New Economic Perspectives

By William K. Black
(Cross-posted from Benzinga.com)

This column comments on Joe Nocera’s September 23, 2011 column entitled: The Phony Solyndra Scandal

Nocera’s column compares the statements of Solyndra’s controlling managers to Dick Fuld’s statements to the public about Lehman’s conditions and asserts with minimal explanation that neither could have been criminal. I have testified before the House Financial Services Committee at some length as to why Lehman was a “control fraud” so I disagree with Nocera. Lehman engaged in extensive accounting and securities fraud and caused massive losses by selling endemically fraudulent liar’s loans to the secondary market. It Soyndra’s controlling managers made false disclosures analogous to those made or permitted to go uncorrected by Fuld, then they too face a serious risk of criminal prosecution – it we ever replace Attorney General Holder with a prosecutor.

I also write to explain why Nocera is wrong to absolve the White House from scandal in the Solyndra matter. Nocera argues that it is inherently highly risky for the government to lend to companies the market will not loan to because their “green” projects are extremely risky commercial projects. He concludes that it is inevitable that many such loans will fail and that such failures do not demonstrate that the federally subsidized loan program for green energy companies is flawed. He concludes by warning that China dominates solar panel manufacture and that China will be the winner if the Republicans cut funding for the green energy programs.

Nocera is correct that the subsidized program is extremely risky. He identifies two of the risks. First, the technology developed may prove unmarketable. Second, entry by competitors may be so robust that the price of the relevant products (e.g., solar panels) suffer a “stunning collapse” and cause the U.S. Treasury-financed firm to fail even if the development of improved technology is modestly successful. 

There are obvious economic arguments against Nocera’s play of the Red Menace card. China heavily subsidizes solar panel manufacturing. Other nations (including the U.S.) subsidize solar panel manufacturing. Solar panels are still a specialty application that is not cost-effective in general usage absent public subsidies. The subsidies to the purchasers are not large enough to develop a market that has kept pace with the tremendous growth of solar panel production. The result has been a glut of solar panel production and a sharp drop in solar panel prices. In sum, the Chinese government is taking the very large financial risks of developing a new technology and the financial losses that come from selling us the solar panels at a low and sharply falling price that is inadequate to defray the costs of production and the risks of new product development. Nocera states that China has provide a $30 billion subsidy to solar panel producers purchasers, which has helped produce a glut of solar panels and caused a “stunning collapse” in their “market” price. That means that the great bulk of the Chinese subsidy has flowed to purchasers of solar panels, including Americans. Even if the Chinese develop a solar panel technology that is cost effective in general residential and commercial real estate usage there is no assurance that the Chinese government or public will find the production subsidies desirable. China may lose its solar panel production lead to a lower-cost producer or a higher quality producer. Other nations’ producers may be less than vigorous in enforcing the intellectual property rights of the Chinese producers, allowing domestic competitors to skip the large risks and costs of the research and development stage.

This column, however, generally emphasizes financial regulation, and there are reasons to use the word “scandal” to describe the administration’s treatment of its regulators in the Solyndra loan. Here is Nocera’s defense of the administration’s behavior:

 “Undoubtedly, the Solyndra “scandal” will draw a little blood: there are some embarrassing e-mails showing the White House pushing to get the deal done quickly so it could tout Solyndra’s green jobs as part of the stimulus package.

But if we could just stop playing gotcha for a second, we might realize that federal loan programs — especially loans for innovative energy technologies — virtually require the government to take risks the private sector won’t take. Indeed, risk-taking is what these programs are all about. Sometimes, the risks pay off. Other times, they don’t. It’s not a taxpayer ripoff if you don’t bat 1.000; on the contrary, a zero failure rate likely means that the program is too risk-averse. Thus, the real question the Solyndra case poses is this: Are the potential successes significant enough to negate the inevitable failures?”

Nocera’s effort to minimize the administration’s misconduct and his misstatements about risk are interrelated and they reprise the mistakes that the Bush administration made in its assault on financial regulation that led to the ongoing financial crisis. Life does not reward all risks. The quintessential risk that it does not reward in lending is failing to underwrite. A lender that fails to underwrite prudently is taking a severe risk, for the failure causes “adverse selection.” Lenders that make large loans (e.g., mortgages or loans to solar panel manufacturers) under conditions of adverse selection have a “negative expected value” – they are gambling against the house. Lenders that make loans with a negative expected value will suffer severe losses.

We are still suffering from a crisis driven by CEOs of lenders who deliberately destroyed essential underwriting in order to maximize the accounting control fraud “recipe” that I have explained many times. The result was “liar’s” loans. By 2006, roughly half of loans called “subprime” were also liar’s loans. Approximately one-third of U.S. mortgage loans made in 2006 were liar’s loans and the fraud incidence in studies of liar’s loans is 90 percent. Liar’s loans caused staggering direct losses and hyper-inflated and extended the residential real estate bubble, driving the Great Recession.

So the “real question” is not the one Nocera framed. The real question is why a lender (the U.S. government in this case) would gratuitously fail to underwrite a loan properly. The fact that the type of loan was inherently extremely risky makes it imperative that the lender engage is superb underwriting. The Obama administration, and Nocera, have failed to learn the most obvious and costly lesson of the ongoing U.S. crisis – liar’s loans cause catastrophic losses and failures and are “an open invitation to fraudsters” (quoting MIRA’s 2006 report to the members of the Mortgage Bankers Association).

Nocera does not explain what is embarrassing about the Obama emails. The government’s professional loan underwriters were worried about lending to Solyndra. They were warning the administration that they had not been able to complete the professional underwriting essential to making loans prudently. The Obama administration officials did not respond by backing their professional regulators. The administration did not stress that it was essential that the loan be approved only after it passed a rigorous underwriting process. The administration responded to the efforts of its professionals to protect the government from loss by abusing the regulators and pressuring them to approve the loans without completing the underwriting. The administration thought it was fine to make a liar’s loan to Solyndra. 

The administration exposed the government to a gratuitous risk of loss of hundreds of millions of dollars in order to achieve an overarching priority – they wanted a presidential photo op. If that isn’t a scandal, if Nocera thinks it is merely business as usual, then our failure to hold Dick Fuld, President Obama, and a host of other elites to a higher standard of accountability is the scandal that will generate repeated scandal.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.


Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.