Bill Black: US Promotes Flawed Economic Dogma that Encourages Fraud and Needlessly Perpetuates a Pattern of Recurring and Intensifying Financial Crises
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:
Watch The Warning on PBS. See more from FRONTLINE
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.