Still Banking on Fraud

A truly amazing thing has happened in banking. After the worst financial crisis in 75 years sparked the “Great Recession,” we have

• Failed to identify the real causes of the crisis
• Failed to fix the defects that caused the crisis
• Failed to hold the CEOs, professionals, and anti-regulators who caused the crisis accountable—even when they committed fraud
• Bailed out the largest and worst financial firms with massive public funds
• Covered up banking losses and failures—impairing any economic recovery
• Degraded our integrity and made the banking system even more encouraging of fraud
• Refused to follow policies that have proved extremely successful in past crises
• Made the systemically dangerous megabanks even more dangerous
• Made our financial system even more parasitic, harming the real economy

And pronounced this travesty a brilliant success.

The Bush and Obama administrations have made an already critically flawed financial system even worse. The result is that the banking industry’s future is bad for banking, terrible for the real economy, horrific for the public—and wonderful for the top executives at the largest banks. This is significantly insane, especially given that over the past 30 years, the savings-and-loan fiasco and other crises provided ample opportunity to learn about those flaws. It appears that we will need to suffer another depression before we are willing to put aside the crippling dogmas that have so degraded the financial system, the real economy, democracy, and the ethical standards of private and public elites.

The Economics Blindfold

Why did most of the experts neither foresee nor understand the forces in the U.S. banking industry that caused this meltdown? The short answer is: their dogmatic belief in neoclassical economic theory that is impervious to the facts, or what I like to call “theoclassical” economics.

Theoclassical economics is premised on the asserted effectiveness of private market discipline. This (oxymoronic) discipline is the basis for the “efficient markets” and “efficient contracts” hypotheses that are the pillars of faith supporting modern finance theory and much of neoclassical microeconomics. Collectively, these hypotheses lead to absolute faith that markets exclude fraud. “A rule against fraud is not an essential or even necessarily an important ingredient of securities markets,” wrote eminent corporate law scholars Frank Easterbrook and Daniel Fischel in their 1991 The Economic Structure of Corporate Law, in a typical statement of that faith.

How are markets supposed to exclude fraud? Easterbrook and Fischel offer two reasons. The first, a circular argument, lies in theoclassical economists’ core belief that markets are by nature efficient. Markets that allow frauds cannot be efficient. Therefore, markets must exclude fraud.

The other argument rests on “signaling” theory. The logical premise is that honest firms have a financial incentive to signal to investors and creditors that they are honest. The false premise is that honest firms have the unique ability to signal that they are honest. Easterbrook and Fischel claim that there are three signals of honesty that only honest firms can transmit: hiring a top-tier audit firm, having the CEO own substantial stock in the firm, and operating with extreme leverage, i.e., a high ratio of debt to capital.

The reality, which Fischel knew before he co-authored the treatise, was that firms engaging in so-called control fraud can mimic each of these signals. Control fraud occurs when the executives at a seemingly legitimate firm use their control to loot the firm and its shareholders and creditors. In banking, accounting is the weapon of choice for looting. Accounting control frauds have shown the consistent ability to get “clean” accounting opinions from top tier audit firms; their CEOs use their stock ownership to loot the firm; and they love to borrow extensively, as that allows them to loot the firm’s creditors.

In fact, the claim that markets inherently exclude fraud runs contrary to all of our experience with securities markets. The role of epidemics of accounting control frauds in driving recent financial crises is well documented. The national commission that investigated the causes of the savings-and-loan debacle found that at the “typical large failure,” “fraud was invariably present.” Similarly, the Enron and WorldCom scandals were shown to be accounting control frauds.

Theoclassical economists, however, refused to acknowledge these frauds because recognizing the existence of control fraud would challenge the assumptions underlying their faith-based economic theories. This economic dogma was so dominant that it drove regulatory policy in the United States, Europe, and Japan during the last three decades. Regulations ignored control fraud and assumed that paper profits produced by fraud were real. The result, from the mid-1990s on, was regulatory complacency endorsed by economists who actually praised the worst of the emerging control frauds because of their high reported profits.

So it is no surprise that the recent U.S. banking crisis was driven by an epidemic of lending fraud, primarily mortgage lenders making millions of “liar’s loans” annually. According to Credit Suisse, for instance, 49% of all mortgage originations in 2006 were stated-income loans, meaning loans based on applicants’ self-reported incomes with no verification. MARI, the Mortgage Bankers Association experts on fraud, warned in 2006 that these loans caused endemic fraud:

Stated income and reduced documentation loans … are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.

One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.”

Why would scores of lenders specialize in making liar’s loans after being warned by their own experts and even by the FBI that such loans led to endemic fraud? (Not that they needed any warnings. Bankers have known for centuries that underwriting is essential to survival in mortgage lending. Even the label “liar’s loan,” widely used in the industry, shows that bankers knew such loans were commonly fraudulent.) How could these fraudulent loans be sold to purportedly the most sophisticated underwriters in the history of the world at grossly inflated values blessed by the world’s top audit firms? How could hundreds of thousands of fraudulent loans be pooled into securities, the now-infamous collateralized debt obligations (CDOs), and receive “AAA” ratings from the top rating agencies? How could markets that are supposed to exclude all fraud instead accommodate millions of fraudulent loans that hyper-inflated the largest financial bubble in history and triggered the Great Recession?

The answer is the financial system is riddled with incentives so perverse that it is criminogenic—it creates fraud epidemics instead of preventing fraud. When compensation levels for banking executives and professionals are very large and based substantially on reported short-term income, financial firms become superb vehicles for control fraud. Add in deregulation and desupervision, and the result is an environment ripe for a fraud epidemic.

Accounting is the weapon of choice for financial sector control frauds. The recipe for a lender to maximize (fictional) reported accounting income has four ingredients:

• Extremely rapid growth
• Lending regardless of borrower creditworthiness, at premium yields
• Extreme leverage
• Minimal loss reserves

The first two ingredients are related. A U.S. housing lender operates in a mature, reasonably competitive industry. A mortgage lender cannot grow extremely rapidly by making high-quality mortgages. If it tried to do so, it would have to cut its yield substantially in order to gain market share. Its competitors would respond by cutting their yields and the result would be modest growth and a serious loss of yield, reducing reported profits. Any lender, however, can guarantee extremely rapid growth and charge borrowers a premium yield simply by making loans to borrowers who most likely cannot repay them. Worse, hundreds of lenders can follow this same recipe because there are tens of millions of potential homebuyers in the United States who would not be able to repay their loans. Indeed, when hundreds of firms follow the same recipe, they hyper-inflate the resultant financial bubble, which in turn allows borrowers to refinance their loans and thereby delay their defaults for years.

Economists George Akerlof and Paul Romer explained in 1993 that accounting fraud is a “sure thing” and explained why it caused bubbles to hyper-inflate, then burst. Note that the same recipe that produces record fictional income in the short-term eventually produces catastrophic real losses. The lender will fail (unless it is bailed out or able to sell to the “greater fool”), but with their compensation largely based on reported income, the senior officers can walk away wealthy. This paradox—the CEO prospers by causing the firm’s collapse—explains Akerlof and Romer’s title, Looting: The Economic Underworld of Bankruptcy for Profit.

Senior executives can also use their ability to hire, promote, compensate, and fire to suborn employees, officers, and outside professionals. As Franklin Raines, chairman and CEO of Fannie Mae, explained to BusinessWeek in 2003:

Investment banking is a business that’s so denominated in dollars that the temptations are great, so you have to have very strong rules. My experience is where there is a one-to-one relation between if I do X, money will hit my pocket, you tend to see people doing X a lot. You’ve got to be very careful about that. Don’t just say: “If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming.

You wave enough money in front of people, and good people will do bad things.

Raines knew what he was talking about: he installed a compensation system at Fannie Mae that produced precisely these perverse incentives among his staff and made him wealthy by taking actions that harmed Fannie Mae.

In an earlier work, Akerlof had explained how firms that gained a competitive advantage through fraud could cause a “Gresham’s” dynamic in which bad ethics drove good ethics from the marketplace. The national commission that investigated the savings and loan debacle documented this criminogenic dynamic: “[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of “Gresham’s Law” in which the bad professionals forced out the good.” The same dynamic was documented by N.Y. Attorney General Andrew Cuomo’s 2007 investigation of appraisal fraud, which found that Washington Mutual blacklisted appraisers who refused to inflate appraisals. An honest secured lender would never inflate, or permit the inflation of, appraisals.

Failure to Respond

The U.S. government’s response to the meltdown has been not merely inadequate, but actually perverse. The Bush and Obama administrations’ banking regulators have left frauds in charge of failed banks and covered up the banks’ losses, allowed the behemoths of the industry to become even larger and more dangerous, and passed a “reform” law that fails to mandate the most critical reforms.

In March 2009, Congress, with the explicit encouragement of Federal Reserve Board Chairman Bernanke and the implicit acceptance of the Obama administration, successfully extorted the Financial Accounting Standards Board on behalf of the banking industry to force it to change the banking rules so that banks did not have to recognize losses on their bad assets until they sold them. Normal accounting rules sensibly require banks to recognize losses on bad loans when the problems with the loans are not “temporary.” The losses at issue in the recent crisis were caused by system-wide fraud and the collapse of the largest financial bubble in world history. They were not temporary—moreover, they were (and are) massive. If banks had recognized these losses as they were required to do under pre-existing accounting rules, many of them would have had to report that they were unprofitable, badly undercapitalized, or even insolvent.

Gimmicking the accounting rules so bankers could lie about their asset values has caused the usual severe problems. First, it allows CEOs to pretend that unprofitable banks are profitable and so continue to pay themselves massive bonuses. This is not only unfair; it contributes to a broadly criminogenic environment. Second, it leads banks to hold onto bad home loans and other assets at grossly inflated prices, preventing markets from clearing and prolonging the recession. This is the Japanese scenario that led to the country’s “lost decade” (now extended). Third, it makes it harder for regulators to supervise vigorously, should they try to do so, because many regulatory powers are triggered only when losses occur with the resulting failure to meet capital requirements. Indeed, the assault on honest accounting was launched with the express purpose of evading the Prompt Corrective Action law, passed in 1991 on the basis of bitter experience: when savings-and-loan CEOs who had looted “their” institutions were allowed to remain in control of them by using fraudulent accounting, the losses and the fallout of the S&L crisis kept growing. Fourth, it embraces dishonesty as an official policy. Indeed, it implies that the solution to the accounting fraud that massively inflated asset valuations is to change the accounting rules to encourage the massive inflation of those same asset values. Effective regulation is impossible without regulatory integrity; lying about asset values destroys integrity.

Even in the case of the roughly 20 massive U.S. financial institutions considered “too big to fail,” the public policy response has been perverse. The terminology itself demonstrates how economists err in their analysis—and how much they identify with the CEOs who helped cause the Great Recession. They refer to the largest banks as “systemically important institutions,” as if these banks deserved gold stars. By the prevailing logic, however, the massive banks are the opposite: ticking time bombs that can take down the global financial system if they fail. So “systemically dangerous institutions,” or SDIs, would be more apt.

It should be a top public policy priority to end the ability of any single bank to pose a global systemic risk. That means that the SDIs should be forbidden to grow, required to shrink over a five-year period to a size at which they no longer pose a systemic risk, and intensively supervised until they shrink to that size. These reforms are vital for all banks but particularly urgent for the SDIs, with their potential to cause massive damage.

Instead, the opposite has been done. Both administrations have responded to the financial crisis by allowing (indeed, encouraging) SDIs, even insolvent ones, to acquire other failed financial firms and become even larger and more systemically dangerous to the global economy. The SDIs’ already perverse incentives were made worse by giving them a bailout plus the accounting cover-up of their losses on terms that made the U.S. Treasury and the Federal Reserve the “fools” in the market.

With small- and medium-size banks likely to continue to fail in high numbers due to residential and commercial real estate losses, the financial crisis has increased the long-term trend toward extreme concentration in the financial industry. The SDIs will pursue diverse business strategies. Some will continue their current strategy of borrowing short-term at extremely low interest rates and reinvesting the proceeds primarily in government bonds. They will earn material, not exceptional, profits but will do little to help the real economy recover. Others will invest in whatever asset category offers the best (often fictional) accounting income. They will drive the next U.S.-based crisis.

What about the long-awaited bank reform law, which Congress finally delivered in July 2010 in the form of the Dodd-Frank Act? The law does not address the fundamental factors that have caused recurrent, intensifying financial crises: fraud, accounting, executive and professional compensation, and regulatory failure. The law does create a regulatory council that is supposed to identify systemic risks. The council, however, will be dominated by economists of the same theoclassical stripe who not only failed to identify the systemic risks that produced the recent financial crises, but actually praised the criminogenic incentives that caused those crises.

The chief international reform, the Basel III accord, shares the fundamental deficiency of the Dodd-Frank Act. Dominated as they were by theoclassical economists, the Basel negotiations not surprisingly produced an agreement that ignores the underlying causes of the crisis. Instead, it focuses on one symptom of the crisis—extreme leverage, the third ingredient of the recipe for optimizing accounting control fraud. The remedy was to restore capital requirements to roughly the levels required under Basel I (Basel II eviscerated European banks’ capital requirements). Fortunately, the United States did not fully implement the Basel II capital reserve reductions, which means that the leverage of non-fraudulent U.S. banks has been significantly lower than their European counterparts. However, capital requirements only have meaning under honest accounting. Once one takes into account the fictional “capital” produced by fraudulent lending—along with the revised accounting rules that are helping banks hide their losses—the irrelevance of the proposed Basel III capital requirements becomes clear. (For more on the Dodd-Frank Act as well as Basel III, see “Underwater” in the November/December 2010 issue of D&S.)

If the Dodd-Frank Act of 2010 and the Basel III proposals are the limits of our response to the crisis, then the most probable outcome in the near- and medium-term is the Japanese scenario—a weak, delayed, and transitory recovery followed by periodic recessions. Banks will remain weak and a poor provider of capital for economic expansion.

With private market “discipline” having become criminogenic, the only hope for preventing the current crisis was vigorous regulation and supervision. Effective supervision is possible. For instance, in 1990-91, savings-and-loan regulators used their hard-won understanding of accounting control fraud to stop a developing pattern of fraud in California involving S&Ls making stated-income loans. Unfor-tunately, at the federal level the dogmatic belief that markets automatically prevent fraud led to complacency and the appointment of anti- regulators chosen for their willingness to praise and serve their banking “customers.” (The “reinventing government” initiative championed by former Vice President Al Gore and by George W. Bush when he was Texas’ governor indeed instructed banking regulators to refer to bankers as their “customers.”) President Obama has generally left in office, reappointed, or promoted the heads (or their “acting” successors) of the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Federal Reserve, the Federal Reserve Bank of New York, and the Federal Housing Finance Agency. Several of these leaders did not simply fail as federal regulators; they actually made things worse by aggressively preempting state regulatory efforts against fraudulent and predatory mortgage lenders.

None of the reforms to date addresses the fundamental criminogenic incentive structures that have produced recurrent, intensifying financial crises. True, liar’s loans have been largely eliminated, and in 2008 the Federal Reserve finally used its regulatory authority under the Home Ownership and Equity Protection Act of 1994 to regulate mortgage bankers (after most of the worst ones had failed), but none of this came soon enough to contain the current crisis and none of it will prevent the next one. The accounting control frauds merely need to switch to a different asset category for a time.

William K. Black is executive director of the Institute for Fraud Prevention and teaches economics and law at the University of Missouri at Kansas City. He is former senior fenderal financial regulator, and is author of The Best Way to Rob a Bank Is to Own One (Univ. of Texas Press, 2005), which focuses on control fraud in the savings-and-loan crisis.

Sources: George A. Akerlof, 1970, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 84(3):488–500; George A. Akerlof and Paul G. Romer, 1993, “Looting: The Economic Underworld of Bankruptcy for Profit,” in W. Brainard and G. Perry, eds., Brookings Papers on Economic Activity 2:1-73; William K. Black, 2003, “Reexamining the Law-and-Economics Theory of Corporate Governance,” Challenge 46(2):22-40; William K. Black, 2005, The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, Austin: University of Texas Press; Frank Easterbrook and Daniel Fischel, 1991, The Economic Structure of Corporate Law, Cambridge, Mass.: Harvard University Press; National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE), 1993, Origins and Causes of the S&L Debacle: A Blueprint for Reform. Washington, D.C.: Government Printing Office.