the United States. When China gets paid, the dollars go into its checking account at the Federal Reserve Bank, and when China buys Treasury securities, all that happens is that the Federal Reserve transfers the funds from their checking account at the Federal Reserve to their securities accounts at the Federal Reserve. U.S. Treasury securities are accounted much like savings accounts at a normal commercial bank. When they do that, it’s called “increasing the national debt”, although when it’s in their checking account it doesn’t count as national debt. The whole point is that the spending of dollars by the federal government is nothing more than the Federal Reserve Bank changing numbers off in someone’s reserve account. The person doing this at the Treasury doesn’t care if funds are in the reserve account at the central bank; it makes no difference at all, operationally. *There is no operational connection between spending, taxing, and debt management.* Operationally, they are completely distinct. And the way any government like the United States or the U.K. or Japan pays off its debt is the same: just transfer funds from someone’s security accounts back to the reserve accounts at your own central bank, that’s it. And this happens every week with hundreds of billions of dollars. None of this acts as an operational constraint on government spending. There is no solvency issue. There is no default condition in the central banks’ computer.

Now, when you get to the EU, it all changes because all this has been moved down to the national government level, and it’s not at some kind of federal level the way it is in the United States. There is no default risk for the U.S., for the U.K., or for Japan where the debt is triple that of the U.S. and double that of Greece. It is all just a matter of transferring funds from one account to another in your own central bank.

*AT*: I’m glad you touched upon the question of China accumulating credits with the U.S., because this is poorly understood. Money that Chinese earn by sending merchandise to the United States are credits in the U.S., and these credit units are nonredeemable, so Chinese owners can do nothing with these things unless they use them to buy American products, and if they do, those units become profits for American firms. But there is also another possibility, which sometimes raises concerns in the larger public, and this is what happens if China should choose to get rid of these dollars by selling the U.S. securities they own. While the amount of dollars owned by foreigners doesn’t change, the price of the dollar would in fact decline. If China sells off American debt, dollar depreciation may be substantial.

*WM*: Operationally, it’s not a problem because if they bought Euros from the Deutsche Bank, we would move their dollars from their account at the Fed to the Deutsche Bank account at the Fed. The problem might be that the value of the dollar would go down. Well, one thing you’ve got to take note of is that the U.S. administration is trying to get China to revaluate currency upward, and this is no different from selling off dollars, right? So, what you are talking about (selling off dollars) is something the U.S. is trying to force to happen, would you agree with that?

*AT*: Yes!

*WM*: Okay, so we’re saying that we’re trying to force this disastrous scenario—that we must avoid at all costs—to happen. This is a very confused policy. *What would actually happen if China were to sell off dollars? Well, first of all, the real wealth of the U.S. would not change: the real wealth of any country is everything you can produce domestically at full employment plus whatever the rest of the world sends you minus what you have to send them, which we call real terms of trade.* This is something that used to be important in economics and has really gone by the wayside. And the other thing is what happens to distribution. While it doesn’t directly impact the wealth of the U.S., *the falling dollar affects distribution within U.S., distribution between those who profits from exports and those who benefit from imports.* And that can only be adjusted with domestic policy. So, number one, we are trying to make this thing happen that we are afraid of, and number two, if it does happen, it is a demand-distribution problem, and there are domestic policies to just make sure this happens the way we want it to be.

*AT*: Would you like to elaborate on another theme of today’s symposium? How do you see the income distribution effects of the U.S. fiscal package? Is it going in the right direction in your opinion?

*WM*: Well, we had 5 percent growth on the average maybe for the last 2 quarters while unemployment has continued to go up. If GDP is rising and people in the world are getting hurt, and real wages are continuing to fall, then who is getting the real growth? Well, everybody else. And so what we’ve seen from a Democratic administration is perhaps the largest transfer of real wealth from low income to high income groups in the history of the world. Now, I don’t think that was the intention of their policies but it has certainly been a result, and it comes from a government that does not understand monetary operations and a monetary system and how it works.

*AT*: Warren, what would be your first priority, the one action that you would enforce immediately to improve the current situation?

*WM*: The United States has a punishing regressive tax which we call payroll taxes. These take out a fixed percent of our income, 15.2 percent (7.6 percent paid by employees and 7.6 percent by employers), so it starts from the very first dollar you earn, and the cap is $108,000 a year. *I would immediately declare a payroll tax holiday, suspend the collection of these taxes. This would fix the economy immediately from the bottom up. A person making $50,000 a year would see an extra $325 a month in his pay check, simply by having the government stop subtracting these funds from his or her pay.*

Our economy has always worked best if people working for a living have enough take-home pay to be able to buy the goods and services that they produce. Right now, in the United States, people working for a living are so squeezed they can pay for gasoline and for food and that’s about it, maybe a little bit of their insurance payments, and so we’ve had an economic and social disaster. *The cause of the financial crisis has been people unable to make their payments.* The only difference between a Triple-A loan and “toxic assets” is whether people are making their payments or not. And you can fund the banks and restore their capital and do everything else, but it doesn’t help anyone making their payments. We’re two years into this and we’re still seeing delinquencies moving up, although they leveled off a little bit, at unthinkably high levels. Hundreds of thousands of people getting thrown out of their homes—that’s the wrong way for a Democratic administration to address a financial crisis. To fund a bank, simply stop taking the money away from people working for a living so they can make their payments and fix the financial crisis from the bottom up. *All that businesses and banks need and want at the end of the day is a market for their products; they want people who can afford to make their payments and buy their products.* So my first policy would deliver exactly that, which is what I think we need to take the first big step to reverse what’s going on.

*AT*: The action you proposed, the payroll tax holiday, entails some form of discretionary fiscal policy and this raises two questions. First, discretionary fiscal policy has been discredited. Economists like to model politicians’ behavior in a way that we cannot trust their decisions as they just aim at winning the next elections. So how do we make sure that discretionary fiscal policy would be used correctly to achieve full employment and avoid inflation?

*WM*: My proposal is not talking about discretionary spending. It’s about cutting taxes and restoring incomes for people who are actually working for a living, who are the people that at the end of the day we all depend on for our lifestyle, so it is not an increase in government spending, it is a tax cut on people working for a living. The only reason this hasn’t happened is because of what I call “the innocent fraud” (from my book, *The seven deadly innocent frauds*, available on my website), that the government has run out of money, the government is broke, the federal government has to get funding, has to get revenues from those who pay tax, or it has to borrow from China and leave it to our children to pay back. This is complete myth, and it is the only barrier between us and prosperity. Now, in terms of using excess capacity and create inflation, the theory says yes, it can happen, though I’ve never seen it in my forty years in the financial markets.

As they say, in order to get out of a hole, first you have to stop digging, right? Right now, we’ve got an enormous amount of excess capacity in the United States. Unemployment is at 10% only because they changed the way they define it. Using the old method, we have up to 22% unemployment.

The payroll tax holiday will both increase spending power and lower costs, so we get a little bit of deflationary effect as spending starts. Should there be a time when we see demand starts threatening the price level, then it can come a point where it makes sense to raise taxes, but not to pay for China, not to pay for social security, not to pay for Afghanistan (we just need to change the numbers up in bank accounts) but to cool down demand. We have to understand that taxes function to regulate aggregate demand and not to fund expenditures.

*AT*: Discretionary fiscal policy also includes discretionary changes in taxes, not only discretionary changes in spending, so how do we make sure that the political ruling class will raise taxes when needed?

*WM*: Well, right now they’re raising taxes, so they don’t seem to have much of a reluctance to do that, and they also understand that voters have an intense dislike for inflation. It’s not justified by the economic analysis, it’s just an emotional dislike for inflation. They believe it’s the government robbing people of their savings and they believe it’s morally wrong. And so they are always under intense pressure to make sure that inflation does not get out of control or they are going to lose their jobs.

But that’s the checks and balances in a democracy. It’s what the population votes for. And the American population has shown itself to vote against inflation time and time again. The population decides they want more or less inflation, it boils down to whether you believe in democracy or you don’t.

And I’m on the side to believe in democracy.

*AT*: In terms of democracy, this choice is not available to Europeans right now. The ECB has been given an institutional mandate of price stability, and the decision of what’s more evil, inflation or unemployment, has been removed from voters’ preferences on the ground that price stability is the premise to growth and full employment!

But I’m afraid our time is over. Warren, thank you very much. Although the volcano in Iceland prevented you from attending today, at least we had this opportunity to discuss via teleconference.

*WM*: Was the volcano a result of the financial crisis over there?

*AF*: It was a way for Iceland to take revenge on the Brits!

Warren, we thank you very much for making this conference possible and thank you for your time. I encourage anybody who is interested to go to your website to get a view of your most recent ideas, and all the best from this side of the Atlantic on your campaign.

*WM*: Thank you. If anyone has more questions just write to my email address [email protected] and I’ll be happy to correspond with anyone looking for more information.

*AT*: Thank you Warren.

*WM*: Okay, thank you all!

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