Tag Archives: Control Fraud

Fannie and Freddie Fantasies

Posted on December 29, 2011 by | Comments Off on Fannie and Freddie Fantasies

By William K. Black

(Cross-posted from Benzinga)

An important but fundamentally flawed debate about Fannie and Freddie’s role in the ongoing crisis has raged since the SEC sued the former senior managers of both entities for securities fraud.  The Wall Street Journal and Peter Wallison (in the WSJ) have claimed that the suit vindicates their positions and discredits the Federal Crisis Inquiry Commission (FCIC).  Joe Nocera, in his New York Times column, has thundered at the SEC and then Wallison,accusing him of “The Big Lie.”  Nocera’s column is also interesting because it (implicitly) argues that the thesis of Reckless Endangerment is incorrect.  His colleague Gretchen Morgenson and Joshua Rosner co-authored that book.  I write to provide yet another view, distinct from each of the sources.

There are two primary issues about Fannie and Freddie and the crisis discussed in the debate. First, why did Fannie and Freddie, relatively suddenly, change their business practices radically and begin purchasing large amounts of nonprime mortgages?  Second, what role did declining mortgage credit quality that did not descend to the level of loans that the industry described as “subprime” play in the Fannie and Freddie crisis?  The first issue is vastly more important and this article focuses on it. (The short answer to the second question is:  “The first issue, for everyone except theSEC, comes down to this question: did Fannie and Freddie’s controlling officers(eventually) cause them to buy large amounts of nonprime loans for the same reason their counterparts running Lehman, Bear Stearns and Merrill Lynch did(the higher nominal short-term yield maximized their current compensation) or because “the government” made them buy the loans?)  (Lehman, Bear Stearns, and Merrill Lynch were not subject to any governmental requirements to purchase any category of nonprime loans.)

I show that Fannie and Freddie’s controlling officers (eventually) caused them to buy huge amounts of nonprime loans for the higher short-term nominal yield (though they knew that the actual yield would be negative as soon as the housing bubble stalled).  I exploit a “natural experiment” provided by liar’s loans – loans made without prudent underwriting of the borrower’s capacity to repay the loan.  No governmental entity ever required any lender, or any purchaser of loans (and that includes Fannie and Freddie), to make liar’s loans. The mortgage industry’s anti-fraud experts, the FBI, and the banking regulators all warned about liar’s loans producing an epidemic of fraud.  If Fannie and Freddie purchased large amounts of liar’s loans, then their controlling managers did so because liar’s loans’higher short-term nominal yield maximized their near-term compensation – not because “the government” made them do so.

OFHEO, which was Fannie and Freddie’s regulator during the relevant period, had ample regulatory authority to prevent Fannie and Freddie from purchasing liar’s loans and its head, James B. Lockhart, was a George Bush appointee and one of his oldest friends (from prep school).  Lockhart had President Bush’s full support and he was in no way intimidated by Barney Frank or Chris Dodd.  Lockhart shared Bush’s anti-regulatory mindset, his inability to envision elite business leaders as felons, and his strong support for even the most perverse executive compensation systems.  Lockhart was not “captured” by Fannie and Freddie.  He was not a supporter of either entity.  He and his senior regulators that I met simply did not believe it was legitimate for the government to regulate compensation or, absent proof that the business practice had already produced large losses, Fannie and Freddie’s business strategy.

The, SEC complaint, takes the unique, naïve, and untenable position that Fannie and Freddie bought very large amounts of nonprime loans in order to increase market share.  This position is exceptionally important because it reveals the SEC’s unwillingness to take on even the most perverse executive compensation systems that are driving our recurrent, intensifying financial crises.  Suffice it to say that the documentary record at Fannie and Freddie is replete with evidence that the controlling officers drove the decision to adopt a new business plan of purchasing vast amounts of nonprime loans and that the reason for the plan was to increase short-term nominal yields. Their risk people repeatedly warned them that the new plan could be disastrous.  High short-term yield produced extraordinary near-term compensation for Fannie and Freddie’s controlling officers,so it is no surprise that the CEOs’ decided in favor of the path that made them wealthy – and produced disaster for Fannie, Freddie, and the government.

Perverse Executive Compensation Systems are Criminogenic

Each of the discussions (and that includes the SEC complaints) is faulty because it proceeds as if Fannie and Freddie suddenly began engaging in accounting and securities fraud late in the crisis.  That is objectively false.  The SEC (and eventually Fannie and Freddie’s regulator – then OFHEO, now called FHFA) documented that Fannie and Freddie had long engaged in accounting and securities fraud – no later than the beginning of the decade that would eventually produce the crisis.  The SEC detected Freddie’s and then Fannie’sfrauds in 1983.  Indeed, the SEC explicitly charged that Fannie’s senior managers caused it to commit accounting fraud for the purpose of maximizing their executive compensation.  I was an expert witness for OFHEO against Raines, et al. in the agency’s enforcement action arising from this earlier fraud.  The SEC and OFHEO’s actions led to Freddie appointing a new CEO in December 2003 (Richard Syron, the most senior defendant in the new SEC suit arising from Freddie’s operations) and Fannie appointing a new CEO in December 2004 (Mr. Mudd, Fannie’s COO during its endemic accounting fraud from 2000-20003). Mudd is the most senior defendant in the SEC suit arising from Fannie’s operations.

One of the delightful acts of unintentional self-parody arising from the crisis is that when the Business Roundtable (the 100 largest U.S. corporations), eventually decided that they needed a spokesperson to respond to the Enron-era epidemic of “accounting control fraud,” they selected Frank Raines (Fannie’s CEO).  BusinessWeek dutifully asked Raines why the fraud epidemic occurred.  Raines responded:

“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.’ It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.”

Raines knew of what he spoke, for his predecessors and he had devised such a bonus system (tied largely to, non-GAAP, earnings per share (EPS) targets purportedly designed to be “stretch” goals).  Fannie’s compensation system produced exactly the perverse results that Raines predicted and explained to Business Week.

“By now every one of you must have 6.46 [EPS] branded in your brains.  You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46,you must be obsessed on 6.46….  Afterall, thanks to Frank, we all have a lot of money riding on it….  We must do this with a fiery determination,not on some days, not on most days but day in and day out, give it your best,not 50%, not 75%, not 100%, but 150%.”

“Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises,ESPP, but substantially over and above if we make 6.46.  So it is our moral obligation to givewell above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.”  (Mr.Rajappa, head of Fannie’s internal audit, emphasis in original.)

I call internal audit the anti-canary.  Miners took canaries into coal mines because the birds are more susceptible than humans to carbon dioxide and monoxide.  If the canary loses consciousness the humans can survive by exiting the mine. Internal audit is supposed to the least susceptible unit in a firm.  The mantra of internal audit is“independence” from the senior managers. If internal audit is suborned by executive compensation then the rot is pervasive in other units.  In considering the import of Rajappa’s speech to his internal audit troops, consider the fact that it was a written speech and that Rajappa provided the text to Raines – and got favorable suggestions to make it even stronger.  Raines knew and approved of the fact that the rot at Fannie was pervasive.

Ireland Imports U.S. Executive Compensation and Produces a Similar Crisis

A word about “stretch goals.”  Consider this exceptionally naïve passage from a Nordic banker (Nyberg) recently asked to write a report on the failed Irish banks.  He is discussing earning targets that maximized executive compensation.

“Targets that were intended to be demanding through the pursuit of sound policies and prudent spread of risk were easily achieved through volume lending to the property sector.” (Nyberg 2011: 30)

The bonus targets, of course, were not “intended to be demanding through the pursuit of sound policies.”  The senior managers chose stretch goals,impossible to reach through prudent lending, because such goals were “easily achieved” by ignoring asset quality (which they proceeded to do).  As George Akerlof and Paul Romer aptly observed in their 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”), accounting control fraud is a “sure thing.”   Whether one is in Ireland or the U.S., the fraud recipe for a lender (or loan purchaser) has four ingredients.

  1. Grow like crazy
  2. By making (or buying) exceptionally bad loans at a premium yield, while
  3. Employing extreme leverage, and
  4. Providing grossly inadequate allowances for loan and lease losses (ALLL)

Indeed, Ireland provides a superb natural experiment that helps us determine why banks make or purchase exceptionally bad loans with grossly deficient underwriting and trivial ALLL.  The fraud recipe is so perverse because it is mathematically guaranteed to produce record (albeit fictional) short-term reported income, huge compensation, and catastrophic losses.  If a material number of banks (or a small number of very large banks) follows the same fraud recipe in an asset category it will hyper-inflate a bubble in that asset. Accounting control frauds often lend into teeth of a glut.

Ireland is so useful because it had no equivalent ofa Community Reinvestment Act (CRA) and no material secondary market (noe quivalent of Fannie and Freddie – hence, no requirements to purchase a subset of below median-income home mortgages). Nevertheless, its real estate bubble was roughly twice as large (in relative terms) as the U.S. bubble and it had twin bubbles in commercial and residential real estate.  Its banks exhibited a collapse of loan quality driven by perverse executive compensation.  Irish bank CEOs followed the same fraud recipe as Lehman, Merrill Lynch, Countrywide, WaMu, Fannie,Freddie and their ilk and produced the same catastrophic losses.

“All of the covered [failed]banks regularly and materially deviated from their formal policies in order to facilitate rapid and significant property lending growth. In some banks, credit policies were revised to accommodate exceptions, to be followed by further exceptions to this new policy, thereby continuing the cycle.”

“Occasionally,management and boards clearly mandated changes to credit criteria. However, in most banks, changes just steadily evolved to enable earnings growth targets to be met by increased lending.” (Nyberg 2011: 34)
“The associated risks appeared relevant to management and boards only to the extent that growth targets were not seriously compromised.” (Nyberg 2011: 49)

That’s right; let nothing get in the way of making it simple to meet the bonus target – even though doing so will destroy the bank.

Fannie and Freddie’s CEOs Led them in Serial Accounting and Securities Fraud

Fannie and Freddie’s accounting frauds in the earlier part of the decade, however, followed a different recipe.  Their managers’ were then “skimmers” instead of “looters.”  We should not be too kind to them.  Their earlier accounting fraud recipe put Fannie and Freddie (and therefore the government) at risk of loss and their phony (“dynamic”) hedging posed a systemic risk.  Fannie and Freddie’s original fraud scheme sought to maximize the senior managers’ income by taking substantial interest rate risk.  This required Fannie and Freddie to grow their portfolios massively.

“[F]rom 1998 to 2003,Freddie Mac’s retained portfolio grew at an annual average rate of about 21 percent. Over the same period of time, Fannie Mae’s mortgage holdings increased by an annual average rate of 17 percent. By 2003, Freddie Mac’s retained portfolio ($661 billion) was about 72 percent as large as Fannie Mae’s ($920billion.)”

The Rise and Fall of Fannie Mae and Freddie Mac: Lessons Learned and Options for Reform.  Richard K. Green and Ann B. Schnare (November 19, 2009: p. 18).

Fannie and Freddie’s controlling officers made the opposite bet on the direction of interest rates.  Fannie lost its bet, so it hid it losses by calling them “hedges.”  This accounting fraud turned Fannie’s real losses into fake profits, maximizing the officers’bonuses.  This bit of accounting and securities fraud caused the SEC to required Fannie to restate its financial statements and recognize millions of dollars in losses.  Naturally, Fannie’s officers did not give back their bonuses.  Freddie won its beton interest rates and, after recognizing enough income to maximize current executive bonuses, it created “cookie jar” loss reserves so that it could draw on them if it failed to meet the targets that maximized future bonuses.  The SEC was not amused and required Freddie to restate its financial statements.

Here is the crazy thing – the SEC, OFHEO, and Department of Justice all failed to demand that Fannie and Freddie end their perverse executive compensation system that made the executives wealthy through fraud and put the entities and the government at risk.  The Bush White House took no action and made no criticism of the compensation system. The Congress (both parties) made no criticism of the compensation systems.  Remember, we had seen these perverse compensation systems blow up the S&L industry and the Enron-era accounting control frauds.

OFHEO even allowed Mr. Mudd, Fannie’s COO during the period of its extensive accounting and securities fraud, to replace Raines’ as CEO in December 2004.  None of this was due to any weakness in OFHEO’s regulatory powers.  The problem was an unwillingness to regulate.  The unwillingness was ideological.  OFHEO’s senior managers did not consider it legitimate to regulate executive compensation or to block Fannie’s choice of its new CEO.  The new SEC suit names Mudd as a defendant.

OFHEO had its maximum leverage over Fannie and Freddie when the SEC discovered their accounting and securities frauds and its own examinations confirmed those frauds in the middle of the critical decade.  OFHEO used its leverage to fight the last war – ensuring that Fannie and Freddie did not take excessive interest rate risk.  It sharply limited the amount that Fannie and Freddie could grow their portfolios and cracked down on hedging abuses.  Unfortunately, the first of these actions, while completely appropriate, helps explain the new accounting and securities fraud that are (or should be in a better complaint and prosecution) the subject of the new SEC action.


Fannie and Freddie’s New Controlling Insiders become Looters

By December 2004, the SEC and OFHEO had forced out Fannie and Freddie’s controlling managers who led the accounting control frauds in the first part of the decade, but they left in place Fannie and Freddie’s exceptionally perverse executive compensation systems that promised that the new senior officers could attain vast wealth if they could cause Fannie and Freddie to report high, short-term profits. Their old scam, interest rate risk plus hedge/cookie jar accounting fraud could no longer be used when Fannie and Freddie’s new controlling officers took power.  There was only one alternative means of creating (fictional) outsized reported profits.  They could not grow their portfolio significantly, but OFHEO failed to require them to divest those portfolios –and those portfolios were massive because of the earlier fraud scheme.

In 2005, Fannie and Freddie’s new controlling officers led them into an orgy of purchasing nonprime loans (liar’s loans, subprime loans, and subprime liar’s loans) – the loans sure to generate the largest short-term nominal yield.  This had the intended effect on the controlling officers’ executive compensation. Fannie and Freddie’s controlling officers increasingly moved prime loans out of portfolio by securitizing and selling them.  Their portfolios increasingly became littered with nonprime loans.  Fannie and Freddie’s controlling officers followed the classic recipe for looters using accounting control fraud.  The difference between Fannie and Freddie and some of its counterparts is that Fannie and Freddie’s risk and (some) underwriting officers mounted considerably greater opposition to the fraud recipe than many other accounting control frauds.  This explains why Fannie and Freddie’s losses (relative to the amount of nonprime loans they purchased) were smaller than many of their counterparts.

It is only by taking into account Fannie and Freddie’s earlier accounting fraud and the SEC and OFHEO’s reactions to those frauds that one can understand why Fannie and Freddie made radical changes in their purchase of nonprime loans in 2005. It is only by taking into account the (moderately) superior professional culture of its risk professionals that one can understand why their losses were not far worse (given the enormous amounts of nonprime loans they purchased from 2005-2007).  Wallison implicitly assumes that if Fannie and Freddie had not purchased these nonprime loans their competitors would not have done so.  That assumption is extraordinary and requires heavy proof.  Wallison provides none.  It was Fannie and Freddie’s competitors who purchased the same nonprime loans so eagerly in 1998-2004 that they eviscerated Fannie and Freddie’s once dominant market share in the secondary market for mortgage loans.  Fannie and Freddie’s combined share of the secondary market fell from well over 90% in 1990 to under one-half by 2004.  Indeed, many of Fannie and Freddie’s losses come from investing in or guaranteeing the financial derivatives issued by its competitors where the underlying asset was nonprime assets, particularly liar’s loans and subprime liar’s loans.

“Private label securities accounted for 56 percent of Fannie Mae’s total mortgage-related security purchases from 2004 through 2006, and 54 percent for Freddie Mac. (See Exhibit 4.) Most of these purchases involved securities backed by subprime or Alt-A mortgages. (See Exhibit 9.) In 2006, the GSEs’ purchases of such securities represented 9.8 percent of the total volume of subprime and Alt-A originations made within the year.” (Green & Shnare 2009: 23)

“Alt-A” is one of the many euphemisms for liar’s loans.  The term is a double lie.  It purports that the loans are prime quality (“A” grade) and it purports that the loans are underwritten through “alternative” means.  In reality, the capacity of the borrower to repay the loan was not underwritten.  Typically, the lenders and their agents fraudulently inflated the borrower’s income. 

Fannieand Freddie were Late to Purchasing Huge Amounts of Nonprime Paper

Fannie (which predated Freddie), created the concept and standard of the “prime” home loan decades ago when it was an independent government agency before it was privatized. When it was a government agency, it was the principal source of desirable market discipline ensuring high mortgage quality.  Nonprime home loans include three primary categories – liar’s loans (loans made without prudent underwriting of the borrower’s capacity to repay the loan), subprime (loans made to borrowers with known, serious credit defects), and subprime liar’s loans (combining both problems).  One of the easy tests of competence is to find whether a writer knows so little that he believes that subprime and liar’s loans are dichotomous. Credit Suisse reports that, by 2006, 49% of the loans called “subprime” were also liar’s loans.

Prior to 2005, nonprime loans were sold overwhelmingly to large investment banks. These banks were not subject to any governmental requirements to purchase such loans.  The investment banks purchased the nonprime loans because doing so maximized their controlling officers’ compensation.  Fannie and Freddie lost enormous market share because of this competition. 

Wallison’s Thesis has been Repeatedly Falsified

The indisputable fact that it was the non-regulated sector (mortgage banks, mortgage brokers, investment banks, and non-bank affiliates that led the epidemic making and purchasing fraudulent nonprime loans has not prevented multiple, major analytical failures about the role that Fannie and Freddie played in the crisis. The historical quibble is that Fannie and Freddie reduced their loan purchase standards well before 2005. That is true, but it does not explain why Fannie and Freddie suffered huge losses on nonprime loans.  Fannie and Freddie’s definition of “prime” created an exceptionally safe standard in which credit losses were minimal.  It was possible to reduce that standard without creating a criminogenic environment and the data review by FCIC demonstrates that the loans that Wallison has lumped together (relying on Pinto’s work) and labeled “subprime” are extremely disparate.

Fannie’s original definition of “prime” was equivalent to an A+.  The loans that themortgage industry called “subprime” were a C-. Liar’s loans were a D-.  Subprime liar’s loans were an F.  There is a large range in credit quality between the original definition of prime and loans the industry called “subprime.”  FCIC showed that the loans that Pinto (but not the industry) classified as “subprime” had dramatically lower default rates than the loans that the industry classified as subprime.  As Charles Calomiris, one of Fannie and Freddie’s most virulent critics has emphasized, the proof as to who is correct in this argument about categorization rests on the performance of the loans.  The loans at Fannie and Freddie that Pinto (but not the industry) termed subprime performed far better than the loans the industry termed subprime.

Nocera’s December 23, 2011 column calls Pinto and Wallison’s work a “big lie” because it categorizes loans that Fannie and Freddie would not have considered “prime” (circa 1982) as “subprime” even when these loans were not considered “subprime” by the industry (circa 2006).

This is unduly harsh.  Pinto and Wallison (and Joshua Rosner and Gretchen Morgenson) are correct that the credit quality of some loans considered prime deteriorated for over a decade.  The real problem is the authors’ lack of consistency.  At root, their point is that differences matter.  Specifically, they argue that making nonprime loans is far riskier than making prime loans.  The same logic, however, requires them to evaluate whether differences matter withinthe vast category that they created and labeled as “subprime.”  They failed to conduct this evaluation.  The FCIC conducted one aspect of the evaluation and found that the differences within the Pinto/Wallison category had enormous consequences for relative performance.  The bulk of Fannie and Freddie’s loans that fall within Pinto/Wallison’s unique and far broader categorization of “subprime” loans perform far better (have much lower default rates) than the narrower, commonly used categorization of subprime.

Second, all the authors advancing this meme failed to evaluate the difference between liar’s loans and non-liar’s loans for the purpose of their real thesis – “the government” caused the crisis by forcing Fannie and Freddie to purchase bad loans. This argument has many factual weaknesses, but one fatal weakness is the fact that there was never any governmental requirement for Fannie and Freddie to purchase liar’s loans.  This provides a natural experiment that allows us to test, and reject, the thesis that Fannie and Freddie purchased bad loans because of governmental mandates.  The CEOs of Fannie and Freddie caused them to buy vast amounts of liar’s loans because the higher nominal yield maximized near-term executive compensation.  The CEOs of Fannie and Freddie acted like the CEOs of Bear Stearns, Lehman, and Merrill Lynch and they did so for the same reasons and with the same fatal consequences.  Akerlof and Romer captured the dynamic in the title of their article (“Looting: the Economic Underworld of Bankruptcy for Profit”).  The firm fails, but the CEO walks away wealthy because accounting control fraud is a “sure thing.”

Remember, the FBI has already warned (in September2004) and the mortgage industry’s own anti-fraud unit (MARI) has warned in early 2006, respectively, that an “epidemic” of mortgage fraud will produce a financial “crisis” if it is not stopped and that liar’s loans are 90% fraudulent.  No honest, financially sophisticated entity would make or purchase liar’s loans (or CDOs backed by liar’s loans) knowing these facts.  Yet, several of the leading investment banks, hundreds of mortgage bankers, WaMu, Countrywide, IndyMac, and Fannie and Freddie rushed to make or purchase endemically fraudulent mortgage paper. This would be irrational for any honest CEO, but it would be optimal for a CEO directing an accounting control fraud.  Fannie and Freddie’s losses on liar’s loans paper are extreme – and note that the authors of the study make the common error of assuming that liar’s loans and subprime loans are dichotomous.  If one examined separately the losses on Fannie and Freddie’s subprime liar’s loans (and CDOs where such loans were the bulk of the underlying) the losses would be catastrophic.

“In 2008, for example,Alt-A mortgages represented just 9.7 percent of Fannie Mae’s book, but accounted for almost 40 percent of the company’s credit losses. The experience at Freddie Mac tells a similar story: the serious delinquency rate on FreddieMac’s Alt-A book (which is 8 percent of the portfolio) is more than three times higher than the total portfolio’s rate.” (Green & Schnare 2009: 24).

Sadly, the SEC fails to exploit this natural experiment involving liar’s loans. Indeed, the SEC complaint appears to have been drafted by someone so poorly informed that he believes that liar’s loans and subprime loans are dichotomous categories.  Nocera is also critical of the SEC complaint, but his criticism arises from his erroneous belief that the complaint rests on Pinto and Wallison’s unique categorization of “subprime” loans.  Nocera is guilty of what he accuses Pinto and Wallison of doing, writing “I still maintain that the S.E.C.’s charges are weak, and that the agency brought the case in part for political reasons: how better to curry favor with House Republicans than to go after former Fannie and Freddie executives?” This is a strong charge requiring at least some proof, but Nocera provides no support.

Nocera (and Wallison) miss entirely the key aspect of the SEC complaint that refutes Wallison’s thesis that Fannie and Freddie bought bad loans because “the government” made them buy bad loans.  Wallison’s facially implausible claim is that Fannie and Freddie were weak political actors forced by crazed Democrats to purchase suicidal loans in order to subsidize poorer minorities that support Democrats.  Fannie and Freddie were exceptionally powerful political entities with strong support from both parties, e.g., Newt Gingrich, but ignore this aspect of unreality solely for the purpose of testing the internal logic of Wallison’s hypothesis.  Wallison’s claim is that Fannie and Freddie were so weak politically that they were forced to take on suicidal loans in order to curry political favor with the Democrats.  If that were true, then Fannie and Freddie should have consistently been leading the purchase of subprime loans from 1993 on (which was when HOEPA became law).  In reality, Fannie and Freddie lost tremendous market share because they (generally) refused to purchase loans the industry categorized as subprime until roughly 2005.  Their rivals, the investment banks (who were not subject to any affordable housing mandates), rushed to purchase massive amounts of these subprime loans.  That is the conventional (compelling) reason to reject Wallison’s thesis.  I have added another reason – Fannie and Freddie would never have purchased liar’s loans under Wallison’s thesis because “the government” never compelled them to purchase liar’s loans and doing so would be suicidal.

The SEC complaint adds an additional reason why Wallison’s thesis fails.  Under Wallison’s thesis Fannie and Freddie should have been exaggerating the amount of subprime loans they were making in order to curry favor with the despicable Democrats.  But the SEC complaint (and Wallison and Pinto’s own work) prove that Fannie and Freddie did the opposite.  Fannie and Freddie’s controlling managers consistently cooked their financial statements and financial disclosures to make it appear that Fannie and Freddie purchased vastly fewer subprime loans than they actually purchased.  (They did the samething with their liar’s loans – for the same reasons.)  Nocera (incorrectly) assumes that the SEC complaint relies on Pinto/Wallison’s unique, ultra-broad categorization of “subprime” loans, but Fannie and Freddie’s documents show that they understated both the number of liar’s loans and subprime loans they purchased (as categorized by conventional industry norms). This makes perfect sense for managers running an accounting control fraud, but it makes no sense under Wallison’s thesis.

We need to be blunt about the source of Wallison’s thesis.  Wallison is one of the leading architects of the global financial crisis in his capacity as AEI’s long-time co-director of their financial deregulation program.  He pushed the criminogenic three “de’s”:  deregulation, desupervision, and de facto decriminalization.  He criticized Fannie and Freddie for notmaking greater amounts of nonprime loans. He is desperately seeking to escape accountability for his major role in creating a global crisis.  He is an ideologue who would have been fired by AEI had he supported financial re-regulation.  His thesis that the crisis was really caused by the government forcing the politically powerless Fannie and Freddie to make suicidal loans is a desperate effort to save himself and his ideology.

Wallison’s thesis cannot survive the laughtest.  It requires that, for over a decade in which the Republicans had control over the Congress and/or the White House Fannie and Freddie’s CEOs knew they were purchasing loans that would eventually prove catastrophic for Fannie and Freddie, the lenders (loan sales to Fannie and Freddie are made with recourse back to the seller), and for the (poorer minorities) purchasing the homes. No one at Fannie and Freddie leaks this to the Republican Congress or the Bush White House even though such leaks would have (under Wallison’s thesis) provided the mother of all Democrat-bashing congressional hearings.  No one at OFHEO, including Bush’s old friend, and strong Republican, James Lockhart (the guy running OFHEO), informs Bush that Fannie and Freddie are headed for catastrophe because the Democrats have forced them to purchase suicidal loans to poorer minorities (i.e., the base of the Democratic Party).

The thesis also requires that, knowing of the coming catastrophe, Fannie and Freddie’s controlling officers, for over 15 years, decided to provide only trivial accounting allowances for the inevitable catastrophic losses – even though GAAP would mandate that they provide massive allowances in such circumstances and even though the controlling officers’ failure to do so could be prosecuted as securities fraud.  The failure to provide massive allowances makes no sense under the Wallison thesis, but it is the standard “fourth ingredient” for an accounting control fraud. Had Fannie and Freddie’s controlling officers appropriate allowances for losses their financial reports would have shown the truth – that the actual long-term yield on liar’s loans was negative.  Fannie and Freddie would have reported substantial losses from 2005 on had they established the allowances required by GAAP, which would have eliminated their bonuses.

Wallison is the Problem and Placing him on FCIC was Scandalous

The Wall Street Journal editorial on the SEC complaints against Fannie and Freddie claims that FCIC should be embarrassed that it ignored the key role that Fannie and Freddie played in the crisis.  Wallison has a new piece in The Atlantic in which he claims “the government” caused the crisis.

If one had to pick one person in the private sector most responsible for causing the global financial crisis it would be Wallison.  As I explained, he is the person, who with the aid of industry funding, who has pushed the longest and the hardest for the three “de’s.”  It was the three “de’s” combined with modern executive and professional compensation that created the intensely criminogenic environments that have caused our recurrent, intensifying crises.  He complained during the build-up to the crisis that Fannie and Freddie weren’t purchasing more affordable housing loans.  He now claims that it was Fannie and Freddie’s purchase of affordable housing loans that caused the crisis.  He ignores the massive accounting control fraud epidemics and resulting crises that his policies generate.  Upon reading that Fannie and Freddie’s controlling officers purchased the loans as part of a fraud, he asserts that the suit (which refutes his claims) proves his claims.

Placing Wallison on FCIC was like placing the Don’s consigliere on a panel that is supposed to investigate the mafia.  What was Wallison going to say as a FCIC member? “Mea Culpa, I’ve been wrong for a quarter-century about everything important and I have come to admit that deregulation, desupervision, and de factodecriminalization are disastrous.” There was a reason no other Republican appointee to FCIC was willing to sign on to Wallison’s dissent.  His dissent is a screed that is devoted to protecting his theoclassical economic ideology.  FCIC did not ignore Pinto’s work, it refuted its analytics. Wallison’s real complaint is that FCIC took Pinto’s work seriously enough to do the analytical work that Pinto and Wallison should have done to determine whether Pinto’s unique categorization of “subprime” produced a category of loans with similar (terrible) performance results.  What Wallison cannot forgive the FCIC staff and other commissioners for is that they did treat his claims seriously despite his obvious self-interest and the logical inconsistency of his claims.  It was taking his claims seriously and evaluating his data that he failed to evaluate that put the final nail in the coffin of his claims.  Wallison and Pinto have had a year to point out any data errors in FCIC’s demonstration that the loans Pinto categorized as “subprime” had greatly superior loan performance compared to loans the industry categorized as “subprime.”

There is no point criticizing the Wall Street Journal’s editorial staff.  They know that FCIC concluded that Fannie and Freddie played a major role in the crisis.  FCIC was correct that Fannie and Freddie were late to the party in terms of purchasing the loans and CDOs that eventually caused the catastrophic losses.  The question was why Fannie and Freddie suddenly began to buy enormous amounts of largely fraudulent nonprime paper in 2005. They did so, as the repeated investigations have found, for the same reason that Fannie and Freddie engaged in accounting control fraud earlier in the decade – it makes the controlling officers wealthy.  It is a “sure thing.”  What I have added is the relevant time line explaining the role that Fannie and Freddie’s earlier accounting control frauds, and the modest sanctions levied by the SEC and OFHEO, played in explaining why they went so heavily into fraudulent nonprime paper around 2005.

Wallison has been conspicuously silent in demanding that elite CEO frauds that drove this crisis be prosecuted.  I ask him, and I ask reporters who discuss any story with him, whether he will now demand that we end the de facto decriminalization of the fraudulent CEOs who drive our financial crises and become wealthy through their frauds.  Does Wallison believe that Fannie and Freddie’s controlling officers would be a good place to begin prosecuting?


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.

Follow him on Twitter: @WilliamKBlack

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Dante’s Divine Comedy: Banksters Edition

Posted on December 15, 2011 by | Comments Off on Dante’s Divine Comedy: Banksters Edition

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

Sixty Minutes’ December 11, 2011 interview of President Obama included a claim by Obama that, unfortunately, did not lead the interviewer to ask the obvious, essential follow-up questions.

“I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn’t illegal.”

Obama did not explain what Wall Street behavior he found least ethical or what unethical Wall Street actions he believed was not illegal. It would have done the world (and Obama) a great service had he been asked these questions. He would not have given a coherent answer because his thinking on these issues has never been coherent. If he had to explain his position he, and the public, would recognize it was indefensible. I offer the following scale of unethical banker behavior related to fraudulent mortgages and mortgage paper (principally collateralized debt obligations (CDOs)) that is illegal and deserved punishment. I write to prompt the rigorous analytical discussion that is essential to expose and end Obama and Bush’s “Presidential Amnesty for Contributors” (PAC) doctrine. The financial industry is the leading campaign contributor to both parties and those contributions come overwhelmingly from the wealthiest officers – the one-tenth of one percent that thrives by being parasites on the 99 percent.

I have explained at length in my blogs and articles why:

  • Only fraudulent home lenders made liar’s loans 
  • Liar’s loans were endemically fraudulent 
  • Lenders and their agents put the lies in liar’s loans 
  • Appraisal fraud was endemic and led by lenders and their agents 
  • Liar’s loans could only be sold through fraudulent reps and warranties 
  • CDOs “backed” by liar’s loans were inherently fraudulent 
  • CDOs backed by liar’s loans could only be sold through fraudulent reps and warranties 
  • Liar’s loans hyper-inflated the bubble 
  • Liar’s loans became roughly one-third of mortgage originations by 2006

Each of these frauds is a conventional fraud that could be prosecuted under existing laws. Hundreds of lenders and over a hundred thousand loan brokers were “accounting control frauds” specializing largely in making fraudulent liar’s loans. My prior work explains control fraud, why accounting is the “weapon on choice” for fraudulent financial firms, and why liar’s loans were superior “ammunition” for committing massive accounting fraud. These accounting control frauds caused greater direct financial losses than any other crime epidemic in history. They also drove the financial crisis that produced the Great Recession and cost millions of Americans their jobs.


In considering my scale of unethical conduct it is important to keep in mind that it is highly likely that anyone that causes very large numbers of people to lose their homes will cause multiple suicides and indirect deaths that arise from the greater vulnerability of the homeless and the blue collar crime effects of destroying neighborhoods inherent to widespread foreclosures. I ignore for this purpose the fact that the fraudulent loans caused the bubble to hyper-inflate and drove the financial crisis that caused millions of people to lose their jobs. The financial accounting control frauds are the weapons of mass destruction of wealth, employment, and happiness. I also ignore the fact that the frauds described here made the perpetrators wealthy. My scale, therefore, systematically and dramatically understates the perpetrators’ moral turpitude. I have also excluded the massive foreclosure frauds from my scale because they did not cause the underlying crisis. When Obama reveals the bankers actions he claims to be legal but highly unethical readers should keep my conscious understatement of the moral depravity of the illegal acts by bankers that drove this crisis in mind when they compare the relative ethical failings.

As a criminologist, I do not favor sentencing criminals to the fates they richly deserve. I would never torture prisoners or place them at risk of assault, rape, or psychological trauma. I do not believe that extremely longer terms of imprisonment are desirable except in rare circumstances. As a lawyer and a criminologist I emphasize that any sentence should come only after a conviction in a trial providing due process protections or a guilty plea.My scale provides a label for the comparative moral depravity of the perpetrator, the deserved punishment (which when vicious is not the far more humane one I would actually impose), and a brief description of the specific frauds that are characteristic of this level of immorality and the number of perpetrators falling in each category. My inspiration was Dante’s circles of hell as described in his Divine Comedy.

The Scale of Ethical Depravity by the Frauds that Drove the Ongoing Crisis

Level 10: Septic tank scum

Eternal Hell: these banksters deserve a physical hell of infinite torment and duration

 Officers that directed control frauds that involved making predatory loans to more than 10,000 homeowners who lost their homes as the result of the frauds. Predatory loans in this context mean deliberately seeking out the elderly or minorities for such loans because they were easier to con into taking loans they could not repay – at a premium yield (interest rate). Dozens of CEOs fall in this category.

Level 9: Pond scum

Time in Hell:  These banksters deservea term in hell


Officers that directed control frauds that led to more than 10,000homeowners losing their homes.  Hundredsof CEOs fall in this category.


Level 8:  Generic scum


Gitmo:  Hell’s starkest suburb


Officers that directed control frauds that led to more than 1,000 homeownerslosing their homes.  Thousands of CEOsfall in this category.


Level 7:  Dante’s deserved denizens


Supermax:   No view, and no way out


The professionals that aided and abetted the overall control frauds byinflating appraisals, giving “clean” audit opinions to fraudulent financialstatements, “AAA” ratings to toxic waste, and accommodating legal opinions tothe frauds.  Thousands of professionalsfall in this category.


Level 6:  Aspiring to great wealththrough fraud 


Alcatraz:  Great view, but no way out


The senior lieutenants of the control frauds who committed the frauds thatcaused more than 10,000 homeowners to lose their homes.  Thousands of senior officers fall in thiscategory.


Level 5:  A large cog in a smallerfraud


Generic Hardcore Prison:  A life ofboredom and the almost total loss of freedom


The senior lieutenants of the control frauds who committed the frauds thatcaused more than 1,000 homeowners to lose their homes.   Thousands of senior officers fall in thiscategory.


Level 4:  The banksters who cost usour money instead of our homes – Goldman Sachs & friends


Generic Prison:  A life of boredom anda severe loss of freedom


The officers that led the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product.  Dozens of officers fall in this category.


Level 3:  The banksters’ seniorlieutenants who cost us our money instead of our homes


Prisons designed for serious, but less physically dangerous felons


The senior officers of the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product.  Scores of senior officers fall in thiscategory.


Level 2:  Banksters who defraudedother bankers (who were willing to be defrauded)


Privatized prisons:  Let them enjoythe consequences of their odes to privatization


The largest control frauds sold tens of billions of dollars of fraudulentloans to each other through fraudulent “reps and warranties.”  The kicker here, as Charles Calomiris hasemphasized, is that the control frauds on both sides of the transactions knew thatthey were engaged in a mutual fraud. Hundreds of senior officers fall in this category.


Level 1:  Small fraudulent fry


Catch and release:  Convict them andput them on probation if they cooperate with the investigations


The small fry are the loan officers, loan broker employees, and borrowerswho knowingly participated in making fraudulent mortgage loans.  Over 100,000 individuals fall in thiscategory.

We Need to End the PAC Doctrine

To date, Bush and Obama have prosecuted none of the mortgage frauds in the top nine levels. I urge reporters to ask him to explain three things about his statements to 60 Minutes.

  • Why are there no prosecutions of the felons that drove the crisis and occupy the nine worst rungs of unethical and destructive acts?

  • Explain the five unethical acts by elite financial institutions that you consider the most destructive and least ethical – but which you believe to be legal. How do you rank the degree of unethical conduct and destruction in those acts?

  • What specific statutory provisions did you propose to make those five unethical acts illegal? As enacted, which provisions of the Dodd-Frank Act made those five unethical acts illegal? Who has been prosecuted for those formerly legal but seriously unethical and destructive acts that were made illegal by the Dodd-Frank Act?

Reporters will have to be persistent in coordinating their follow-up questions to get Obama to provide direct answers to these questions.

I request that private citizens write President Obama to ask him to provide specific, written answers to these three questions. I will be proposing a series of questions that I will urge citizens to demand answers to because it is clear that the regular media will rarely ask demanding questions of elite politicians or bankers. It is up to us to hold them accountable and end the doctrine of Presidential Amnesty for Contributors.

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.

Follow him on Twitter: @WilliamKBlack

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The Virgin Crisis: Systematically Ignoring Fraud as a Systemic Risk

Posted on November 8, 2011 by | Comments Off on The Virgin Crisis: Systematically Ignoring Fraud as a Systemic Risk

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

One of the most revealing thingsabout this crisis is the unwillingness to investigate whether “accountingcontrol fraud” was a major contributor to the crisis.  The refusal to even consider a major role forfraud is facially bizarre.  The bankingexpert James Pierce found that fraud by senior insiders was, historically, theleading cause of major bank failures in the United States.  The national commission that investigated thecause of the S&L debacle found:

“Thetypical large failure [grew] at an extremely rapid rate, achieving highconcentrations of assets in risky ventures…. [E]very accounting trick availablewas used…. Evidence of fraud was invariably present as was the ability of theoperators to “milk” the organization” (NCFIRRE 1993)  

Two of the nation’s topeconomists’ study of the S&L debacle led them to conclude that the S&Lregulators were correct – financial deregulation could be dangerouslycriminogenic.  That understanding wouldallow us to avoid similar future crises. 

“Neitherthe public nor economists foresaw that [S&L deregulation was] bound toproduce looting.  Nor, unaware of theconcept, could they have known how serious it would be.  Thus the regulators in the field whounderstood what was happening from the beginning found lukewarm support, atbest, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (GeorgeAkerlof & Paul Romer.  “Looting: theEconomic Underworld of Bankruptcy for Profit.” 1993: 60).

The epidemic of accounting controlfraud that drove the second phase of the S&L debacle (the first phase wascaused by interest rate risk) was followed by an epidemic of accounting controlfraud that produced the Enron era frauds. 

The FBI warned in September 2004that there was an “epidemic” of mortgage fraud and predicted that it wouldcause a financial “crisis” if it were not contained.  The mortgage banking industry’s ownanti-fraud experts reported in writing to nearly every mortgage lender in 2006that:

“Stated income and reduced documentation loans speedup the approval process, but they are open invitations to fraudsters.”  “When the stated incomes were compared to theIRS figures: [90%] of the stated incomes were exaggerated by 5% or more.[A]lmost 60% were exaggerated by more than 50%. [T]he stated income loandeserves the nickname used by many in the industry, the ‘liar’s loan’” (MARI2006).

Weknow that accounting control fraud is itself criminogenic – fraud begetsfraud.  The fraudulent CEOs deliberatelycreate the perverse incentives that that suborn inside and outside employeesand professionals.  We have known forfour decades how these perverse incentives produce endemic fraud by generatinga “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace.

“[D]ishonest dealings tend to drive honest dealingsout of the market. The cost of dishonesty, therefore, lies not only in theamount by which the purchaser is cheated; the cost also must include the lossincurred from driving legitimate business out of existence.”  George Akerlof (1970).

Akerlofnoted this dynamic in his seminal article on markets for “lemons,” which led tothe award of the Nobel Prize in Economics in 2001.  It is the giants of economics who haveconfirmed what the S&L regulators and criminologists observed when wesystematically “autopsied” each S&L failure to investigate its causes.  Modern executive compensation has madeaccounting control fraud vastly more criminogenic than it once was asinvestigators of the current crisis have confirmed.

“Over the last several years, the subprime markethas created a race to the bottom in which unethical actors have been handsomelyrewarded for their misdeeds and ethical actors have lost market share…. Themarket incentives rewarded irresponsible lending and made it more difficult forresponsible lenders to compete.”  Miller,T. J. (August 14, 2007).  Iowa AG.

Liar’s loans offer what we call asuperb “natural experiment.”  No honestmortgage lender would make a liar’s loan because such loans have a sharplynegative expected value.  Notunderwriting creates intense “adverse selection.”  We know that it was overwhelmingly thelenders and their agents that put the lies in liar’s loans and the lenderscreated the perverse compensation incentives that led their agents to lie aboutthe borrowers’ income and to inflate appraisals.  We know that appraisal fraud was endemic andonly agents and their lenders can commit widespread appraisal fraud.  Iowa Attorney General Miller’s investigationsfound:

“[Manyoriginators invent] non-existent occupations or income sources, or simplyinflat[e] income totals to support loan applications. Importantly, ourinvestigations have found that most stated income fraud occurs at thesuggestion and direction of the loan originator, not the consumer.”

New York Attorney General (nowGovernor) Cuomo’s investigations revealed that Washington Mutual (one of theleaders in making liar’s loans) developed a blacklist of appraisers – whorefused to inflate appraisals.  No honestmortgage lender would ever inflate an appraisal or permit widespread appraisalinflation by its agents.  Surveys ofappraisers confirm that there was widespread pressure by nonprime lenders andtheir agents to inflate appraisals.

We also know that the firms thatmade and purchased liar’s loans followed the respective accounting controlfraud “recipes” that maximize fictional short-term reported income, executivecompensation, and (real) losses.  Thoserecipes have four ingredients: 
  1.  Growlike crazy
  2.  Bymaking (or purchasing) poor quality loans at a premium yield
  3.  Whileemploying extreme leverage, and
  4.  Providingonly grossly inadequate allowances for loan and lease losses (ALLL) against thelosses inherent in making or purchasing liars loans


Firms that follow these recipesare not “gamblers” and they are not taking “risks.”  Akerlof & Romer, the S&L regulators,and criminologists recognize that this recipe provides a “sure thing.”  The exceptional (albeit fictional) income,real bonuses, and real losses are all sure things for accounting controlfrauds.

Liar’s loans are superb“ammunition” for accounting control frauds because they (and appraisal fraud)allow the fraudulent mortgage lenders and their agents to attain the unholyfraud trinity: (1) the lender can charge a substantial premium yield, (2) on aloan that appears to relatively lowerrisk because the lender has inflated the borrowers’ income and the appraisal,while (3) eliminating the incriminating evidence of fraud that realunderwriting of the borrowers’ income and salary would normally place in theloan files.  The government did notrequire any entity to make or purchase liar’s loans (and that includes Fannieand Freddie).  The states and the federalgovernment frequently criticized liar’s loans. Fannie and Freddie purchased liar’s loans for the same reasons thatMerrill, Lehman, Bear Stearns, etc. acquired liar’s loans – they wereaccounting control frauds and liar’s loans (and CDOs backed by liar’s loans)were the best available ammunition for maximizing their fictional reportedincome and real bonuses. 

Liar’s loans were large enough tohyper-inflate the bubble and drive the crisis. They increased massively from 2003-2007.

“[B]etween2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent,respectively.

Thehigher levels of originations after 2003 were largely sustained by the growthof the nonprime (both the subprime and Alt-A) segment of the mortgage market.”  “Alt-A: The Forgotten Segment of the MortgageMarket” (Federal Reserve Bank ofSt. Louis 2010).
     
The growth of liar’s loans wasactually far greater than the extraordinary rate that the St. Louis Fed studyindicated.  Their error was assuming that“subprime” and “alt-a” (one of the many misleading euphemisms for liar’s loans)were dichotomous.  Credit Suisse’s early2007 study of nonprime lending reported that roughly half of all loans called“subprime” were also “liar’s” loans and that roughly one-third of home loansmade in 2006 were liar’s loans.  Thatfact has four critical implications for this subject.  The growth of liar’s loans was dramaticallylarger than the already extraordinary 340% in three years reported by the St.Louis Fed because, by 2006, half of the loans the study labeled as “subprime”were also liar’s loans.  Because loansthe study classified as “subprime” started out the period studied (2003) as amuch larger category than liar’s loans the actual percentage increase in liar’sloans from 2003-2006 is over 500%.  Thefirst critical implication is that it was the tremendous growth in liar’s loansthat caused the bubble to hyper-inflate and delayed its collapse. 

The role of accounting controlfraud epidemics in causing bubbles to hyper-inflate and persist is anotherreason that accounting control fraud is often criminogenic.  When such frauds cluster they are likely todrive serious bubbles.  Inflating bubblesoptimize the fraud recipes for borrowers and purchasers of the bad loans bygreatly delaying the onset of loss recognition. The saying in the trade is that “a rolling loan gathers no loss.”  One can simply refinance the bad loans todelay the loss recognition and book new fee and interest “income.”  When entry is easy (and entry into becoming amortgage broker was exceptionally easy), an industry becomes even morecriminogenic.    

Second, liar’s loans (and CDOs“backed” by liar’s loans) were large enough to cause extreme losses.  Millions of liar’s loans were made and thoseloans caused catastrophic losses because they hyper-inflated the bubble,because they were endemically fraudulent, because the borrower was typicallyinduced by the lenders’ frauds to acquire a home they could not afford topurchase, and because the appraisals were frequently inflated.  Do the math: roughly one-third of home loans made in 2006 were liar’s loans and theincidence of fraud in such loans was 90%. We are talking about an annual fraud rate of over one million mortgageloans from 2005 until the market for liar’s loans collapsed in mid-2007. 

Third, the industry massivelyincreased its origination and purchase of liar’s loans after the FBI warned of the developing fraud “epidemic” andpredicted it would cause a crisis and then massively increased its originationand purchase of liar’s loans after the industry’s own anti-fraud experts warnedthat such loans were endemically fraudulent and would cause severe losses.  Again, this provides a natural experiment toevaluate why Fannie, Freddie, et alia, originated and purchased theseloans.  It wasn’t because “thegovernment” compelled them to do so. They did so because they were accounting control frauds.

Fourth, the industry increasinglymade the worst conceivable loans that maximized fictional short-term income andreal compensation and losses.  Making (orpurchasing) liar’s loans that are also subprime loans means that the originatoris making (or the purchaser is buying) a loan that is endemically fraudulent toa borrower who has known, serious credit problems.  It’s actually worse than that because lendersalso increasingly added “layered” risks (no downpayments and negativeamortization) in order to optimize accounting fraud.  Negative amortization reduces the borrowers’short-term interest rates, delaying delinquencies and defaults (but producingfar greater losses).  Again, thisstrategy maximizes fictional income and real losses.  Honest home lenders and purchasers of homeloans would not act in this fashion because the loans must cause catastrophiclosses.

To sum it up, the known facts ofthis crisis refute the rival theories that the lenders/purchasersoriginated/bought endemically fraudulent liar’s loans because (a) “thegovernment” made them (or Fannie and Freddie) do so, or (b) because they weretrying to maximize profits by taking “extreme tail” (i.e., an exceptionallyunlikely risk).  The risk that a liar’shome loan will default is exceptionally high, not exceptionally low.  The known facts of the crisis are consistentwith accounting control frauds using liar’s loans (in the United States) astheir “ammunition of choice” in accordance with the conventional fraud “recipe”used that caused prior U.S. crises. 

It is bizarre that in suchcircumstances the automatic assumption of the Bush and Obama administrationshas been that fraud isn’t even worth investigating or considering in connectionwith the crisis.  It is as if millions ofliar’s loans purchased and resold as CDOs largely by systemically dangerous institutionsare an inconvenient distraction from campaign fundraising efforts.  Instead, we have the myth of the virgincrisis unsullied by accounting control fraud. Indeed, contrary to theory, experience, and reality, the Department ofJustice has invented the faith-based fiction that looting cannot occur. 

“BenjaminWagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases inSacramento, Calif., points out that banks lose money when a loan turns out tobe fraudulent. “It doesn’t make any sense to me that they would be deliberatelydefrauding themselves,” Wagner said.”

Wagner’s statement isembarrassing.  He conflates “they”(referring to the CEO) and “themselves” (referring to the bank).  It makes perfect sense for the CEO to lootthe bank.  Looting is a “sure thing” guaranteedto make the CEO wealthy.  “Looting”destroys the bank (that’s the “bankruptcy” part of Akerlof & Romer’s title)but it produces the “profit” for the CEO. It is the deliberate making of masses of bad loans at premium yieldsthat allows the CEO to profit by looting the bank.  When the top prosecutor in an epicenter ofaccounting control fraud defines the most destructive form of financial crimeout of existence he allows elite fraud to occur with impunity.   

As embarrassing as Wagner’s statement is, however,it cannot compete on this dimension with that of his boss, Attorney GeneralHolder.  I was appalled when I reviewedhis testimony before the Financial Crisis Inquiry Commission (FCIC).  Chairman Angelides asked Holder to explainthe actions the Department of Justice (DOJ) took in response to the FBI’swarning in September 2004 that mortgage fraud was “epidemic” and its predictionthat if the fraud epidemic were not contained it would cause a financial“crisis.”  Holder testified:  “I’m not familiar myself with that [FBI]statement.”  The DOJ’s (the FBI is partof DOJ) preeminent contribution with respect to this crisis was the FBI’s 2004warning to the nation (in open House testimony picked up by the national media.  For none of Holder’s senior staffers whoprepped him for his testimony to know about the FBI testimony requires thatthey know nothing about the department’s most important and (potentially)useful act.  That depth of ignorancecould not exist if his senior aides cared the least about the financial crisisand made it even a minor priority to understand, investigate, and prosecute thefrauds that drove the crisis. Because Holder was testifying in January 14,2010, the failure of anyone from Holder on down in his prep team to know aboutthe FBI’s warnings also requires that all of them failed to read any of therelevant criminology literature or even the media and blogosphere.

In addition to claiming that the DOJ’s response tothe developing crisis under President Bush was superb, Holder implicitly tookthe position that (without any investigation or analysis) fraud could not anddid not pose any systemic economic risk. Implicitly, he claimed that only economists had the expertise tocontribute to understanding the causes of the crisis.  If you don’t investigate; you don’tfind.  If you don’t understand“accounting control fraud” you cannot understand why we have recurrent,intensifying financial crises.  If Holderthinks we should take our policy advice from Larry Summers and Bob Rubin,leading authors’ of the crisis, then he has abdicated his responsibilities tothe source of the problem.       

 “Now let mestate at the outset what role the Department plays and does not play inaddressing these challenges” [record fraud in investment banking andsecurities].

“The Department of Justice investigates andprosecutes federal crimes.…”

 “As a generalmatter we do not have the expertise nor is it part of our mission to opine onthe systemic causes of the financial crisis. Rather the Justice Department’s resources are focused on investigatingand prosecuting crime.  It is within thiscontext that I am pleased to offer my testimony and to contribute to your vitalreview.”  

Two aspects of Holder’s testimony were preposterous,dishonest, and dangerous.

“I’m proud that we have put in place a lawenforcement response to the financial crisis that is and will continue to be isaggressive, comprehensive, and well-coordinated.”

DOJ has obtained ten convictions of senior insidersof mortgage lenders (all from one obscure mortgage bank) v. over 1000 felonyconvictions in the S&L debacle.  DOJhas not conducted an investigation worthy of the name of any of the largestaccounting control frauds.  DOJ isactively opposing investigating the systemically dangerous institutions (SDIs).

Holder’s most disingenuous and dangerous sentence,however, was this one:

“Our efforts to fight economic crime are a vitalcomponent of our broader strategy, a strategy that seeks to foster confidencein our financial system, integrity in our markets, and prosperity for theAmerican people.”


Yes, the “confidencefairy” ruled at DOJ.  It is the rationalenow for DOJ’s disgraceful efforts to achieve immunity for the SDIs’ endemicfrauds.  The confidence fairy trumped andtraduced “integrity in our markets” and “prosperity for the Americanpeople.”  Prosperity is reserved for theSDIs and their senior managers – the one percent.



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.

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Corruption and Crony Capitalism Kill

Posted on October 31, 2011 by | Comments Off on Corruption and Crony Capitalism Kill

By William K. Black

The recent Turkish earthquake, as with its modern predecessors, has shown that the witches’ brew that crony capitalism produces is a leading cause of death and severe injury. Control fraud, the use of a seemingly legitimate entity by those that control it to defraud, exists in all three major sectors – private, public, and non-profit. Crony capitalism typically involves the interaction of public and private sector control fraud. I have written primarily about accounting control frauds, which are property crimes of mass destruction. Anti-customer, anti-public, and anti-employee control frauds can all cause mass casualties. Earthquakes and the tsunamis they produce can kill hundreds of thousands of people. Government programs have been exceptionally successful in reducing the loss of life from natural disasters. Early warnings, evacuation routes, barriers, and training can greatly reduce the losses caused by tsunamis. Seismic building codes, if properly enforced, can reduce direct deaths from earthquakes to exceptionally low levels even in severe seismic events. The saying is: earthquakes don’t kill people; collapsing structures do.

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An Open Letter to California Attorney General Harris

Posted on October 7, 2011 by | 1 comment

By William K. Black

First, let me join with New York Attorney General Schneiderman in congratulating you for your decision to withdraw from the mortgage foreclosure settlement. Two of the states with the largest number of victims have decided that the proposed settlement is inadequate and dangerous because of the scope of the releases. Your explanation for your decision in your letter to Attorney General Miller was concise, polite, and persuasive. Attorney General Miller deserves credit for his efforts – four years ago – to warn the Federal Reserve about endemic mortgage fraud by nonprime lenders. I quote key passages from his warnings below.

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Why do Banking Regulators bother to Conduct Faux Stress Tests?

Posted on September 20, 2011 by | Comments Off on Why do Banking Regulators bother to Conduct Faux Stress Tests?

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

One of the many proofs that banking regulators do not believe that financial markets are even remotely efficient is their continued use of faux stress tests to reassure markets. But why do markets need reassurance? If markets do need reassurance that banks can survive stressful conditions, why are they reassured by government-designed stress tests designed to be non-stressful?

Stress tests were first mandated for Fannie and Freddie by statute. Fannie and Freddie’s managers referred to them as “nuclear winter” scenarios – impossibly unlikely and stark disasters. The managers used the ability of Fannie and Freddie to pass the stress tests as proof that the institutions were safe and so well capitalized that they could survive even a lengthy depression. In reality, Fannie and Freddie had exceptionally low capital levels. Fannie and Freddie met their capital requirements under a newly toughened version of the statutory stress test weeks before they collapsed and were revealed to be massively insolvent.

AIG passed its stress test immediately before it failed. The three big Icelandic banks passed their stress tests shortly before they were revealed to be massively insolvent. Lehman passed its stress tests. The stress tests ignored the actual primary causes of losses and failures – extreme losses on fraudulent liar’s loans and CDOs.

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William Black: Why Nobody Went to Jail During the Credit Crisis

Posted on September 17, 2011 by | 5 comments

Jim welcomes Professor of Economics and Law William Black to Financial Sense Newshour. He explains to Jim why no one has gone to jail four years after the beginning of the historic Credit Crisis. Professor Black believes that the level of corruption and fraud is so pervasive that very few of the guilty will ever be brought to justice.

Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.
(Click here to listen to the interview)

Transcript

Jim Puplava: Joining me on the program is Professor William Black. He is a Lawyer and an Associate Professor of Economics and Law at the University of Missouri, Kansas City. He was a Director of the Institute for Fraud Prevention from 2005 to 2007. He taught at the LBJ School of Public Affairs at the University of Texas. He was also a Litigation Director for the Federal Home Loan Bank Board. He is also author of the book “The Best Way to Rob a Bank Is to Own One.”

And Professor, you played a critical role during the S&L crisis in exposing congressional corruption. During that period of time, a lot of corruption was exposed; a lot of people in the financial sector went to jail, including Charles Keating. I wonder if you would contrast that to the last credit crisis, let us say from 2007 to 2009 where a lot of money was lost, a lot of things went wrong, but nobody went to jail. Instead of going to jail, they walked out instead with multi-million dollar bonuses. What was the difference, what was behind this in your opinion?

William Black: Well, I say the both of them were driven by fraud. The Savings & Loan crisis was a tragedy in two parts. First part was not fraud, it was interest rate risk. But the second phase, which was vastly more expensive, was to defraud and the National Commission that looked into the causes of the crisis said that the typical large failure fraud was invariably present. And there were real regulators then. Our agency filed well over 10,000 criminal referrals that resulted in over 1,000 felony convictions and cases designated as nature. And even that understates the grade in which we went after the elite. Because we worked very closely with the FBI and the Justice Department, to prioritize cases—creating the top 100 list of the 100 worst institutions which translated into about 600 or 700 executives—and so the bulk of those thousand felony convictions were the worst fraud, the most elite frauds.

In the current crisis, of course they appointed anti-regulators. And this crisis goes back well before 2007 and of course it is continuing, it does not end at 2009. So the FBI warned in open testimony in the House of Representatives, in September 2004—we are now talking seven years ago—that there was an epidemic of mortgage fraud, their words, and they predicted that it would cause a financial crisis, crisis being their word, if it were not contained. Well no one thinks that it was contained.

All right so you have massive fraud driving this crisis, hyperinflating the bubble, an FBI warning and how many criminal referrals did the same agency do, in this crisis. Remember it did well over 10,000 in the prior crisis. Well the answer is zero. They completely shut down making criminal referrals and whichever administration you hate the most, you can hate because while most of this certainly occurred in the Bush Administration, the Obama Administration has obviously not changed it. Obviously did not see it as a priority to prosecute these elite criminals who caused this devastating injury.

Another way to look at it is, how much fraud is there and we know the following: There are no official statistics on sub prime and similar categories because there are no official definitions. So there is a little wishy-wishy in this but the best numbers we have are that by 2006, half of all the loans called sub-prime, were also liars loans. Liars loans means that there was no prudent underwriting of the loan. And total, about one-third of all the loans made in 2006, were liars loans.

Now that’s an extraordinary number, especially when you look at the studies. And here I am going to quote from the Mortgage Bankers Association. That is the trade association of the perps and this is their Anti-Fraud Specialist Unit, and they reported this to every member of the Mortgage Bankers Association in 2006. So nobody can claim they did not know. They found three critical things, first they said this kind of loan where you do not do underwriting is, and I am quoting again, “an open invitation to fraudsters.” Second, they said “the best study of this found a 90% fraud incident.” In other words, if you look at 100 liars loans, 90 of them are fraudulent. And third they said, therefore these loans where the euphemism is stated income are Alt-A loans, actually deserve the title that the industry calls the Behind Closed Doors, and that is liars loans. The other thing we know from other studies and investigations, is that it was overwhelmingly lenders and their agents that put the ‘lie’ in liars loans. Now that is obvious when you look at the lies about appraisals, because homeowners cannot inflate appraisals. But lenders can and how they did it was shown in an investigation by then New York Attorney General Cuomo, now Governor, who found that Washington Mutual, which is called WAMU, and is the largest bank failure in the history of the United States, and indeed the history of the world, had a black list of appraisers. But you got on the black list if you were an honest appraiser, and refused to inflate the appraisal.

Similarly, we know that you could get, for example, a California jumbo mortgage, that’s one say the size of $800,000. As a loan broker, just one of these, you could get a fee of $20,000. If it hit certain parameters. And those parameters would have to do with what is the interest rate, but also what is the loan to value ratio, and what is the debt to income ratio. So the loan to value ratio is how big is the loan compared to the value of your house. Well that is an easy ratio to gimmick, and we have just explained why, by inflating the appraisal. If you inflate the appraisal then the loan to value ratio falls and the loan looks like it is a lot safer, and you can sell it to Wall Street for significantly more. The debt to income ratio, well that is even easier to gain. The debt is simply how much are you going to borrow to buy the house. And the income is, what is the income stated on the loan application for the borrower. Except that this is a liars loan, so the lender has agreed that it is not going to check. It is not going to verify whether the income is real. And so the loan broker can write down any income number he or she wants. And that will gimmick that ratio and again it will put it into the sweet spot, for all of these things, so that you could get your $20,000 fee. Now step back and ask yourself, many of these guys who are loan brokers, their previous job was literally flipping burgers, right. So are you going to leave it up to the borrower to come up magically with the right income and the right appraisal when they don’t even know what the magic numbers are and cannot inflate the appraisal? Of course not. You are going to do it as the loan broker. You are going to tell the borrower to write in a greatly inflated income number, or maybe you are afraid that they are too honest, so you may simply write it in yourself, which happened in many cases.

So again, we got thirty, roughly one-third of all the loans by 2006, after these warnings. They rapidly increased the number of liars loans they made. One-third of them are liars loans and 90% of them are fraudulent, which is to say, that the amount of fraud annually was well over a million fraud a year. We are talking about hundreds of billions of dollars in fraudulent instruments.

Jim Puplava: Professor, I guess one question I would have is, did the guys at the top of the bank not know that this was going on? I mean I would find it hard to believe that if I am the CEO of a financial organization, that I don’t know that our loan standards, that we went to liar loans and that we were not documenting or verifying. I mean what happened to 20% down, two years worth of tax returns, I mean how would somebody at the top, not know this.

William Black: You mean you think liars loan might be a hint?

Jim Puplava: Yeah, maybe just a little (sarcasm).

William Black: Yeah, we have known for centuries, that if you don’t underwrite loans, or if you don’t underwrite insurance, you’ll get something called “adverse selection”. And that means you get the worse possible borrowers or people being insured and the expected value of lending to somebody, in conditions of serious adverse selection, is negative. Or to put that in English, that means if you lend this way, you lose money. And we have known this for centuries. This is like betting against the house in Las Vegas. You could win some individual bets, but you stay at the table for three years, and you are going to lose everything. And as we say, you will lose the house, to the house. And, that is exactly what is going to happen here. So yeah, the CEO’s knew all about this. Why did they do it? And the answer is, here is the recipe, it’s got four ingredients for creating what the Nobel Prize Winner in Economics, George Akerlof and his colleague Paul Romer said in 1993 was “a sure thing”. And that sure thing is what in criminology we call accounting control fraud.

So control fraud is when the person who controls a seemingly legitimate entity, uses it as a weapon to fraud. In the financial sphere, the weapon of choice is accounting. So here are the four ingredients of the recipe that produce a sure thing of record accounting income.

  1. Grow like crazy
  2. Make preposterously bad loans but at a premium yield.
  3. Have extreme leverage. That means you have a ton on debt.
  4. Put aside only ridiculously low allowances for future loan losses.

You do those four things, you are mathematically guaranteed to report record, albeit fictional, profits in the short term. You are also guaranteed with modern executive compensation, to make the Senior Executives wealthy, and you are guaranteed, because after all, if you think about those four ingredients, they are the perfect recipe as well for maximizing real losses. And that’s why the title of Akerlof and Romer’s article says it all, “Looting: The Economic Underworld of Bankruptcy for Profit.” The firm fails but the executives walk away rich. This is the same concept with my book “The Best Way to Rob a Bank Is to Own One.” It is these internal people who control the seemingly legitimate entity that can get away with financial murder. And here is the really bad news. I mean that is bad news right there, but the really bad news, is that this tends to happen as the FBI warned, and again in 2004, seven years ago. So the next time you hear some moron tell you that no one could have predicted this, it was predicted by the Premiere Law Enforcement entity in the world dealing with white-collar crime.

Jim Puplava: You know, we just talked about, with these liar loans being made, the executives at the top knew that this was going on. But it was driving record profits that they were reporting, their stock prices were going up. They were getting paid bonuses and you know their option values were worth just, you know, some of these compensation packages were just unreal. But here’s the thing that I guess some of these people did know as we mentioned the executives at the top, but some knew how to make profit from them. For example, we found out in congressional testimony that Goldman Sachs at the same time that they were selling these mortgage polls to let’s say many of it’s customers, at the same time, internal memos and e-mails said the stuff was garbage and they were shorting it, making money. Is it because they control so many of Congress that this time there was no law enforcement by the regulators coming in and looking at these guys that walked away with these bonus packages. Or the fact that you had conflicts of interest of selling bogus mortgage polls that you knew that were garbage. And at the same time you were selling them to a customer, you were taking the opposite side of the trade and shorting it.

William Black: So to just close the loop on what I was saying, if a bunch of folks follow the same strategy at the same time, they hyper-inflate a financial bubble. And when you have huge financial bubbles and they collapse, that’s when you get great recession. So your question is, so why, this is the greatest financial crime in the history of the world and no one senior, at any of the major places that drove the crisis, has gone to jail? In fact, no one has been indicted. There were some at Bear Stearns, for the real specialized stuff, but for the basic fraud we are talking about, no one has even been charged with a crime. What has happened? And the answer, the first answer is it all has to start with the regulators. The regulators have to serve as the Sherpas on something like this, in criminal prosecution. The Sherpas of course, are the folks that help you get to the top of the Himalayan Mountains. And this is a hard task, it is hard to prosecute sophisticated white-collar crimes, and they do have the best criminal defense lawyers in the world. So it is not an easy thing. And getting those thousand plus felony convictions in the Savings and Loan crisis, was a massive success for which the Department of Justice, the FBI and the agencies deserve a lot of credit. What do the Sherpas do? The Sherpas do two functions. One, they do the heavy lifting and in this context, that means they the great bulk of the investigative work. And two, they serve as the guides, they have the expertise, they’ve seen this before, they know what works and what does not. And in this context, that means they have expertise in the fraud mechanisms, the fraud schemes, identifying it and explaining it. And so a criminal referral is not just a sort of a useful thing, it is the absolutely essential thing. Criminal referral in our era might be twenty to thirty pages and have two hundred to three hundred pages of attachments of all the key documents. It would be the roadmap to continue this metaphor that says, here’s the fraud, here’s how it works, here are the key people, here is where the money moved, here are the key documents to be able to prove the case. Here are the key witnesses, this is how you contact them, right? And I told you that we went to zero criminal referrals from well over ten thousand. That has made it impossible for the FBI and the justice department to have any substantial success. But of course, this is not the question of them simply not having substantial success, they ain’t having no success. And there you have to look at what, after a brilliant start with this September 2004 warning, with no help from the regulators, well you could not get any significant number of FBI agents assigned in the Bush Administration, to investigate these cases.

Now part of what has happened is in some sense understandable, when the 9/11 attacks ten years ago occurred, we of course found that our national security FBI agents, could not infiltrate Al Qaeda. So what we could do is follow the money. And the experts at following the money are the white-collar FBI agents. So they transferred 500 white collar FBI Specialists, over to National Security. Okay, we can understand why they do that. What you cannot understand is why the Bush Administration refused to allow the FBI to replace this enormous loss of white-collar specialists. And so as a whole, white collar prosecutions fell significantly in the Bush Administration. That meant that as recently as fiscal year 2007, there were nationwide, only 120 FBI agents working all mortgage fraud cases. To give you a comparison, at the peak of the Savings and Loan Crisis, there were 1,000 FBI agents working the cases.

Jim Puplava: Wow

William Black: Eight times more FBI agents than were working the cases in fiscal year 2007. And this crisis is forty times bigger and worse than the Savings and Loan Crisis. So you would have required massively more people. To give you another idea of scope, to investigate Enron, and Enron was complex, but it was nowhere near as big and as complex as Washington Mutual. It took 100 FBI agents. So you can see that with 120 nationwide, at most you could have done one major case. But instead, they divided them up in what the military would call, Penny Packets, which is to say two or three agents per field office. And that means they cannot investigate anything substantial. So they were put on relatively smaller cases. And they being diligent FBI agents, they worked those cases, and that’s where they wrote the memos, okay we found this, prosecute these people, don’t prosecute these people. The FBI in late 2007 – 2008, figures out this cannot work. Remember I told you there were over a million cases of mortgage fraud a year and that overwhelmingly it’s lenders who foot the fraud, the lie in the liars loan. But the FBI couldn’t and didn’t investigate any of the major lenders. So it is looking at these relatively small folks, and that is what it reports back. The FBI decides you know, as I said, this cannot work. This is like going to a beach in San Diego and throwing handfuls of sand in the Pacific Ocean and wondering when you are going to be able to walk to Hawaii. Every year, with a million plus cases of fraud a year, if you prosecute a thousand of them or two thousand of them or three thousand of them, you are a million cases further behind every year, right. It is just insane. So the FBI says we got to start going after the big guys at which point Bush’s Attorney General Mukasey says no, he refuses to even create a National Task Force against mortgage fraud, saying famously, this is simply the equivalent of, and I am quoting again, “White Collar Street Crime,” little tiny stuff. Well of course he has assigned the FBI to only look at little cases and they report back, hey we’re finding little cases. And the Mukasey interprets from that, hey only little cases exist.

Jim Puplava: Yeah, but you know, in the S&L Crisis, you had some high profile cases. For example Charles Keating, and that got a lot of play. So maybe if they didn’t have the manpower, maybe going after some very high profile cases, might have made the point. You are saying they backed off from that. What about the Obama Administration?

William Black: They never did it. They didn’t even back off. They never, you can tell from the numbers that they have, in how many FBI personnel it takes to do a really sophisticated, large institutional investigation. They have never done what would have been considered a real investigation in the Savings and Loan era of any, any of the major fraudulent lenders and investment banks that created the worthless financial derivates—not worthless, but not worth very much—financial derivatives.

Jim Puplava: What about the Obama Administration? Had they came in, they continued with the same policy basically, they ignored it. Where they could have had let us say, an opportunity. Is it because Professor, that the process is you know, some have said that Congress is bought and paid for by the financial industry. I mean, is that part of the reason?

William Black: Well, it’s not just Congress of course. The President has said that he wants to raise a billion dollars in the reelection effort and despite all the press you may have heard about how the White House is despised by finance—in fact, last I read, a bigger percentage and a bigger absolute dollar amount of contributions in this effort, than in the original effort had come from finance. And so both parties are tremendously beholden to finance. That is part of it but again, the Obama Administration was better than the Bush Administration. The Obama Administration was willing to create a task force and it’s the numbers of FBI Agents have been increased, but they are still looking at relatively small cases. And they are nowhere near the numbers required and so unless something dramatic or radical changes, this is going to be the greatest case of elite fraud with impunity in the history of the world. And it is only going to change if we express our outrage as the people and demand that it is changed. Let me tell you how bad it is. The Federal Housing Finance Administration, has just last week, or about ten days ago now, filed fifteen hundred plus pages of complaints against seventeen financial entities. And about ten of them are among the biggest financial entities in the world saying, every investigation has found repeated enormous fraud at these entities. So, and there is a track record, a paper trail of that fraud. But these entities got reports saying these assets were trash and that they lied and then sold the assets to Fannie and Freddie by making acts of deceit, which is of course, the key element of fraud.

So, now that this has happened, there are really only two possibilities. Either the Federal Housing Finance Administration has gotten all those documents wrong, and there is no such record, or there is such a record in which case, where is the Justice Department, why is it not bringing criminal prosecution against most of the largest banks in the world.

Jim Puplava: You know, there was a documentary film called “Inside Job,” which won an Oscar this year, and it ended with the Director and Producer pointing out the fact that you just brought up—not one single prosecution was brought in this entire situation, what is probably the largest fraud committed in history. And yet it still goes on Professor, we still have the financial industry contributing large amounts of money to politicians in both parties, both at the national level, the local level, and so basically, what you have is influence buying here. Because it seems to me that there were so many obviously cases, even in the hearings, where I think it was, Senator Levin, basically talking about the conflicts of interest in internal e-mails. I thought my goodness, there was enough evidence to go after but not one thing was done. And even when a lot of these firms went under, as the shareholders lost everything, the taxpayers losing everything, the guys at the top walked away with some of the biggest bonus packages I’ve seen in my investment career.

William Black: Again, Akerlof and Romer have been proven correct. Akerlof and Romer worked with us and strongly support the kind of efforts that need to be done. The title of their article again is “Looting: The Economic Underworld of Bankruptcy for Profit.” The firm failed because you followed the fraud recipe that I gave you, which causes catastrophic losses but their CEO’s and other Senior Officers can walk away incredibly rich. There is, by the way, one case and was done after the movie, the documentary that you are talking about, and it’s the proverbial exception that proves the rule. The Taylor case, and it refers to a pretty obscure mortgage-banking firm in the southeast. Ten people have been convicted who were officers. But the only reason they were convicted was because these people after thousands of acts of fraud, over a ten-year period, tried to defraud the TARP Program and the Special Inspector General to the TARP Program, which is called SIGTARP, was very good. He has since left the government service. And they found this and they made the criminal referral. What we discovered in the course of that, was that Fanny Mae discovered this fraud in 2000 but refused to make a criminal referral.

They refused to make a criminal referral because it wanted to secretly dump the paper that had been provided by this mortgage-banking firm. And so the mortgage banking firm, the fraudulent mortgage banking firm, they would have been caught red handed doing the frauds. Simply went across the street, metaphorically, and defrauded Freddie Mac for nine years. So again, if people, I do not understand who have never done this, how absolutely critical the criminal referrals are.

Jim Puplava: Well, it seems like as we have seen here, as you pointed out, zero criminal referrals have been brought in this entire case, and you just cannot help but believe that this goes on and meanwhile, you and I as taxpayers, are going to have to front the bill for this. It is unfortunate. Let me ask you a final question, we supposedly as a result of all of this, we had Dodd Frank, that was supposed to bring in like Sarbanes-Oxley, all this financial legislation that would basically prevent this kind of thing from happening again. Will Dodd Frank help us in this way or is it just more red tape and which is useless if regulators and let’s say the FBI, aren’t allowed to do their job.

William Black: Dodd Frank has some individual components that are useful and the Republican Party unfortunately is trying to kill each of them. The Administration is not necessarily fighting strong for any, the Dodd Frank Bill was not created and designed to deal with the actual causes of the crisis. And so it most likely will not stop the next crisis. But the focus on legislation is a bit misleading. Under the existing laws and regulation, this was an easy crisis to prevent. People think of it as much more difficult and complex. But as I say, it was overwhelmingly driven by liars loans. Liars loans were easy to figure out. We, as regional regulators in 1990 and 1991, killed a wave of liars loans that was starting, especially in Orange Country Savings and Loans. And as a result, those lenders gave up their Federal Deposit Insurance precisely to escape our jurisdiction, and created mortgage banks. But the Fed, the Federal Reserve Board, had authority from 1994 on, in other words, a long time before the crisis, to regulate anybody that did home loans. And it was an easy call that something called a liars loan had to be stopped. Alan Greenspan and Ben Bernanke refused to do their statutory authority to stop them. Because they didn’t believe in regulation. Bernanke was reappointed by President Obama. You know, I tried as little, what one little person could, to stop that. We need to have a complete new crew. Geithner needs to go, Attorney General Holder needs to go, and Bernanke needs to go and we need to put people in who will make a high priority ending the ability to loot institutions with impunity.

Jim Puplava: Yeah, that was one of the aspects that was brought out in the documentary, “Inside Job.” A lot of the people, Larry Summers who until recently was in the Obama Administration, Geithner, Alan Greenspan tried to stop Brooksley Born on derivatives. And it seems like the guys that were behind all of this are the same people that have been put in charge of fixing it. Well listen Professor, your book once again is “The Best Way to Rob a Bank Is to Own One.” And you have written several articles so if our listeners would like to follow the work that you do, I hope you keep up the good work because we do need hopefully some day we will get honest people in there that will care more about doing what is right than about their positions and the pay that they get.

William Black: We have written hundreds of articles that if folks are interested, check out “New Economic Perspectives”, the UMKC Economics blog.

Jim Puplava: Okay, one more time?

William Black: “New Economic Perspectives”, the blog of the Economics Department at the University of Missouri at Kansas City.

Jim Puplava: All right, well we have been speaking with Professor Black, Professor thank you for coming on the program and helping to clarify why this big crime really went unpunished, which is a real tragedy for not only most Americans but all of us as taxpayers who have paid for the bill.

William Black: Thank you sir, take care.

Jim Puplava: Thank you.

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Who Put the Rot in Herr Hummler’s Wurst?

Posted on September 12, 2011 by | 5 comments

By William K. Black

 
I write this column as I am flying home from presenting a keynote address Friday to the 32nd annual Burgenstock Meeting (now held in Interlaken, Switzerland).  The Burgenstock meeting is one of the top international meetings on financial derivatives and attracts a mixture of senior regulators, market participants, and a scattering of academics.  I changed the presentation I intended to make entirely in order to respond to Thursday’s famous Thursday keynote presenter, Dr. Hummler, the head of the oldest private bank in Swizerland.  Dr. Hummler is famous for his monthly newsletters, which goes out to a select mailing list of 100,000 and often prompt significant discussion.  I found his keynote address provocative.  I was not adequately aware of his work, so I stayed up until 4:00 a.m. researching his positions and then prepared a new keynote address responding to his central thesis.

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FHFA Complaints: Can Control Frauds Recover for Being Defrauded by other Control Frauds?

Posted on September 6, 2011 by | Comments Off on FHFA Complaints: Can Control Frauds Recover for Being Defrauded by other Control Frauds?

By William K. Black 

(Cross-posted from Benzinga.com)

Reading the FHFA complaints against many of the world’s largest banks is a fascinating and troubling process for anyone that understands “accounting control fraud.” The FHFA, a federal regulatory agency, sued in its capacity as conservator for Fannie and Freddie. Its complaints are primarily based on fraud. The FHFA alleges that the fraud came from the top, i.e., it alleges that many of the world’s largest banks were control frauds and that they committed hundreds of thousands of fraudulent acts. The FHFA complaints emphasize that other governmental investigations have repeatedly confirmed that the defendant banks were engaged in endemic fraud. The failure of the Department of Justice to convict any senior official of a major bank, and the almost total failure to indict any senior official of a major bank has moved from scandal to farce.

The FHFA complaints are distressing, however, intheir failure to explain why the frauds occurred and how an accounting controlfraud works.  The FHFA complaint againstCountrywide is particularly disappointing because it accepts hook line andsinker Countrywide’s internal claim that it acted improperly for the purpose ofattaining a larger market share. Executive compensation drops entirely out of the story even though it isthe reason the frauds occur and the means by which controlling officers loot“their” banks.  The FHFA complaintagainst Countrywide ignores executive compensation.  The FHFA complaint against J.P. Morgan(purchaser of WaMu) mentions only that loan officers’ compensation was based onloan volume rather than loan quality. 

The complaints fail to explain the extraordinarysignificance of widespread appraisal fraud – something that only the lender andits agents can produce and a “marker” of accounting control fraud.  No honest lender would inflate, or permit tobe inflated, appraisals.

The complaints also fail to explain why no honestmortgage lender would make “liar’s” loans. The FHFA complaint against Countrywide notes that Countrywide loanofficers would use undocumented loans to aid their creation of fraudulent loanapplications.

Even neoclassical economists – the weakest of allfields in understanding fraud – understand that this crisis was driven byexecutive compensation.  Consider theadmirably short piece entitled
“Fake alpha or Heads I win, Tails you lose” by Raghuram Rajan.  Rajan’spiece is badly flawed, but it at least understands the importance ofcompensation, accounting, and risk. 

“Whatthe shareholder will really pay for is if the manager beats the S&P 500index regularly, that is, generates excess returns while not taking more risk.Hence pay for alpha.”
Rajan is correct that the neoclassicaltheory of CEO compensation is that the CEO should only be compensated for high (“excess”)returns if they were not generated by“taking more risks.”  Modern bonus plans oftenpurport to provide exceptional compensation to CEOs who achieve extreme short-term“excess” returns that are not generated by “taking more risks.”  Rajan gets the next point analytical pointcorrect as well:  “In reality, there areonly a few sources of alpha for investment managers.  [S]pecial ability is by definition rare.”  It is the “rare” CEO who can achieve massivebonuses through exceptional performance, but all CEOs desire massive bonuses.  
Rajan gets the next step in theanalytics correct – the answer to the CEO’s dilemma is to create “fake alpha,”but he falls off the rails in the last clause.
“Alphais quite hard to generate since most ways of doing so depend on the investment managerpossessing unique abilities – to pick stock, identify weaknesses in managementand remedy them, or undertake financial innovation. Unique ability is rare. Howthen can untalented investment managers justify their pay? Unfortunately, alltoo often it is by creating fake alpha – appearing to create excess returns butactually taking on hidden tail risk.” 
In his recent book, Rajan explainsthat by “hidden tail risk” he means taking risks that will only cause losses inhighly unusual circumstances.  I willreturn to why this aspect of Rajan’s reasoning is false. 
Rajan gets the next part correct– generating fake alpha will cause the bank to fail when the risks blow up.  Rajan’s “tail risk” theory, however, predictsthat these risks will only blow up rarely.
Rajan then stresses, correctly,that executive compensation based largely on short-term reported income willcreate perverse incentives to generate fake alpha.  He also        
“Truealpha can only be measured in the long run ….  Compensation structures that reward managersannually for profits, but do not claw these rewards back when lossesmaterialize, encourage the creation of fake alpha.”
Rajan, being a good neo-classicaleconomist, recognizes the vital need to change compensation, but has no urgencyabout doing so. 
“[U]nlesswe fix incentives in the financial system, we will get more risk than webargain for. And the enormous pay of financial sector managers, which has hithertobeen thought of as just reward for performance, will deservedly come underscrutiny.”
Corporations have changedexecutive compensation in response to the crisis – by making it even moredependent on short-term reported income. Rajan does not ask why corporations base executive compensation onshort-term reported income without clawbacks. Rajan is correct that such compensation systems create intenselyperverse incentives that cause managers to loot the shareholders and creditorsand cause the bank to fail. 
Rajan’s extreme tail risk theorydescribes an accounting control fraud. Rajan does not understand that he is describing conduct that wouldconstitute accounting fraud.  Rajan alsodoes not understand that his hypothetical has nothing to do with what actuallyhappened in the crisis.  The extreme tailrisk scheme he hypothesizes would be a terrible fraud scheme.  He does not understand accounting controlfraud.
The real investments that drovethe financial crisis were not assets that would suffer losses only in rarecircumstances.  They were nonprimeloans.  Roughly 30% of total loansoriginated by 2006 were “liar’s” loans – with a 90% fraud incidence.  Liar’s loans and subprime are not mutuallyexclusive categories.  By 2006, half ofall loans called subprime were also liar’s loans.  Appraisal fraud was also epidemic.  The probability of endemically fraudulentloans causing losses (instead of fictional “excess return”) was certainty.  The loss recognition could only be delayedthrough a combination of accounting fraud (failing to provide remotely adequateallowances for loan and lease losses (ALLL)) and hyper-inflating thebubble.  Hyper-inflating the bubbleincreases the ultimate losses.
Making extreme tail riskinvestments is a deeply inferior fraud scheme. Rare risks produce tiny risk premiums and the entire game is to createsubstantial risk premiums.  Making liar’sloans allows exceptional growth (part one of the fraud “recipe” for a lender)and booking a premium yield (if one engages in accounting fraud on theALLL).  The key is found in GeorgeAkerlof and Paul Romer’s article title – “Looting: the Economic Underworld ofBankruptcy for Profit” (1993).  As theycorrectly observed, the fraud recipe is a “sure thing” – it maximizes(fictional) short-term reported income, executive bonuses, and real losses.
Rajan got many things correct andmany things wrong about generating fake alpha, but at least he sought toexplain the perverse dynamic.  The FHFAcomplaints lose explanatory power and persuasiveness because they ignorecompensation and accounting.  It pays tounderstand accounting control fraud.       
                 

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The Washington Mutual Wish List: Optimizing a Criminogenic Environment

Posted on August 30, 2011 by | 3 comments

By William K. Black

(Cross-posted from Benzinga.com)

On November 7, 2007, the Financial Services Roundtable released its “The Blueprint for U.S. Financial Competitiveness.” I explained in a three-part series of columns how Federal Home Loan Bank Board Chairman Ed Gray and Office of Thrift Supervision Director Tim Ryan led crackdowns on the “control frauds” that caused the S&L debacle. I emphasized how Gray did so in the face of enormous political opposition from the Reagan administration, Speaker of the House Jim Wright, a majority of the House of Representatives, and the “Keating Five.” One of the odd moments during these political attacks was that a Republican Representative from the Dallas area requested a meeting with Gray when Speaker Wright’s attacks on Gray’s reregulation of the industry and actions against the control frauds were becoming public an notorious. In my naiveté, I thought that Bartlett requested the meeting to support his fellow Republican, Gray. Of course, Bartlett’s purpose was the opposite. He was enraged by our efforts against the Texas control frauds and wanted us to back off. Years later, after a stint as Dallas’ mayor, the Financial Services Roundtable made Bartlett its head, a position he continues to occupy.

Naturally, Bartlett learned nothing productive from being proven disastrously wrong about the S&L debacle. The financial industry chose him as its lead representative because he never learned. He remains an implacable anti-regulator.

The Blueprint describes and situates this anti-regulatory effort, which was the product of a “Blue Ribbon Commission” co-chaired by “Richard M. Kovacevich, Chairman, Wells Fargo & Company; and James Dimon, Chairman and CEO, JPMorgan Chase and Co.”

“Within the past year, three reports on U.S. financial competitiveness—including the Bloomberg-Schumer Report—have called for a system of principles-based regulation. Last March, Treasury Secretary Henry M. Paulson, Jr. said, “[W]e should also consider whether it would be practically possible and beneficial to move to a more principles-based regulatory system as we see working in other parts of the world.”

The Blueprint was part of a coordinated anti-regulatory effort with Goldman Sachs alums at the U.S. Treasury Department and the Chamber of Commerce.

“Three major studies – the bipartisan report by New York Mayor Michael R. Bloomberg and New York Senator Charles E. Schumer (D-NY), the U.S. Chamber report, and the study by the Committee on Capital Markets – have concluded that the United States is losing its position as the world’s leading financial marketplace.1”

The text of the footnote shows the “race to the bottom” rationale that characterized each of these purportedly “independent” “studies.”

“1 Michael R. Bloomberg and Charles E. Schumer, Sustaining New York’s and the US’ Global Financial Services Leadership, January 2007 at www.nyc.gov; hereafter, Bloomberg-Schumer Report. See also Michael R. Bloomberg and Charles E. Schumer, “To Save New York, Learn from London,” Wall Street Journal, November 1, 2006, p. A-18; Committee on Capital Markets Regulation, Interim Report, November 2006 at www.capmktsreg.org; hereafter, Interim Report; Commission on the Regulation of U.S. Capital Markets in the 21st Century (U.S. Chamber of Commerce), Report and Recommendations, March 2007 at www.uschamber.com; hereafter, U.S. Chamber Report.”

“To Save New York, Learn from London.” Mayor Bloomberg and Senator Schumer (D. NY) urged the U.S. to adopt the UK’s approach to financial regulation, which during this era was the three “de’s” – deregulation, desupervision, and de facto decriminalization. Henry Paulson was confirmed by the Senate as Bush’s Treasury Secretary on June 28, 2006. Paulson’s top priority was deregulation. In particular, he worked to weaken Sarbanes-Oxley (SoX) on an urgent basis. Paulson’s strategy was to generate a series of anti-regulatory studies and proposals that would serve as the basis for a broad legislative assault on what remained of financial regulation. He was gearing up to propose this assault when the markets collapsed. This led to the March 31, 2008 roll out of the Treasury’s incoherent “reform” package. The Paulson plan was incoherent for an excellent reason. His plan’s analysis consisted overwhelmingly of an embrace of the standard anti-regulatory “race to the bottom” dynamic contained in the Blueprint, the Bloomberg-Schumer writings, and the Chamber of Commerce, married to a grudging concession that financial regulation had been too weak. This made no sense, for the U.S. and most of the Western world had just run a real world experiment in which the three “de’s” had once again proven intensely criminogenic precisely because they invariably lead to the “bottom.” Paulson’s plan was dead on arrival.

By late March 2008, the absurdity of embracing the anti-regulatory “race to the bottom” – and then admitting that the dynamic was disastrous – was so obvious that the public reacted with scorn to the Paulson plan. The Blueprint’s analytics presented in support of the race to the bottom were even worse than the analytics presented by Paulson, for they did not contain any concession that such a race must cause regulation to become catastrophically weak and lead to crises. The Blueprint was very late in the game – November 2007. The bubble had collapsed over a year ago. Most large mortgage banks had failed – catastrophically. Nonprime mortgage defaults were surging. The secondary market in nonprime mortgages collapsed. The authors of the Blueprint knew that the central dynamic they were embracing – the purported “need” to “win” the anti-regulatory race to the bottom – had again proven disastrous.

“More recently, the liquidity crisis and ensuing credit crunch in several significant capital markets sectors has revealed weaknesses in the regulatory system. Many homeowners have been confronted with the prospect of foreclosure, and U.S. financial markets have been roiled by problems that can be traced to aggressive practices by some firms, gaps between national and state regulation of the U.S. mortgage industry, and opaqueness in some structured financial instruments innovations. Many of these problems also have impacted the broader credit and capital markets, both domestically and globally.”

The passage illustrates the Blueprint’s authors’ refusal to be honest with the reader. They embraced euphemisms for fraud (“aggressive practices”) and gravely understated the financial crisis that was sweeping like a tornado through the financial markets. They ignored how the industry had deliberately ignored the FBI’s September 2004 warning that the developing “epidemic” of mortgage fraud would cause a financial “crisis.” They ignored how the fraud epidemic, generated overwhelmingly by lenders and their agents, hyper-inflated the largest bubble in financial history. But all of this pales against the Blueprint’s fundamental dishonesty. Why were there “gaps” between national and state regulation? The mortgage lending industry deliberately cultivated a race to the bottom by creating regulatory black holes and because the industry successfully urged Fed Chairmen Greenspan and Bernanke not to use their statutory authority under HOEPA to ban fraudulent “liar’s” loans. Why were “structured financial instrument innovations” “opaque?” The financial industry demanded passage of the Commodities Futures Modernization Act of 2000 for the specific purpose of making the credit default swap (CDS) market wholly opaque. The express goal of the Act was to prevent all federal and state regulation of CDS. The Act, as the industry intended, created a regulatory black hole. The Fed economist who testified to Congress premised the Fed’s support for this obscene Act on the purported need to win the race to the bottom in competition with the City of London.

The problem that the Blueprint identified was the insane idea that because the UK, Germany, Ireland, and Iceland were racing toward the anti-regulatory bottom and creating an extraordinarily criminogenic environment the U.S. should respond by creating an even more criminogenic anti-regulatory environment so that more of the accounting control fraud would take place in the U.S. and cause even more catastrophic losses here instead of in Europe. The Blueprint is bizarre primarily because it calls for the U.S. to embrace even more fully the anti- regulatory bottom – even though the disastrous consequences of doing so were obvious at the time the Blueprint was published. The Blueprint (implicitly) identified the problem (the anti-regulatory race to the bottom to “win” global competitiveness – and called it the solution. This was significantly insane.

The Blueprint, having found that the anti-regulatory race to the bottom was suicidal, urged the U.S. to run faster.

“External factors threatening the competitive position of U.S. financial firms and the stability of financial markets include the relentless growth in international financial services competition, rapidly expanding foreign financial markets, and foreign regulatory regimes purposefully designed to adjust quickly to market developments.”

This is nonsensical. The “competitive position of U.S. financial firms” would have been aided immeasurably by competent financial regulation, of the kind we employed in 1990-1991 to forbid S&Ls to make liar’s loans. The actions that most impaired the competitive position of U.S. financial firms were the three “de’s.” Our firms would have had a decisive competitive advantage over European banks, to an extent not seen since the early post-World War II years, had we not destroyed effective financial regulation.

Note the lack of logical coherence in the sentence quoted above. The Blueprint concedes that Europe’s race to the bottom “threaten[s] … the stability of financial markets.” That concession is true and it has enormous analytical importance (that escaped the authors). It means that the Europe’s anti-regulatory race to the bottom does not “threaten” “the competitive position of U.S. financial firms.” Indeed, it must do the opposite. The European banks are inherently destroying themselves as competitive threats when they destroy effective financial regulation because such an action is so criminogenic. The Blueprint’s fundamental incoherence leads the authors to recommend anti-regulatory policies that are the opposite of what their logic (if made internally consistent) would recommend. The authors’ total blindness to the internal inconsistency of their logic is revealed in this sentence.

Similarly, if Europe’s anti-regulatory race has led to “regulatory regimes” that serve as cheerleaders (“adjust quickly”) for criminogenic lending practices (“market developments”) then this is the last thing the U.S. should emulate. The way to enhance both U.S. competitiveness and financial stability, particularly if our competitors are racing to the criminogenic bottom, is to employ effective financial regulation. It’s a lot like every mother advises her child: “And if Johnny jumps off a cliff do you think that you should also jump off the cliff?”

We all know that the CEOs who co-chaired the “Blue Ribbon” group that produced the Blueprint did not write the Blueprint. Who actually produced this blueprint for creating an even ore criminogenic environment sure to produce recurrent, intensifying financial crises?

“The Roundtable is grateful for the outstanding guidance provided throughout this project by William A. Longbrake of Washington Mutual, Inc., who also is the Anthony T. Cluff Senior Policy Advisor to The Financial Services Roundtable.”

Yes, unintentional self-parody remains unbeatable. The Financial Services Roundtable, with 100 massive members, chose as its “Senior Policy Advisor” and go-to guy on the Blueprint a WaMu’s Vice Chairman. Longbrake served as the Chairman of The Financial Services Roundtable’s Housing Policy Council during the hyper-inflation of the housing bubble. When you need expertise on creating the most intensely criminogenic environment possible it only makes sense to go to a bank that made, purchased, and sold hundreds of thousands of fraudulent mortgage loans. Longbrake’s bio describes his work for WaMu.

“From 1982 to 1994 Longbrake was chief financial officer of Washington Mutual except for a two-year stint when he was the principal executive responsible for retail banking and home lending. When he returned to Washington Mutual from the FDIC in 1996 he resumed the position of chief financial officer until 2002 when he became the bank’s first chief enterprise risk officer. In 2001, Longbrake was named CFO of the Year in the Driving Revenue Growth category by CFO Magazine. From 2004 until retirement he served in a non-executive position as the company’s liaison with regulators, legislators, and industry trade organizations.”

Kerry Killinger, WaMu’s Chairman and CEO, was a member of the “Blue Ribbon” group that created the Blueprint for disaster.


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.

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