Surreal Fiddling While Rome Burns

The essays and responsive commentary to date reflect the imperturbable quality of economists and neoclassical economics. The economic world could be burning — in contradiction to their theories and as a result of the policies they had designed — and economists would compete to serve as Concertmaster.

One might think that economists might reconsider whether their models — each of which is premised on efficient markets — should be reexamined in light of the fact that the capital markets have proven extraordinarily efficient at destroying wealth through fraud. Instead, without even discussing whether the models might be wrong, the debate’s primary focus is on the importance of omitted variables in the failed neoclassical models. A policy maker attempting to avoid future crises reading the debate would be mystified by the intricate but monotonous medley, startled by the efforts to minimize the worst financial crisis in our lifetimes, and disappointed that it was bereft of useful praxis.

Casey offers this recipe for how economists should proceed:

The methodology of economics specifies a clear recipe for assigning blame for today’s financial crisis. First, alternative hypotheses are articulated. Second, the alternatives are compared on the basis of empirical predictions. Third, empirical tests are conducted to gauge the relative importance of the alternative hypotheses.

I argue that, overwhelmingly, economists (because of implicit prior assumptions) have not followed this recipe in past crises and are not following it in the current crises. The most critical failure is in the first step — ignoring “alternative hypotheses.” Note that Casey ignores alternative hypotheses such as control fraud. I also argue that the (unacknowledged) omitted variable problem means that econometric techniques produce flawed data that leads economists to fail to learn the proper lessons from prior crises and recommend policies that produce recurrent, intensifying crises.

I begin by discussing omitted variables that have enormous importance for praxis. The current crises are tragic because they could have been avoided had we learned the correct lessons from prior crises, such as the S&L debacle. Neoclassical theory and methodology produce the worst possible policy advice when financial bubbles are inflating. The controversy over the “direct investment” rule provides a good example. A direct investment is ownership of an equity interest in an investment, as opposed to lending funds to an investor. [1] The Federal Home Loan Bank Board (Bank Board) proposed to restrict S&Ls from making direct investments in excess of 10 percent of their total assets.

Charles Keating retained George Benston and Alan Greenspan to attempt to block adoption of the direct investment rule. Benston and Greenspan “studied” the S&Ls that made direct investments in excess of the threshold. They found that such S&Ls reported that they were far more profitable, and had fewer large losses, than other S&Ls. They concluded that the Bank Board should encourage other S&Ls to emulate the 32 S&Ls that exceeded the threshold. They argued that portfolio diversification theory supported making large direct investments.

Within roughly two years all 32 S&Ls had failed — many of them operating in states with robust economic growth. The variable that Benston and Greenspan omitted was control fraud. They assumed that (1) financial markets are efficient, (2) CEOs sought to maximize the firm’s long-term profitability, (3) CEOs added direct investments pursuant to portfolio diversification theory in order to increase that profitability, and (4) CEOs do not commit control fraud. Tellingly, the last assumption was implicit. [2] Unstated assumptions cause the greatest risk of choosing policies that produce financial crises because we are not even aware of the risk.

The obvious question is why direct investments were financial cyanide. “Risk,” at least as we conventionally teach the concept in finance (uncertainty) does not explain the pattern. The two obvious aspects of the pattern are outcomes: record profits followed by certain, unusually costly failure. Accounting control fraud creates certain profits — and looting by the CEO makes failure certain. [3] The S&Ls that Greenspan and Benston lauded didn’t all fail because honest direct investments are moderately riskier than honest traditional mortgages. They all failed because they choose to make large amounts of direct investments because doing so optimized accounting control fraud. Direct investments were one of the two investments S&Ls could make that (1) made it easy to create fraudulent “income” and (2) best hid real losses (Black 2005; Akerlof & Romer 1993).

The less obvious aspect of the pattern, operations, was also consistent with control fraud and inconsistent with rational risk taking. The National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE, 1993: 3-4) described the pattern:

The typical large failure was a stockholder-owned, state-chartered institution in Texas or California where regulation and supervision were most lax. … The failed institution typically had experienced a change of control and was tightly held, dominated by an individual with substantial conflicts of interest. … In the typical large failure, every accounting trick available was used to make the institution look profitable, safe, and solvent. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization through high dividends and salaries, bonuses, perks and other means. In short, the typical large failure was one in which management exploited virtually all the perverse incentives created by government policy.[4]

The element of the operational pattern that neoclassical economists have had the most difficulty grasping, unfortunately, is the most important element. As James Pierce, NCFIRRE’s Executive Director explained:

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 offer the high loan fees and interest required for the best looting. It was rational for operators to drive their institutions ever deeper into insolvency as they looted them. [5]

Optimizing a lending institution to grow rapidly by making bad loans that will not be repaid also creates a distinctive operational strategy that is rational if one is engaged in accounting control fraud and profoundly irrational if one is running an honest lender. The strategy requires the CEO to suborn internal and external controls and to systematically pervert underwriting. [6] A control fraud that grows extremely rapidly by making bad loans during the expansion phase of a bubble is mathematically guaranteed to report record profits. [7] This explains why econometric studies conducted during the expansion phase produce the worst possible policy recommendations. They will show whatever practices optimize accounting control fraud (which maximizes real losses) will have the strongest association with “income” and (because accounting control frauds fool markets) share price. Econometric studies almost exclusively use accounting “income” or share price as their “performance” measure. Of course, the catastrophic methodological failure — and, in particular, the failure of economists to change their methodology despite repeatedly giving the worst possible policy advice during the expansion phase of bubbles — evinces an underlying failure of theory.

The CEO is in a unique position to optimize the firm as a “weapon.” He can place the firm in business lines that are optimal for inflating accounting values and covering up real losses. He can cause the firm to grow extremely rapidly. He suborns controls by creating perverse financial incentives. Control frauds promote and shower compensation on those who cooperate with management’s goal of ignoring credit quality; those who don’t are punished.

The Bank Board contained the S&L debacle, despite a critical shortage of funding and personnel, and in the face of intense political opposition because it identified the epidemic of accounting control fraud and correctly analyzed how to respond to it. In 1983, the control frauds grew at an average annual rate of over 50 percent. They purported to be the most profitable S&Ls and they had very low (recognized) losses.

The Bank Board, under Bank Board Chairman Ed Gray, figured out three things about the epidemic of S&L control fraud that were critical to praxis. [8] All three aspects were contrary to the economic conventional wisdom. First, they recognized that the frauds relied on accounting as their weapon. Therefore, the claimed record earnings and relatively small amount of realized losses did not demonstrate that the firms were successful and conventional econometric studies would yield perverse results. Second, the agency realized that it could spot the distinctive operational pattern of accounting control frauds and prioritize such S&Ls for examination and closure at early dates when they were still reporting record earnings. Third, the agency realized that growth is the Achilles’ heel of any Ponzi scheme. The agency adopted a rule restricting growth from 1985 onward. The rule caused the remaining control frauds to collapse. [9] It also, in conjunction with the 1986 tax act (which ended the perverse incentives of the 1981 tax act), burst the bubble in Southwest commercial real estate. Had the S&L and bank control frauds been permitted to extend and further hyperinflate that bubble the ultimate losses would have been far greater (NCFIRRE 1993).

Taken together, we can now describe what economists should have learned from the S&L debacle. Akerlof & Romer demonstrated three manners in which epidemics of control fraud caused severe damages. Fraud, of course, causes direct losses to the individual lender. They also demonstrated two indirect fraud losses. Control frauds extend and hyperinflate financial bubbles because they deliberately make bad loans and grow exceptionally rapidly in order to optimize accounting fraud. The losses that occur when a bubble hyperinflates are likely to be nonlinear, so a material increase in the length and size of a bubble is likely to create a very large increase in losses. Akerlof & Romer also explained that control frauds’ (their term was “looters”) exceptional accounting “profits” and eagerness to lend to developers that purchased land for commercial real estate projects at grossly inflated prices sent false price signals to other market participants. The false signals would further extend and hyperinflate the bubble.

Akerlof, in his original article on markets for lemons, explained how a Gresham’s dynamic could spread the incidence of control fraud. (His seminal article discusses anti-consumer control frauds in which the seller misrepresents quality.) Pierce warned about a similar dynamic in S&L accounting frauds (see n. 7).

What has been added since 1993, and has made the criminogenic environment for accounting fraud far more intense, is a Gresham’s dynamic caused by the modern executive compensation system and the extension of the perverse dynamic described by Pierce to the rating agencies.

These changes, plus a very different response by regulators and law enforcement, explain why the current crises are so much more severe than prior epidemics of control fraud during the S&L debacle, the Enron-era frauds, Russian privatization, and the worst of the Washington Consensus in Latin America.

Mortgage bankers have always been the cowboys of the mortgage industry. Without deposit insurance, they could not grow unless they could sell large amounts of their product. They weren’t able to cause enormous losses in the past because they could only sell their product if it was a high quality, conventional product. What changed all this was the rating agencies’ willingness to give AAA ratings to “toxic” mortgage product and investment bankers’ willingness to securitize and sell the toxic paper (and retain a great deal of the most toxic product in their off balance SIVs).

The Gresham’s dynamic arising from the other major change since 1993, perverse compensation systems, explains why investment banking firms (and rating agencies) were eager to inflate the ratings and make these toxic investments. As I noted in my essay, the pay systems do the opposite of “aligning” the interests of shareholders, CEOs, and other managers. [10]

Changes in regulation provided the third major reason that the existing crises are far larger, and created systemic crises. There were no Ed Grays in the current administration. [11] Yes, Edward Gramlich warned Alan Greenspan. Yes, William Donaldson knew there was a developing problem. Like Arthur Levitt (under Clinton), neither was willing to go to the wall to fight for reregulation. Unlike Donaldson, Gray refused to resign and continued to put in place the reregulation and vigorous supervision that prevented the debacle from becoming a catastrophe. (Gray’s career, unsurprisingly, was destroyed. Unlike Donaldson and Levitt he was not wealthy, powerful, and near the end of his career.)

No federal regulator responded effectively when the mortgage bankers could suddenly make (1) loans that were certain to have catastrophic default rates and (2) sell them in vast amounts so that they could grow rapidly. The Fed had unique authority to regulate mortgage bankers — it refused to do so. Greenspan went so far as to praise ARMs (at the precise time they were morphing into “exploding rate” ARMs that the borrowers were incapable of paying after the initial teaser rate. He even praised equity stripping. OFHEO could have banned Fannie and Freddie from buying subprime paper. It declined to do so. The only area in which the federal agencies were vigorous was in preempting state agencies that sought to take action against some of the worst mortgage control frauds.

The Office of Thrift Supervision (OTS) and the FDIC desupervised. The first FDIC Chair under this administration slashed the staff and made it impossible for the FDIC to exercise its “backup” examination authority in any meaningful manner. The OTS Director, as I noted, was far worse. The final straw was when the OTS promoted back to a senior leadership position the (infamous) professional regulator most responsible for caving in to Charles Keating’s demands for unprincipled concessions by the Bank Board. The Director of OTS viewed his “supervision” of WAMU and his concessions to Countrywide so favorably that he appointed him head of the Western Region — which is where the biggest S&L control frauds specializing in nonprime mortgages were located. This is financial desupervision at its most pernicious, and the cost has been catastrophic. The OTS desupervised so completely that like IndyMac, which the FDIC estimates will cost roughly $9 billion to resolve (roughly twice the most expensive prior failure of an insured institution), was not even on the “troubled institutions” list prior to its closure. (The OTS’ effort to blame Charles Schumer for IndyMac’s failure was equally parts dishonest and shameful. He did the taxpayers a service by hastening the closure of an institution that should have been closed five years ago.) [12]

The defining element at law that separates fraud from other forms of larceny is deceit. Deceit is used to cause the victim to trust the perpetrator — who then betrays that trust. As a result, control fraud is a powerful acid to erode market trust. Widespread accounting control fraud creates systemic crises because it makes trust extremely risky. Indeed, it makes it impossible to evaluate risk because everything we use to quantify risk is premised on the assumption that the numbers we input are not fraudulent. The current systemic crises are primarily the product of bankers no longer trusting other bankers. Most of us attend meetings periodically where bottled water is served. How many of us would drink from the bottle if we knew that one in fifty were contaminated? Well before fraud becomes endemic it can cause systemic crises by eroding trust.

In the current crises we have (1) an epidemic of accounting control fraud (arising in the United States primarily, but not exclusively, in nonprime mortgage lending), (2) a complete breakdown in effective regulation, which means that key markets are opaque and even if the industry provides some data they are not verified by a truly independent, competent, and vigorous regulator, and, (3) our most elite private institutions not only failed to exert “private market discipline,” but often also led or aided the accounting fraud.

When we chose not to regulate a financial activity through non-regulation, deregulation, or desupervision we often create adverse consequences that neoclassical economists are unlikely to have understood or intended. First, as I explained immediately above, it frequently makes the market opaque and the data it produces unreliable. This helps allow control fraud to grow to epidemic levels and threatens a systemic crisis of trust. (The data unreliability will typically be masked during the expansion phase of the bubble. This helps explain the problem Brad DeLong has been struggling with — why things (e.g., spreads) are so discontinuous and volatile and why do “mere” trillion dollar fraud losses lead to systemic crises and much larger wealth losses?)

Second, regulators are the equivalent to the “cops on the beat” in the white-collar crime context. No one calls the Houston Police Department and says: “I think there’s a problem with Enron’s accounting. Please check it out.” When we don’t regulate or supervise financial markets we, de facto, decriminalize accounting control fraud. Yes, the SEC and the FBI will still exist and they will investigate some cases on their own. But the truth is that neither can be effective without financial regulators taking the lead. We have to make the criminal and SEC referrals. To be useful, a referral requires extensive work. We then have to train the FBI agents and Assistant U.S. Attorneys (AUSAs) about the industry and how the frauds work. We have to “detail” key staff to the FBI to serve as their internal experts. We provide (free) expert witnesses to the AUSAs for grand jury and trial testimony. We have to fight to get the FBI to investigate our referrals and to get the AUSAs to bring the cases (and prioritize them properly). We are only part of the effort, but we are an essential part of the effort. If we are not there, vigorously, symbolic prosecutions may occur, but there will be no meaningful deterrence to stop a developing epidemic of control fraud. Most of the worst mortgage fraud occurred in the unregulated sectors. Most of the worst mortgage fraud in the regulated sector occurred at S&Ls (and AIG!), which OTS was supposed to regulate. The desupervision is so crippling that mortgage fraud prosecutions have become shambolic. To date, large mortgage control frauds have had more reason to worry about being struck by lightning than being prosecuted.

So, on the subject of omitted variables, I would ask my colleagues what it would take before they would treat accounting control fraud seriously? The incidence of nonprime lender mortgage fraud is exceptionally high. I don’t doubt discussions among economists at Berkeley and Chicago about the crises overwhelmingly omit fraud and the direct and indirect losses it creates. Even though the “typical large [S&L] failure” “invariably” involved control fraud, the conventional economic wisdom about the debacle relegates such frauds to a paragraph (in a book) or a clause (in an article). It is no answer that your models cannot input fraud as a variable and that your theories ignore it.

Here’s the deal. If it’s good criminology, it’s good economics. If it’s bad criminology, it’s bad economics. For example, control fraud does exist. It frequently suborns private market discipline. It causes greater financial losses than all other forms of property crime combined.

Anti-consumer control frauds also maim and kill. China provides topical examples: infant formula, cough syrup, and toys are all contaminated (and the formula also lacks milk and therefore lacks vital nutrients). In each case there is a Gresham’s dynamic because the sellers that cheat gain a cost advantage over honest firms. Another example is school construction. China recently admitted (then retracted) that over 19,000 students died in the Sichuan earthquake when their schools collapsed. The schools appear to have collapsed because contractors purported, but did not in fact, build them in accordance with seismic codes. (Turkey has similar problems with fraud and corruption — which is public sector control fraud). Absent effective regulation and supervision the markets will be deeply inefficient because of this Gresham’s dynamic.

There is no excuse in this debate for ignoring fraud. You have had to read the conclusions of at least some of our research. Ignoring our literature has led economics and economists to recurrent, grave mistakes. Economists have praised the worst frauds in the nation as exemplars. They have repeatedly recommended policies that maximize the criminogenic nature of the environment. [13] They have ignored the successful, real world test of S&L reregulation and resupervision in 1984–87.

More bizarrely, when economists omit fraud as a variable they ignore economics — economic theory that garnered a Nobel. Reread Akerlof’s seminal article before you read Akerlof & Romer. No, Akerlof’s “lemons” article does not use the word fraud. The examples he discusses are frauds. Indeed, they are anti-consumer control frauds. Unfortunately, the profession responded to his article with a literature that focuses overwhelmingly on “the market’s” clever adaptations that (purportedly) solve the problems arising from the information asymmetry.

Information asymmetry, however, is the essence of fraud. Fraud perpetrators manipulate asymmetry. The most elegant frauds use deceit to make the victim feel that the perpetrator is being transparent when he is really presenting only the illusion of transparency. Information asymmetry and accounting control fraud pose a central, existential challenge to efficient capital markets. They are not peripheral topics. They have taken our capital markets to the cleaners and produced the worst global financial crisis of our lifetimes. Our most “sophisticated” specialists and financial elites that have survived many prior challenges are dead or on public life support. Our markets and our elites acted as vectors in this epidemic of control fraud instead of disciplining it. Casey appears to exclude the possibility of deceit. He attempts to explain the bubble as, in large part, the product of improved information.

Much of the banking and real estate value added relates to information. Bankers screen borrowers and value heterogeneous collateral. Real estate brokers match heterogeneous families to heterogeneous properties. Hall and Woodward (2008) claim:

Recent years have seen great improvements in data, especially the introduction of credit scores, which gave lenders new powers to forecast mortgage defaults and to adjust interest rates offered to prospective borrowers. In 1990, credit scores were rare; by 1996, they were standard.

Perhaps lenders also expected to use information technology to better monitor and collect on loans, and therefore put subprime lending programs in place.

I find Hall and Woodward’s claim remarkable. What we have just experienced is that these “great improvements” in information were great degradations. The “new powers to forecast mortgage defaults and to adjust interest rates” is certainly a desirable concept. Unfortunately, reality went in the opposite direction, as they surely knew by the time they wrote their piece. We know the models’ “forecast[ed]” mortgage default rates proved grossly too low. We know that they effectively ignored the risk that there was a bubble. We know that they forecast default rates for nonprime mortgages that were substantially below rates experienced in the past in prior business cycles.

We know that alt-a lending was premised on credit scores and avoiding underwriting and verification. When the market calls something a “liar’s loan” it pays to take it seriously. This is an excellent way to maximize adverse selection and destroy a lender. We have known that for centuries. The passage from Hall and Woodward that Casey cites does not acknowledge any of these reasons why, in fact, the quality of information deteriorated. More importantly, it does not acknowledge that control frauds would engage in each of the errors I have just discussed in order to optimize short-term accounting profits.

Hall and Woodward also should have known that nonprime lenders did not “adjust interest rates offered to prospective borrowers” to reflect their heterogeneous credit risk. They did the opposite. First, they increasingly went to exploding rate ARMs and “qualified” borrowers only at the teaser rate. Those practices do not compensate for credit risk (which is what Casey, and Hall and Woodward, are arguing) — they create it. Indeed, they maximize credit risk while reducing (long-term) return. This is profoundly irrational for an honest lender, but optimizes accounting control fraud by facilitating rapid growth through lending to the uncreditworthy. Second, they increasingly did no real underwriting, so they did not know the credit risk they were taking and they maximized adverse selection. Again, this is inconsistent with Casey’s (and Hall and Woodward’s) assertions, but rational for accounting control fraud. Third, spreads on nonprime loans declined while (1) underwriting declined, (2) the epidemic of mortgage fraud increased rapidly, (3) the quality of the borrowers fell, and (4) delinquencies rose. So, far from using superior information and enhanced underwriting to adjust individual interest rates to compensate the nonprime lenders for the individual risks they were taking, the already grossly inadequate spread fell materially when it should have been surging. This makes no sense under the model Casey supports, but is sensible for accounting control frauds. Note also that this ignores some of the most important factors actually driving those who should have qualified for conventional loans to nonprime loans — the borrower’s race and ethnicity.

Casey understands that underwriting is essential because he says, “Perhaps lenders also expected to use information technology to better monitor and collect on loans, and therefore put subprime lending programs in place.” The neoclassical theory of financial intermediation is premised on the assumption that banks use their superior informational advantage to properly underwrite loans. The problem is reality. Nonprime lending specialists did the opposite. They used their information technology to approve bad loans more quickly. They structured loans, and conducted (limited, perverse) underwriting to approve bad loans (e.g., exploding rate ARMs to borrowers that often did not even have the ability to pay the teaser interest rate). They gutted the internal controls that are supposed to underwrite, to require adequate credit quality, and to monitor credit quality. All of these actions optimize accounting control fraud. The reality, among nonprime lending specialists is the opposite of Casey’s speculation (“perhaps”).

If you think that the ongoing crises were materially caused by changes in housing tastes or informational technology changes then you are necessarily saying that our markets are so fragile that relatively minor changes inevitable in any dynamic nation can send the global economy spinning into a severe recession and gut virtually all our leading financial firms. That means you have to turn to understanding why we are so fragile and what we need to do to reduce dramatically that fragility. (And I don’t want to hear about “creative destruction” — what we’re experiencing is a wealth- and efficiency-destroying potlatch of epic proportions.)

Rome is burning. We need to stop fiddling. It isn’t simply the economy that is in crisis. Neoclassical economic theory, methodology and praxis need fundamental reexamination. The “Imperial Science” has suffered the fate common to arrogant imperialists.

While Becker famously boasted that an economist had no need to know anything about the criminology literature to advise policy makers about appropriate criminological praxis, white-collar criminologists generally value the study of economics. We both study markets and institutions. We find many economic theories persuasive and sound.

White-collar criminologists generally believe, however, that criminological research has falsified the key economics and finance theories underlying modern finance. For example, efficient markets and contracts are, at best, special cases. Some markets are endemically inefficient because of control fraud and corruption. Some markets experience periodic epidemics of control fraud and baseline levels of control fraud inconsistent with the efficient market hypothesis (because fraud almost always creates a systematic bias, e.g., accounting fraud overwhelmingly is used to make firms appear more profitable). We also generally believe that econometric analyses are likely to become perverse whenever control frauds are material. When top neoclassical economists praise the worst firms in the industry as the best (in the case of S&Ls that was a ranking error of over 3000 positions) and recommend investment strategies that are invariably fatal there is a vital problem that requires resolution. If economists were part of the air force their commanders would have long since ordered a profession-wide “stand down” designed to ensure that the profession learned why it was recurrently flying jets into mountains and adopt changes to prevent such crashes from recurring.

White-collar criminologists rarely find literature in which an economist explicitly considers whether the praxis s(he) recommends, e.g., deregulation, will make an environment more criminogenic. Relative to neoclassical economics, we believe our models have demonstrated superior predictive power in explaining financial crises, our research methodologies produce superior results, and our recommendations on praxis are drawn from what worked in the real world and prevented the S&L debacle from becoming catastrophic — as it would have done had the Bank Board continued to follow the advice of financial economists. We may, of course, be wrong. We’re happy to debate economists about the causes of these crises. We’d be even happier to have you be part of a multi-disciplinary effort to develop sound theory, methodology, and praxis designed to reduce these crises.

Notes

[1] Direct investments also included transactions structured nominally as loans in which the lender was, in economic substance, taking an equity risk, i.e., the lender could only be repaid if the project succeeded.

[2] Keating also retained Daniel Fischel to help block the rule’s adoption. The Bank Board’s had cited studies showing that (1) S&L direct investments earned lower returns than traditional mortgages and (2) direct investments were riskier than traditional mortgages. Fischel argued that the efficient market hypothesis made it impossible for both facts to be facts — absent fraud. Fischel then proceeded to ignore the possibility of control fraud. Keating’s Lincoln Savings, of course, was the most notorious S&L control fraud, costing the taxpayers $3.4 billion.

[3] Akerlof, George A., and Paul M. Romer. 1993. “Looting: The Economic Underworld of Bankruptcy for Profit.” Brookings Papers on Economic Activity 2:1-73.

[4] Brad is correct that Austrian economists invariably blame the government, but that bias is common among neoclassical economists. James Pierce, the author of the NCFIRRE report, argued that deposit insurance was the principal cause of the perverse incentives (as did Akerlof & Romer). All three economists believed (then) that the efficient contracts hypothesis required that private market discipline defeat control fraud. Deposit insurance must, therefore, remove the incentive for creditors to exert market discipline. Other NCFIRRE officials challenged Pierce’s view. We argued that uninsured creditors (e.g., subordinated debt holders and S&L counterparties) and shareholders never exercised effective discipline against an S&L control fraud. Enron, WorldCom and their ilk ended any claim that deposit insurance was necessary to an epidemic of control fraud. Akerlof & Romer changed their views in light of that experience; Pierce did not.

[5] Pierce, J. ASSA presentation, 1994: 10-11. See also Robinson, M., 1990. Overdrawn: The Bailout of American Savings. Plume, N.Y.

[6] Note that this is the opposite strategy that one would follow if one were engaged in lawful “gambling for resurrection.” By making underwriting perverse, control frauds maximize adverse selection. The expected value of lending in circumstances that maximize adverse selection is sharply negative. Those engaged in honest, high-risk gambles would optimize through superior underwriting (Black, Calavita & Pontell 1995).

[7] If they can get a clean opinion from a top tier audit firm “blessing” their claimed income. Accounting control frauds have repeatedly shown the ability to achieve such opinions.

Abusive operators of S&Ls sought out compliant and cooperative accountants. The result was a sort of “Gresham’s Law” in which the bad professionals forced out the good. (NCFIRRE 1993: 76)

[8] It recognized that econometric tests produced perverse results and instead relied on in depth review of the causes of failure at the institutions it closed. These “autopsies,” as they were called at the Bank Board, revealed accounting control frauds’ distinctive outcome and operational patterns.

[9] The administration was enraged by Gray’s reregulation. Don Regan made strong efforts to force him from office. Speaker Wright held the “FSLIC Recapitalization” bill hostage to prevent Gray from getting to additional funds to close more Texas control frauds. (Texas and California deregulated and desupervised far more than the federal government did and its S&Ls caused disproportionate losses.) The administration attempted to appoint two members (to the three member Bank Board) chosen by Charles Keating. This would have given Keating majority control of the agency. That would have caused losses to top a trillion dollars. The “Keating Five” (Cranston, DeConcini, Glenn, McCain, and Riegle) successfully pressured the agency, on Keating’s behalf, not to take enforcement action Lincoln Savings’ $615 million violation of the direct investment rule. The administration threatened to prosecute Gray criminally for the “crime” of closing too many S&Ls. The administration’s top priority at all times was covering up the scale of the S&L debacle. The administration’s Treasury spokesman testified in front of Congress that insolvency was irrelevant for S&Ls because they could always meet their liquidity needs by simply growing and using the cash received from new depositors to pay past depositors. While the Treasury’s endorsement of a Ponzi scheme for insolvent S&Ls was remarkable, it promptly exceeded its congressional testimony by testifying on behalf of a failed S&L in its lawsuit against the Bank Board alleging that it was arbitrary and capricious to place it in receivership because it was insolvent. Note that if the owners of the failed S&L had prevailed they would almost certainly have next sued Treasury for damages. The administration did not want even failed S&Ls closed because doing so required them to recognize their massive collective insolvency.

The administration and Speaker Wright reached a secret deal in which the administration agreed not to reappoint Gray to the Bank Board and not to oppose regulatory “forbearance” provisions (pushed by the control frauds’ attorneys) in return for Wright endorsing a $15 billion recapitalization of the FSLIC fund. (Wright, of course, reneged on his end of the deal by sending the word to House Democrats that they should ignore his floor speech on behalf of the $15 billion bill — which they promptly rejected in favor of a farcical $5 billion bill.)

Gray’s successor, who caved in to the Keating Five’s intervention on behalf of Keating, was chosen by the administration because he did not support Gray’s policies. He cut back on Gray’s policies of vigorous examination but the growth rule still proved fatal to the control frauds.

[10] The claim that compensation systems “aligned” the interests is a classic example of “assume a can opener.” The “logic” was that (1) CEOs’ existing compensation misaligns those interests because, de facto, CEOs control their compensation and maximize their self-interest (at the shareholders’ expense) by deliberately misaligning those interests and (2) “therefore” we should encourage CEOs to dramatically increase their compensation because this would cause them to align their interests with the shareholders’ interests. But if CEOs control their compensation, and they commonly act in their self-interest at shareholders’ expense then it follows that if we raise the stakes enormously by offering them annual bonuses so large as to make them vastly wealthy for life, they should have an overwhelming interest in misalignment. It is in their self-interest to make large amounts of money regardless of whether they aid or harm the firm’s long-term interests. Two clear means to maximize their self-interest are causing the corporation to engage in accounting control fraud (which guarantees that they will become extremely wealthy) and backdating/repricing stock options. Both forms of control fraud ensure short-term “success.”

[11] CFTC Chair Brooksley Born was such a hero under Clinton. A bipartisan coalition of anti-regulatory officials, including Summers, Levitt and Rubin, killed her efforts to regulate CDS.

[12] IndyMac specialized in originating for sale “alt-a” loans (aka, “liar’s loans). The FDIC expects to lose roughly $9 billion on a shop that (purportedly) only had $33 billion in assets (apparently it had only $24 billion in assets). This is obviously awful news, but it greatly understates the problem. First, the actual credit losses at IndyMac must have been materially larger than $9 billion because in a receivership the FDIC does not pay the subordinated debt holders. In a receivership loss calculation the FDIC also ignores the loss of roughly $3 billion in GAAP capital. This means IndyMac’s credit losses are likely closer to $12 billion — and that ignores liability claims from purchasers of IndyMac’s alt-a mortgages. Second, economic theory predicts that IndyMac would have taken advantage of asymmetrical information and sold the worst of its alt-a product and held in portfolio the best of its alt-a product. If true, that suggests that the percentage losses to purchasers of its mortgages will be even larger than the (catastrophic) percentage losses on mortgages it held in portfolio. IndyMac served as a “vector” that spread the fraud losses broadly.

[13] Black, W., 2003. Reexaming the Law-and-Economics Theory of Corporate Governance. Challenge 46, No. 2 March/April, 22-40.

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Lead Essay

  • What Really Happened? by Lawrence H. White

    In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • Adam Smith Was Right about Corporate CEOs’ Incentives absent Effective Regulation by William K. Black

    In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages – even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud – and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • Fundamental Origins of the Housing Boom and Bust by Casey B. Mulligan

    The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests – especially about the aggregate wealth effects of the boom and bust – would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Liquidity, Default, Risk by J. Bradford DeLong

    Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story – focusing on the money supply and government policy to encourage bad home loans – cannot be the right one.

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