Capitalism Without Failure

Release the Hounds!

2012-05-26T12:02:00.002-07:00

Cute illustration of the state of Dodd-Frank, but it's missing a synapse; Obama should have one hand discretely sticking out behind him waiting for payment.

David McWilliams: Eurozone Policy that Rewards the Reckless at the Expense of Taxpayers, and Crushes the Periphery, must be Resisted

2012-05-23T23:10:00.000-07:00

Economist David McWilliams describes what led to the crisis, who is being bailed out, the terrible policy decisions being made, and the negotiating position of peripheral countries in the Eurozone. McWilliams' whiteboard animations are embedded following these select notes:

The bill for individual and institutional debt that led to the crisis has been passed on to people who had nothing to do with creating that debt.
Europe has been turned from a democracy to a bankocracy.
There are 2 ways out of a debt crisis: squeeze the debtor, or forgive the debt. If you squeeze the debtor - a.k.a. austerity - you make it less likely that the debtor will be able to pay back the debt.
The more austerity, the less growth. The less growth, the less tax revenue. It is like putting someone in debtor's prison for being in debt; no one in prison has any way to make money to pay off debt.
A fiscal union is supposed to help regions when they get into trouble - that's what happens in the American fiscal union. In Europe, it is working the opposite way.
The German solution will cause more recessions in the periphery.
The ECB solution is "cash for trash", where bust European banks give the ECB trash as collateral. In return, the ECB gives the banks cash. The insolvent banks lend that money to insolvent governments at 6%. The ECB is lending one trillion Euros to the banks in this fashion. The banks borrow at 1% and lend it to governments at 6%. The taxpayer pays the bill for the banks to be bailed out.
The banks get all the money they need. But when the people ask to keep hospitals and schools open, they are told there is no money available.
Central banks around the world are trying to reflate the bubble by injecting liquidity in order to avoid the consequences of the bursting of the bubble in the first place; when the next crash comes it will be bigger and more devastating.
Over the last 3.5 years, Europe and the US have pumped $8.7 trillion into the banks. Cash looking for a home means higher prices - for oil, for example. The cash will find its way into assets and then will produce inflation. We may see Volckeresque interest rates when that happens.
Government debts and fiscal deficits did not cause the Eurozone's problems. For example, in 2008, Spain's debt to GDP ratio was lower than Germany's. Government debt and spending exploded in response to, not ahead of, the crisis.
Financial panics do not cause the destruction of wealth; financial panics only tell you the extent to which wealth has already been destroyed by reckless speculation.
The German elite do not want a United States of Europe; they want a Federal Republic of Europe, based on the Federal Republic of Germany. They want a Europe that looks and feels democratic, where Germany makes the important decisions.
The Germans want the Euro to remain intact in order to sustain their strong trade position. They also benefit greatly from the weak Euro - a Deutschmark would be far stronger and would weaken their trade advantage.

In Part IV, McWilliams describes the negotiating positions of Eurozone members, and calls on voters to oppose current policy.

Part I

Part II

Part III

Part IV

David McWilliams is an Irish economist and journalist who is calling for a much tougher stance in negotiating with the European Union. You can visit his website at http://www.davidmcwilliams.ie.

Link to the series at CapitalismWithoutFailure.com

Bill Black: On JP Morgan's "Hedge", Jamie Dimon's Integrity, and the Epic Conflicts of Interest in the Federal Reserve System

2012-05-15T17:00:00.001-07:00

Bill Black is interviewed by Amy Goodman for Democracy Now. Video of the full interview is embedded following these notes.

The story that JP Morgan is telling us: They had about $15 billion in distressed European debt. Europe has been in trouble, so those investments were losing value. Their story, which does not make sense, is that they decided to hedge this position with a derivative of a derivative. In this case, it was an index of credit default swaps, which is the form of derivative that blew up AIG. JP Morgan's story is that instead of offsetting the risk, the hedge increased the losses dramatically. They woke up one morning, and they had a $2 billion loss.

Why it does not make sense: If you have distressed European debt, you are supposed to have already reserved against the losses in it. So why hedge the position at all? Just sell it. Get rid of these incredibly risky assets before they can suffer any additional losses. If you already have losses, it is not necessary to recognize a loss, because you have already reserved for it. So, you should not have had to hedge, period

Second, the way you would hedge something like this is by buying a credit default swap which is protection against the bad assets. In other words, if you lost on the value of the European debt, the credit default swap would go up in value, and you would be protected against loss. Instead, they have allegedly bet in the opposite direction by buying this derivative of a derivative - so if the European debt lost value, the derivative of the derivative was also likely to lose value. That is not a hedge. That is double speculation in the same direction.

And the reason you are calling it a hedge is that it is illegal, under the Volcker Rule, to speculate in this fashion. So the story coming out of JPMorgan does not make any sense as a financial matter. It seems reasonably clear that these are faux hedges. This is to hedging, as truthiness is to truth. This is hedginess: not really a hedge, but you call it a hedge to evade the law.

Jamie Dimon on Meet the Press: We support getting rid of "too big to fail." ...[We] support "too big to fail." We want the government to be able to take down a big bank like JPMorgan, and it can be done. We think Dodd-Frank, which we supported parts of, gave the FDIC the authority to take down a big bank, and when it happens, I believe compensation should be clawed back, the board should be fired, the equity should be wiped out, and the bank should be dismantled, and the name should be buried in disgrace. That’s what I believe. We need to put that back in the system, and we’ll work with the regulators to try to get that back in the system.

Bill Black's response to Dimon's statement: You cannot have a system work the way he is saying. If the institution is allowed to stay this large, it will be too big to fail, and its creditors will be bailed out; that is to prevent what is feared to be a cascade of failures, in which one big bank would then cause the failure of the next big bank, etc., etc., and you would have a global crisis. Even conservative economists call this crony capitalism, and they say that it creates such competitive advantage for the systemically dangerous institution—JPMorgan in this case—that it is the equivalent, when they compete with smaller banks, of — and I’m quoting — "bringing a gun to a knife fight."

What is needed to correct the danger posed by Systemically Dangerous Institutions (TBTF banks): The only way this can work is to shrink the systemically dangerous institutions— the 20 largest banks in the United States — down to the point that they no longer pose a systemic risk, they are no longer too big to fail, and, therefore, they will no longer have this implicit federal subsidy that completely distorts competition.

The threat of "too big to fail" to democracy: Having banks this big destroys democracy, because these giant institutions have so much political power.

On Dimon's integrity in making such a statement: The statement is completely disingenuous because JPMorgan in fact opposes all efforts to get rid of "too big to fail."

On Dimon's assertion (see video) that the acquisitions of Bear Stearns and Washington Mutual were beneficial to us all: The world is not made better off by the acquisitions of Bear Stearns and Washington Mutual; the banks made themselves even more powerful and made it even more impossible to have them fail, and therefore vastly increased their political and their economic power.

On the financial sector's record supporting responsible regulation: The big banks lobbied to create the Gramm-Leach-Bliley Act, which repealed Glass-Steagall. Glass-Steagall had worked brilliantly. It separated commerce and investment. And it would have prohibited and prevented the losses that JPMorgan just suffered. The big banks also pushed the Commodity Futures Modernization Act. If that act had not been passed, we would have avoided much of the entire financial crisis that we just went through, and we might well have avoided the $2 billion loss that JPMorgan has just suffered. The big banks fought tooth and nail, and continue to fight tooth and nail, to destroy the Volcker Rule. Again, if the Volcker Rule had been in place - with real regulations - this loss would have been prevented. The big banks also fought tooth and nail to prevent transparency in the derivatives market - through a clearing house - which also would have prevented this $2 billion loss. That rule is not in effect because JPMorgan led the effort to delay the adoption of these rules and to weaken these rules so much that they are completely unenforceable.

On Elizabeth Warren's call for Jamie Dimon to resign from his position as Director of the New York Fed: There are 12 regional Reserve Banks in the USA. They have as their directors, overwhelmingly, executives from the banks that they are supposed to regulate. Most regulation in the Federal Reserve is done through the field, through these regional Federal Reserve banks. Timothy Geithner was supposed to be the top regulator in New York in his role as president. But no real regulation occurs, of course, because you cannot expect people to regulate their bosses.

Congress has acted previously to correct an analogous conflict of interest: Congress recognized this in a completely analogous situation. In 1989, in the FIRREA legislation to deal with the savings-and-loan crisis, it looked at the Federal Home Loan Bank System, which was set up in a parallel way to the Federal Reserve banks. And it said this is an impossible conflict of interest. You cannot regulate your bosses. And so, it removed all governmental authority from the Federal Home Loan Banks. The same thing desperately needs to be done in the Federal Reserve, where it is far more damaging because these are much bigger players and much more destructive players.

On the current state of the Volcker Rule: There is a Volcker Rule because it was these derivative positions that caused the global financial crisis. All of the systemically dangerous institutions failed in large part because of these financial derivatives - what we call the green slime. That's what brought down Fannie and Freddie and Lehman Brothers and Bear Stearns and Washington Mutual, Lehman, Merrill Lynch and Wachovia. After those catastrophic disasters that caused the Great Recession, cost six billion Americans their jobs directly, prevented another five to eight million jobs from being created, helped lead to a global crisis called the Great Recession—after that, the banks still fought to be allowed to do exactly the same kind of derivative trades. And even when the Volcker Rule was adopted, over the banks' opposition and over the opposition of the Federal Reserve and of Treasury Secretary Timothy Geithner, they gutted the rule—at least the draft rule to implement the Volcker Rule. Unless it is changed, the Volcker Rule will be essentially unenforceable, because the current draft allows financial institutions to simply call their trades "hedges", even though they operate exactly opposite to the way a hedge would work.

Link to video and full transcript at democracynow.org

Link to video and concise notes at capitalismwithoutfailure.com

Dishonesty in our Media concerning Economics: Charles Lane is Exhibit A

2012-05-10T13:00:00.000-07:00

Charles Lane's "editorial" entitled The Folly of the US Housing Bubble is a textbook example of the problem with our mainstream media. Let us not waste more time than necessary on this deficient apologia. I will cut directly to Lane's conclusion:

Foote, Gerardi and Willen admit that economists are no closer to explaining the U.S. house mania than they are to understanding the tulip mania in Holland almost four centuries ago.

Foote, Gerardi, Willen, and Lane have some homework to do (start with this and this). Bill Black explains the "housing mania" over and over again. First of all, it was a credit bubble. The "housing mania" was a product of that credit bubble. The credit bubble was the product of fraud. The fraud was the product of perverse incentives:

On how perverse incentives encourage fraud: Perverse incentives produce criminogenic environments that encourage fraud. When people are able to steal a lot of money, with no threat of imprisonment, nor having to live in disgrace, an environment conducive to fraud is established. Establishing such an environment in practice requires the 3 D's: Deregultation, Desupervision, and de facto Decriminalization. Deregulation: you get rid of the rules. Desupervision: any rules that remain, you do not enforce. Decriminalisation: even if you sometimes sue the perpetrators and get a fine, you do not put them in prison.

On the ideal perverse incentives for accounting fraud: Accounting fraud thrives most with really high pay based on short-term reported income with no way to claw it back -even when it proves to be a lie. Also helpful is for assets to not have a readily verifiable market-value; this makes it easy to inflate the asset prices and easy to hide real losses. For a true epidemic of fraud, it is also helpful to have easy entry into the industry.

Bill Black's Recipe for Bankers to become Billionaires: 1. Grow massively, 2. By making very poor quality loans at high rates of interest, 3. Use extreme leverage (high corporate debt), and 4. Set aside virtually no loss reserves for the massive losses that will be coming. If you do these four things, you are mathematically guaranteed to report record short-term income. Akerlof and Romer referred to it as a sure thing - it is guaranteed.

Mr. Lane, since you write extensively about the intersection of economics, law, and policy, you have certainly come across Bill Black's work - and, hopefully, you have read Akerlof and Romer. It is dishonest to claim that economists are unable to explain bubble behavior without even mentioning that there is an entire body of work that explains the bubbles, the behavior, and what can be done to prevent them from happening in the future.

Bill Black: Geithner Channels Greenspan and Airbrushes Fraud out of our Crises

2012-05-02T15:06:00.001-07:00

On April 25, 2012, Treasury Secretary Geithner made remarkable statements about the role of elite financial fraud and greed in producing our recurrent, intensifying financial crises.

In this first installment I focus on the first of five problems with Geithner’s claims: (1) he does not understand the causes of prior crises, (2) he does not understand the causes of the ongoing crisis, (3) he does not understand that if he were correct about the first two points our nation would be in even greater peril and the urgency of Geithner leading a radical transformation of finance and regulation would be greater still, (4) he is not correct that we are prosecuting the elite criminals who drove the ongoing crisis, and (5) the media continues its nine-year pattern of failing to challenge Geithner’s fictions and his failures to lead the radical transformation that he should be desperately seeking given his stated beliefs about the causes of financial crises.

Here are the specifics of what Geithner said about financial crises, fraud, and greed.
"The wheels of justice are turning now," Geithner said at an event in Portland after touring a factory there. "They are not turning as fast as people would like, but we have the best system in the world for making sure we can enforce the laws of the land," he said.

Geithner suggested that holding people accountable for the wreckage caused by the recent housing collapse and the ensuing financial meltdown was not that simple since most crises were not caused by criminal activity.

"Most financial crises are caused by a mix of stupidity and greed and recklessness and risk-taking and hope," said Geithner, who helped tackle the crisis for the Bush administration when he was the head of the New York Federal Reserve and has been urging Europe to act more aggressively to contain its debt problems.

"You can't legislate away stupidity and risk-taking and greed and recklessness. What you can do is make sure when it happens it does not cause too much damage and to do that you have to make sure you have good rules against fraud and abuse, better protections and you force banks to hold more capital against their risk," he said.

Link: http://www.huffingtonpost.com/2012/04/25/timothy-geithner-wheels-justice-turning-now_n_1454235.html

Geithner’s first claim is that “most financial crises” are caused by non-criminal acts. “Stupidity” is the lead cause of financial crises, compounded by “risk-taking and greed and recklessness.” Fraud does not even make Geithner’s list of contributing factors to financial crises. The U.S. has experienced three recent financial crises – the S&L debacle (which is the subject of this first installment), the Enron era frauds, and the ongoing crisis. Accounting control fraud is the leading cause of each of the crises. “Control fraud” is the term white-collar criminologists use to refer to frauds in which the person controlling a seemingly legitimate entity uses it as a “weapon” to defraud. Accounting is the “weapon of choice” for elite financial frauds. Control frauds cause greater financial losses than all other forms of property crime – combined.

Three preliminary comments are in order. First, Geithner was selected to be the President of the Federal Reserve Bank of New York (FRBNY) in 2003. The President of the FRBNY has the second most important position in the Federal Reserve System. It is essential that the FRBNY President study and understand the causes of financial crises. Geithner had ample time and incentive to conduct such a study. Second, no one challenged Geithner when he (implicitly) claimed that fraud was not even worthy of mention or consideration as a contributor to financial crises. Third, even if Geithner were correct that fraud was only a relatively small contributor to the Great Recession that would provide no basis for not prosecuting the elite frauds who made that illegal contribution.

It is useful to expand slightly on the second point. No one appears to have asked Geithner how he came to believe that “stupidity” is the primary cause of financial crises. I am flabbergasted at the claim. The individuals who are principally responsible for the crisis (whether due to their stupidity or fraud) are the CEOs of the largest financial institutions who made, purchased, pooled, and resold as collateralized debt obligations the pervasively fraudulent liar’s loans that drove the crisis. The enormous extent and growth of liar’s loans and their endemically fraudulent nature is not in dispute. The green slime that drove the crisis is not at issue.

The only issue is why the CEOs made and purchased vast amounts of loans they were repeatedly warned were fraudulent and sure to cause catastrophic losses as soon as the housing bubble stalled. Assume solely for the purposes of analysis that Geithner is correct that they did so because of stupidity rather than fraud. That assumption requires the CEOs of Countrywide, Ameriquest, Indymac, WaMu, Fannie, Freddie Mac, Fannie Mae, Lehman, Bear Stearns, Merrill Lynch, Wachovia, Bank of America, Citicorp, and all the largest mortgage banks to have been terminally “stupid.” It also requires the boards of directors of each of these entities to have either been so stupid that they failed to notice that the CEO was stupid or so devoid of integrity and respect for their fiduciary duties that they were indifferent to their CEO’s stupidity.

Geithner’s assertion also requires that the regulators to have been so stupid or so insipid that they could not recognize that the CEOs were terminally stupid or so indifferent to their oaths of office that they did not object to stupid CEOs running the largest financial organizations in the United States. Since Geithner dealt personally with these CEOs, his assertion, if true, would require him to either be stupid or indifferent to his oath of office.

That’s a lot of abject stupidity among the most elite CEOs – drawing an average salary of about $10 million annually in compensation for their stupidity. The boards, the regulators, the media, and shareholders are incapable of recognizing the CEOs stupidity. Everyone suspended disbelief and emulated the fools in the movie “Being There” who treated Peter Seller’s character’s (Chance the Gardener’s) inane ramblings as profound pearls of wisdom. If Geithner is correct, big bank CEOs never shave with Occam’s razor – and stupidity is omnipresent in the C-suites. Geithner also doesn’t seem to view it as particularly alarming that many of most elite CEOs are paid hundreds of millions of dollars as rewards for their surpassing stupidity.

Geithner does not reveal, and the media lacked the curiosity to ask, how he determines the answers to questions as essential to the performance of his duties as “why are we suffering recurrent, intensifying financial crises?” I will explain how I approached that question when it was essential to the performance of my duties upon becoming an S&L regulator on April 2, 1984. I decided that it was critical to study what was causing over one S&L per week to fail.

I was the newly minted Litigation Director of the Federal Home Loan Bank Board (Bank Board) and every failure came across my desk so that I could (1) prepare to defend a legal challenge to our placing failed S&Ls in receivership and (2) determine whether we should sue the failed S&L’s officers, directors, and professionals because acted negligently or fraudulently. We called the process the “autopsy” and I was the “chief coroner.”

We decided that the financial autopsies provided us a priceless opportunity to study systematically the causes of the failures and to search for patterns and indicators that we could use to spot the frauds prior to their failures and to prove that they were frauds. This required us to distinguish between officers who were fraudulent, stupid, or engaged in high risk, but not illegal, “gambles for resurrection.”

To assist our analytics we worked with agency accountants, appraisers, real estate experts, and economists to provide multidisciplinary lenses with which to understand the failures. We also worked closely with the examiners who best knew the facts about the individual institutions. The examination reports and supervisory files contained the failed S&Ls’ officers’ explanations and attempted rebuttals of the examiners’ criticisms.

We did not know we were doing it (because no agency has a “Chief Criminologist”), but we had implemented the suggestion of two researchers who studied elite white-collar crimes and proposed two years earlier that investigators develop analogs to CSI-style crime labs to study elite white-collar crime. Wheeler, S., Rothman, M., 1982. The Organization as Weapon in White Collar Crime. Michigan Law Review 80, No. 7: 1403-1426.

We found that there was a distinctive fraud pattern, that the frauds used accounting as their “weapon of choice” (a metaphor that we also developed in parallel to Wheeler and Rothman), and that they followed a fraud “recipe” that was a “sure thing.” The recipe had four ingredients:

Grow like crazy
By making really crappy loans at a premium yield
While employing extreme leverage, and
Providing only trivial allowances for loan and lease losses (ALLL)

The recipe produced three sure things. The S&L was certain to report extreme (albeit fictional) income in the near term, the CEO would ensure that the S&L adopted a plan of executive compensation that would turn the fictional reported income into real wealth to the CEO, and the S&L was certain to suffer catastrophic losses because the loans had a negative expected value when made.

These three “sure things” allowed us to understand several things that proved critical in containing the S&L debacle, which was growing rapidly in 1984. One, we realized that “risk” as we conventionally conceptualize it in finance had nothing to do with the frauds. Optimizing the recipe, by making loans at a premium yield, caused them to make loans that would have been exceptionally risky for an honest lender, but the risk was irrelevant to the frauds’ decision-making.

Looting is liberating for the CEO. The frauds weren’t engaged in an honest gamble for resurrection. They were following a strategy that ensured they could loot the S&L and walk away wealthy when it failed.

Two, we recognized the fraud recipe explained the frauds’ distinctive (reported) performance. If firms were engaged in honest, extreme-risk gambles for resurrection we should have seen a wide dispersion of results. There should have been some exceptionally big winners, some mixed, and many abject failures. Instead, they all reported extreme profits in the short-term, they all failed, and they all suffered catastrophic losses when they failed. The fraud recipe produces that pattern of (reported) outcomes, honest gambling does not.

Three, we realized that we were seeing a weapon of mass destruction of wealth. The fraud recipe was easy to mimic – it is easy to make bad loans. The frauds clustered where deregulation and deregulation were most extreme – in Texas, Arizona, and California, particularly in state-chartered S&Ls in those states. We realized that entry was easy because of the desupervision, the creation of “daisy chains” of fraudulent S&Ls that would fund each other’s acquisitions, and the mass insolvency of the industry due to the first phase of the S&L debacle (caused by interest rate risk losses). This clustering plus the first two ingredients of the fraud recipe meant that the S&L frauds had perfectly perverse incentives to hyper-inflate a bubble.

The fraudulent daisy chain allowed them to refinance each other’s bad loans to greatly delay loss recognition. The saying in the industry was: “a rolling loan gathers no loss.” In combination, these aspects allowed the frauds to greatly extend the life of their zombie S&Ls, which allowed ever greater looting.

We also recognized that the first two ingredients of the formula required fraudulent S&Ls to adopt distinctive operational characteristics that no honest firm would follow. An honest conventional (as opposed to microfinance) lender has redundant internal and external controls designed to prevent the lender from making bad loans. Honest conventional real estate lenders engage in excellent underwriting to prevent credit losses. Historically, home lenders have engaged in such effective underwriting that credit losses were minimal and fraud losses were trivial. The fraud recipe, however, required the lender to be willing to make enormous amounts of bad loans. To do so, however, the lender had to gut its controls and underwriting – sure “markers” of accounting fraud.

For example, an honest lender would never inflate, or permit to be inflated, appraisals of the value of the real estate pledged as collateral for the loan. Fraudulent lenders often inflate appraisals. We recognized that the fraudulent lenders were finding means to create perverse incentives to suborn their key controls, particularly the outside auditor and the appraisers, into becoming fraud allies.

We were familiar with George Akerlof’s already famous article on markets for “lemons” and his warning that if frauds gained a competitive advantage they would produce a “Gresham’s” dynamic in which bad ethics drove good ethics out of the marketplace. Note that this does not require the frauds to suborn all or even most appraisers and auditors. A small percentage of appraisers and auditors willing to sign off on inflated asset values is sufficient to permit endemic “accounting control fraud.”

We used these analytical insights to contain the S&L debacle. We reconceptualized the nature of the crisis. It was no longer an “interest rate” or “gambling for resurrection” crisis. It was becoming a fraud crisis led by the CEOs. Deregulation, desupervision, ease of entry, and perverse executive and professional compensation were creating an environment that created endemic fraud. (Criminologists call this a “criminogenic environment,” but we did not know anything about criminology until we met Henry Pontell and his colleagues in 1993.) We reregulated and resupervised the industry.

We cracked down further on entry. Bank Board Chairman Gray had begun the crackdown in November 1983.

We used our knowledge of the fraud recipe to identify the worst frauds while they were still reporting record profits, positive capital, and minimal losses. Much of the industry went crazy. Our new strategy caused Keating to put the Keating Five into action to try to block his closure and (soon-to-be) Speaker Wright and a majority of his House colleagues to block reregulation.
We also realized that the recipe meant that the frauds had an Achilles’ heel – their need for extreme growth. We restricted growth to 25% annually, a ridiculously high level (it was the only way to get the other Bank Board Members’ to adopt the rule), that still proved fatally low for the frauds.

We made the removal of the frauds from the industry our top priority and their prosecution our second priority. We trained our staff, the FBI, and the prosecutors to recognize the distinctive accounting control fraud pattern. We made over 30,000 criminal referrals. We created over 30 fraud working groups with the FBI and U.S. Attorneys to get continuous feedback on the quality of our referrals so that we could continuously improve our training and quality control to produce superb referrals. We “detailed” dozens of examiners to serve as internal experts for the FBI on sophisticated investigations. We worked intensively with FBI and the Justice Department to create the “Top 100” list of the worst frauds that became the highest priority. We served as fact and expert witnesses for the prosecutions.

I helped shape our criminal referral process, made and edited criminal referrals, provided internal and external training, testified as an expert in court, and testified on behalf of my agency or office a half-dozen times before Congress about the role of fraud in the S&L debacle. In the course of my written and oral testimony on fraud researched the data on fraud and prosecutions and I studied and often listened to the testimony of other senior regulators and law enforcement officials on the subject.

In 1993, the Department of Justice finally funded criminological research into the S&L debacle. (One of the great, unknown scandals is that the Justice Department rarely funds research into elite white-collar crime.) Henry Pontell and Kitty Calavita of UC Irvine and Robert Tillman of St. John’s began to investigate the role of fraud in the S&L debacle. They interviewed scores of agency officials. I asked for copies of their final and draft papers and began to add criminological theory into our multi-disciplinary analysis of the S&L frauds. Their study for Department of Justice, their many academic papers about the role of fraud in the debacle, and their book confirmed the decisive role that senior insider fraud played in driving the crisis. Calavita, K., Pontell, H., Tillman, R., 1997. Big Money Crime. University of California Press, Berkeley.

Two additional fusions of knowledge occurred when I served as the Deputy Staff Director of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) the national commission charged with finding the causes of the debacle) where I worked directly and extensively with James Pierce (economics, UC Berkeley). I produced ten lengthy staff reports for NCFIRRE on a wide range of subjects. At least five of them dealt materially with fraud. Dr. Pierce introduced me to his colleagues George Akerlof and Paul Romer, who had been independently studying the role of fraud in the S&L debacle and other crises here and abroad.

I had developed an extensive piece explaining how to differentiate among potential defendants who were senior lenders based on whether they were acting due to fraud, honest “gambling for resurrection”, or stupidity. Akerlof and Romer invited me to three academic presentations of their paper, read the staff reports relevant to fraud that I produced for NCFIRRE, and discussed our views extensively. Their final paper reflects the collegial exchange of views (and, of course, the influence ran in both directions). The title of their 1993 paper captures their thesis – Looting: the Economic Underworld of Bankruptcy for Profit.

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=227162 [5]

Ever generous, the first footnote to their paper notes the mutual collaboration. The passage below adopts the view I had argued about the fact that the operational pattern of the worst S&L failures was optimal for an accounting control fraud but would be insane for anyone engaged in an honest “gamble for resurrection.”

“The problem with this explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.5 Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else's problem.

They were right.”

5. Black (1993b) forcefully makes this point.
[This reference was to one of my staff reports that Akerlof & Romer cited.]
Black, WilliamK . 1990." Ending OurForebearers' Forbearances:FIRREAa nd Supervisory Goodwill." Stanford Law and Policy Review 2(1):102-16. .
1993a. "Junk Bonds." Staff Report 7. San Francisco: National Commission on Financial Institution Reform, Recovery, and Enforcement (April 8).
1993b. "The Incidence and Cost of Fraud and Insider Abuse." Staff report 13. San Francisco: National Commission on Financial Institution Reform, Recovery, and Enforcement (April 12).
(1993 p. 4 & n. 5 and p. 70).

I then returned to school and received a Ph. D in criminology from UC Irvine. I did my dissertation on the theory of control fraud and its application to the S&L debacle. I also wrote a book on the subject that remains in print.

I do not know what research process Geithner followed in claiming that fraud was not even worth listing as a material contributor to our financial crises. I do know that the Obama folks know better because they filmed the heart of a campaign video in our living room here in Kansas City, MO and sent it to six million people. I took the notes of the “Keating Five” (where we explained to the Senators that they were trying to prevent us from taking a vital enforcement action against a fraud) that led to Senate ethics investigation. Senator John McCain was one of those Senators. To no one’s surprise, the campaign video represents the last time the Obama administration has wanted my input.

It is inescapably vainglorious, but it makes sense to explain to the reader that it would have been sensible for the last three administrations to ask for suggestions from my former regulatory and prosecutorial colleagues and me. Our reregulation of the S&L industry began in 1983. This was one year after Congress and the Reagan administration enthused over deregulating the industry through the Garn-St Germain Act of 1982, which passed with only one dissenting vote in each chamber.

Think for a moment of what an “in your face” move that was by “unelected bureaucrats” rejecting the nearly unanimous views of the administration, Congress, the industry, the media, and economists favoring deregulation. The reregulation and resupervision of the industry stopped a raging epidemic of accounting control fraud that was hyper-inflating real estate bubbles in the Southwest and saved the nation a trillion dollars in losses. It destroyed the careers of the Bank Board Chairman, Edwin Gray and Joseph Selby, the man Gray personally recruited to serve like a “Texas Ranger” (their slogan is: “One Riot, one Ranger) who would control the worst real estate fraud hotspot in the nation – Texas. This was a remarkable success and public administration scholars have been lavish in their praise for our actions, which included repeatedly blowing the whistle on prominent political cronies and regulatory lackeys.

Our regulatory careers are profiled in Chapter 2 of Professor Riccucci's book Unsung Heroes (Georgetown U. Press: 1995), Chapter 4 (“The Consummate Professional: Creating Leadership”) of Professor Bowman, et al’s book The Professional Edge (M.E. Sharpe 2004), and Joseph M. Tonon’s article: “The Costs of Speaking Truth to Power: How Professionalism Facilitates Credible Communication” Journal of Public Administration Research and Theory 2008 18(2):275-295.

Similarly, as I will discuss, our combined efforts with the FBI and the Department of Justice to identify, remove, sue, and prosecute elite white-collar criminals remains the most successful program in history in any nation. We would be happy to explain the things that worked best and the things we felt were unsuccessful. The last three administrations have wanted no advice from those who succeeded. None of them has been willing to bear the “Costs of Speaking Truth to Power.” Indeed, they want nothing to do with us because they know that we will tell them the unvarnished truth as we understand the truth. They find the truth beyond inconvenient because it threatens their fraudulent big finance contributors.

The question remains how Geithner decided that accounting control fraud was not material in the Enron era frauds and the S&L debacle. He could have read what experts have termed the definitive book on the S&L debacle.

Robert Kuttner, in his Business Week column, proclaimed: “Black's book is partly the definitive history of the savings-and-loan industry scandals of the early 1980s. More important, it is a general theory of how dishonest CEOs, crony directors, and corrupt middlemen can systematically defeat market discipline and conceal deliberate fraud for a long time -- enough to create massive damage.”

George Akerlof called the book “a classic.” Paul Volcker wrote about my description of how Ed Gray knowingly sacrificed his career to prevent a national catastrophe by standing up for us all:

“Bill Black has detailed an alarming story about financial - and political - corruption. The … lessons are as fresh as the morning newspaper. One of those lessons really sticks out: one brave man with a conscience could stand up for us all.”

Does anyone think that Geithner will emulate Gray and sacrifice his career in order to “stand up for us all” against the elite bank frauds and their political cronies?

Geithner could have learned about the role of fraud in the crisis through other means. The most obvious means would be to read the NCFIRRE report on the causes of the debacle. Because the subject is vital and Geithner has an extensive staff he could have them summarize the relevant NCFIRRE staff papers on the fraud, particularly:

Black, William K., "The Incidence and Cost of Fraud and Insider Abuse." Staff report 13. San Francisco: National Commission on Financial Institution Reform, Recovery, and Enforcement (April 12).

Or, he could just read one long paragraph in the NCFIRRE report.

NCFIRRE Details how Accounting Control Fraud Drove the S&L Debacle
The national commission that investigated the causes of the S&L debacle found:
“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization” (NCFIRRE 1993).

“Invariably” present at “the typical large failure.” The “milk[ing]” by “operators” refers to the CEOs looting “their” S&Ls through modern executive compensation. Their “weapon of choice” is accounting, which produces enormous, albeit fictional, reported income. Modern executive compensation turns that fictional income into real, enormous wealth.

Criminologists Explained Why Fraud, not Stupidity or Risk, Drove the S&L Debacle
There is a peer-reviewed criminology piece that explains how to differentiate among fraud, stupidity, and honest gambles for resurrection. The article explains why the evidence in the S&L debacle is consistent with accounting control fraud and falsifies the stupidity and gambling hypotheses.

The Savings and Loan Debacle of the 1980's: White-Collar Crime or Risky Business? (Black, William K., K. Calavita and H. Pontell)Law and Policy. Vol. 17, No. 1 (January 1995: 23-55).

As I have explained, criminologists specializing in the study of elite white-collar crimes have published over a dozen articles, two major books, and an official report commissioned by the Department of Justice explaining why the crisis was driven by accounting control fraud. Of course, if the SEC, the Fed, and Treasury were to hire “Chief Criminologists” they would have known all these things decades ago and we could have prevented the ongoing crisis.

The U.S. Attorney General explained Fraud’s Major Contribution to the S&L Debacle
Former Attorney General Dick Thornburgh called the S&L debacle “the biggest white-collar swindle in history.”

Link: http://photo.pds.org:5012/cqresearcher/document.php?id=cqresrre2002101106 [6]

In a July 24, 1990 Senate hearing:
“Thornburgh said Justice officials sifted through 18,000 criminal referrals and identified 100 extreme cases for all-out prosecution based on criteria ranging from the degree of the alleged ripoff to the involvement of public officials. The cases involve 310 S&Ls, he said.
Efforts in those cases have yielded 51 indictments and 39 convictions so far, Thornburgh said.
The less severe cases will be prosecuted as time, money and prosecutorial discretion allow, he told the panel.

"With limited resources, we have to concentrate," Thornburgh said. "I'm sorry to tell you ... that these are not all going to be prosecuted by (a U.S. Attorney)."

Note that the “Top 100” list involved 310 S&Ls and hundreds of individual prospective defendants. Thornburgh testified that it would take DOJ five years to prosecute those cases. We made thousands of referrals in “major” cases that did not make the Top 100 list and were doomed never to be prosecuted because of a lack of resources.

Link: http://articles.mcall.com/1990-07-25/news/2760633_1_thornburgh-defends-s-l-probes-justice-department-secret-service [7]

As I explain in my book, in 1993, the incoming Clinton administration deprioritized the S&L prosecutions and shifted resources to health care fraud so many additional elite S&L defendants escaped prosecution.

The FBI Director Testified that Fraud was a Major Contributor to the Debacle
Here is what a criminal investigator sounds like. We haven’t heard language like this in far too long. The statement is from William Sessions, the FBI Director, in April 1990.
“Sessions said prosecuting thrift cases is difficult because they are complex, but added that going after S&L looters is needed to restore public faith in financial institutions.

"The American public relied upon banking institutions and financial institutions being soundly managed by people who were honest. Therefore, it is absolutely essential that this program go forward to the end no matter how long that takes," Sessions said.”

Link: http://articles.latimes.com/1990-04-20/business/fi-1366_1_bank-fraud [8]

Sessions used analytics to realize when excuses for criminal conduct were inapplicable. In his testimony to House banking in April 1990 he explained.

“Of the more than 3,000 pending bank fraud and embezzlement cases with losses in excess of $100,000, 451 are in Texas, he said.

Sessions discounted past arguments that Texas' economy was the root cause for the state's financial crisis.

"Although it was the general economic downturn in Texas that surfaced the problem, it appears to the FBI as if a pervasive pattern of fraudulent lending activity began much earlier.'”
Link: http://www.chron.com/CDA/archives/archive.mpl/1990_696315/s-amp-l-probe-in-texas-beefed-up-fbi-s-fraud-team.html [9]

Indeed, Geithner or his staff could have learned about the role of fraud in the S&L debacle by reading the transcript of the hearing, or even the short news article for which I just provided a link.

“Sessions' testimony began two-day hearings into the effectiveness of law enforcement efforts in prosecuting bank fraud. Sessions was one of 10 witnesses who discussed the most common means of financial fraud and the problems involved in prosecuting those responsible.”
We have forgotten what a real, substantive congressional oversight hearing does and why such hearings are vital to democracy. The 1990 hearing revealed:

“Fraud played a significant role in the vast majority of thrift failures, according to testimony. Committee Chairman Henry B. Gonzalez, D-San Antonio, said afterward that a conservative estimate of thrift failures involving fraud would be more than 75 percent.

The FBI is sending 202 new special agents and 100 accounting technicians to Texas specifically to tackle the state's bank and thrift fraud investigations, Sessions said. There are already about 400 special agents and 43 accounting agents assigned to the Texas problem. Sessions expects the new hires to be trained and in place by August.”

Joe Selby and I testified at the hearing at the request of the Committee.

“In many Texas failures, directors, officers or major stockholders have looted the institutions for their own benefit, Sessions said. Because these transactions involve falsifying records and, usually, people with no criminal records, bank employees are often reluctant to help with the investigations, he said.

There was also a reluctance by regulators to deal with the problems at failing institutions when they first were detected, witnesses said.

The number of criminal referrals regarding possible thrift fraud surged when Joe Selby, former director of regulatory affairs at the Federal Home Loan Bank of Dallas, took the office in 1986.
"There was enormous pressure on us to ease up," he said.”

By April 1990, Selby had been forced out as our top supervisor in Texas as a result of industry pressure and Selby’s refusal to support the removal of our (the Federal Home Loan Bank of San Francisco’s) jurisdiction over Lincoln Savings under the political pressure of the Keating Five and Speaker Wright. Indeed, by April 1990, our blowing of the whistle on Danny Wall, the pusillanimous head of the Office of Thrift Supervision who caved to the political pressure from Keating and his political cronies, had led to his decidedly involuntary resignation. Gray recruited Selby in 1985, so the improvement in the making of criminal referrals came relatively early.

Another concise article summarizing the Gonzalez hearing reports an even more powerful statement by FBI Director Sessions.

“The Director of the Federal Bureau of Investigation said today that fraud in the savings and loan institutions seized by Federal regulators was ''pervasive'' and warned that pursuing the hundreds of cases would be a costly effort stretching out over several years.

''This is truly a national crisis,'' William S. Sessions, the bureau's Director, said in testimony before the House Banking Committee here.”

The article cited another expert on S&L fraud on the results of his agency’s empirical study.
“L. William Seidman, chairman of the Resolution Trust Corporation, the new agency created to run the rescue program, has said that criminal fraud was discovered in 60 percent of the savings institutions seized by the Government in 1989 - triple the fraud rate in failures of commercial banks.”

Link: http://www.nytimes.com/1990/04/12/business/sick-savings-units-riddled-by-fraud-fbi-head-asserts.html?pagewanted=all&src=pm [10]

Convictions show that Fraud Was a Major Contributor to the Debacle
The defendants that were the subject of the “Top 100” priority list were the primary subjects of prosecution in 2000-2003 and even prosecutions in prior years were overwhelmingly made of elites. These defendants often had substantial economic resources and hired the best white-collar defense counsel in the world.

In response to the S&L control frauds we secured over 1,000 felony convictions in cases designated as “major” by the Department of Justice. Most of those were major case convictions were of the highest priority defendants from the “Top 100” cases. We worked with the FBI to designate the 100 worst S&Ls (roughly 500-600 defendants). Nearly all of these defendants were prosecuted. Overall, our conviction rate was over 90%. The essential prerequisite to these convictions, which represent the greatest success in history against elite white-collar criminals, was that we (the S&L regulators) made over 30,000 criminal referrals.

Let me emphasize that again, S&Ls and banks will virtually never make criminal referrals against their controlling officers. Unless the banking regulators make the criminal referrals the FBI will never investigate widespread accounting control frauds. Sources: GAO: Bank and Thrift Criminal Fraud (January 1993: Tables 5.3 and 2.1 – note the “as of” dates in the tables); Black, W. (“The Best Way to Rob a Bank is to Own One” 2005).

Similarly, unless banking examiners are “detailed” to the FBI to serve as internal experts for the investigation, the prosecution of elite bank frauds will often fail. “Non-Justice staff expertise provided by IRS agents and regulatory examiners is often needed for successful prosecutions of financial institution fraud” (GAO 1993: 50).

“In December 1989, the Attorney General announced a plan to meet the “enormous and unprecedented challenge” of bank and thrift fraud” (GAO 1993: 58)
“As of July 1992, the Dallas task force staffing included

26 Fraud Section attorneys and 6 attorneys from the Northern District of Texas;
2 paralegals and 9 other support staff.
6 tax attorneys from Justice’s Tax Division;
9 full-time special agents and 6 revenue agents from IRS; and
52 special agents (32 full-time and 20 part-time), 9 financial analysts, 3 supervisors, and 10 support staff from FBI” (GAO 1993: 59).

“Many U.S. Attorneys have coordinated their efforts through local bank Working Groups fraud working groups. These groups are informal networking bodies that meet periodically. The primary objective of these groups is to improve Coordinated Bank and coordination and cooperation among federal law enforcement and Thrift Fraud Activities financial regulatory agencies. Several working groups predate the Attorney General’s 1989 task force strategy announcement; the first was established in Chicago in 1986. As of late 1991, there were at least 36 bank fraud working groups in various judicial districts, with more planned” (GAO 1993: 63).

“Between October 1, 1933 and June 30, 1992, Justice charged 3,270 defendants through
indictments and informations and convicted 2,603 defendants (110 defendants were acquitted, establishing a conviction rate near 96 percent). The courts sentenced 1,706 of 2,205 offenders to jail (77.4 percent)” (GAO 1993:76) (the data are solely on cases designated as “major”).

“The Department of Justice has made financial institution fraud one of its highest enforcement priorities.’ As of July 31,1992, the Federal Bureau of Investigation (FBI) was investigating 768 cases of fraud that may have contributed to the failure of an institution, along with 4,264 cases in which the alleged fraud involved $100,000 or more. The U.S. Attorneys charged 976 defendants during the first 9 months of fiscal year 1992 in “major” fraud cases alone….” (GAO 1993: 12).

“[I]n June 1992, the Resolution Trust Corporation (RTC), which is responsible for investigating and developing claims against potential assets of thrifts it oversees as designated conservator and/or receiver, estimated that potentially criminal conduct by insiders contributed to the failure of about 33 percent of the RTC thrifts. Roughly 64 percent of RTC controlled thrifts have had suspected criminal misconduct referred to Justice. Regardless of the exact incidence of criminal fraud in financial institutions, it is clear that fraud and insider abuse have been major factors in a significant portion of financial institution failures in the 1980s” (GAO 1993: 13).

“Real estate frauds are common vehicles for defrauding financial institutions. According to one witness testifying before the Commerce, Consumer, and Monetary Affairs Subcommittee of the House Committee on Government Operations, large fraudulent loans, especially for real estate projects, are the “perfect device for fraud and insider abuse” and are very effective in “destroying institutions.“* (GAO 1993:14).

*Statement of Wllllam K. Black, Deputy Director, Federal Savings and Loan Insurance Corporation, Hearing Before a Subcommittee of the Committee on Government Operations, House of Representatives, June 13,1987, p. 165.

The S&L crisis was accompanied by several smaller financial crises. The Maryland and Ohio thrift systems, which were privately insured, collapsed in widespread runs triggered by the collapse of a single accounting control fraud in each state system (Home State in Ohio and Old Court in Maryland). Continental Bank, one of the largest banks in America, suffered a massive run and required FDIC assistance because of fraud at Penn Square Bank (Oklahoma).

Economists that studied S&L Fraud found it was a Major Contributor to the Debacle
Accounting fraud is a “sure thing” that is guaranteed to make the CEO wealthy within months (George Akerlof and Paul Romer “Looting: the Economic Underworld of Bankruptcy for Profit” 1993). George Akerlof was awarded the Nobel Prize in Economics in 2001.
Akerlof and Romer chose this paragraph as their conclusion in order to emphasize their central policy message.

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

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=227162 [5]

Akerlof and Romer found that looting via accounting control fraud was a “sure thing” (1993: 5). They explained the analytical flaw in the honest gambler theory.

“[M]any economists still seem not to under-stand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (1993: 4-5).

Akerlof and Romer took advantage of the extensive factual records developed and made public by our prosecutions and civil and administrative suits to perform their analytics.

“[W]e examine detailed accounts of the savings and loan crisis for indications that looting did indeed take place. We find abundant evidence of investments designed to yield artificially high accounting profits and strategies designed to pay large sums to officers and shareholders. [B]y adding up the available accounts of looting, it becomes clear that looting could have been a significant contributor to the S&L crisis” (1993: 23).

Akerlof and Romer’s findings were consistent with the fraud recipe’s first and second ingredients (particularly the making of loans with a negative expected value at the time they are made), the creation of mass, acute “adverse selection”, and the capacity of clustered accounting control frauds to hyper-inflate a financial bubble (1993: 23-36; 36-42)

Conclusion:
Geithner is not simply wrong about fraud playing no significant role in prior crises. His senior staff is also wrong, or unwilling to speak truth to power. Geithner is not slightly wrong, he is grotesquely wrong. The fact that he is so wrong a quarter-century after the facts on fraud were made public would be disturbing for any official, but for the U.S. Treasury Secretary who has just seen the global economy crushed by an orgy of accounting control fraud by the world’s most elite bankers it is terrifying.

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. [11]

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 [12] and at the blog New Economic Perspectives [13]

Link to article at New Economic Perspectives

Link to article at Capitalism Without Failure

Link to article at Financial Sense

Marty Kaplan: Big Media Diverts us from Facts, Truth, and Accountability

2012-04-30T04:11:00.001-07:00

Citizens have given the public airways to private interests - for free. Facts, truth, and accountability are considered poison to ratings. The result is a "Disney World of democracy".

Big money and big media have coupled to create a ‘Disney World’ of democracy in which TV shows, televised debates, even news coverage is being dumbed down, just as the volume is being turned up. The result is a public certainly more entertained, but less informed and personally involved than they should be, says Marty Kaplan, director of USC’s Norman Lear Center and an entertainment industry veteran. Bill Moyers talks with Kaplan about how taking news out of the journalism box and placing it in the entertainment box is hurting democracy and allowing special interest groups to manipulate the system.

“It’s all about combat. If every political issue is [represented by] combat between two polarized sides, then you get great television because people are throwing food at each other,” Kaplan tells Moyers. “And you have an audience that hasn’t a clue at the end of the story, which is why you’ll hear, ‘Well, we’ll have to leave it there.’”

“The problem is that there’s not that much information out there if you’re an ordinary citizen. You can ferret it out, but it ought not be like that in a democracy,” Kaplan says. “Education and journalism were supposed to, according to our founders, inform our public and make democracy work.

Book referenced in the discussion: Amusing ourselves to death

Marty Kaplan is the Norman Lear Professor of Entertainment, Media and Society at the University of Southern California’s Annenberg School for Communication & Journalism. He is the founding director of the School’s Norman Lear Center, a nonpartisan research and public policy center that “studies the social, political, economic and cultural impact of entertainment on the world.”

Kaplan’s expertise draws on his broad career in government and the entertainment industry. He was chief speechwriter to Vice President Walter F. Mondale and served as deputy campaign manager of Mondale’s 1984 presidential race, where he was responsible for policy, speechwriting, and research. He was an executive assistant to the U.S. Commissioner of Education Ernest L. Boyer, and his work in education policy continued through his roles as a program officer at the Aspen Institute, guest scholar at the Brookings Institution, and senior adviser at the Carnegie Foundation for the Advancement of Teaching.

Kaplan’s work in entertainment includes his 12 years with Walt Disney Studios, where Kaplan was vice president of production for live-action feature films and a writer-producer under exclusive contract. He wrote and executive produced the political comedy The Distinguished Gentleman, starring Eddie Murphy, adapted Michael Frayn’s play into the film Noises Off by Peter Bogdanovich, and was a writer on the action-adventure Max Q, produced for television by Jerry Bruckheimer.

His frequent appearances in the press include So What Else Is News?, the nationally-syndicated program about media, politics, and pop culture, that he created and hosted on Air America Radio. He has also been a featured commentator on NPR’s All Things Considered and Marketplace. His writing has appeared in The Huffington Post, where he has been a blogger since the website’s inception, and Jewish Journal of Greater Los Angeles, where he is a columnist. He was deputy op-ed editor and columnist for theWashington Star and a commentator on the CBS Morning News.

Kaplan graduated from Harvard with a degree in molecular biology. While at Harvard he was president of The Harvard Lampoon and the Signet Society and on the editorial boards of The Harvard Crimsonand The Harvard Advocate. He received his Master’s degree in English at Cambridge University as a Marshall Scholar and received a Ph.D. in Modern Thought and Literature from Stanford University as a Danforth Foundation Fellow.

Bill Black: The Fraud Recipe for CEO's, Why Banks Hate Free Markets and Love Crony Capitalism, and the Dysmal Legacy of Mainstream Economists

2012-04-27T15:04:00.001-07:00

The selected notes below are from William K. Black's presentation at the Modern Monetary Theory Summit in Rimini, Italy, in Febuary of this year. The audio is embedded in this post following the text.

On the "technocrats" running the show in Europe: There are no 'technocrats,' especially ‘genius’ technocrats. I suggest a new rule of thumb for judging a 'genius technocrat.' They have to be right at least two out of ten times. There is not a single economist in Europe, who calls himself a technocrat, that could do the equivalent of making two penalty kicks out of ten.

What we learned from the Savings & Loan crisis: George Santayana famously said that, "those who cannot remember the past are condemned to repeat it." But, even if we remember the mistakes we have made, the new policy we pick could be another mistake. Here is what we learned about the incidence of fraud leading up to the savings and loan crisis, according to the national commission that investigated the causes of that crisis:

"'The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures... [E]very accounting trick available was used... Evidence of fraud was invariably present, as was the ability of the operators to 'milk' the organisation.'

On Control Fraud: Control Fraud occurs when the person who controls a seemingly legitimate entity uses it as a weapon to defraud. In finance, accounting is the weapon of choice. These accounting frauds cause greater losses than all other property crimes combined, yet economists never talk about it.

On the danger Control Frauds pose to society: When many of these frauds occur in the same area, they hyperinflate financial bubbles, which is what causes financial crises and mass unemployment. It makes the CEOs wealthy, produces Balzac scandals, and destroys democracy.

What the Recipe for Fraud will Guarantee: 1. The bank will report record profits (fictional profits), 2. The CEO will promptly become wealthy, and 3. Down the road, the bank will suffer catastrophic losses. As a bonus, if many banks do this simultaneously, a bubble will be hyperinflated.

Why bankers hate free markets and effective market competition, and adore crony capitalism: If you are a banker and wish to grow your bank (lending) at 50% per year - as was happening in Iceland, Ireland and much of Europe, for example - you would have to beat your competition - as in charge a lower interest rate. But if markets are working properly, your competition will try to match your rates - and you wouldn't end up making more loans, and your income would fall. All bankers would lose. That's why banks are the biggest proponents of crony capitalism - and are the world leaders in crony capitalism.

Why bad loans are perfect for bank fraud: When loans are made to people who cannot afford to repay them, banks that do basic underwriting are no longer an issue in terms of competition. And,when you lend to people with no intention to pay back a loan, you can charge very high interest and very high fees - thus maximizing short-term paper gains. And if enough banks get into the business, the bubble is hyperinflated, the bad loans can be rolled over into new bad loans, and the losses can be hidden for years. The bottom line is that mediocre bankers cannot make money in a competitive market, but they are guaranteed to make enormous money by using the fraud recipe. Here is a quote from the economist who led the national investigation of the Savings and Loan crisis, James Pierce: "‘Accounting abuses also provided the ultimate perverse incentive: it paid to seek out bad loans because only those who had no intention of repaying would be willing to pay the high loan fees and interest required for the best looting. It was rational for operators’—that’s CEOs—‘to drive their banks ever deeper into insolvency, as they looted them.’

So the best and surest way to become wealthy, as a bank CEO, is to make the worst possible loans. In order to make so many bad loans, they have to gut the underwriting process. Underwriting is what an honest bank does to make sure that it’s going to get repaid.

How Adverse Selection and Gresham's Dynamics permeate an industry: Imagine you run a Competent Honest Bank and you do underwriting. And you can tell can tell high-risk and low-risk borrowers. Low risk borrowers you charge 10%. High-risk borrowers you charge 20%. I run Bill’s Incompetent Bank; I can’t tell risk. So, I charge everybody 15%. Which borrowers come to me? Only the absolute worst borrowers. No good borrower would come because they could borrow at your bank at 10%. In economics, we call this adverse selection. And it means that a bank that makes loans this way must lose vast amounts of money. No honest banker would operate this way. And the banks that engage in these frauds also create criminogenic environments themselves to recruit fraud allies. For example, when it comes to the people that value homes, if they won’t inflate the value, the dishonest banks won’t use them. Do they need to corrupt every person that values homes? No, five percent of the profession is sufficient. They just send all their business to the corrupt appraisers. This is called a Gresham’s Dynamic; and it means that cheaters prosper and bad ethics drives good ethics out of the marketplace.

On how to battle fraud: We need a coast guard for our banks. We can no longer allow CEOs to desert their posts after running their banks aground and causing such great destruction. The elite bank CEOs that destroyed the global economy remain wealthy, powerful, and famous because they looted. They were bailed out. They did not leave in a lifeboat in the dark of night. They left in their yachts - yachts that the governments paid for.

On the disaster known as contemporary Economists: The dominant economists are truly terrible at one thing; They are terrible at economics. Occasionally they go beyond economics and they are abysmal on ethics. They are the leading opponents and dangers to democracy throughout the EU, in particular, but in America as well.

On Economists' awful predictive abilities and lack of morality - including three individual examples: Economists tell us they want to be judged on their predictive ability. We welcome their admission because their record in prediction is pitiful. But, of course, it is precisely the fact that they have been wrong about everything important for three decades that makes them unwilling to admit their error and evermore insistent on continuing their worst policy advice. Economics is particularly awful when it gets into the concept of morality.

Black provides examples of three individuals who wield(ed) enormous influence but got everything wrong:

1. Greg Mankiw

Recall the quotation above from the economist who conducted the investigation of the Savings and Loan crisis. He pointed out that it was ‘rational’ for looters to make bad loans. Here is the reaction of one economist, Greg Mankiw, to hearing the work of that national commission and of that Nobel Prize winner-to-be, George Akerlof. Keep in mind that Mankiw was the official discussant; he had the paper a week in advance; he thought about these remarks. He said:

"‘[...] it would be irrational for savings and loans [CEOs] not to loot.’

Mankiw takes a statement about how fraud is maximized by making bad loans, to the ethical proposition that it must be the appropriate action, even though the rational action is to defraud.

Greg Mankiw is not a random economist. President Bush made him Chairman of the President’s Council of Economic Advisers, the most prominent economic position in the U.S.A., after he had said these things.

2. Daniel Fischel

The next two gentlemen are the leading law and economics scholars on corporate law: Daniel Fischel and Judge Frank H. Easterbrook. The following is a quote from their treatise in 1991 - so, an entire generation of U.S. lawyers have been taught this next phrase:

“‘A rule against fraud is not an essential or [...] an important ingredient of securities markets.’

The key economist there—who is not really an economist, he’s a lawyer—is Daniel Fischel. He worked for three of the worst control frauds, including the absolute worst savings and loan control fraud, praised them as the best firms in the USA, and then wrote this two years later without ever admitting in his book that he had tried his theories in the real world and they had led him to praise the worst frauds. So, this is rank academic dishonesty on top of getting everything wrong. And what happened to Fischel after he got everything wrong? He was made Dean of the University of Chicago Law School, one of the most prominent academic positions in the USA.

3. Alan Greenspan

Alan Greenspan also worked for the worst fraud in the savings and loan crisis: Charles Keating’s Lincoln Savings. Greenspan personally recruited, as a lobbyist for this worst fraud, the five U.S. Senators who would intervene with us [regulators] to try and prevent us from taking enforcement action against the largest violation in the history of our agency because that violation was by Charles Keating and Lincoln Savings. And those five senators became known and ridiculed as the Keating Five.

Alan Greenspan then wrote a letter saying we should allow Lincoln Savings to do these terrible investments because ‘they posed no foreseeable risk of loss to the federal insurance fund.’ Lincoln Savings' failed investments proved to be the largest cost to the insurance fund. After he had gotten it as wrong as it is possible to get something wrong, we made him Chairman of the Federal Reserve. So, here you have a record of - we promote and honor the people who get it spectacularly wrong, as long as they get it wrong for powerful banks that are frauds.

On the predictions that Neoclassical (theoclassical) Economists got wrong: This is the short list. Neoclassical economists predicted that because markets were efficient they were self-correcting, fraud was automatically excluded, and financial bubbles could not occur. They assured us that because of bankers’ interest in their reputations and auditors and appraisers, that they would never commit a fraud and never assist a fraud. They predicted that massive financial derivatives would stabilize the economic system. They told us, even when the bubble had reached proportions larger than any in the history of the world, that there was no housing bubble in the United States, that there was no housing bubble in Ireland, that there was no housing bubble in Japan, that there was no housing bubble in Spain. They told us that if we paid CEOs massive amounts of money based on short-term performance, it would align the interests of the CEO with the shareholders and the public and be the best possible thing.

Every one of these predictions proved to be utterly false. Actually, every single one of these predictions had been falsified before the economists ever said them; and they did not change their message.

The Cato Institute's contribution: In 2007, Cato released the following statement: ‘Iceland’s economic renaissance is an impressive story. Supply-side reforms’—ie tax cuts—‘along with policies, such as privatisation and deregulation, have yielded predictable results; Incomes are rising, unemployment is almost non-existent, and the government is collecting more revenue from a larger tax base.’

They cut taxes but overall tax revenue grew because the country was growing at a massive rate. Why? Because the big three banks in Iceland were all accounting control frauds. They were growing at an average rate of 50% every year. And by the time they collapsed in 2008, they were ten times the GDP of Iceland. And they suffered 60% losses on their assets. That was Cato's prediction; proof-positive that deregulation, low taxes, and privatisation produce economic booms.

They said something very similar about Ireland in an article entitled 'It’s Not Luck':

"Ireland [...] boasts the fourth highest gross domestic product per capita in the world. In the mid-1980s, Ireland was a backwater with an average income level 30% below that of the European Union. Today, Irish incomes are 40% above the EU average. Was this dramatic change the luck of the Irish? Not at all. It resulted from a series of hard-headed decisions that shifted Ireland from big government stagnation to free market growth.'

They wrote this in 2007, a year after the Irish bubble had popped and Ireland was going into freefall. And what are we being told now is the answer? Hard-headed decisions that shift the economies from big government stagnation to free market growth. They have learned absolutely nothing from their past failed ‘predictions.’

On the role of banks in the Enron fiasco, and the state of relevant law in the USA: Most of the world’s largest banks eagerly aided and abetted Enron’s frauds. They knew Enron was engaged in fraud; and they thought that was a good thing because they would get more deal flow, more volume. These frauds were documented extensively by investigations - hundreds of pages about it. Not a single one of the large conventional bankers was prosecuted. There was a prosecution about Merrill Lynch, which the courts obstructed. Indeed, the U.S. Supreme Court ruled that only the government could bring civil suits against banks that aided and abetted fraud. Think of that! You could have indisputable proof that the bank had aided Enron, knowingly done so, caused you billions in losses, and you could not sue the bank. That’s how bad the law has become in the United States.

On the reaction to the Fed's Head of Supervision when he voiced concern that banks had aided in the Enron fraud: The Fed leadership actively resisted bringing any action against the banks - not even a slap on the wrist. It was only when the Securities and Exchange Commission took a slap on the wrist that the Federal Reserve was embarrassed into taking any action. The long-time head of supervision at the Federal Reserve was deeply disturbed by the fact that most of the largest banks in the world had aided Enron’s fraud. He put together a comprehensive briefing for the leadership of the Federal Reserve. At that meeting, the senior officials of the Federal Reserve and the senior Economists of the Federal Reserve did not criticise Enron and they did not criticise the banks that aided Enron’s frauds. They were enraged.. at the Supervisor. How dare he criticise banks? This illustrates the current state of thinking in the United States; this is the era of Reinventing Government, which pursues is a neoclassical, neoliberal, be soft on bankers agenda.

On the Fed reaction to the fact that big American banks aided and abetted in the Parmalat fraud: Italy entered the control fraud picture in a big way in 2004 - well into the bankers-can-do-no-evil era - with Parmalat. Parmalat turned out to be a massive accounting control fraud where the CEO was looting the company and taking the money out of Italy to tax havens where he could hide it in a wave of special complex corporate forms designed for that purpose. And what did the Federal Reserve say about all of this? First they bragged about their ‘enforcement’ action. Note that they would not name the large institutions:

"'In these enforcement actions, certain large institutions were required to revise their risk management practices where examiners found failures by these institutions to identify those transactions that presented heightened legal and reputational risk, particularly, in cases where transactions were used to facilitate a customer’s accounting or tax objective that resulted in misrepresenting the company’s true financial condition to the public and regulators.'

This passage requires translation because it’s in gobbledygook. First, they are bragging about an enforcement action that they tried very hard not to bring and which was utterly useless. Second, their concern is heightened legal and reputational risk. They are worried that when a bank aids Enron or Parmalat’s frauds they will get caught and then their reputations will suffer. They are not worried about Enron’s shareholders. They are not worried about the 12,000 Enron employees who lose their jobs. They are not worried about Parma’s economy. None of that matters. They don’t even discuss it. And they are not worried about morality. Call me old school, but I thought, when I was a regulator, if the banks I was regulating were engaged in fraud, first, my job was to stop it. Second, my job was to remove the CEO from office. Third, my job was to help prosecute him and put him in prison. And, fourth, my job was to sue him, so that he walked away with not a lira or a euro or a dollar. But all of that is gone.

On what permitted the crisis to occur in Europe and the USA: The National Commission Report on the US crisis stated:

"'We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts [...] due to the widely-accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves.'

The Report goes on to specifically blame Greenspan and his deregulatory ideology. What was the regulatory common denominator in the USA and Europe? The common-causal mechanism that resulted in crisis was deregulation, desupervision and the absurd executive compensation that swept Europe and the USA. In the end, Economists got what they wanted, and they predicted that it would be wonderful. It produced a catastrophe.

Audio of William K. Black's presentation:

Link to the original audio post at kpfa.org

Link to full transcript of the broadcast

William K. Black is Associate Professor of Law and Economics at the University of Missouri, Kansas City. He is a lawyer, former bank regulator, and author of The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry.

William K. Black's presentations took place on Saturday, February 25th in Rimini, Italy at the first Italian grassroots economic Summit on Modern Money Theory produced by Italian Journalist Paolo Barnard.

I thank Bonnie Faulkner for making the material in this presentation available through her show, Guns and Butter. If you missed Bonnie Faulkner's excellent February interview with Bill Black, I highly recommend a listen.

Please visit the University of Missouri, Kansas City New Economic Perspectives blog at www.NewEconomicPerspectives.org. Visit the website for the first Italian Summit on Modern Money Theory at www.DemocraziaMMT.info.

Portions of the above notes were taken from the transcript prepared by Felipe Messina for Media Roots and Guns and Butter

Keiser Report including coverage of Goldman Sachs' latest scandal, JP Morgan's Tripling of Risk, and an Interview with Matt Taibbi

2012-04-22T16:31:00.001-07:00

Max and Stacy discuss the latest of Goldman Sachs serial scandals. Goldman will pay $22m to the SEC to settle "allegations" that they engaged in weekly huddles where analysts would pass on information to traders and certain clients. Goldman had paid a penalty in 2003 for the same violation. Max and Stacy discuss what happens when huddles turn into cuddles and the SEC's tendency to treat crimes as "technical violations".

Max and Stacy also address the tripling of risk taken on by JP Morgan's chief investment office over the past 5 years: "They get too big to unwind on purpose so they don't have to unwind. This is a scheme to extract rent." One JP Morgan trader, Bruno Iksil, is now referred to by some in the industry as "Voldemort"owing to his enormous positions in market-derivatives.

In the second half the show, Max interviews Matt Taibbi, who likens reporting on Wall Street activity to covering organized crime.

Taibbi touches on his recent article, Bank of America: Too Crooked to Fail: BoA got very big because of acquiring Countrywide and Merril Lynch. Those terrible acquisitions should have resulted in BoA going out of business. But those acquisitions made BoA so big, that we cannot allow that to happen. Now we slap them on the wrist every time they violate the law - and they do that often - and hope they get better. Some of BoA's recent violations: municipal bond manipulation, rigging LIBOR, the mortgage backed securities rip-offs, ripping off the HAMP program, ripping off people who have prepaid BoA cards for Unemployment Insurance...

Open Letter to the Chief Confidence Officer of the United States of America

2012-04-18T23:45:00.001-07:00

Dear Dr. Bernanke,

My nephew is a bad kid. He's into drugs, engages in high-risk sex, and has a steady stream of brushes with the law. But he always manages to avoid prosecution- probably because he is smart and good looking... and he has a rich uncle.

Recently he got into trouble. He was involved in some illegal gambling and had resorted to the Martingale strategy - right up until he ran out of money. Just as he lost that last hand, the hall was raided and he was arrested. I had, in the past, told him that if he ever needed help, he should call. But this time was tough for me. I knew that I could throw money at the situation and the problem would disappear; the gamblers would go away, the police would go away, and there would be no court case. I would basically restore public confidence in this boy by buying his way out of scrutiny. He would then go on to screw up another day - probably in a much bigger way.

The alternative was for me to let him collect his lumps, and watch as he got a taste of where he would end up if uncle was not around to bail him out - or if uncle chose not to bail him out because he was the cause of all his trouble.

I had to decide what the moral thing was for me to do: Shower the situation with money and make it go away; or let him learn a hard lesson - replete with bruises and a likely criminal record.

From the public's point of view, the answer was obvious; society would be better off if I let him take his lumps. He might be scared straight. And a criminal record would constitute a public record - a warning to anyone who took the time to find out about his proclivities.

But personal morality is a different beast. I have a certain loyalty to my brother to think about. And I did promise my nephew that if he ever got into trouble, I would be there for him. At the time, I did not include any contingencies in that promise. And it would break my mother's heart if my nephew went to jail - or if he was beaten up for not paying his debt.

I had to side with my posse, Dr. Bernanke. I bailed out my nephew. I paid off his gambling debt. And I found a lawyer who knows the DA - and the whole problem disappeared. It cost me a few dollars - but my brother is forever grateful. And my mother remains happy and ignorant. The cost to society, on the other hand, is going to be higher; this kid now thinks he's untouchable. Watch out, world.

On the face of it, your and my decision-making processes seem similar. Faced with a moral question of how best to restore confidence following a crisis, you too decided not to let your nephew-equivalents take their lumps; you shoveled money, just like I did, to protect those bad apples... to restore confidence in them... to restore confidence in the system.

There are a few differences in terms of the decision you made and the decision I made. For example, who, for you, is the equivalent of my brother? And who, for you, is the equivalent of my mother? And I was using my own money - thus the money was used in a way that would benefit me and my interests. Whose money were you using?

I am playing with you, Dr. Bernanke. I know where your allegiances lie, and whose money you used; you used my money. And your brothers and nephew are bankers - bad bankers. You took my money, and you funded your posse so that they would not have to face the repercussions of their dangerous ways. That is not moral, Dr. Bernanke. And it is a lot more dangerous than me letting my no-good nephew continue down his self-destructive path. I protected an insignificant fool with my own money, while you took my money and protected a behemoth - a massive, corrupt, and systemically dangerous juggernaut - in a way that ultimately imperils me, my family, and my community.

I may have done something unseemly from a public perspective, but it was my prerogative and I did what I had to do to protect my family. You did something obscene from a public perspective; you used the public's money to protect a corrupt core of powerful criminals who had imperiled our entire economy - and who, thanks to your largess, will eventually do so again. That is not central banking, Dr. Bernanke; that is centralized criminality.

You had a choice when it came to how you were going to restore confidence in our economy. You could have done it in a way that eliminated many of the industry people and practices that led to the crisis - in which case our confidence would arguably be based on having a more sound financial sector; or you could have sought to restore confidence by reinforcing the status quo - systemically dangerous institutions and people who pose a threat to our well-being - by flooding the financial sector with no-strings-attached money. You, somehow, chose the latter approach. You chose to protect the wrongdoers at the expense of the victims, you did it with the victims' money, and you did it in such a way so as to guarantee a future threat to those same victims. That is downright diabolical.

Is there something wrong with you, Dr. Bernanke?

Uncle.

Aaron Krowne: FHA has become Vehicle for Fraud

2012-04-03T18:09:00.000-07:00

Aaron Krowne of ML-Implode.com discusses the transfer of fraudulent mortgages to the Federal Housing Administration (interview begins at 13:00):

Bill Black: JOBS Act is Invitation to Commit Fraud

2012-04-02T11:49:00.000-07:00

Bill Black on the JOBS Act: Fundamentally this Act brings to equities the equivalent of shadow banking - which enabled the crisis to take place. Opaqueness - which the JOBS Act creates - is one road to disaster. It is a dream bill for every pump and dump scam in existence. We already had endemic problems way beyond the SEC's ability to deal with. It is truly an atrocity.

Bill Black: All Those who Doeth Evil, Hateth the Light

2012-03-22T01:46:00.001-07:00

James Grant: The Alternative to what we have now is Capitalism

2012-03-15T15:14:00.000-07:00

On what the Fed and other central banks are doing: We should call this what it is: Market manipulation.
The Fed is manhandling the structure of interest rates in order to achieve what it believes to be desirable macro outcomes. If the government, instead of manipulating the interest rate, would go down to the farmer's market at 14th Street and fiddle with the scales, there would be understandable outrage from customers. The Fed and other central banks are, in unprecedented ways, manipulating the value of their currencies; they are printing by the ton. Central banks are being recklessly procreative. The Fed in this latest gambit wants to manipulate long term interest rates lower. But in so doing, it is manipulating perceptions of risk and it is creating real inflation in the sense that people who want to retire on their savings, now need much more cash to do so. By repressing interest rates, the Fed is dulling the risk sensors of the entire marketplace. It's all terribly dangerous.

On what history tells us: Ben Bernanke can't stop talking about the 30's but there is an instructive lesson from the early 20's. In 1920-21, the economy fell off a cliff. The treasury balanced the budget, the Fed raised interest rates, and the recession ended. That's a real living historical example of us doing the opposite of what is being done now - and it was successful.

On what the alternative is to what the Fed is doing: The alternative to what we have now is capitalism. We should be discussing a currency that is not created at the whim of a bunch of mandarins.

Nassim Taleb: I am not a libertarian - but Ron Paul is the only candidate addressing fundamental issues facing the USA

2012-03-14T19:50:00.013-07:00

Nassim Taleb on MSNBC (video below text:)

Why Taleb feels compelled to speak about a political candidate: Taleb says he is non-political; he bases his outlook solely on risk. Based on this analysis, he feels it is his duty as a US citizen to publicly support the one candidate who is prepared to address the structural issues that now face the United States. That candidate is Ron Paul.

Taleb bases his support on the following risk centers:

1. Deficits and metastatic governments,
2. The problem of the Federal Reserve,
3. Defence tendencies, and
4. The notion that bailouts do not serve the USA - bailouts weaken economies by preserving failed entities in power positions.

On what Ron Paul does right: Paul is against the notion of just giving Novocaine to a patient when the patient has a major problem; if the condition calls for a root canal, do the root canal. None of the other candidates are addressing the real problems facing the USA. They are all poised to continue with Novocaine after Novocaine.

On the current state of affairs: We are gambling with future generations' money and we are gambling with hyperinflation. That is fundamentally wrong. And we have a metastatic government; civil servants live better than civilians - and they are protected. Obama's advisers are part of the problem; they are compromised and are friends of the bankers. The Republicans cannot be trusted to address deficits.

What Ron Paul is addressing: Paul is against gambling to feed the family. He is against gambling with economic ruin. He is against bailouts. He is the only candidate who will address our structural problems.

Robert Reich: The Difference Between Private and Public Morality

2012-03-13T23:09:00.002-07:00

TUESDAY, MARCH 13, 2012

Republicans have morality upside down. Santorum, Gingrich, and even Romney are barnstorming across the land condemning gay marriage, abortion, out-of-wedlock births, access to contraception, and the wall separating church and state.

But America’s problem isn’t a breakdown in private morality. It’s a breakdown in public morality. What Americans do in their bedrooms is their own business. What corporate executives and Wall Street financiers do in boardrooms and executive suites affects all of us.

There is moral rot in America but it’s not found in the private behavior of ordinary people. It’s located in the public behavior of people who control our economy and are turning our democracy into a financial slush pump. It’s found in Wall Street fraud, exorbitant pay of top executives, financial conflicts of interest, insider trading, and the outright bribery of public officials through unlimited campaign “donations.”

Political scientist James Q. Wilson, who died last week, noted that a broken window left unattended signals that no one cares if windows are broken. It becomes an ongoing invitation to throw more stones at more windows, ultimately undermining moral standards of the entire community

The windows Wall Street broke in the years leading up to the crash of 2008 remain broken. Despite financial fraud on a scale not seen in this country for more than eighty years, not a single executive of a major Wall Street bank has been charged with a crime.

Since 2009, the Securities and Exchange Commission has filed 25 cases against mortgage originators and securities firms. A few are still being litigated but most have been settled. They’ve generated almost $2 billion in penalties and other forms of monetary relief, according to the Commission. But almost none of this money has come out of the pockets of CEOs or other company officials; it has come out of the companies — or, more accurately, their shareholders. Federal prosecutors are now signaling they won’t even bring charges in the brazen case of MF Global, which lost billions of dollars that were supposed to be kept safe.

Nor have any of the lawyers, accountants, auditors, or top executives of credit-rating agencies who aided and abetted Wall Street financiers been charged with doing anything wrong.

And the new Dodd-Frank law that was supposed to prevent this from happening again is now so riddled with loopholes, courtesy of Wall Street lobbyists, that it’s almost a sham. The Street prevented the Glass-Steagall Act from being resurrected, and successfully fought against limits on the size of the largest banks.

Windows started breaking years ago. Enron’s court-appointed trustee reported that bankers from Citigroup and JP Morgan Chase didn’t merely look the other way; they dreamed up and sold Enron financial schemes specifically designed to allow Enron to commit fraud. Arthur Andersen, Enron’s auditor, was convicted of obstructing justice by shredding Enron documents, yet most of the Andersen partners who aided and abetted Enron were never punished.

Americans are entitled to their own religious views about gay marriage, contraception, out-of-wedlock births, abortion, and God. We can be truly free only if we’re confident we can go about our private lives without being monitored or intruded upon by government, and can practice whatever faith (or lack of faith) we wish regardless of the religious beliefs of others. A society where one set of religious views is imposed on a large number of citizens who disagree with them is not a democracy. It’s a theocracy.

But abuses of public trust such as we’ve witnessed for years on the Street and in the executive suites of our largest corporations are not matters of private morality. They’re violations of public morality. They undermine the integrity of our economy and democracy. They’ve led millions of Americans to conclude the game is rigged.

Regressive Republicans have no problem hurling the epithets “shameful,” “disgraceful,” and “contemptible” at private moral decisions they disagree with. Rush Limbaugh calls a young woman a “slut” just for standing up for her beliefs about private morality.

Republicans have staked out the moral low ground. It’s time for Democrats and progressives to stake out the moral high ground, condemning the abuses of economic power and privilege that characterize this new Gilded Age – business deals that are technically legal but wrong because they exploit the trust that investors or employees have place in those businesses, pay packages that are ludicrously high compared with the pay of average workers, political donations so large as to breed cynicism about the ability of their recipients to represent the public as a whole.

An economy is built on a foundation of shared morality. Adam Smith never called himself an economist. The separate field of economics didn’t exist in the eighteenth century. He called himself a moral philosopher. And the book he was proudest of wasn’t “The Wealth of Nations,” but his “Theory of Moral Sentiments” – about the ties that bind people together into societies.

Twice before progressive have saved capitalism from its own excesses by appealing to public morality and common sense. First in the early 1900s, when the captains for American industry had monopolized the economy into giant trusts, American politics had sunk into a swamp of patronage and corruption, and many factory jobs were unsafe – entailing long hours of work at meager pay and often exploiting children. In response, we enacted antitrust, civil service reforms, and labor protections.

And then again in 1930s after the stock market collapsed and a large portion of American workforce was unemployed. Then we regulated banks and insured deposits, cleaned up stock market, and provided social insurance to the destitute.

It’s time once again to save capitalism from its own excesses — and to base a new era of reform on public morality and common sense.

Link to original article at robertreich.org

Wall Street’s Broken Windows

2012-03-08T06:20:00.001-08:00

By William K. Black, New Economic Perspectives

James Q. Wilson was a political scientist who often studied the government response to blue collar crime. The public knows him best for his theory called “broken windows.” The metaphor was what happens to a vacant building when broken windows are not promptly repaired. Soon, most of the windows in the abandoned building are broken. The criminals feel little compunction against petty destruction because the building’s owners evince no concern for the integrity of their building. Wilson took social norms, community, and ethics seriously. He argued that as community broke down fewer honest citizens were active in monitoring and policing behavior. The breakdown in community was criminogenic – it led to widespread serious blue collar crime. He urged us to take even minor blue collar crimes and breaches of civility seriously and to demand that they be contained through social pressure and policing.
New York City’s police strategy embraced “broken windows.” The police increased the priority with which they responded to even minor offenses that upset the community – “squeegee men,” graffiti, and street prostitution. Reported blue collar crime fell in New York City. It also fell sharply in most other cities, which did not implement “broken windows” programs, but Wilson and the NYPD got the credit and popular fame for the sharp fall in reported blue collar crime in New York City. Wilson became one of the most famous blue collar criminologists in the world.

Wilson’s broken window theory remains controversial among many blue collar criminologists. As a celebration of his life and research I offer this discussion of applying “broken windows” theory and policies to elite white-collar crime.

Wilson was strongly conservative. His research focus in criminology was almost exclusively blue collar crime. That was a shame because “broken windows” theory is most compelling in the context of elite white-collar crime and because the application would reveal interesting twists in the theory’s potential. Such an application, however, would have been outside Wilson’s comfort zone. Wilson tended to use the word “crime” to refer exclusively to blue collar crime and his emphasis was on very low status criminals. In a book entitled, Thinking About Crime, Wilson argued that criminology should focus overwhelmingly on low-status blue collar criminals.

This book [does not deal] with “white collar crimes”…. Partly this reflects the limits of my own knowledge, but it also reflects my conviction, which I believe is the conviction of most citizens, that predatory street crime is a far more serious matter than consumer fraud [or] antitrust violations … because predatory crime … makes difficult or impossible maintenance of meaningful human communities (1975: xx).
I am rather tolerant of some forms of civic corruption (if a good mayor can stay in office and govern effectively only by making a few deals with highway contractors and insurance agents, I do not get overly alarmed)…. (1975: xix).

Notice that Wilson’s explanation is antithetical to his “broken windows” reasoning. There are, of course, relatively minor white-collar crimes. Wilson emphasized that it was the willingness of society to tolerate relatively minor blue collar crimes that led to social disintegration and epidemics of severe blue collar crimes, but he engaged in the same willingness to tolerate and excuse less severe white collar crimes. He predicted in his work on “broken windows” that tolerating widespread smaller crimes would lead to epidemic levels of larger crimes because it undermined community and social restraints. The epidemics of elite white collar crime that have driven our recurrent, intensifying financial crises have proven this point. Similarly, corruption that is excused and tolerated by elites is unlikely to remain at the level of “a few deals.” Corruption is likely to spread in incidence and severity precisely because it undermines community and the rule of law and it is likely to grow more pervasive and harmful the more we “tolera[te]” it.

“Broken windows” theory, in the white collar crime context, would lead us to make the prevention and deterrence of consumer frauds and anti-trust violations through prosecutions a high priority because of their tendency to produce a “Gresham’s” dynamic in which businesses or CEOs that cheat gain a competitive advantage and bad ethics drives good ethics out of the markets. These offenses degrade ethics and erode peer restraints on misconduct.

The ongoing crisis demonstrates that anti-consumer frauds are a direct assault on community. Mortgage fraud – and it was overwhelmingly the lenders and their agents who put the lies in millions of liar’s loans – physically and socially destroy community by producing mass defaults, homelessness, and vacant homes.

Taking Wilson’s “broken windows” reasoning seriously in the elite white collar crime context would require us to take a series of prophylactic measures to restore integrity and strengthen peer pressures against misconduct. Indeed, we have implicitly tested the applicability of “broken windows” reasoning in that context by adopting policies that acted directly contrary to Wilson’s reasoning. We have adopted executive and professional compensation systems that are exceptionally criminogenic. We have excused and ignored the endemic “earnings management” that is the inherent result of these compensation policies and the inherent degradation of professionalism that results from allowing CEOs to create a Gresham’s dynamic among appraisers, auditors, credit rating agencies, and stock analysts. The intellectual father of modern executive compensation, Michael Jensen, now warns about his Frankenstein creation. He argues that one of our problems is dishonesty about the results. Surveys indicate that the great bulk of CFOs claim that it is essential to manipulate earnings. Jensen explains that the manipulation inherently reduces shareholder value and insists that it be called “lying.” I have seen Mary Jo White, the former U.S. Attorney for the Southern District of New York, who now defends senior managers, lecture that there is “good” “earnings management.”

Fiduciary duties are critical means of preventing broken windows from occurring and making it likely that any broken windows in corporate governance will soon be remedied, yet we have steadily weakened fiduciary duties. For example, Delaware now allows the elimination of the fiduciary duty of care as long as the shareholders approve. Court decisions have increasingly weakened the fiduciary duties of loyalty and care. The Chamber of Commerce’s most recent priorities have been to weaken Sarbanes-Oxley and the Foreign Corrupt Practices Act. We have made it exceptionally difficult for shareholders who are victims of securities fraud to bring civil suits against the officers and entities that led or aided and abetted the securities fraud. The Private Securities Litigation Reform Act of 1995 (PSLRA) has achieved its true intended purpose – making it exceptionally difficult for shareholders who are the victims of securities fraud to bring even the most meritorious securities fraud action.

The Supreme Court has held that banks and other entities that aid and abet securities fraud are immune from suit by the victims of securities fraud. Only the federal government may sue those that aid and abet fraud. The federal government has cut the number of financial fraud prosecutions by over one-half over the last twenty years even as financial fraud has grown massively. No elite CEO leading a control fraud that helped drive the current crisis has even been indicted. Elite CEOs can defraud with near impunity and become wealthy. Elite white collar fraud is a “sure thing” – the only strategy likely to make a mediocre CEO wealthy and famous.

Because Wilson did not research elite white collar crimes he did not direct his formidable intellectual energies and expertise to the study of who could prevent the breaking of corporate windows and repair those that were broken. This was a great loss because his studies of varieties of police behavior in response to blue collar crime are justly famous among criminologists. The central truth he would have quickly recognized had he thought of seeking to reduce elite white collar crimes is that only the financial regulators can serve as the “regulatory cops on the beat.” The police do not deal with elite white collar crimes. A small cadre of FBI special agents works on elite white collar crimes. There are roughly three special agents assigned to white collar crime investigations per industry in the U.S., so they never “patrol a beat.” They investigate only when someone brings a possible white collar crime to their attention. That means whistleblowers, but it overwhelmingly means criminal referrals from the federal financial regulators. Financial institutions may make criminal referrals against their customers, but they will virtually never make them against their CEOs. Only the regulators can make the thousands of criminal referrals against elite white collar criminals essential to a successful prosecutorial effort against the epidemics of accounting control fraud that drive our worst financial crises. In the lead up to the ongoing crisis we gutted the federal regulators, preempted the state regulators, and appointed anti-regulators to head the agencies. A majority of the U.S. House of Representatives is trying to further gut the Commodities Futures Trading Commission (CFTC). If we want to stop the criminals who are destroying our economy and our communities by breaking windows on an epic scale the first step is to rebuild a regulatory force committed to serving as the essential “cops on the beat.”

I listened in stunned amazement to the presentations of law professors who specialize in white collar crime and securities law at the two annual meetings that followed the ongoing financial crisis. Virtually every speaker in these sections presented arguments calling for reducing white collar criminal liability and liability for securities fraud. At the time they were speaking, the Justice Department had already ceased prosecuting major firms and the SEC brought a pathetically high percentage of its small number of enforcement actions against tiny firms with fewer than 10 employees.

We have systematically reduced effective peer restraints in our most important controls against financial fraud. Law firms, audit firms, and investment banks used to be professional partnerships. Each partner was potentially liable for any firm misconduct, which maximized the incentive to insist on higher levels of integrity. These firms are now virtually all corporations or limited liability partnerships. The incentive of partners to monitor other partners’ actions to ensure their integrity has largely been lost.

In the elite white collar crime context we have been following the opposite strategy of that recommended under “broken windows” theory. We have been breaking windows. We have excused those who break the windows. Indeed, we have praised them and their misconduct. The problem with allowing broken windows is far greater in the elite white collar crime context than the blue collar crime context. The squeegee guys make tiny amounts of money and are hated and politically powerless. The mediocre financial CEO who engages in accounting control fraud because it is a “sure thing” causes the bank to report record (albeit fictional) profits and becomes wealthy and politically powerful. He uses his wealth to make charitable and political contributions that make him far harder to sanction. He claims that any crackdown on him is “class warfare” by “neo-Bolsheviks.” Incredibly, the Wall Street Journal continues to serve as the cheerleader and apologist for those who become wealthy by breaking windows, communities, and economies.

Wilson warned of blue collar “super predators.” He called them “feral” – wild animals. These criminals are in fact dangerous, but they are odd candidates for the title of “super predators.” Wilson noted that they were disproportionately black and that they were confined almost entirely to the poorest neighborhoods in America where their pickings are poor. Accounting control frauds occupy Wall Street and other financial centers – the richest neighborhoods in the world. Their “take” from fraud is extraordinary. The blue collar criminals that occupied Wilson’s attention late in his career were politically and socially powerless. The fraudulent CEOs that drive our recurrent, intensifying financial crises are wealthy and socially and politically dominant.

Wilson had a fabulous career and added greatly to the policy debate about how to respond to blue collar crime. Our most fitting tribute to him and contribution to his legacy would be to apply his “broken window” theory to the elite white collar crimes and criminals that drive our financial crises. The troubling paradox is that the strongest proponents of “broken windows” theory and policies in the blue collar crime context are the strongest opponents of applying analogous policies in the elite white collar crime context. The Wall Street Journal is the most prominent example of this class-based incoherence.

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.

Bill Black: US Promotes Flawed Economic Dogma that Encourages Fraud and Needlessly Perpetuates a Pattern of Recurring and Intensifying Financial Crises

2012-03-06T18:31:00.015-08:00

Bonnie Faulkner interviews former bank regulator, William K. Black. There is more to this 1-hour interview than what is contained in these notes. Audio of the interview is available following this text.

On banks' traditional role as middleman: Some banks do very useful things for the world. According to economic theory, banks act as a middleman. Banks take savings, accumulate money, make loans to companies to invest productively... Middlemen serve a very useful purpose, but should not be very big and should not make a lot of money... based on the efficiency principal.

On what has happened to our elite financial institutions: In the world we live in, finance has become the dog instead of the tail. In the USA, 30% to 40% of all profits in business come from the financial sector. They have become a parasite... They weaken the economy. Overall, finance has lost its way - in an immensely destructive way. Why is it that our most elite institutions are our worst institutions? Why are our most elite institutions the ones that time after time violate the law and cause recurrent intensifying crises?

Why the crisis has not abated in Europe: Europe does not have its own currency. It makes the crisis far worse for them. In Europe it has become a core vs. periphery issue. The core is becoming increasingly furious with the periphery. But the core largely caused the crisis. The victims are being blamed.

On the natural tendency of unregulated capitalism to evolve into crony capitalism: Pure capitalist systems do not exist anywhere - for very good reason; they throw lots of humanity into the ditch, and they produce elite criminals. Unregulated capitalism tends to evolve into crony capitalism. Conservative economists like Adam Smith have recognized this from the beginning. They always emphasize that government must be there. And they always emphasize one key role for government: Enforcing the law against fraud. Even Ayn Rand emphasized that the government is essential to stop businesses from using fraud.

How economics has lost its way: Over the past 30 years in the US and Europe, we have witnessed a new breed of economist - the theoclassical economist - as in economists who maintain views akin to religious dogma. Theoclassical economists believe that government must be removed from everything. The leading theoclassical scholars in economic law have now taught a generation of lawyers that a rule against fraud is not necessary or important. Their position is that markets automatically make fraud disappear. Unfortunately, that is a view that has no basis in reality or in any sound economic theory. It is contradicted by all human experience.

On Alan Greenspan's role in infusing theoclassical doctrine into government: The Warning (embedded below this interview) is a (superb) documentary about the warning that Brooksley Born, Chair of the Commidities Futures Trading Commission, delivered about derivatives in the 90's. Alan Greenspan, then Chairman of the Federal Reserve, along with a host of Democrats and Republicans, proceeded to crush her. President Clinton signed the Commodities Futures Modernization Act of 2000 into law with the active support of then-Treasury Secretary Rubin and his replacement, Larry Summers.The Commodities Futures Modernization Act of 2000 forbade us from having any kind of regulation of derivatives. The Act went so far as to prevent the establishment of a rule against fraud. Alan Greenspan's position was that markets automatically exclude fraud. This is insanity. But it is insanity that has been widely adopted and propounded by expert economists.

On the treatment of fraudulent liars loans in the 90's: In 1990 and 1991, we saw fraudulent liars' loans created by S&L's. We stopped it. The leading maker of liars loans gave up its federal charter and gave up federal deposit insurance for the sole purpose of escaping our regulatory jurisdiction - and proceeded to commit fraud. Ultimately, he was sued by 49 Attorney Generals and the Federal Trade Commission, settled for 100's of millions of dollars in penalties, and was promptly named Ambassador to the Netherlands by George W. Bush; he had been the leading political contributor. This is what we do for our elite frauds; we impose a minor fine and then we give them our greatest honors and power.

Comparing prosecutions following the S&L crisis, to prosecutions following our more recent crisis: The first Bush administration had been a leader in prosecuting the S&L debacle frauds. The Ofiice of Thrift Supervision had killed liar's loans and had made over 30,000 criminal referalls. Their prosecutions resulted in over 3000 convictions. This included convictions of over 1000 elite players. Flash forward to our current crisis, the same agency made zero criminal referalls and there have been zero elite prosecutions.

On the movement to cut regulation, supervision, and prosecution of fraud: The Clinton administration immediately deprioritized prosecutions in S&L's. It moved prosecutors to healthcare fraud. The Clinton administration also embraced the "Reinventing Government" movement. It was Al Gore as Vice President who was in charge of this anti-regulatory movement. This movement led to sharp cutbacks in regulation, supervision, and prosecutions of financial frauds.

Bank regulators were instructed by Washington to consider banks to be their clients: Under Reinventing Government, Bill Black personally witnessed regulators being instructed by Washington to refer to banks as their clients, and to think of them as their clients. Black objected and stated that the people of the United States of America were their clients. The regulators were told that the issue was not negotiable; under the Reinventing Government initiative, the bank was the client. It was a very hostile view.

How deregulation and desupervision leads to criminogenic envioronments: The Clinton administration pushed the "3 D's": deregulation, desupervision (rules stay but no one enforces them), and de facto decriminalization. This trend was expanded under Bush. Between the 3 D's, and what happened to executive compensation, we produced a criminogenic environment: An environment where the incentives are so perverse that they produce epidemics of crime. In this case we produced epidemics of fraud in the most elite financial institutions.

An iconic image: There is an iconic image that comes out of the Office of Thrift Supervision in the Federal Deposit Insurance Corporation 2003 Annual Report. It is a picture of the Head of the Office of Thrift Supervision, James Gilleran, holding a chain saw. He is standing next to the three leading bank lobbyists in America, and the Deputy Head of the FDIC, who will become his successor. The other gentlemen are holding pruning shears. The message is that they will destroy regulation - the rules. They will work hand in glove with the lobbyists to do so. Gillerin, holding the chain saw, is signalling that he is going to be completely indiscriminate.

The view was that government was a failure, the private sector was a success, and the way for government to become successful would be to emulate and embrace the private sector - and to wack back with a chainsaw the role of government. Wherever possible the goal was to privatize and remove government. Where it was not possible to privatize, it would be downsized, put it in partnership with the private sector, and regulators were instructed to treat the business as the client. This was a not a partisan effort. Everyone agreed... apart from a small group of rational folks who said this was insane.

The USA exports theoclassical dogma, and resulting criminogenic environments, to the world: Americans tend to think of Europe as socialist and highly regulated. But one of our leading exports is economists. We train much of the world through our PhD programs. The senior ranks of much of Europe - the key technocrats - have largely been taught theoclassical dogma. The result is that across the entire EU, banking regulation largely disappeared.

Europe adopts US-style deregulation, desupervision, and a model for encouraging fraud: Even when rules were left in place and violations were found, there were no serious actions taken against the violators. The result was the establishment of perverse incentives, where executives knew they could get away with fraud, knew that it would create massive (though fictional) profits, and knew that with modern executive compensation they would be wealthy within a couple of years; the firm might fail but the executives would walk away wealthy. Policy-makers and regulators completely ignored what had actually worked in the S&L crisis. And they ignored criminology.

Financial crises can be avoided... but not if we close our eyes to reality: The seminal work in this area is the 1993 article, Looting: The Economic Underworld of Bankruptcy for Profit, by George Akerlof and Paul Romer. The article is an in-depth analysis of the criminogenic pattern we have been discussing: a CEO figures out that he can loot the bank, the bank fails, the CEO walks away wealthy. The article concludes that regulators in the S&L crisis figured out the dynamic, and that such crises can be avoided: "Now we know better. If we learn the lessons, we need not have these crises." And what did we proceed to do? We substituted dogma about failed policies that actually produced the crises; we ignored entirely what we know works. Instead of stamping out liars loans when they came back, nothing effective was done.

It isn't the things you don't know that cause crises; it's the things you do know that are not true: The people making decisions believe in this theoclassical dogma, instead of in any real-world economics or real-world criminology; they know things that are not true. It isn't the things you don't know that cause crises; it's the things you do know that are not true.

Theoclassical dogma makes things easy for regulators: Theoclassical dogma leaves the regulator fat and happy; they know fraud cannot exist, they know bubbles cannot exist, and they know that markets are efficient. So there is no reason to regulate. Why should they listen to the amateur regulators in the field who are finding fraud? Regulators in the field don't have doctorates in economics.

The crisis was predictable; we were warned: In September of 2004, the FBI declared that they had discovered an "epidemic of mortgage fraud." They predicted, and warned, that it would cause a financial crisis. This was years before the crisis. Then, in early 2006, the fraud prevention department of the Mortgage Bankers Association (the trade association for the people making these loans), were warning: 1. that stated-income loans were an "open invitation to fraudsters", 2. that the incidence of fraud accompanying stated-income loans is over 90%, 3. that stated-income loans deserve the moniker for them adopted by the industry - "liars' loans", 4. that the industry seems to have forgotten that these loans existed previously and had caused hundreds of millions in losses, and 5. that the banking regulatory agencies are warning constantly not to make these loans.

On the failure of the Federal Reserve to act on warning after warning after warning: One agency did have the statutory authority to deal with the non-federally-insured lenders who were driving this crisis through their fraud; The Federal Reserve had the authority since 1994 - under the Home Ownership and Equity Protection Act. Alan Greenspan and then Ben Bernanke, despite the warnings from the FBI, despite warnings from the industry's own trade association, despite pleas from many organizations, refused to use that authority. By 2006 we were looking at over 2 million liars' loans. The bubble was hyper-inflated because of this surge of fraudulent lending - and because the Federal Reserve refused to act. The Fed did finally take action on July 14, 2008 - which was about a year after the loans had disappeared. So, after the horses had escaped, the barn had burned down, and the farm had been razed... then they then came out and put padlocks on the... ground. It was incredibly insane. Why does it occur? Because both Greenspan and Bernanke, when it comes to fraud, are in the grips of this theoclassical dogma that says government is the enemy and private sector is the solution.

When banks collude to inflate appraisals, fraud must be present. Where are the prosecutions?: One common practice leading up to the crisis was for banks to support efforts to inflate appraisals. Why would an honest lender ever inflate an appraisal? There is no reason an honest lender would ever inflate an appraisal; The appraisal is the great protection against loss. This is a superb marker of the presence of fraud. The then-Attorney General of New York, Anthony Cuomo, ran an investigation of Washington Mutual. WaMu maintained a blacklist of uncooperative appraisers - as in appraisers were put on the blacklist if they were honest and refused to inflate the appraisal. This is the type of thing a jury can understand in 10 to 15 seconds. Why are there no prosecutions? Why does Obama keep emphasizing that things were not necessarily illegal? Of course they are not always illegal. That doesn't mean that you don't prosecute where they were illegal. What is going on?

On the decline in prosecutions of financial institutions over the past 20 years: Financial institution prosecutions are down from peak by more than 1/2 over the past 20 years. The 2nd Bush administration had a terrible record. The Obama administration's record is slightly worse in terms of these prosecutions.

On the law-enforcement effort following the S&L crisis and the law-enforcement effort now: For prosecutors to achieve over 1000 elite convictions following the S&L crisis, at peak they had 1000 FBI agents investigating. The S&L crisis cost $150bn. This crisis is at least 70 tmes larger than the S&L crisis. The role of fraud is concomitantly as large. As recently as fiscal year 2007, we had a total of 120 FBI agents assigned to all cases of mortgage fraud in the USA. And they were investigating only tiny cases.

On the moral hazard we are creating: What happens when our most elite institutions engage in fraud, that fraud results in enormous wealth for CEO's and other senior executives , the institutions are bailed out, and no one is ever prosecuted? They learn an important lesson: Crime pays. Fraud is the primarily route to enormous wealth among financial institution executives at elite institutions. Not all banks and all bankers... but at our largest institutions, that is primarily how they prosper.

Banks aided and abetted the fraud at Enron, and the paper trail that has been ignored: Enron's insider frauds were only possible because the largest banks in the world eagerly aided and abetted those frauds. And there is a wonderful factual record, because of the bankruptcy investigation - that shows that the big banks knew that they were aiding frauds. Not a single one of the banks was prosecuted for that.

On our nonsensical approach to dealing with systemically dangerous institutions, and what it means for capitalism: One of the reasons that these institutions can defraud with impunity is, as the government has been telling us, that we have a number of institutions - approximately 20 - that are so large, they could bring down our entire economy; it's a question of "when", not "if". And yet, following the crisis, they have been made larger - by allowing massive acquisitions of institutions such as WaMu, Countrywide, and Merrill Lynch, by those already-systemically-dangerous institutions. They are a ticking time-bomb. Talk about destroying capitalism... This is the definition of crony capitalism. Finance is the leading contributor to both parties. They have immense political power. With the Citizens United decision, they are able to exploit that power. That dominance is even bigger in parts of Europe.

On fictional accounting: A number of our financial institutions are insolvent on any real economic basis. The Obama administration, with support from Ben Bernanke, and Congress, put a figurative gun to the head of the Financial Accounting Standards Board; they threatened to remove FASB's standard-setting authority if FASB did not change the accounting rules so that the banks would not have to recognize losses. FASB caved.

On farcical stress-tests: As for the faux-stress-tests that Geithner ginned up, all the big failures passed stress tests before they failed - they all passed with flying colors. Stress tests are always a farce. In this case, they were ordered to do stress tests in which they ignored losses. In Europe they were ordered to do stress tests in which they ignored the sovereign debt crisis... which, of course, is the crisis taking down Europe.

On how Americans and Europeans are being treated: They think we are children. They think they can lie to us and that they can be really clumsy in their lies - and we'll just think, "OK. We guess these banks are really healthy now. What brilliance!" They don't think we are bright enough to put it together. They think we have lost any capacity for outrage.

The government has chosen to risk everything: The government is working with banks to hide their losses, and is permitting them to remain systemically dangerous institutions. They have chosen a path which means that we are rolling the dice twenty times a day, to see when we are going to have the next crisis. They are insane.

Audio of the interview of Bill Black by Bonnie Faulkner:

Link to this interview at kpfa.org: http://www.kpfa.org/archive/id/78274

Video of The Warning:

Watch The Warning on PBS. See more from FRONTLINE.

Michael Lewis: How did no one notice that 24-year-olds who knew nothing were being paid $2 million?

2012-03-03T11:02:00.003-08:00

Janet Tavakoli: Financial Sector Executives Commit Fraud, Avoid Prosecution, and Make Future Crises Inevitable

2012-02-23T09:07:00.010-08:00

Janet Tavakoli discusses her new book, The New Robber Barons:

On how money is used to prevent enforcement of criminal law: When trillions of dollars are at stake, no one tells the truth and everyone plays for keeps. We have had sufficient legislation and regulation on the books, but our laws have not been enforced. Instead, bankers use their massive wealth to lobby Congress and to get off with a slap on the wrist. They have successfully prevented prosecution for widespread, massive fraud.

On the fraud committed in the C-Suites: At the top of these institutions, we had CEO's and CFO's who signed off on accounting statements that were false. In 2007, HSBC wrote down massive losses. Our banks did not. Under Sarbanes Oxley, they signed off on statements that they knew, or should have known, to be false.

On how CFO's and CEO's have used campaign contributions to place themselves above the law: They have bought off Congress through campaign contributions - in order to prevent investigations and prosecutions. We should be seeing multiple thousands of indictments - and not just people at the bottom, but also the people at the top who were in charge of our largest banks during the financial crisis.

On whether we have taken steps to prevent another financial crisis: We are vulnerable for a repeat. When fraud goes unpunished, the stage is set for ever greater financial failure. This is exacerbated by having printed money indiscriminately to try to bail people out of the previous failure.

Janet Tavakoli is President of Tavakoli Structured Finance. She has been a member of the CWF A-List since its inception.

Jim Bianco on Money Printing, Quantitative Easing, and Misguided Federal Reserve Policy

2012-02-21T06:11:00.000-08:00

On the definition of "money printing": Ben Bernanke's use of the term "money printing" is evolving. In the past, he used the term to refer to the Federal Reserve's ability to increase the Reserve Accounts of the banks. He is now attempting to change the definition to encompass only the actual coinage that the mint engages in.

On how the Federal Reserve creates money: Every bank in the country has a Reserve Account with the Fed. They are each required to keep a certain ratio of assets to reserves. The Fed has the ability to change the number for any given bank's Reserve Account. The idea is to either spur banking activity by increasing the reserve, or to restrict banking activity by decreasing the reserve.

On Quantitative Easing: Quantitative Easing consists of the Fed purchasing securities. They do so by increasing the number in the Reserve Account. If anyone other than the Fed did this, it would be considered fraud and counterfeiting. But when the Fed does it, it is sophisticated monetary policy.

On our Fractional Reserve Banking System: Dealers and banks sell their securities to the Fed, but the Fed does not have any money. They just change the Reserve Account number for that particular bank. When the Reserve Account value is increased, the banks are able to lend out more money and buy securities. That is a form of money creation.

On current Fed policy: Federal Reserve actions in the fall of 2008 and the spring of 2009 can be considered emergency measures. But step back and consider why we had a bursting of the housing bubble and such turmoil in financial markets; we had malinvestment and markets that were mispriced. These markets must return to equilibrium. But the Fed is trying to prevent equilibrium. Maybe housing prices are still too high, and maybe further deleveraging is necessary. The Fed is attempting to stop that from happening. Things cannot get better until we reach that equilibrium. The Fed is making it worse in the long run.

On what Fed policy means for the future: The Fed's all-out attempt to stop an equilibrium from being reached - from manipulating interest rates, to advising Congress on foreclosure policy aimed at preventing price adjustment - will just hold things up for a while. It is the equivalent of shooting a pain patient up with morphine; it does not treat the underlying issues - it just makes the patient feel better for a little while.

Link to video at The Daily Ticker

Link to Bianco Research, L.L.C.

Charles Hugh Smith on Why Honest People Turn to Corruption, Increasing Turmoil in Greece, and a Perplexing Decline in Energy Consumption

2012-02-20T07:41:00.000-08:00

On why basically honest people end up with a completely corrupt country: When the top level of a society and economy is corrupt, everyone below realizes that they must game the system to attempt to get ahead. Smith refers to this as "social fractals".

On the turmoil in Greece: When you deny democracy, when you put the social and political realm in the hands of bankers, you create a form of neo-feudal society. Of course the population will rebel.

On oil imports to Greece from Iran having been cut off: This is part of an unfolding tragedy in Greece.
The government is ceasing to function as an entity that can serve its people.

On what the fall in energy consumption is telling us: We are seeing unprecedented declines in energy consumption, yet we are hearing that our economy is expanding and unemployment is declining. Both cannot be simultaneously true.

Interview with Charles Hugh Smith begins at 12:20:

The Keiser Report can be found at http://maxkeiser.com/

Charles Hugh Smith's work can be found at http://www.oftwominds.com/

Bill Black: How Fraud Leads to Recurrent, Intensifying Financial Crises, and Steps We Must Take To Stop that Cycle

2012-02-10T17:06:00.000-08:00

The selected notes below do not encapsulate the entire conversation between Russ Roberts and Bill Black. The audio of the 73 minute conversation is provided below this text.

William K. Black's Regulatory Background: On April 2, 1985, William K. Black became the Litigation Director of the Federal Home Loan Bank Board - the primary federal regulator of Savings and Loan Associations. That agency subsequently became the Office of Thrift Supervision. Black ultimately had a docket of 10,000 cases and an outside-counsel budget of $100M. Soon after his appointment, there was a $6bn run on the largest S&L in the USA - American Savings. Bill Black was made staff leader of the emergency task force set up to handle that crisis. This led to his anti-fraud efforts.

Comparing the Fed's efforts at Lehman to how American Savings was handled: The SEC and the Fed sent staff into Lehman in its final months of distress. The Fed, knowing that Lehman was in desperate shape, sent 2 staff members. Black's team had sent 45 people to American Savings. Those 45 worked around the clock in shifts going through collateral. They made emergency lines of credit available on the basis of reasonable collateral. American Savings survived the run. Black's team used their leverage as a lender to force out Charlie Knapp.

The Fraud at American Savings and other S&L's: The major fraud was initially missed by the SEC and by investors. Ultimately, it was discovered that they were engaging in what the industry termed "cash for trash".

Illustration of "Cash for Trash": A borrower would come in to the bank seeking a $1m loan for a project such as a strip mall. The S&L would instead lend the borrower $80m on condition that $78m of that loan would be used to buy a project that the S&L had previously financed and which was not fiscally viable.
The borrower would keep $2m and would vastly overpay ($78m) for the failing investment. The lender would often have an "equity kicker", meaning that the lender would get 50% of the profit at the time of a successful sale. The result would be the transformation of a real economic loss into a fictional gain. "When these frauds are dealt lemons, they don't make lemonade; they make Dom Perignon."

On what made this possible: Back in the 80's, there were rules that stated: 1. You must underwrite (determine the risks of the loan and the required yield) a loan before you make it, 2. You must establish that the borrower has the apparent ability to repay the loan, and 3. You must document 1 and 2. Note that these rules just codify what any prudent lender would do as good business practice - as in "rules that libertarian economists could love". There were arguably zero economic costs - in that any prudent lender would be doing this anyway.

On what happens when underwriting is not done: In the mortgage context, not underwriting creates an intensely negative expected value. Not underwriting will result in acute adverse selection; it pulls in the worst possible borrowers, and results in underpriced debt.

On what the crime was: At the core of it, the borrower would have documented income that did not exist. However, it was overwhelmingly the lender that would be encouraging, and in many cases preparing, the false documentation. This was true during the S&L crisis, and is also the case now.

On why it was done: As George Akelof and Paul Romer stated in Looting: The Economic Underworld of Bankruptcy for Profit, "Accounting control fraud is a sure thing." At the time people were doing this, no one was going to jail.

On moral hazard and market discipline: In economic theory it is supposed to be the subordinated debt-holders who enforce market discipline. They have the right incentives and are sophisticated actors. There were zero cases of effective private market discipline by either shareholders or subordinated debt holders in the S&L Crisis. More recently, the creditors in Enron, Bear Stearns, Lehman, Merrill Lynch were all private creditors. In theory they are supposed to provide discipline. But they do not.

On bailing out mismanaged banks: The treatment of Systemically Dangerous Institutions that allows them to hold the economy hostage and produce bailouts is completely destructive to any theory of how an economic system should run.

On how Dick Pratt's deregulation exacerbated the problem: By mid-1982 the S&L industry, in the wake of Paul Volcker's interest rate hikes, was insolvent. Dick Pratt, the conservative head of the Federal Home Loan Bank Board, created the key deregulatory bill - the Garn–St. Germain Depository Institutions Act of 1982. Pratt asked economists at the agency which state had the best results. Texas was where S&L's were showing the best returns. He used Texas as the model for deregulation. The problem was that the Texas S&L's were market leaders and innovators - in fraud. Pratt's deregulation was the key fraud-friendly event. (This is the fundamental problem with relying on econometrics during the expansion phase of an epidemic of accounting control fraud.)

On the progression of fraud from then to now: Liars loans became significant in 1990-1991. It began in large part at Long Beach Savings. Black was part of the regional regulator at that point. They determined that Long Beach Savings was not going to be doing requisite underwriting, would be creating immense adverse selection, and were setting themselves up to lose money doing it. It only made sense as a fraud scheme. Black and his team wiped out liars loans in Orange County using normal supervisory means in the region. Long Beach Savings then gave up their federal charter and federal deposit insurance and became a mortgage banker for the sole purpose of escaping Black's jurisdiction. They changed their name to Ameriquest. It was the first big and infamous producer of liars loans and other nonprime loans, and was also a predatory lender. Ameriquest ultimately was sued by 48 state attorney generals and the FTC. They settled for $400m. Bush then appointed the CEO of Ameriquest to be the Ambassador to the Netherlands.

On how liars loans became prominent: Lenders would send out "term sheets" to brokers with the following optimization: 1. Higher yield => bigger fee for the broker, 2. Lower loan to value ratio => higher fee for the broker, 3. Lower debt to income ratio => bigger fee for the broker. In California you could get a $20,000 fee for doing a single jumbo loan. They incentivized brokers to bring in "optimized" loans in as high a volume as possible. Because they were "no doc" or "liars' loans", the brokers were able to gimmick the paperwork to make it fit those parameters.

The Fraud Recipe for lenders: 1. Grow like crazy by making crappy loans at a premium yield, 2. With extreme leverage, and 3. With virtually no meaningful allowances for losses. But the mortgage market is a mature market with many competitors. In order to grow like crazy - the average growth was 50% per year - they must open up the field to borrowers who cannot afford homes.

On what can be achieved by following the Lender Recipe for Fraud: If you follow the above recipe for fraud, you create three things: 1. You are mathematically guaranteed to report record profits, 2. With modern executive compensation, you will beceome wealthy, and 3. You will maximize real economic losses.

On the fraud recipe for a purchaser of debt: 1. Grow like crazy by purchasing crappy loans at a premium yield, 2. With extreme leverage, and 3. With virtually no meaningful allowances for losses.

On how long it can last: The fraud can go on for 8 to 10 years if these things cluster and we hyperinflate the bubble. The saying in the industry is, "A rolling loan gathers no loss." Bad loans can be refinanced and delinquencies can be hidden for a decade.

On the regulatory change that enabled liars loans: In 1993, under Clinton, they got rid of the Underwriting Rule. It was changed from a Rule to a Guideline - which is unenforceable. That made the liars loan the perfect vehicle for fraud.

On the enforcement effort following the S&L Crisis vs. our current enforcement effort: Ultimately, Black's team developed an extremely effective means to deal with the frauds. Their agency alone made well over 10,000 criminal referrals - which resulted in over 1,000 convictions. The same agency made ZERO criminal referrals after our more recent crisis.

On what we have done by ignoring fraud and bailing out Systemically Dangerous Institutions: We have made the world much more criminogenic. Why do we have recurrent, intensifying financial crises, brought on by these kinds of frauds? They are unintended consequences of deregulation and modern executive compensation.We have created perverse incentives.

On what we must do to stop the recurrent, intensifying financial crises: First, we must diminish the size of Systemically Dangerous Institutions. The current administration calls them systemically important institutions - as if they deserve a gold star. But they are inefficient and dangerous. We would make the world more efficient and dramatically safer if we shrunk them to the size where they posed no systemic risk of global collapse. As long as they are this big, they are going to get away with murder. And worse, they will create a Gresham's Dynamic (see George Akerlof's The Market for Lemons): where cheaters prosper, bad ethics can drive good ethics out of the marketplace.

Second, we must restore the criminal referral process which has been essentially eliminated in the regulatory agencies.

Third, we must stop any settlement in which the Justice Department will give immunity from criminal prosecution for fraud in the process of making loans. It is in the process of making loans in which the fraud overwhelmingly takes place.

Fourth, we must reinstate the Underwriting Rule. Guidelines are a useless regulatory activity. Anyone that needs the rules will ignore guidelines.

On the appropriate role of financial regulators: The fundamental task of financial regulators is to make private market discipline more effective - by removing cheaters who create perverse incentives.

On the role of government leading to the crisis: Lenders made bad loans because they made individuals in their industry much wealthier. No one told those companies to issue liars loans. Even the Bush Administration, which was not fond of regulation, consistently disparaged those kinds of loans. No one ever required that Fannie and Freddie purchase a liar's loan. Private entities created the incentive structures to grow their businesses as quickly as possible.

On the five-letter F-word: This is a story driven overwhelmingly by accounting control fraud in private industry - just as in the Enron era and during the S & L Crisis. But fraud is now almost never discussed. Fraud is the tribal taboo that still exists in economics.

Audio of Russ Roberts' interview of William K. Black:

Link to original post at EconTalk: http://www.econtalk.org/archives/2012/02/william_black_o.html

Summary by Jaime Levine

Bill Black: On Why White Collar Crime is on the Rise, How to "Hotspot" Elite Financial Crimes, and Why Republicans and Democrats are Not Interested

2012-02-08T22:36:00.000-08:00

On why we have high and rising levels of white collar crime: Bush and Obama both cut prosecutions of white collar criminals. It has been a unilateral disarmament.

On why Republicans and Democrats are not pursuing elite white collar crime: It would hurt campaign contributions. Finance is the leading source of campaign contributions for both parties.

On how to "hotspot" white collar crime: Going after issuers of "liars' loans" would have been the obvious way to go. You always have insufficient resources so you always look for choke-points. There are only 3 credit rating agencies, for example. If you investigated even one of them for the frauds they were committing - giving AAA ratings to liars' loans - you would have shut down the entire secondary market and the fraudulent loans. There are also only 5 investment banks. If you had gone after one of them... Lehman Brothers, for example. Or Aurora - where they fired the fraud guy because he made a criminal referral. With very few resources you could have prevented the entire crisis.

On how hotspotting would have stopped the fraud: Hotspotting puts a shot across the bow of the rest of the industry. You have to have the regulatory cops on the beat... and they took the cops off the beat.

Bill Black on Financial Fraud Investigations

2012-02-07T06:35:00.000-08:00

Theresa Riley of BillMoyers.com checked in with banking fraud expert Bill Black for his take on the ongoing investigation into the U.S. financial crisis. February 6 was the deadline for the multistate foreclosure settlement between state attorneys general and the major banks. If the purported $25 billion deal goes through, it will provide some relief to those who have experienced foreclosure (or are in danger of it) and require banks to overhaul their foreclosure practices.

Theresa Riley: Last week there were many rumors about the types of fraud that will be covered in the multistate foreclosure settlement. Initially there were reports that it would be limited to robo-signing abuses — and then there were reports to the contrary. What is expected to be included in the settlement?

Photo by Robin Holland

William Black: The newest (pro-release) rumors are that the current draft of the settlement includes some releases for mortgage origination fraud and secondary market fraud, but that those releases are limited. We are not told how limited.

Riley: If the deal goes through as reported, what could this mean for future criminal investigations and reforms?

Black: The leaks about the proposed deal occurred in conjunction with President Obama’s State of the Union Address and a series of press releases and conferences by Attorney General Holder about a newly created “working group.” That working group is intended to investigate secondary market fraud. There is no comprehensive investigation of the over $1 trillion in mortgage origination fraud. There are no prosecutions of any of the elite bank officers who led, and became wealthy from, the epidemic of mortgage origination fraud. The State AGs do not have the resources to investigate even two of the largest fraudulent lenders.

The major development this past week is that New York Attorney General Schneiderman filed suit, alleging that the Mortgage Electronic Registration System (MERS) is aiding foreclosure fraud and ruining America’s public recordation system for real estate, which conservative economists praised as one of the key reasons America became so prosperous. MERS is enormous and it is fundamentally flawed and dangerous, so this could be a tremendously useful action.

Riley: Speaking of Schneiderman, what’s your view of President Obama’s SOTU announcement of a new Financial Crimes Unit (the Residential Mortgage-Backed Securities (RMBS) Working Group) co-chaired by him?

Black: If Schneiderman had been named Attorney General of the United States, we would know that the administration really intended to hold accountable the frauds that drove the crisis. Instead, the top two Justice Department officials that are supposed to be prosecuting the elite frauds have consistently failed to even investigate the frauds, have denied the existence of material fraud, and came from the same law firm that represented many of the big, fraudulent banks and was critical to the creation of the notorious Mortgage Electronic Registration System (MERS) that contributed to the foreclosure fraud.

AG Schneiderman was appointed to the working group because he has broad credibility as a real prosecutor. His refusal to support the earlier drafts of the robo-signing deal (which was so bad that I described it as the formal surrender of the U.S. to crony capitalism) led the State AGs to kick him out of the settlement discussions.

Schneiderman is only one of the co-chairs of the new working group. The others are federal prosecutors or officials who were the strongest proponents of the cynical deal that would have de facto immunized the elite criminals from civil and even criminal sanctions. The working group is set up so that Schneiderman can give the group credibility while being marginalized. He can be outvoted in any matter in which he proposes vigorous prosecutions.

Riley: It sounds like you don’t think this new working group is going to get the job done. Last week, Schneiderman said that he thinks he has the resources (particularly the IRS and the Consumer Protection Unit) and the political will to pursue the investigation in a meaningful way. Why do you disagree?

Black: First, the “investigation” will not investigate what was by far the largest and most destructive fraud — control frauds — the origination of millions of fraudulent loans. Second, the working group’s resources to investigate secondary market fraud are ludicrously inadequate.

Let me provide specifics on scale.

The total staffing of the working group (once completed in several months) is 55. At peak, there were roughly 1000 investigators (and hundreds of prosecutors) assigned to the S&L prosecutions 20 years ago. The current crisis caused losses far exceeding the S&L debacle and involves frauds that are massively greater than the frauds that drove the S&L debacle.

But the issue of resources is not where the discussion needs to begin. The keys are information, expertise, understanding of control fraud, and prioritization of investigations and prosecutions. Absent criminal referrals from the financial regulators and whistleblowers, absent dozens of banking regulators being “detailed” to serve with the FBI as their internal experts, absent training of the investigators and prosecutors on how to detect and prosecute control frauds (the Justice Department uses the mortgage lending industry’s “definition” of mortgage fraud — and, surprise, it defines the lenders and their CEOs who made millions of fraudulent liar’s loans as the good guys/victims of mortgage fraud rather than the perpetrators), and absent the immediate reversal of the current system of making smaller mortgage frauds our top criminal justice priority — absent all of these things there can be episodic prosecutorial successes, but continued systemic failure is certain.

We will know that there is a real commitment to prosecuting the elite frauds when the Justice Department takes these essential, foundational steps — and the Department quadruples the number of FBI agents assigned to investigate mortgage fraud.

Riley: What would you like to see happen?

Black: We have descended too fully into the cesspool of crony capitalism when our most elite banks can commit what SEC investigations find to be fraud and still claim in filings to the SEC that they have “a strong record of compliance with securities laws” — and the SEC buys such a preposterous claim hook, line, sinker, rod, reel, and the canoe they paddled into the swamp.

Where are the “soft on crime” conservatives when you need them? This is the perfect story for Republicans to use in attacking President Obama’s policies. Why are they so silent?

I want the elite criminals who ran the control frauds to be prosecuted and imprisoned if found guilty. Under President Bush, the Justice Department’s prosecution of financial frauds was pathetic. Even though financial fraud reached unprecedented levels, the Bush administration prosecuted fewer than one-half as many financial frauds as during the S&L debacle. The bad news is that the Obama administration has proven even more disgraceful failures in holding elite criminals accountable than did the Bush administration. The Obama administration has convicted a few bankers from non-elite banks and it may eventually convict a token elite banker, but it will continue to fail systemically to hold elite bankers accountable for their frauds.

Link to original post: http://billmoyers.com/2012/02/06/bill-black-on-financial-fraud-investigations/

Barry Ritholtz: Time for a Modern-Day Pecora Commission

2012-02-05T19:49:00.000-08:00

Barry Ritholtz
January 28 2012

~~~

What shall we make of this surprise pronouncement in President Obama’s State of the Union address? A belated investigation has been launched into the role of fraud in the financial crisis.

This much is clear: Despite rampant illegalities, bank fraud and countless cases of perjury, the response to date — at the federal level and from most, but not all, states — has been underwhelming, cowardly even. A few principled holdouts — the attorneys general of Delaware, New York, Nevada and California — refuse to rubber-stamp a pre-investigation settlement with banks, but that’s all. Despite chances to bring crooks to justice, there has been little action.

So, here we are, four years after the great financial collapse, three years after the recovery began and in the last year of Obama’s term — and the president has finally decided to investigate the role of fraud in the great global financial crisis. Hence, this new task force — the unit of Mortgage Origination and Securitization Abuses — begins behind the curve. The statute of limitations is, in many cases, close to elapsing.

Even so, do not dismiss the investigation out of hand because of the timing:
History informs us that a serious investigation can begin four years after the fact. Recall that Ferdinand Pecora was the fourth chief counsel for the Senate committee that investigated the Wall Street crash of 1929 and subsequent Depression. He was appointed in 1932 and received broad investigatory powers in 1933. His report ran thousands of pages. Thanks in large part to Pecora’s findings, Congress passed the Glass-Steagall Banking Act, which separated commercial and investment banking; the Securities Act of 1933, which established penalties for filing false information about stock offerings; and the Securities Exchange Act, which created the Securities and Exchange Commission to regulate the stock exchanges. Nearly 50 years of financial stability followed.

The personality in charge can make all the difference. In an encouraging sign, Obama appointed to the task force New York Attorney General Eric Schneiderman, one of the few attorneys general not railroaded into a premature settlement with banks of the robo-signing-foreclosure scandal.

Critics have derided the task force as little more than election maneuvering. The politics are obvious: Both Occupy Wall Street and the tea party were very unhappy with the bank bailouts; they seem even less happy with the lack of prosecution.

It’s fair to ask: Is this new task force a meaningless exercise?

It is too soon to tell, of course. Like good poker players, we can look for “tells” that signal whether this will be a farce or a serious player. We’ll find clues in the structural setup of the office as well as the areas it investigates.

In the setup of the office, four aspects are crucial:

• Does the office have subpoena power (as the New York attorney general’s office has through the Martin Act)?

• Are there going to be public hearings (preferably in the Senate)?

• Will the commission have a significant budget?

• Will it be a forum for whistleblowers and crowdsourcing?

Without such powers, the office would be a farce, helping to shield banks from the fallout of their wrongdoings.

What the office investigates will also reveal how serious this is. Both pre- and post-crisis topics should be investigated, including:

• MERS: Mortgage Electronic Registration Systems was created by banks without any authority or enabling legislation. It allowed the rapid transfer of mortgages, avoiding state and county filing fees amounting to billions of dollars. Without MERS, it’s hard to imagine that the massive volume of mortgage securitizations could have occurred. How were lenders able to circumvent mortgage filings with town and county registrars? Did they engage in illegalities? How many billions of dollars do they owe in fees for transferred notes? And what percentage of MERS assignments were fraudulent, made for entities that did not exist?

• Origination fraud: Why did lenders accept “stated income” loans? Why did they abandon traditional standards? Michael White, a Countrywide subprime unit employee, called this “origination fraud,” observing, “Eliminate the verification of income for a mortgage borrower, and you eliminate your ability to predict the likelihood of repayment or default.”

• RMBS: Wall Street’s securitized mortgage pools (residential mortgage-backed securities) contained a broad variety of flaws, some so egregious that they amounted to fraud. In plain English, we’re talking about bad paperwork and misrepresented pools of mortgages to borrowers whose debts were significantly understated and whose median incomes and credit scores were significantly overstated.

• Insurance fraud: Look at a bank tactic in which legitimate home insurance is canceled and new insurance provided at a substantially higher fee through a subsidiary or affiliate of the bank mortgage holder. This extra expense in some cases led to foreclosures.

• “Pyramid” servicing fees: An illegal practice in which current payments are applied to past late fees, generating more late fees and additional interest owed and creating a delinquency where none existed. This tactic also led to foreclosures that were probably unlawful.

• Lost mortgage notes: How is it possible that the most important part of the mortgage contract — the promissory note — was consistently lost or misplaced by banks? It is unfathomable to anyone who has ever handled documents. At best, it’s gross incompetence. At worst, it’s willful document destruction during litigation.

•Document fraud for sale: There were many examples of alleged document fraud, but the one crying out for investigation involves Lender Processing Services’ DOCX subsidiary. The firm seems to have been selling fabricated documents for a fee to lawyers and banks. Indeed, Lender Processing Services, which processes nearly half of all U.S. foreclosures, could require a separate investigation.

•False affidavits, perjury (robo-signing): We do not know who ordered the robo-signing of foreclosure documents, the false notarizations, fraudulent written statements to courts and perjury. This should be easy to investigate, like flipping a nickel-bag dealer to get to the drug kingpin. Astoundingly, this easy-to-investigate felony (via notarized perjurious statements submitted to foreclosure courts) has yet to be prosecuted.

• Foreclosure mills, process servers: Law firms engaged in rampant fraud that corrupted the foreclosure process. If found guilty, those folks should be disbarred and jailed. Same for the “sewer service” process servers who threw away legally required notices to delinquent homeowners.

• Soldiers and Sailors Relief Act: Federal law protects active-duty service members from foreclosure and eviction. I find violation of this law reprehensible. If it were up to me, I would let the Special Forces — Navy Seals and Army Green Berets — handle this as they see fit.

Even with criminal statutes of limitations elapsing, we can achieve some measure of justice against the crisis wrongdoers. Lawyers can be disbarred and corporate insiders banned from serving in publicly held firms again. CEOs and CFOs can be fired. A significant investigation, with subpoena powers, a real budget and public hearings would go a long way toward restoring public confidence.

Schneiderman has an opportunity to create a legacy for himself that lasts far beyond the next election cycle. If he lacks the tools to do so, he should demand them or resign in protest.

~~~

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture.

Link to original post at The Big Picture