Tag Archives: deregulation

Texas is the New Jerusalem of Free Market Fundamentalism, but how’s that working out for the Lone Star State’s great unwashed?

By Glenn Stehle

Texas is the De Civitate Dei, the new holy city of free market fundamentalism, and Ted Cruz, the upstart Tea Party senator from Texas, has been quick to canonize himself as its patron saint.  In case you haven’t heard it yet, Texas is now “the light and the way,” and if you don’t believe it, just ask Ted Cruz or Rick Perry, or better yet ALEC:

The Texas growth narrative is well-known by now. Texas’ population grew by 11 million people (79 percent) between 1980 and 2011, more than double the rate of growth of the nation as a whole.   With that population growth came job growth. Since the 1990s, the rate of Texas job growth has been a full percentage point or more above the national average most years.

The American Legislative Exchange Council, among others, has suggested that other states should adopt policies that will make them more like Texas in order to grow their economies. One example from the introduction to ALEC’s recent Rich States, Poor States report: “[M]any governors are looking at Texas, which has led the nation in job growth over the past three years, as the state with the best policy to emulate.”   In particular, ALEC notes the state’s tax policy as a plus.

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“Budget Hero” – Public Media’s Most Despicable Financial Propaganda

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

We know that the supporters of austerity simultaneously urge us to reject “European socialism” while adopting the key European strategies that drove Europe into recession – twice.  American conservatives assume that Europe must epitomize stringent financial regulation.  The opposite is true.  Europe adopted “light touch” financial regulation pursuant to neo-liberal economic theory.  Its embrace of the three “de’s” – deregulation, desupervision, and de facto decriminalization was far more extreme than the United States.  The City of London “won” the regulatory race to the bottom with the U.S.  European’s Continue reading

Romney’s Lead Economist Urges Policies that will Cause the Next Financial Crisis

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

Presidential nominees of either U.S. party can secure economic advice from any economist in the world.  This makes it all the more amazing and sad that they choose economists with track records of disastrous policy advice.  Bill Clinton chose Robert Rubin, George W. Bush chose Gregory Mankiw, Obama chose Lawrence Summers, and Mitt Romney chose Mankiw.  Rubin and Summers led the Clinton administration’s efforts to gut financial regulation.  Mankiw led the efforts under Bush.  Collectively, these efforts created the criminogenic environment that produced endemic financial fraud (“green slime”).

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The Cost of Theoclassical Economics and Economists

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

Hernando de Soto is an extremely interesting Peruvian economist who is simultaneously deeply conservative and highly innovative. He published a column in the Washington Post on October 7, 2011 entitled “The Cost of Financial Ignorance” that caused me to reexamine “The Washington Consensus” [TWC].

I agree with de Soto, but his title would have been more accurate if it read: “The Costs of Theoclassical Economics and Economists.” The nature of the TWC is itself highly contested, so I will hold off providing “the” definition of TWC other than to warn that its originator and its proponents are engaged in historical revisionism to try to hide the damage TWC has done.

I agree with de Soto’s criticisms of financial deregulation. Indeed, I will (briefly) add to those criticisms. But de Soto’s argument that the deregulators violated TWC is not correct. Indeed, the opposite is true – TWC encouraged the disastrous deregulation. TWC had 10 points of supposed consensus. Three of them are of greatest relevance to de Soto’s column and my response.

John Williamson is a deficit hyper-hawk with the Peterson Institute for International Economics. The Peterson Institute’s mission, if you are a supporter, is to save the Republic from an avalanche of debt by making major cuts to Social Security, etc. Williamson created the ten-point TWC in preparation for a November 1989 conference as a purported statement of consensus policies favored by economists in the U.S. government, IMF, and the World Bank as to how best to spur development in Latin America.

Three of Williamson’s points are of particular relevance to de Soto’s column and my response. In reviewing them, I discovered that Williamson, stung and embittered by the criticism of TWC, began to rewrite the original points. That would have been fine; of course, if what he was doing was changing his recommendations based on the facts. However, Williamson, and now de Soto, are passing off the revisionist points of the TWC as if they were Williamson’s original points when the actual TWC doctrines contradict the revisionism and caused catastrophic crises. I will also show (briefly) that this revisionism establishes the validity of a broader criticism of TWC by economists such as Luiz-Carlos Bresser Pereira (Brazil’s former finance minister) that most distresses Williamson.

Williamson has created a revisionist history for two TWC policies that are the subject of this column. 


“However, the main rationale for privatization is the belief that private industry is managed more efficiently than state enterprises, because of the more direct incentives faced by a manager who either has a direct personal stake in the profits of an enterprise or else is accountable to those who do. At the very least, the threat of bankruptcy places a floor under the inefficiency of private enterprises, whereas many state enterprises seem to have unlimited access to subsidies. This belief in the superior efficiency of the private sector has long been an article of faith in Washington (though perhaps not held quite as fervently as in the rest of the United States), but it was only with the enunciation of the Baker Plan in 1985 that it became official US policy to promote foreign privatization. The IMF and the World Bank have duly encouraged privatization in Latin America and elsewhere since.” 


“Another way of promoting competition is by deregulation. This was initiated within the United States by the Carter administration and carried forward by the Reagan administration. It is generally judged to have been successful within the United States, and it is generally assumed that it could bring similar benefits to other countries.”

“Productive activity may be regulated by legislation, by government decrees, and case-by-case decision making. This latter practice is widespread and pernicious in Latin America as it creates considerable uncertainty and provides opportunities for corruption. It also discriminates against small and medium-sized businesses which, although important creators of employment, seldom have access to the higher reaches of the bureaucracy.” 

Williamson made his TWC proposals at a time when the three “de’s” – deregulation, desupervision, and de facto decriminalization had created the criminogenic environment that unleashed the epidemic of accounting control fraud that drove the second phase of the S&L debacle. The debacle was widely described as the nation’s worst financial scandal and Williamson’s original TWC article mentions it but ignores the accounting control fraud and its ties to financial deregulation.

The original TWC did not recognize or warn of the risk of corrupt private parties (i.e., the CEOs running control frauds) that drive financial crises. TWC did the opposite; it provided strong, unambiguous support for deregulation. Indeed, he expressly argued that there was a consensus in Washington that deregulation, which had just caused the U.S.’s worst financial scandal in its history, was “successful.”  This supposed consensus on the success of deregulation ignores the severe crisis that the deregulation caused and the dramatic reregulation of the industry that we had implemented in 1983-86. It also ignores the adoption of the Financial Institution Reform, Recovery and Enforcement Act of 1989. FIRREA reregulated and “bailed out” the S&L industry. President Bush, who had chaired President Reagan’s Financial Deregulatory Task Force, had recognized the catastrophic error of the very consensus deregulatory policies that had led to the S&L debacle and drafted FIRREA to undue his errors. It is remarkable that Williamson presented a discredited deregulatory policy that had caused catastrophic losses and been repudiated by its leader as a desirable “consensus” policy that Latin America should adopt.

Williamson’s privatization discussion further confirms his fallacious theoclassical dogma that private elites could not be accounting control frauds and could not survive bankruptcy. The language he uses reveals the dogmatic nature of the consensus. He explains that it is “an article of faith” that the private sector is efficient (despite the S&L debacle) because of modern executive compensation and the discipline of bankruptcy. It is the combination of the powerfully perverse incentives produced by modern executive and professional compensation with the three “de’s” that combined to produce the criminogenic environments that drive our recurrent, intensifying financial crises.

Williamson’s failure to understand the multiple limits of bankruptcy’s limits in restraining financial crises driven by epidemics of accounting control fraud is total. First, individual accounting control fraud can delay bankruptcy for years and become massively insolvent through accounting fraud. Creditors do not discipline accounting control frauds – they fund their massive growth. Second, epidemics of accounting control fraud can hyper-inflate financial bubbles and simultaneously delay the collapse for many more years and cause the losses to become crippling. Third, once the fraud epidemic and bubble collapse bankruptcy is not stabilizing but systemically destabilizing.  Accounting control frauds, particularly if it hyper-inflates a bubble, can cause cascade failures as the losses they impose on their creditors can render them insolvent. Fourth, private sector banks, even investment banks with no deposit insurance, are frequently bailed out by the public sector when they are sufficiently politically connected or considered to be systemically dangerous institutions (SDIs) whose failures could trigger systemic collapses.

Here is how Williamson’s revisionist history of those same three points as he offered it on November 6, 2002. The title of the article shows that it was part of his effort to defend TWC: “Did the Washington Consensus Fail?”

8. Privatization. “This was the one area in which what originated as a neoliberal idea had won broad acceptance. We have since been made very conscious that it matters a lot how privatization is done: it can be a highly corrupt process that transfers assets to a privileged elite for a fraction of their true value, but the evidence is that it brings benefits when done properly.”

9. Deregulation. This focused specifically on easing barriers to entry and exit, not on abolishing regulations designed for safety or environmental reasons.”

I have no criticism of Williamson modifying his original 1989 views on privatization in a 2002 publication that acknowledges that he now has a better understanding of the risks of corruption causing privatization to become perverse. I fault him for claiming that his original statement of TWC covered only regulations restricting entry and exit. His 1990 paper does not limit his support of deregulation to easing entry barriers and it does not exempt safety and environmental rules. (I also fault him for not understanding that such regulations are essential to the safety of banking – easy entry poses critical risk.)

By April 22, 2009, Williamson had added to his historical revisionism in order to defend TWC from criticism that its policies had helped create the global crisis.

“Skeptics may also be inclined to point to the recommendation to deregulate. But in the days when Dan Quayle was Vice President I already made it clear that this was intended to endorse freeing entry and exit, rather than to advocate an absence of regulations intended to protect the consumer, or the environment, or to supervise the banking system. With that interpretation there is no contradiction.”

Williamson’s original TWC document did not “make it clear” that its deregulation recommendation excluded banking supervision.

Williamson is deeply embittered by criticisms of TWC. He refers to them as “foaming” at the mouth like rabid dogs. He dismisses economists who respect Keynes’ work as leftist cranks: “Left-wing believers in “Keynesian” stimulation via large budget deficits are almost an extinct species.” Williamson cites the following exchange as evidence that he had become a “global whipping boy” because he developed TWC.

“The other incident that I recall clearly occurred in Washington in 1993 but concerns a Brazilian, an ex-finance minister called Luiz-Carlos Bresser Pereira. He told me that just because I had invented the term, [that] did not give me the right to say what it meant. He still believes this and is still attacking it, as he told me two weeks ago when I was in Sao Paulo.”

Williamson thinks Bresser Pereira’s statement is obviously false, but the fact that Williamson has succumbed repeatedly to the temptation to improve his original statement of TWC via historical revisionism shows that Bresser Pereira’s warning to Williamson was correct. Williamson’s description of the means by which he determined the existence of a “consensus” also disqualifies him as the arbiter of judging what TWC really was.

“I looked around. I thought there was a broad agreement in Washington that these were good policies. And then I relied on the three people I asked to be discussants that spanned the range of ideological views in Washington: Allan Meltzer, Richard Feinberg and Stan Fischer. The most important reservation I got was from Feinberg, who thought I had misnamed it, that it should have been called the “Universal Convergence.””  

Think about Williamson’s exchange with Feinberg in late 1989. Williamson tells Feinberg that he thinks that there is a consensus in Washington, D.C. that a particular idea, e.g., deregulation is unambiguously good, and Feinberg responds that there isn’t a mere consensus – there’s universal agreement in favor of deregulation. Meanwhile, deregulation has just caused the U.S. to suffer its worst financial scandal, a scandal so severe that the President of the United States – formerly the leader of financial deregulation – changes his policies and reregulates the S&L industry. The top industry advocate of deregulation, Charles Keating of Lincoln Savings infamy, has been revealed to be a control fraud.  The S&L regulators have been reregulating for six years in a desperate effort to stem the epidemic of accounting control fraud. None of this penetrates the theoclassical bubble inhabited by Williamson and Feinberg. If the three economists Williamson chose as discussants truly “spanned the range of ideological views in Washington” then Washington has to start seeing other people. The narrow range of differences in the views of the scholars Williamson chose as his discussants for the conference made it easy for them to form a “consensus” and to conclude that all of “Washington” and “Latin America” shared that consensus. Williamson demonstrated his self-blindness with this conclusion:

“I submit that it is high time to end this debate about the Washington Consensus. If you mean by this term what I intended it to mean, then it is motherhood and apple pie and not worth debating.”

He thinks there really is a Universal Convergence in favor of theoclassical economic dogma and that his dogmas are universally good for the world and supported by all intelligent persons.

De Soto’s Revisionism about Property Rights 

De Soto’s column provides the revisionist interpretation of the tenth TWC point. Williamson originally phrased it this way:

Property Rights

“In the United States property rights are so well entrenched that their fundamental importance for the satisfactory operation of the capitalist system is easily overlooked. I suspect, however, that when Washington brings itself to think about the subject, there is general acceptance that property rights do indeed matter. There is also a general perception that property rights are highly insecure in Latin America (see, for example, Balassa et al. 1986, chapter 4).”

In 2002, Williamson used similar phrases to describe the tenth point.

“10. Property Rights. This was primarily about providing the informal sector with the ability to gain property rights at acceptable cost.”

Here is de Soto’s revisionism about the meaning of point ten of TWC. Note that under de Soto’s account of the facts, Bernanke is also guilty of historical revisionism about TWC. De Soto uncritically asserts that TWC was a great success in Latin America and that the U.S. needs to adopt TWC. Precisely the opposite was true – TWC’s policies deregulatory and privatization policies proved criminogenic in much of Latin America, just as they did in the U.S. S&L debacle. TWC led to such severe problems that electorates through most of Latin America have voted out of office TWC supporters. The U.S. crisis was driven by the criminogenic environment that TWC principles created.

 “Federal Reserve Chairman Ben Bernanke said recently that, given the ongoing credit contraction, “advanced economies like the U.S. would do well to re-learn some of the lessons” that have led to success among emerging market economies. Ironically, those economies in the 1990s accepted 10 points for promoting economic growth that were known as the “Washington Consensus.”  

Advanced nations seem to have forgotten Point 10 of that consensus: how important documenting assets and transactions is to the creation of credit. Consider that most private credit is made up not of bills and coins, anchored in bank reserves, but in papers that establish rights over the assets, equity and liabilities that guarantee loans. Over the past 15 years, however, as they package, bundle and resell securities, Americans and Europeans have gradually undermined the reliability of the records that guarantee or make credit trustworthy — the deeds, titles, liens and other documentation that establish who owns what and how much, and who holds the risks.  

Not having reliable information reduces confidence, which in turn leads to credit contractions, fewer or smaller transactions, and declines in demand. And these cause employment and the value of assets to fall.” 

I agree with de Soto that transparency is vital and that anti-fraud provisions are essential if markets are to approach efficiency. I also agree that government must provide these functions. Contrary to theoclassical economics’ predictions, when we forbade effective regulation of financial derivatives the result was not efficient markets, an optimal level of disclosures, financial stability, or the exclusion of fraud. Theoclassical dogma, as was the norm, proved to be false.

The problem is that TWC did not embrace transparency and effective financial regulation. It proposed the opposite – deregulation – and its proponents did not serve as vigorous proponents of effective financial regulation in the U.S. or in Latin America. Economists stress the reliability of “revealed preferences” – not self-serving statements after the fact that rewrite history. The revealed preferences of Williamson during the lead up to the crisis demonstrate that he did not understand and strive to counter criminogenic environments, the perverse incentives of modern executive and professional compensation, epidemics of control fraud, Gresham’s dynamics, the hyper-inflation of financial bubbles, or the collapse of effective financial regulation led at agencies run by anti-regulators.

De Soto is correct that Williamson should have made point 10 of TWC far broader, embracing effective regulation as an essential component of effective and stable markets, but he knows that Williamson did not do so. Instead, point 10 simply held that private parties should be able to own property. De Soto errs in praising Bernanke. Bernanke was a strong anti-regulator, consistent with TWC. He appointed Patrick Parkinson as head of all Fed supervision. Parkinson is an anti-regulatory economist with no real supervisory or examination experience. Parkinson was the Fed’s lead economist urging Congress to remove the CFTC’s statutory authority to regulate credit default swaps (CDS).The effort to squash CFTC Chair Born’s proposed rule restricting CDS succeeded and created a regulatory black hole that contributed greatly to systemic risk for the reasons de Soto explained in his recent column. De Soto is correct that regulation and effective markets are not mutually exclusive choices. Rather, financial markets are better able to remain effective when regulation provides the necessary transparency and reduces fraud risks. Financial deregulation in the U.S. and the EU was the enemy of effective markets, honest bankers, customers, and shareholders. The fact that Bernanke thinks that the theoclassical anti-regulatory dogma contained in TWC was the solution rather than the problem in the U.S. demonstrates that he has failed to learn the most basic lessons about the crisis.

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

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

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.

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Mr. Greenspan takes it all back. His Old Time Religion was right after all.

By Michael Hudson

It all seems so long ago! On October 23, 2008, Alan Greenspan choked up a mea culpa for his deregulatory policy as Federal Reserve Chairman. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform. “The whole intellectual edifice, however, collapsed in the summer of last year.”
For a moment he seemed to be rethinking his lifelong assumption that the financial sector would seek to protect its reputation by behaving so honestly that its customers would gain from dealing with it. “I had been going for 40 years with considerable evidence that it was working exceptionally well” – the idea that regulation was not needed because bankers would seek to protect their reputations and their “counter-parties” would look to their own interest.
“Were you wrong?” Congressman Henry Waxman prompted him to elaborate.
“Partially,” the Maestro replied. “I made a mistake in presuming that the self-interest of organizations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms.” The fact that they simply sought predatory gains for themselves – in the form of losses for their customers and clients (and it turns out, taxpayers”) was “a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”
But the past two or three years evidently have given Mr. Greenspan enough time for a re-think. In Wednesday’s Financial Times (March 30, 2011) he returns to his old job proselytizing for deregulation. His op-ed, “Dodd-Frank fails to meet test of our times,” is a mea culpa to his co-religionists for his apostate 2008 mea culpa. “The US regulatory agencies will in the coming months be bedevilled by unanticipated adverse outcomes,” he warns, “as they translate the Dodd-Frank Act’s broad set of principles into a couple of hundred detailed regulations.” The Act “may create … regulatory-induced market distortion,” because neither lawmakers nor “most regulators” understand how “complex” the financial system is.
But Mr. Greenspan refused to acknowledge the obvious: If Wall Street’s collateralized debt obligations (CDOs) and other derivatives are too complex for regulators to understand, they also must be too complex for buyers and other counterparties to evaluate. This negates a key free market assumption. How can one make an informed choice without understanding the market and the consequences of one’s action? On this logic regulators would follow free market orthodoxy in rejecting derivatives and other such “complex” products.

Many critics would say that CEOs of the banks that went bust don’t understand the complexity that led to their negative equity either. Or, they know all too clearly that they can take a gamble and be bailed out by the government, simply by threatening that the alternative would be monetary anarchy that would drag down consumer banking along with casino banking. The problem is not so much complexity, but gambling – increasingly with computer models and fast mega-trading of swaps and derivatives. This is how investment bankers have made (and often lost) their money.
But they want the game to continue. That is the bottom line. On balance, even if they lose, they will be bailed out. So of course they are all for “complexity” that enables them to make gains at the economy’s expense (Mr. Greenspan’s “flaw” in the system).
But alas, he does not acknowledge the fact that Wall Street blackballs regulators who do understand how the financial system works. An ideological blind spot free-market style is a precondition for deregulators such as Mr. Greenspan. It’s as if he still doesn’t understand that this is precisely why he was hired for his job at the Fed! After rejecting Brooksley Born’s attempt to regulate credit-default swaps at the Commodity Futures Trading Commission in 1998, he served his banking benefactors by passionately supporting Robert Rubin and Larry Summers in pressing the Clinton Administration to repeal Glass-Steagall, opening the door to make consumer banking dependent on wild financial gambling by the likes of Citibank and what has become Bank of America. This self-imposed blindness cost to the economy trillions of dollars and has left a dysfunctional commercial banking system. (At least former S.E.C. Chairman Arthur Levitt has apologized to Ms. Born.)
Mr. Greenspan’s euphemism for dysfunctional is “complex.” His op-ed says what priests or nuns tell parochial school pupils who ask about how God can let so many bad things happen here on earth. The answer is simply to say: “God is too complex for you to understand. Just have faith.” Nobody has sufficient skills to be “entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are importantly altered.” Just look at how Bush Administration happy-face appointees at the FDIC and IMF expressed faith that risks were declining in 2007-08. “Regulators were caught ‘flat-footed’ by a breakdown we had erroneously thought was more than adequately reserved against.” Who could have seen that fraud was going on? Certainly nobody that was let into the Fed’s policy meetings.
Federal Reserve Board Governor Ed Gramlich’s warning about subprime mortgage fraud is ignored as an anomaly here. When Mr. Greenspan says “we” in the above quote he means the useful idiots that Wall Street insists that the government hire – true believers in the deregulatory kool-aid being doled out on behalf of their financial god too complex for mortals to know. “The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems.” But the “regulators who never got more than glimpse” were co-religionists headed by Bubblemeister Greenspan himself. He bears his failure to “more than glimpse” like a badge of honor.
It seems that only bankers really understand what they’re selling, but you must trust Wall Street to do the right thing. (If Mr. Greenspan mouthed such a claim in Wisconsin, where five school districts were suckered into borrowing $200 million in addition to their original investment in CDOs, he would meet with considerable ridicule.) If bankers do not make money for their customers, they will lose their trust. Why would bankers and financial institutions act in such a way as to profiteer at their customers’ expense (and that of the overall economy for that matter)?
The reason, of course, is that the financial sector notoriously lives in the short run. Countrywide Financial, Lehman Brothers, WaMu, Bear Stearns, A.I.G. et al. gave their managers enormous salaries and even more enormous bonuses to turn themselves into a new power elite with fortunes large and “complex” enough to endow their heirs for a century.
The Federal Reserve Bank of Minneapolis has just published statistics showing that the wealthiest 1% of America’s population doubled its share of wealth over the decade ending in 2007 as the bubble reached its peak. No doubt this polarization is widening as the economy shrinks under the weight of its debt overhead. Mr. Greenspan acknowledges criticisms that Wall Street has used TARP and other bailout money simply to maintain “the outsized (to some, egregious) bankers’ pay packages.” But he points out that “small differences in the skill level of senior bankers tend to translate into large differences in the bank’s bottom line.” Skill is expensive.
What amazes me about mismanagers like Countrywide’s chairman Angelo Mozilo and his counterparts is that when the S.E.C., F.B.I. and state attorneys general open a investigation to see whether to charge them with criminal felonies, the bankers always insist that they were out of the loop, had no idea of what was going on, and are shocked, shocked, to find out that there’s gambling going on in this place.
If they are so unknowledgeable to be even more blind than the regulators and economists who warned about what was happening that has required a $13 trillion government bailout, how can they insist that they are worth whatever they can grab? For that matter, how did they manage to avoid jail terms? This is the real question that “free market” economists should be asking.
Most Wall Street firms have paid substantial settlements, and Mr. Mozilo recently paid the Securities and Exchange Commission $67.5 million to avoid going to trial for civil fraud and insider dealing. But only Martha Stewart became an insider jailbird. For Wall Street, paying a civil fine “without acknowledging wrongdoing” blocks victims from recovering civil damages in the event that they try to sue to get their money back. Evidently the Obama Administration believes that to make the banks pay would simply require yet further bailouts of “taxpayer money.” By refraining from prosecuting, Mr. Geithner at the Treasury and other regulators thus can claim to be saving taxpayers – while permitting the large banks to have grown 20 percent larger today than they were when the bailouts began, by extorting high credit card fees and penalties, and using tax breaks and almost free Fed credit such as the $600 billion QE2 to make money by fleeing the dollar to speculate in foreign currencies and make casino capitalist bets.
Mr. Greenspan insists that the economy would be even poorer under financial regulation. “One of the [Dodd-Frank] law’s provisions,” he criticizes, “made credit-rating organisations legally liable for their opinions about risks.” To avoid killing business with such regulation, “the Securities and Exchange Commission in effect suspended the need for a credit rating.” The idea was to save the ratings agencies from having to take responsibility for the tens of billions of dollars lost as a result of their pasting AAA ratings on junk mortgages.
It is as if fraud is simply part of the free market. In this respect, I find his Financial Times op-ed more damning than his evidently temporary burst of candor in his October 2008 Congressional testimony. Mr. Greenspan has rejoined his flock. And to show how thoroughly he has been cured from his temporary apostasy from free market religion, he belittles the fact that: “In December, the Federal Reserve … proposed to reduce banks’ share of debit card fees associated with retail transactions, leading many lenders to contend they would no longer be able to afford to issue debit cards.”
But can there be a better logic to promote the “public option” and have the Treasury issue credit cards as well as debt cards? The rake-off charged by banks from sellers and buyers alike (not to mention late fees that yield the card companies even more than their interest charges these days) has been a major factor eating into retail profits and personal incomes.
The banks are arguing, in effect: “If we can’t earn back enough profits to cover the losses we’ve made on our junk loans, we’ll organize our own lockout of customers – to force you to pay whatever we demand to cover our costs, pay our salaries and bonuses.” This has been their threat ever since the Lehman Brothers meltdown. They threaten to create financial anarchy if the government does not save them from loss, by shifting it onto taxpayers!
The problem is that the bankers’ solution – the inevitable result of Mr. Greenspan’s policy of shifting central planning onto Wall Street – is that it will culminate in the anarchy of debt deflation, deepening unemployment, more real estate foreclosures, and capital flight out of the dollar. So why not let the government say, “OK, we’ll provide a public-option alternative. And if this works, we’ll use it as a model for our public health insurance option. And then we will look to public banking options, and perhaps to Dennis Kucinich’s American Monetary Act to turn you commercial banks back into savings banks to stem your wild speculation at the economy’s expense.” (Just a modest proposal here for argument’s sake to quiet down the bankers’ threats.)
Mr. Greenspan argues that if banks are regulated to reduce the risk they pose to the economy, they may pack up and take their dealings to London: “concerns are growing that without immediate exemption from Dodd-Frank, a significant proportion of the foreign exchange derivatives market would leave the US.” My own response is to say fine, let them leave. Let Britain’s Serious Fraud Office and bank regulators pick up the pieces from their next opaque gamble “too complex” to understand.
Most slippery is Mr. Greenspan’s attempt to divert attention away from the instability that financial deregulation causes – the extreme and rapid polarization of wealth, the mushrooming of bad debt beyond the ability to pay, and the impoverishment of the economy as a result of its debt overhead. Don’t look there, he says; look at how “the global ‘invisible hand’ has created relatively stable exchange rates, interest rates, prices, and wage rates.” But real estate prices have not been stable – they have been inflated with debt, and then crashed the net worth of hapless borrowers. Employment is not stable, wealth distribution is not stable, nor are commodity prices, especially not the price of Mr. Greenspan’s beloved gold bullion.
Nevertheless, Mr. Greenspan concludes, there can be no such thing as a science of regulation. “Financial market behaviour is subject to so wide a variety of ‘explanations,’ especially in contrast to the physical sciences where cause and effect is much more soundly grounded.” But what sets the physical sciences apart from junk economics is the fact that it is not directly self-interested. There are no huge financial rewards for having a blind spot (except of course for scientists denying global warming or that nuclear power might be dangerous or deep-water oil drilling a risky proposition). There is method in the madness of today’s free market orthodoxy opting for GIGO (garbage in, garbage out) financial models that sing along with maestro Greenspan that Wall Street wealth will all trickle down.
“Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago?” he asks rhetorically. By “simpler” banking practices of days of yore, he really means more honest practices, subject to knowledgeable public regulation. It was a world where banks held onto the mortgages they made rather than flipping them to third parties without any responsibility for truth in lending – or in selling, for that matter. “That may not be possible if we wish to maintain today’s levels of productivity and standards of living.” So regulation will make us poorer, not save us from financial fraud and $13 trillion bailouts.
Postulating an admittedly “as yet unproved tie between the degree of financial complexity and higher standards of living,” Mr. Greenspan suggests that wealth at the top is the price to be paid for rising living standards. But they are not rising; they are falling! have Instead of being job creators, bankers are debt creators – and debt deflation is pushing the economy into depression, raising unemployment and driving housing prices further down.
So it sounds like Mr. Greenspan today would do just what he did years ago, and reject warnings that the Fed should regulate reckless bank lending and outright fraud. His mantra is still that the invisible hand is too complex to regulate. It sounds like Willy Sutton bemoaning the fact that policemen keep interfering with his business!
For further commentary on Mr. G’s remarkable “I take it all back” op-ed, I recommend the excellent column of Yves Smith, “OMG, Greenspan Claims Financial Rent Seeking Promotes Prosperity!” Naked Capitalism, March 30, 2011. And if you still believe that Mr. Greenspan can be trusted to provide objective help to today’s financial policy makers, Google the name Brooksley Born and watch the Frontline show “The Warning.” Describing how ferociously Mr. Greenspan and his deregulatory Rubinomics colleagues fought against her attempts to provide information about derivatives so that they might be regulated (saving the U.S. government trillions of dollars), Ms. Born told her interviewer: “They were totally opposed to it. That puzzled me. What was it that was in this market that had to be hidden?”
We now know the answer. Investment bankers were making fortunes at what turned out to be public expense. And that is the real flaw in today’s financial system: most fortunes today, as in past centuries, are made by privatizing wealth from the public domain. To the grabbers, nothing must be allowed to stop that. They insist that is too complex for the regulators to cope with.

Wallison: Leader of the Financial Wrecking Crew

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.

Can Better Risk Management Techniques Prevent “It” From Happening Again?

by Eric Tymoigne

The risk-management approach to financial regulation has been around for a long time and it has failed consistently. It has not only failed to promote safer economic decisions and prevent the emergence of crises, but it has also failed to provide a relevant protection against major financial problems. Since at least 1864, with the imposition of capital adequacy ratios on national banks, regulators have tried to establish adequate buffers against expected and unexpected financial losses. Over time, the calculation of those buffers (liquidity, loan provisions, capital equity, etc.) has been refined, and Basel II was supposed to provide the latest improvements in this area. The current crisis has already made Basel II obsolete and many economists have noted the importance of accounting for liquidity issues in addition to loss issues.

Recent reports (e.g., CRMPG, BIS, IMCB, FSF, and the Department of the Treasury) have suggested that risk management can be improved by accounting for systemic risk and liquidity risk, and by making capital adequacy ratios more countercyclical. In addition, improvements were suggested in terms of reinforcing the role of risk officers in the governance of companies and in terms of remuneration methods.

Two of the major drawbacks of these proposals are that, first, like all previous risk-management policies, they do not deal with the core cause of financial instability and, second, they aim at being the least “intrusive,” which gives them only a very indirect impact on the management of financial stability.

Regarding the latter point, the philosophy of the past and current regulatory approaches has been to let individuals take whatever risk they find appropriate given market signals. Regulation is just there to tweak costs and returns in order to give an incentive to make “prudent” decisions as defined by arbitrary ratios of capital and liquidity (as well as by insurance premiums). As a consequence, as long as financial institutions meet the regulatory ratios, they are assumed to be safe and prudently managed, no matter how risky their asset positions and funding methods are. In addition, financial institutions can self-righteously complain further supervisory scrutiny if they meet their capital requirements, which greatly limits the effectiveness of supervision. All this is rather a permissive approach to financial regulation that is highly reluctant to forbid unsustainable financial practices. This is all the more so that economic agents are willing, and are forced by market mechanisms, to use those financial practices to improve their economic situations (unfortunately without consideration for the long-term indirect consequences of their choices).

Regarding the former point, the core cause of systemic financial crisis is the growing use of Ponzi finance over enduring periods of economic expansion. Ponzi finance means that the servicing of a given amount of debts requires the growing use of refinancing operations and/or liquidation of assets at rising prices. Ponzi funding methods are usually associated with crooks like Madoff, but the most devastating Ponzi processes are those that involve legal economic activities that are at the core of the economic growth process. Consumer finance for the past twenty years and the mortgage booms of the past ten years were Ponzi processes that involved honest and creditworthy borrowers who just wanted to improve their standard of living; lenders were more than eager to promote this trend to maintain their profitability and competitiveness, which was seen as a proud achievement of American free enterprise. Thus several Ponzi processes were at play and they all were used “judiciously” to maintain economic growth and business activities.

The problem with the type of Ponzi processes that we have experienced, is that, no matter how sophisticated and well informed financial players are, and no matter how efficient financial markets are, it always fails; and when it does, no buffer, no matter how high it is, can protect against the collapse. Pyramid Ponzi processes cannot be “risk managed.”

To better prevent the emergence of Ponzi processes an emphasis should be put on cash flows (rather than accounting profit) and on how economic entities plan to meet their financial commitments. Rather than asking, “Will you pay on time?” to determine creditworthiness, a more relevant question would be, “How will you pay on time?” And rising collateral price and access to refinancing channels should not be used to determine the expected capacity to repay of a borrower. Collateral liquidation (and so price) would only be used as a defensive means to protect banks against unexpected default, rather than as an offensive means to grow market shares and lending volumes. Ponzi processes should be eliminated or discouraged, no matter how good (or necessary) they appear for the competitiveness and (short-term) improvement of standards of living.

All financial institutions should be regulated, and the restructuring of the financial system should be based on promoting hedge financing of economic activities. By focusing on the financial practices of financial institutions, strong financial stability will be promoted and economic growth will proceed on more solid grounds (albeit probably at a slower pace).

The Two Documents Everyone Should Read to Better Understand the Crisis

By William K. Black (Via Huffington Post)

As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an “epidemic” of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds.* When the person that controls a seemingly legitimate business or government agency uses it as a “weapon” to defraud we categorize it as a “control fraud” (“The Organization as ‘Weapon’ in White Collar Crime.” Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds’ “weapon of choice” is accounting. Control frauds cause greater financial losses than all other forms of property crime — combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a “criminogenic environment” (Big Money Crime. Calavita, Pontell & Tillman 1997.)

The FBI correctly identified the epidemic of mortgage control fraud at such an early point that the financial crisis could have been averted had the Bush administration acted with even minimal competence. To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud.

Don’t ask; don’t tell: book profits, “earn” bonuses and closet your losses
The first document everyone should read is by S&P, the largest of the rating agencies. The context of the document is that a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages “underlying” the derivative. A senior manager sends a blistering reply with this forceful punctuation:

“Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.”

Fraud is the principal credit risk of nonprime mortgage lending. It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, “most investors” (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The “AAA” rating is supposed to indicate that there is virtually no credit risk — the risk is equivalent to U.S. government bonds, which finance refers to as “risk-free.” We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this era rises like a stairway to heaven [PDF]. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud.

Worse, the S&P document demonstrates that the investment and commercial banks that purchased nonprime loans, pooled them to create financial derivatives, and sold them to others engaged in the same willful blindness. They did not review samples of loan files because doing so would have exposed the toxic nature of the assets they were buying and selling. The entire business was premised on a massive lie — that fraudulent, toxic nonprime mortgage loans were virtually risk-free. The lie was so blatant that the banks even pooled loans that were known in the trade as “liar’s loans” and obtained AAA ratings despite FBI warnings that mortgage fraud was “epidemic.” The supposedly most financially sophisticated entities in the world — in the core of their expertise, evaluating credit risk — did not undertake the most basic and essential step to evaluate the most dangerous credit risk. They did not review the loan files. In the short and intermediate-term this optimized their accounting fraud but it was also certain to destroy the corporation if it purchased or retained significant nonprime paper.

Stress this: stress tests are useless against the nonprime problems

What commentators have missed is that the big banks often do not have the vital nonprime loan files now. That means that neither they nor the Treasury know their asset quality. It also means that Geithner’s “stress tests” can’t “test” assets when they don’t have the essential information to “stress.” No files means the vital data are unavailable, which means no meaningful stress tests are possible of the nonprime assets that are causing the greatest losses.

The results were disconcerting

A rating agency (Fitch) first reviewed a small sample of nonprime loan files after the secondary market in nonprime loan paper collapsed and nonprime lending virtually ceased. The second document everyone should read is Fitch’s report on what they found.

Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.
[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.

Fitch also explained [PDF] why these forms of mortgage fraud cause severe losses.
For example, for an origination program that relies on owner occupancy to offset other risk factors, a borrower fraudulently stating its intent to occupy will dramatically alter the probability of the loan defaulting. When this scenario happens with a borrower who purchased the property as a short-term investment, based on the anticipation that the value would increase, the layering of risk is greatly multiplied. If the same borrower also misrepresented his income, and cannot afford to pay the loan unless he successfully sells the property, the loan will almost certainly default and result in a loss, as there is no type of loss mitigation, including modification, which can rectify these issues.”
The widespread claim that nonprime loan originators that sold their loans caused the crisis because they “had no skin in the game” ignores the fundamental causes. The ultra sophisticated buyers knew the originators had no skin in the game. Neoclassical economics and finance predicts that because they know that the nonprime originators have perverse incentives to sell them toxic loans they will take particular care in their due diligence to detect and block any such sales. They assuredly would never buy assets that the trade openly labeled as fraudulent, after receiving FBI warnings of a fraud epidemic, without the taking exceptional due diligence precautions. The rating agencies’ concerns for their reputations would make them even more cautious. Real markets, however, became perverse — “due diligence” and “private market discipline” became oxymoronic. These two documents are enough to begin to understand:
  • the FBI accurately described mortgage fraud as “epidemic”
  • nonprime lenders are overwhelmingly responsible for the epidemic
  • the fraud was so endemic that it would have been easy to spot if anyone looked
  • the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a “don’t ask; don’t tell” policy
  • willful blindness was essential to originate, sell, pool and resell the loans
  • willful blindness was the pretext for not posting loss reserves
  • both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed
  • the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses
  • the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation
  • many of the big banks are deeply insolvent due to severe credit losses
  • those big banks and Treasury don’t know how insolvent they are because they didn’t even have the loan files
  • a “stress test” can’t remedy the banks’ problem — they do not have the loan files

* “Mortgage Fraud: Strengthening Federal and State Mortgage Fraud Prevention Efforts” (2007). Tenth Periodic Case Report to the Mortgage Bankers Association, produced by MARI.

Did Greenspan “Blow” It?

Click here to read Stephanie Kelton’s presentation at the UMKC Carolyn Benton Cockefair. She discussed the current financial crisis and the prospects for recovery offered by the government stimulus plan, bailout packages and regulatory initiatives.