Tag Archives: Control Fraud

NPR’s Robert Siegel Interviews William K. Black on the Investigation of S&P

Posted on August 19, 2011 by | 6 comments

Listen to William Black explain how investigations into the recent financial crisis differ from inquiries into previous disasters. Also, you’ll find Professor Black’s review of Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance below the fold.

http://www.npr.org/v2/?i=139763198&m=139763179&t=audio

Guaranteed to Loot: The Perverse Incentives of Systemically Dangerous Institutions’ CEOs
A Book Review for Fidedoglake by William K. Black of:
Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance
by
Viral V. Acharya
Matthew Richardson
Stijn Van Nieuwerburgh
Lawrence J. White
(Princeton: 2011)
The Authors’ Revolutionary Indictment of Systemically Dangerous Institutions (SDIs)
Overview of the Authors’ Logic

Fannie and Freddie, like all U.S. systemically dangerous institutions (SDIs) were privately-owned and their liabilities were not guaranteed by the Treasury. Nevertheless, all SDIs have an implicit Treasury guarantee of their debts because any SDI failure could cause a global systemic crisis. The SDIs obtain the implicit guarantee by implicitly hold our economy hostage. The perverse incentives arising from this guarantee are the authors’ core concept.

The authors are finance professors at NYU’s Stern School. Their logic makes this a revolutionary book. The book is a case study of the perverse behavior of the managers controlling two SDIs, but the authors generalize the perverse incentives as controlling all SDIs.

The authors’ findings support James Galbraith’s thesis in The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too. Our financial leaders are the SDIs’ CEOs who make “free” markets impossible. The authors found that SDIs cause “a highly distorted market with two types of institutions – LCFI King Kongs and GSE Godzillas – both implicitly backed by the government….” (p. 55). (LCFI: “large complex financial institutions” – the authors’ polite euphemism for SDIs.) Their conclusion that “there was nothing free about these [housing finance] markets” applies to all the SDIs (p. 21).

“[T]he failure of the LCFIs and the GSEs is quite similar – a highly leveraged bet on the mortgage markets by firms that were implicitly backed by the government with artificially low funding rates only to differing degrees” (p. 49).

They adopt the CBO’s simile: living with Fannie and Freddie is like sharing a canoe with a bear.
“Because the GSEs are currently under the conservatorship of the government, it would be crazy not to kill off the “bear” and move forward with a model that did not again create a too-big-to-fail – and, more likely, a too-big-to-reform – monster” (p. 74).

The authors’ revolutionary logic is that it would “be crazy not to kill off the bear[s]” – the SDIs are inherently “monster[s]” that hold our economy hostage and block real markets and real democracy.
The authors argue that it is impossible even for massive SDIs to compete with the largest SDIs. Their simile is that the largest SDIs’ advantages are so great that it is “like bringing a gun to a knife fight” (p. 22).

In 1993, George Akerlof and Paul Romer authored Looting: the Economic Underworld of Bankruptcy for Profit. Akerlof & Romer explained how financial CEOs used accounting fraud to make record reported profits a “sure thing” (p. 5). The record, albeit fictional, reported profits were certain to make the CEO wealthy, while the bank was guaranteed to fail.

The authors confirmed Akerlof & Romer’s thesis. The CEOs’ perverse incentive creates three concurrent guarantees: the bank will report high (albeit fictional) short-term profits, the controlling officers will extract large increases in wealth, and the bank will suffer large losses. The bank fails, but the controlling officers walks away rich. “Control frauds” represent the ultimate form of “rent-seeking.” The SEC charged Fannie’s controlling officers with accounting and securities fraud to inflate its reported income so that they could extract greater bonuses.

The Authors Related Tenets: “Tail Risk” and the “Race to the Bottom”

The authors do not explain their concept of an extreme tail gamble, but they say that Fannie and Freddie’s tail gamble was purchasing nonprime loans. Those purchases were not honest “bets” and they were not subject to loss only in “rare” circumstances. Pervasively fraudulent “liar’s” loans sank the SDIs, hyper-inflated the bubble, and caused the great recession. Liar’s loans were certain to default catastrophically as soon as the housing bubble stalled. The housing bubble was certain to stall.

I believe that the authors’ logic chain is as follows:

1. SDI executives caused “their” banks to make investments that had a negative expected value, but a high nominal yield

2. In violation of generally accepted accounting principles (GAAP), the SDIs did not provide remotely adequate allowances for those future losses (ALLL)

3. This created a “sure thing” – SDIs were guaranteed to report high (fictional) short-term

4. This guaranteed fictional income led to the guaranteed massive executive bonuses

5. The officers controlling the SDIs used professional compensation (e.g., of auditors, appraisers, and rating agencies) to create a “race to the bottom” that led to widespread “echo” fraud epidemics among appraisers and credit rating agencies

6. The SDIs did the same thing to produce echo epidemics by loan officers and brokers

7. The accounting control frauds created a “race to the bottom” that drove the officers controlling other SDIs to mimic their frauds

8. This hyper-inflated the housing bubble

9. The hyper-inflation of the bubble allowed the SDIs to hide losses The SDIs’ creditors did not provide (expensive) market discipline because of the implicit government guarantee protected them from loss

10. The SDIs’ regulators did not act as the regulatory “cops on the beat” to break this private sector “race to the bottom” because the SDIs’ used their political power and ideological “capture” to create a regulatory “race to the bottom” (p. 191, n. 3)

11. SDIs following this fraud strategy were guaranteed to suffer massive loan losses and fail

12. These fraud epidemics and SDI failures triggered the Great Recession

The Authors’ Proposed Reforms are Criminogenic

Any analysis that ignores control fraud is certain to distract us from the reforms essential to prevent our recurrent, intensifying financial crises. Ignoring fraud led the authors to propose reforms that are criminogenic.

The authors’ suggestion that the Treasury charge the SDIs a fee equivalent to the value of their implicit Treasury subsidy would encourage accounting control fraud. Frauds use deceit to hide the risks the lender or purchaser is taking. The result would be an intensified Gresham’s dynamic because the accounting frauds would have an even greater advantage (due to the grossly inadequate charge for their implicit Treasury subsidy) over their honest competitors. Under the authors’ own logic and simile we must kill all of the bears.

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The High Price of the President’s Council of Economic Advisors’ Failure to Read Akerlof & Romer

Posted on July 25, 2011 by | 2 comments
By William K. Black

(Cross-posted from Benzinga.com)

By reviewing the annual reports (2005-2007) of President Bush’s Council of Economic Advisors (CEA) I learned that the Council had some interest in fraud, but no understanding of elite fraud and its implications for the economy.  The reports make sad reading.  They deny the developing crisis entirely and they do so for reasons that reflect badly on economics and economists. 

The CEA’s reports’ analysis of the developing fraud epidemics and crisis reveal critical weaknesses in theory, methodology, empiricism, candor, objectivity, and multi-disciplinarity.  Overwhelmingly, the reports ignored the developing crises and their causes.  Worse, as late as 2007, they denied – even after the bubble had popped – that there was a housing bubble.  When the nation and the President vitally needed a warning from its Council of Economic Advisors the CEA did not simply fail to warn, but actually advised that those who warned of a coming crisis were wrong. 

This column does not focus on the CEA’s claims that there was no housing bubble.  Like the National Association of Realtors’ top economist who became known to the trade press as “Baghdad Bob” (the mocking nickname journalists gave Saddam Hussein’s press flack after he denied U.S. troops were in Baghdad), the CEA’s specious bubble denial is an obvious embarrassment.  Their Japanese counterparts did far better in warning of the developing real estate bubble in the 1980s.  The collapse of the twin Japanese bubbles in 1990 and the resultant “lost decade” should have caused the CEA to recognize the gravity of the risk bubbles pose and importance of identifying them promptly.  Instead, the CEA gave in to the temptation to claim that the President’s brilliant policies had produced a wonderful economy.  The reality was that the economy was headed over the precipice.

The focus of this column is on the portion of the CEA’s annual report for 2006 that discussed the theory of financial intermediation and financial regulation.  Indeed, the column focuses on a small subset of the defects in those portions of the report.  I write to emphasize how a theory (“control fraud”) developed two decades ago by regulators, criminologists, and economists could have saved the CEA from analytical and policy errors with regard to financial crises and regulation and led it to identify the crisis and recommend effective measures to contain it.  The tragedy is that the CEA discussion of the theory of financial regulation embraces three of the most useful theoretical insights – adverse selection, lemon’s markets, and the centrality and criticality of sound underwriting to the survival of lending institutions.  These theories are interrelated and they are essential components of control fraud theory.  

Had the CEA understood the true import of these three economic theories it could have gotten the crisis right instead of making things worse.  White-collar criminologists and economists share these three theories (among others) and employ a (limited) “rational actor” model.  (Criminologists never made the mistake of assuming purely rational behavior.  Even neoclassical economists now generally acknowledge that behavioral economics research demonstrates that economic behavior can be irrational in important settings.)  In the 1980s and early 1990s, the efforts of a small group of criminologists, economists, and regulators to understand the causes of the developing S&L debacle led them to develop a synthetic theory that criminologists refer to as “control fraud theory.”  Unfortunately, the typical theoclassical economic treatment of these three theories, exemplified by the CEA’s 2006 report, ignores control fraud.  The result is that the 2006 CEA report misstated the predictions of each of the three theories that it discussed and concluded “no problem here.”  In reality, the three theories predicted that there were epidemics of accounting control fraud 
that were leading inevitably to a catastrophic crisis.

The context of the 2006 CEA report’s discussion of the three theories is a treatise on the theory of financial intermediation and its implications for financial regulation.  The treatise is over the top in its praise of the U.S. financial industry.  The CEA claimed that the U.S. financial deregulation gave its financial sector a “comparative advantage” over other nations.  The CEA cited the financial sector’s rapid growth in size and profits as proof of this comparative advantage and asserted that the financial sector’s rapid growth led to more rapid U.S. economic growth and increased financial stability.  The CEA’s theory of financial intermediation posited that banks exist to minimize the informational difficulties that beset lending and investment.  The CEA concluded that U.S. banks were growing rapidly because deregulation made them ever more efficient in minimizing these informational defects.

Adverse Selection
The CEA addressed three forms of informational defects that banks helped reduce.  The CEA began by discussing “adverse selection.”  Adverse selection was the key to understanding and preventing the developing crisis.  In the lending context, adverse selection arises when a lender’s policies selectively encourage lending to borrowers who pose greater credit risks that are unknown or underestimated by the lender.  Adverse selection can be one of the consequences of “asymmetrical information.”  (Adverse selection also poses a serious risk to honest insurance companies.) 

Because the lender does not know (and therefore is not compensated for) the full extent of the risk of default adverse selection produces a “negative expected value” for lenders.  In plain English, they lose money.  For a residential mortgage lender, adverse selection is fatal because the loans are so large and the loan proceeds are fully disbursed at closing.  It is essential to understand that adverse selection is not equivalent to credit risk.  A mortgage lender makes money by taking prudent credit risks.  Banks “underwrite” prospective borrowers and collateral in order to identify, understand, quantify, and price credit risk.  Prudent underwriting minimizes adverse selection.  Mortgage lenders that fail to underwrite create severe adverse selection and fail.  Honest home lenders would never gut their underwriting standards and create adverse selection.    

The existence of a secondary market does not change an honest home lender’s incentive to engage in prudent underwriting.  Neoclassical theory predicts that the ultra sophisticated investment banks that ran the secondary market would only purchase loans they had prudently underwritten.  A lender that failed to underwrite effectively would be unable to sell its loans in the secondary market.  Neoclassical theory also predicts that the secondary market would only purchase loans sold with guarantees against fraud.  The first prediction, of course, proved false but the second prediction was typically true.  All of the mortgage lenders that specialized in making large numbers of loans under conditions that maximized adverse selection failed even before the cost of the guarantees would have destroyed them because their “pipeline” losses exceeded their trivial (fictional) capital.       

The most severe form of adverse selection is fraud.  The ultimate form of adverse selection is accounting control fraud.  Any experienced banker or insurer knows that adverse selection can lead to fraud.  Fraud maximizes the asymmetry of information because the information provided to the victim contains data that are false and material.  The fraud makes the loan look far less risky than it really is. 

In 2006, MARI, the anti-fraud group of the Mortgage Bankers Association (MBA), reported to MBA members that “stated income” loans were an “open invitation to fraudsters” and that they deserved the term used behind closed doors in the industry, “liar’s loans,” because the incidence of fraud in liar’s loans was 90 percent.  The defining element of liar’s loans was the failure to conduct essential underwriting.  Moreover, fraudulent nonprime lenders typically simultaneously maximized adverse selection and created deniability by creating large networks of loan brokers to prepare the fraudulent loan applications. 

The percentage of nonprime loans made without prudent underwriting is not known with precision because there were no official definitions of stated income, alt-a, or liar’s loans.  Subprime and liar’s loans were not mutually exclusive.  By the time the CEA wrote its 2006 report roughly half of the loans lenders termed “subprime” were also liar’s loans.  Credit Suisse’s March 12, 2007 study (“Mortgage Liquidity du Jour: Underestimated No More”) presented data estimates that roughly 30% of all mortgage loans made in 2006 were liar’s loans.  That frequency produces an annual mortgage fraud incidence of well over one million.  The FBI had put the entire nation on alert about the developing “epidemic” of mortgage fraud in its September 2004 House testimony.  The FBI predicted that the fraud epidemic would cause a financial “crisis” unless the epidemic was contained.  In 2006, no one believed that the epidemic was being contained. 
What everyone, including the CEA, knew in 2006 was that mortgage underwriting standards for nonprime loans were in freefall while other “layered risk” characteristics were multiplying.  This meant that nonprime lenders were dramatically increasing adverse selection while making loans that were ever more vulnerable to losses from adverse selection.  Everyone, including the CEA, knew that the only reason this could occur was the rapid growth of the three “de’s” – deregulation, desupervision, and de facto decriminalization.  Everyone, including the CEA, knew that no one was forcing the nonprime lenders to make liar’s loans.  That should have led the CEA to ask why the senior officers controlling nonprime lenders were deliberately causing the lenders to make loans that created intense adverse selection, endemic fraud, massive (longer-term) losses, and the failure of the lender.  That behavior makes no sense under the theory of financial intermediation advanced by the CEA.  No honest lender CEO would engage in that pattern of behavior.  The nonprime lender CEOs’ behavior only makes sense if they are engaged in accounting control fraud.  The recipe for maximizing fictional accounting income has four ingredients and adverse selection optimizes the first two (rapid growth through making very poor quality loans at premium yields).      
Unfortunately, the CEA’s 2006 report was devoid of any real analytics or facts related to adverse selection.  Indeed, the report’s entire discussion of financial institutions is bizarre because it is not simply removed from any factual context but based on factual assumptions that were contrary to reality and becoming ever more contrary to reality in 2006.  The discussion is a surreal theoretical exercise based on unstated factual assumptions that are the opposite of reality.  The (inevitable) result of its unstated assumptions is the worst possible financial regulatory policy advice that the CEA could give in 2006 – everything is wonderful because our financial intermediaries prevent adverse selection.  The CEA wrote to warn us of the dangers of excessive financial regulation at a time when financial regulation had been eviscerated.
The CEA’s discussion of adverse selection ignored the risk of fraud during what the FBI had aptly termed a fraud “epidemic.”  Instead, it premised its concern on managers of high quality projects being unwilling to seek commercial loans from banks because banks charged excessive interest rates for even high quality projects because of their inability to differentiate bad and high quality business projects.  In reality, interest rates on commercial loans were exceptionally low – even for poor quality business projects.  The CEA’s discussion of adverse selection was premised on an alternate universe.
Lemon Markets
The CEA discussed lemon markets in conjunction with its discussion of adverse selection.  A lemon market reaches its nadir when bad quality products drive good quality products out of the marketplace.  Control fraud theory agrees that lemon market and adverse selection are interrelated theories and provide the keys to understanding why control frauds cause such devastating injury.  George Akerlof was awarded the Nobel Prize in Economics in 2001 for his 1970 article on markets for lemons, which was a pioneering article on fraud and asymmetrical information.  As I have explained, fraud produces the epitome of adverse selection and control fraud is the ultimate form of fraud.  The examples Akerlof provided of sales of goods that posed lemon problems were anti-customer control frauds.
The CEA does not mention Akerlof in its discussion of lemon markets.  This was deeply unfortunate, for it reinforced the CEA’s failure to discuss the epidemic of control fraud by nonprime lenders.  The CEA also failed to explain one of Akerlof’s most important theoretical contributions in his 1970 article, the “Gresham’s” dynamic.  Akerlof used Gresham’s law (bad money drives good money out of circulation in hyperinflation) as a metaphor to explain why market forces became perverse in the presence of asymmetrical information.  The anti-customer control fraud that sells an inferior good through the claim that it is a high quality good gains a large cost advantage over its honest competitors.  If they are driven into bankruptcy or emulate the fraudulent practices good quality goods – and honest sellers – will be driven from the marketplaces by competition.  This happened recently in the Chinese infant formula market, where honest manufacturers were driven out of the market, six infants were killed, and over 300,000 were hospitalized.  The perverse effects of extreme executive compensation largely driven by short-term reported earnings have now created a perverse Gresham’s dynamic in many firms, particularly in the finance industry.  The CEA did not mention the perverse incentives produced by control fraud and modern executive compensation and why markets make the environment even more criminogenic rather than restraining fraud.  Implicitly, however, the CEA recognized that there was some perverse market dynamic that could drive lemon markets to their nadir where “only the worst-quality” good would be sold. 
The CEA compounded its error of not discussing Akerlof’s 1970 analysis of control fraud and the Gresham’s dynamic by failing to address George Akerlof and Paul Romer’s 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”).  Their 1993 article analyzed accounting control frauds.  The CEA’s discussion of financial intermediaries also included a discussion of “moral hazard.”  As with its discussion of adverse selection, the CEA’s discussion of moral hazard implicitly excluded all fraud.  There is no theoretical basis for this exclusion.  Economics (and reality) has long recognized that moral hazard can lead to excessive risk or fraud.  Fraud is often a superior strategy (in terms of expected value – not morality).  As Akerlof & Romer stressed, accounting control fraud is a “sure thing” (1993: 5).  “Gambling for resurrection” is a near sure thing, but in the opposite direction.  The economic theory of how the insolvent or failing bank’s owners maximize the value of their “option” predicts that they will engage in such extraordinary risk that their gamble will nearly always fail. 
But Akerlof & Romer endorsed another point that S&L regulators and criminologists stressed – the manner in which S&Ls purportedly engaged in honest gambling due to moral hazard made no sense for a rational (honest) actor.  Please read their explanation with particular care for its obvious application to our ongoing crisis should be glaring.
“The problem with [economists’ conventional description of moral hazard as an] explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending:  maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.*  Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem.  They were right (1993: 4).”
Akerlof & Romer went on to explain that accounting control frauds optimize fictional income by making loans with a negative expected value and by deliberately seeking out borrowers with poor reputations (1993: 17).  Their logic relies implicitly on the deliberate creation of adverse selection by the lender and the creation of a Gresham’s dynamic both among borrowers and those that aid and abet the CEO’s frauds, e.g., the appraisers when they inflate appraisals.

There is no good explanation for why the CEA would cite the Akerlof’s famous theory on lemon markets yet ignore the FBI’s 2004 warning, the experience of the S&L debacle (and the public administration literature on the successful regulatory fight against the control frauds), the Enron era accounting control frauds, Akerlof & Romer’s theory of accounting control fraud, and criminology’s theory of control fraud.  The basic fraud mechanisms had so many parallels that one is forced to the conclusion that the CEA and its staff never read the most important modern economic article on bank failures.  Akerlof & Romer explicitly noted that accounting fraud created perverse “lemon” projects (1993: 29).  It is bizarre that the CEA wrote in 2006 for the express purpose of opposing essential financial regulation and thought that the best way to make its case was to cite theories most closely associated with George Akerlof while ignoring his application of those theories to financial regulation and his research findings on the reality of accounting control fraud.  Note that Akerlof & Romer were writing about precisely the point the CEA was discussing – the role of banks with respect to information asymmetries.  Worse, Akerlof & Romer’s point was that one could not assume that banks acted to reduce information asymmetries because banks engaged in accounting control fraud did the opposite.  Akerlof & Romer also explained how accounting control frauds caused Texas real estate bubbles to hyper-inflate.  If there was one economics article the CEA needed to read carefully it was Akerlof & Romer.  Akerlof was a Nobel Prize winner well before the CEA wrote its 2006 annual report.   
But the CEA could have learned the same vital facts about fraud and financial crises had it read the criminology literature, the regulatory literature on the S&L debacle, or the public administration literature.  The CEA had experienced recently the Enron-era accounting control frauds and the S&L debacle was relatively recent.  The CEA’s failure to even consider the role of fraud in financial crises, particularly after the FBI’s stark warning in 2004, was unconscionable.  Akerlof & Romer went out of their way to warn economists of the dangers of control fraud.
“Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself (1993: 60).”
My criminology colleagues and I sent the same warnings, as did the S&L regulators and public administration scholars.  The FBI sent an explicit warning.  None of us were able to get through to the Clinton, Bush, or Obama administrations.  They have all ignored the epidemic of accounting control fraud that hyper-inflated the real estate bubbles and drove the financial crisis.    
The Necessity and Centrality of Effective Underwriting
The CEA report continues its triumphal “just so” story approach to financial services by explaining how banks develop expertise in evaluating credit risk and use collateral as a means of inducing borrowers to “truthfully” rather than “strategically” release information on the true value of the real estate to the lender.  By 2006, the nonprime industry was notorious for deliberately inflating appraisal values so that it could make more and larger fraudulent loans.  Surveys of appraisers showed widespread efforts by lenders and their agents to coerce appraisers to inflate valuations.  No honest lender would ever coerce an appraiser to inflate a collateral valuation.  Only lenders and their agents can engage in widespread appraisal fraud.  Appraisal fraud is a “marker” of accounting control fraud.  The “strategic” behavior with regard to appraisers was by fraudulent lenders and their agents.  It relied on endemic, deliberate deceit.  Appraisal fraud is particularly egregious in residential home lending because it can lead borrowers to overpay for their home and to fail to understand the risks of purchasing a home. 
The greatest analytical defect in this section of the CEA report, however, is its false dichotomy between economic efficiency and financial regulation.  The CEA was on to something important.  A well run banking system does reduce adverse selection and make markets less inefficient.  A well run banking system does so by engaging in expert underwriting of significant loans such as home loans.  A bank that does not engage in expert underwriting poses a grave danger.  At best, it is incompetent.  Far more dangerously, it is often engaged in accounting control fraud.  A regulation that requires a lender to engage in prudent underwriting imposes no costs on honest banks and it saves society from vast amounts of damage.  When the regulatory agencies gutted the underwriting rules by turning them into guidelines they set us on the road to the Great Recession.  Effective financial regulation begins with mandating prudent underwriting.  Rules mandating prudent underwriting make financial markets far more efficient and stable by blocking the perverse Gresham’s dynamic that otherwise can create a criminogenic environment.  
The CEA was correct in explaining that the raison d’être of financial intermediaries is the provision of exemplary underwriting.  It is, of course, significantly insane that the CEA would implicitly assume in 2006, contrary to known facts, that nonprime lenders, the investment banks packaging CDOs, and the rating agencies were prospering because they were engaged in exemplary underwriting.  The CEA, in the two most important reports it issued in modern times (2005 and 2006), got the developing financial crisis and regulatory policy as wrong as it is possible to get something wrong. 
Conclusion
No economist should be allowed to graduate from a doctoral program without reading Akerlof & Romer.  It would also be salutary to expose any doctoral candidate interested in finance or regulation to the relevant work of criminologists and public administration scholars.  Collectively, our work on control fraud has shown great predictive strength while neoclassical economic work (both macro and micro) and “modern finance” have suffered repeated, abject predictive failures. 

Every financial regulatory agency should have a “chief criminologist.”  The financial regulatory agencies are civil law enforcement entities whose primary responsibility is to limit control fraud, but they virtually never have anyone in authority with expertise in identifying, investigating, and sanctioning control frauds.


* Black (1993b) forcefully makes this point.

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Mitch Daniels Uses Benefit-Cost Analysis to Teach his Daughter Ethics

Posted on May 23, 2011 by | 1 comment

By William K. Black

(Cross-posted with Benzinga.com)

This is the fourth and final article in a series of pieces discussing the claim by a Cato scholar at CIFA’s recent meeting in Monaco that formal benefit-cost tests by economists were essential to prevent regulatory excess. The second column focused on a speech in 2001 by Mitch Daniels, then President Bush’s Office of Management and Budget (OMB) director to the Competitive Enterprise Institute (CEI).

Mitchell E. Daniels, Jr., Competitive Enterprise Institute Speech, 05/22/2002

Daniels is the nation’s leading proponent of benefit-cost tests, and the purpose of his speech was to advance arguments in favor of OMB economists’ use of benefit-cost tests to block the adoption of regulations. The column discussed Daniel’s use of a “mistress metaphor” to explain why economists’ formal benefit-cost tests are vital.

Continue reading →

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Wallison: Leader of the Financial Wrecking Crew

Posted on January 28, 2011 by | 4 comments

By William K. Black

The most theoclassical economists are often non-economists like Peter Wallison. His bio emphasizes the passion that has consumed his adult life.

From June 1981 to January 1985, he was general counsel of the United States Treasury Department, where he had a significant role in the development of the Reagan administration’s proposals for deregulation in the financial services industry….

[He] is co-director of American Enterprise Institute’s (“AEI”) program on financial market deregulation.

Wallison is back in the media because the Republican Congressional leadership appointed him to the Financial Crisis Inquiry Commission. The Commission has four Republicans and six Democrats. Three of the Republicans were architects of the financial deregulation policies that made possible the current crisis. The fourth, Bill Thomas, was an ardent Congressional supporter of those policies that helped make those policies law. Unsurprisingly, none of the Republicans is willing to support the findings of the Commission’s staff’s investigations of the causes of the crisis because deregulation, desupervison, and de facto deregulation (the three “des”) played a decisive role in making the crisis possible. Each of the Republican members of the Commission is in the impossible position of being asked to investigate his own policies, which the Commission’s investigations have shown to have had disastrous consequences.

Even within the Republicans, however, Wallison stands out for the zeal of his efforts to blame everything on the government and working class Americans. He decided that his Republican colleagues had been too weak in condemning the staff’s findings and wrote a separate, lengthy dissent to make his case. Wallison’s actions were predictable. He was famous prior to his appointment for creating the narrative that the government’s desire to help working class Americans purchase homes twisted Fannie and Freddie into the Great Satans that caused the crisis. He believes in complete deregulation – banks deposits should not be insured by the public and banks should not be regulated.

I have critiqued Wallison’s claims about the current crisis and explained why I think he errs. I will return to this task in future columns now that he has written a lengthy dissent. In this column I will discuss a portion of a shorter, even more revealing article that he wrote that exemplifies what I will argue are the consistent defects introduced by his anti-regulatory dogma in each of his apologies for a series of financial deregulatory disasters over the last 30 years.

Wallison wrote an article in Spring 2007 (“Banking Regulation’s Illusive Quest”) criticizing a conservative law and economics scholar, Jonathan Macey, who had written an article about financial regulation. Wallison was disappointed that Macey, who typically opposes regulation, concluded that banking regulation was necessary. Wallison wrote the article to rebut Macey. I’ll discuss only the portion of Wallison’s article that seeks to defend S&L deregulation.

Wallison begins his critique of Macey by asserting:

If the business of banking is inherently unstable, it would long ago have been supplanted by a stable structure that performs the same functions without instability.

Why? That assumes that there are banking systems that are inherently stable and that the market will inherently establish such systems. There is nothing in logic or economic history that requires either conclusion. Economic theory predicts the opposite. Indeed, the paradox of stability producing instability was Hyman Minsky’s central finding.

Wallison does not support his assertion. The accuracy of the assertion is critical to Wallison’s embrace of financial deregulation. If banks are inherently stable, then financial regulation is unnecessary. He assumes that which is essential to his conclusion. His closest approach to reasoning is circular and unsupported.

In the absence of regulation or deposit insurance, one would expect to see banks hold sufficient capital for this purpose, simply because instability would result without it and instability would make it difficult for banks to acquire deposits.

So, absent regulation and deposit insurance, bank instability cannot exist because instability would make banks unstable. Banks would want to be stable, so Wallison “expects” that they would hold “sufficient capital.” His “expectation” is his conclusion. One does not prove one’s conclusions by “expect[ing]” that they are true.

Wallison cited his (then) co-director of AEI’s deregulatory program, Charles Calomiris, who argued that early U.S. banks with broad branching authority had low failure rates. The study design could not prove Wallison’s argument about private market discipline. Mr. Calomiris’ attempt to employ his theories in the real world led to the failure in 2009 of the S&L he controlled. His brother, George, tried unsuccessfully to get Charles removed from his control of the S&L:

In 2004, after the company posted large losses, George Calomiris asked the board to replace Charles Calomiris and Amos with “qualified, experienced management,” he said in a letter to the board.

That request fell on deaf ears, George Calomiris said in an interview. “Since that time, I and everyone else who protested my brother’s total incapacity to do anything in the real world have seen the truth. … It’s been a total disaster.”

He said he has lost more than $1 million he invested in the bank. “This is not sour grapes. I’m not the only guy who has lost a fortune here.”

While calling his brother an esteemed professor, George Calomiris said “he hasn’t any idea how to run a bank.”

Several local banking experts and investors shared that sentiment, but declined to go on the record.

And that really is the central point of why Wallison, Calomiris, and AEI’s financial deregulatory efforts have caused so much harm to America. AEI’s financial deregulation efforts have been immensely influential even though they were run by individuals who had a “total incapacity to do anything” successful “in the real world.” Accounting and fraud happen in the real world and they turn these anti-regulatory dogmas into “a total disaster.” Indeed, they turn them into recurrent, intensifying disasters. That is why Tom Frank’s famous book title: “The Wrecking Crew” describes Wallison so well. He has led the financial wrecking crew. As his track record of failure has increased, so has his refusal to accept personal responsibility for those failures.

The dynamic Wallison relies upon, private market discipline, cannot be “expect[ed]” to be reliable. Even if we assumed that creditor and shareholders act in accordance with the rational actor model that Wallison implicitly relies upon (and economists and psychologists have proven that assumption is unreliable) it would not follow that private market discipline would be effective to make banks stable.

Private market discipline becomes harmful – not simply ineffective – in four common circumstances even if actors are purely rational. First, if creditors and shareholders believe they can rely on the bank having “sufficient capital” then control frauds will use accounting fraud to create fictional bank capital so that they can defraud the creditors and shareholders.

Second, given the risks of accounting control fraud to creditors and shareholders, creditors and shareholders will realize that reported net worth may be a lie. That uncertainty means that the creditors and shareholders may not be willing to lend to and invest in banks that are actually solvent. Indeed, the depositors may stage a run on a healthy bank. Capital does not save banks from serious runs.

Third, when the bank is an accounting control fraud its senior officers will use their ability to hire, fire, promote, and compensate to create perverse incentives that suborn its employees and internal and external controls (the appraisers, auditors, and credit rating agencies) and turn them into fraud allies. The perverse incentives create a “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace. This produces what white-collar criminologists refer to as “echo” epidemics of fraud.

Fourth, banks engaged in accounting control fraud can generate Gresham’s dynamics and produce “echo” epidemics of fraud in “upstream” providers of loans. Bank control frauds create pay systems for loan brokers, and loan products, i.e., “liar’s” loans, that produce such intensely perverse financial incentives that they are intensely criminogenic. This produced endemic fraud in liar’s loans obtained by loan brokers.

Note that these failures demonstrate that deposit insurance does not end private market discipline. Fraudulent CEOs systematically pervert market incentives and use their power as purchasers and their ability to massively inflate reported income and capital to exert discipline and produce perverse behavior. Indeed, they create an environment so perverse that it becomes criminogenic.

Famous economists, Akerlof & Romer 1993 (“Looting: the Economic Underworld of Bankruptcy for Profit), the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) 1993 (which investigated the causes of the S&L debacle) and many of the nation’s top white-collar criminologists, Calavita, Pontell & Tillman 1997 (Big Money Crime), and a number of my works had explained how accounting fraud worked many years before Wallison wrote this article.

Wallison relies on the same circularity when he turns explicitly to the S&L debacle.

Because they were backed by the government, the s&ls were not required to hold capital that was commensurate with the risk they were taking, and depositors and other creditors were not concerned about this risk for the same reason.

His first clause merely asserts that the S&Ls would have been required to hold more capital absent deposit insurance. His second clause is even weaker. Why do “other creditors” – uninsured creditors at risk of suffering severe losses upon the failure of the S&L – should have exercised effective market discipline against the S&Ls. They never did so. Many S&Ls had subordinated debt. Anti-regulatory proponents like Wallison assert that subordinated debt provides superb private market discipline against banks. The purchasers of sub debt are not insured, they are supposed to be financially sophisticated, and they often buy large amounts of sub debt – all factors that are supposed to optimize private market discipline. The problem is that they have consistently failed to do so in reality. Deeply insolvent S&Ls were able to issue sub debt.

Neither Macey nor Wallison address the consistent failure of uninsured S&L creditors and shareholders – a failure that destroys their underlying assumption that deposit insurance is the cause of market discipline failures. But recall that Macey and Wallison were writing well after the S&L debacle. They were writing after the failure of the Enron-era accounting control frauds – frauds at firms that had no deposit insurance. Market discipline becomes an oxymoron in the presence of accounting control fraud. As Akerlof & Romer (1993) stressed, fraud is a “sure thing.” Creditors rush to lend to uninsured non-financial firms that report record (albeit fictional) income. The control frauds loot the creditors and shareholders. Despite having seen “private market discipline” fund rather than discipline hundreds of huge frauds, Macey and Wallison simply assumed that private market discipline would succeed absent deposit insurance.

Macey writes, “Without government regulation to substitute for the market discipline typically supplied by contractual fixed claimants, disaster ensued.” True enough, but regulation was clearly the underlying cause of the problem.

Wallison’s description of S&L deregulation is remarkably selective and disingenuous.

The deregulation that occurred was an effort to compensate for the earlier regulatory mistakes, but it was too late. Many in the industry were already hopelessly insolvent.

Deregulation was an expedient that came too late to halt the slide of the s&l industry toward insolvency.

And allowing undercapitalized or insolvent s&ls to continue to function — attracting deposits through use of their government insurance — guaranteed a financial catastrophe.

Only the last assertion is sound, but Wallison misinterprets even it, for it was a product of the deregulation that his department (Treasury) imposed on the Federal Home Loan Bank Board. Relatively few S&L were “hopelessly insolvent” as a result of the interest rate increases of 1979-82. NCFIRRE’s estimate is that $25 billion (of the $150 billion in total, present value cost ($1993) of resolving the debacle) was caused by interest rate increases. Interest rates began to fall later in 1982 and generally continued to fall. The great bulk of S&L failures – and the overwhelming bulk of the cost of resolving those failures – was caused by credit losses. Accounting control fraud was a major cause of those costs.

Wallison, understandably, focuses on the most benign aspects of S&L deregulation. Federally chartered S&L were permitted to issue adjustable rate mortgages (ARMs) and S&Ls were permitted to pay depositors higher interest rates. (S&L regulators had long supported both of those changes. Congress was the problem.) I quoted above from Wallison’s bio to show his emphasis on his leadership role in framing the Reagan administration’s financial deregulation.

The deregulation, desupervision, and de facto decriminalization of the S&L industry that the Reagan administration initiated (including the “competition in laxity” that federal deregulation triggered at the State level) was far broader than Wallison discusses and was a dominant contributor to the cost of resolving the debacle. The “three des” created an exceptionally criminogenic environment. Absent reregulation, which we implemented over Wallison’s virulent opposition, it would have caused catastrophic losses. Here are only the most destructive of the “three des” that the administration initiated.

• Reducing the number of Federal Home Loan Bank Board examiners and froze hiring

• Sought to prevent the agency’s decision to double the number of examiners

• Perverting the accounting rules to hide losses and cover up the industry’s mass insolvency – which created fake capital and income that made it far harder to act against the frauds. Covering up the mass insolvency of the industry was at all time the Reagan administration’s dominant S&L industry priority.

• Reducing capital requirements

• Increasing the permissible loan-to-value (LTV) and loan-to-one-borrower (LTOB) ratios to the point where a single large, bad loan could render the S&L insolvent

• Allowed acquirers to create massive fictional assets – goodwill via mergers that made real losses disappear from accounting recognition and created large, fictional income from mergers of two insolvent S&Ls

• Allowed acquirers to have intense conflicts of interest

• Allowed single acquirers, overwhelmingly real estate developers, to take complete control of S&Ls

• Ceased placing insolvent S&Ls in receivership

• Created hundreds of new S&Ls (de novos), overwhelmingly controlled by real estate developers

• Attempted to appoint (on a recess basis without the Senate’s advice and consent) two members to run our federal agency selected by Charles Keating – the most infamous S&L control fraud. The agency was run by three members, so this would have given Charles Keating effective control of the agency.

• Testified before Congress and in a deposition taken in support of a lawsuit by the owners of an S&L challenging the Carter administration’s appointment of a receiver for the S&L based on its acknowledged insolvency. A senior Reagan administration Treasury official testified that insolvency

• The OMB threatened to file a criminal referral against the head of the agency, Ed Gray, who was reregulating the industry, on the purported grounds that he was closing too many failed S&Ls

• Treasury Secretary Baker met secretly with House Speaker James Wright and struck a deal under which the administration would not re-nominate Ed Gray,

The overall effect of the “three des” was that the S&L control frauds were originally able to loot with impunity. Roughly 300 fraudulent “high fliers” grew at an average rate of 50% in 1983. Gray began reregulating the industry in 1983, roughly six months after he became Chairman. The S&L frauds were able to hyper-inflate a regional real estate bubble in the Southwest. Reregulation contained the crisis by promptly and substantially reducing the growth of the fraudulent portion of the industry. Had deregulation continued an additional three years the costs of resolving the crisis would have risen to over $1 trillion. Note that Gray reregulated over the opposition of the Reagan administration (including Wallison), a majority of the members of the House, the Speaker of the House, the “Keating Five”, the industry trade association, and (at first) the media.

Wallison consistently refuses to even discuss the failures of private market discipline caused by accounting control fraud. His lengthy Financial Crisis Inquiry Commission rebuttal, for example, mentions the word fraud once. That reference ignores the evidence before the Commission on the endemic fraud by nonprime lenders and their agents that and mentions only fraud by borrowers. Accounting control fraud is the Achilles’ heel of private market discipline. Effective private market discipline is the sole pillar underlying Wallison’s anti-regulatory policies. He is one of the principal architects of the criminogenic environments that were principal causes of the second phase of the S&L debacle, the Enron-era frauds, and the current crisis. The recurrent, intensifying crises his policies generate have left him with a full time job as apologist-in-chief for his deregulatory disasters.

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William Black Interviewed on Parker & Spitzer

Posted on December 21, 2010 by | 1 comment

William Black was interviewed recently on the subject of unethical banking practices for Parker and Spitzer’s blog (cnn.com).  The full interview is available here.

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William Black interviewed on Portland’s KBOO Community Radio

Posted on November 3, 2010 by | 1 comment

William Black was recently interviewed on KBOO’s ‘Old Mole Variety Hour’ regarding corruption in the banking industry.

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William Black interviewed by GFS News

Posted on November 3, 2010 by | Comments Off on William Black interviewed by GFS News

William Black was recently interview regarding the Obama administrations response to the financial collapse: “Obama has ignored the savings and loans crisis to this point. The position of the administration was that there were no lessons to be learned from the savings and loan crisis. I find that very bizarre.”  See the full story.

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Geithner and Greenspan do Standup

Posted on March 22, 2010 by | 1 comment

By William K. Black

My friends have to put up with my complaints that Brits think Americans are incapable of irony when, in reality, we are world class. Further proof of our preeminence in the irony department comes in the last five days from Geithner and Greenspan. The G2 are locked in a competition for droll humor. Today, in prepared remarks – he didn’t make some impromptu slip – he told Americans that when it comes to financial regulatory reform:

Listen less to those whose judgments brought us this crisis. Listen less to those who told us all they were the masters of noble financial innovation and sophisticated risk management.

Because I took his advice to heart I stopped reading his prepared remarks at that point and cannot report to you on the remainder of the regulatory advice given by an exemplar of “those whose judgments brought us this crisis.” The gentle reader will recall that Geithner testified to Congress that he had never been a regulator. True, but you’re not supposed to admit it. Your job statement required you to be a regulator and protect the public. Geithner’s advice means that we should all stop listening to Rubin, Summers, Greenspan, Bernanke, Gramm, Dodd, Patrick Parkinson (the Fed’s anti-supervisor), Dugan (OCC), Bowman (OTS), and Mary Shapiro (SEC). Thank you Mr. Geithner! Your advice is incredibly liberating.

Moreover, the Geithner corollary is that we should listen more to those that warned that war on regulation was producing an epidemic of fraud, a massive bubble, and an economic crisis. I trust that similar calls will be coming any minute to Ed Gray, Mike Patriarca, and our colleagues that led the successful reregulation of the S&L industry and prevented the S&L debacle from causing a recession (much less a Great Recession). Geithner’s novel idea that we should take our regulatory advice from regulators with a track record of success, courage, and integrity hasn’t been tried in over a decade.
Greenspan’s entry into the irony sweepstakes was a paper entitled “The Crisis” in which he purported to give advice about financial regulation. Seriously! The man that Charles Keating, the most infamous S&L fraud, used as a lobbyist to troll the Senate office buildings to recruit the infamous “Keating Five,” who wrote that Keating’s Lincoln Savings posed “no foreseeable risk of loss” (it turned to be the most expensive failure), and who praised the types of investments that Lincoln Savings’ (unlawfully) made that caused its catastrophic failure – all this before he became Fed Chairman – went on to become the leading anti-regulator that ignored copious warnings of the bubble and the “epidemic” of mortgage fraud to produce the environment that caused the Great Recession. Greenspan giving advice on regulation is standup at its finest.

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Echoes of The ‘80s and The Collateral Damage of Fraud

Posted on March 17, 2010 by | 3 comments

By Sigrún Davíðsdóttir

Recently, I talked to the CEO of a very successful Icelandic company that has grown steadily over the decade it’s been operating. Every year, the CEO would go through the annual report, lean back and think with great satisfaction that his company was indeed showing a healthily steady growth. Then the banks and their satellite companies would come out with their annual accounts – and the CEO’s heart would sink, questioning what on earth was he was doing: compared to these companies his company’s growth was pitiful. Now, anno 2010, his company is still doing well and even hiring people. The three main Icelandic banks collapsed in October 2008 and most of the companies owned by those favoured by the banks are now bankrupt.*

This conversation came to mind as I read ‘Den of Thieves’ by WSJ journalist James B. Stewart, on the insider trading involving the arbitrageur king of the 1980s, Ivan Boesky and junk bond emperor Michael Milken. Their apparent success became a gold standard everyone else tried to achieve. But as it was based on questionable business practices and outright fraud this measure proved an unhealthy standard. Their success was also a measurement in remuneration, again not a healthy measure. The same happened in Iceland: the banks rapidly raised salaries after they had become entirely privatised in 2003. With hindsight, their success can now be doubted and their rising remuneration levels affected the whole business community.

In his book Stewart points out that the ‘arrival of the big-money ‘star’ system in the eighties had made national celebrities’ out of people like Milken, Boesky and others who were condemned for fraud and doomed old-fashioned investment bankers that earlier had dominated the financial world. There is no need to be unduly nostalgic about the old way of banking but one of the great but too little noticed harm of fraudsters like Milken ed al. is the unhealthy standards they created in terms of growth rates and remuneration.
We still do not know the extent of fraud within the Icelandic banking bubble. The Icelandic FME, comparable to the UK Financial Services Authorities, has already sent several extensive cases of alleged market manipulation to the Office of Special Prosecutor, set up to deal with possible cases of criminal activity connected to the collapse of the banks. The Special Prosecutor is both conducting his own investigations and working on specific cases that have been sent to him from i.a. the FME and the resolution committees of the collapsed banks.
Apart from the general damage of fraud by creating harmful standards it feels as if some of those who led the Icelandic banking bubble had reopened the tool kit of the prolific fraudsters that Stewart writes about. The difference is of course that Milken was working for his own benefit, often at the cost of the bank where he worked, whereas the Icelandic banks, in cahoots with major shareholders seemed to favour certain clients more than others and possibly worked against the interest of other shareholders.
In the Icelandic context, two of the counts to which Milken pleaded guilty are of particular interest. Milken pleaded guilty to selling stock without disclosing that included in the deal was the understanding that the purchaser would not lose money. The other count involves selling securities to a client and then buying those securities back at a real loss to the customer, but with an understanding that Milken would try to find a future profitable transaction to make up for any losses.

One of the peculiarities of Icelandic banking up until the collapse is that certain clients were sold stock with a kind of ‘no loss guarantee.’ This was particularly common among key staff at the banks: the staff would get a loan from the bank where they worked to buy shares in that same bank. In most cases these were bullet loans, the staff wasn’t expected to pay anything off the loans but had the shares at their disposal to reap the dividend. The benefit for the bank was that the shares would not be used for short-selling. This practice escalated in 2007 and 2008 as foreign banks made margin calls on some of their big Icelandic clients who had pledged Icelandic bank shares against foreign loans. In order to avoid dumping these shares into the market, causing further decline in the share price, the banks would ‘park’ them with their staff, lend against them, with the understanding that these arrangement wouldn’t harm the borrower.

A bank manager from one of the collapsed banks informed me recently that among the big favored clients there was an understanding that in deals where the client lost money the bank would then try to find a profitable transaction to make up the loss. There would be many ways of making this happen, i.a. buying assets at a price above market price. It’s difficult to ascertain if and when this happened but certain sales guarantees could be scrutinised.

The interesting thing is that Milken and others convicted at the end of the ‘80s were rogues in the financial markets who defrauded clients and the banks they worked for. The Icelandic example suggests that the banks’ management, together with their main shareholders, were operating like the rogue bankers of the ‘80s bubble. It is still early day, no big cases of fraud have so far been brought to court and when that happens it will take a while until the first cases are brought to closure. So far, the possibility of a certain echo of the ’80s’ financial fraudsters remains only an intriguing thought based on striking but so far unproven parallels.

* For more on various aspects of the collapse of the Icelandic banks and connections with international banking see Icelog, my blog at http://uti.is/

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What Do Our Nation’s Biggest Banks Owe Us Now?

Posted on March 16, 2010 by | 6 comments

By William K. Black

This week, ABC News World News with Diane Sawyer is airing a series about the struggling middle class. The show’s producers posed the following question to a few of the nation’s leading economic and financial analysts, including UMKC’s own William K. Black.

QUESTION: As the nation’s largest banks have regained their footing, what, if anything, can or should they do to help Americans still struggling as a result of the financial crisis and recession?  Are there specific solutions or actions the banks should take or HAVE they already done enough?  Do the banks have an “ethical obligation” to help those average American families still struggling?
ANSWER: First, banks have not recovered.  It is essential to remember that the banks used their political clout last year to induce Congress to extort the Financial Accounting Standards Board (FASB) to change the accounting rules such that banks no longer have to recognize losses on their bad assets unless and until they sell them.  Absent this massive accounting abuse, hiding over a trillion dollars in losses, banks would (overall) not be reporting these fictional “profits” and would not be permitted to award the exceptional executive bonuses that they have paid out.


Second, banks have, in reality (as opposed to their fictional accounting ala Lehman) been suffering large losses for at least five years.  They only appeared to be profitable in 2005-2007 because they provided only trivial loss reserves (slightly over 1%) while making nonprime loans that, on average, suffer roughly 50% losses.  Loss reserves fell for five straight years as bank risks exploded during those same five years.  Had they reserved properly for their losses the industry would have reported large losses no later than 2005. 
Third, banks have performed dismally when they were supposedly profitable.  They funded the nonprime and the commercial real estate (CRE) bubbles that not only cause trillions of dollars of losses and the Great Recession, but also misallocated assets (physical and human) during those bubbles.  Far too few societal resources went to productive investments that would increase productivity and employment.  Our nation has critical shortages of workers with expertise in physics, engineering, and mathematics — precisely the categories that we misallocated to finance instead of science and production.  In finance, they (net) destroyed wealth by creating “mark to myth” financial models that maximized executive bonuses by inflating asset values and understating risk. 

Fourth, when finance seems to be working well in the modern era it is working badly.  Finance is a “middleman.”  Its sole function is to allocate capital to the most useful and productive purposes in the real economy.  As with any middleman, the goal is to have the middleman be as small and take as little profit as possible.  Finance has not functioned that way.  It has gone from roughly 5% of total profits to roughly 40% of total profits.  That means that finance has, increasingly, become wildly inefficient.  It is a morbidly obese parasite (in economics terms) that drains capital from the productive sectors of the economy.   
Fifth, the things that finance is good at are harmful to our nation.  Finance is very good at exporting U.S. jobs to other nations.  Finance is very good at fostering immense speculation.  When banks “win” their speculative bets Americans suffer, e.g., when their speculation increases gas and food prices.  When they lose their bets the American people bail them out.  (The least they could do would be to support the proposed Volcker rules.  In reality, of course, they will gut them.)  For the overwhelmingly majority of Americans, increased speculation simply causes economic injury.  In very poor countries, however, “successful” speculation by hedge funds that runs up the price of basic food kills people.  Speculation has also become intensely political.  The right wing Greek parties engaged in accounting fraud to allow Greece to issue the Euro.  When a left wing Greek party defeated the right at the polls the banks and hedge funds decided to engage in a speculative frenzy designed to cripple the nation’s recovery from recession.  Finance is also superb at increasing inequality. 
Sixth, the rise of “systemically dangerous institutions” (SDIs) that the government will not allow to fail optimizes moral hazard (fraud and speculation) and means that future crises will be common and unusually severe. 
Seventh, while lending by smaller banks is flat, funding by SDIs fell by over $1/2 trillion.   
Eighth, banking theory is horribly flawed.  Financial markets are normally not “efficient”, markets do not inevitably “clear,” and banks fund “accounting control frauds” rather than providing effective “private market discipline.”  

To sum it up, whether I’m wearing my economics, law, regulatory, or white-collar criminologist hat the situation in banking demands prompt, fundamental reform so that banking will stop being so harmful.  Then we have to keep working to make it helpful. 

Banks cannot do many of the things that need to be done to fix our economy.  In the interest of limiting space, I’ll talk about only five economic priorities.  I think banks can be helpful in only a few of these priorities.  The most important thing we can do with financial institutions is reduce the damage they cause. 
1)  It is nuts that we think it is OK for 8 million Americans to lose their jobs (and far more lose their ability to work full time) and that we think that it makes sense to pay people not to work but is “socialism” to pay them to work during a Great Recession.  We need a government-funded jobs program. 

2) It is a disgrace that well over 20% of American children grow up in poverty.  It is a greater moral failing that ending this is not a national priority.  The banks have done a terrible job in this sphere.  They caused the greatest loss of working class wealth since the Great Depression and have made tens of thousands homeless.  This is overwhelmingly the product of what the FBI began warning of in 2004 — and “epidemic” of mortgage fraud.  The FBI states that 80% of the fraud is driven by finance industry insiders. 

3) It is insanity to the nth to run our state and local governments into massive cutbacks during a Great Recession when that undercuts the need for stimulus.  The obvious answer is a public policy with impeccable Republican origins — revenue sharing.  It passes all understanding that the Republicans and blue dog Democrats targeted revenue sharing for attack and reduced it to a pittance (relative to the scale of the crisis).  The best things the banks could do in this regard are to stop (a) all participation in “pay to play” corruption involving state & local bond issuances, and (b) stop all sales of unsuitable financial products to governments (and the public).  The opposite is happening:  Goldman fleeces its public sector clients, the SDIs sell toxic derivatives to small Scandinavian cities, the investment bankers are all over public pension funds desperate for higher yields (on their underfunded pension funds) selling them grotesquely unsuitable financial products (typically, the “dogs” they can’t unload on more sophisticated investors), and the inimitable Goldman Sachs helping Greek governments deceive the EU. 
4) Related to points two and three above, the most productive investment we can make is educating superbly the coming generations.  The best thing the banks can do is get out of student lending.  The governmental lending program for college students was administered in a much cheaper fashion.  The privatized lending program is an inefficient scandal that keeps on giving.
5) Banks could put the payday lenders out of business by outcompeting them.  That would be a real public service.
And, on a level of fantasy, banks as a group could tell FASB to restore honesty in accounting.  Individual banks could report their real losses and change their executive compensation systems to accord with the premises that purportedly underlie performance pay.  They could start making criminal referrals against the mortgage frauds (a mere 25 banks and S&Ls make over 80% of the total criminal referrals for mortgage fraud) — most banks refuse to file and help us jail the crooks.  They could stop adding to the glut in commercial real estate.  They could support the Kaptur bill to authorize the FBI to hire an additional 1000 agents so that we can investigate and jail elite financial felons.  They could support a prompt end to the existence of systemically dangerous institutions (SDIs) by supporting rules and regulatory policies to require them to shrink to the point that they no longer endanger the global economic system.  Pinch me if any of these dreams come true.  I’d like to be awake to experience and celebrate the miracle.

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