Tag Archives: too big to fail

William K. Black on the MF Global Cover-up: “All those that doeth Evil hateth the light!”

Did Dodd-Frank Act End “Too Big To Fail”?

By Robert E. Prasch

Since the triumphal passage of the Dodd-Frank Wall Street Regulation and Consumer Protection Act on 21st of July 2010, we have been told repeatedly that the United States would “never again” be confronted with a “choice” between bailing out a large insolvent financial institution “or else.” If so, this means that one of the most pernicious and damaging features of capitalism has been forever solved. Were we convinced that the 111th Congress and the Obama Administration had actually achieved this, all right-minded persons would surely exclaim, “What a gift to the country, what a gift to humanity!” Yet, it is evident that few of us are doing that. Is the problem in ourselves? Are American voters hopeless ingrates? Or, is it that our suspicions are well-grounded?

With the emergence of Occupy Wall Street only a year before the 2012 elections, the prospects and promise of the Dodd-Frank Act is – as it should be — pivotal to our assessment of the record of this Congress and Administration. As such, let us take a moment to contemplate the specifics of the much-vaunted process that – we are told – will ensure the most important promise of Dodd-Frank – the anticipation and prevention of another fantastically costly bailout. The recent and very public troubles of Bank of America suggest that a test may be coming soon. If Dodd-Frank works as advertised, BofA’s pending failure should not cost the public a cent – and that certainly is good news, is it not? 

To assess this core claim of Dodd-Frank, let us contemplate the specifics of the process that will — we have been told — successfully identify, take over, and resolve large systemically important financial institutions before they fail. To reiterate, we have been told that firms fitting this description can and will be taken over before they are insolvent, and especially before the problem becomes a charge on the public purse. As this process is best understood by an example, let us begin by supposing that one of the nation’s largest systemically important bank holding companies (BHC) is in trouble (although it could be any financial institution designated previously as systemically important). Let us further suppose that this BHC – as so many do — relies upon short-term borrowing in the markets to support a highly-leveraged portfolio of speculative, risky, and now-troubled assets. To keep it real, let us suppose that few of these assets can be traded and thereby “priced” in open or competitive markets. It is, of course, unnecessary to point out that when traders and senior managers put together these deals they greatly enriched themselves. But, they have long since cashed their bonus checks, so the problem now belongs to the bank – and potentially the public.

Today, the BHC’s stock price is falling, credit default swap premiums on its assets and the debt it issues are rising, and counter-parties are demanding ever-greater collateral to provide short-term financing. Many money-managers who have had long-standing lending relationships with this bank are refusing to provide further financing at any price, and large clients are beginning to withdraw their funds and move their accounts. Stated bluntly, the future of this firm is bleak and the situation is worsening at an accelerating pace.

What happens now? The bank’s first defense is — as always — a flat-out denial that they are in trouble. But such protests are unlikely to convince its peers, big-time money managers, or other savvy counter-parties or players. In the nineteenth century, it used to be said that if a lady had to publically defend her reputation, it was too late. Times may have changed in these matters, but for financial institutions this old adage remains true. A need to publically proclaim its solvency can — and should — be taken as prima facie evidence that a bank either is, or is about to be, insolvent. Let us, then, suppose that the situation continues to worsen for our hypothetical firm.

The bank’s second step is to highlight its internal audit, along with the clean bill of health it has received from its highly reputable outside accountants and lawyers. Wall Street will not be convinced. Why? Because they know that these audits are readily and routinely rigged through “creative accounting.” To illustrate this point, I have my classes guess how many quarterly earnings statements showed losses at New Century Financial before its massive collapse in March 2007. The answer, dear reader, is zero. The process by which one goes from being a high-flying and highly-profitable darling of financial innovation to catastrophic bankruptcy without ever passing through an unprofitable quarter is, I will submit, “complicated.” Indeed, the SEC also thought that it was “complicated” and brought a suit. Unfortunately, this suit was settled for essentially a pittance – a “lesson” not lost on other Wall Street players and those who are obliged to interact with them. Least this case be considered a singular event, I remind them that S&P gave Lehman Brothers an “A” rating until weeks before its collapse. Similar examples abound throughout this and earlier crises.

Third, an upsurge of campaign “donations” from the troubled BHC will ensure that at a substantial portion – if not a majority — of Congresspersons will avidly assent to the firm’s own assessment of its condition and prospects (Let us note that if it is indeed insolvent, these donations and other lobbying and public relations expenses are de facto additions to the federal debt). Although the reasoning and arguments then presented to the public by these august tribunes of the people might be embarrassingly shallow, we can be sure that they will lean on the political appointees heading the regulatory agencies to take “a broad interpretation” of the situation. Simultaneously, the bank’s senior compliance and legal advisors, who in all likelihood are former senior staff at the regulatory agencies to which it answers, will contact their old colleagues to argue and reargue the bank’s version of its financial condition. They will emphasize its singularly sunny prospects for future success.

Let me digress by observing that it will not escape the attention of those who staff the government’s regulatory agencies that their former colleagues have moved into substantially higher tax brackets and much tonier neighborhoods. To that end, perhaps we should allow our regulators to indulge in a moment of wistfulness. After all, in the aftermath of such reunions it is only human to feel somewhat conscious of one’s own comparably modest socio-economic status. If our public servants are at all like most people, they might pause to consider a career move… But such ruminations are beside the point. Or are they?

Let us suppose that our regulators remain stalwart, undaunted, resolute, and unmoved by such considerations. They are good people, professionals who readily eschew fantastic opportunities to remain faithful public servants. Nevertheless, as a consequence of the bank’s previous moves, Congress is in an uproar, the White House is worried, and Wall Street has closed ranks behind the bank (the latter are sufficiently intertwined with its fortunes that they stand to take large losses). Outside of the halls of power, think-tank “experts,” television “opinion leaders,” newspaper reporters, and editorialists are running unfavorable stories about the supposed “anti-market” bias of regulators, etc. Meanwhile, the regulators, if they are doing their job properly, are not conducting interviews or discussing the story with the media. Consequently, their side of the story – and only they have access to the bank’s balance sheet – is underrepresented in the press. Moreover, those few newspapers running stories that suggest that the bank’s problems may be real will be accused of being irresponsible or anti-business. They may even have been – quietly — threatened with lawsuits claiming libel. We should recall that even spurious lawsuits can be expensive for most daily or weekly newspapers.

As the disinformation campaign moves into high gear, the regulators must get the Board of Directors of the FDIC to vote that this bank is on the brink of collapse and for that reason should be taken over quickly, before it becomes insolvent and thereby a public charge. This Board, let us recollect, is made up of three permanent members serving six year terms in addition to the head of the Office of the Comptroller of the Currency and the head of the Office of Thrift Supervision, who both serve in ex officio status. All of them are appointed by the President with Senate approval and no more than three of the five of them may be from the same political party. Stated simply, the Board may represent a variety of views, but we can be confident that the largest financial institutions have had an opportunity to carefully vet all of the participants in the discussion. After all, few administrations or senators have the stomach to fight the nation’s most powerful industry over what — to the public — may appear to be relatively obscure bureaucratic appointments. However, to give credit where it is due, over the last five years the FDIC is one of the few agencies to have shown some life in regulatory matters. One reason may be the personalities involved. Another may be that it is their funds that are used to cover depositors’ accounts and, for that reason, they are the agency left “holding the bag” in the event of a catastrophic failure.

Supposing that the FDIC has decided that this bank must be resolved, the next to vote is the Federal Stability Oversight Council (FSOC). This group is Chaired by the Secretary of the Treasury and its nine other voting members include the Chairman of the Federal Reserve Board, the Chair of the Commodity Futures Trading Corporation, the Comptroller of the Currency, the Chair of the Securities and Exchange Commission, etc. Each and every one of these individuals took their positions only after a Presidential appointment and a Senate hearing. Once again, banker views were fully present and accounted for. In short, these are people known in Wall Street/D.C. circles for their “sound views” — that is to say long-standing sympathy toward politically prominent banks, bankers, and related financial institutions. In many if not most instances, they were themselves formerly bankers or worked in law or accounting firms catering to the financial sector. This characterization also describes the bulk of their deputies. The final step is to formerly notify and advise the President of the FSOC’s decision. While lawyers and others who have examined Frank-Dodd have not agreed as to whether the President has the authority to override a vote of the FSOC, it is difficult to imagine that these several senior appointees would have allowed the process to advance this far without White House approval.

Now, let us recall that all of the above will occur as the large financial institution in question is in the throes of a rapid and accelerating downward spiral – yet it is supposed to be completed even as the firm remains – if just barely – solvent. While the Feds might try to keep their deliberations a secret, it is hard to imagine that financial markets will long remain in the dark about them. For that reason, the bank in question will find that it must post ever-greater collateral to retain the short-term financing it requires to operate. Credit Default Swaps will soar, ratings agencies might decide to (belatedly) issue a downgrade on the firm’s debt, and the bank will struggle to place its commercial paper or otherwise raise funds. Consequently, it will become increasingly dependent upon the Fed’s Discount Lending facility, which means that that latter institution stands to be even more embarrassed by the pending failure, and for that reason inclined to postpone the resolution of this bank.

Since the passage of Dodd-Frank a year ago, I have attended multiple conferences in a variety of locations in the United States and Canada. At each of them, I have informally polled a range of colleagues studying monetary and financial economics to find out if they believed that the above process has any chance of working as described. I specifically ask them if they believe that the FDIC and FSOC could (1) identify a pending failure some time before it becomes insolvent, and then (2) organize the regulatory and political will to take over a massive, interconnected, and politically powerful institution, and (3) navigate the process of arriving at a decision in a time frame sufficiently short to avoid a massive run on the institution, a run that could readily spread to similar institutions and to those firms dependent upon them. Let us recall that the prevention of just such a run is the primary task of financial regulation. To date, I have not found a single individual who believes that it will work.

For myself, I will continue to accept the view of Vermont Senator Bernie Sanders (I-VT), that “If an institution is too big to fail, it is too big to exist.” Despite what we were told, alternatives to Frank-Dodd do, and did, exist. For example, on November 6th 2009, Senator Sanders introduced legislation that would give the Secretary of the Treasury 90 days to report to the Senate with a list of commercial banks, investment banks, hedge funds, insurance companies, and other financial institutions that were “Too Big To Fail” (TBTF). The Secretary would then be granted a year from the date of that report to break them up. Sanders’ bill was not taken up.

Later, Senators Sharrod Brown (D-OH) and Ted Kaufman (D-DE) actually got a bill called the SAFE Banking Act of 2010 to the Senate floor. It would have imposed binding leverage and liability limits on bank holding companies and financial institutions, thereby effectively breaking up the largest of them. This bill was opposed by most Republicans and leading Senate Democrats (including Senators C. Dodd (CT), D. Feinstein (CA), J. Kerry, and both Senators from New York and New Jersey). The White House and the Treasury Department were also opposed. Unsurprisingly, it failed by a vote of 61-33 on June 17th, 2010 despite attracting the support of three Republicans. Senator Judd Gregg (R-NH), whose “centrist” views had once moved the Obama Administration to nominate him for Secretary of Commerce, summarized the sentiments of those voting against this act, “I don’t understand this Brown-Kaufman Amendment. Basically, what it says is if you’re successful … you’re going to break them up? I mean, where does this stop?”

Alternatives to Frank-Dodd’s cumbersome resolution authority clearly exist, and continue to exist. The key is prevention – do not allow individual banks to become so large or so leveraged as to threaten the system (while the system itself can be a source of risk, that is a separate issue). The problem was and remains a lack of political will on the part of both political parties. On the matter of Too Big To Fail, Occupy Wall Street and the broader American public are themselves asking, “Where does this stop?” Good question, maybe the Senator from New Hampshire, one of his colleagues from the Democratic Party, or someone from the Treasury or the White House will deign to let us know. 

Robert E. Prasch is Professor of Economics at Middlebury College where he teaches courses on Monetary Theory and Policy, Macroeconomics, the History of Economic Thought, and American Economic History. His latest book is How Markets Work: Supply, Demand and the ‘Real World’ (Edward Elgar, 2008).

A Suggested Theme for the Occupation of Wall Street

The systemically dangerous institutions (SDIs) are inaccurately called “too big to fail” banks.  The administration calls them “systemically important,” and acts as if they deserve a gold star.  The ugly truth, however, is what Wall Street and each administration screams when the SDIs get in trouble.  They warn us that if a single SDI fails it will cause a global financial crisis.  There are roughly 20 U.S. SDIs and about the same number abroad.  That means that we roll the dice 40 times a day to see which SDI will blow up next and drag the world economy into crisis.  Economists agree that the SDIs are so large that they are grotesquely inefficient.  In “good times,” therefore, they harm our economy.  It is insane not to shrink the SDIs to the point that they no longer hold the global economy hostage.  The ability — and willingness — of the CEOs that control SDIs to hold our economy hostage makes the SDIs too big to regulate and prosecute.  It also allows them to extort, dominate, and degrade our democracies.  The SDIs pose a clear and present danger to the U.S. and the world.

It takes a global effort against the SDIs because they constantly put nations in competition with each other in order to generate a “race to the bottom.”  We are always being warned that if the U.S. adopts even minimal regulation of its SDIs they will flee to the City of London or be unable to compete with Germany’s “universal” banks.  The result of the race to the bottom, however, as Ireland, Iceland, the UK, and U.S. all experienced is that we create intensely criminogenic environment that creates epidemics of “control fraud.”  Control fraud — frauds led by CEOs who use seemingly legitimate entities as “weapons” to defraud — cause greater financial losses than all other forms of property crime — combined.  Because of the political power of the SDIs and the destruction of effective regulation these fraudulent SDIs now commit endemic fraud with impunity.

Effective financial regulation is essential if markets are to work.  Regulators have to serve as the “cops on the beat” to keep the fraudsters from gaining a competitive advantage over honest firms.  George Akerlof, the economist who identified and labeled this perverse (“Gresham’s”) dynamic was awarded the Nobel Prize in 2001 for his insight about how control fraud makes market forces perverse.

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

One of the most perceptive observers of humanity recognized this same dynamic two centuries before Akerlof.

“The Lilliputians look upon fraud as a greater crime than theft.  For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.”  Swift, J. Gulliver’s Travels

We are the allies of honest banks and bankers.  We are their essential allies, for only effective regulation permits them to exist and prosper.  Think of what would happen to banks if we took the regular cops off the beat and stopped prosecuting bank robbers.  That’s what happens when we take the regulatory cops off the beat.  The only difference is that it is the controlling officers who loot the bank in the absence of the regulatory cops on the beat.  It is the anti-regulators who are the enemy of honest banks and bankers.

Top criminologists, effective financial regulators, and Nobel Laureates in economics have confirmed that epidemics of control fraud, such as the FBI warned of in September 2004, can cause financial bubbles to hyper-inflate and drive catastrophic financial crises.  Indeed, the FBI predicted in September 2004 that the developing “epidemic” of mortgage fraud would cause a financial “crisis” if it were not stopped.  It grew massively after 2004.  The fraudulent SDIs (who were far broader than Fannie and Freddie, indeed, they only began to dominate the secondary market in sales of fraudulent loans after 2005) ignored the FBI and industry fraud warnings for the most obvious of reasons — they were leaders the frauds.  The ongoing U.S. crisis was driven overwhelmingly by fraudulent “liar’s” loans.  Studies have shown that the incidence of fraud in liar’s loans is 90% (MBA/MARI 2006) and that by 2006 roughly one-third of all mortgage loans were liar’s loans (Credit Suisse 2007).  Rajdeep Sengupta, an economist at the Federal Reserve Bank of St. Louis, reported in 2010 in an article entitled “Alt-A: The Forgotten Segment of the Mortgage Market” that:

“[B]etween 2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent, respectively.  The higher levels of originations after 2003 were largely sustained by the growth of the nonprime (both the subprime and Alt-A) segment of the mortgage market.”

Sengupta’s data greatly understate the role of “Alt-A” loans (the euphemism for “liar’s loans”) for they ignore the fact that by 2006 half of the loans called “subprime” were also liar’s loans (Credit Suisse: 2007).  It was the massive growth in fraudulent liar’s loans that hyper-inflated and greatly extended the life of the bubble, producing the Great Recession.  The growth of fraudulent loans rapidly increased, rather than decreased, after government and industry anti-fraud specialists warned that liar’s loans were endemically fraudulent.  No one in the government ever told a bank that it had to make or purchase a “liar’s” loan.  No honest mortgage lender would make liar’s loans because doing so must cause severe losses.  Criminologists, economists aware of the relevant criminological and economics literature on control fraud, and a host of investigations have confirmed the endemic nature of control fraud in the ongoing U.S. crisis.

But the banking elites that led these frauds have been able to do so with impunity from prosecution.  Take on federal agency, the Office of Thrift Supervision (OTS).  During the S&L debacle, the OTS made well over 10,000 criminal referrals and made the removal of control frauds from the industry and their prosecution its top two priorities.  The agency’s support and the provision of 1000 FBI agents to investigate the cases led to the felony conviction of over 1,000 S&L frauds.  The bulk of those convictions came from the “Top 100” list that OTS and the FBI created to prioritize the investigation of the worst failed S&Ls.  In the ongoing crisis — which caused losses 40 times larger than the S&L debacle, the OTS made zero criminal referrals, the FBI (as recently as FY 2007) assigned only 120 agents nationally to respond to the well over one million cases of mortgage fraud that occurred annually, and the OTS’ non-effort produced no convictions of any S&L control frauds.  OTS’ sister agencies, the Fed and the OCC, have the same record of not even attempting to identify and prosecute the frauds.  The FDIC was better, but still only a shadow of what it was in fighting fraud in the early 1990s.  If control frauds can operate with impunity from criminal prosecutions, then the perverse Gresham’s dynamic is maximized and market forces will increasingly drive honest banks and firms from the marketplace.

The Financial Crisis Inquiry Commission reported on the results of the Great Recession that was driven by this fraud epidemic:

“As this report goes to print, there are more than 26 million Americans who are out of work, cannot find full-time work, or have given up looking for work. About
four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process or are seriously behind on their
mortgage payments. Nearly $11 trillion in household wealth has vanished, with retirement accounts and life savings swept away. Businesses, large and small, have felt the sting of a deep recession.”

It is the fraudulent SDIs that are the massive job killers and wealth destroyers.  It is the Great Recession that the fraudulent SDIs produced that caused most of the growth in the federal deficits and made the fiscal crises in our states and localities acute.  The senior officers that led the control frauds are the opposite of the “productive class.”  No one, without the aid of an army, has ever destroyed more wealth and dreams than the control frauds.  It is essential to hold them accountable, to help their victims recover, and to end their ongoing frauds and corruption that have crippled our economy, our democracy, and our nation.