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Well the inevitable remains inevitable. Talk about Israel and Egypt and some folks will become enraged and cast dark aspersions – there must be some evil reason why he discusses the topic. One reader responded to Mr. Rosner’s JPost column about me by remarking that I must be a professor of “traitors.” The readers who post comments on JPost columns tend to have strident views. Sadly, I have distressed at least one reader of our UMKC blog. “Anonymous” writes:

The context is that Anonymous is responding to my reply to his inquiry about why I was “obsessed” with JPost columnists. I explained that I was so interested because the JPost columnists were implicitly criticizing President Obama for not successfully bribing the Egyptian army to launch a wave of terror against the Egyptian people for the purposes of keeping Mubarak in power and keeping the Camp David Peace Accords in force. I explained why Israel refused to follow this strategy for moral and pragmatic reasons – and expressed the view that it was obscene to denounce the U.S. for refusing to adopt a strategy that Israel rightly refused to follow.

So let me go through Anonymous’ complaint. First, he thinks terror is as important as fraud and corruption. I said nothing about their relative “ranks.” Indeed, I pointed out that the suggested corruption was designed to produce a wave of terror by the Egyptian army against its citizens.

Second, he asks “were you turning a blind eye to PLO corruption?” PLO corruption is irrelevant to the strategy that the JPost columnists were implicitly advocating of the U.S. bribing Egyptian generals in order to induce them to murder and maim Egyptian civilians. No one was implying that Israelis were uniquely corrupt. The corruption at issue was Egyptian corruption.

Third, Anonymous thinks my posts are “anti-Israel” unless I can produce multiple posts attacking PLO corruption. Putting aside the fact that the “PLO era” (if I understand how Anon. is using that phrase) ended before I began making posts a bit over two years ago, the writer misses a more fundamental point. None of my columns are about Israel — they are about particular JPost columnists. My columns are distinctly pro-Israel (without being anti-Muslim). I stress that Israel has, despite its military dominance, refused for moral and pragmatic reasons to employ “Hama Rules.” I stress that Israel has refused to attempt to bribe Egyptian generals to induce them to launch a wave of terror against their citizens for the purpose of keeping Mubarak in power. Anonymous makes the error of conflating specific JPost columnists with Israel. Again, I stress that Israel refused to follow their strategy suggestions – Israel returned the Sinai to the nation from which it was taken by force of arms – Egypt. Israel refused to employ the bribery/terror strategy. I believe that the policies the columnists have recommended would have been anti-Israel, anti-Egypt, and anti-U.S. I think President Carter’s successful shepherding of the Peace Accords was pro-Israel, pro-Egypt, and pro-U.S. I think that if President Obama had employed the bribery/terror strategy that the JPost columnists advocate it would have been anti-Israel, anti-Egypt, and anti-U.S.

While I did not blog until fairly recently, I did write a letter to the editor of Al-Ahram, Egypt’s leading English-language paper, nearly a decade ago. I’ve set out the full text below.

But I add a caution. What if I didn’t have this letter to the editor? Would it be appropriate to write that I was a “traitor” or imply that I was “obsessed” about Israel for bigoted reasons? Why not respond to the substance of our arguments rather than our imagined motives?

Shmuel Rosner, in his Jerusalem Post column, criticizes Professor Telhami’s prediction in the New York Time’s “Room for Debate” feature that: “Benjamin Netanyahu will likely be seen by future Israelis as the prime minister who lost Egypt.” Rosner’s response: “you say ‘prediction’ – I say ‘wishful thinking.” Rosner explains:

Rosner’s comment brings to mind the famous joke. It is 1936. A German Jew stops just at the entrance to a meeting hall where a Nazi speaker is whipping up the crowd.

The Jew yells an answer before the rest of the crowd can react: “the bicyclists!” The Nazi speaker and the crowd are stunned. The bewildered Nazi finally asks, “why the bicyclists?” The Jew responds: “why the Jews?”

I understand and agree with Rosner’s criticism of Telhami’s prediction. It makes no sense to blame Bibi (Netanyahu’s popular nickname) for something “on which he had no control.” But the JPost is chock full of columns, including one by Rosner, that blame President Obama for Mubarak’s fall. Unlike Telhami’s column, which is respectful, the tone of the JPost columns attacking Obama is exceptionally strident. Why doesn’t Rosner recognize that it is absurd to blame either the bicyclists (Obama) or the Jews (Netanyahu) for Mubarak’s loss of power? Why not blame Mubarak and his cronies and family – who the Egyptians came to despise?

The efforts by JPost columnists to blame Obama for Mubarak’s fall are less coherent than Telhami’s critique of Netanyahu. Ms. Honig claims “Obama ushered in chaos even if he chose Cairo as his venue for the 2009 speech in which he sucked up to Islam [sic].” Obama gave a speech on June 4, 2009 that supposedly caused street revolts in Cairo 18 months later. In reality, the revolt in Tunisia sparked the protests in Cairo and the revolt in Tunisia was caused by the usual combination of corrupt, failed, and autocratic leadership plus a random event. As even Honig concedes, Mubarak could not remain in power in any event because “Mubarak is old and ill.” He also had no successor with legitimacy that Israel would find desirable. Honig projects magic powers onto Obama – a speech, in English, by an American produced a national movement in Egypt.

But Rosner asks the right question, though he fails to ask it of his JPost colleagues: how was Netanyahu or Obama supposed to “control” either the Egyptian military or the protestors? Rosner finds the answer to that question about Netanyahu so obvious that it is clear that he considers the question foolish. Netanyahu could not “control” either the Egyptian military or the protestors. Netanyahu had no magic button he could push that would give him such control. Rosner sees all this with clarity. But he and his colleagues cannot see that Obama had no magic button. No one seriously believes that Obama can give a speech and cause the residents of Cairo to start or to end a revolt. The only conceivable magic button is bribery of senior Egyptian generals.

There are three crippling problems with the hypothesized Obama magic bribery button. First, what is supposed to happen if the bribe succeeds? “Successful” bribery would require the Egyptian army to kill, torture, and imprison enough Egyptians to terrorize the protestors to the point that the protests ended and did not resume. Even if the bribe and the repression succeeded, how long would Mubarak live and what destabilizing forces would the campaign of terror against Egyptians unleash? Second, the bribe would likely fail and blow up in the face of the nation offering the bribe. Imagine Al Jazeera interviewing an Egyptian general explaining that a foreign government offered him a $200 million bribe in return for a promise to order the Egyptian army to attack the protestors. Third, if Obama has a magical bribery button that can create a “successful” Egyptian army war of terror against the Egyptian people – then Netanyahu does as well. Mossad can run a “false flag” bribery operation of an Egyptian general by representatives of a pseudo-Saudi prince. Indeed, since JPost columnists have long employed their most derisive and insulting prose to demonstrate that the American government is hopelessly incompetent in understanding and influencing Arab and Iranian officials, Mossad should be dramatically superior to our CIA in arranging such bribes and directing the resulting campaign of terror against the Egyptian people. If Obama “lost” Egypt by failing to bribe the Egyptian generals, then Netanyahu “lost” Egypt. (Indeed, every major nation with a intelligence service “lost” Egypt under this “logic.”)

The three crippling problems with the magic bribery button theory also prompt a question: why do the JPost columnists think that Obama has a duty to act as Netanyahu’s “Shabbos Goy”? Is there some secret codicil to the Israeli-Egyptian Peace Accords under which America agreed to bribe the Egyptian military to terrorize and murder Egyptian civilians should they ever revolt? How many Egyptians did we agree to kill? If Israel felt it was essential to its national security to use bribery to spark a wave of terror against the Egyptian protestors then it was Israel’s responsibility to undertake that murderous strategy and to take the moral and strategic consequences of unleashing the terror. It is obscene for Israelis to criticize the U.S. for refusing to act despicably when Israelis (correctly!) refuse to engage in those same despicable acts. We should never act as Israel’s or any other nation’s Shabbos Goy.

Why didn’t Bibi order Mossad to bribe the Egyptian generals to order the army to attack Egyptian civilians? Because doing so would have been morally depraved, unsuccessful, and harmful to Israel. I am a white-collar criminologist. I study fraud and bribery by elites and have helped conduct investigations to detect it and systems to reduce it. Corruption is a severe problem in Egypt (and Israel), and corrupt senior leaders pose a risk to national security. But bribery has great limitations even in corrupt nations. A general who grows rich through kickbacks from defense contractors will typically refuse even huge bribes that would require him to murder fellow citizens who are peacefully demonstrating for change. It is easier to bribe the military to engage in terror when the nation is fighting a vicious civil war along ethnic divisions in which terror is the norm. That is not the situation in Egypt – and no Western nation understood that fact better than Israel. I predict that the Mossad did not present using bribery to instigate a wave of terror against the Egyptian protestors as an option to Netanyahu. I predict that the same is true of the CIA and Obama.

The CIA, contrary to JPost columnists’ typical derision, combined bribery, small units of special forces, and smart air strikes brilliantly in the initial campaign in Afghanistan in response to the 9/11 attacks. But the CIA also learned early in that campaign the limits of relying on bribery (and financial incentives such as rewards) to capture or kill the most senior Taliban and al-Qaeda leaders. Afghanistan also demonstrates the typical weakness of trying to create a reliable national government – seen by the population as legitimate – through bribery and the provision of ample opportunities for corrupt gain.

Mubarak lost Egypt – to the Egyptian people – who no longer feared or respected him or his children. None of us know what will come next. Mubarak’s successors could be far worse. Neither the U.S. nor Israel has a magic button to push that will determine his successors. There are great limits to U.S. and Israeli power and life is uncertain. That is the nature of the real world.

The Jerusalem Post’s columnists’ consuming hatred of President Obama has prompted several of them to make clear their vision of Israel’s future.  That vision is so grim, so self-destructive for Israel, and so dangerous for America that it behooves Americans to find out the direction in which some of the most influential Israeli columnists have been successfully, and dramatically moving Israel’s policies.  Mubarak’s fall from power has caused several JPost columnists to excoriate Obama, claiming that he acted like President Carter (who these columnists claim “lost” Iran).  The fear of these columnists is that Mubarak’s successor might abrogate the 1978 Camp David Peace Accords, which produced the “cold peace” between Egypt and Israel that has endured for over 30 years and which the IDF considers to have been an enormous strategic benefit to Israel’s national security.  The embarrassing problem for these JPost columnists is that it was President Carter who worked so successfully to broker the Peace Accords.  It is inconvenient that one of the JPosts’ favorite demons is in fact the man who produced the Peace Accords.  The JPost columnists that support the Peace Accords typically deal with the inconvenience by ignoring Carter’s role.    also has columnists, however, who attack Carter – for bringing peace between Israel and Egypt!  These columnists favor eternal war against Muslims.  Indeed, they explicitly favor conquest through war.  Israel should seize other nations’ oil (and beaches!).  Ms. Honig complains:

Freddie Mac made a terse announcement Wednesday in a securities filing about the resignation of its chief operating officer, Bruce Witherell. Freddie said that Witherell resigned “for personal reasons.” His departure was effective immediately and he received no termination benefits. He had been receiving several millions of dollars in annual compensation from Freddie. The Wall Street Journal reporter commented:

It is true that pay at Fannie and Freddie used to be even more criminogenic. According to the Los Angeles Times:

Those were the days, when you could in a single year be made wealthy for destroying a company and causing scores of billions of dollars of losses to the taxpayers. The title of Akerlof & Romer’s famous 1993 article has never looked more prescient — “Looting: the Economic Underworld of Bankruptcy for Profit.”

I do not know why Witherell resigned. I hope he is not facing a family emergency. I write to ask why he was hired. Witherell’s principal experience was with Lehman. In particular, he was chief executive officer of Aurora Loan Services from 2003 to 2006. Lehman owned Aurora. Aurora specialized in purchasing and reselling “liar’s” loans.

I testified before the House Financial Services Committee on April 21, 2010 about Lehman and Aurora’s pervasive accounting fraud. A copy of that testimony can be found here.

The key point is that Aurora was a massive fraud — purchasing and selling often fraudulent mortgages. It is virtually certain that Freddie purchased material amounts of Aurora’s fraudulent mortgages (directly, or by purchasing collateralized debt obligations (CDOs) that were supposed to be backed by Aurora’s liar’s loans). As my colleague Randy Wray has emphasized, we need a new term for the toxic MBS (mortgage-backed securities) because they often weren’t backed by mortgages due to lender fraud.

The proverbial bottom line is that a global search for talent, after Fannie and Freddie’s second descent into accounting control fraud bankrupted both firms, Fannie and Freddie (with its regulators’ blessing, chose Witherell. (Heidrick & Struggles, which describes itself as the leading executive search firm, issued a press release praising itself for finding Witherell.) When Obama knew he had to clean up the Stygian Stables that were Fannie and Freddie — knew that their senior managers and their regulators had failed catastrophically — he left in charge the failed regulatory leadership team. The regulator team allowed Freddie to select as its COO one of the leaders in the creation of the liar’s loans that were the greatest single contributor to Freddie’s failure and the financial crisis. This was bizarre politics — the senior regulator Obama left in power until his voluntary resignation was a Republican chosen because he was George Bush’s close friend since their days together in prep school. It was even more insane regulatory policy.

Freddie (and Fannie) should be suing Aurora/Lehman for their frauds. Freddie and Fannie should be making thousands of criminal referrals against Aurora’s fraudulent loans. Witherell would be a key witness in the cases. Freddie placed him in impossible positions due to his conflicts of interest.

Aurora was notorious — why would anyone, much less Freddie, hire a top official from one of the firms most responsible for the frauds that destroyed Freddie and cost the taxpayers billions of dollars in losses? Is there anything that a business leader can do that disqualifies him from receiving millions of dollars annually — paid for by the taxpayers? It’s bad enough that our elites now loot with impunity. Do we really have to make them even richer?

Fannie and Freddie have no need to pay these high salaries to senior managers. It was the perverse executive compensation that drove the accounting control frauds at Fannie and Freddie — as the SEC explicitly charged. Executive compensation created the perverse managerial incentives that destroyed Fannie and Freddie. This was an unanticipated consequence of their privatization. Because Fannie and Freddie were privatized, their officers designed their compensation system in the same perverse manner as most firms (Bebchuk & Fried 2004). The mangers stood to gain enormous compensation if they inflated short-term accounting income, and as Akerlof & Romer famously observed, accounting fraud is a “sure thing.” Mr. Raines explained in response to a media question what was causing the repeated scandals at elite financial institutions:

If we are going to continue Fannie and Freddie’s existence then the business model they should follow is simple and requires modest executive pay. Fannie and Freddie should purchase only prime loans and it should promptly package those loans to form MBS and sell the MBS. This will minimize credit and interest rate risk. Fannie and Freddie can hedge the modest interest rate risk created by the “pipeline” of inventory without the need for any esoteric derivatives. The safe business turns out to be a simple business.

(cross posted with the Huffington Post)  

The Jerusalem Post columnist Shmuel Rosner has written a revealing column: “Why Israel Hates the Egyptian Uprising.” His conclusion: “when Israel looks at the revolutionary forces in Egypt, it doesn’t see “change,” or “hope,” or “democracy,” or the “end of oppression.” It doesn’t see Egyptians rejoicing in anticipation of their new beginning. All Israel sees is trouble.”

But where Rosner is most interesting from an American perspective is in his description of the Israeli views of U.S. policy towards Egypt and the interaction with Israeli policies. Rosner tells us that Israelis’ view of Mideast policy makers is strictly dichotomous. Rosner accurately portrays the Israeli view as reflecting a consensus — policy views towards Israel’s Arab neighbors once held only by Israel’s ultra right wing parties now dominate all but its rapidly withering left. One branch of the dichotomy contains the philosophers who worry about democracy. They are fools, “wise-ass[es].” Israelis’ hold them in contempt and rightly ignore their consistently bad advice.

The alternative source of policy advice is to “learn from experience.” Experience teaches Israelis that everything that changes in the Mideast harms Israel — except Mubarak’s “cold peace.” Rosner believes that experience counsels Israelis to fear and reject Arab democracy and peace proposals.

So where do American presidents fit in this dichotomy? Well, the supreme success from this Israeli perspective is — President Carter. The Camp David Peace Accords with Mubarak’s assassinated predecessor Anwar Sadat resulted in the peace treaty with Egypt that Mubarak honored. That peace, even if cold, gave Israel the critical strategic advantage of not having to defend against a major conventional attack from its South (more precisely, it reduced the risk of such an attack and provided time for the IDF to mobilize to halt such an attack). The Israeli opponents of the Camp David Peace Accords were the settlers — the group that now purportedly exemplifies “learn from experience” under Rosner’s dichotomy. The settlers, the leading “pragmatists” (as Rosner terms the Israeli opponents of Arab democracy) sought to block the Camp David Peace Accords that Rosner now concludes were the greatest boon to Israeli security.

Under Rosner’s dichotomy, the naïve philosophers obsessed with democracy were George Bush and the U.S. neocons who eagerly launched a voluntary war against Iraq based on lies. Rosner writes to emphasize “that there’s no such thing as an Israeli neocon. The Israeli establishment never believed in promoting democracy in the Arab world, and it still doesn’t. It never much cared about Arab democracy, period.” Rosner thinks that Americans do not understand Israelis; that we had the absurd belief that Israel cared about democracy. Americans have many weaknesses in understanding other nations, but Rosner has picked an area in which Americans largely got it right. As Rosner opines, even among U.S. neocons, the most deluded segment of Americans about the Mideast, “most of them do” know that Israelis do not favor democracy. Quite the opposite — democracy and demographics are Jewish Israelis’ greatest fears because they know that Israeli Jews and Arab Muslims and Christians despise and fear each other. Even Israeli Jews and Arabs have sharply negative views of each other. Jewish demographics push Israel steadily to the right and towards the ultra-religious.

As Rosner pictures the relationship, Israelis originally viewed the neocons and Bush as useful idiots. All the talk of democracy was pure foolishness, but Likud originally believed that having America invade Iraq and provide ever greater military support to the IDF would prove exceptionally useful. Israelis came to doubt how useful the neocons policies were when they observed (1) the voluntary invasion of Iraq made Iran dominant in the region, (2) the wars in Iraq and Afghanistan weakened the U.S. military and greatly reduced its power to credibly project power elsewhere in the Mideast, and (3) the neocons’ Arab democracy ideas led to Hamas taking control of Gaza in relatively democratic elections. The neocons proved to be un-useful idiots to Israel under Rosner’s dichotomy.

As any reader of the Jerusalem Post would find “completely predictable,” the villain of Rosner’s piece is not President Bush, but President Obama. President Obama is the villain because he is like President Carter. Rosner cites Binyamin Ben Eliezer’s attack on Obama as proof of Obama’s pro-democracy folly — because Obama is purportedly risking the peace treaty that Carter negotiated over the opposition of Israel’s leading “pragmatists” — the settlers. Neither Ben Eliezer nor Rosner feel the need to inform the reader that Carter negotiated the treaty that provided the great strategic advantage to Israel and over 35 years of peace between Israel and Egypt.

 

The difficulty with all this Israeli pragmatism is that it isn’t pragmatic and it isn’t honest. Israelis demonize Carter because the Shah of Iran “lost” Iran while Carter was President. The Shah was a dying man who had lost the support of “his” people. His military was unwilling to murder thousands of citizen protesters to keep him in power. The U.S., to its credit, was unwilling to urge the Shah to murder thousands of Iranian protesters in the hopes that he could terrorize the population sufficiently to remain in power. Carter did not “lose” Iran, the U.S. did not lose Iran — the Shah lost Iran. The U.S. was not eager to force the Shah from office. The Carter administration, as with prior administrations, was quite willing to have friendly relationships with the autocratic Shah despite SAVAK’s depredations. The U.S.’ dealings with the Shah were always based on pragmatism. If he could stay in control without mass murder and remain friendly to the U.S. the U.S. would be happy to be his ally.

Once the Shah lost control of “his” nation the U.S. goals included arranging safe exile for the Shah (which the U.S. did at some substantial cost, including the seizure of our Embassy and staff). U.S. solicitude for the Shah was an act of pragmatism — we were showing our autocratic allies that even if they lost control and were in danger of being executed the U.S. would be willing to safeguard them and their families even when that would enrage the new government.

It is fantasy, not pragmatism, to believe that Carter had some magic button he could have pressed that would have kept the Shah in power. What was Carter supposed to do? Instruct SAVAK to launch a dirty war of torturing, disappearing, and murdering the Shah’s political opponents? Instruct Iran’s military to turn automatic weapons on the crowds? Assassinate Khomeini? Fly in the ready brigade of the AirCav? To do what? The Shah was a weak, dying, and hated man. Any of these options were almost certain to fail, they would make us hated with a passion, and they would betray everything that makes America a great nation. Does Israel want the U.S. to adopt Assad’s “Hama rules”? (When Haffez al-Assad was faced with revolt in Hama, Syria’s fourth largest city, in 1982, he responded by destroying much of the city and murdering thousands of “his” citizens. The terror “worked” — the revolt was crushed.)

Israel has, for 37 years, had the ability to follow Hama rules because of its decisive military power. It has refused to do so for moral and pragmatic reasons. It should not criticize the U.S. for refusing to descend to a depth of depravity and anti-pragmatic stupidity that Israel wisely refuses to plumb.

The conventional wisdom in Israel about the situation in Egypt today, and the U.S. response to it is fantasy posing as pragmatism. Under the Israeli rewrite of history, the U.S. was eager to push democracy in Egypt and too naïve to understand that the Muslim Brotherhood would come to power and destroy the Camp David Peace Accords with Israel. In the real world, the Obama administration consistently emphasized its support for President Mubarak and refused to criticize him for his consistent denial of democratic rights to the Egyptian people. When the mass protests began recently in Egypt, Obama and Secretary of State Clinton responded by emphasizing their support for him and cautioning against the protests.

What changed the U.S. policy response was that it became clear that Mubarak had lost control of Egypt. The U.S. had no good choices from either the U.S. or the Israeli perspective. Pragmatism means recognizing the limits of one’s power and options and not assuming that there is some “silver bullet” solution that makes difficulties disappear.

The U.S. did not urge Mubarak to conduct a peaceful transition of power until it was clear that he had lost control of Egypt. Rosner’s language choices are all slanted to make Obama the villain. Consider the sentence he uses to begin the critical discussion.

The sentence may be literally true, but it is also deliberately misleading. It would be far more accurate to state that Mubarak has lost control of Egypt because Egyptians no longer respect or fear him. President Obama and Secretary of State Hillary Clinton, after supporting Mubarak for their entire terms in office, finally decided (pragmatically) that even with their continued support Mubarak could not regain control of Egypt without engaging in a campaign of terror against Egyptians. That option was unacceptable to the U.S. on pragmatic and moral grounds. (It may have been unacceptable to Mubarak and the Egyptian Army on the same grounds.)

The U.S. was pragmatic, not naïve, in deciding that it could not keep Mubarak in power. Obama’s dominant policy goal was to attempt to influence the transition in order to maximize the chances that the successor government would continue to honor the Camp David Peace Accords with Israel. No good deed goes unpunished.

Consider also Rosner’s subtle slanting of this passage.

Rosner conflates the head of state with the nation. The U.S. did not “desert” anyone, and it certainly did not desert Egypt. Our alliance is with Egypt. We never allied with Mubarak against the Egyptian people. We never promised to keep Mubarak in power regardless of the will of Egyptians.

The U.S. remains Egypt’s closest ally. That alliance is not hostile to Israel, indeed, it was essential to attain Egypt’s willingness to enter into the peace accords with Israel — which Rosner and Ben Eliezer agree is the most favorable event for Israel in over 30 years. U.S. taxpayers have provided tens of billions of dollars in aid to Egypt and Israel as part of our broader agreements to support the Camp David accords. Even in the Great Recession the American people have continued this aid without complaint.

The Egyptian people “dumped Mubarak.” If, and only if, Mubarak’s successor repudiates the Camp David Peace Accords, the U.S. will cease its aid to Egypt. Rosner is even more disingenuous in his claims that Israelis are worried that because we have not urged Mubarak to respond to the protestors with terror, Israel may be “next in line for the boot.”

Rosner then adds this bit of faux reassurance to Israelis.

Because U.S. ties with Israel are “stronger and deeper” than our ties with Egypt we will not “abandon” Israel “with such haste.” The fears he first describes as “nonsense” end up being somehow sensible. Again, he implicitly conflates the head of state with the nation. Consider a hypothetical that makes clear the absurdity of this reasoning. Assume that a future Israeli Prime Minister has a strong majority in the Knesset. The PM has been a good friend of the U.S. and our President and Secretary of State have strongly supported him for years. The PM is indicted because there is compelling evidence that he extorted kickbacks from contractors, but the MKs continue to support his government. Seven hundred thousand Israelis protest in Tel Aviv demanding that the PM resign and that new elections be held. The protests continue and lead to general strike that paralyzes the Israeli economy and endangers the IDF’s ability to mobilize reserves. The U.S. President states that he believes that the PM should call new elections within the month and, for the good of Israel, resign. Israelis might criticize the U.S. President’s comments as an interference in Israeli internal affairs, but it would be insane to claim that the President was “abandon[ing]” either the Israeli PM or Israel. The U.S. never promises to keep a particular Israeli PM in power against the will of the Israeli people. The U.S. alliance is with Israel and it is not dependent on the identity of Israel’s PM.

Peter Wallison dissented from the Commission’s finding that deregulation played a material role in the crisis. Here are the key excerpts.

The Commission report and the dissents do not distinguish between the three “des” – deregulation, desupervision, and de facto decriminalization. Deregulation occurs when one reduces, removes, or blocks rules or laws or authorizes entities to engage in new, unregulated activities. Desupervision occurs when the rules remain in place but they are not enforced or are enforced more ineffectively. De facto decriminalization means that enforcement of the criminal laws becomes uncommon in the relevant industries. These three regulatory concepts are often interrelated. The three “des” can produce intensely criminogenic environments that produce epidemics of accounting control fraud. In finance, the central task of financial regulators is to serve as the regulatory “cops on the beat.” When firms gain a competitive advantage by committing fraud, “private market discipline” becomes perverse and creates a “Gresham’s” dynamic that can cause unethical firms and officials to drive their honest competitors out of the marketplace. The combination of the three “des” was so criminogenic that it generated an unprecedented level of accounting control fraud, which in turn produced unprecedented levels of “echo” fraud epidemics. The combination drove the crisis in the U.S. and several other nations.

Wallison discusses only one example of deregulation – the repeal of the Glass-Steagall Act. I show that his claim that “no significant deregulation of financial institutions occurred in the last 30 years” is false.

I do not discuss here in detail the enormous S&L deregulation and desupervision that occurred at the federal and state level that occurred in 1982-83 and made possible the second phase of the S&L debacle – then the worst financial scandal in U.S. history. The first phase of the debacle was caused by interest rate risk. It, ultimately, cost the taxpayers roughly $25 billion to resolve. The second phase of the debacle was driven by the epidemic of accounting control fraud by S&Ls. Deregulation and desupervision in 1981-1983 created the criminogenic environment that allowed that epidemic of fraud. I have written about it extensively in my staff reports to the National Commission on Financial Institution Reform, Recovery and Enforcement and my book: The Best Way to Rob a Bank is to Own One. Akerlof & Romer (1993) used the second phase of the debacle as an exemplar of the title of their article – “Looting: the Economic Underworld of Bankruptcy for Profit.” The criminologists Calavita, Pontell, and Tillman discuss the fraud epidemic in their book – Big Money Crime. Airbrushing the deregulation and desupervision that permitted the second phase of the S&L debacle out of history is necessary to Wallison’s central task – defending his disastrous lobbying for decades for financial deregulation. We will see that the S&L deregulation and desupervision are not alone in disappearing from Wallison’s rewrite of history.

I will also not discuss in detail the enormous desupervision that occurred at the SEC that permitted the Enron-era frauds. The budget and staffing of the SEC were kept relatively flat while its workload grew enormously. The percentage of fillings it reviewed declined to five percent. Congressional Republicans consistently sought to cut the SEC’s budget and staffing levels in the 1990s. Criminologists refer to the result as a “systems capacity” problem. (see here and here)

As SEC enforcement director Robert Khuzami emphasizes, the SEC must serve as the regulatory “cops on the beat.” The staff and budgetary limits rendered the SEC incapable of performing its primary statutory mission.

In sum, Wallison’s history excludes the deregulation and desupervision that permitted the two massive financial crises that preceded the current crisis. We will see that Wallison also ignores the major acts of deregulation, desupervison and de facto decriminalization that made possible the current crisis.

Deregulation

This column addresses the role of deregulation in allowing the current crisis. I break the discussion in to three subsets: deregulation by legislation, deregulation by rule changes, and an odd hybrid – the SEC’s Consolidated Supervised Entities (CSE) program.

Deregulation by Legislation

Gramm-Leach-Bliley (1989) repeals the Glass-Steagall Act and Reduces CRA Examination

The repeal of Glass-Steagall demonstrates the complexity of what deregulation can mean. The banking regulatory agencies were extremely hostile to the Glass-Steagall Act. They eviscerated the Act by adopting rules and interpretations that created so many exceptions to Act’s separation of “banking and commerce” that the separation was rendered ineffective. The federal regulators also did not enforce the remaining provisions of the Act vigorously even before it was repealed in 1999. The combination of deregulation and desupervision by the banking regulators so gutted the Act that its formal repeal by the Gramm-Leach-Bliley Act in 1999 had little practical effect.

Wallison refers to a modest regulatory strengthening of the CRA rules in 1995, but he does not inform the reader that the GLB Act reduced the frequency of examinations of smaller and rural banks under the Community Reinvestment Act (CRA) and sought to discourage alleged extortion by housing activist organizations (e.g., ACORN) by requiring the disclosure of any agreements they made with banks not to challenge mergers. Senators Dodd and Schumer led the group of Democrats that successfully pushed these anti-CRA provisions on a reluctant White House because the Democrats were so eager to repeal Glass-Steagall. (see here)
Wallison does not disclose this deregulatory aspect of the GLB Act because it falsified his claim that the CRA caused the crisis.

There are many crippling flaws in Wallison’s claim that the CRA was “responsible for the … crisis.” Here, I note only the fact that the timing and direction of regulatory changes falsify his claim that the CRA was responsible for the crisis. The obvious problem is that the CRA had been in effect since 1977 – so one must assume a fictional latency effect of 15 years, a period that included two recessions, before the CRA suddenly became toxic. The recessions should have exposed any toxic aspects of the CRA long before the current crisis. The less obvious problem is that the CRA was weakened, not strengthened, after 1999. This refutes Wallison’s assertion that the CRA was “responsible for the … crisis.” As I will explain, the statutory weakening of the CRA in 1999 was compounded by other forms of deregulation and desupervision during the run-up to the crisis in 2001-2007.

I prepared the chart below by searching the FFIEC data base for CRA rating by date of the CRA examination.(see FFIEC website here)

The chart confirms a number of points that anyone who has ever been a financial regulator after the passage of the CRA in1977 knows. CRA ratings have long been like Lake Woebegon’s children: they’re virtually all above average. Fewer than ten banks get rated as a serious problem – and even they get treated with kid gloves. Examine the data for 1999 and 2000. The examiners discover seven serious CRA problems in 1999 – slightly above one-tenth of one percent of the banks examined. That CRA rating “substantial noncompliance” triggered a requirement for annual CRA reexaminations of the non-magnificent seven and should have led to immediate enforcement actions. Clinton was President and had appointed each of the regulatory leaders. By 2000 the regulators appointed by Clinton (who Wallison seeks repeatedly to cast as the villains) acted so aggressively against the seven that the 2000 exams revealed that there were still seven awful banks. It’s not like banks were failing frequently in this period and requiring the regulators’ attention to be paid solely to “safety and soundness.” The claim that banks lived in fear of the CRA and that the CRA drove their lending decisions is pure fiction. Banks routinely got satisfactory or outstanding ratings by making good loans. Banks had to try hard to get poor ratings and even the tiny minority that did so rarely faced any meaningful sanction.

The data in the chart also show that the statutory deregulation, reducing CRA examination frequency, was significant. The number of annual CRA examinations in the 2000s was typically well under one-half of the number of CRA examinations in 1995. Wallison is deliberately disingenuous in stopping his discussion of CRA changes in 1995. Both statutory and regulatory deregulation of the CRA occurred after that date. (My next column will also discuss the desupervision of CRA compliance that occurred during the 2000s.) The CRA, and its enforcement, became weaker as the mortgage fraud epidemic surged. That (further) falsifies Wallison’s claims that the CRA was “responsible for the … crisis.”

Statutory changes that allowed the creation of “private label” MBS

The SEC, Department of the Treasury, and OFHEO (which regulated Fannie and Freddie) created a joint task force, which issued: A Staff Report of the Task Force on Mortgage-Backed Securities Disclosure in January 2003.

The Task Force report explained two key statutory changes that made possible the rise of private label

The statutory changes that allowed the creation of an extensive private label MBS system were major contributors to the crisis. Wallison has particularly compelling reasons for seeking to blot the deregulation that led to the rise of private label MBS out of existence. As I explained in a prior column, Wallison praised the role of private label MBS, praised its provision of subprime loans, and derided Fannie and Freddie for failing to make as many loans to less wealthy Americans as their private label competitors did.
The existence and business practices of the private label competitors refute Wallison’s claims. The private label competitors were not subject to affordable housing goals. If they securitized toxic CDOs (and they did), and if they did so before Fannie and Freddie became the dominant purchaser of toxic CDOs (and they did), then Wallison’s claim that Fannie and Freddie’s affordable housing goals caused the crisis fails yet again.

As late as October 2006, the view from the mortgage industry was that the private label MBS issuers were dominant and likely to remain dominant over Fannie and Freddie precisely because the private label issuers were far more aggressive than Fannie and Freddie in making far riskier loans to less wealthy Americans. Here’s how the Mortgage Bankers Association’s (MBA) trade magazine explained the role of Fannie and Freddie vis-a-vis Fannie and Freddie.

By the first half of 2006, the private-label share has strengthened still more to 57 percent or $577 billion, according to Inside Mortgage Finance. Agency issues totaled $439 billion of the $1.12 trillion market.

Note the comprehensive refutation of Wallison’s thesis provided by the findings of the MBA study. The MBA was an opponent of Fannie and Freddie because it believed that they acted to reduce yields on home loans. The MBA was overjoyed that Fannie and Freddie were losing market share. The MBA attributed Fannie and Freddie’s loss of market dominance to the private label issuers’ far greater willingness to make extreme risk loans to less wealthy Americans. The MBA explained that it was investors’ growing willingness to purchase toxic MBS issued by private label firms that was driving the rapid growth of the private label firms. The MBA study did not find that Fannie and Freddie were the investors purchasing the private label issuers’ toxic MBS. Douglas Holtz-Eakin, later appointed by the Republican Congressional leadership as an FCIC Commissioner, was one of the consultants to the MBA’s Council to Shape Change.

Wallison ignores the passage of the Commodities Futures Modernization Act of 2000

The Commodities Futures Modernization Act of 2000 created two regulatory black holes. Enron exploited one to help create the California energy crisis of 2001. The Act also created a massive regulatory black hole with regard to credit default swaps (CDS). Wallison does not mention the passage of the CFMA. He concedes that AIG took crippling losses from its CDS exposure but dismisses it as an “outlier” (p. 447).

Deregulation by Rule

Wallison fails to mention the major acts of deregulation by rule or interpretation that made substantial contributions to the crisis. I discuss four examples of this form of deregulation.

Rules Reducing Underwriting and Recordkeeping Requirements

On December 31, 1992, the Office of Thrift Supervision (OTS), and its sister federal banking agencies, adopted the Real Estate Lending Standards Rule (RELS), 12 CFR § 560.100-101. The OTS’ prior standard required minimum underwriting demonstrating that the borrower could repay the loan and that the collateral value was adequate to repay the loan in the event that the borrower did not pay. The OTS’ rule was of tremendous value in allowing the OTS to take effective supervisory and enforcement actions and the Justice Department’s fraud prosecutions. The OTS rules also required contemporaneous documentation of that the borrower had conducted the required underwriting. The joint agency standards, however, allowed the lender to establish its underwriting standards and its documentation standards. The result was a very substantial deregulation and impaired ability to supervise, take enforcement actions, and prosecute frauds.

Basel II Reduces Capital Requirements

Wallison mentions the Basel II deregulation only once in passing, without seeming to realize that it refutes his claim that there was no important deregulation in 30 years.

As weak as U.S. banking regulators were during the crisis, they had great concerns about Basel II’s deregulation and limited it. The Shadow Financial Regulatory Committee expressed similar concerns. Europe, unfortunately, bought into Basel II’s deregulation whole hog, which explains why their banks’ reported leverage was far higher than U.S. banks. (One must always remember that banks’ actual leverage is often dramatically greater than reported leverage.)

Rules and Interpretations Preempting State Laws and Rules

Wallison ignores deregulation via preemption even though it was a major aspect of deregulation in the current crisis. It is particularly understandable that Wallison does not acknowledge preemption because he favored federal regulators’ preemption of state efforts against predatory lending in his capacity as a member of the anti-regulatory and self-selected “Shadow Financial Regulatory Committee.” Statement No. 195 of the Shadow Financial Regulatory Committee on Predatory Lending and Federal Preemption of State Laws (September 22, 2003); Statement No. 186 of the Shadow Financial Regulatory Committee on State and Federal Securities Market Regulation (calling for federal preemption of then NY Attorney General Spitzer’s actions against securities firms) (February 24, 2003).

The federal agencies actually competed to be the most aggressive preemptors. The competition in laxity added greatly to the desupervision that will be the subject of my next column, but it also produced deregulation at the state level. The Commission report makes this plain.

Note that the strident efforts that federally insured banks and S&Ls made to preempt state efforts to prevent predatory loans by non-insured affiliates further demonstrates that banks and S&Ls made nonprime loans for the purpose of maximizing short-term reported income – not because of the CRA. They were eager to expand their fraudulent liar’s loans and feared State enforcement efforts against such lending.

Rules Further Reducing the Scope of the CRA

In addition to the statutory deregulation of CRA provisions wrought by adoption of the Gramm-Leach-Bliley Act in 1999, the federal regulatory agencies further reduced enforcement of the CRA by rule in 2004 and 2005 by expanding the definition of small banks from $250 million in assets to those with assets up to $1 billion. The rule changes reduced substantially the amount of information on loans the banks now considered small would have to provide and make public and reduced CRA examination frequency for many banks.

A Hybrid: the SEC’s Consolidated Supervised Entity (CSE) Program

There are regulatory actions that do not fall neatly into any category. The SEC, for example, created a regulatory structure for the purpose of blocking regulation. The context was that the European Union (EU) issued its Financial Conglomerates Directive was going to regulate the largest U.S. investment banks – unless they were regulated by the U.S. on a “consolidated supervision” basis. The SEC rushed to create a regulatory structure that the investment banks could voluntarily opt into – the Consolidated Supervised Entities (CSEs). The SEC’s CSE program was a sham. The SEC was supposed to act in an unprecedented capacity as a safety and soundness regulator (in addition to its role as a regulator of disclosures) over five of the largest, most complex financial institutions in the world. The SEC had no expertise and no systems that would allow it to succeed. But the Sec didn’t even try, its CSE program was a sham designed to block EU regulation of the largest investment banks. Each of the largest U.S. investment banks promptly volunteered to be regulated by the SEC’s CSE program. (The OTS, the weakest of the weak banking regulators, entered the competition in laxity with the SEC – and lost decisively. Each of the large investment banks voluntarily joined the CSE program. When an agency makes it clear that it will be a clearly weaker regulator than the OTS during the 2000s one knows that the agency has attained the status of flagrantly farcical.) The CSE program was so understaffed that it had three employees assigned to supervising Lehman. The CSE program was faux regulation. It created a de facto regulatory black hole for the largest investment banks that effectively reduced the investment banks’ capital requirements. The Commission report discusses the CSE program (pp. 150-155), the Republican dissents do not.

Conclusion

The three “des” – deregulation, desupervision and de facto decriminalization are the defining regulatory characteristics that, along with the perverse incentives of modern executive compensation and the ability of accounting control frauds to suborn purported “controls” (credit rating agencies, auditors, and appraisers) created the criminogenic environment that produced the epidemics of fraud that drove the current crisis. Wallison is correct that federal banking regulation law was made tougher in 1989 and 1991. On the SEC front, Sarbanes-Oxley attempted to toughen the securities laws. Each of those attempted positive statutory actions was overwhelmed by the rampant desupervision. Wallison is incorrect in claiming that there has been no significant financial deregulation in the last 30 years. There has been very little desirable financial deregulation in the last 30 years, but there has been extensive, destructive deregulation. Deregulation played a major role in the S&L debacle and the current crisis.

The big news in U.S. regulation last week was the release of the Financial Crisis Inquiry Commission reports. (There’s a major article in the New York Times about Kabul Bank that supports warnings made in my earlier column on that scandal.) The Commission report and the two dissents discuss some of the most important topics in financial regulation, so I will devote a series of columns to the reports, beginning with the dissent of the nation’s leading anti-regulator – Peter Wallison. Wallison’s passion, for forty years, has been financial deregulation and desupervision. The Republican Congressional leadership appointed him to the Commission to serve as apologist-in-chief for the deregulation and desupervison that made the crisis possible.

We’ll explore Wallison’s dissent in greater detail in future columns, but this overview column addresses his three primary arguments: Fannie and Freddie are the Great Satans, they caused the crisis because of demands politicians put on it to purchase the subprime loans that caused the crisis, and all of this was compounded by the Fed’s easy money policies.

This column discusses Wallison’s views on the first two subjects while the crisis was developing. Wallison is well-known for his long-standing criticisms of Fannie and Freddie, but most people do not know the nature of those criticisms. Wallison praised subprime mortgage loan and complained that Fannie and Freddie purchased too few subprime loans. Wallison (correctly) explained that Fannie and Freddie’s CEOs acted to maximize their wealth – not to fulfill any public purpose involving affordable housing. He also explained that they used accounting abuses to make themselves wealthy. He predicted that low capital costs would increase economic growth. Wallison’s prior views contradict his current claims. Aspects of Wallison’s prior views were correct. They support the conclusion that Fannie and Freddie were accounting control frauds.

Wallison’s Ode to Low Interest Rates

http://www.aei.org/speech/16590

Testimony before the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Affairs
By Peter J. Wallison
Senate Committee on Banking, Housing, and Urban Affairs
(July 19, 2000)

(Parenthetically, Wallison’s July 19, 2000 Senate testimony disputed the claim that there was a high tech bubble – even as the bubble was collapsing.)

Wallison’s Ode to Subprime Lending

Wallison and his AEI colleague Charles Calomiris co-chaired AEI’s project on financial market deregulation . They were also members of the Shadow Financial Regulatory Committee (a self-selected group of deregulatory scholars and practitioners associated with AEI).

Statement of the Shadow Financial Regulatory Committee on Predatory Lending
December 3, 2001. Statement No. 173

Wallison Criticized Fannie & Freddie for Making too Few Loans to the Less Wealthy

Wallison’s critique of Fannie and Freddie emphasized their failure to make more subprime loans and loans to minorities.

http://www.aei.org/speech/16994

H.R. 3703 and its Effects on Government Sponsored Enterprises
By Peter J. Wallison
House Subcommittee on Capital Markets
(September 06, 2000)

http://www.aei.org/speech/19

The Public Trust of a GSE
By Peter J. Wallison
2002 Federal Home Loan Bank Directors Conference
(November 14, 2002)

Wallison dismisses the concept that Fannie and Freddie’s senior managers (the “genuinely wealthy”) even consider the public interest – their “government mission is irrelevant” to their decision-making. He explains that Fannie and Freddie’s leaders act like fully private CEOs.

http://www.aei.org/speech/18075

Fannie Mae and Freddie Mac
By Peter J. Wallison
House Subcommittee on Commerce, Trade and Consumer Protection
(July 22, 2003)

Wallison’s verbal assault on Fannie and Freddie was vigorous. He viewed their failure to make more loans to minorities to be a “sad fact” and a “scandal.”

I will begin the explanation in this column of why Wallison’s lack of understanding of accounting fraud leads him to err in his view that Fannie and Freddie’s senior managers were acting to fulfill their fiduciary duties to the shareholders. (It’s an odd error for a man whose normal premise is wealth maximization. As with “public choice” theory, the neoclassical prediction should be that the CEO will act to maximize his wealth – not the shareholders’ wealth. Term it “CEO choice theory.”) Wallison does not understand that Fannie and Freddie’s controlling officers would come to see that purchasing large amounts of “liar’s” and subprime loans was an ideal strategy for short-term wealth maximization. Nonprime mortgage loans made it easy for Fannie and Freddie’s senior officers to supply the first two ingredients in the four-part recipe by which lenders (and purchasers of loans) that are accounting control frauds maximize short-term accounting income.

1. Extreme growth

2. Through making bad loans at premium yields

3. With extreme leverage, and

4. Providing only trivial loss reserves

As Akerlof & Romer (1993) explained, accounting fraud is a “sure thing.” A lender that follows the recipe is guaranteed to report record income in the short-term, which translates to making the senior officers wealthy. The SEC’s complaint against Freddie’s senior managers stated that the reason they caused Freddie to engage in accounting fraud was to maximize their compensation. Fannie and Freddie’s CEOs eventually came to see that there was no conflict between their desire to become personally wealthier and purchasing bad loans with high nominal yields (and real losses).

Wallison is correct, however, that it was only after Fannie and Freddie’s use of an alternative accounting fraud scheme based on rapid growth and taking serious interest rate risk was discovered by the SEC and ordered terminated by OFHEO that Fannie and Freddie vastly increased their purchase of nonprime loans and MBS. Fannie and Freddie were late to the nonprime party – the giant investment and commercial banks were the leaders in securitizing toxic mortgages to form toxic collateralized debt obligations (CDOs).

Wallison Welcomed a Federal Crackdown on Fannie and Freddie

http://www.aei.org/speech/19

The Public Trust of a GSE
By Peter J. Wallison
2002 Federal Home Loan Bank Directors Conference
(November 14, 2002)

In part, I blame HUD for letting Fannie and Freddie get away with this. Over both Republican and Democratic administrations, HUD has failed to adopt regulations that would require Fannie Mae and Freddie Mac to use a significant portion of the profits they derive from their government support to add appreciably to the housing finance resources available to low-income families. This is in part because the HUD regulations establish a single broad category for low and moderate income families–allowing Fannie and Freddie to meet their requirements through the purchase primarily of moderate income mortgages–and also define underserved areas so broadly that Fannie and Freddie are not compelled to purchase many of the mortgages that banks and thrifts make in meeting their CRA obligations. In a memorable demonstration at an AEI conference two years ago, Jonathan Brown of Essential Information showed aerial views of Chicago neighborhoods with overlays for areas where Fannie and Freddie were and were not purchasing mortgages. Brown’s overlays showed clearly that the low income and minority areas of Chicago were being bypassed by Fannie Mae and Freddie Mac.

To be sure, the jury is still out on the Bush administration’s stewardship of HUD. In a June speech, the President identified increasing home ownership for minorities as a key goal of his administration. In October, he hosted a conference on minority home ownership, where he proposed a $200 million fund to provide up to 40,000 minority families with downpayment assistance. An amount of this size would be a fraction of what Fannie and Freddie earn each year through their government support. It may well be that HUD, in vigorously pursuing all avenues to advance the President’s program will seek to tap this source in some significant way. I hope so, but it remains to be seen. Only then, albeit under duress, will Fannie and Freddie be in any sense fulfilling the public trust of a GSE.

http://www.aei.org/speech/21206

HUD’s Affordable Housing Regulations
Introduction
By Peter J. Wallison
AEI event on HUD’s housing regulations
(September 13, 2004)

Wallison “blame[d]” HUD for not cracking down on Fannie and Freddie’s relatively small purchases of loans to poorer minorities. He noted with relief that HUD had “finally” decided to crack down after reviewing “years” of “study after study” demonstrating that Fannie and Freddie purchased fewer nonprime loans than did the large banks. Wallison called HUD’s new effort “valiant. He wrote “I hope so” in reference to the possibility that President Bush would compel Fannie and Freddie to increase greatly their provision of affordable housing loans.

http://www.aei.org/speech/17662

Are Fannie Mae and Freddie Mac Meeting Their Obligations?
By Peter J. Wallison
AEI event on Fannie Mae & Freddie Mac
(June 09, 2003)

Introduction by Peter J. Wallison at 6/9/2003 “Are Fannie Mae and Freddie Mac Meeting Their Obligations?” event.

Wallison’s Recognition that only Fannie and Freddie’s Actions Mattered

Wallison repeatedly emphasized that Fannie and Freddie’s CEOs were wealth-maximizers who used affordable housing as propaganda to cover-up their self-interested behavior.

http://www.aei.org/speech/21206

HUD’s Affordable Housing Regulations
Introduction
By Peter J. Wallison
AEI event on HUD’s housing regulations
(September 13, 2004)

There is a cottage industry in former Fannie and Freddie officers trying to claim that they were forced to purchase bad loans by the government to help poorer Americans. Wallison never believed it then, but he purports to believe it now when it is useful to his historical revisionism.

Wallison was Concerned about Fannie and Freddie’s Interest Rate Risk, not Credit Risk

http://www.aei.org/speech/18075

Fannie Mae and Freddie Mac
By Peter J. Wallison
House Subcommittee on Commerce, Trade and Consumer Protection
(July 22, 2003)

Wallison gave this testimony in the context of the SEC’s exposure of Fannie and Freddie’s accounting fraud. The scheme was to take substantial interest rate risk. Freddie bet that rates would fall and Fannie bet they would rise – they fell. If the gamble worked the firm would report record profits and maximize the officers’ bonuses. Indeed, Freddie’s profits were so large that it (unlawfully) created “cookie jar” reserves that it could draw on in lean quarters to “hit the number” and maximize executive bonuses. Fannie unlawfully hid the losses on its interest rate bets by improperly calling them hedges. Wallison’s emphasis was always on Fannie and Freddie’s interest rate risk. In order to optimize the accounting scam, Fannie and Freddie had to grow rapidly by holding loans and MBS in portfolio so that they could take much larger interest rate bets. When Fannie and Freddie sell MBS they transfer the interest rate risk to the purchaser.

Wallison’s incomplete Understanding of Accounting Control Fraud

Wallison gets many of the elements of control fraud correct, but he comes from such a warped perspective when it comes to accounting fraud that he never quite gets it. The irony is that Franklin Raines, Fannie’s CEO during much of the time that Wallison was focused on Fannie and Freddie, could have taught Wallison everything he needed to know. In response to the Enron-era accounting control frauds the Business Roundtable made Raines its spokesperson on fraud and integrity. Business Week interviewed him on May 19, 2003.

Wallison’s description of accounting control fraud at Fannie and Freddie is confusing. He could not seem to believe that the GSEs were in grave danger because of their leaders and business practices.

http://www.aei.org/speech/18075

Fannie Mae and Freddie Mac
By Peter J. Wallison
House Subcommittee on Commerce, Trade and Consumer Protection
(July 22, 2003)

Wallison’s use of the word “routine” is simultaneously accurate and enormously disturbing. He is correct that many of our most elite corporations deliberately manipulate their financial statements. It is disturbing that Wallison does not find that alarming and does not understand how much damage it causes. He actually believes that it is lawful to manipulate the earnings and it does not appear he believes it raises any moral issues.

Again, this passage has some basis in reality and is disturbing both for what it says about business elites and the nation’s leading apologist for those elites. Yes, GAAP statements are exceptionally “malleable” if the senior officers choose to act like a blacksmith and hammer them into the shapes that the CEO desires. The fact that reserves require judgments about the likelihood of future events does not mean, as Wallison appears to believe, that the CEO and CFO can put in whatever number will maximize their bonuses. And if he does think it means that then he should be working feverishly to end it.

This passage contains a critical understanding. Fannie and Freddie’s managers could – at will – produce financial statements that made them look exceptionally profitable even when they were in fact suffering losses. Moreover, they could get a clean opinion from a top tier audit firm and they could deceive their regulator. Taken together, that meant that if the senior officers were wealth-maximizers they could easily find accounting control fraud to be their optimal strategy. Wallison seemed to understand that the frauds came from the top.

Wallison missed the fact that competent regulators always focus on the CEO. The Bush administration had overwhelmingly appointed regulatory leaders on the basis of their anti-regulatory dogma, so Wallison didn’t have many effective role models.

Despite these concerns about Fannie and Freddie’s accounting fraud, Wallison did not see credit risk as serious.

Wallison realized that shareholders could not exert effective private market discipline over accounting control frauds. He also knew that the CEO could suborn the internal and external controls and turn them into his most valuable fraud allies.

http://www.aei.org/speech/14874

The Significance of Enron
By Peter J. Wallison
Le Centre Francais sur les Etats-Unis
(May 15, 2002)

Why did all these controls fail simultaneously? Because the CEO can use his ability to hire, fire, promote, and compensate to create perverse incentives and drive a powerful “Gresham’s” dynamic that will select for the least ethical. Again, Fannie would have provided Wallison the perfect example.

Unfortunately, Raines’ insights the risk of good people doing bad things stemmed from his implementation of an executive compensation system that gave huge bonuses if Fannie reached the “stretch” goal of $6.46 EPS. Raines knew that the unit that should have been most resistant to this “overwhelming” financial incentive, Fannie Mae’s Internal Audit department, had succumbed to it. Mr. Rajappa, its head, instructed his internal auditors in a formal address in 2000 (and provided the text to Raines, who praised it):

Internal audit is the “anti-canary” in the corporate “mines”; by the time it is suborned every other unit is corrupted.

Unfortunately, accounting control fraud would so rock Wallison’s anti-regulatory dogma that he keeps stepping back from his ability to even recognize (much less condemn) frauds by business elites as a common problem.

http://www.aei.org/speech/15714

Poor Diagnosis; Poor Prescription
The Error at the Heart of the Sarbanes-Oxley Act
By Peter J. Wallison
AEI Event on Audited Earnings
(January 23, 2003)

Let us review the bidding as Wallison describes it. CEOs are able to choose which “earnings” to report from a “broad range” of values. If actual income is negative or too low to maximize the CEO’s bonus he will, typically, reduce the provision of loss reserves (for a bank, the ALLL) to be able to transmute a loss into a gain. The CEO picks which earnings to report to maximize his compensation. A CEO that does this “is not dishonest.” Indeed, he is “certainly rational.”

Wallison is channeling Gregory Mankiw’s (President Bush’s Chairman of the Council of Economic Advisors) infamous remark as discussant after hearing George Akerlof and Paul Romer present their paper “Looting: the Economic Underworld of Bankruptcy for Profit” (1993) (“it would be irrational for operators of the savings and loans not to loot”).

Wallison is a lawyer, and he is read primarily by other lawyers and senior corporate officials. In criminology, we refer to what he and Mankiw did as “neutralization.” It’s designed to render the criminal and immoral acceptable. Neutralization increases crime. In a word: no. It is dishonest to report false loss reserves in order to make your bonus. It frequently constitutes looting. It typically requires the CEO to commit multiple felonies.

Again, more importantly, if Wallison believes what he is saying then he should study philosophy and ethics and work every day to undue the corrupt culture his anti-regulatory policies have created. His dissent doubts the ethics of subprime borrowers. If he believes what he says about CEOs and CFOs he should place his ethical focus at the top of the food chain.

The key point is that the Republican leadership knew exactly what it would get when it appointed Wallison to the Financial Crisis Inquiry Commission. He was there because he would have to repudiate his entire career before he could ever join in a bipartisan report. The tragic effect is that by trying to discredit the staff’s findings Wallison has most benefited the CEOs who have been able to commit fraud with impunity. His apologia for their “rational” “not dishonest” accounting manipulations marks a new low point in his anti-regulatory zeal. He now defends fraudulent CEOs, those he aptly calls the “genuinely wealthy,” and claims that they should be able to manipulate the accounting to maximize their bonuses. America needed a unanimous Commission willing to write that Wallison’s homo economicus concept of morality is depraved and is producing recurrent, intensifying crises. As authors of the book Moral Markets (a very pro-market volume) emphasize – homo economicus is a sociopath.