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Two Billion Dollars Lost because the FDIC Ignored United Commercial Bank’s Frauds

Posted on October 17, 2011 by | Comments Off on Two Billion Dollars Lost because the FDIC Ignored United Commercial Bank’s Frauds

By William K. Black

The good news is that we finally have the second group ofindictments of senior bank officers.  The prosecution involves officers of United Commercial Bank (UCB), a roughly $10 billion San Francisco bank that originally specialized in lending to Chinese-Americans and became primarily a commercial real estate (CRE) lender.  The indictment deals only withthe cover up phase of UCB’s senior officers’ frauds.  I will show in future posts that the reportedfacts on UCB’s loans were consistent with accounting control fraud.   The UCB case is so rich in lessons that itwill take a series of articles to capture what the case reveals about thedegradation of regulation and prosecution of elite accounting controlfrauds. 

Here are the most essential facts.  In 2002,a court found that UCB’s senior managers had engaged in fraud to hide losses ona large loan for the purpose of fraudulently inducing another bank to bear thelosses.  It found the senior officers’conduct so outrageous that it awarded substantial punitive damages.  The FDIC, the SEC, and the Department ofJustice did nothing in response to the fraud.  

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The Cost of Theoclassical Economics and Economists

Posted on October 10, 2011 by | Comments Off on The Cost of Theoclassical Economics and Economists

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

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

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

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

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

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

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


Privatization

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

Deregulation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

De Soto’s Revisionism about Property Rights 

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

Property Rights

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

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

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

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

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

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

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

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

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

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


Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

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A Suggested Theme for the Occupation of Wall Street

Posted on October 4, 2011 by | 5 comments

By William K. Black

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




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


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

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

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

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

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

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

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

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

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

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

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

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

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The Solyndra Loans as Liar’s Loans

Posted on September 26, 2011 by | 8 comments

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

This column comments on Joe Nocera’s September 23, 2011 column entitled: The Phony Solyndra Scandal

Nocera’s column compares the statements of Solyndra’s controlling managers to Dick Fuld’s statements to the public about Lehman’s conditions and asserts with minimal explanation that neither could have been criminal. I have testified before the House Financial Services Committee at some length as to why Lehman was a “control fraud” so I disagree with Nocera. Lehman engaged in extensive accounting and securities fraud and caused massive losses by selling endemically fraudulent liar’s loans to the secondary market. It Soyndra’s controlling managers made false disclosures analogous to those made or permitted to go uncorrected by Fuld, then they too face a serious risk of criminal prosecution – it we ever replace Attorney General Holder with a prosecutor.

I also write to explain why Nocera is wrong to absolve the White House from scandal in the Solyndra matter. Nocera argues that it is inherently highly risky for the government to lend to companies the market will not loan to because their “green” projects are extremely risky commercial projects. He concludes that it is inevitable that many such loans will fail and that such failures do not demonstrate that the federally subsidized loan program for green energy companies is flawed. He concludes by warning that China dominates solar panel manufacture and that China will be the winner if the Republicans cut funding for the green energy programs.

Nocera is correct that the subsidized program is extremely risky. He identifies two of the risks. First, the technology developed may prove unmarketable. Second, entry by competitors may be so robust that the price of the relevant products (e.g., solar panels) suffer a “stunning collapse” and cause the U.S. Treasury-financed firm to fail even if the development of improved technology is modestly successful. 

There are obvious economic arguments against Nocera’s play of the Red Menace card. China heavily subsidizes solar panel manufacturing. Other nations (including the U.S.) subsidize solar panel manufacturing. Solar panels are still a specialty application that is not cost-effective in general usage absent public subsidies. The subsidies to the purchasers are not large enough to develop a market that has kept pace with the tremendous growth of solar panel production. The result has been a glut of solar panel production and a sharp drop in solar panel prices. In sum, the Chinese government is taking the very large financial risks of developing a new technology and the financial losses that come from selling us the solar panels at a low and sharply falling price that is inadequate to defray the costs of production and the risks of new product development. Nocera states that China has provide a $30 billion subsidy to solar panel producers purchasers, which has helped produce a glut of solar panels and caused a “stunning collapse” in their “market” price. That means that the great bulk of the Chinese subsidy has flowed to purchasers of solar panels, including Americans. Even if the Chinese develop a solar panel technology that is cost effective in general residential and commercial real estate usage there is no assurance that the Chinese government or public will find the production subsidies desirable. China may lose its solar panel production lead to a lower-cost producer or a higher quality producer. Other nations’ producers may be less than vigorous in enforcing the intellectual property rights of the Chinese producers, allowing domestic competitors to skip the large risks and costs of the research and development stage.

This column, however, generally emphasizes financial regulation, and there are reasons to use the word “scandal” to describe the administration’s treatment of its regulators in the Solyndra loan. Here is Nocera’s defense of the administration’s behavior:

 “Undoubtedly, the Solyndra “scandal” will draw a little blood: there are some embarrassing e-mails showing the White House pushing to get the deal done quickly so it could tout Solyndra’s green jobs as part of the stimulus package.

But if we could just stop playing gotcha for a second, we might realize that federal loan programs — especially loans for innovative energy technologies — virtually require the government to take risks the private sector won’t take. Indeed, risk-taking is what these programs are all about. Sometimes, the risks pay off. Other times, they don’t. It’s not a taxpayer ripoff if you don’t bat 1.000; on the contrary, a zero failure rate likely means that the program is too risk-averse. Thus, the real question the Solyndra case poses is this: Are the potential successes significant enough to negate the inevitable failures?”

Nocera’s effort to minimize the administration’s misconduct and his misstatements about risk are interrelated and they reprise the mistakes that the Bush administration made in its assault on financial regulation that led to the ongoing financial crisis. Life does not reward all risks. The quintessential risk that it does not reward in lending is failing to underwrite. A lender that fails to underwrite prudently is taking a severe risk, for the failure causes “adverse selection.” Lenders that make large loans (e.g., mortgages or loans to solar panel manufacturers) under conditions of adverse selection have a “negative expected value” – they are gambling against the house. Lenders that make loans with a negative expected value will suffer severe losses.

We are still suffering from a crisis driven by CEOs of lenders who deliberately destroyed essential underwriting in order to maximize the accounting control fraud “recipe” that I have explained many times. The result was “liar’s” loans. By 2006, roughly half of loans called “subprime” were also liar’s loans. Approximately one-third of U.S. mortgage loans made in 2006 were liar’s loans and the fraud incidence in studies of liar’s loans is 90 percent. Liar’s loans caused staggering direct losses and hyper-inflated and extended the residential real estate bubble, driving the Great Recession.

So the “real question” is not the one Nocera framed. The real question is why a lender (the U.S. government in this case) would gratuitously fail to underwrite a loan properly. The fact that the type of loan was inherently extremely risky makes it imperative that the lender engage is superb underwriting. The Obama administration, and Nocera, have failed to learn the most obvious and costly lesson of the ongoing U.S. crisis – liar’s loans cause catastrophic losses and failures and are “an open invitation to fraudsters” (quoting MIRA’s 2006 report to the members of the Mortgage Bankers Association).

Nocera does not explain what is embarrassing about the Obama emails. The government’s professional loan underwriters were worried about lending to Solyndra. They were warning the administration that they had not been able to complete the professional underwriting essential to making loans prudently. The Obama administration officials did not respond by backing their professional regulators. The administration did not stress that it was essential that the loan be approved only after it passed a rigorous underwriting process. The administration responded to the efforts of its professionals to protect the government from loss by abusing the regulators and pressuring them to approve the loans without completing the underwriting. The administration thought it was fine to make a liar’s loan to Solyndra. 

The administration exposed the government to a gratuitous risk of loss of hundreds of millions of dollars in order to achieve an overarching priority – they wanted a presidential photo op. If that isn’t a scandal, if Nocera thinks it is merely business as usual, then our failure to hold Dick Fuld, President Obama, and a host of other elites to a higher standard of accountability is the scandal that will generate repeated scandal.

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.

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Upcoming Appearances

Posted on September 19, 2011 by | Comments Off on Upcoming Appearances

Catch our bloggers live and in person.  Bill Black speaks tonight at UMKC and Marshall Auerback will speak at an event in Amsterdam on Wednesday, Sept 21st, and he will speak in Dublin on Thursday, Sept. 22nd.  Visit our Upcoming Appearances page for more details.
And here is the rest of it.[[ NOTE: If this is a Primer posting, it must have ‘MMP’ as the last label or it will not be removed from the NEP homepage ]]

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William Black: Why Nobody Went to Jail During the Credit Crisis

Posted on September 17, 2011 by | 5 comments

Jim welcomes Professor of Economics and Law William Black to Financial Sense Newshour. He explains to Jim why no one has gone to jail four years after the beginning of the historic Credit Crisis. Professor Black believes that the level of corruption and fraud is so pervasive that very few of the guilty will ever be brought to justice.

Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.
(Click here to listen to the interview)

Transcript

Jim Puplava: Joining me on the program is Professor William Black. He is a Lawyer and an Associate Professor of Economics and Law at the University of Missouri, Kansas City. He was a Director of the Institute for Fraud Prevention from 2005 to 2007. He taught at the LBJ School of Public Affairs at the University of Texas. He was also a Litigation Director for the Federal Home Loan Bank Board. He is also author of the book “The Best Way to Rob a Bank Is to Own One.”

And Professor, you played a critical role during the S&L crisis in exposing congressional corruption. During that period of time, a lot of corruption was exposed; a lot of people in the financial sector went to jail, including Charles Keating. I wonder if you would contrast that to the last credit crisis, let us say from 2007 to 2009 where a lot of money was lost, a lot of things went wrong, but nobody went to jail. Instead of going to jail, they walked out instead with multi-million dollar bonuses. What was the difference, what was behind this in your opinion?

William Black: Well, I say the both of them were driven by fraud. The Savings & Loan crisis was a tragedy in two parts. First part was not fraud, it was interest rate risk. But the second phase, which was vastly more expensive, was to defraud and the National Commission that looked into the causes of the crisis said that the typical large failure fraud was invariably present. And there were real regulators then. Our agency filed well over 10,000 criminal referrals that resulted in over 1,000 felony convictions and cases designated as nature. And even that understates the grade in which we went after the elite. Because we worked very closely with the FBI and the Justice Department, to prioritize cases—creating the top 100 list of the 100 worst institutions which translated into about 600 or 700 executives—and so the bulk of those thousand felony convictions were the worst fraud, the most elite frauds.

In the current crisis, of course they appointed anti-regulators. And this crisis goes back well before 2007 and of course it is continuing, it does not end at 2009. So the FBI warned in open testimony in the House of Representatives, in September 2004—we are now talking seven years ago—that there was an epidemic of mortgage fraud, their words, and they predicted that it would cause a financial crisis, crisis being their word, if it were not contained. Well no one thinks that it was contained.

All right so you have massive fraud driving this crisis, hyperinflating the bubble, an FBI warning and how many criminal referrals did the same agency do, in this crisis. Remember it did well over 10,000 in the prior crisis. Well the answer is zero. They completely shut down making criminal referrals and whichever administration you hate the most, you can hate because while most of this certainly occurred in the Bush Administration, the Obama Administration has obviously not changed it. Obviously did not see it as a priority to prosecute these elite criminals who caused this devastating injury.

Another way to look at it is, how much fraud is there and we know the following: There are no official statistics on sub prime and similar categories because there are no official definitions. So there is a little wishy-wishy in this but the best numbers we have are that by 2006, half of all the loans called sub-prime, were also liars loans. Liars loans means that there was no prudent underwriting of the loan. And total, about one-third of all the loans made in 2006, were liars loans.

Now that’s an extraordinary number, especially when you look at the studies. And here I am going to quote from the Mortgage Bankers Association. That is the trade association of the perps and this is their Anti-Fraud Specialist Unit, and they reported this to every member of the Mortgage Bankers Association in 2006. So nobody can claim they did not know. They found three critical things, first they said this kind of loan where you do not do underwriting is, and I am quoting again, “an open invitation to fraudsters.” Second, they said “the best study of this found a 90% fraud incident.” In other words, if you look at 100 liars loans, 90 of them are fraudulent. And third they said, therefore these loans where the euphemism is stated income are Alt-A loans, actually deserve the title that the industry calls the Behind Closed Doors, and that is liars loans. The other thing we know from other studies and investigations, is that it was overwhelmingly lenders and their agents that put the ‘lie’ in liars loans. Now that is obvious when you look at the lies about appraisals, because homeowners cannot inflate appraisals. But lenders can and how they did it was shown in an investigation by then New York Attorney General Cuomo, now Governor, who found that Washington Mutual, which is called WAMU, and is the largest bank failure in the history of the United States, and indeed the history of the world, had a black list of appraisers. But you got on the black list if you were an honest appraiser, and refused to inflate the appraisal.

Similarly, we know that you could get, for example, a California jumbo mortgage, that’s one say the size of $800,000. As a loan broker, just one of these, you could get a fee of $20,000. If it hit certain parameters. And those parameters would have to do with what is the interest rate, but also what is the loan to value ratio, and what is the debt to income ratio. So the loan to value ratio is how big is the loan compared to the value of your house. Well that is an easy ratio to gimmick, and we have just explained why, by inflating the appraisal. If you inflate the appraisal then the loan to value ratio falls and the loan looks like it is a lot safer, and you can sell it to Wall Street for significantly more. The debt to income ratio, well that is even easier to gain. The debt is simply how much are you going to borrow to buy the house. And the income is, what is the income stated on the loan application for the borrower. Except that this is a liars loan, so the lender has agreed that it is not going to check. It is not going to verify whether the income is real. And so the loan broker can write down any income number he or she wants. And that will gimmick that ratio and again it will put it into the sweet spot, for all of these things, so that you could get your $20,000 fee. Now step back and ask yourself, many of these guys who are loan brokers, their previous job was literally flipping burgers, right. So are you going to leave it up to the borrower to come up magically with the right income and the right appraisal when they don’t even know what the magic numbers are and cannot inflate the appraisal? Of course not. You are going to do it as the loan broker. You are going to tell the borrower to write in a greatly inflated income number, or maybe you are afraid that they are too honest, so you may simply write it in yourself, which happened in many cases.

So again, we got thirty, roughly one-third of all the loans by 2006, after these warnings. They rapidly increased the number of liars loans they made. One-third of them are liars loans and 90% of them are fraudulent, which is to say, that the amount of fraud annually was well over a million fraud a year. We are talking about hundreds of billions of dollars in fraudulent instruments.

Jim Puplava: Professor, I guess one question I would have is, did the guys at the top of the bank not know that this was going on? I mean I would find it hard to believe that if I am the CEO of a financial organization, that I don’t know that our loan standards, that we went to liar loans and that we were not documenting or verifying. I mean what happened to 20% down, two years worth of tax returns, I mean how would somebody at the top, not know this.

William Black: You mean you think liars loan might be a hint?

Jim Puplava: Yeah, maybe just a little (sarcasm).

William Black: Yeah, we have known for centuries, that if you don’t underwrite loans, or if you don’t underwrite insurance, you’ll get something called “adverse selection”. And that means you get the worse possible borrowers or people being insured and the expected value of lending to somebody, in conditions of serious adverse selection, is negative. Or to put that in English, that means if you lend this way, you lose money. And we have known this for centuries. This is like betting against the house in Las Vegas. You could win some individual bets, but you stay at the table for three years, and you are going to lose everything. And as we say, you will lose the house, to the house. And, that is exactly what is going to happen here. So yeah, the CEO’s knew all about this. Why did they do it? And the answer is, here is the recipe, it’s got four ingredients for creating what the Nobel Prize Winner in Economics, George Akerlof and his colleague Paul Romer said in 1993 was “a sure thing”. And that sure thing is what in criminology we call accounting control fraud.

So control fraud is when the person who controls a seemingly legitimate entity, uses it as a weapon to fraud. In the financial sphere, the weapon of choice is accounting. So here are the four ingredients of the recipe that produce a sure thing of record accounting income.

  1. Grow like crazy
  2. Make preposterously bad loans but at a premium yield.
  3. Have extreme leverage. That means you have a ton on debt.
  4. Put aside only ridiculously low allowances for future loan losses.

You do those four things, you are mathematically guaranteed to report record, albeit fictional, profits in the short term. You are also guaranteed with modern executive compensation, to make the Senior Executives wealthy, and you are guaranteed, because after all, if you think about those four ingredients, they are the perfect recipe as well for maximizing real losses. And that’s why the title of Akerlof and Romer’s article says it all, “Looting: The Economic Underworld of Bankruptcy for Profit.” The firm fails but the executives walk away rich. This is the same concept with my book “The Best Way to Rob a Bank Is to Own One.” It is these internal people who control the seemingly legitimate entity that can get away with financial murder. And here is the really bad news. I mean that is bad news right there, but the really bad news, is that this tends to happen as the FBI warned, and again in 2004, seven years ago. So the next time you hear some moron tell you that no one could have predicted this, it was predicted by the Premiere Law Enforcement entity in the world dealing with white-collar crime.

Jim Puplava: You know, we just talked about, with these liar loans being made, the executives at the top knew that this was going on. But it was driving record profits that they were reporting, their stock prices were going up. They were getting paid bonuses and you know their option values were worth just, you know, some of these compensation packages were just unreal. But here’s the thing that I guess some of these people did know as we mentioned the executives at the top, but some knew how to make profit from them. For example, we found out in congressional testimony that Goldman Sachs at the same time that they were selling these mortgage polls to let’s say many of it’s customers, at the same time, internal memos and e-mails said the stuff was garbage and they were shorting it, making money. Is it because they control so many of Congress that this time there was no law enforcement by the regulators coming in and looking at these guys that walked away with these bonus packages. Or the fact that you had conflicts of interest of selling bogus mortgage polls that you knew that were garbage. And at the same time you were selling them to a customer, you were taking the opposite side of the trade and shorting it.

William Black: So to just close the loop on what I was saying, if a bunch of folks follow the same strategy at the same time, they hyper-inflate a financial bubble. And when you have huge financial bubbles and they collapse, that’s when you get great recession. So your question is, so why, this is the greatest financial crime in the history of the world and no one senior, at any of the major places that drove the crisis, has gone to jail? In fact, no one has been indicted. There were some at Bear Stearns, for the real specialized stuff, but for the basic fraud we are talking about, no one has even been charged with a crime. What has happened? And the answer, the first answer is it all has to start with the regulators. The regulators have to serve as the Sherpas on something like this, in criminal prosecution. The Sherpas of course, are the folks that help you get to the top of the Himalayan Mountains. And this is a hard task, it is hard to prosecute sophisticated white-collar crimes, and they do have the best criminal defense lawyers in the world. So it is not an easy thing. And getting those thousand plus felony convictions in the Savings and Loan crisis, was a massive success for which the Department of Justice, the FBI and the agencies deserve a lot of credit. What do the Sherpas do? The Sherpas do two functions. One, they do the heavy lifting and in this context, that means they the great bulk of the investigative work. And two, they serve as the guides, they have the expertise, they’ve seen this before, they know what works and what does not. And in this context, that means they have expertise in the fraud mechanisms, the fraud schemes, identifying it and explaining it. And so a criminal referral is not just a sort of a useful thing, it is the absolutely essential thing. Criminal referral in our era might be twenty to thirty pages and have two hundred to three hundred pages of attachments of all the key documents. It would be the roadmap to continue this metaphor that says, here’s the fraud, here’s how it works, here are the key people, here is where the money moved, here are the key documents to be able to prove the case. Here are the key witnesses, this is how you contact them, right? And I told you that we went to zero criminal referrals from well over ten thousand. That has made it impossible for the FBI and the justice department to have any substantial success. But of course, this is not the question of them simply not having substantial success, they ain’t having no success. And there you have to look at what, after a brilliant start with this September 2004 warning, with no help from the regulators, well you could not get any significant number of FBI agents assigned in the Bush Administration, to investigate these cases.

Now part of what has happened is in some sense understandable, when the 9/11 attacks ten years ago occurred, we of course found that our national security FBI agents, could not infiltrate Al Qaeda. So what we could do is follow the money. And the experts at following the money are the white-collar FBI agents. So they transferred 500 white collar FBI Specialists, over to National Security. Okay, we can understand why they do that. What you cannot understand is why the Bush Administration refused to allow the FBI to replace this enormous loss of white-collar specialists. And so as a whole, white collar prosecutions fell significantly in the Bush Administration. That meant that as recently as fiscal year 2007, there were nationwide, only 120 FBI agents working all mortgage fraud cases. To give you a comparison, at the peak of the Savings and Loan Crisis, there were 1,000 FBI agents working the cases.

Jim Puplava: Wow

William Black: Eight times more FBI agents than were working the cases in fiscal year 2007. And this crisis is forty times bigger and worse than the Savings and Loan Crisis. So you would have required massively more people. To give you another idea of scope, to investigate Enron, and Enron was complex, but it was nowhere near as big and as complex as Washington Mutual. It took 100 FBI agents. So you can see that with 120 nationwide, at most you could have done one major case. But instead, they divided them up in what the military would call, Penny Packets, which is to say two or three agents per field office. And that means they cannot investigate anything substantial. So they were put on relatively smaller cases. And they being diligent FBI agents, they worked those cases, and that’s where they wrote the memos, okay we found this, prosecute these people, don’t prosecute these people. The FBI in late 2007 – 2008, figures out this cannot work. Remember I told you there were over a million cases of mortgage fraud a year and that overwhelmingly it’s lenders who foot the fraud, the lie in the liars loan. But the FBI couldn’t and didn’t investigate any of the major lenders. So it is looking at these relatively small folks, and that is what it reports back. The FBI decides you know, as I said, this cannot work. This is like going to a beach in San Diego and throwing handfuls of sand in the Pacific Ocean and wondering when you are going to be able to walk to Hawaii. Every year, with a million plus cases of fraud a year, if you prosecute a thousand of them or two thousand of them or three thousand of them, you are a million cases further behind every year, right. It is just insane. So the FBI says we got to start going after the big guys at which point Bush’s Attorney General Mukasey says no, he refuses to even create a National Task Force against mortgage fraud, saying famously, this is simply the equivalent of, and I am quoting again, “White Collar Street Crime,” little tiny stuff. Well of course he has assigned the FBI to only look at little cases and they report back, hey we’re finding little cases. And the Mukasey interprets from that, hey only little cases exist.

Jim Puplava: Yeah, but you know, in the S&L Crisis, you had some high profile cases. For example Charles Keating, and that got a lot of play. So maybe if they didn’t have the manpower, maybe going after some very high profile cases, might have made the point. You are saying they backed off from that. What about the Obama Administration?

William Black: They never did it. They didn’t even back off. They never, you can tell from the numbers that they have, in how many FBI personnel it takes to do a really sophisticated, large institutional investigation. They have never done what would have been considered a real investigation in the Savings and Loan era of any, any of the major fraudulent lenders and investment banks that created the worthless financial derivates—not worthless, but not worth very much—financial derivatives.

Jim Puplava: What about the Obama Administration? Had they came in, they continued with the same policy basically, they ignored it. Where they could have had let us say, an opportunity. Is it because Professor, that the process is you know, some have said that Congress is bought and paid for by the financial industry. I mean, is that part of the reason?

William Black: Well, it’s not just Congress of course. The President has said that he wants to raise a billion dollars in the reelection effort and despite all the press you may have heard about how the White House is despised by finance—in fact, last I read, a bigger percentage and a bigger absolute dollar amount of contributions in this effort, than in the original effort had come from finance. And so both parties are tremendously beholden to finance. That is part of it but again, the Obama Administration was better than the Bush Administration. The Obama Administration was willing to create a task force and it’s the numbers of FBI Agents have been increased, but they are still looking at relatively small cases. And they are nowhere near the numbers required and so unless something dramatic or radical changes, this is going to be the greatest case of elite fraud with impunity in the history of the world. And it is only going to change if we express our outrage as the people and demand that it is changed. Let me tell you how bad it is. The Federal Housing Finance Administration, has just last week, or about ten days ago now, filed fifteen hundred plus pages of complaints against seventeen financial entities. And about ten of them are among the biggest financial entities in the world saying, every investigation has found repeated enormous fraud at these entities. So, and there is a track record, a paper trail of that fraud. But these entities got reports saying these assets were trash and that they lied and then sold the assets to Fannie and Freddie by making acts of deceit, which is of course, the key element of fraud.

So, now that this has happened, there are really only two possibilities. Either the Federal Housing Finance Administration has gotten all those documents wrong, and there is no such record, or there is such a record in which case, where is the Justice Department, why is it not bringing criminal prosecution against most of the largest banks in the world.

Jim Puplava: You know, there was a documentary film called “Inside Job,” which won an Oscar this year, and it ended with the Director and Producer pointing out the fact that you just brought up—not one single prosecution was brought in this entire situation, what is probably the largest fraud committed in history. And yet it still goes on Professor, we still have the financial industry contributing large amounts of money to politicians in both parties, both at the national level, the local level, and so basically, what you have is influence buying here. Because it seems to me that there were so many obviously cases, even in the hearings, where I think it was, Senator Levin, basically talking about the conflicts of interest in internal e-mails. I thought my goodness, there was enough evidence to go after but not one thing was done. And even when a lot of these firms went under, as the shareholders lost everything, the taxpayers losing everything, the guys at the top walked away with some of the biggest bonus packages I’ve seen in my investment career.

William Black: Again, Akerlof and Romer have been proven correct. Akerlof and Romer worked with us and strongly support the kind of efforts that need to be done. The title of their article again is “Looting: The Economic Underworld of Bankruptcy for Profit.” The firm failed because you followed the fraud recipe that I gave you, which causes catastrophic losses but their CEO’s and other Senior Officers can walk away incredibly rich. There is, by the way, one case and was done after the movie, the documentary that you are talking about, and it’s the proverbial exception that proves the rule. The Taylor case, and it refers to a pretty obscure mortgage-banking firm in the southeast. Ten people have been convicted who were officers. But the only reason they were convicted was because these people after thousands of acts of fraud, over a ten-year period, tried to defraud the TARP Program and the Special Inspector General to the TARP Program, which is called SIGTARP, was very good. He has since left the government service. And they found this and they made the criminal referral. What we discovered in the course of that, was that Fanny Mae discovered this fraud in 2000 but refused to make a criminal referral.

They refused to make a criminal referral because it wanted to secretly dump the paper that had been provided by this mortgage-banking firm. And so the mortgage banking firm, the fraudulent mortgage banking firm, they would have been caught red handed doing the frauds. Simply went across the street, metaphorically, and defrauded Freddie Mac for nine years. So again, if people, I do not understand who have never done this, how absolutely critical the criminal referrals are.

Jim Puplava: Well, it seems like as we have seen here, as you pointed out, zero criminal referrals have been brought in this entire case, and you just cannot help but believe that this goes on and meanwhile, you and I as taxpayers, are going to have to front the bill for this. It is unfortunate. Let me ask you a final question, we supposedly as a result of all of this, we had Dodd Frank, that was supposed to bring in like Sarbanes-Oxley, all this financial legislation that would basically prevent this kind of thing from happening again. Will Dodd Frank help us in this way or is it just more red tape and which is useless if regulators and let’s say the FBI, aren’t allowed to do their job.

William Black: Dodd Frank has some individual components that are useful and the Republican Party unfortunately is trying to kill each of them. The Administration is not necessarily fighting strong for any, the Dodd Frank Bill was not created and designed to deal with the actual causes of the crisis. And so it most likely will not stop the next crisis. But the focus on legislation is a bit misleading. Under the existing laws and regulation, this was an easy crisis to prevent. People think of it as much more difficult and complex. But as I say, it was overwhelmingly driven by liars loans. Liars loans were easy to figure out. We, as regional regulators in 1990 and 1991, killed a wave of liars loans that was starting, especially in Orange Country Savings and Loans. And as a result, those lenders gave up their Federal Deposit Insurance precisely to escape our jurisdiction, and created mortgage banks. But the Fed, the Federal Reserve Board, had authority from 1994 on, in other words, a long time before the crisis, to regulate anybody that did home loans. And it was an easy call that something called a liars loan had to be stopped. Alan Greenspan and Ben Bernanke refused to do their statutory authority to stop them. Because they didn’t believe in regulation. Bernanke was reappointed by President Obama. You know, I tried as little, what one little person could, to stop that. We need to have a complete new crew. Geithner needs to go, Attorney General Holder needs to go, and Bernanke needs to go and we need to put people in who will make a high priority ending the ability to loot institutions with impunity.

Jim Puplava: Yeah, that was one of the aspects that was brought out in the documentary, “Inside Job.” A lot of the people, Larry Summers who until recently was in the Obama Administration, Geithner, Alan Greenspan tried to stop Brooksley Born on derivatives. And it seems like the guys that were behind all of this are the same people that have been put in charge of fixing it. Well listen Professor, your book once again is “The Best Way to Rob a Bank Is to Own One.” And you have written several articles so if our listeners would like to follow the work that you do, I hope you keep up the good work because we do need hopefully some day we will get honest people in there that will care more about doing what is right than about their positions and the pay that they get.

William Black: We have written hundreds of articles that if folks are interested, check out “New Economic Perspectives”, the UMKC Economics blog.

Jim Puplava: Okay, one more time?

William Black: “New Economic Perspectives”, the blog of the Economics Department at the University of Missouri at Kansas City.

Jim Puplava: All right, well we have been speaking with Professor Black, Professor thank you for coming on the program and helping to clarify why this big crime really went unpunished, which is a real tragedy for not only most Americans but all of us as taxpayers who have paid for the bill.

William Black: Thank you sir, take care.

Jim Puplava: Thank you.

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FHFA Complaints: Can Control Frauds Recover for Being Defrauded by other Control Frauds?

Posted on September 6, 2011 by | Comments Off on FHFA Complaints: Can Control Frauds Recover for Being Defrauded by other Control Frauds?

By William K. Black 

(Cross-posted from Benzinga.com)

Reading the FHFA complaints against many of the world’s largest banks is a fascinating and troubling process for anyone that understands “accounting control fraud.” The FHFA, a federal regulatory agency, sued in its capacity as conservator for Fannie and Freddie. Its complaints are primarily based on fraud. The FHFA alleges that the fraud came from the top, i.e., it alleges that many of the world’s largest banks were control frauds and that they committed hundreds of thousands of fraudulent acts. The FHFA complaints emphasize that other governmental investigations have repeatedly confirmed that the defendant banks were engaged in endemic fraud. The failure of the Department of Justice to convict any senior official of a major bank, and the almost total failure to indict any senior official of a major bank has moved from scandal to farce.

The FHFA complaints are distressing, however, intheir failure to explain why the frauds occurred and how an accounting controlfraud works.  The FHFA complaint againstCountrywide is particularly disappointing because it accepts hook line andsinker Countrywide’s internal claim that it acted improperly for the purpose ofattaining a larger market share. Executive compensation drops entirely out of the story even though it isthe reason the frauds occur and the means by which controlling officers loot“their” banks.  The FHFA complaintagainst Countrywide ignores executive compensation.  The FHFA complaint against J.P. Morgan(purchaser of WaMu) mentions only that loan officers’ compensation was based onloan volume rather than loan quality. 

The complaints fail to explain the extraordinarysignificance of widespread appraisal fraud – something that only the lender andits agents can produce and a “marker” of accounting control fraud.  No honest lender would inflate, or permit tobe inflated, appraisals.

The complaints also fail to explain why no honestmortgage lender would make “liar’s” loans. The FHFA complaint against Countrywide notes that Countrywide loanofficers would use undocumented loans to aid their creation of fraudulent loanapplications.

Even neoclassical economists – the weakest of allfields in understanding fraud – understand that this crisis was driven byexecutive compensation.  Consider theadmirably short piece entitled
“Fake alpha or Heads I win, Tails you lose” by Raghuram Rajan.  Rajan’spiece is badly flawed, but it at least understands the importance ofcompensation, accounting, and risk. 

“Whatthe shareholder will really pay for is if the manager beats the S&P 500index regularly, that is, generates excess returns while not taking more risk.Hence pay for alpha.”
Rajan is correct that the neoclassicaltheory of CEO compensation is that the CEO should only be compensated for high (“excess”)returns if they were not generated by“taking more risks.”  Modern bonus plans oftenpurport to provide exceptional compensation to CEOs who achieve extreme short-term“excess” returns that are not generated by “taking more risks.”  Rajan gets the next point analytical pointcorrect as well:  “In reality, there areonly a few sources of alpha for investment managers.  [S]pecial ability is by definition rare.”  It is the “rare” CEO who can achieve massivebonuses through exceptional performance, but all CEOs desire massive bonuses.  
Rajan gets the next step in theanalytics correct – the answer to the CEO’s dilemma is to create “fake alpha,”but he falls off the rails in the last clause.
“Alphais quite hard to generate since most ways of doing so depend on the investment managerpossessing unique abilities – to pick stock, identify weaknesses in managementand remedy them, or undertake financial innovation. Unique ability is rare. Howthen can untalented investment managers justify their pay? Unfortunately, alltoo often it is by creating fake alpha – appearing to create excess returns butactually taking on hidden tail risk.” 
In his recent book, Rajan explainsthat by “hidden tail risk” he means taking risks that will only cause losses inhighly unusual circumstances.  I willreturn to why this aspect of Rajan’s reasoning is false. 
Rajan gets the next part correct– generating fake alpha will cause the bank to fail when the risks blow up.  Rajan’s “tail risk” theory, however, predictsthat these risks will only blow up rarely.
Rajan then stresses, correctly,that executive compensation based largely on short-term reported income willcreate perverse incentives to generate fake alpha.  He also        
“Truealpha can only be measured in the long run ….  Compensation structures that reward managersannually for profits, but do not claw these rewards back when lossesmaterialize, encourage the creation of fake alpha.”
Rajan, being a good neo-classicaleconomist, recognizes the vital need to change compensation, but has no urgencyabout doing so. 
“[U]nlesswe fix incentives in the financial system, we will get more risk than webargain for. And the enormous pay of financial sector managers, which has hithertobeen thought of as just reward for performance, will deservedly come underscrutiny.”
Corporations have changedexecutive compensation in response to the crisis – by making it even moredependent on short-term reported income. Rajan does not ask why corporations base executive compensation onshort-term reported income without clawbacks. Rajan is correct that such compensation systems create intenselyperverse incentives that cause managers to loot the shareholders and creditorsand cause the bank to fail. 
Rajan’s extreme tail risk theorydescribes an accounting control fraud. Rajan does not understand that he is describing conduct that wouldconstitute accounting fraud.  Rajan alsodoes not understand that his hypothetical has nothing to do with what actuallyhappened in the crisis.  The extreme tailrisk scheme he hypothesizes would be a terrible fraud scheme.  He does not understand accounting controlfraud.
The real investments that drovethe financial crisis were not assets that would suffer losses only in rarecircumstances.  They were nonprimeloans.  Roughly 30% of total loansoriginated by 2006 were “liar’s” loans – with a 90% fraud incidence.  Liar’s loans and subprime are not mutuallyexclusive categories.  By 2006, half ofall loans called subprime were also liar’s loans.  Appraisal fraud was also epidemic.  The probability of endemically fraudulentloans causing losses (instead of fictional “excess return”) was certainty.  The loss recognition could only be delayedthrough a combination of accounting fraud (failing to provide remotely adequateallowances for loan and lease losses (ALLL)) and hyper-inflating thebubble.  Hyper-inflating the bubbleincreases the ultimate losses.
Making extreme tail riskinvestments is a deeply inferior fraud scheme. Rare risks produce tiny risk premiums and the entire game is to createsubstantial risk premiums.  Making liar’sloans allows exceptional growth (part one of the fraud “recipe” for a lender)and booking a premium yield (if one engages in accounting fraud on theALLL).  The key is found in GeorgeAkerlof and Paul Romer’s article title – “Looting: the Economic Underworld ofBankruptcy for Profit” (1993).  As theycorrectly observed, the fraud recipe is a “sure thing” – it maximizes(fictional) short-term reported income, executive bonuses, and real losses.
Rajan got many things correct andmany things wrong about generating fake alpha, but at least he sought toexplain the perverse dynamic.  The FHFAcomplaints lose explanatory power and persuasiveness because they ignorecompensation and accounting.  It pays tounderstand accounting control fraud.       
                 

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The Washington Mutual Wish List: Optimizing a Criminogenic Environment

Posted on August 30, 2011 by | 3 comments

By William K. Black

(Cross-posted from Benzinga.com)

On November 7, 2007, the Financial Services Roundtable released its “The Blueprint for U.S. Financial Competitiveness.” I explained in a three-part series of columns how Federal Home Loan Bank Board Chairman Ed Gray and Office of Thrift Supervision Director Tim Ryan led crackdowns on the “control frauds” that caused the S&L debacle. I emphasized how Gray did so in the face of enormous political opposition from the Reagan administration, Speaker of the House Jim Wright, a majority of the House of Representatives, and the “Keating Five.” One of the odd moments during these political attacks was that a Republican Representative from the Dallas area requested a meeting with Gray when Speaker Wright’s attacks on Gray’s reregulation of the industry and actions against the control frauds were becoming public an notorious. In my naiveté, I thought that Bartlett requested the meeting to support his fellow Republican, Gray. Of course, Bartlett’s purpose was the opposite. He was enraged by our efforts against the Texas control frauds and wanted us to back off. Years later, after a stint as Dallas’ mayor, the Financial Services Roundtable made Bartlett its head, a position he continues to occupy.

Naturally, Bartlett learned nothing productive from being proven disastrously wrong about the S&L debacle. The financial industry chose him as its lead representative because he never learned. He remains an implacable anti-regulator.

The Blueprint describes and situates this anti-regulatory effort, which was the product of a “Blue Ribbon Commission” co-chaired by “Richard M. Kovacevich, Chairman, Wells Fargo & Company; and James Dimon, Chairman and CEO, JPMorgan Chase and Co.”

“Within the past year, three reports on U.S. financial competitiveness—including the Bloomberg-Schumer Report—have called for a system of principles-based regulation. Last March, Treasury Secretary Henry M. Paulson, Jr. said, “[W]e should also consider whether it would be practically possible and beneficial to move to a more principles-based regulatory system as we see working in other parts of the world.”

The Blueprint was part of a coordinated anti-regulatory effort with Goldman Sachs alums at the U.S. Treasury Department and the Chamber of Commerce.

“Three major studies – the bipartisan report by New York Mayor Michael R. Bloomberg and New York Senator Charles E. Schumer (D-NY), the U.S. Chamber report, and the study by the Committee on Capital Markets – have concluded that the United States is losing its position as the world’s leading financial marketplace.1”

The text of the footnote shows the “race to the bottom” rationale that characterized each of these purportedly “independent” “studies.”

“1 Michael R. Bloomberg and Charles E. Schumer, Sustaining New York’s and the US’ Global Financial Services Leadership, January 2007 at www.nyc.gov; hereafter, Bloomberg-Schumer Report. See also Michael R. Bloomberg and Charles E. Schumer, “To Save New York, Learn from London,” Wall Street Journal, November 1, 2006, p. A-18; Committee on Capital Markets Regulation, Interim Report, November 2006 at www.capmktsreg.org; hereafter, Interim Report; Commission on the Regulation of U.S. Capital Markets in the 21st Century (U.S. Chamber of Commerce), Report and Recommendations, March 2007 at www.uschamber.com; hereafter, U.S. Chamber Report.”

“To Save New York, Learn from London.” Mayor Bloomberg and Senator Schumer (D. NY) urged the U.S. to adopt the UK’s approach to financial regulation, which during this era was the three “de’s” – deregulation, desupervision, and de facto decriminalization. Henry Paulson was confirmed by the Senate as Bush’s Treasury Secretary on June 28, 2006. Paulson’s top priority was deregulation. In particular, he worked to weaken Sarbanes-Oxley (SoX) on an urgent basis. Paulson’s strategy was to generate a series of anti-regulatory studies and proposals that would serve as the basis for a broad legislative assault on what remained of financial regulation. He was gearing up to propose this assault when the markets collapsed. This led to the March 31, 2008 roll out of the Treasury’s incoherent “reform” package. The Paulson plan was incoherent for an excellent reason. His plan’s analysis consisted overwhelmingly of an embrace of the standard anti-regulatory “race to the bottom” dynamic contained in the Blueprint, the Bloomberg-Schumer writings, and the Chamber of Commerce, married to a grudging concession that financial regulation had been too weak. This made no sense, for the U.S. and most of the Western world had just run a real world experiment in which the three “de’s” had once again proven intensely criminogenic precisely because they invariably lead to the “bottom.” Paulson’s plan was dead on arrival.

By late March 2008, the absurdity of embracing the anti-regulatory “race to the bottom” – and then admitting that the dynamic was disastrous – was so obvious that the public reacted with scorn to the Paulson plan. The Blueprint’s analytics presented in support of the race to the bottom were even worse than the analytics presented by Paulson, for they did not contain any concession that such a race must cause regulation to become catastrophically weak and lead to crises. The Blueprint was very late in the game – November 2007. The bubble had collapsed over a year ago. Most large mortgage banks had failed – catastrophically. Nonprime mortgage defaults were surging. The secondary market in nonprime mortgages collapsed. The authors of the Blueprint knew that the central dynamic they were embracing – the purported “need” to “win” the anti-regulatory race to the bottom – had again proven disastrous.

“More recently, the liquidity crisis and ensuing credit crunch in several significant capital markets sectors has revealed weaknesses in the regulatory system. Many homeowners have been confronted with the prospect of foreclosure, and U.S. financial markets have been roiled by problems that can be traced to aggressive practices by some firms, gaps between national and state regulation of the U.S. mortgage industry, and opaqueness in some structured financial instruments innovations. Many of these problems also have impacted the broader credit and capital markets, both domestically and globally.”

The passage illustrates the Blueprint’s authors’ refusal to be honest with the reader. They embraced euphemisms for fraud (“aggressive practices”) and gravely understated the financial crisis that was sweeping like a tornado through the financial markets. They ignored how the industry had deliberately ignored the FBI’s September 2004 warning that the developing “epidemic” of mortgage fraud would cause a financial “crisis.” They ignored how the fraud epidemic, generated overwhelmingly by lenders and their agents, hyper-inflated the largest bubble in financial history. But all of this pales against the Blueprint’s fundamental dishonesty. Why were there “gaps” between national and state regulation? The mortgage lending industry deliberately cultivated a race to the bottom by creating regulatory black holes and because the industry successfully urged Fed Chairmen Greenspan and Bernanke not to use their statutory authority under HOEPA to ban fraudulent “liar’s” loans. Why were “structured financial instrument innovations” “opaque?” The financial industry demanded passage of the Commodities Futures Modernization Act of 2000 for the specific purpose of making the credit default swap (CDS) market wholly opaque. The express goal of the Act was to prevent all federal and state regulation of CDS. The Act, as the industry intended, created a regulatory black hole. The Fed economist who testified to Congress premised the Fed’s support for this obscene Act on the purported need to win the race to the bottom in competition with the City of London.

The problem that the Blueprint identified was the insane idea that because the UK, Germany, Ireland, and Iceland were racing toward the anti-regulatory bottom and creating an extraordinarily criminogenic environment the U.S. should respond by creating an even more criminogenic anti-regulatory environment so that more of the accounting control fraud would take place in the U.S. and cause even more catastrophic losses here instead of in Europe. The Blueprint is bizarre primarily because it calls for the U.S. to embrace even more fully the anti- regulatory bottom – even though the disastrous consequences of doing so were obvious at the time the Blueprint was published. The Blueprint (implicitly) identified the problem (the anti-regulatory race to the bottom to “win” global competitiveness – and called it the solution. This was significantly insane.

The Blueprint, having found that the anti-regulatory race to the bottom was suicidal, urged the U.S. to run faster.

“External factors threatening the competitive position of U.S. financial firms and the stability of financial markets include the relentless growth in international financial services competition, rapidly expanding foreign financial markets, and foreign regulatory regimes purposefully designed to adjust quickly to market developments.”

This is nonsensical. The “competitive position of U.S. financial firms” would have been aided immeasurably by competent financial regulation, of the kind we employed in 1990-1991 to forbid S&Ls to make liar’s loans. The actions that most impaired the competitive position of U.S. financial firms were the three “de’s.” Our firms would have had a decisive competitive advantage over European banks, to an extent not seen since the early post-World War II years, had we not destroyed effective financial regulation.

Note the lack of logical coherence in the sentence quoted above. The Blueprint concedes that Europe’s race to the bottom “threaten[s] … the stability of financial markets.” That concession is true and it has enormous analytical importance (that escaped the authors). It means that the Europe’s anti-regulatory race to the bottom does not “threaten” “the competitive position of U.S. financial firms.” Indeed, it must do the opposite. The European banks are inherently destroying themselves as competitive threats when they destroy effective financial regulation because such an action is so criminogenic. The Blueprint’s fundamental incoherence leads the authors to recommend anti-regulatory policies that are the opposite of what their logic (if made internally consistent) would recommend. The authors’ total blindness to the internal inconsistency of their logic is revealed in this sentence.

Similarly, if Europe’s anti-regulatory race has led to “regulatory regimes” that serve as cheerleaders (“adjust quickly”) for criminogenic lending practices (“market developments”) then this is the last thing the U.S. should emulate. The way to enhance both U.S. competitiveness and financial stability, particularly if our competitors are racing to the criminogenic bottom, is to employ effective financial regulation. It’s a lot like every mother advises her child: “And if Johnny jumps off a cliff do you think that you should also jump off the cliff?”

We all know that the CEOs who co-chaired the “Blue Ribbon” group that produced the Blueprint did not write the Blueprint. Who actually produced this blueprint for creating an even ore criminogenic environment sure to produce recurrent, intensifying financial crises?

“The Roundtable is grateful for the outstanding guidance provided throughout this project by William A. Longbrake of Washington Mutual, Inc., who also is the Anthony T. Cluff Senior Policy Advisor to The Financial Services Roundtable.”

Yes, unintentional self-parody remains unbeatable. The Financial Services Roundtable, with 100 massive members, chose as its “Senior Policy Advisor” and go-to guy on the Blueprint a WaMu’s Vice Chairman. Longbrake served as the Chairman of The Financial Services Roundtable’s Housing Policy Council during the hyper-inflation of the housing bubble. When you need expertise on creating the most intensely criminogenic environment possible it only makes sense to go to a bank that made, purchased, and sold hundreds of thousands of fraudulent mortgage loans. Longbrake’s bio describes his work for WaMu.

“From 1982 to 1994 Longbrake was chief financial officer of Washington Mutual except for a two-year stint when he was the principal executive responsible for retail banking and home lending. When he returned to Washington Mutual from the FDIC in 1996 he resumed the position of chief financial officer until 2002 when he became the bank’s first chief enterprise risk officer. In 2001, Longbrake was named CFO of the Year in the Driving Revenue Growth category by CFO Magazine. From 2004 until retirement he served in a non-executive position as the company’s liaison with regulators, legislators, and industry trade organizations.”

Kerry Killinger, WaMu’s Chairman and CEO, was a member of the “Blue Ribbon” group that created the Blueprint for disaster.


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.

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

Posted on August 19, 2011 by | 6 comments

Listen to William Black explain how investigations into the recent financial crisis differ from inquiries into previous disasters. Also, you’ll find Professor Black’s review of Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance below the fold.

http://www.npr.org/v2/?i=139763198&m=139763179&t=audio

Guaranteed to Loot: The Perverse Incentives of Systemically Dangerous Institutions’ CEOs
A Book Review for Fidedoglake by William K. Black of:
Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance
by
Viral V. Acharya
Matthew Richardson
Stijn Van Nieuwerburgh
Lawrence J. White
(Princeton: 2011)
The Authors’ Revolutionary Indictment of Systemically Dangerous Institutions (SDIs)
Overview of the Authors’ Logic

Fannie and Freddie, like all U.S. systemically dangerous institutions (SDIs) were privately-owned and their liabilities were not guaranteed by the Treasury. Nevertheless, all SDIs have an implicit Treasury guarantee of their debts because any SDI failure could cause a global systemic crisis. The SDIs obtain the implicit guarantee by implicitly hold our economy hostage. The perverse incentives arising from this guarantee are the authors’ core concept.

The authors are finance professors at NYU’s Stern School. Their logic makes this a revolutionary book. The book is a case study of the perverse behavior of the managers controlling two SDIs, but the authors generalize the perverse incentives as controlling all SDIs.

The authors’ findings support James Galbraith’s thesis in The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too. Our financial leaders are the SDIs’ CEOs who make “free” markets impossible. The authors found that SDIs cause “a highly distorted market with two types of institutions – LCFI King Kongs and GSE Godzillas – both implicitly backed by the government….” (p. 55). (LCFI: “large complex financial institutions” – the authors’ polite euphemism for SDIs.) Their conclusion that “there was nothing free about these [housing finance] markets” applies to all the SDIs (p. 21).

“[T]he failure of the LCFIs and the GSEs is quite similar – a highly leveraged bet on the mortgage markets by firms that were implicitly backed by the government with artificially low funding rates only to differing degrees” (p. 49).

They adopt the CBO’s simile: living with Fannie and Freddie is like sharing a canoe with a bear.
“Because the GSEs are currently under the conservatorship of the government, it would be crazy not to kill off the “bear” and move forward with a model that did not again create a too-big-to-fail – and, more likely, a too-big-to-reform – monster” (p. 74).

The authors’ revolutionary logic is that it would “be crazy not to kill off the bear[s]” – the SDIs are inherently “monster[s]” that hold our economy hostage and block real markets and real democracy.
The authors argue that it is impossible even for massive SDIs to compete with the largest SDIs. Their simile is that the largest SDIs’ advantages are so great that it is “like bringing a gun to a knife fight” (p. 22).

In 1993, George Akerlof and Paul Romer authored Looting: the Economic Underworld of Bankruptcy for Profit. Akerlof & Romer explained how financial CEOs used accounting fraud to make record reported profits a “sure thing” (p. 5). The record, albeit fictional, reported profits were certain to make the CEO wealthy, while the bank was guaranteed to fail.

The authors confirmed Akerlof & Romer’s thesis. The CEOs’ perverse incentive creates three concurrent guarantees: the bank will report high (albeit fictional) short-term profits, the controlling officers will extract large increases in wealth, and the bank will suffer large losses. The bank fails, but the controlling officers walks away rich. “Control frauds” represent the ultimate form of “rent-seeking.” The SEC charged Fannie’s controlling officers with accounting and securities fraud to inflate its reported income so that they could extract greater bonuses.

The Authors Related Tenets: “Tail Risk” and the “Race to the Bottom”

The authors do not explain their concept of an extreme tail gamble, but they say that Fannie and Freddie’s tail gamble was purchasing nonprime loans. Those purchases were not honest “bets” and they were not subject to loss only in “rare” circumstances. Pervasively fraudulent “liar’s” loans sank the SDIs, hyper-inflated the bubble, and caused the great recession. Liar’s loans were certain to default catastrophically as soon as the housing bubble stalled. The housing bubble was certain to stall.

I believe that the authors’ logic chain is as follows:

1. SDI executives caused “their” banks to make investments that had a negative expected value, but a high nominal yield

2. In violation of generally accepted accounting principles (GAAP), the SDIs did not provide remotely adequate allowances for those future losses (ALLL)

3. This created a “sure thing” – SDIs were guaranteed to report high (fictional) short-term

4. This guaranteed fictional income led to the guaranteed massive executive bonuses

5. The officers controlling the SDIs used professional compensation (e.g., of auditors, appraisers, and rating agencies) to create a “race to the bottom” that led to widespread “echo” fraud epidemics among appraisers and credit rating agencies

6. The SDIs did the same thing to produce echo epidemics by loan officers and brokers

7. The accounting control frauds created a “race to the bottom” that drove the officers controlling other SDIs to mimic their frauds

8. This hyper-inflated the housing bubble

9. The hyper-inflation of the bubble allowed the SDIs to hide losses The SDIs’ creditors did not provide (expensive) market discipline because of the implicit government guarantee protected them from loss

10. The SDIs’ regulators did not act as the regulatory “cops on the beat” to break this private sector “race to the bottom” because the SDIs’ used their political power and ideological “capture” to create a regulatory “race to the bottom” (p. 191, n. 3)

11. SDIs following this fraud strategy were guaranteed to suffer massive loan losses and fail

12. These fraud epidemics and SDI failures triggered the Great Recession

The Authors’ Proposed Reforms are Criminogenic

Any analysis that ignores control fraud is certain to distract us from the reforms essential to prevent our recurrent, intensifying financial crises. Ignoring fraud led the authors to propose reforms that are criminogenic.

The authors’ suggestion that the Treasury charge the SDIs a fee equivalent to the value of their implicit Treasury subsidy would encourage accounting control fraud. Frauds use deceit to hide the risks the lender or purchaser is taking. The result would be an intensified Gresham’s dynamic because the accounting frauds would have an even greater advantage (due to the grossly inadequate charge for their implicit Treasury subsidy) over their honest competitors. Under the authors’ own logic and simile we must kill all of the bears.

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If you liked Sheila Bair you would have loved Ed Gray and Tim Ryan – Part 3

Posted on August 16, 2011 by | 3 comments

By William K. Black

(Cross-posted with Benzinga.com)

This is the third part in a series discussing financial regulation. Sheila Bair, FDIC Chair, has justly reserved praise for her service. Her willingness to support meaningful regulation distressed the Obama administration (and would have enraged the Bush administration). Without in any way diminishing her accomplishments it is important to understand that regulation has become so pathetic that Bair’s actions seem to be the zenith of regulatory vigor. We live in a time when even progressives have given up on regulation. Effective financial regulation is not only possible but essential if we are to avoid suffering recurrent, intensifying financial crises. We need to insist that regardless of the party in power the financial regulatory professionals are supported in accomplishing their prime mission – serving as the regulatory “cops on the beat.” Only regulatory cops on the beat can break the “Gresham’s dynamic” that accounting control fraud causes that can produce fraud epidemics, hyper-inflate bubbles, and cause financial crises. This installment shows how vigorous and effective regulation can be.


My first two installments explained how Federal Home Loan Bank Board Chairman Ed Gray reregulated the S&L industry over near total opposition and saved the nation $1 trillion by preventing a financial crisis. Gray realized that the central problem had become frauds led by CEOs (what we now call “control fraud”). He made the agency’s two top priorities the closure of the control frauds and their prosecution. Under Gray, the agency created a formal criminal referral process and hired top supervisors with a reputation for courage, competence, and vigor to attaining those priorities.

The Reagan administration’s cynical secret deal with Speaker of the House Jim Wright to not reappoint Gray as Chairman when his term ended on June 30, 1987 led to the appointment of M. Danny Wall (Senator Garn’s top aide). Wall had, as Garn’s aide, advised Gray to give in to Wright’s “request” that we fire our most prestigious and important supervisor, Joe Selby. Gray had personally recruited Selby to supervise Texas S&Ls, the largest hunting ground of the control frauds. Wall immediately sought to reverse many of Gray’s policies. He publicly took “credit” for forcing Selby to resign. He removed our (the Federal Home Loan Bank of San Francisco’s (FHLBSF) jurisdiction over Lincoln Savings because we continued to insist that it should be taken over. Wall was terrified by Charles Keating’s political power, which included the five U.S. Senators that became known as the “Keating Five” after they unsuccessfully sought to intimate us at the April 9, 1987 meeting, and Wright. Wall’s staff refused to forward our referrals to the enforcement agencies against the largest S&L in the nation. He stated that, “by definition,” we did not place Texas S&Ls in receivership, and he took credit for reducing the number of enforcement actions. Wall’s self-description was that he was a “child of the Senate” and his actions demonstrated the accuracy of his admission.

Enforcement had long been the Bank Board’s weakest link. I referred to it as “the land of the invertebrates.” Left to its own devices, it had always been a serious barrier to regulatory effectiveness. How bad was it – the lawyers representing fraudulent S&Ls actively sought to get our enforcement lawyers in the room when discussing supervisory problems. Our enforcement director was so clueless that she thought this was a good thing.

When the first President Bush took office he faced a dilemma in determining the regulatory response to the S&L debacle. As Reagan’s Vice President, Bush Chaired the administration’s financial deregulation task force. He was, therefore, as culpable as anyone in the nation for the deregulation and desupervision that made the S&L industry a criminogenic environment. We now know from document obtained through discovery from Lincoln Savings that Keating’s lobbyists viewed VP Bush’s offices as containing strong supporters of Keating and Gray’s fiercest critics. Bush also owed Wall a large political debt. Wall’s nickname on the Hill was “M. Danny Isuzu.” (Isuzu was running commercials then featuring a car salesman who was an obvious, inveterate liar.) The central lie that Wall was spreading in 1988 in the run-up to the election was that there was no S&L crisis and no need for federal funds. This lie was of significant benefit to Bush’s candidacy.

Bush also knew, however, that Wall was a disaster. Bush’s response to the dilemma was politically astute. He immediately ordered that the Bank Board would no longer run any receiverships but would instead appoint the FDIC as its receiver for any new failed S&Ls. He framed the FIRREA bill that terminated FSLIC and transferred the S&L insurance function to the FDIC. Both of these actions enraged Wall. The FIRREA bill, however, did something extraordinary for Wall. It appointed him as head of the successor agency (the Office of Thrift Supervision (OTS)) without the advice and consent of the Senate. Bush was warned in advance that this act could be held to be unconstitutional. The Senate Banking Committee was delighted not to hold hearings. Its chairman and ranking Democrat were members of the Keating Five and the ranking Republican, Garn, was co-sponsor of the Garn-St Germain Act of 1982 (the key deregulation bill) and Wall’s great patron. Senate confirmation hearings would have been intensely embarrassing to the new Bush administration, Wall, and the Senate Banking committee’s most powerful members.

FIRREA became law, Wall was appointed head of OTS by statute without the Senate’s advice and consent, and a federal court declared Wall’s appointment unconstitutional. The key development, however, was that Henry B. Gonzalez became Chairman of the House Financial Services Committee and began holding hearings on Wall’s regulatory failures at Lincoln Savings. Gonzalez’ actions were brave. Four of the five members of the Keating Five were Democrats. Many of Gonzalez’ Democratic senior colleagues were enraged that Gonzalez would hold hearings that were certain to embarrass the Keating Five.

Gonzalez’ series of hearings led to our powerful testimony explaining in detail Wall’s refusal to take action against Keating. Wall used the enforcement director as his attack dog to respond by attacking the FHLBSF and Gray – and to claim that Keating was the victim. Bush eventually responded by indicating that he no longer had confidence in Wall and Wall was forced to resign. His resignation was reported on December 5, 1989. Bush nominated Timothy Ryan to head the OTS and gave him a simple mandate – find the most prominent S&L frauds and take them down in the most public fashion to show that there was a new sheriff in town.

Our testimony also led to the resignation of the agency’s top supervisor, Mr. Dochow, who returned to a relatively low level supervisory position in our most obscure office – Seattle. Dochow was notorious because of his support for Wall’s cowardly caving in to Keating’s political pressure.

Ryan came into office shortly after we had provided a graphic example of how effective regulation could be. Pinnacle West, MeraBank’s holding company, had signed a net worth maintenance agreement as a condition of acquiring MeraBank. MeraBank was deeply insolvent, which meant that Pinnacle West was on the hook for many hundreds of millions of dollars. Pinnacle West’s lawyers came up with a clever means of evading the net worth maintenance agreement. They would dividend to their shareholders Pinnacle West’s ownership of MeraBank. The net worth maintenance agreement only obligated entities that “controlled” MeraBank to maintain MeraBank’s net worth, and because Pinnacle West’s shareholders were diverse there would be no one remaining (after the dividend) who owned a controlling interest in MeraBank.

There were only three problems to the clever scheme. First, there was a mechanical problem. As part of the deal in which Pinnacle West acquired 100% of MeraBank, the parties agreed that MeraBank would issue a single share certificate representing that 100% ownership to Pinnacle West. Pinnacle West’s lawyers thought they had a straight forward answer to the mechanical problem – MeraBank would issue hundreds of thousands of individual share certificates to Pinnacle West and Pinnacle West would dividend them to its shareholders.

That lawyerly solution to the mechanical problem, however, ran into the second and third problems. The second problem was the FHLBSF. After he removed the FHLBSF’s jurisdiction over Lincoln Savings, Wall’s effort to cover up its insolvency and frauds were blown up by courageous examiners from the California Department of Savings and Loan and several other Federal Home Loan Banks (special kudos to the FHLB Chicago staff). Wall realized that he was faced with a disaster on multiple dimensions and that he had to stop his jihad against the FHLBSF. That meant that he could no longer block us from taking vigorous regulatory actions, e.g., against Pinnacle West.

The third problem was that it would be a naked violation of their fiduciary duties for MeraBank’s board of directors to vote to issue additional shares. Pinnacle West’s primary asset was the net worth maintenance agreement. Voting to effectively remove that agreement would violate the duty of care. If the MeraBank directors who were also Pinnacle West officers voted to effectively destroy the net worth maintenance agreement that would violate the duty of loyalty (because of their crippling conflict of interest) and the duty of care. The FHLBSF’s senior staff flew to Arizona to address the MeraBank board of directors meeting to make this explicit to each director. In the trade in the U.S., this is known as a “come to Jesus” meeting. The MeraBank directors promptly decided that there was no way to issue the additional share certificates.

The FHLBSF then took the lead in negotiating an agreement that released Pinnacle West from its net worth maintenance agreement – in return for a $450 million payment. (Note: the enforceability of net worth maintenance agreements had never been litigated and our commercial ability to recover even if we were successful in establishing that enforceability was unclear. Pinnacle West, on a stand-alone basis, was insolvent. The net asset value of the holding company was tied up in its Arizona public utility and it was unlikely that the Arizona Public Utility Commission would approve a massive increase in electrical rates in order to provide funds to Pinnacle West so that Pinnacle West could pay the federal insurance fund a billion dollars. In sum, there were good litigation reasons for us to settle instead of suing.) Pinnacle agreed to the $450 million deal and OTS approved the settlement on December 7, 1989 (Pearl Harbor’s anniversary and the same day that President Bush announced his acceptance of Wall’s resignation.

The Pinnacle West deal confirmed Ryan’s view that OTS could accomplish great things if it were vigorous. He recruited Harris Weinstein, an accomplished, senior litigation partner at one of the nation’s most prestigious firms as his Chief Counsel. Among their first acts were to make clear that they supported fully the FHLBSF’s vigorous approach to regulation. (Most FHLB’s shared that same approach, but openly embracing us signaled that Wall’s jihad against the FHLBSF was over. Weinstein proved adept as a manger. He did not fire or criticize the enforcement director. He simply removed her monopoly over enforcement. OTS established three regional enforcement bodies headed by its most vigorous personnel and parallel enforcement bodies in Washington. The supervisors were permitted to use whichever enforcers they found most effective. The former litigation director left the agency for private practice.

The OTS took actions against the most elite control frauds on four fronts: regulation, civil actions, administrative enforcement actions, and support for criminal prosecutions. It closed the remaining frauds, virtually all of which had collapsed due to Gray’s rule restricting growth. (For a Ponzi scheme, growth is life.) More impressively, the West Region of OTS (staffed by supervisory personnel from the FHLBSF), killed through normal supervision the growing practice in Orange County, California of making “liar’s” loans and imprudent subprime loans. Michael Patriarca, personally recruited by Gray to crack down on the Western frauds, led the West Region’s crackdown. The effort was so successful that the leading nonprime S&L lender, Roland Arnall, gave up his federal charter (and federal deposit insurance) in order to escape our jurisdiction. Arnall created Ameriquest, a mortgage banker, to take advantage of a regulatory “black hole.” Arnall’s leading competitors also came from the S&L industry, e.g., the Jedinaks, who we “removed and prohibited” from the federally-insured financial industry through an enforcement action.

Ryan and Weinstein were exceptionally effective in prompting effective enforcement actions. In interpreting the magnitude of the increase in enforcement actions in 1990 over 1989 one must recall that the administration did not select Ryan until March 1990. Ryan then had to go through a bitterly contested Senate investigation and vote to secure appointment. Ryan’s selection of Weinstein became public on May 9, 1990. It, of course, took Weinstein months to create the parallel enforcement structure that I described and staff it.

In 1989, the agency issued 34 cease and desist (C&D) orders. In 1990, agency issued 63 C&Ds. In 1989, the agency issued 47 removal and prohibition (R&P) orders, in 1990 it issued 78. In 1990, the agency used its new grant of enforcement powers (via FIRREA) to issue 26 civil money penalties (CMPs). In 1989, the agency entered into 260 formal agreements, in 1990 that number rose to 347. The cliché “hit the ground running” applies to Ryan and Weinstein. In 1991, the agency completed 868 enforcement actions and in 1992 it completed 667 actions. Ryan announced his intent to resign on November 9, 1992.

In addition to the dramatic increase in the number of enforcement actions one must take into account that the actions brought under Ryan and Weinstein were far more major than the actions brought under Wall. Ryan and Weinstein went after the most elite, politically connected frauds to demonstrate that no one was above the law. The classic proof was the agency’s enforcement action against President Bush’s son, Neil. The enforcement action antagonized the Bush family. William Seidman’s (then, FDIC chair), book about his governmental service recounts how a senior White House staffer got the bright idea of convincing the FDIC to take over the case from the OTS so that the FDIC could kill the action. He called the FDIC’s general counsel to propose the idea. The general counsel, being a bear of very little brain, went to Seidman with the proposal. Seidman told him the idea was insane and not to get involved with it. The general counsel, being a bear with very little brain and soul, called the OTS to pitch the idea. Ryan made sure that the OTS filed an ethics complaint. The OTS went ahead and issued the enforcement order. (In truth, the order was a slap on the wrist – but royalty doesn’t think it should be slapped by peons.) From that day on, Ryan’s chances for advancement under President Bush were dead.

“But Mr. Ryan said that there were occasions when his decisions bore personal, as well as political, repercussions. He said some former political associates, whom he would not identify, had stopped talking to him after the Office of Thrift Supervision had decided to censure Neil Bush, the President’s son, for his role as a director of the Silverado Banking, Savings and Loan Association of Denver, one of the largest failures on record.

“Because of Neil Bush, I was persona non grata,” Mr. Ryan said. “At first I think it was because they did not want to influence me, and afterward I don’t know why they did not talk to me.””

http://www.nytimes.com/1992/11/09/business/regulator-of-s-l-s-resigns.html?src=pm

Regulator Of S.& L.’s Resigns
By STEPHEN LABATON
Published: November 09, 1992

The amazing aspect of the Bush administration’s response to the OTS enforcement action against Neil Bush is that it never became a scandal. In the current era, it would lead to an immediate demand for impeachment.

Weinstein made most of the legal community enraged when he brought an enforcement action against one of Keating’s primary law firms and “froze” its assets. “Froze” is an inaccurate description, but the one the bar used. Weinstein also moved to invoke the “fraud crime” exception to the ability to withhold the production of documents on the grounds of attorney client privilege. The law firm settled and its insurer made a major payout.

The agency’s and the Resolution Trust Corporation’s (RTC’s) civil suits were equally vigorous and effective. They produced billions of dollars in recoveries, often from what were then known as the “Big 8” audit firms. The lawsuits, of course, enraged the auditors.

On the criminal prosecution front, Ryan and Weinstein returned to Gray’s policy of making the support of criminal investigations and prosecutions a top agency priority. The agency met with the Department of Justice (DOJ) to create a formal prioritization of these cases – the “Top 100.” The dirty 100 were overwhelmingly S&Ls, as opposed to individuals, so this prioritization led to the prosecution of over 500 of the most elite and destructive criminals. The agency made well over 10,000 criminal referrals. Our criminal referral specialists liaised constantly with the FBI to get feedback on how to prepare the most useful referrals and trained our staff to produce superb referrals. (In modern management jargon, we really engaged in “continuous improvement.” Our criminal referrals were often 20 to 30 pages in length with two to three hundred pages of attachments. The referrals provided the detailed road map explaining the fraud and providing the key documents. The agency “detailed” a significant number of examiners to the FBI to serve as internal experts during the investigations (for the lawyers: this allowed them access to “6 (e)” grand jury materials). (The FHLBSF had pioneered an even more selfless approach – it paid the salary of an AUSA in Los Angeles dedicated to prosecuting S&L frauds. He did not, of course, answer to the FHLBSF.) Agency officials trained agency personnel, FBI agents, and AUSAs on detecting, investigating, and prosecuting elite financial frauds. We also served as free expert witnesses for the AUSAs in cases that came to trial. The results were spectacular. The conviction rate in S&L cases designated as “major” by DOJ was roughly 90 percent – against many of the top criminal defense lawyers in the world. We secured over 1000 felony convictions in “major” cases, and by prioritizing the “Top 100” we ensured that we acted against each of the worst frauds.

In 1993, the new Clinton administration moved DOJ resources to refocus on health care fraud. That may have been a correct prioritization of DOJ resources given out success against the worst S&L frauds, but it does mean that our 1000 convictions represents only a portion of fraud identified in our criminal referrals.

By the time Ryan and Weinstein left governmental service the S&L industry was cleansed of major frauds. The “liar’s” loans lenders had been driven out of the industry. The OTS criminal referral process was superb.

In the current crisis, President Bush (the Second) appointed “Chainsaw” Gilleran as OTS director – providing the crisis’ iconic image. Gilleran is holding a chain saw and standing next to the nation’s three leading bank lobbyists and the FDIC’s Vice-Chair, who are holding pruning shears. They are poised and posed over a pile of regulations. To make the imagery clear, the regulations are tied up in elaborate red tape. The image makes clear Gilleran’s and the FDIC’s intention to slash through all regulation. (Mission Accomplished!) Naturally, the anti-regulators were so proud of this image that they featured it the FDIC’s 2003 annual report.

The OTS leaders decided that the key to destroying regulation was to bring back to power the nation’s most notorious professional regulator – Dochow (of Keating infamy). Dochow rode Washington Mutual (WaMu) (based in Seattle) back to power. WaMu was a great “success” because it engaged in a variant of the accounting control fraud that made Keating infamous, but Dochow was not one to learn from his mistakes. The OTS leadership then used Dochow to convince Countrywide to convert its charter and become an S&L in order to avoid a potential enforcement by the somnolent Office of the Comptroller of the Currency (OCC). Dochow finally had to be asked to leave when he was caught agreeing to allow IndyMac (which, like WaMu, specialized in making “liar’s” loans) to backdate documents to inflate its financial “strength.”

So, how many criminal referrals did OTS make in current crisis? Zero – during what the FBI aptly described in September 2004 as an “epidemic” of mortgage fraud that the FBI aptly predicted would cause a financial “crisis” if it were not contained. Gray, Patriarca, Ryan, and Weinstein were all available to the second President Bush (and Obama) to use their expertise, integrity, and vigor to clean up the Stygian stables of the fraudulent and systemically dangerous institutions (SDIs) that drove this crisis. They are all available now, as are many of the people that helped these leaders clean up the industry. Patriarca and Ryan are young enough to serve as full time regulatory leaders. To my knowledge, the Bush II and Obama administrations have not drawn on the expertise of any of these leaders or their principal lieutenants who led the successful struggle against prior epidemics of accounting control fraud to implement an effective response to this crisis.

What would it take for the Geithners and Holders of the world to admit that allowing control fraud to occur with impunity is insane and that they should learn from people with a track record of success, integrity, and courage? Geithner, like “M.Danny Isuzu Wall,” is still pretending that he “resolved” the crisis at virtually no cost and kvetching that the world doesn’t applaud his genius. Like the Wizard of Oz, he demands that we: “ignore the man behind the screen,” i.e., the man holding the liar’s loans at Fannie and Freddie that will cause hundreds of billions of dollars of losses, the man at the Fed with hundreds of billions of dollars of losses on fraudulent mortgage paper pledged to Fed (which the Fed will eventually dump on Fannie and Freddie – which is to say, the Treasury), and the men holding the hundreds of billions of dollars of unrecognized losses among the SDIs. Geithner’s con has only fooled one person. Unfortunately, the man that fell for the Geithner con is President Obama, he of the infamous “man crush” for the admitted tax evader he appointed to be in charge of our nation’s tax collection.

One of our proudest moments at OTS (under Ryan and Weinstein) was issuing an R&P against Lee Henkel – one of the presidential appointees that ran our predecessor agency. President Reagan, at the behest of one of his leading contributors (Charles Keating), made Henkel a “recess” appointment to run the Federal Home Loan Bank Board. Henkel served as Keating’s “mole” at the agency. He resigned after I blew the whistle on him as part of a deal with the FBI to drop its criminal investigation of him. The OTS, however, made sure he would not come back to harm the public by issuing a removal and prohibition from federally insured depositories. If only Sheila Bair had possessed the nerve to remove and prohibit Geithner’s Treasury minions that he recruited from the fraudulent SDIs…. Sigh, one can dream.

By volume, Part 3 of my column has focused on enforcement, civil suits, and prosecutions. It is vital to keep in mind that these are after the fact remedies. It is vastly more important for financial regulators to understand accounting control fraud mechanisms and patterns so that they can identify and take regulatory action that will prevent the crisis. Patriarca’s actions to end liar’s loans in by Orange County S&Ls (taken while Ryan was Director) are a classic example of how successful a regulator can be when it understands the need to function as a “cop on the beat” and prevent the Gresham’s dynamics that drive fraud epidemics. The same actions show one of the important lessons of regulation. No one builds a bank vault and then puts an unguarded and unlocked hole in it, but our anti-regulators constantly seek to achieve the equivalent by creating financial regulatory systems that are designed to fail. The Fed had unique authority under HOEPA to close all of these regulatory black holes. Alan Greenspan and Ben Bernanke refused to do so. If Gray, Ryan, Patriarca, or Weinstein had been in charge there would have been no epidemic of mortgage fraud, no crisis at Fannie and Freddie, no overall financial crisis, and no Great Recession. (I’m not suggesting they had the power to end recessions and business cycles.)

We see the consequences of what happens when, during the last three administrations, we did not care to send the very best into the ranks of regulatory leadership. There were times during the Civil War in which thousands of men’s lives were thrown away because their senior officers were incompetent political hacks. Why do we routinely send incompetent political hacks and the equivalent of “flat earth” anti-regulatory ideologues to be our regulatory leaders and then blame “regulation” for the disaster? Even the Soviets figured out that one of the secrets of success was to “never reinforce failure.” We promote our failures and give them presidential medals. The high priests of theoclassical economics and their law and economics acolytes will always fail as regulators. They are trained to create and worship intensely criminogenic environments.

I do not know whether you, the reader, has focused on the politics of the leaders I have been praising. Gray and Ryan are Republicans. I worked for years with Patriarca and Weinstein and do not know their political affiliation. It never mattered to us. We despise the elite frauds and their professional and political toadies regardless of their party.

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