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What if the SEC investigated Banks the way it is investigating Mutual Funds?

Posted on December 27, 2011 by | Comments Off on What if the SEC investigated Banks the way it is investigating Mutual Funds?

By William K. Black 

The Wall Street Journal ran a story today (12/27/11) entitled “SEC Ups Its Game to Identify Rogue Firms.”

“Rogue” is an interesting word with a range of definitions. When it is used as an adjective its meaning is: “a playfully mischievous person; scamp.” The trivialization of the most destructive elite frauds is one of the most common forms of what criminologists call “neutralization” of the moral content of wrong doing. Neutralization increases crime.

The actual story makes it clear that the criminals that the SEC was identifying were not “rogues.” They were the CEOs of seemingly legitimate firms. The SEC is identifying “accounting control frauds” – the frauds that cause greater financial losses than all other forms of property crime combined. The SEC is not identifying a few rotten apples, but roughly 100 hedge funds likely to have engaged in accounting fraud. The WSJ describes the SEC’s identification system:

“The list is the low-tech product of a high-tech effort by the SEC to crack down on fraud at hedge funds and other investment firms. After the agency failed to detect the $17.3 billion Ponzi scheme by Bernard L. Madoff, who wowed investors with steady returns over several decades, SEC officials decided they needed a way to trawl through performance data and look for red flags that might signal a possible fraud.

In 2009, the SEC began developing a computer-powered system that now analyzes monthly returns from thousands of hedge funds. Officials won’t say exactly how it works or how much it cost to build, but the agency has announced four civil-fraud lawsuits filed as a result of what it calls the “aberrational performance initiative.””The SEC should be applauded for finally understanding that “if it’s too good to be true; it probably isn’t true.” Our agency put a similar system in place in 1984 to identify the S&L accounting control frauds that were driving that crisis. A quarter-century later, the SEC began to follow our well-trodden trail – but only with regard to felons inhabiting the middle of the fraud food chain (hedge funds). 

The SEC has, inevitably, discovered that accounting fraud is common among hedge funds. It is unlikely that the SEC system is really “high-tech” in information science terms. Low-tech information systems have been capable of identifying “aberrational performance” for at least thirty years. We did not have to create any pioneering software in 1984 in order to identify aberrational performance. The cost and time to create our “red flags” was trivial (a few hours of programming time by an agency staffer). (We were collecting the data and computing the necessary ratios anyway. One simply decides the level of a few key variables worthy of being flagged. There’s nothing magic about a “flag.” All it means is that suspicious levels are highlighted on the computer screen and on physical copies of the periodic reports so that they capture the reader’s attention.)

The SEC took two years to create its “aberrational performance” system and is embarrassed enough about the cost that it wants to keep it secret. The two year development process allowed the SEC to make a major advance relative to our system – they invented a title consisting of two words and eight syllables. Devising a title that recondite doubtless accounts for six months of the time it took the SEC to develop its flags.

The most interesting aspects of the WSJ story, however, are two unexamined topics that should have been central to the story. First, there is not a word in the article about criminal prosecutions for the frauds the SEC has identified. The frauds, as described in the article, are so blatant that they would make relatively simple to prosecute. There is no indication that the SEC wanted the WSJ to know that they had made well over a hundred criminal referrals against hedge fund CEOs and senior officers. There is no indication that the WSJ reporters were interested in whether the SEC had made criminal referrals against these moderately elite felons. As a result, we have no information on whether the SEC has in fact made hundreds of criminal referrals against the senior officers at the hedge funds that they have identified as having engaged in likely fraud. Indeed, we have no evidence that they have made any criminal referrals. Neither the SEC nor the WSJ reporters indicated that any prosecutions, or even Department of Justice investigations, resulted from the SEC hedge fund investigations.

Second, why isn’t the SEC’s top priority the systemically dangerous institutions (SDIs)? The SDIs are the financial institutions that are so large that the administration fears that their failure will cause a new global crisis. The SDIs pose by far the greatest risk to the economy and investors of any entity. Their frauds reached “epidemic” proportions and drove our ongoing crisis and the Great Recession. The SEC, however, applied its “aberrational performance” system to its smallest entities and is now expanding it to mutual funds. There is no indication that the SEC intends to use the system to spot fraudulent SDIs. There is no indication that the SEC has even contemplated using the system to spot fraudulent SDIs. There is no indication that the WSJ reporters asked why the SEC was failing to use its system where it was most needed.

Applying the SEC system to the SDIs would have led the SEC to develop a more sophisticated analytical approach to identifying fraud. There is no indication that the SEC has any familiarity with the criminology, economics, and regulatory literature about how to identify accounting fraud. Admittedly, the SEC (finally) has taken seriously the warning that generations of parents have impressed upon their children – “if it’s too good to be true; it probably isn’t true.” The Achilles’ heel of the SEC analytics is that it assumes fraud must be aberrational and its flags are (at least as described in the story) all tied to identifying aberrations premised on the implicit assumption that fraud cannot be endemic. The SEC official told the WSJ reporter that they looked for “outliers.” Accounting control fraud, however, can become endemic, particularly in a product line, because it produces a “Gresham’s dynamic” in which bad ethics drives good ethics out of the market. Accounting control frauds report results that are too good to be true, but they all report extraordinary results because accounting fraud is a “sure thing” (George Akerlof and Paul Romer, “Looting: the Economic Underworld of Bankruptcy for Profit, 1993). Accounting control fraud was far more common among the SDIs than the SEC system has identified among hedge funds.

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President Obama’s view of fraud “from 40,000 feet” (without an oxygen mask)

Posted on December 20, 2011 by | Comments Off on President Obama’s view of fraud “from 40,000 feet” (without an oxygen mask)

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


Sixty Minutes’ December 11, 2011interview of President Obama included the following gem:

KROFT: One of the things that surprised me the mostabout this poll is that 42%, when asked who your policies favor the most, 42%said Wall Street. Only 35% said average Americans. My suspicion is some of thatmay have to do with the fact that there’s not been any prosecutions, criminalprosecutions, of people on Wall Street. And that the civil charges that havebeen brought have often resulted in what many people think have been slap onthe wrists, fines. “Cost of doing business,” I think you called it inthe Kansas speech. Are you disappointed by that?

PRESIDENT OBAMA: Well, I think you’re absolutelyright in your interpretation. And, you know, I can’t, as President of theUnited States, comment on the decisions about particular prosecutions. That’sthe job of the Justice Department. And we keep those things separate, so that there’sno political influence on decisions made by professional prosecutors. I cantell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.

That’s exactly why we had to change the laws. Andthat’s why we put in place the toughest financial reform package since F.D.R.and the Great Depression. And that law is not yet fully implemented, butalready what we’re doing is we’ve said to banks, “You know what? You can’ttake wild risks with other people’s money. You can’t expect a taxpayer bailout.

Hallucinations occur at high altitude when you become oxygen deprived.  Let’s review the bidding on theBush/Obama record in prosecuting the elite control frauds that drove theongoing crisis.  There are noconvictions of the Wall Street elites that made, purchased, packaged, and soldmillions of fraudulent liar’s loans. There are no federal prosecutions of the major banks that committed over100,000 fraudulent foreclosures. There are a few settlements that sound like large dollar amounts, butare merely what even Obama concedes to be the (deeply inadequate) “cost ofdoing (fraudulent) business.” Fraud pays – it pays enormously and our elites now commit it withimpunity as a means of becoming wealthy. We have just witnessed the travesty of Wachovia admitting to criminalconduct in their (grotesquely weak) settlement with the Department of Justice(which has a policy of no longer prosecuting large corporations that commitcrimes) – and having the SEC refuse to require Wachovia to make similaradmissions in its settlement.  Allthis, the President implicitly or even explicitly concedes.



But the President asserts:  “Ican tell you, just from 40,000 feet, that some of the most damaging behavior onWall Street, in some cases, some of the least ethical behavior on Wall Street,wasn’t illegal.”  Kroft, sadly, didnot follow up on this incredible and, if true, extraordinarily importantassertion.  Obama’s statementsabout fraud and ethics are inaccurate on multiple levels. 
Obama’s factual assertions about the failure to prosecute fraud areunresponsive to the question, false, and logically inconsistent.  Note the artful manner in which Obamaevaded answering Kroft’s question. Kroft asks why there are no prosecutions of the Wall Street frauds thatdrove the crisis.  Obama answersthat “some” unethical Wall Street actions were not illegal.  Obama’s answer implicitly admitted thatmost Wall Street actions that causedthe crisis were criminal.  Hesimply argues that some highlyunethical behavior by Wall Street that was not illegal contributed to thatcrisis.  As David Cay Johnstonemphasized in his column about Obama’s response to Kroft’s question, Obama’s answeris a non-answer.  Why has he failedto prosecute any of the criminal conduct by Wall Street that drove thefinancial crisis?  The (alleged)fact that “some” destructive Wall Street conduct was highly unethical, but notillegal, obviously provides no basis for not prosecuting what Obama concedeswas primarily criminal conduct.   


Obama claims that the purported legality of Wall Street’s (unspecified)“least ethical behavior” is “exactly why we had to change the laws.”  He then describes the two specificchanges in the Dodd-Frank law that he asserts make illegal that “least ethical behavior” for the firsttime.  Obama claims that Dodd-Frankmakes it illegal to “take wild riskswith other people’s money” and for bankers to “expect a taxpayer bailout.”  Obama is a lawyer and former lawprofessor, so these are matters as to which he is capable of precision.   Dodd-Frank does not make it illegal for bankers to take “wildrisks.”  Banks inherently takerisks “with other people’s money” so that bit of rhetoric issuperfluous. 
Dodd-Frank does not make it illegal for a banker to “expect a taxpayerbailout.”  Dodd-Frank does not makeit illegal (and could not constitutionally do so) for bankers to lobby for abailout.  We have all seen thesuccess of such lobbying with the Bush and Obama administrations.  Both administrations have refused toorder an end to the “systemically dangerous institutions” (SDIs) (inaccuratelyreferred to as “too big to fail”). Both administrations asserted that when the next SDI failed it was likelyto cause a global systemic crisis. (It is a matter of “when”, not “if” they will fail, or more precisely,when we will admit that they failed.) 


The SDIs are also too big to manage – they are inefficiently large.  We can increase efficiency,dramatically reduce global systemic risk, and reduce the SDI’s exceptionalpolitical dominance by ordering them to shrink over the next five years to apoint that they no longer pose a systemic risk.  Instead, the Obama administration continues the Bushpractice of referring to the SDIs as “systemically important” (as if theydeserved a gold star for putting the world’s economy at risk).  The Bush and Obama administrations haveallowed, even encouraged, the SDIs to grow larger.  That policy is insane. It poses a clear and present danger to the U.S. and global economy andto our democracy.  The SDIs will be“bailed out” when they fail. Indeed, they are being bailed out continuously by policies the Fed andTreasury follow that are designed to provide massive governmental subsidiesprimarily for the benefit of the zombie SDIs that have already failed in realeconomic terms, e.g., Bank of America and Citi.

“Wild risks” are not remotely Wall Street’s “least ethicalbehavior.”  It is impossible, givenObama’s generalities and Kroft’s failure to probe to know what “wild risks”Obama is talking about, but none of the (supposed) risky loans banks made evenapproach lenders’ “least ethical behavior.”  The riskiest loans that banks made were liar’s loans toborrowers with bad credit histories. Credit Suisse reported in early 2007 that, by 2006, 49 percent of loansthat lenders called “subprime” (because they were made to borrowers with known,serious credit defects) were also liar’s loans (loans made without prudentunderwriting).  I agree with Obamathat making a subprime liar’s loan is exceptionally “damaging.”  Such loans damaged the lender, theborrower, the purchaser of such loans, and the purchaser of the collateralizeddebt obligations (CDOs) that were backed by subprime liar’s loans.  (Of course, “backed” deserves to be inquotation marks.)  Such loans wouldbe dumb, but they wouldn’t be among the banks’ “least ethical” actions if theloans were lawful.  Indeed, ifmaking subprime liar’s loans were merely risky, one could argue morepersuasively that the banks were acting altruistically when they made suchloans. 

What Obama missed, and Kroft failed to call him on, is that “wildrisk” by banks are typically frauds. I have explained these matters at length in previous posts, so I willprovide the ultra short version here. Honest home lenders do not make liar’s loans.  In particular, honest lenders do not make subprime liar’sloans.  Honest home lenders do notmake such loans because they create intense “adverse selection” and create a“negative expected value” (in plain English, they will lose money).  No government (here or abroad),required any lender or other entity (i.e., Fannie and Freddie) to make oracquire liar’s loans.  In fact, thegovernment repeatedly criticized liar’s loans.  The FBI warned of an “epidemic” of mortgage fraud inSeptember 2004.  The mortgagelending industry’s own anti-fraud body (MARI) warned every member of theMortgage Bankers Association (MBA) in writing in the 2006 that “stated income”loans were “an open invitation to fraudsters,” had a fraud incidence of 90percent, and deserved the term the industry used behind closed doors todescribe them – “liar’s” loans. Despite these warnings, lenders massively increased the number of liar’sloans they made. 

Home lenders made subprime liar’s loans because they were“accounting control frauds.”  Subprimeliar’s loans were ideal “ammunition” for accounting fraud.  They reduced the paper trailestablishing that the lender knew the loan was fraudulent and they optimizedthe four-ingredient “recipe” for a lender engaged in accounting controlfraud.  (Grow rapidly by making badloans at a premium yield, while employing extreme leverage and providing onlygrossly inadequate allowances for loan and lease losses (ALLL)).  The CEOs of lenders that made subprimeliar’s loans as part of this recipe were not taking risks in the conventionalmanner we discuss in finance (uncertainty).  As George Akerlof and Paul Romer explained in their famous1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”),accounting control fraud is a “sure thing.”  The lender is guaranteed to report record (albeit fictional)profits in the near term, which makes the CEO wealthy when he uses modernexecutive compensation to loot the lender.  Unfortunately, the same recipe that creates extremefictional income produces massive real losses.

Making liar’s home loans inherently requires lenders tocreate perverse incentives for widespread mortgage fraud.  It was lenders and their agents thatoverwhelmingly put the lies in liar’s loans.  The CEOs of the lenders who made subprime liar’s loanscompounded their initial mortgage origination fraud by making fraudulent repsand warranties to sell the endemically fraudulent mortgages.  The growth in liar’s loans (roughlyhalf of them were also subprime loans) was so extreme – over 500% from 2003 to2006 – that it caused the bubble to hyper-inflate).  Making fraudulent loans that placed millions of workingclass borrowers in loans that they frequently could not afford to repay andwere deeply underwater caused them a massive loss of wealth and wasdistressingly unethical.  Theofficers controlling the lenders that made fraudulent liar’s loans were evenmore unethical because they caused this devastation in order to become exceptionallywealthy.  The most morally depravedof the CEOs running accounting control frauds sought out the least financiallysophisticated borrowers, often minorities, as their victims.    

Obama has unintentionallyproved the accuracy of the plurality of survey responders who concluded that heserves Wall Street’s interests at the expense of the public.  He cynically evaded responding to theprimary reason why the public “gets it” – the abject failure of his administrationto prosecute the elite financial frauds that drove the financial crisis and theGreat Recession.  Obama offered thepathetic (and factually inaccurate) non-excuse that “some” unethical conductmight be legal.  It is time forObama (and Attorney General Holder) to “man up.”  If they refuse to do so and are going to continue to be lapdogs for the elite financial frauds they should at least change the name of theJustice Department. 


Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.


Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives. 


Follow him on Twitter: @WilliamKBlack

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Watch William K. Black’s Latest Appearance on The Dylan Ratigan Show

Posted on December 16, 2011 by | Comments Off on Watch William K. Black’s Latest Appearance on The Dylan Ratigan Show

http://www.msnbc.msn.com/id/32545640

Visit msnbc.com for breaking news, world news, and news about the economy

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Dante’s Divine Comedy: Banksters Edition

Posted on December 15, 2011 by | Comments Off on Dante’s Divine Comedy: Banksters Edition

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

Sixty Minutes’ December 11, 2011 interview of President Obama included a claim by Obama that, unfortunately, did not lead the interviewer to ask the obvious, essential follow-up questions.

“I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn’t illegal.”

Obama did not explain what Wall Street behavior he found least ethical or what unethical Wall Street actions he believed was not illegal. It would have done the world (and Obama) a great service had he been asked these questions. He would not have given a coherent answer because his thinking on these issues has never been coherent. If he had to explain his position he, and the public, would recognize it was indefensible. I offer the following scale of unethical banker behavior related to fraudulent mortgages and mortgage paper (principally collateralized debt obligations (CDOs)) that is illegal and deserved punishment. I write to prompt the rigorous analytical discussion that is essential to expose and end Obama and Bush’s “Presidential Amnesty for Contributors” (PAC) doctrine. The financial industry is the leading campaign contributor to both parties and those contributions come overwhelmingly from the wealthiest officers – the one-tenth of one percent that thrives by being parasites on the 99 percent.

I have explained at length in my blogs and articles why:

  • Only fraudulent home lenders made liar’s loans 
  • Liar’s loans were endemically fraudulent 
  • Lenders and their agents put the lies in liar’s loans 
  • Appraisal fraud was endemic and led by lenders and their agents 
  • Liar’s loans could only be sold through fraudulent reps and warranties 
  • CDOs “backed” by liar’s loans were inherently fraudulent 
  • CDOs backed by liar’s loans could only be sold through fraudulent reps and warranties 
  • Liar’s loans hyper-inflated the bubble 
  • Liar’s loans became roughly one-third of mortgage originations by 2006

Each of these frauds is a conventional fraud that could be prosecuted under existing laws. Hundreds of lenders and over a hundred thousand loan brokers were “accounting control frauds” specializing largely in making fraudulent liar’s loans. My prior work explains control fraud, why accounting is the “weapon on choice” for fraudulent financial firms, and why liar’s loans were superior “ammunition” for committing massive accounting fraud. These accounting control frauds caused greater direct financial losses than any other crime epidemic in history. They also drove the financial crisis that produced the Great Recession and cost millions of Americans their jobs.


In considering my scale of unethical conduct it is important to keep in mind that it is highly likely that anyone that causes very large numbers of people to lose their homes will cause multiple suicides and indirect deaths that arise from the greater vulnerability of the homeless and the blue collar crime effects of destroying neighborhoods inherent to widespread foreclosures. I ignore for this purpose the fact that the fraudulent loans caused the bubble to hyper-inflate and drove the financial crisis that caused millions of people to lose their jobs. The financial accounting control frauds are the weapons of mass destruction of wealth, employment, and happiness. I also ignore the fact that the frauds described here made the perpetrators wealthy. My scale, therefore, systematically and dramatically understates the perpetrators’ moral turpitude. I have also excluded the massive foreclosure frauds from my scale because they did not cause the underlying crisis. When Obama reveals the bankers actions he claims to be legal but highly unethical readers should keep my conscious understatement of the moral depravity of the illegal acts by bankers that drove this crisis in mind when they compare the relative ethical failings.

As a criminologist, I do not favor sentencing criminals to the fates they richly deserve. I would never torture prisoners or place them at risk of assault, rape, or psychological trauma. I do not believe that extremely longer terms of imprisonment are desirable except in rare circumstances. As a lawyer and a criminologist I emphasize that any sentence should come only after a conviction in a trial providing due process protections or a guilty plea.My scale provides a label for the comparative moral depravity of the perpetrator, the deserved punishment (which when vicious is not the far more humane one I would actually impose), and a brief description of the specific frauds that are characteristic of this level of immorality and the number of perpetrators falling in each category. My inspiration was Dante’s circles of hell as described in his Divine Comedy.

The Scale of Ethical Depravity by the Frauds that Drove the Ongoing Crisis

Level 10: Septic tank scum

Eternal Hell: these banksters deserve a physical hell of infinite torment and duration

 Officers that directed control frauds that involved making predatory loans to more than 10,000 homeowners who lost their homes as the result of the frauds. Predatory loans in this context mean deliberately seeking out the elderly or minorities for such loans because they were easier to con into taking loans they could not repay – at a premium yield (interest rate). Dozens of CEOs fall in this category.

Level 9: Pond scum

Time in Hell:  These banksters deservea term in hell


Officers that directed control frauds that led to more than 10,000homeowners losing their homes.  Hundredsof CEOs fall in this category.


Level 8:  Generic scum


Gitmo:  Hell’s starkest suburb


Officers that directed control frauds that led to more than 1,000 homeownerslosing their homes.  Thousands of CEOsfall in this category.


Level 7:  Dante’s deserved denizens


Supermax:   No view, and no way out


The professionals that aided and abetted the overall control frauds byinflating appraisals, giving “clean” audit opinions to fraudulent financialstatements, “AAA” ratings to toxic waste, and accommodating legal opinions tothe frauds.  Thousands of professionalsfall in this category.


Level 6:  Aspiring to great wealththrough fraud 


Alcatraz:  Great view, but no way out


The senior lieutenants of the control frauds who committed the frauds thatcaused more than 10,000 homeowners to lose their homes.  Thousands of senior officers fall in thiscategory.


Level 5:  A large cog in a smallerfraud


Generic Hardcore Prison:  A life ofboredom and the almost total loss of freedom


The senior lieutenants of the control frauds who committed the frauds thatcaused more than 1,000 homeowners to lose their homes.   Thousands of senior officers fall in thiscategory.


Level 4:  The banksters who cost usour money instead of our homes – Goldman Sachs & friends


Generic Prison:  A life of boredom anda severe loss of freedom


The officers that led the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product.  Dozens of officers fall in this category.


Level 3:  The banksters’ seniorlieutenants who cost us our money instead of our homes


Prisons designed for serious, but less physically dangerous felons


The senior officers of the control frauds who targeted their customers forthe purchase of more than $10 million in fraudulent product.  Scores of senior officers fall in thiscategory.


Level 2:  Banksters who defraudedother bankers (who were willing to be defrauded)


Privatized prisons:  Let them enjoythe consequences of their odes to privatization


The largest control frauds sold tens of billions of dollars of fraudulentloans to each other through fraudulent “reps and warranties.”  The kicker here, as Charles Calomiris hasemphasized, is that the control frauds on both sides of the transactions knew thatthey were engaged in a mutual fraud. Hundreds of senior officers fall in this category.


Level 1:  Small fraudulent fry


Catch and release:  Convict them andput them on probation if they cooperate with the investigations


The small fry are the loan officers, loan broker employees, and borrowerswho knowingly participated in making fraudulent mortgage loans.  Over 100,000 individuals fall in thiscategory.

We Need to End the PAC Doctrine

To date, Bush and Obama have prosecuted none of the mortgage frauds in the top nine levels. I urge reporters to ask him to explain three things about his statements to 60 Minutes.

  • Why are there no prosecutions of the felons that drove the crisis and occupy the nine worst rungs of unethical and destructive acts?

  • Explain the five unethical acts by elite financial institutions that you consider the most destructive and least ethical – but which you believe to be legal. How do you rank the degree of unethical conduct and destruction in those acts?

  • What specific statutory provisions did you propose to make those five unethical acts illegal? As enacted, which provisions of the Dodd-Frank Act made those five unethical acts illegal? Who has been prosecuted for those formerly legal but seriously unethical and destructive acts that were made illegal by the Dodd-Frank Act?

Reporters will have to be persistent in coordinating their follow-up questions to get Obama to provide direct answers to these questions.

I request that private citizens write President Obama to ask him to provide specific, written answers to these three questions. I will be proposing a series of questions that I will urge citizens to demand answers to because it is clear that the regular media will rarely ask demanding questions of elite politicians or bankers. It is up to us to hold them accountable and end the doctrine of Presidential Amnesty for Contributors.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.


Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

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Listen to Bill Black on Open Your Mind Ireland Radio.

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Senator McCain’s Economist Warns: If you Criticize Banksters They will Prolong Recessions

Posted on November 29, 2011 by | Comments Off on Senator McCain’s Economist Warns: If you Criticize Banksters They will Prolong Recessions

By William K. Black

Steven J. Davis, Senator McCain’s chief economics advisor during his presidential campaign, has written a political hit piece on the man that defeated his candidate.  His co-authors were Scott R. Baker and Nicholas Bloom.  For the sake of brevity I will refer to the authors as “the authors” or “Davis.”  They published the piece in Bloomberg.  The article purports to be a straight scientific piece, but it is a partisan screed relying on faux statistics created by Davis to support his views.  Davis’ statistical methodology is not simply unscientific, it is embarrassingly bad.

Davis’ argument, long discredited by actual surveys of employers, is that unemployment is so high because employers refuse to hire because of Democratic policies.  As Paul Krugman has long noted, employers, when surveyed, have consistently and emphatically refuted this claim.  Given that the employers answering the surveys are disproportionately Republicans and opponents of regulation who have strong incentives to blame the regulations for their failure to hire, their failure to do so makes the survey results particularly compelling.  Davis’ statistical index provides no evidence of why employers are not hiring.  Indeed, it is inherently incapable of providing such evidence. 

Davis is a partisan Republican.  He is a theoclassical economist and a proud representative of the one percent.  He has worked for the Hoover Institution, AEI, and Michael Milken’s foundation (the infamous fraud whose crimes destroyed Drexel Burnham Lambert).  He is a professor at U. Chicago’s business school. 


Davis missed the developing crisis entirely, publishing an article about “the Great Moderation” in 2008 as the financial crisis was ripping across the world.  His ideological blinders are so complete that he cannot even consider the obvious – the crisis was brought on by the criminogenic environment produced by the three “de’s” – deregulation, desupervision, and de facto decriminalization plus perverse executive and professional compensation.  The economists George Akerlof and Paul Romer wrote an article about accounting control fraud entitled “Looting: the Economic Underworld of Bankruptcy for Profit.”  They concluded the article with this passage about the criminogenic environment produced by S&L deregulation in the 1980s.

“Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself (1993: 60).”

The reason we have tragic levels of unemployment is the financial crisis, which was fully preventable had the anti-regulators put in place by Presidents Clinton and Bush simply understood the concepts of looting and criminogenic environments that we had made clear a quarter-century ago.  As I will show, Davis takes the remarkable position that we must not learn from our deregulatory mistakes and close the resulting regulatory black holes.    
 
Absent the restoration of effective financial regulation and prosecutions, and the removal of the perverse compensation systems (which also requires regulation), we will continue to suffer recurrent, intensifying financial crises and the severe unemployment they produce.  Effective financial regulation greatly reduces uncertainty by increasing transparency and by preventing Gresham’s dynamics.  George Akerlof explained to the profession 41 years ago in his famous article on markets for “lemons.”

“[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.”  

Consider the grave “uncertainty” that would exist in a nation without effective police forces.  Somalia is a good example.  The police do not, and cannot, deal with sophisticated financial crimes.  The FBI’s white-collar crime specialists do not patrol a beat and look for crimes.  They sometimes act on anonymous tips or leads from other investigations, but overwhelmingly they depend on criminal referrals from the regulators.  Our principal function as regulators is to serve as the regulatory cops on the beat to prevent the Gresham’s dynamic by aggressively finding the frauds, putting them out of business, and providing the criminal referrals that make it possible to prosecute the elite frauds.  Absent effective regulators, honest firms often face extinction and their employees will lose their jobs.  

In Davis’ world, however, regulation is unnecessary and harmful.  The former U. Chicago professors, Frank Easterbrook and Daniel Fischel, wrote what remains the U. Chicago bible on accounting control fraud.  A generation of American lawyers has been taught this profession of faith from Easterbrook and Fischel’s 1991 treatise: “A rule against fraud is not an essential or even necessarily an important ingredient of securities markets….”  The Economic Structure of Corporate Law (1991).  Markets are self-correcting, bubbles are impossible, and economic crises are impossible.  This was the theoclassical profession of faith in a miraculous trinity.  Each of these dogmas has been repeatedly falsified by real life, but facts cannot trump blind faith.  Senator McCain’s was a member of the “Keating Five.”  Charles Keating, the most infamous S&L fraud, used the Senators to try to intimidate us into not taking any regulatory action against Lincoln Savings’ massive regulatory violation – a violation that led to billions of dollars in losses.  Neither McCain nor Davis learned any useful lesson from this scandal. 

Davis has mounted politically consistent attacks on the Democrats based on the high unemployment caused by the epidemic of accounting control fraud that hyper-inflated the bubble and drove the U.S. financial crisis.  On January 3, 2010 he published an op-ed with Gary Becker and Kevin Murphy in the Wall Street Journal blaming the Democrats for the high unemployment caused by the Great Recession.  This was their tag line:  “A recession is a terrible time to make major changes in the economic rules of the game.”

Consider the logic of that assertion.  The “economic rules of the game” have just led to an epidemic of accounting control fraud, a hyper-inflated bubble, a Great Recession, and severe unemployment and the theoclassical answer to the catastrophe that their faith-based policies have caused is – engrave those rules in bronze.  They literally call on us to repeat the mistakes of the past.  Theoclassical economists take their cue from the White Queen, who bragged to Alice that with practice she had learned to believe “as many as six impossible things before breakfast.” 

The authors acknowledged that the Great Recession had caused severe unemployment, but added the claim that it was the election of Democrats that prevented a prompt recovery.

“Liberal Democrats won a major victory in the 2008 elections, winning the presidency and large majorities in both the House and Senate. They interpreted this as evidence that a large majority of Americans want major reforms in the economy, health-care and many other areas.”

Obama’s economic team (Summers, Geithner, and Bernanke) was strongly neoclassical and economically conservative.  The authors then singled out any effort to deal with climate change as particularly undesirable.  Apparently it is now a violation of theoclassical principles to require manufacturers to internalize the cost of negative externalities.  That is contrary to economics and would lead to a poisoned world in which firms that spent money to restrict harmful emissions would be driven out of business by their competitors who avoided such expenses and obtained a decisive cost advantage.  This is another example of a Gresham’s dynamic in which bad ethics drives good ethics from the marketplace.  The authors ended by opposing allowing the Bush tax cuts for the wealthy to expire.  They presented no evidence in support of their partisan attack on Democrats and their ideological attack on “liberals.”

On July 15, 2011, Davis wrote an article entitled “Why Employers Are Slow to Fill Jobs.”  

Davis mentioned “policy uncertainty” as one of the contributors to the employers’ failure to hire workers in this article, but what he stressed was that the Great Recession so depressed private sector demand for goods and services that most employers felt little desire to hire additional workers because they could not sell additional output.  He noted that employers had reduced the intensity of their recruiting because they were in a buyer’s market in which they were deluged with applicants and could afford to hire only the most ideal candidates.  Even when Davis discussed uncertainty his primary emphasis was on economic uncertainty – the Great Recession.  He ended by blaming unemployment on the unemployed.  The long-term unemployed were spending fewer hours looking for jobs.  Davis called for ending unemployment benefits for the long-term unemployed.  The prospect of starving in a fortnight would concentrate their minds wonderfully.  (Yes, Davis’ last argument contradicts his earlier arguments, but this is faith-based callousness posing as science.)  His “summing up” paragraph has one clause referencing “uncertainty” as a purported tertiary contributor to the slow reduction in unemployment.  Again, Davis offered no support for this assertion.

Davis’ latest (October 5, 2011) partisan attack is entitled “Policy Uncertainty Is Choking Recovery.”  In five months, Davis’ tertiary, minor asserted contributor to the slow recovery has suddenly morphed into a monster that is the cause of the problem.  You might think that the survey results showing that businesses have repeatedly falsified this claim would pose a problem for this meme, but the authors hit on the obvious answer to inconvenient truths – they ignored them.  Lest you think that this was due to tight space limits placed on a Bloomberg op ed, check their academic paper, which, also ignores the actual surveys.  “Measuring Economic Policy Uncertainty” (October 10, 2011).   This begins to explain why their work is embarrassingly bad.

The partisan slanting of the article is also embarrassing, as is the failure to identify Davis’ role as McCain’s principal economics advisor.  Here is the authors’ thesis:

“But the persistence of policy uncertainty wasn’t inevitable. Rather, it reflects deliberate policy decisions, harmful rhetorical attacks on business and “millionaires,” failure to tackle entitlement reforms and fiscal imbalances, and political brinkmanship.”

Their thesis boils down to the claim that capitalists are wusses.  The reality is that politicians of both parties fall all over themselves saying nice things about business and that the criticisms are addressed to corporate criminals and the wealthy who pay what the vast bulk of Americans view as grossly inadequate taxes.  Moreover, according to the neoclassical economics canon these authors purport to believe raising taxes on the wealthy would be a valuable change that would reduce “fiscal imbalances.”  The authors, instead, assert that any increase in taxes on the wealthy destroys jobs.  By their logic, we should eliminate taxes on the wealthy.  By entitlement “reforms” they mean reducing Social Security benefits – that will do wonders for private sector demand and robust jobs growth. 

Indeed, the authors’ thesis is eerily reminiscent of Jon Stewart’s famous riff when Dick Cheney shot his elderly hunting companion in the face.  Stewart noted that Cheney was so powerful that the victim apologized to Cheney for being shot – by Cheney.  The authors want us to apologize to the elite financial frauds that became wealthy through the accounting control fraud epidemic that drove the crisis, the Great Recession, the great bulk of the federal budget deficit, the state and local government financial crisis, and severe unemployment.  It wasn’t enough that we bailed them out and gimmicked the accounting rules at their demand to ensure that “their” banks could continue to pay them massive bonuses even though they were in economic reality insolvent.  How dare we make “harmful rhetorical attacks” on the frauds!  We should all apologize immediately to the productive class.

Speaking of “rhetorical attacks,” consider this partisan assault by the authors:

“The Patient Protection and Affordable Care Act that President Barack Obama signed into law in March 2010 is another example. Rather than simple reforms aimed at efficiency improvements and cost savings, the law seeks to remake the U.S. health-care delivery system, dramatically expanding the role of government and imposing new burdens on businesses and individuals. Even in narrowly economic terms, the measure adds to the uncertainty facing households and businesses.

Moreover, its political durability is in doubt. The Democratic leadership in Congress opted to pursue the most radical plan that could muster the necessary 60 votes in the Senate and a thin majority in the House. As a result, the legislation failed to attract a single Republican vote in either chamber. That political strategy ensured the act would become the focus of future electoral battles and rollback efforts. “

The authors then go on to complain that the lawsuits challenging the constitutionality of the Act (which they do not note were brought by Republicans) add to uncertainty.  Whatever, the Act is, it is assuredly not “radical.”  It is modeled on a scheme created by a then conservative Republican Governor, Mitt Romney.    


In reality, the Obama administration made obsessive efforts to craft a bill with bipartisan support – substantially weakening an already weak bill and taking out, at the demand of Republican and “blue dog” Democrats, the central “cost savings” provision in the bill – the public option.  The “simple reform” that would vastly increase efficiency and cost savings – and boost the international competitiveness of U.S. firms – is single payer health care funded by the public rather than (largely) through tax-subsidized but still expensive private health insurance provided by employers.  The Republicans and “blue dog” Democrats promised to kill any such bill.  The authors’ dread “liberal Democrats” favored a bill that would produce superior health care at a far lower price in line with other developed nations.  The private health insurers promised to bury such a bill, so the Obama administration went for the ultra conservative alternative developed by Romney.  The authors’ partisan slant causes them to deliberately and comprehensively misstate the facts.

The authors then move to describing their uncertainty “index.”

“We constructed our index by combining three types of information: the frequency of newspaper articles that refer to economic uncertainty and the role of policy, the number of federal tax code provisions set to expire in coming years, and the extent of disagreement among forecasters about future inflation and government spending.” 

To which the obvious first question is:  why?  I begin my analysis with their tax provisions component.  They know that a historically unusual number of tax provisions are set to expire in coming years, so they know that when they use that component they will produce at index showing a surge in uncertainty. 

“Scheduled expirations of federal tax code provisions were rare before 2000 but have grown rapidly. More than 130 provisions are slated to expire in 2011 and 2012, in many cases setting the stage for new political battles.”

Davis wants to report high uncertainty to fit his priors that he has been asserting without any proof.  This is a hopelessly unsound means to produce an index.  Any of us could pick a variable that would “prove” our priors.  The psychological temptation to prove we are right (especially for theoclassical economists who have gotten everything important horribly wrong) is overwhelming.  The bad news is that the tax expirations are the least embarrassing aspect of their index.


An even more ludicrous component is: “the frequency of newspaper articles that refer to economic uncertainty and the role of policy.”  First, the authors know, because Davis has been a part of promoting this meme, that Republicans have organized a coordinated campaign to claim that “regulation” and “taxes” are causing the weak recovery from the recession.  To now use the publicity that one political party, and at least one of the framers of the index, is generating for partisan purposes as purported objective evidence of the harms of ending the regulatory black holes is so unprincipled as to be beneath contempt.  Indeed, the absurdity of this component is demonstrated by the fact that their effort to publicize their index in the form of a partisan op ed and a partisan academic paper has already had the effect of driving their index higher and “proving” their point.  Moreover, this is not a new Republican strategy.  They followed the same strategy of attacking regulation and regulators for years, but the coordinated attacks on regulation emanating from the right’s “think tanks” (funded by firms that wish to prevent effective regulation) have increased greatly since the passage of Sarbanes-Oxley.  Self-generated attacks on regulation become “policy uncertainty,” which becomes a purported empirical basis for preventing effective regulation.  The index provides an elegant solution to the Koch brothers’ policy goals.     


The authors’ third component is almost humorously bad:  “the extent of disagreement among forecasters about future inflation and government spending.”  We have a vastly more reliable means to judge the risks of future inflation in the U.S.  It is called the U.S. bond market.  It prices the risk of inflation continuously.  It already incorporates “government spending” because such spending can affect inflation.  The U.S. bond markets have consistently been telling us since the crisis became public knowledge that there is no material risk of inflation.  Why do the authors believe that “forecasters” are more reliable than bond markets?  Why do they believe that businesses are failing to hire because they are concerned that the inflation hawks have remained delusional in their claims that hyper-inflation is just around the corner?  What does any of this have to do with regulation?  If CEOs were worried about hyper-inflation because they remained in thrall to some inflation hawk analyst who had been proven grotesquely wrong in every forecast over the last five years, wouldn’t those CEOs be happy that the Bush tax cuts were set to expire?  Why do CEO’s base their decision to hire on the variance among analysts as to the size of the federal budget instead of the size of the federal budget deficit?  The authors do not address these issues in their formal paper or op ed.  


The authors then assigned arbitrary weights to their three components.  The news stories measure is weighted one-half, while the tax repeals and both forms of variance in forecasts (inflation and government spending) each receive an individual weight of one-sixth. 

The authors claim in their op ed (but not in their paper, which claims only “some suggestive evidence on causation”) that their index somehow establishes causality and confers the ability to quantify the jobs that would be created if the Republicans would stop their media campaign of blaming “radical” regulation for the slow recovery.  (Of course, the authors don’t phrase it that way, but given the extreme weight they gave to this single component of their index and the fact that the senior author of the paper is a Republican activist pushing this meme in the media, that is how circular and perverse “causality” is in their index.)

“So how much near-term improvement could we gain from a stable, certainty-enhancing policy regime? We estimate that restoring 2006 levels of policy uncertainty would yield an additional 2.5 million jobs over 18 months. Not a full solution to the jobs shortfall, but a big step in the right direction.”

They make no such claim in their paper.  “Yield” is a statement of causality.  Their study inherently cannot establish causality.  Further, as they admit, even they see at best only “some suggestive evidence on causation” – and they are being remarkably over-generous to themselves even in going that far for their study does not present any such “suggestive evidence.” 


They also do not explain how we could undo “uncertainty” – as “measured” under their index.  As long as the right generates attacks on regulation and claims that it causes uncertainty and those complaints are repeated by their array of web sites the index will “measure” high uncertainty.  We went through a remarkable period of radical deregulation, desupervision, and de facto decriminalization that created the criminogenic environments that produced three major crises in 25 years and one party is still demanding that we make the three “de’s” far worse.  Are we supposed to repeal Dodd-Frank?  Would the repeal increase or decrease “policy uncertainty”?  How are we supposed to prevent analysts from being hyper-inflation hawks?  Would making the tax laws longer remove uncertainty?  Congress could still change them at will.  The repeal as of a date certain was meant to reduce uncertainty. 


Every aspect of this index is farcical and a naked partisan weapon of attack on the regulations and prosecutions essential to preventing our recurrent, intensifying financial crises.  Theoclassical economists were the architects of these crises.  They were the great destroyers of jobs and wealth.  The claim that we can never undo their criminogenic designs and that any attempt to even criticize the elite frauds will lead to job losses is pure extortion.  Their index does not allow any statements about causality, and they know that the claims of causality and quantification that they made in their op ed are indefensible.  The direct surveys of employers do allow us to evaluate causality because they are statements (largely) against the political interests of the business people being surveyed.  Those surveys refute the argument. 


Restoring effective regulatory cops on the beat will increase transparency and reduce the Gresham’s dynamic that is the bane of honest firms.  Both effects reduce uncertainty and increase employment.  For example, there were far more aggressive regulatory and prosecutorial responses to the S&L debacle than the current crisis.  We convicted over 1,000 elites in cases designated by the Justice Department as “major” and we brought thousands of civil and enforcement actions against S&L executives.  We largely ended nonprime lending, particularly liar’s loans by S&Ls in 1990-1991.  We placed many hundreds of S&Ls and banks in receivership.  We consistently wiped out the shareholders and subordinated debt holders in those resolutions.  We greatly boosted capital requirements, got rid of junk accounting, and put formal requirements for prompt corrective action in place.  We rapidly sold the bad assets in our liquidating receiverships.  None of these things has been done in Bush and Obama administrations’ tepid response to the current crisis.  The recovery from the recession in the early 1990s was relatively rapid.  Our aggressive regulatory actions added greatly to certainty because our actions were consistent, added to transparency, and helped honest firms.  That result would be consistent with the authors’ purported theory (gratuitous uncertainty poses an undesirable risk that slows recovery), but not with their ideological blinders that cause them to see regulation as inherently adding to uncertainty.


Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.


Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.


Follow him on Twitter: @WilliamKBlack

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“Greedy Bastards”: A Review of Dylan Ratigan’s Views on the Financial Crisis

Posted on November 22, 2011 by | Comments Off on “Greedy Bastards”: A Review of Dylan Ratigan’s Views on the Financial Crisis

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

Dylan Ratigan, MSNBC’s financial expert, has writtena book about how markets have become perverse. It is an interesting example of how strange “competition” hasbecome.  One oddity presented itself onthe cover of the package in which the book arrived.  The cover proclaimed “Simon & Schuster: ACBS Company.”  The author works forNBC.  Only in America!

I was concerned by the title (“Greedy Bastards”).  I thinkthat greed is unlikely to have changed greatly over the last quarter century inwhich the U.S. has suffered three recurrent, intensifying financialcrises.  I don’t call people bastards,even the self-made ones, because my mother reacted poorly to Speaker Wrightreferring to me as the “red-headed SOB.” Ratigan’s view on these points turns out to be similar to mine.  He argues that the issue is not greed, butperverse incentives.  When CEOs haveincentives adverse to the public and their customers they tend to act on thoseincentives and harm the public and their customers.  This observation is one of those obvious butessential points so often overlooked.  ACEOs’ principal function is creating, monitoring, and adjusting thecorporation’s incentive structures. There is a massive business literature on this function and CEOsuniformly believe that incentive structures for officers and employees arecritical in shaping their behavior.

There is only one (disingenuous) exception to thisrule – when officers and employees act criminally because the CEO has createdperverse incentive structures.  Suddenly,the CEO is shocked that his officers and employees acted criminally in responseto the CEO’s incentive structures that encourage criminal conduct.  Ratigan focuses on precisely thisexception.  Anyone that has had themisfortune to listen to compulsory business ethics training by his or heremployer will have learned that the key is the “tone at the top” set by theCEO.  True, but that always ends the discussion.  No employee is going to be trained by hisemployer as to what to do when the tone at the top set by the CEO is pro-fraud.

As Ratigan demonstrates, our most elite financialCEOs typically created and maintained grotesquely perverse incentive structuresthat encouraged their officers and employees as well as “independent”professionals to act criminally in a manner that harmed customers, the public,and shareholders – but made the controlling officers wealthy.  Is there any CEO of a lender incapable ofunderstanding that the loan officers and brokers’ compensation depends onvolume and yield – not quality – the result will be catastrophic?  Is there any CEO of a lender incapable ofunderstanding that if the loan brokers’ fees depend as well on the reported debt-to-income andloan-to-value ratios and the broker is permitted to make liar’s loans theresult will be that the brokers will engage in endemic, severe inflation of theborrowers’ incomes and their homes’ appraised values?  Is there any reader that doubts that the CEOsintended to produce precisely what their perverse incentives were certain toproduce?  A CEO cannot send a memo to50,000 loan brokers instructing them to inflate appraisals and use liar’s loansto inflate the borrowers incomes’ but he can, and does, send the same messagethrough his compensation system.  None ofthese perverse incentives produces an unexpected result.

Ratigan gets right two of the three essentials tounderstand why we suffer recurrent, intensifying financial crises.  First, cheating has become the dominantstrategy in finance.  Second, cheating isdominant because finance CEOs create such intensely perverse incentives thatfraud becomes endemic.  The BusinessRoundtable (the largest100 U.S. corporations), had to react to the Enron erafrauds.  It chose as its spokesperson aCEO who embodied the best of American big business.  This was the response he gave to Business Week when their reporter askedwhy so many top corporations engaged in accounting control fraud:

“Don’t just say:”If you hit this revenue number, your bonus is going to be this.” Itsets up an incentive that’s overwhelming. You wave enough money in front ofpeople, and good people will do bad things.”

How did the CEO know about the “overwhelming” effectof creating incentives so perverse that they would routinely cause “good people[to] do bad things”?  He knew because hedirected and administered such a perverse compensation system.  An SEC complaint would soon identify thatcompensation system as driving accounting control fraud at his firm.  His name was Franklin Raines, CEO of FannieMae.


Ratigan can add tothe effectiveness of his explanation by adding a description of the thirdessential driving our perverse incentives. Accounting control fraud, as criminologists, economists, and (competent)financial regulators recognize is a “sure thing”.  See GeorgeAkerlof and Paul Romer, “Looting: the Economic Underworld of Bankruptcy forProfit” (1993).  It produces guaranteed,record (albeit fictional) short-term reported profits if one follows the fraud“recipe” for a lender, which produces guaranteed, extreme compensation for thecontrolling officers, and causes catastrophic losses.  It is trifecta of guaranteed results that causesCEOs to adopt the perverse incentives they know will cause their officers andemployees to follow the fraud recipe.  Itis the three “de’s” – deregulation, desupervision, and de facto decriminalization that allow the CEOs to put theseperverse incentives in place with impunity and produce the criminogenicenvironments that drive our recurrent, intensifying financial crises.


Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.


Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.


Follow him on Twitter: @WilliamKBlack

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Bill Black’s Address To #OccupyLA

Posted on November 10, 2011 by | Comments Off on Bill Black’s Address To #OccupyLA

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The Virgin Crisis: Systematically Ignoring Fraud as a Systemic Risk

Posted on November 8, 2011 by | Comments Off on The Virgin Crisis: Systematically Ignoring Fraud as a Systemic Risk

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

One of the most revealing thingsabout this crisis is the unwillingness to investigate whether “accountingcontrol fraud” was a major contributor to the crisis.  The refusal to even consider a major role forfraud is facially bizarre.  The bankingexpert James Pierce found that fraud by senior insiders was, historically, theleading cause of major bank failures in the United States.  The national commission that investigated thecause of the S&L debacle found:

“Thetypical large failure [grew] at an extremely rapid rate, achieving highconcentrations of assets in risky ventures…. [E]very accounting trick availablewas used…. Evidence of fraud was invariably present as was the ability of theoperators to “milk” the organization” (NCFIRRE 1993)  

Two of the nation’s topeconomists’ study of the S&L debacle led them to conclude that the S&Lregulators were correct – financial deregulation could be dangerouslycriminogenic.  That understanding wouldallow us to avoid similar future crises. 

“Neitherthe public nor economists foresaw that [S&L deregulation was] bound toproduce looting.  Nor, unaware of theconcept, could they have known how serious it would be.  Thus the regulators in the field whounderstood what was happening from the beginning found lukewarm support, atbest, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (GeorgeAkerlof & Paul Romer.  “Looting: theEconomic Underworld of Bankruptcy for Profit.” 1993: 60).

The epidemic of accounting controlfraud that drove the second phase of the S&L debacle (the first phase wascaused by interest rate risk) was followed by an epidemic of accounting controlfraud that produced the Enron era frauds. 

The FBI warned in September 2004that there was an “epidemic” of mortgage fraud and predicted that it wouldcause a financial “crisis” if it were not contained.  The mortgage banking industry’s ownanti-fraud experts reported in writing to nearly every mortgage lender in 2006that:

“Stated income and reduced documentation loans speedup the approval process, but they are open invitations to fraudsters.”  “When the stated incomes were compared to theIRS figures: [90%] of the stated incomes were exaggerated by 5% or more.[A]lmost 60% were exaggerated by more than 50%. [T]he stated income loandeserves the nickname used by many in the industry, the ‘liar’s loan’” (MARI2006).

Weknow that accounting control fraud is itself criminogenic – fraud begetsfraud.  The fraudulent CEOs deliberatelycreate the perverse incentives that that suborn inside and outside employeesand professionals.  We have known forfour decades how these perverse incentives produce endemic fraud by generatinga “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace.

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

Akerlofnoted this dynamic in his seminal article on markets for “lemons,” which led tothe award of the Nobel Prize in Economics in 2001.  It is the giants of economics who haveconfirmed what the S&L regulators and criminologists observed when wesystematically “autopsied” each S&L failure to investigate its causes.  Modern executive compensation has madeaccounting control fraud vastly more criminogenic than it once was asinvestigators of the current crisis have confirmed.

“Over the last several years, the subprime markethas created a race to the bottom in which unethical actors have been handsomelyrewarded for their misdeeds and ethical actors have lost market share…. Themarket incentives rewarded irresponsible lending and made it more difficult forresponsible lenders to compete.”  Miller,T. J. (August 14, 2007).  Iowa AG.

Liar’s loans offer what we call asuperb “natural experiment.”  No honestmortgage lender would make a liar’s loan because such loans have a sharplynegative expected value.  Notunderwriting creates intense “adverse selection.”  We know that it was overwhelmingly thelenders and their agents that put the lies in liar’s loans and the lenderscreated the perverse compensation incentives that led their agents to lie aboutthe borrowers’ income and to inflate appraisals.  We know that appraisal fraud was endemic andonly agents and their lenders can commit widespread appraisal fraud.  Iowa Attorney General Miller’s investigationsfound:

“[Manyoriginators invent] non-existent occupations or income sources, or simplyinflat[e] income totals to support loan applications. Importantly, ourinvestigations have found that most stated income fraud occurs at thesuggestion and direction of the loan originator, not the consumer.”

New York Attorney General (nowGovernor) Cuomo’s investigations revealed that Washington Mutual (one of theleaders in making liar’s loans) developed a blacklist of appraisers – whorefused to inflate appraisals.  No honestmortgage lender would ever inflate an appraisal or permit widespread appraisalinflation by its agents.  Surveys ofappraisers confirm that there was widespread pressure by nonprime lenders andtheir agents to inflate appraisals.

We also know that the firms thatmade and purchased liar’s loans followed the respective accounting controlfraud “recipes” that maximize fictional short-term reported income, executivecompensation, and (real) losses.  Thoserecipes have four ingredients: 
  1.  Growlike crazy
  2.  Bymaking (or purchasing) poor quality loans at a premium yield
  3.  Whileemploying extreme leverage, and
  4.  Providingonly grossly inadequate allowances for loan and lease losses (ALLL) against thelosses inherent in making or purchasing liars loans


Firms that follow these recipesare not “gamblers” and they are not taking “risks.”  Akerlof & Romer, the S&L regulators,and criminologists recognize that this recipe provides a “sure thing.”  The exceptional (albeit fictional) income,real bonuses, and real losses are all sure things for accounting controlfrauds.

Liar’s loans are superb“ammunition” for accounting control frauds because they (and appraisal fraud)allow the fraudulent mortgage lenders and their agents to attain the unholyfraud trinity: (1) the lender can charge a substantial premium yield, (2) on aloan that appears to relatively lowerrisk because the lender has inflated the borrowers’ income and the appraisal,while (3) eliminating the incriminating evidence of fraud that realunderwriting of the borrowers’ income and salary would normally place in theloan files.  The government did notrequire any entity to make or purchase liar’s loans (and that includes Fannieand Freddie).  The states and the federalgovernment frequently criticized liar’s loans. Fannie and Freddie purchased liar’s loans for the same reasons thatMerrill, Lehman, Bear Stearns, etc. acquired liar’s loans – they wereaccounting control frauds and liar’s loans (and CDOs backed by liar’s loans)were the best available ammunition for maximizing their fictional reportedincome and real bonuses. 

Liar’s loans were large enough tohyper-inflate the bubble and drive the crisis. They increased massively from 2003-2007.

“[B]etween2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent,respectively.

Thehigher levels of originations after 2003 were largely sustained by the growthof the nonprime (both the subprime and Alt-A) segment of the mortgage market.”  “Alt-A: The Forgotten Segment of the MortgageMarket” (Federal Reserve Bank ofSt. Louis 2010).
     
The growth of liar’s loans wasactually far greater than the extraordinary rate that the St. Louis Fed studyindicated.  Their error was assuming that“subprime” and “alt-a” (one of the many misleading euphemisms for liar’s loans)were dichotomous.  Credit Suisse’s early2007 study of nonprime lending reported that roughly half of all loans called“subprime” were also “liar’s” loans and that roughly one-third of home loansmade in 2006 were liar’s loans.  Thatfact has four critical implications for this subject.  The growth of liar’s loans was dramaticallylarger than the already extraordinary 340% in three years reported by the St.Louis Fed because, by 2006, half of the loans the study labeled as “subprime”were also liar’s loans.  Because loansthe study classified as “subprime” started out the period studied (2003) as amuch larger category than liar’s loans the actual percentage increase in liar’sloans from 2003-2006 is over 500%.  Thefirst critical implication is that it was the tremendous growth in liar’s loansthat caused the bubble to hyper-inflate and delayed its collapse. 

The role of accounting controlfraud epidemics in causing bubbles to hyper-inflate and persist is anotherreason that accounting control fraud is often criminogenic.  When such frauds cluster they are likely todrive serious bubbles.  Inflating bubblesoptimize the fraud recipes for borrowers and purchasers of the bad loans bygreatly delaying the onset of loss recognition. The saying in the trade is that “a rolling loan gathers no loss.”  One can simply refinance the bad loans todelay the loss recognition and book new fee and interest “income.”  When entry is easy (and entry into becoming amortgage broker was exceptionally easy), an industry becomes even morecriminogenic.    

Second, liar’s loans (and CDOs“backed” by liar’s loans) were large enough to cause extreme losses.  Millions of liar’s loans were made and thoseloans caused catastrophic losses because they hyper-inflated the bubble,because they were endemically fraudulent, because the borrower was typicallyinduced by the lenders’ frauds to acquire a home they could not afford topurchase, and because the appraisals were frequently inflated.  Do the math: roughly one-third of home loans made in 2006 were liar’s loans and theincidence of fraud in such loans was 90%. We are talking about an annual fraud rate of over one million mortgageloans from 2005 until the market for liar’s loans collapsed in mid-2007. 

Third, the industry massivelyincreased its origination and purchase of liar’s loans after the FBI warned of the developing fraud “epidemic” andpredicted it would cause a crisis and then massively increased its originationand purchase of liar’s loans after the industry’s own anti-fraud experts warnedthat such loans were endemically fraudulent and would cause severe losses.  Again, this provides a natural experiment toevaluate why Fannie, Freddie, et alia, originated and purchased theseloans.  It wasn’t because “thegovernment” compelled them to do so. They did so because they were accounting control frauds.

Fourth, the industry increasinglymade the worst conceivable loans that maximized fictional short-term income andreal compensation and losses.  Making (orpurchasing) liar’s loans that are also subprime loans means that the originatoris making (or the purchaser is buying) a loan that is endemically fraudulent toa borrower who has known, serious credit problems.  It’s actually worse than that because lendersalso increasingly added “layered” risks (no downpayments and negativeamortization) in order to optimize accounting fraud.  Negative amortization reduces the borrowers’short-term interest rates, delaying delinquencies and defaults (but producingfar greater losses).  Again, thisstrategy maximizes fictional income and real losses.  Honest home lenders and purchasers of homeloans would not act in this fashion because the loans must cause catastrophiclosses.

To sum it up, the known facts ofthis crisis refute the rival theories that the lenders/purchasersoriginated/bought endemically fraudulent liar’s loans because (a) “thegovernment” made them (or Fannie and Freddie) do so, or (b) because they weretrying to maximize profits by taking “extreme tail” (i.e., an exceptionallyunlikely risk).  The risk that a liar’shome loan will default is exceptionally high, not exceptionally low.  The known facts of the crisis are consistentwith accounting control frauds using liar’s loans (in the United States) astheir “ammunition of choice” in accordance with the conventional fraud “recipe”used that caused prior U.S. crises. 

It is bizarre that in suchcircumstances the automatic assumption of the Bush and Obama administrationshas been that fraud isn’t even worth investigating or considering in connectionwith the crisis.  It is as if millions ofliar’s loans purchased and resold as CDOs largely by systemically dangerous institutionsare an inconvenient distraction from campaign fundraising efforts.  Instead, we have the myth of the virgincrisis unsullied by accounting control fraud. Indeed, contrary to theory, experience, and reality, the Department ofJustice has invented the faith-based fiction that looting cannot occur. 

“BenjaminWagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases inSacramento, Calif., points out that banks lose money when a loan turns out tobe fraudulent. “It doesn’t make any sense to me that they would be deliberatelydefrauding themselves,” Wagner said.”

Wagner’s statement isembarrassing.  He conflates “they”(referring to the CEO) and “themselves” (referring to the bank).  It makes perfect sense for the CEO to lootthe bank.  Looting is a “sure thing” guaranteedto make the CEO wealthy.  “Looting”destroys the bank (that’s the “bankruptcy” part of Akerlof & Romer’s title)but it produces the “profit” for the CEO. It is the deliberate making of masses of bad loans at premium yieldsthat allows the CEO to profit by looting the bank.  When the top prosecutor in an epicenter ofaccounting control fraud defines the most destructive form of financial crimeout of existence he allows elite fraud to occur with impunity.   

As embarrassing as Wagner’s statement is, however,it cannot compete on this dimension with that of his boss, Attorney GeneralHolder.  I was appalled when I reviewedhis testimony before the Financial Crisis Inquiry Commission (FCIC).  Chairman Angelides asked Holder to explainthe actions the Department of Justice (DOJ) took in response to the FBI’swarning in September 2004 that mortgage fraud was “epidemic” and its predictionthat if the fraud epidemic were not contained it would cause a financial“crisis.”  Holder testified:  “I’m not familiar myself with that [FBI]statement.”  The DOJ’s (the FBI is partof DOJ) preeminent contribution with respect to this crisis was the FBI’s 2004warning to the nation (in open House testimony picked up by the national media.  For none of Holder’s senior staffers whoprepped him for his testimony to know about the FBI testimony requires thatthey know nothing about the department’s most important and (potentially)useful act.  That depth of ignorancecould not exist if his senior aides cared the least about the financial crisisand made it even a minor priority to understand, investigate, and prosecute thefrauds that drove the crisis. Because Holder was testifying in January 14,2010, the failure of anyone from Holder on down in his prep team to know aboutthe FBI’s warnings also requires that all of them failed to read any of therelevant criminology literature or even the media and blogosphere.

In addition to claiming that the DOJ’s response tothe developing crisis under President Bush was superb, Holder implicitly tookthe position that (without any investigation or analysis) fraud could not anddid not pose any systemic economic risk. Implicitly, he claimed that only economists had the expertise tocontribute to understanding the causes of the crisis.  If you don’t investigate; you don’tfind.  If you don’t understand“accounting control fraud” you cannot understand why we have recurrent,intensifying financial crises.  If Holderthinks we should take our policy advice from Larry Summers and Bob Rubin,leading authors’ of the crisis, then he has abdicated his responsibilities tothe source of the problem.       

 “Now let mestate at the outset what role the Department plays and does not play inaddressing these challenges” [record fraud in investment banking andsecurities].

“The Department of Justice investigates andprosecutes federal crimes.…”

 “As a generalmatter we do not have the expertise nor is it part of our mission to opine onthe systemic causes of the financial crisis. Rather the Justice Department’s resources are focused on investigatingand prosecuting crime.  It is within thiscontext that I am pleased to offer my testimony and to contribute to your vitalreview.”  

Two aspects of Holder’s testimony were preposterous,dishonest, and dangerous.

“I’m proud that we have put in place a lawenforcement response to the financial crisis that is and will continue to be isaggressive, comprehensive, and well-coordinated.”

DOJ has obtained ten convictions of senior insidersof mortgage lenders (all from one obscure mortgage bank) v. over 1000 felonyconvictions in the S&L debacle.  DOJhas not conducted an investigation worthy of the name of any of the largestaccounting control frauds.  DOJ isactively opposing investigating the systemically dangerous institutions (SDIs).

Holder’s most disingenuous and dangerous sentence,however, was this one:

“Our efforts to fight economic crime are a vitalcomponent of our broader strategy, a strategy that seeks to foster confidencein our financial system, integrity in our markets, and prosperity for theAmerican people.”


Yes, the “confidencefairy” ruled at DOJ.  It is the rationalenow for DOJ’s disgraceful efforts to achieve immunity for the SDIs’ endemicfrauds.  The confidence fairy trumped andtraduced “integrity in our markets” and “prosperity for the Americanpeople.”  Prosperity is reserved for theSDIs and their senior managers – the one percent.



Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

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