By Lars Schall, April 21, 2010

The following exclusiveinterview with William K. Black is a Joint Venture between New Deal 2.0 in the USA (www.newdeal20.org)and MMNews in Germany (www.mmnews.de).

PARTTWO: ECONOMIC WARFARE

Mr. Black, founded in1850, Lehman Brothers failed in September of 2008. What broke its neck afterall those years?

The bankruptcy examiner conducted aninvestigation of Lehman Brothers.  Thereport reveals that Lehman Brothers was engaged in large scale accounting andsecurities fraud by failing to recognize losses so large that it had failed asan enterprise.  Lehman’s seniorexecutives sought to cover up its failure with a series of very large ($50billion) quarter end REPO transactions. Curiously, the report puts no emphasis on the underlying fraud thatdrove the fraud concentrates on the second-stage REPO cover up.

Here is a link to the full series of thebankruptcy examiner’s reports:

http://lehmanreport.jenner.com/

What are your thoughtson Goldman Sachs facing serious difficulties with the SEC related to fraud? Isthis what you get when you do “God’s Work on Earth”?

We have learned from the SEC charges related toGoldman Sachs that it should be added to the list of elite financial frauds. Itis a tale of two (unrelated) Paulsons. Hank Paulson, while Goldman’s CEO, had Goldman buy large amounts ofcollateralized debt obligations (CDOs) backed by largely fraudulent “liar’sloans.”  He then became U.S. TreasurySecretary and launched a successful war against securities and bankingregulation.  His successors at Goldmanrealized the disaster and began to “short” CDOs.  Mr. Blankfein, Goldman’s CEO, recently saidGoldman was doing “God’s work.”  If true,then we know that God wanted Goldman to blow up its customers.

Goldman designed a rigged trifecta:  (1) it turned a massive loss into a materialprofit by selling deeply underwater, toxic CDOs it owned, (2) helped make JohnPaulson (CEO of a huge hedge fund that Goldman would love to have as an ally) amassive profit – in a “profession” where reciprocal favors are key, and (3)blew up its customers that purchased the CDOs. Paulson and Goldman were shorting because they believed that the liar’sloans were greatly overrated by the rating agencies.  Goldman let John Paulson design a CDO inwhich he was able to pick the nonprime packages that were most badly overrated(and, therefore, overpriced).  Paulsoncreated a CDO “most likely to fail.”  Goldmanconstructed, at John Paulson’s request, a “synthetic” CDO that had a creditdefault component (CDS).  The CDS allowedJohn Paulson to bet that the CDO he had constructed (with Goldman) to be “mostlikely to fail” would in fact fail – in which case John Paulson would be becomeeven wealthier because of the profit he would make on the CDS.

Now, any purchaser of the “most likely to fail”CDO would obviously consider it “material information” that the investment wasstructured for the sole purpose of increasing the risk of failure (and gettingrid of Hank Paulson’s worst investments). The SEC complaint says that Goldman therefore defrauded its owncustomers by representing to them that the CDO was “selectedby ACA Management.”  ACA was supposed tobe an independent group of experts that would “select” nonprime loans “mostlikely to succeed” rather than “most likely to fail.”  The SEC complaint alleges that therepresentations about ACA were false.

Also, I'd add a fourth advantage toGoldman from the Abacus scheme. When you're shorting (and its critical thatboth Goldman and John Paulson were shorting the same thing) you want moreshorting. So Goldman and Paulson were a mutual aid society.

The obvious question is:  did John Paulson and ACA know that Goldmanwas making these false disclosures to the CDO purchasers?  Did they “aid and abet” what the SEC allegeswas Goldman’s fraud?  Why have there beenno criminal charges?  Why did the SEConly name a relatively low-level Goldman officer in its complaint?  Where are the prosecutors?

And there is the key question thatwe (Eliot Spitzer, Frank Partnoy and I) asked in our December 19, 2009 op ed inthe New York Times – why haven’t theAIG emails and key deal documents been made public so that we can investigatethe elite control frauds?  (I have calledfor the same disclosures of Fannie and Freddie’s key documents. )  Goldman used AIG to provide the CDS on thesesynthetic CDO deals and Hank Paulson used our money to bail out Goldman whenAIG’s scams drove it to failure.

Mr. Black, can you putthe crisis we’re going through into an international perspective as an act ofeconomic warfare, please?

Finance has become a parasite in most developednations.  It is supposed to serve the“real economy as an “intermediary.”  Itsfunction is to move capital to its most valuable use at the lowest possiblecost.  Instead, it creates massivebonuses and crises when it works badly. When it works “well” it misallocates capital and funds speculativeattacks on commodities and national currencies. It is particularly harmful to workers in Europe and the U.S. None of this requires any conspiracy. Finance is not run in the interest of financial firms.  It is run in the interests of the senior officersthat control the financial firms.  Theysimply maximize their income (often through accounting control fraud).  They enter into tactical coalitions, but theyhave no permanent alliances.  They arenot loyal to the nation or the firm. They represent the closest thing to “homo economicus” – the rational,selfish, ethics-free, and wealth-maximizing economic agent that neoclassicaleconomists imagined.  As authors in thetriumphal book about market economies (MoralMarkets) conclude, “homo economicus is a sociopath.”  Increasingly, our most elite business leaders(and this gives them great political power as well) are sociopaths.  This is a recipe for recurrent, intensifyingcrises and increasing inequality.

One of the most distressing elements of thecrisis, which is true in both Europe and the United States, is the death of accountability ofour financial elites.  Europe went overwhelmingly toanti-regulation.  Strict regulation wasthe evil.  It smacked of retributiveAmerican approaches.  Elite bankers werethe solution, not the problem.  The Britscalled the approach “softly, softly.” Regulation was not delegitimized. Markets were inherently self-regulating. It was all very clubby.  Germany and France emulated the Brits.  The Eastern European nations never hadserious regulatory capacity and they generally followed the lead of the twoEuropean financial centres – the UK and Germany.

President Bush picked regulators designed tosignal his administration’s intent to end effective regulation.  He chose Harvey Pitt to head the SEC preciselybecause Pitt was infamous as the leading opponent of serious securities lawenforcement.  Pitt’s first major speechcontinued this symbolism.  He spoke to ameeting of accountants and bemoaned the fact that the SEC had not always been a“kinder and gentler” place for accountants. He blamed this on his agency – not the top tier firms that consistentlygave clean audit opinions to the financial statements of massively insolventaccounting control frauds that falsely purported that the firms were highlyprofitable.

This regulatory rot began in the U.S. under President Reagan (whodemonized regulation and regulators), was reduced under the first PresidentBush, and began to decay again under President Clinton.  Europeans’ first thought when they hear thename “Gore” is probably global climate change, but when he was Vice Presidenthis priority was “reinventing government.” The premise of reinventing government was that it needed to befundamentally changed to more closely resemble a private corporation and topartner with private firms.  Financialregulators were instructed to refer to the banks and S&Ls they weresupposed to regulate as their “customers.” 

Former OTS Director John Reich, who served from2005 to 2009, referred to WaMu Chief Executive Kerry Killinger as "mylargest constituent" in a 2007 e-mail:

www.latimes.com.

Reich also appears in the signature photo ofthe U.S. contribution to the global crisis.  The star of the photo is ”Chainsaw Gilleran“(then the OTS Director).  (The OTS issupposed to regulate S&Ls.)  He isholding a chainsaw.  The next threeindividuals are the top U.S. banking lobbyists, and Reich, thenDeputy Chair of the FDIC, rounds out the group. They are all grinning.  Everyonebut Gilleran is holding pruning shears. They are posed over a pile of federal regulations and the message theyare sending is that the industry/anti-regulator partnership will work togetherto destroy financial regulation.  Well, ”Mission accomplished!“ The anti-regulators were so incapable of shame that they were proud ofthis tableau (which most resembled Soviet agitprop) and placed it in the 2003annual report of the FDIC, which your readers can access online.  It is no surprise that the federallyregulated (sic) financial institutions which produced the worst frauds (or, atleast, the worst we know of at this point) were S&Ls.

How long will it beeconomic warfare? Are we heading into a major war as a Last Exit Strategy?[i]

No one knows. The next severe economic crisis could be substantially worse than theGreat Recession.  I don’t think there isany grand conspiracy of financiers or that financiers as a group are eager toproduce a war.

In your analysis: Whatis Germany’s role in all of this? Do you agree with Chancellor Merkel’s proposalsdo deal with the crisis?

Germany was a typical weak financialregulator.  German banks are far largerthan in many nations, and more integral to the economy, so they caused severedamage to the German economy.  Germany played a significant role in the U.S. decision to terminate one of themost successful Great Depression-era U.S. reforms – the Glass-SteagallAct.   Glass-Steagall required aseparation between commercial and investment banking because of the inherentconflicts of interest of combining both operations in the same entity.  (And everyone knows that “Chinese Walls” failwhen they are most needed.)

U.S. opponents of Glass-Steagall (ourlargest banks) argued that we had to do away with Glass-Steagall to end theircompetitive disadvantage vis a vis German “universal” banks.  This was dangerous nonsense (there are noeconomies of scale to the German banks – and the conflict endangers the bank),but it also kept alive a perverse dynamic, the “competition in laxity.”  This dynamic creates incentives to weakencontinuously financial regulation to the point that it will fail.  This was the goal of theanti-regulators.  They made regulatoryfailure a self-fulfilling prophecy.  TheFed, through Patrick Parkinson, made the same “race to the bottom” argument infavour of passage of the Commodities Futures Modernization Act (which banned allregulation of credit default swaps).  Heclaimed that if the U.S. regulated CDS the major playerswould move to the City of Londonand New York and the U.S. would be the losers.  We should have been so lucky!  Americans would have been overjoyed had AIGrun it CDS scams out of a corporation in the City of London.

Germany is playing a negative role inresponding to the crisis.  The Eurostability pact is inherently unsound. Nations facing serious recessions make things far worse when they respondwith “austerity.”  Even conservativeeconomists – even the IMF – had come to a general understanding that the IMFausterity strategy made crises worse.  Germany, of all nations, should understandthat demanding the economic (not moral) equivalent of “reparations” from Iceland or Greece cannot work.  It will make the regional economic crisesworse (and harm German exports).  Germanscan understand what the reaction of any Greek has to be to a suggestion fromGerman leaders that Greece should sell its land (islands inthis case) to other nations.  Merkel seemsto have backed off some of her strongest demands against the Greeks, but shehas been leading the charge for IMF austerity policies.  Absent the (U.S.) Fed’s interventions on behalf ofnations like Switzerland (or, more precisely, its banks),the EU banks would have had to engage in massively greater bailouts of theirbanks.

Ben Bernanke is Time’sMan of the Year 2009. I guess, that’s a better choice than in 1938 (AdolphHitler). Nevertheless, your opinion on Mr. Bernanke being Time’s Man of theYear 2009?

Bernanke is a failed regulator that ignoredevery warning and refused on ideological grounds to act under HOEPA to stop thefraud epidemic.  If he had any moralstrength he would resign.  Your readersneed to know that he remains an active force against the public.  He appointed, in late 2009, another failedeconomist, Patrick Parkinson, to run all examination and supervision at theFed.  Parkinson has no experience as an examineror supervisor.  He is notorious fortaking the lead at the Fed in the successful effort to destroying Ms. Born’sefforts to protect the nation by regulating financial derivatives, particularlyCDS, in 1999 and 2000.

Bernanke also took the lead in encouraging thebanks to use their lobbing power to induce Congress to extort the FinancialAccounting Standards Board (FASB) (the professional group that determines U.S.GAAP accounting standards) to change GAAP so that banks would not have torecognize currently the great bulk of their losses on bad assets (includingthose financial derivatives that Bernanke, Parkinson, and Greenspanchampioned).  This unprincipled powerplay was successful.  The ability to hidethe massive losses has been attractive to the Obama administration (whichregularly trumpets the false claim that it has resolved the crisis at virtuallyno ultimate cost to the taxpayers) and to bank officers.  Overall, if the banks had to recognize theirlosses the bank bonuses could not be paid at many banks.

I am frank enough toask one question that many people in the world have: Shouldn’t the FederalReserve, as it exists today, being abolished for the sake of humanity?

It depends on what one means by “as it existstoday.”  My colleague Randy Wray is theexpert on this.  He makes the persuasivepoint that the Fed’s essential operations are extremely limited and notterribly complex.  There is also noreason to keep so many of their operations opaque.

A first step to “TheFed’s End As We Know It”, I assume, could be the Audit the Fed bill. Do yousupport the House Resolution 1207 Federal Reserve Transparency Act of 2009?

Yes, I’m one of the signatories of a lettersupporting that audit.

A colossal problem inthis crisis are derivatives in the global financial system of at least  600 trillion US-dollars.[ii] First part, how wasthis mess created? Second part, would you like to explain to me on a basis ofrationality how this mess can be fixed? Isn’t a collapse of the systeminevitable?

It exists because it is unregulated and (a veryfew) financial firms exploit this regulatory black hole to benefit their seniorofficers.  Exchange traded derivativescan be valuable and pose little risk, but they are a tiny percentage of theoutstanding derivatives.  Theoverwhelming bulk of derivative transactions produce no value to the realeconomy.  They are, however, capable ofcreating immense damage to the real economy. They are a ticking time bomb (except those that have already blown up.)

That derivatives willcause – as Johnny Carson would put it – “a really,really BIG” problem was predicted from early on, like Adam Hamilton did,when he wrote on September 7, 2001 about “TheJPM Derivatives Monster.”[iii] How could it be that this problem was allowed to grow for years andyears – and is there anybody out there responsible for it?

No, there is literally no one in charge.  Greenspan, Bernanke, Geithner, Summers,Rubin, and Parkinson all got their way in eliminating any protection for thepublic.

Short Selling is onemore aspect of the financial mess we’re in, I believe, especially Naked ShortSelling.

Short selling is not inherently evil, but it isat best a “second-best” solution. Consider accounting control frauds like Charles Keating’s LincolnSavings and Loan.  Some marketparticipants decided that Lincoln Savings’ purported profits werefraudulent.  They entered into “shortsales” in which they would gain if the share price of Lincoln Savings’ parentcompany fell.  Such sales could serve tosignal regulators that there was something suspicious happening at LincolnSavings.  (In reality, the causality ranthe opposite direction.  The regulators’concerns prompted the short sales.)  Thebest solution would be to fix what ails regulation (which is primarilyappointing anti-regulators as leaders) and have the bank regulators and the SECattack the underlying accounting control fraud directly.

The SEC action against Goldman confirms one ofthe reasons we should be concerned about short selling.  According to the SEC complaint, John Paulson(who runs one of the world’s large hedge funds), wanted to “short” nonprimeloans in mid-2007.  Note that this is fartoo late to provide the vital price signal that such loans were massivelyovervalued.  By mid-2007, the secondarymarket in nonprime loans had already collapsed. Mortgage brokers were going bankrupt every week.  Housing prices were declining.  So, at best, Paulson was speculating in amanner that could not contain the crisis. Paulson’s actions were despicable. If he knew that Goldman was making false securities disclosures his actionscould even be criminal.  But they did notcause the decline in nonprime prices. The collapse in CDO prices was because CDOs were backed by nonprimemortgages that were endemically fraudulent and were made near the peak of thelargest bubble in history because the epidemic of mortgage fraud hyper-inflatedthe bubble.

What kind of damagecaused Naked Short Selling during the last years? Shouldn’t it be illegalrather today than tomorrow?

That is hotly contested.  We have too few facts because data on shortselling, and most other securities transactions is often not collected and wasrarely subject to competent, critical examination by aggressiveregulators.  You can’t make short sellingillegal today.  One can construct creditdefault swaps (which remain unregulated) that create the economic equivalent ofshorting a security. Again, this is why Eliot Spitzer, Frank Partnoy, and Ihave called for the release of the AIG emails and the relevant pricing modelsand data on CDS and other financial derivatives (and why I’ve called for thesame public release by Fannie and Freddie). We should not have to guess about these matters.  The facts should be made public.

I know that you payclose attention to what’s going on at A.I.G. Bob Chapman from “The InternationalForecaster” wrote not so long ago on the hearings beforethe House Oversight and Reform Committee:

 “Each day brings more revelations of effortsof the NY Fed and Goldman Sachs to hide the details of the criminal conspiracyof the AIG bailout. . . . This is a real crisis on the scale of Watergate.Corruption at its finest.”[iv]

Is this an exaggeration or an understatement?

Well, “each day” is anexaggeration.  It is also hard forfederal officials to commit a crime through bad regulation unless they areactually bribed or commit perjury.  Butthe heart of claim is correct.  Put asidefor a moment any focus on criminal law and ask whether a nation can longprosper under crony capitalism.  Cronycapitalism is inherently corrupt and corrupting.  It leads to terrible business decisions.  It creates massive inequality andresentment.  Our crony capitalism is adifferent model than Suharto.  It is notbased on family.  But it is built onconnections and Goldman has exploited its connections to an unprecedenteddegree.  The key problem is that there isnot a U.S. consensus thatGoldman’s role is a national disgrace and a grave threat to our economy,democracy, and souls.  Hank Paulsonengaged in such a blatant conflict of interest, and cost the American people suchlarge amounts of money by bailing out Goldman (and many others) that he shouldhave been persona non grata among hispeers.  But he lacks any moral compassand the elites no longer make even a pretence of having norms demandingcivilized behaviour.

Mr. Black, we havereasoned some aspects of economic warfare. Can you tell us in this contextabout the importance of liquid cash flow generated through drug traffickingwithin and without the U.S.A. for banks primarily based in New York City and London via their off-shore connections (sic!)? A.I.G. seems to be also heavilyinvolved in drug money – at least for sure in the past.[v] And the UN-chief ondrugs, Antonio Maria Costa, stated that “liquid investment capital” generatedfrom drug trafficking helped to keep the financial system going in 2008. Hesaid:

“Inthe second half of 2008, liquidity was the banking system's main problem andhence liquid capital became an important factor … Inter-bank loans were fundedby money that originated from the drugs trade and other illegal activities ...There were signs that some banks were rescued that way.” [vi]

Isn’t that a littlebit of an embarrassing problem for the global financial system?

Yes, but I repeat that we do not know (and Mr.Costa does not know) the facts.  Thereare two “first-best” solutions.  One, weshould legalize drugs.  (For the readerswho are about to stop reading; please continue a bit.  First, I am 58 and I have never tried anillegal drug.  I don’t even drink.  I do not think drugs are good.  I think they do awful things to people.  Second, my policy advice is shaped by myexperience as a criminologist, regulator, and teacher of economics.  I’m with Milton Friedman on this issue.)  We should legalize drugs because our policyof criminalizing it has failed – and will fail. That failure is catastrophic.  Theprice of drugs gives us excellent market evidence on the success of our currentpolicies.  Drugs are generally cheapernow.  I don’t care how many photo ops westage of drug busts – the drug war has failed.

Our current policies make rich the worst, mostdangerous people in the world and caused tragedy in nations like Columbia and Mexico (a tragedy spreading to the U.S.). We do not know how much money really goes to the druggies, terrorists,and corrupt politicians, but the number is large.  We could defund many of the people out toharm our nation if we end this failed effort at Prohibition.

The other first-best solution is to get thefacts and to seize as many billions as possible of those funds from thecartels, Taliban, and corrupt officials. The way to do that is to (1) end the tax havens (which are also havensfor the scum of the earth), (2) to use undercover investigators and electronicsurveillance against financial institutions with suspicious cash flows, and (3)to seize the existing proceeds.

The OECD launched an initiative against the taxhavens.  The Bush administration blockedthe initiative because it wanted to create a “race to the bottom” of taxationby encouraging tax evasion through the use of tax havens.  After the 9/11 attacks (which were fundedthrough tax havens), the administration allowed a weakened version of the OECDinitiative to proceed.  The Obamaadministration should, with the aid of the OECD (Germany would likely be very supportive onthis given its intelligence services’ recent initiatives on your neighbouringtax haven), should lead a campaign to end all tax havens.  The U.S. has the economic power, even if hadto act unilaterally without OECD support, to end the tax havens.  The Fed could use its leverage for somethingconstructive!

Antonio Maria Costasaid furthermore, that drug money is by “now a part of the officialsystem.”  Is this naïve or deceptive tosay that from Mr. Costa’s side? It is widely known that the Pakistani bank BCCIfor example was involved with drug money during the 1980’s and then-Secretaryof Treasury, James Baker III, did nothing against it “because he thought aprosecution of the bank would damage the United States’ reputation as a safehaven for flight capital and overseas investments.“[vii] So my question is:Nothing New in the West, is it?

Yes, BCCI (informally, and accurately, known asthe “Bank of Crooks and Criminals, International”) was a massive controlfraud.  Yes, there is nothingfundamentally new about fraud schemes. The U.S. has long been complicit in refusingto crack down on the tax havens.  Thedeal it made with UBS was scandalous.  Wehave to end the “race to the bottom.”  Wecan end it.  It would do enormous goodfor the world in a wide range of spheres – and it would be immensely politicalpopular.  It would, however, enrage therichest Americans who evade taxes (but make political contributions).

From a criminologicalpoint of view: it’s the criminalized status of drugs that makes this wholebusiness possible, right?

Yes, as I just explained, that is the key.  Prohibition “sells” in politics, but it failsin the real world.

One lastquestion, Mr. Black. If we would compare the world with an asylum for insanepeople: isn’t that asylum run and controlled by the most criticallyill lunatics among the patients, just as John Lennon putit in an interview with the BBC in June 1968:

"Our society is run by insanepeople for insane objectives.... I think we’re being run by maniacs formaniacal ends ... and I think I’m liable to be put away as insane forexpressing that. That’s what’s insane about it."[viii]

We face recurrent, intensifying economic crises(and economic stagnation for the working and middle class in the developed West)because our financial elites are unworthy. They are too often outright criminals – control frauds.  They have no sense of accountability, nosense of duty to the nation (or community or world).  Herr Henkel demonstrates how pathetic theyhave become.  Their anti-regulatory,pro-greed ideology triumphed and produced a global Great Recession.  But for government intervention and bailoutsthey would have caused a second Great Depression worse than the original.  And what do our elites do?  They blame the least powerful citizens forthe crisis the elites designed, implemented, and grew rich on.  Herr Henkel even descends to the last refugeof a modern scoundrel – racism.

Thank you very muchfor taking your time, Mr. Black!

Bitte schön.

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