Tag Archives: Financial crisis

JPMorgan targeted for role in financial crisis

Posted on October 3, 2012 by Devin Smith | 4 comments

JPMorgan Chase & Co. has become the first target of the task force that the Justice Department created this year to hold big Wall Street banks accountable for their role in the financial crisis. NEP’s William Black provides input regarding these first steps taken by regulators to prosecute in an article at the LA Times. You can read the LA Times article here.

The Globe and Mail has also published an article on the prosecution of JPMorgan Chase & Co with input from William Black. You can read the Globe and Mail article here.

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Posted in William K. Black

Tagged accounting control fraud, banksters, Financial crisis

Effectiveness of Mortgage Fraud Task Force

Posted on September 12, 2012 by Devin Smith | 1 comment

RT America discusses with William Black just how aggressive the investigation by the President’s Mortgage Fraud Task Force has actually been.

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Posted in William K. Black

Tagged banksters, Financial crisis, jail the banksters, liar loans, mortgage fraud

Washington Post and the AIG Bailout

Posted on September 10, 2012 by Devin Smith | Comments Off

The Washington Post (9/10) published an article on the the “success” of the AIG bailout. NEP’s William Black explains the issue of perverse incentives created by the successful bailout.

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Posted in William K. Black

Tagged AIG, crony capitalism, Financial crisis, perverse incentives

Going after Wall Street – and watching the clock

Posted on August 13, 2012 by Devin Smith | 2 comments

NEP’s William K. Black provides input on the approaching deadline imposed by statute of limitations on prosecutions related to the economic crisis. You can read the article here.

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Posted in William K. Black

Tagged Financial crisis, prosecutions

W. Black’s 8/10 Appearance on CNBC’s Closing Bell

Posted on August 11, 2012 by Devin Smith | 10 comments

By William K. Black

My August 10th appearance on CNBC’s Closing Bell opposite Bethany McLean. The debate topic was the failure to prosecute Goldman Sachs for any role in the financial crisis.

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Posted in William K. Black

Tagged bank fraud, Control Fraud, Financial crisis, goldman sachs, liar loans

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

Posted on August 19, 2011 by admin | 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

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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Posted in Uncategorized, William K. Black

Tagged Control Fraud, Financial crisis, Rating agencies, systemically dangerous institutions, William K. Black

The Case Against the Ratings Agencies

Posted on August 19, 2011 by admin | 2 comments

By Michael Hudson
(Cross-posted from Counterpunch.org)

In today’s looming confrontation the ratings agencies are playing the political role of “enforcer” as the gatekeepers to credit, to put pressure on Iceland, Greece and even the United States to pursue creditor-oriented policies that lead inevitably to financial crises. These crises in turn force debtor governments to sell off their assets under distress conditions. In pursuing this guard-dog service to the world’s bankers, the ratings agencies are escalating a political strategy they have long been refined over a generation in the corrupt arena of local U.S. politics.

Why ratings agencies use public selloffs rather than sound tax policy: The Kucinich Case Study

In 1936, as part of the New Deal’s reform of America’s financial markets, regulators forbid banks and institutional money managers to buy securities deemed “speculative” by “recognized rating manuals.” Insurance companies, pension funds and mutual funds subject to public regulation are required to “take into account” the views of the credit ratings agencies, providing them with a government-sanctioned monopoly. These agencies make their money by offering their “opinions” (for which they have never been legally liable) as to the payment prospects of various grades of security, from AAA (as secure government debt, the top rating because governments always can print the money to pay) down to various depths of junk.

Moody’s, Standard and Poor’s and Fitch focus mainly on stocks and on corporate, state and local bond issues. They make money twice off the same transaction when cities and states balance their budgets by spinning off public enterprises into new corporate entities issuing new bonds and stocks. This business incentive gives the ratings agencies an antipathy to governments that finance themselves on a pay-as-you-go basis (as Adam Smith endorsed) by raising taxes on real estate and other property, income or sales taxes instead of borrowing to cover their spending. The effect of this inherent bias is not to give an opinion about what is economically best for a locality, but rather what makes the most profit for themselves.

Localities are pressured when their rising debt levels lead to a financial stringency. Banks pull back their credit lines, and urge cities and states to pay down their debts by selling off their most viable public enterprises. Offering opinions on this practice has become a big business for the ratings agencies. So it is understandable why their business model opposes policies – and political candidates – that support the idea of basing public financing on taxation rather than by borrowing. This self-interest colors their “opinions.”

If this seems too cynical an explanation for today’s ratings agencies self-serving views, there are sufficient examples going back over thirty years to illustrate their unethical behavior. The first and most notorious case occurred in Cleveland, Ohio, after Dennis Kucinich was elected mayor in 1977. The ratings agencies had been giving the city good marks despite the fact that it had been using bond funds improperly for general operating purposes to cover its budget shortfalls by borrowing, leaving Cleveland with $14.5 million owed to the banks on open short-term credit lines.

Cleveland had a potential cash cow in Municipal Light, which its Progressive Era mayor Tom Johnson had created in 1907 as one of America’s first publicly owned power utilities. It provided the electricity to light Cleveland’s streets and other public uses, as well as providing power to private users. Meanwhile, banks and their leading local clients were heavily invested in Muni Light’s privately owned competitor, the Cleveland Electric Illuminating Company. Members of the Cleveland Trust sat on CEI’s board and wielded a strong influence on the city council to try and take it over. In a series of moves that city officials, the U.S. Senate and regulatory agencies found to be improper (popular usage would say criminal),[1] CEI caused a series of disruptions in service and worked with the banks and ratings agencies to try and force the city to sell it the utility. Banks for their part had their eye on financing a public buyout – and hoped to pressure the city into selling, threatening to pull the plug on its credit lines if it did not surrender Muni Light.

It was to block this privatization that Mr. Kucinich ran for mayor. To free the city from being liable to financial pressure from its vested interests – above all from the banks and private utilities – he sought to put the city’s finances on a sound footing by raising taxes. This threatened to slow borrowing from the banks (thereby shrinking the business of ratings agencies as well), while freeing Cleveland from the pressures that have risen across the United States for cities to start selling off their public enterprises, especially since the 1980s as tax-cutting politicians have left them deeper in debt.

The banks and ratings agencies told Mayor Kucinich that they would back his political career and even hinted financing a run for the governorship if he played ball with them and agreed to sell the electric utility. When he balked, the banks said that they could not renew credit lines to a city that was so reluctant to balance its books by privatizing its most profitable enterprises. This threat was like a credit-card company suddenly demanding payment of the full balance from a customer, saying that if it were not paid, the sheriff would come in and seize property to sell off (usually on credit extended to customers of the bankers).

The ratings agencies chimed in and threatened to downgrade Cleveland’s credit rating if the city did not privatize its utility. The financial tactic was to offer the carrot of corrupting the mayor politically, while using the threat of forcing the city into financial crisis and raising its interest rates. If the economy did not pay higher utility charges as a result of privatization, it would have to pay higher interest.

But standing on principle, the mayor refused to sell the utility, and voters elected to keep Muni light public by a 2-to-1 margin in a referendum. They proceeded to pay down the city’s debt by raising its income-tax rate in order to avoid paying higher rates for privatized electricity. Their choice was thoroughly in line with Book V of Adam Smith’s Wealth of Nations provides a perspective on how borrowing ends up with a proliferation of taxes to pay the interest. This makes the private sector pay higher prices for its basic needs that Cleveland Mayor Tom Johnson and other Progressive Era leaders a century ago sought to socialize in order to lower the cost of living and doing business in the United States.

The bankers’ alliance with the Cleveland’s wealthy would-be power monopoly led it to be the first U.S. city to default since the Great Depression as the state of Ohio forced it into fiscal receivership in 1979. The banks used the crisis to make an easy gain in buying up bond anticipation notes that were sold under distress conditions exacerbated by the ratings agencies. The banks helped fund Mayor Kucinich’s opponent in the 1979 mayoral race.

But in saving Muni Light he had saved voters hundreds of millions of dollars that the privatizers would have built into their electric rates to cover higher interest charges and financial fees, dividends to stockholders, and exorbitant salaries and stock options. In due course voters came to recognize Mr. Kucinich’s achievement have sent him to Congress since 1997. As for Mini Light’s privately owned rival, the Cleveland Electric Illuminating Company, it achieved notoriety for being primarily responsible for the northeastern United States power blackout in 2003 that left 50 million people without electricity.

The moral is that the ratings agencies’ criterion was simply what was best for the banks, not for the debtor economy issuing the bonds. They were eager to upgrade Cleveland’s credit ratings for doing something injurious – first, borrowing from the banks rather than covering their budget by raising property and income taxes; and second, raising the cost of doing business by selling Muni Light. They threatened to downgrade the city for acting to protect its economic interest and trying to keep its cost of living and doing business low.

The tactics by banks and credit rating agencies have been successful most easily in cities and states that have fallen deeply into debt dependency. The aim is to carve up national assets, by doing to Washington what they sought to do in Cleveland and other cities over the past generation. Similar pressure is being exerted on the international level on Greece and other countries. Ratings agencies act as political “enforcers” to knee-cap economies that refrain from privatization sell-offs to solve debt problems recognized by the markets before the ratings agencies acknowledge the bad financial mode that they endorse for self-serving business reasons.

Why ratings agencies oppose public checks against financial fraud

The danger posed by ratings agencies in pressing the global economy to a race into debt and privatization recently became even more blatant in their drive to give more leeway to abusive financial behavior by banks and underwriters. Former Congressional staffer Matt Stoller cites an example provided by Josh Rosner and Gretchen Morgenson in Reckless Endangerment regarding their support of creditor rights to engage in predatory lending and outright fraud.[2] On January 12, 2003, the state of Georgia passed strong anti-fraud laws drafted by consumer advocates. Four days later, Standard & Poor announced that if Georgia passed anti-fraud penalties for corrupt mortgage brokers and lenders, packaging including such debts could not be given AAA ratings.

Because of the state’s new Fair Lending Act, S&P said that it would no longer allow mortgage loans originated in Georgia to be placed in mortgage securities that it rated. Moody’s and Fitch soon followed with similar warnings.

It was a critical blow. S&P’s move meant Georgia lenders would have no access to the securitization money machine; they would either have to keep the loans they made on their own books, or sell them one by one to other institutions. In turn, they made it clear to the public that there would be fewer mortgages funded, dashing “the dream” of homeownership.

The message was that only bank loans free of legal threat against dishonest behavior were deemed legally risk-free for buyers of securities backed by predatory or fraudulent mortgages. The risk in question was that state agencies would reduce or even nullify payments being extracted by crooked real estate brokers, appraisers and bankers. As Rosner and Morgenson summarize:

Standard & Poor’s said it was taking action because the new law created liability for any institution that participated in a securitization containing a loan that might be considered predatory. If a Wall Street firm purchased loans that ran afoul of the law and placed them in a mortgage pool, the firm could be liable under the law. Ditto for investors who bought into the pools. “Transaction parties in securitizations, including depositors, issuers and servicers, might all be subject to penalties for violations under the Georgia Fair Lending Act,” S&P’s press release explained.

The ratings agencies’ logic is that bondholders will not be able to collect if public entities prosecute financial fraud involved in packaging deceptive mortgage packages and bonds. It is a basic principle of law that receivers or other buyers of stolen property must forfeit it, and the asset returned to the victim. So prosecuting fraud is a threat to the buyer – much as an art collector who bought a stolen painting must give it back, regardless of how much money has been paid to the fence or intermediate art dealer. The ratings agencies do not want this principle to be followed in the financial markets.

We have fallen into quite a muddle when ratings agencies take the position that packaged mortgages can receive AAA ratings only from states that do not protect consumers and debtors against mortgage fraud and predatory finance. The logic is that giving courts the right to prosecute fraud threatens the viability of creditor claims endorses a race to the bottom. If honesty and viable credit were the objective of ratings agencies, they would give AAA ratings only to states whose courts deterred lenders from engaging in the kind of fraud that has ended up destroying the securitized mortgage binge since September 2008. But protecting the interests of savers or bank customers – and hence even the viability of securitized mortgage packages – is not the task with which ratings agencies are charged.

Masquerading as objective think tanks and research organizations, the ratings agencies act as lobbyists for banks and underwriters by endorsing a race to the bottom – into debt, privatization sell-offs and an erosion of consumer rights and control over fraud. “S&P was aggressively killing mortgage servicing regulation and rules to prevent fraudulent or predatory mortgage lending,” Stoller concludes. “Naomi Klein wrote about S&P and Moody’s being used by Canadian bankers in the early 1990s to threaten a downgrade of that country unless unemployment insurance and health care were slashed.”

The basic conundrum is that anything that interferes with the arbitrary creditor power to make money by trickery, exploitation and outright fraud threatens the collectability of claims. The banks and ratings agencies have wielded this power with such intransigence that they have corrupted the financial system into junk mortgage lending, junk bonds to finance corporate raiders, and computerized gambles in “casino capitalism.” What then is the logic in giving these agencies a public monopoly to impose their “opinions” on behalf of their paying clients, blackballing policies that the financial sector opposes – rulings that institutional investors are legally obliged to obey?

Threats to downgrade the U.S. and other national economies to force pro-financial policies

At the point where claims for payment prove self-destructive, creditors move to their fallback position. Plan B is to foreclose, taking possession of the property of debtors. In the case of public debt, governments are told to privatize the public domain – with banks creating the credit for their customers to buy these assets, typically under fire-sale distress conditions that leave room for capital gains and other financial rake-offs. In cases where foreclosure and forced sell-offs are not able to make creditors whole (as when the economy breaks down), Plan C is for governments simply to bail out the banks, taking bad bank debts and other obligations onto the public balance sheet for taxpayers to make good on.

Standard and Poor’s threat to downgrade of U.S. Treasury bonds from AAA to AA+ would exacerbate the problem if it actually discouraged purchasers from buying these bonds. But on the Monday on August 8, following their Friday evening downgrade, Treasury borrowing rates fell, with short-term T-bills actually in negative territory. That meant that investors had to lose a small margin simply to keep their money safe. So S&P’s opinions are as ineffectual as being a useful guide to markets as they are as a guide to promote good economic policy.

But S&P’s intent was not really to affect the marketability of Treasury bonds. It was a political stunt to promote the idea that the solution to today’s budget deficit is to pursue economic austerity. The message is that President Obama should roll back Social Security and Medicare entitlements so as to free more money for more subsidies, bailouts and tax cuts for the top of the steepening wealth pyramid. Neoliberal Harvard economics professor Robert Barro made this point explicitly in a Wall Street Journal op-ed. Calling the S&P downgrade a “wake-up call” to deal with the budget deficit, he outlined the financial sector’s preferred solution: a vicious class war against labor to reduce living standards and further polarize the U.S. economy between creditors and debtors by shifting taxes off financial speculation and property onto employees and consumers.

First, make structural reforms to the main entitlement programs, starting with increases in ages of eligibility and a shift to an economically appropriate indexing formula. Second, lower the structure of marginal tax rates in the individual income tax. Third, in the spirit of Reagan’s 1986 tax reform, pay for the rate cuts by gradually phasing out the main tax-expenditure items, including preferences for home-mortgage interest, state and local income taxes, and employee fringe benefits—not to mention eliminating ethanol subsidies. Fourth, permanently eliminate corporate and estate taxes, levies that are inefficient and raise little money. Fifth, introduce a broad-based expenditure tax, such as a value-added tax (VAT), with a rate around 10%.[3]

Bank lobbyist Anders Aslund of the Peterson Institute of International Finance jumped onto the bandwagon by applauding Latvia’s economic disaster (a 20 percent plunge in GDP, 30 percent reduction of public-sector salaries and accelerating emigration as a success story for other European countries to follow. As they say, one can’t make this up.

As the main advocate and ultimate beneficiary of privatization, the financial sector directs debtor economies to sell off their public property and cut social services – while increasing taxes on employees. Populations living in such economies call them hell and seek to emigrate to find work or simply to flee their debts. What else should someone call surging poverty, death rates and alcoholism while a few grow rich? The ratings agencies today are like the IMF in the 1970s and ‘80s. Countries that do not agree sell off their public domain (and give tax deductibility to the interest payments of buyers-on-credit, providing multinationals with income-tax exemption on their takings from the monopolies being privatized) are treated as outlaws and isolated Cuba- or Iran-style.

Such austerity plans are a failed economic model, but the financial sector has managed to gain even as economies are carved up. Their “Plan B” is foreclosure, extending to the national scale. By the 1980s, creditor-planned economies in Third World debtor countries had reached the limit of their credit-worthiness. Under World Bank coordination, a vast market in national infrastructure spending for creditor-nation bank debt, bonds and exports. The projects being financed on credit were mainly to facilitate exports and provide electric power for foreign investments. After Mexico announced its insolvency in 1982 when it no longer could afford to service foreign-currency debt, where were creditors to turn?

Their solution was to use the debt crisis as a lever to start financing these same infrastructure projects all over again, now that most were largely paid for. This time, what was being financed was not new construction, but private-sector buyouts of property that had been financed by the World Bank and its allied consortia of international bankers. There is talk of the U.S. Government selling off its national parks and other real estate, national highways and infrastructure, perhaps the oil reserve, postal service and so forth.

S&P’s “opinion” was treated seriously enough by John Kerry, the 2004 Democratic Presidential nominee, as a warning that America should “get its house in order.” Despite the fact that on page 4 of its 8-page explanation of why it downgraded Treasury bonds, S&P’s stated: “We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act,” was one of the three senators appointed to the commission under the debt-ceiling agreement. He chimed in to endorse the S&P action as a helpful nudge for the country to deal with its “entitlements” program – as if Social Security and FICA withholding were a kind of welfare, not actual savings put in by labor, to be wiped out as the government empties its coffers to bail out Wall Street’s high rollers.

No less a financial publication than the Wall Street Journal has come to the conclusion that “in a perfect world, S&P wouldn’t exist. And neither would its rivals Moody’s Investors Service and Fitch Ratings Ltd. At least not in their current roles as global judges and juries of corporate and government bonds.”[4] As its financial editor Francesco Guerrera wrote quite eloquently in the aftermath of S&P’s bold threat to downgrade the U.S. Treasury’s credit rating: “The historic decision taken by S&P on Aug. 5 is the culmination of 75 years of policy mistakes that ended up delegating a key regulatory function to three for-profit entities.”

The behavior of leading banks and ratings agencies Cleveland and other similar cases – of promising to give good ratings to states, counties and cities that agree to pay off short-term bank debt by selling off their crown jewels – is not ostensibly criminal under the law (except when their hit men actually succeed in assassination). But the ratings agencies have made an compact with crooks to endorse only public borrowers that agree to pursue such policies and not to prosecute financial fraud.

To acquiescence in such economically destructive financial behavior is the opposite of fiscal responsibility. Cutting federal taxes and Social Security payments to obtain a more positive S&P “opinion” would give banks an ability to “pull the plug” and force privatization and anti-labor austerity plans by refraining from rolling over the U.S. debt – and cutting taxes Tea-Party style rather than funding spending by taxation on a pay-as-you-go-basis.

The present meltdown of the euro provides an object lesson for why policy-making never should be left to central bankers, because their mentality is pro-creditor. Otherwise they would not have the political reliability demanded by the financial sector that has captured the central bank, Treasury and regulatory agencies to gain veto power over who is appointed. Given their preference for debt deflation of the “real” economy – while trying to inflate asset prices by promoting the banks’ product (debt creation) – central bank and Treasury solutions tend to aggravate economic downturns. This is self-destructive because today’s major problem blocking recovery is over-indebtedness.

[1] See http://en.wikipedia.org/wiki/Cleveland_Public_Power, as well as http://en.wikipedia.org/wiki/Dennis_Kucinich. The financial ploy included hiring a Mafia hit man to shoot Mr. Kucinich at a parade – which he fortunately did not attend. For Mr. Kucinich’s own narrative of these events, see “Kucinich and Muny Light – Battle with the Banks,” truthdig.com, December 15, 2008, also available at http://www.dailypaul.com/76343/kucinich-and-muny-light-battle-with-the-banks.

[2] Matt Stoller, “Standard & Poor’s Predatory Policy Agenda,” Naked Capitalism, August 7, 2011.

[3] Robert Barro, “How to Get That AAA Rating Back,” Wall Street Journal, August 8, 2011.

[4] Francesco Guerrera, “Here’s How to Rejigger the U.S. Credit-Rating System,” Wall Street Journal, August 16, 2011.

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Posted in Michael Hudson, Uncategorized

Tagged Financial crisis, Michael Hudson, Rating agencies

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

Posted on July 25, 2011 by admin | 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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Posted in Policy and Reform, Uncategorized, William K. Black

Tagged Control Fraud, Financial crisis, Financial system, Policy and Reform, William K. Black

The Financial Road to Serfdom: How Bankers are using the Debt Crisis to Roll Back the Progressive Era

Posted on June 13, 2011 by admin | 8 comments

By Michael Hudson

Financial strategists do not intend to let today’s debt crisis go to waste. Foreclosure time has arrived. That means revolution – or more accurately, a counter-revolution to roll back the 20th century’s gains made by social democracy: pensions and social security, public health care and other infrastructure providing essential services at subsidized prices or for free. The basic model follows the former Soviet Union’s post-1991 neoliberal reforms: privatization of public enterprises, a high flat tax on labor but only nominal taxes on real estate and finance, and deregulation of the economy’s prices, working conditions and credit terms.

What is to be reversed is the “modern” agenda. The aim a century ago was to mobilize the Industrial Revolution’s soaring productivity and technology to raise living standards and use progressive taxation, public regulation, central banking and financial reform to distribute wealth fairly and make societies more equal. Today’s financial aim is the opposite: to concentrate wealth at the top of the economic pyramid and lower labor’s returns. High finance loves low wages.

The political lever to achieve this program is financial. The European Union (EU) constitution prevents central banks from financing government deficits, leaving this role to commercial banks, paying interest to them for creating credit that central banks readily monetize for themselves in Britain and the United States. Governments are to go into debt to bail out banks for loans gone bad – as do more and more loans as finance impoverishes the economy, stifling its ability to pay. Yet as long as we live in democracies, voters must agree to pay. Governments are sovereign and debt is ultimately a creature of the law and courts.

But first they need to understand what is happening. From the bankers’ perspective, the economic surplus is what they themselves end up with. Rising consumption standards and even public investment in infrastructure are seen as deadweight. Bankers and bondholders aim to increase the surplus not so much by tangible capital investment increasing the overall surplus, but by more predatory means, headed by rolling back labor’s gains and stiffening working conditions while gaining public subsidy. Banks “create wealth” by providing more credit (that is, debt leverage) to bid up asset prices for real estate and enterprises already in place – assets that either are being foreclosed on or sold off under debt pressure by private owners or governments. One commentator recently characterized the latter strategy of privatization as “tantamount to selling the family silver only to have to rent it back in order to eat dinner.” [1]

Fought in the name of free markets, this counter-revolution rejects the classical ideal of markets free of unearned income paid to special interests. The financial objective is to squeeze out a surplus by maximizing the margin of prices over costs. Opposing government enterprise and infrastructure as the road to serfdom, high finance is seeking to turn public infrastructure into rent-extracting tollbooths to extract economic rent (the “free lunch economy”), while replacing labor unions with non-union labor so as to work it more intensively.

This new road to neoserfdom is an asset grab. But to achieve it, the financial sector needs a political grab to replace democracy with financial technocrats. Their job is to pretend that there is no revolution at all, merely an increase in “efficiency,” “creating wealth” by debt-leveraging the economy to the point where the entire surplus is paid out as interest to the financial managers who are emerging as Western civilization’s new central planners.

Frederick Hayek’s Road to Serfdom portrayed a dystopia of public officials seeking to regulate the economy. In attacking government so one-sidedly, his ideological extremism sought to replace the checks and balances of mixed economies with a private sector “free” of regulation and consumer protection. His vision was of a post-modern economy “free” of the classical reforms to bring market prices into line with cost value. Instead of purifying industrial capitalism from the special rent extraction privileges bequeathed from the feudal epoch, Hayek’s ideology opened the way for unchecked financial power to make a travesty of “free markets.”

The European Union’s financial planners claim that Greece and other debtor countries have a problem that is easy to cure by imposing austerity. Pension savings, Social Security and medical insurance are to be downsized so as to “free” more debt service to be paid to creditors. Insisting that Greece only has a “liquidity problem,” European Central Bank (ECB) extremists deem an economy “solvent” as long as it has assets to privatize. ECB executive board member Lorenzo Bini Smaghi explained the plan in a Financial Times interview:

FT: Otmar Issing, your former colleague, says Greece is insolvent and it “will not be physically possible” for it to repay its debts. Is he right?

LBS: He is wrong because Greece is solvent if it applies the programme. They have assets that they can sell and reduce their debt and they have the instruments to change their tax and expenditure systems to reduce the debt. This is the assessment of the IMF, it is the assessment of the European Commission.

Poor developing countries have no assets, their income is low, and so they become insolvent easily. If you look at the balance sheet of Greece, it is not insolvent.

The key problem is political will on the part of the government and parliament. Privatisation proceeds of €50bn, which is being talked about – some mention more – would reduce the peak debt to GDP ratio from 160 per cent to about 140 per cent or 135 per cent and this could be reduced further. [2]

A week later Mr. Bini Smaghi insisted that the public sector “had marketable assets worth 300 billion euros and was not bankrupt. ‘Greece should be considered solvent and should be asked to service its debts,’ … signaling that the bank remained firmly opposed to any plan to allow Greece to stretch out its debt payments or oblige investors to accept less than full repayment, a so-called haircut.” [3] Speaking from Berlin, he said that Greece “was not insolvent.” It could pay off its bonds owed to German bankers ($22.7 billion), French bankers ($15 billion) and the ECB (reported to be on the hook for $190 billion) by selling off public land and ports, water and sewer rights, ownership of the telephone system and other basic infrastructure. In addition to getting paid in full and receiving high interest rates reflecting “market” expectations of non-payment, the banks would enjoy a new credit market financing privatization buy-outs.

Warning that failure to pay would create windfall gains for speculators who had bet that Greece would default, Mr. Bini Smaghi refused to acknowledge the corollary: to pay the full amount would create windfalls for those who bet that Greece would be forced to pay. He also claimed that: “Restructuring of Greek debt would … discourage Greece from modernizing its economy.” But the less debt service an economy pays, the more revenue it has to invest productively. And to “solve” the problem by throwing public assets on the market would create windfalls for distress buyers. As the Wall Street Journal put matters bluntly: “Greece is for sale – cheap – and Germany is buying. German companies are hunting for bargains in Greece as the debt-stricken government moves to sell state-owned assets to stabilize the country’s finances.” [4]

Rather than raising living standards while creating a more egalitarian and fair society, the ECB’s creditor-oriented “reforms” would roll the time clock back to oligarchy. Not the post-feudal oligarchy of landlords owning land conquered militarily, but a financial oligarchy accumulating banking claims and bonds growing inexorably and exponentially, leaving little over for the rest of the economy to invest or consume.

The distinction between illiquidity and insolvency

If a homeowner loses his job and cannot pay his mortgage, he must sell the house or see the bank foreclose. Is he insolvent, or merely “illiquid”? If he merely has a liquidity problem, a loan will help him earn the funds to pay down the debt. But if he falls into the negative equity that now plagues a quarter of U.S. real estate, taking on more loans will only deepen his net deficit. Ending this process by losing his home does not mean that he is merely illiquid. He is in distress, and is suffering from insolvency. But to the ECB this is merely a liquidity problem.

The public balance sheet includes land and infrastructure as if they are surplus assets that can be forfeited without fundamentally changing the owner’s status or social relations. In reality it is part of the means of survival in today’s world, at least survival as part of the middle class.

For starters, renegotiating his loan won’t help an insolvency situation such as the jobless homeowner above. Lending him the money to pay the bank interest (along with late fees and other financial penalties) or stretching out the loan merely will add to the debt balance, giving the foreclosing bank yet a larger claim on whatever property the debtor may have available to grab.

But the homeowner is in danger of being homeless, living on the street. At issue is whether solvency should be defined in the traditional common-sense way, in terms of the ability of income to carry one’s current obligations, or a purely balance-sheet approach taken by creditors seeking to extract payment by stripping assets. This is Greece’s position. Is it merely a liquidity problem if the government is told to sell off $50 billion in prime tourist sites, ports, water systems and other public assets in order to pay foreign creditors?

At issue is language regarding the legal rights of creditors vis-à-vis debtors. The United States has long had a body of law regarding this issue. A few years ago, for instance, the real estate speculator Sam Zell bought the Chicago Tribune in a debt-leveraged buyout. The newspaper soon went broke, wiping out the employees’ stock ownership plan (ESOP). They sued under the fraudulent conveyance law, which says that if a creditor makes a loan without knowing how the debtor can pay in the normal course of business, the loan is assumed to have been made with the intent of foreclosing on property, and is deemed fraudulent.

This law dates from colonial times, when British speculators eyed rich New York farmland. Their ploy was to extend loans to farmers, and then call in the loans when the farmer’s ability to pay was low, before the crop was harvested. This was indeed a liquidity problem – which financial opportunists turned into an asset grab. Some lenders, to be sure, created a genuine insolvency problem by making loans beyond the ability of the farmers to pay, and then would foreclose on their land. The colonies nullified such loans. Fraudulent conveyance laws have been kept on the books since the United States won its independence from Britain.

Creditors today are using debt leverage to force Greece to sell off its public domain – having extended credit beyond its ability to pay. So the question now being raised is whether the nation should be deemed “solvent” if the only way to carry its public debt (that is, roll it over by replacing bad old loans with newer and more inexorable obligations) is to forfeit its land and basic infrastructure. This would fundamentally alter the relationship between public and private sectors, replacing its mixed economy with a centrally planned one – planned by financial predators with little care that the economy is polarizing between rich and poor, creditors and debtors.

The financial road to serfdom

Financial lobbyists are turning the English language – and economic terminology throughout the world – into a battlefield. Creditors are to be permitted to take the assets of insolvent debtors – from homeowners and companies to entire nations – as if this were a normal working of “the market” and foreclosure was simply a way to restore “liquidity.” As for “solvency,” the ECB would strip Greece clean of its public sector’s assets. Bank officials have spoken of throwing potentially 150 billion euros of property onto the market.

Most people would think of this as a solvency problem. Solvency means the ability to maintain the kind of society one has, with existing public/private checks and balances and living standards. It is incompatible with scaling down pensions, Social Security and medical insurance to save bondholders and bankers from taking a loss. The latter policy is nothing less than a political revolution.

The asset stripping that Europe’s bankers are demanding of Greece looks like a dress rehearsal to prevent the “I won’t pay” movement from spreading to “Indignant Citizens” movements against financial austerity in Spain, Portugal and Italy. Bankers are trying to block governments from writing down debts, stretching out loans and reducing interest rates.

When a nation is directed to replace its mixed economy by transferring ownership of public infrastructure and enterprises to a financial class (mainly foreign), this is not merely “restoring solvency” by using long-term assets to pay short-term debts to maintain its balance-sheet net worth. It is a radical transformation to a centrally planned economy, shifting control out of the hands of elected representatives to those of financial managers whose time frame is short-term and extractive, not long-term and protective of social equity and basic needs.

Creditors are demanding a political transformation to replace democratic lawmakers with technocrats appointed by foreign bankers. When the economic surplus is pledged to bankers rather than invested at home, we are not merely dealing with “insolvency” but with an aggressive attack. Finance becomes a continuation of war, by economic means that are to be politicized. Acting on behalf of the commercial banks (from which most of its directors are drawn, and to which they intend to “descend from heaven” to take their rewards after serving their financial class), the European Central Bank insists on a political revolution to replace democratic government by a technocratic elite – not of industrial engineers, but of “financial engineers,” a polite name for asset stripping financial warriors. If Greece does not comply, they threaten to wreak domestic financial havoc by “pulling the plug” on Greek banks. This “carrot and stick” approach threatens that if Greece does not sign on, the ECB and IMF will withhold loans needed to keep its banking system solvent. The “carrot” was provided on May 31 they agreed to provide $86 billion in euros if Greece “puts off for the time being a restructuring, hard or soft,” of its public debt. [5]

It is a travesty to present this revolution simply as a financial exercise in solving the “liquidity problem” as if it were compatible with Europe’s past four centuries of political and classical economic reforms. This is why the Syntagma Square protest in front of Parliament has been growing each week, peaking at over 70,000 last Sunday, June 5.

Some protestors drew a parallel with the Wisconsin politicians who left the state to prevent a quorum from voting on the anti-labor program that Governor Walker tried to ram through. The next day, on June 6, thirty backbenchers of Prime Minister George Papandreou’s ruling Panhellenic Socialist party (Pasok) were joined by some of his own cabinet ministers threatening “to resign their parliamentary seats rather than vote through measures to cut thousands of public sector jobs, increase taxes again and dispose of €50bn of state assets, according to party insiders. ‘The biggest issue for the party is stringent cuts in the public sector … these go to the heart of Pasok’s model of social protection by providing jobs in state entities for its supporters,’ said a senior Socialist official.” [6]

Seeing the popular reluctance to commit financial suicide, Conservative Opposition leader Antonis Samaras also opposed paying the European bankers, “demanding a renegotiation of the package agreed last week with the ‘troika’ of the EU, IMF and the European Central Bank.” It was obvious that no party could gain popular support for the ECB’s demand that Greece relinquish popular rule and “appoint experienced technocrats to half a dozen essential ministries to implement the EU-IMF programme.” [7]

ECB President Trichet depicts himself as following Erasmus in bringing Europe beyond its “strict concept of nationhood.” This is to be done by replacing elected officials with a bureaucracy of cosmopolitan banker-friendly planners. The debt problem calls for new “monetary policy measures – we call them ‘non standard’ decisions, strictly separated from the ‘standard’ decisions, and aimed at restoring a better transmission of our monetary policy in these abnormal market conditions.” The task at hand is to make these conditions a new normalcy – and re-defining solvency to reflect a nation’s ability to pay debts by selling the public domain.

The ECB and EU claim that Greece is “solvent” as long as it has assets to sell off. But if populations in today’s mixed economies think of solvency as existing under existing public/private proportions, they will resist the financial sector’s attempt to proceed with buyouts and foreclosures until it possesses all the assets in the world, all the hitherto public and corporate assets and those of individuals and partnerships.

To minimize opposition to this dynamic the financial sector’s pet economists understate the debt burden, pretending that it can be paid without disrupting economic life and, in the Greek case for example, by using “mark to model” junk accounting and derivative swaps to simply conceal its magnitude. Dominique Strauss-Kahn at the IMF claims that the post-2008 debt crisis is merely a short-term “liquidity problem” and one of lack of “confidence,” not insolvency reflecting an underlying inability to pay. Banks promise that everything will be all right when the economy “returns to normal” – as if it can “borrow its way out of debt,” Bernanke-style.

This is what today’s financial warfare is about. At issue is the financial sector’s relationship to the “real” economy. From the latter’s perspective the proper role of credit – that is, debt – is to fund productive capital investment and spending, because it is out of the economic surplus that debts are paid. This requires a financial regulatory system and tax system to maximize growth. But that is precisely the fiscal policy that today’s financial sector is fighting against. It demands preferential tax-deductibility for interest to encourage debt financing rather than equity. It has disabled truth-in-lending laws and regulations to keeping interest rates and fees in line with costs of production. And it blocks governments from having central banks to freely finance their own operations and provide economies with money. And to cap matters it now demands that democratic society yield to centralized authoritarian financial rule.

Finance and democracy: from mutual reinforcement to antagonism

The relationship between banking and democracy has taken many twists over the centuries. Earlier this year, democratic opposition to the ECB and IMF attempt to impose austerity and privatization selloffs succeeded when Iceland’s President Grímsson insisted on a national referendum on the Icesave debt payment that Althing leaders had negotiated with Britain and the Netherlands (if one can characterize abject capitulation as a real negotiation). To their credit, a heavy 3-to-2 majority of Icelanders voted “No,” saving their economy from being driven into the debt peonage.

Democratic action historically has been needed to enforce debt collection. Until four centuries ago royal treasuries typically were kept in the royal bedroom, and loans to rulers were in the character of personal debts. Bankers repeatedly found themselves burned, especially by Habsburg and Bourbon despots on the thrones of Spain, Austria and France. Loans to such rulers were liable to expire upon their death, unless their successors remained dependent on these same financiers rather than turning to their rivals. The numerous bankruptcies of Spain’s autocratic Habsburg ruler Charles V exhausted his credit, preventing the nation from raising funds to defeat the rebellious Low Countries to the north.

The problem facing bankers was how to make loans permanent national obligations. Solving this problem gave an advantage to parliamentary democracies. It was a major factor enabling the Low Countries to win their independence from Habsburg Spain in the 16th century. The Dutch Republic committed the entire nation to pay its public debts, binding the people themselves, through their elected representatives who earmarked taxes to their creditors. Bankers saw parliamentary democracy as a precondition for making sound loans to governments. This security for bankers could be achieved only from electorates having at least a nominal voice in government. And raising war loans was a key element in military rivalry in an epoch when the maxim for survival was “Money is the sinews of war.”

As long as governments remained despotic, they found that their ability to incur more debt was limited. At this time “the legal position of the King qua borrower was obscure, and it was still doubtful whether his creditors had any remedy against him in case of default.” [8] Earlier Dutch-English financing had not satisfied creditors on this count. When Charles I borrowed 650,000 guilders from the Dutch States-General in 1625, the two countries’ military alliance against Spain helped defer the implicit constitutional struggle over who ultimately was liable for British debts.

The key financial achievement of parliamentary government was thus to establish nations as political bodies whose debts were not merely the personal obligations of rulers, but truly public and binding regardless of who occupied the throne. This is why the first two democratic nations, the Netherlands and Britain after its 1688 dynastic linkage between Holland and Britain in the person of William I, and the emergence of Parliamentary authority over public financing. They developed the most active capital markets and became Europe’s leading military powers. “A funded debt could not be formed so long as the King and Parliament were fighting for the mastery,” concludes the financial historian Richard Ehrenberg. “It was only after the [1688] revolution that the English State became what the Dutch Republic had long been – a real corporation of individuals firmly associated together, a permanent organism.” [9]

In sum, nations emerged in their modern form by adopting the financial characteristics of democratic city states. The financial imperatives of 17th-century warfare helped make these democracies victorious, for the new national financial systems facilitated military spending on a vastly extended scale. Conversely, the more despotic Spain, Austria and France became, the greater the difficulty they found in financing their military adventures. Austria was left “without credit, and consequently without much debt” by the end of the 18th century, the least credit-worthy and worst armed country in Europe, as Sir James Steuart noted in 1767 [10]. It became fully dependent on British subsidies and loan guarantees by the time of the Napoleonic Wars.

The modern epoch of war financing therefore went hand in hand with the spread of parliamentary democracy. The situation was similar to that enjoyed by plebeian tribunes in Rome in the early centuries of its Republic. They were able to veto all military funding until the patricians made political concessions. The lesson was not lost on 18th-century Protestant parliaments. For war debts and other national obligations to become binding, the people’s elected representatives had to pledge taxes. This could be achieved only by giving the electorate a voice in government.

It thus was the desire to be repaid that turned the preference of creditors away from autocracies toward democracies. In the end it was only from democracies that they were able to collect. This of course did not necessarily reflect liberal political convictions on the part of creditors. They simply wanted to be paid.

Europe’s sovereign commercial cities developed the best credit ratings, and hence were best able to employ mercenaries. Access to credit was “their most powerful weapon in the struggle for their freedom,” notes Ehrenberg, in an age whose “growth in the use of fire arms had forced them to surround themselves with stronger fortifications.” [11] The problem was that “Anyone who gave credit to a prince knew that the repayment of the debt depended only on his debtor’s capacity and will to pay. The case was very different for the cities, who had power as overlords, but were also corporations, associations of individuals held in common bond. According to the generally accepted law each individual burgher was liable for the debts of the city both with his person and his property.”

But the tables are now turning, from Icelandic voters to the large crowds gathering in Syntagma Square and elsewhere throughout Greece to oppose the terms on which Prime Minister Papandreou has been negotiating an EU bailout loan for the government – to bail out German and French banks. Now that nations are not raising money for war but to subsidize reckless predatory bankers, Jean-Claude Trichet of the ECB recently suggested taking financial policy out of the hands of democracy.

But if a country is still not delivering, I think all would agree that the second stage has to be different. Would it go too far if we envisaged, at this second stage, giving euro area authorities a much deeper and authoritative say in the formation of the country’s economic policies if these go harmfully astray? A direct influence, well over and above the reinforced surveillance that is presently envisaged? …

At issue is sovereignty itself, when it comes to government responsibility for debts. And in this respect the war being waged against Greece by the European Central Bank (ECB) may best be seen as a dress rehearsal not only for the rest of Europe, but for what financial lobbyists would like to bring about in the United States.

[1] Yves Smith, “Wisconsin’s Walker Joins Government Asset Giveaway Club (and is Rahm Soon to Follow?)” Naked Capitalism, February 22, 2011.

[2] Ralph Atkins, “Transcript: Lorenzo Bini Smaghi,” Financial Times, May 30, 2011.

[3] Jack Ewing, “In Asset Sale, Greece to Give Up 10% Stake in Telecom Company,” The New York Times, June 7, 2011.

[4] Christopher Lawton and Laura Stevens, “Deutsche Telekom, Others Look to Grab State-Owned Assets at Fire-Sale Prices,” Wall Street Journal, June 7, 2011.

[5] Landon Thomas Jr., “New Rescue Package for Greece Takes Shape,” The New York Times, June 1, 2011.

[6] Kerin Hope, “Rift widens on Greek reform plan,” Financial Times, June 7, 2011.

[7] Ibid. See also Kerin Hope, “Thousands protest against Greek austerity,” Financial Times, June 6, 2011: “‘Thieves, thieves … Where did our money go?’ the protesters shouted, blowing whistles and waving Greek flags as riot police thickened ranks around the parliament building on Syntagma square in the centre of the capital. … Banners draped nearby read ‘Take back the new measures’ and ‘Greece is not for sale’ – a reference to the government’s plans to include state property and real estate for tourist development in the privatisation scheme.”

[8] Charles Wilson, England’s Apprenticeship: 1603-1763 (London: 1965), p. 89.

[9] Richard Ehrenberg, Capital and Finance in the Age of the Renaissance (1928), p. 354.

[10] James Steuart, Principles of Political Oeconomy (1767), p. 353.

[11] Ehrenberg, op. cit., pp. 44f., 33.

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Why Iceland Voted “No”

Posted on April 10, 2011 by admin | 3 comments

By Michael Hudson

About 75% of Iceland’s voters turned out on Saturday to reject the Social Democratic-Green government’s proposal to pay $5.2 billion to the British and Dutch bank insurance agencies for the Landsbanki-Icesave collapse. Every one of Iceland’s six electoral districts voted in the “No” column – by a national margin of 60% (down from 93% in January 2010).

The vote reflected widespread belief that government negotiators had not been vigorous in pleading Iceland’s legal case. The situation is reminiscent of World War I’s Inter-Ally war debt tangle. Lloyd George described the negotiations between U.S. Treasury Secretary Andrew Mellon and Stanley Baldwin regarding Britain’s arms debt as “a negotiation between a weasel and its quarry. The result was a bargain which has brought international debt collection into disrepute … the Treasury officials were not exactly bluffing, but they put forward their full demand as a start in the conversations, and to their surprise Dr. Baldwin said he thought the terms were fair, and accepted them. … this crude job, jocularly called a ‘settlement,’ was to have a disastrous effect upon the whole further course of negotiations …”

And so it was with Iceland’s negotiation with Britain. True, they got a longer payment period for the Icesave payout. But how is Iceland to obtain the pounds sterling and Euros in the face of its shrinking economy. This is the major payment risk that is still unaddressed. It threatens to plunge the krona’s exchange rate.

Furthermore, the settlement included running interest charges on the bailout since 2008, even the extra-high interest charges that led depositors to put their funds in Icesave in the first place. Icelanders viewed these interest premiums as compensation for risks – that were taken and should be lost by the high-interest Internet depositors.

So the Icesave problem will now go to the courts. The relevant EU directive states “that the cost of financing such schemes must be borne, in principle, by credit institutions themselves.” As priority claimants Britain and the Netherlands will indeed get the lion’s share of what is left from the Landsbanki corpse. That was not the issue before Iceland’s voters. They simply aimed at saving Iceland from an open-ended obligation to take the bank’s losses onto the public balance sheet without a clear plan of just how Iceland is to get the money to pay.

Prime Minister Johanna Sigurdardottir warns that the vote may trigger “political and economic chaos.” But trying to pay also threatens this. The past year has seen the disastrous experience of Greece, Ireland and now Portugal in taking reckless private sector bank debts onto the public balance sheet. It is hard to expect any sovereign nation to impose a decade or more of deep depression on its economy inasmuch as international law permits every nation to act in its own vital interests.

Attempts by creditors to persuade nations to bail out their banks at public expense thus is ultimately an exercise in public relations. Icelanders have seen how successful Argentina has been since it imposed a crew haircut on its creditors. They also have seen the economic and political disruption in Ireland and Greece resulting from trying to pay beyond their means.

Creditors did not give accurate advice when they told Ireland that it could pay for its bank failures without plunging the economy into depression. Ireland’s experience stands as a warning to other countries about trusting overly optimistic forecasts by central bankers. In Iceland’s case, in November 2008 the IMF staff projected yearend-2009 gross external public and private debt at 160% of GDP – but observed that an exchange rate depreciation of 30% would push the ratio to 240% of GDP, which would be “clearly unsustainable.” But the most recent IMF staff report (January 14, 2011) shows end-2009 gross external debt at 308% of GDP, and estimates end-2010 gross external debt at 333% – even before taking the Icesave and other debts into account!

The main problem with Iceland’s obligation to Britain and the Netherlands is that foreign debt is not paid out of GDP. Apart from what is recovered from Landsbanki (now with the help of Britain’s Serious Fraud Office), the money must be paid in exports. But there has been no negotiation with Britain and Holland over just what Icelandic goods and services these countries would be willing to take in payment. Already in the 1920s, John Maynard Keynes pointed out that the Allied creditor nation had to take some responsibility just how Germany could pay its reparations, if not by exporting more to these countries. In practice, German cities borrowed in New York, turned the dollars over to the Reichsbank, which paid Britain and France, which paid the money back to the U.S. Government for their Inter-Ally Arms debts. In other words, Germany tried to “borrow its way out of debt.” It never works over time.

The normal practice would be for Iceland to appoint a Group of Experts to lay out the strongest possible case. No sovereign nation can be expected to acquiesce in imposing a generation of financial austerity, economic shrinkage and forced emigration of labor to pay for the failed neoliberal experiment that has dragged down so many other European economies.