First of all, I have a confession to make: I have never taken a formal course in economics, which makes me a rather unusual speaker for this kind of meeting. But what I have had is 40 years experience of investigating financial crime and fraud. And I’m going to shock you: The first time I investigated sub-prime mortgage fraud was in 1969. A hundred-and-some-odd people went to jail. What happened was that Senator which would then be bundled and sold off to Fannie Mae and Freddie Mac. And lo and behold, Freddie Mac and Fannie Mae sold securities to brokerage firms, and many of those firms went bust because those ins- truments became known as « pass-through » - and the brokers, after they were unemployed, were called « pass-outs ».
Now, you would say, 1969 - why didn’t you fix it if you knew about it? The answer is that the strongest lobby in Congress are the local real estate agents, mortgage bankers and builders, so the prospect of getting reform through the banking committee was zero.
This story would be interesting, historical, whatever, except for the fact that one of the firms we put out of business was called Eastern Services Corporation, owned by a husband and wife named Bernstein, and they had an adult son who escaped prosecution. Then in 1989, while reading The New York Times, I learned that the son was being prosecuted for the same thing, only this time it was regulatory, and he has taken it up an order of magnitude. The Times story was a complete recounting of the earlier episode.
So when I pick up The New York Times today, and read stories about foreclosures, and they show a street in Boston, I’m practically nauseated - it’s the same street I stood on for the anti-trust sub-com- mittee in 1969. Everything in the current financial mess has been out there in plain sight for everybody to see for the last 20 years at the very least; and if you look carefully, for much longer than that.
Instead of recounting all the different warning signals, I would like to talk about what has to be done, what’s going on in the regulatory structure and why anyone who’s interested in finding a solution has to get into the nuts and bolts of these institutions, understand how they work and what’s wrong with them.
UBS had written a note to all their people saying : « We’re politically connected in the U.S., so don’t worry about pressure from the U.S. government. »
First of all, in our globalized economy, there are some 90 jurisdictions who have no accounting laws. There are corporate laws that allow you to incorporate with no responsibility whatsoever, where the directors have no fiduciary responsibility, where the directors have no idea what the business of the corporation is or any records of what the corporation is doing.
To be blunt about it, these jurisdictions give every financial institution in the world a place to go hide the crap. And they do. Many of these institutions operate in ways that put off their balance sheets what’s really going on. So for example, right now, if credit markets are frozen, it’s because every financial institution knows what they have hidden, and they know that all their counter-parties have hidden the same kinds of things in the same places. Since they don’t know what the counter-parties have, they won’t deal with them.
You can’t run a regulated banking system without knowing what’s going on, and that requires regulators to be able to see through and actually get an idea of the world-wide position of an institution. But we don’t have a system capable of doing that. You would think that after Enron - and again, this is another one of the many warning signs that things had run amok - when we discove- red 300-and-some-odd offshore entities, that somebody might have said « you can’t have’em ».
But no, nobody said that, on the contrary: the banks thought this is a terrific idea, and we came up with SIVs(2). This to me is an intole- rable situation. You can’t solve any of these problems through regulation in a system where the players can arbitrage the rules of jurisdiction and move to places where there is no regulation. It just can’t work.
Now there’s a second part to this problem which is equally obnoxious: by moving it all offshore, they took whatever speculative financial products they had and actually injected steroids in it by the fact that it’s all tax-free. And they did not report it. So if you have any doubt about the dimension of tax evasion, read yesterday’s Wall Street Journal: the most senior official in private banking at UBS was indicted because UBS had 19,000 undeclared accounts for Americans. And I really urge you to read the indictment: UBS had written a note to all their people saying « we’re so politically connected in the U.S., you don’t have to worry about pressure from the U.S. government to get the information."
You might think that it was an overstatement. Let me put that in context. How much money is it in these 19,000 accounts? $20 bil- lion dollars. $200 million a year in fees to UBS. UBS turned up with dollar obligations outstanding four times the GDP of Switzerland and needed $40 billion to keep going. The Swiss central bank could not provide U.S. dollars. It had to go to the Fed because if it tries to go to the open market, a Swiss franc would be worth about what last year’s Kleenex on a New York City subway platform would be worth. So they go to the Fed - and the Fed, instead of asking them to turn over the names or play transparency, the Fed said: « Here, take the money on a swap. We do that. We’re central bankers. We don’t regulate anything ». This can’t continue, it has to change.
How does regulation work inside financial institutions? Every financial institution has a risk-management department. These people are supposed to do either risk management or risk oversight - they’re supposed to know what’s going on in the place. Some of them know what’s going on; but they also know that you don’t tell anybody else in the place, and you most certainly don’t tell your boss not to do it, because that’s a very career-disruptive move. The job that the people in compliance and risk management tend to have is akin to the people in the circus who follow the elephants sweeping up the droppings. And unless government absolutely reinforces the role of those people through regulation, they’re there as window dressing.
Now the question is, where is the government in all this? In deep anesthesia. Take a look at the last four election cycles, at the largest contributors to both political parties and all presidential campaigns. And we all know that these matters are so complicated that ordinary people have no idea of what it really means or how it works. The average Congressman is slightly better than that but not much; when they’re told by the people who have just given them all this money that there are no problems, who are they to argue?
We have to get them out of this anesthesia. And the only way we can do that is by going back to something that happened in the 1930s, when a commission was set up, and a judge, Ferdinand Pecora, was put in charge of it. The commission could dig into the detail of what had occurred: who did what to who, how things were manipulated, and what the real problems were. And out of that we got very speci- fic legislation. We need the same thing now because without public understanding, without real disclosure of the depth of the manipulation, of the nonsensical instruments, of these 400-page prospectuses that didn’t mean anything, that weren’t vetted by the SEC because somebody ruled they weren’t financial instruments - all of this has to be put out in public and discussed.
Let me mention another aspect of this: the weakness of the regulators in the face of complexity and the size of the financial institutions. These regulatory agencies hire kids fresh out of law school, out of accounting school, some of your finer students; but they have no idea how the institutions they’re looking at work, and they have no idea how the instruments that they’re supposedly looking at work. Now how can I say this? Well, I’ve been on the other side, I’ve watched them trying to figure out what’s going on, and I’ve watched them spun; what’s really depressing is how easily they’re spun. And just about at the point where they can figure out what’s really happening, they get a much better job. This is not a working regulatory system.
We also have a business of chipping away at the law. This goes on in the tax law all the time, where ingenious lawyers figure out how to put together code sections, or write opinions, and all of this sort of sneaks something past the current understanding and rules of IRS [Internal Revenue Service], which then has to be corrected. It’s sort of an ongoing game. This has been going on in the securities industry for 40 years. You explain to me how a credit default swap isn’t an insurance policy, and I’ll take you back to a whole series of quiet opinion letter and interpretations; and lo and behold, it’s not regulated. Well, if it’s not that, maybe it is a financial instrument that needs a certain kind of prospectus and review? But then again, we have another ways to take it out from under the law. You really have to be in the business to understand it.
I would argue that we can discuss economic theory to the end of time if we don’t get into those nuts and bolts; if we don’t start looking at the globalization arbitrage problem - that is, the arbitraging of dif- ferent jurisdictions and different national laws - and get some idea of what’s really going on through accounting, so this off-the-books, contingent liability, we-don’t-know-what-we-owe-anybody is gone; and change the system so the risk managers, the ones who are supposed to be saying « no » get more than a shovel and a broom, we’re never going to fix it.
(1)A mortgage with federally sponsored mortage guaranty insurance provided through the Federal Housing Administration.
(2)Structured investment vehicle, used in the shadow banking system.
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