On financial environment and why the the f-word is almost never used

L’intervention de Bill Black lors de la conférence « The Financial Crisis, the US Economy, and International Security in the New Administration », New York, 14 novembre 2008.

par William K. Black

I was asked to talk about financial architecture; but it only makes sense in terms of the environment where you’re going to put that architecture. Let me thus broaden that discussion to include the environment as well. I would like to suggest the old saw is the best saw here, and that it’s not so much the things that you don’t know that produce disaster; it’s the things that you know aren’t true that produce disaster.

The first such thing is that, naturally, fraud couldn’t happen. Even in a meeting like this, where it’s not so much the old fogies, the f-word is almost never used. We have George Akerlof’s famous article(3), every single example of which is about fraud; but the word fraud is never used. Akerlof came back with his article on looting, an article for which he got the Nobel Prize(4); and that article is virtually never quoted by people discussing these crises, even though it is the most relevant single piece in the conventional economics literature.

Instead, we have a theory telling us that fraud cannot occur. And we « know » fraud cannot occur because if there were substantial fraud, markets wouldn’t be efficient; and since markets are efficient, there can’t be fraud. The small little fact that there were over a thousand insider convictions, senior insider convictions, in the Savings and Loan debacle(5), was no particular reason to revisit that issue; nor the fact that since September 2004, the FBI has been testifying that there is an « epidemic » of mortgage fraud developing; nor the fact that only 20 percent of those who make home loans are required to make criminal referrals, and that 20 percent made over 50,000 referrals for mortgage fraud; nor the fact that according to the FBI, 80 percent of mortgage fraud is induced by the companies, not by the borrowers.

By the way, most of the frauds are never discovered; so you have to multiply not just by 5 to get the total number, but probably by 10. International ratings agencies like Fitch and others have looked at small samples and found in subprime an incidence of fraud of over 40 percent; indeed, typically 40-60 percent. So we have a massive pro- blem which we don’t talk about, and we certainly don’t provide resources to resolve it. We have 200 FBI agents chasing roughly a half-million frauds a year.

We can talk about architecture all you want but that’s the environment. You can have any architecture you want; it’s not going to work in those circumstances.

Thus, we knew that fraud couldn’t occur so even when we knew fraud was occurring, and knew it was occurring on massive scale, we didn’t even bother to put that in the literature. If you search scientific databases and the Social Science Research Network (SSRN), you may find a footnote buried here and there, admitting that there maybe could be a little fraud, too - with no numbers, typically.

Beyond that, our methodology that we are so proud of, econometrics, produces, in the expansion phase of a bubble, the worst possible policy advice conceivable, and it must do so whenever there is a subs- tantial amount of accounting fraud. Because whatever practices you choose for accounting fraud, you’ll have to show the strongest R-squared, positive R-squared, with profitability, and that flows through ear- nings per share and such in terms of stock market. Why the worst possible? Because the way you optimize accounting fraud, and these are accounting frauds, is to loan to the worst possible borrowers. Why? Because they’ll agree to pay the highest fees and interest rates. Note that I stress the word agree. It’s not actual cash flow. There are ways to scam that as well, through refinancing, and that is the story and has been the story in this crisis and in other crises.

By the way, who did the FBI decide to make its strategic partner in dealing with mortgage fraud? The Mortgage Bankers Association, the organization of perks. Can you imagine that happening in the blue-collar sphere? It is the apparent legitimacy that makes these white-collar crimes so devastating.

So the first thing that we knew was true, but actually wasn’t, was that you couldn’t have fraud. And it certainly couldn’t amount to any- thing like an economic variable in its own right, something like a bubble.

The second thing that we « knew » was that regulation couldn’t work. And so it became a self-fulfilling prophesy. You have people in charge that believe that regulation won’t work. Naturally, they’ll suc- ceed in proving that it doesn’t work; all the appointees in the Bush administration succeeded in doing that.

The third: as long as you can think of any conceivable place where some aspect of this might be beneficial, you shouldn’t ban. So even the fact that it helps produce the largest economic disaster of our lifetime isn’t sufficient reason to say « no, we’re not going to do this activity ».

By the way, when people say that CDOs [Collateralized Debt Obligations] haven’t defaulted, well, they’re structured so they don’t default. That doesn’t mean they don’t lose their economic value. Of course, if you structure it so it doesn’t default, you simply have the right to whatever the first bit of cash is and then it’s tiered. It won’t default because by its terms it doesn’trequire any payment. That doesn’t mean it doesn’t lose virtually all its economic value; in many cases that is precisely what happened.

« According to the FBI, 80% of mortgage fraud is induced by the companies, not by the borrowers."

Bill Cosby said once there are a lot of things in life that are absolutely inexplicable unless you assume there was a coin toss and that somebody lost it. You remember the joke about General Washington and General Cornwall having a coin toss? Obviously Washington won, and Cornwall said: “You have won the toss; what do you choose?” And Washington replied, “We will have rifle barrels, we’ll have camouflage, we’ll stand behind trees, we’ll shoot at you and you have to stand in long red lines with muskets and get shot”. You need something like that to understand the architecture that was set up for regulation – which is, of course, essentially nonregulationin all of this.

First, standard economics, or at least classical economics: reputation trumps all, and therefore conflicts of interest are irrelevant. Indeed, the literature claimed that it’s a good thing to usurp corporate opportunities, because that gives it to the highest and best use, and it just reduces overall compensation, and it’s really a great thing. It was a good thing that outside auditors would also be consultants, because then they’d be so much more knowledgeable and efficient. Alan Greenspan was the leading purveyor of this view. Go back to his speeches, which are on the website at the Federal Reserve, and you will see these odes to reputation and how reputation conquers all.

Second, private market discipline removes any need for regulation. Indeed, it means that regulation is counterproductive, because regulation will commonly reduce the incentives for private market discipline, and therefore it’s bad.

Third, a specific example of that rule: we should encourage subordinated debt and rely on subordinated debt as one of our prin- ciple forms of regulating bank institutions. How many people here have actually been financial regulators? How many people have actually investigated these things directly? There’s always a handful in these kinds of groupings. I’ve never been able to find anyone who would show me where a subordinated debt holder prevented a single one of these frauds. And I’ve raised this issue in many groupings.

The same goes for executive compensation - extreme executive compensation is good because it aligns the interests and therefore we needn’t worry about incentive incompatibility. The agency problem has been dealt with. You see again this theme that everything is fine, and therefore we don’t much need regulation.

International competition means we must respond by progressively weakening our regulation. We must get rid of the Glass-Steagall Act(6) because we have to compete with the universal banks of the Germans.

Any remaining problems can be dealt with prompt corrective action. Because now, as soon as there’s a problem, we mandate by sta- tute, regulators go in and firms like Washington Mutual, Wachovia and others are closed before there are any significant losses. And of course these actions forget all about accounting fraud. So we have prompt corrective action, but driven off of numbers that are created through accounting fraud. And what happens when you engage in accounting fraud? You use it to make sure that you’re one of the most profitable institutions in the country, because that’s what allows you to pay that very large compensation and, in a way that dramatically reduces the risk of prosecution, convert firm assets into your perso- nal benefit through normal corporate mechanisms - dividends, stock appreciation, etc.

In addition, the theory claimed that we have backup regulation. We have the Federal Deposit Insurance Corporation (FDIC). But it turns out the FDIC regulation only kicks in when you’re failing your capital requirements, which comes back to accounting fraud, which makes it look like you have extraordinary unprofitability.

According to President Bush, the problem was that we had old- fashioned regulation that didn’t have sufficient capital requirements. But Basel II was designed specifically to reduce capital requirements and specifically capital requirements for those holding large amounts of mortgage assets. And it specifically encouraged the largest banks to use proprietary models to value their assets, even though everybody knew that that was a recipe for disaster. So it’s not just the United States. We have infected the rest of the world with a deficient econo- mic theory. In the United States, the competition and laxity among the federal regulator agencies constantly pushed towards the weakest control at the federal level. And we decided to preempt any states that were vigorous in trying to enforce against things like predator lending.

Control frauds, the most audacious ones, were able to create black holes in the regulation. The most famous one is Enron, and the one that Enron exploited to create the California energy crisis through its cartel operation. And note what happened then. Who did we take our policy advice from to deal with the California energy crisis? Anyone remember? Enron’s CEO Ken Lay was able to arrange a meeting with the Vice President of the United States of America giving talking points, opposing any efforts to deal with the price rise. And Vice President Cheney, the next day, read pretty much from those talking points, encouraged the Federal Energy Regulatory Commission to take no action on behalf of California.

I took the notes at the Keating Five meeting (7). Where was the intervention in that case? Once again, the regulators were fooled by the appa- rent legitimacy of the entities and the fact that they reported record pro- fits - Lincoln Savings reported it was the most profitable savings and loan company in America. It’s easy if you use accounting fraud.

In addition to all these forms of deregulation, do not forget de-supervision. You can have all the rules in place you want; if you put in leaders who do not believe in regulating, you will get completely ineffective regulation. Do you recall James Gilleran, the head of OTS (Office of Thrift Supervision), first appointed by President Bush, who came to the press conference with a chainsaw and the federal regis-ter to demonstrate his commitment to destroy all regulation?

To summarize, we have to think more broadly than just about the regulatory structure. When you deregulate a financial industry, de facto you decriminalize it. The FBI cannot make these cases on its own. I spend a huge amount of my time doing this at the agency. We are the ones who make the substantial criminal referrals. We are the ones who identified the leading purveyors, the weak points, the Achilles heels in these systems. We are the people that train the FBI agents. We detail our staff to serve on the grand juries if they’re going to be effective; we serve as their expert witnesses. I did this on a number of occasions. When those things do not exist, the industry is decriminalized de facto. Nobody calls the Houston Police Department and says, « I think there’s a problem at Enron. Could you come on over and look?" It seems absurd to even think of that.

Similarly, we have gutted the ability of plaintiffs to bring civil fraud suits, and we have put in place frequently, in the Securities and Exchange Commission, people who did not believe in doing it at all. The other thing that you do when you deregulate or de-supervise is that you make an area opaque. Often one of the problems of the Treasury and Fed was they simply didn’t know who the counter-parties were. They didn’t know within $5 trillion what the notional amount of credit default swap was. Plus or minus $5 trillion is a little off.

(3) George A. Akerlof, “The Market for “Lemons”: Quality Uncertainty and the Market Mechanism”, The Quarterly Journal of Economics, Vol. 84, No. 3. August 1970, pp. 488-500.

(4) Akerlof, George A. and Romer, Paul M., “Looting: The Economic Underworld of Bankruptcy for Profit”, April 1994. NBER Working Paper No. R1869.

(5) In reference to the crisis of local Savings and Loan associations in the 1980s.

(6) Separating investment and commercial banking activities.

(7) In 1987, in the middle of the Savings and Loan crisis, a group of U.S. senators met federal savings and loan regulators at the request of Charles Keating from Lincoln Savings and Loan. “The Keating Five meeting was the event that transformed the savings and loan debacle from a story buried in the business section to one of the worst financial and political scandals in U.S. history though the current financial crises have proven even worse)”. William K. Black, {“The Keating Five Legacy”, April 9th, 2008, available at www.ourfuture.org/progressive-opinion/keating-five-legacy

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