By Lars Schall, April 21, 2010

WilliamK. Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC).  He teaches White-Collar Crime, Public Finance, Antitrust,Law & Economics (all joint, multidisciplinary classes for economics and lawstudents), and Latin American Development (co-taught with Professor Grieco,UMKC).

Theapproach of the economists at UMKC, which has been dubbed “The Kansas City School,” builds on the work of Abba P. Lerner, John MaynardKeynes and Hyman P. Minsky.

Blackwas a senior federal financial regulator during the Savings & Loan crisisof the 1980’s. He was the staff leader of the re-regulation of the industry,which included making criminal referrals and supporting criminal prosecutions.He testified before Congress on several occasions about the role of fraud inthe debacle and the Federal Home Loan Bank Board’s (and OTS’) programs tosupport criminal prosecution of the frauds.

Heserved as the Deputy Staff Director of the National Commission on FinancialInstitution Reform, Recovery and Enforcement (NCFIRRE) and authored the staffreport on the role of fraud in the debacle and the criminal justice effortagainst such frauds. He met Dr. George Akerlof in the course of his NCFIRREwork. Dr. Akerlof’s work on the role of fraud in the S&L debacle drew onMr. Black’s research. Dr. Akerlof was later awarded the Nobel Prize inEconomics, in large part for his work on “lemons markets” (which explains howsellers defraud consumers by exploiting informational advantages).

Blackhas taught previously at the LBJ School of Public Affairs at the University ofTexas at Austin and at Santa Clara University, where he was also thedistinguished scholar in residence for insurance law and a visiting scholar atthe Markkula Center for Applied Ethics.

Moreover, he was litigation director of the FederalHome Loan Bank Board, deputy director of the FSLIC, SVP and General Counsel ofthe Federal Home Loan Bank of San Francisco, and Senior Deputy Chief Counsel,Office of Thrift Supervision. His regulatorycareer is profiled in Chapter 2 of Professor Riccucci's book Unsung Heroes(Georgetown University  Press 1995),Chapter 4 (“The Consummate Professional: Creating Leadership”) of ProfessorBowman, et al’s book The Professional Edge (M.E. Sharpe 2004), and Joseph M. Tonon’s article: “The Costs of Speaking Truth to Power:How Professionalism Facilitates Credible Communication”, Journal of Public Administration Researchand Theory 2008 18(2):275-295.

Robert Kuttner, in hisBusiness Week column, proclaimed William K. Blacks “The Best Way to Rob a Bankis to Own One” (University of TexasPress2005):

“Black's book is partly the definitivehistory of the savings-and-loan industry scandals of the early 1980s. Moreimportant, it is a general theory of how dishonest CEOs, crony directors, andcorrupt middlemen can systematically defeat market discipline and concealdeliberate fraud for a long time -- enough to create massive damage.”

William K. Black developed the concept of “Control Fraud” and focuses inhis research on the factors of“criminogenic environments” that produce epidemics of Control Fraud.

Who better to ask on mattersof economic warfare?

And fraud?

And since lately, on a certainGerman opinion-maker?

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).

PARTONE: THE BUBBLE & HERR HENKEL

Recently I conductedan interview with economist James K. Galbraith and asked him at the beginning:What caused the crisis?[i] In his analysis of thequestion if there were people who might have foreseen the crisis, Mr. Galbraithmentioned “white-collar criminologists” by stating:

“This group had theexperience of what happened in the Savings and Loan crisis of the 1980’s, whencertain patterns of behaviour, which are relatively standard in criminalfinancial activity, were very clearly present. These patterns re-emerged in theearly 2000’s in the Enron, Worldcom, and Tyco scandals, and they werere-emerging again in the housing sector. To these people it was entirelyobvious that a massive problem was developing.”[ii]

Mr. Black, you aresuch a white-collar criminologist. Can you describe for us these “certainpatterns of behaviour, which are relatively standard in criminal financialactivity” and explain why they occurred?

The fuller question is why we haverecurrent, intensifying crises in so many nations.  The principal cause is epidemics of “controlfraud.”  “Control frauds” areseemingly legitimate entities controlled by persons that use them as a fraud“weapon.”  (The person that controls thefirm is typically the CEO, so that term is used in this article.)  A single control fraud can cause greaterlosses than all other forms of property crime combined.  Neo-classical economic theory, methodology,and praxis is optimizing criminogenic environments that hyper-inflate financialbubbles and produce recurrent, intensifying financial crises.  Financial control frauds’ “weapon of choice”is accounting.  Neo-classical theory,which dominates law & economics, is criminogenic because it assumes thatcontrol fraud cannot exist while recommending legal policies that optimize anindustry for control fraud.  Itshostility to regulation, endorsement of opaque assets that lack readilyverifiable market values, and support for executive compensation that createsperverse incentives to engage in accounting control fraud and optimizes fraudulentCEOs’ ability to convert firm assets to the CEO’s personal benefit have createda nearly perfect crime. 

GeorgeAkerlof’s famous article about lemons markets (1970) illustrated one of theworst problems that asymmetical information could cause and began the researchthat led to the award of the Nobel Prize in Economics in 2001.  The examples of lemons markets that Akerlofexplored in that article were all anti-consumer control frauds in which thedeceit hides quality defects in the merchandise.  Akerlof explained that this could cause a “Gresham’s” dynamicin which cheaters prospered and market forces drove honest competitors out ofthe industry.

Neo-classicaleconomics failed to build on Akerlof’s work to develop a coherent theory offraud, bubbles, or financial crises. Epidemics of control fraud are superb devices for hyper-inflatingfinancial bubbles.  The epidemic ofmortgage fraud was essential to the creation of the largest bubble in history,the U.S. housingbubble. 

Fraud isinstrinsically dangerous to markets in another fashion that can causecrises.  At law, the defining element offraud that distinguishes it from other forms of larceny is deceit.  A fraudster gets the victim to trust him –and then betrays that trust.  Fraud,therefore, is the most effective acid for destroying trust.  Epidemics of accounting control fraud lead tomassively overstated asset values.  Thiscan cause bankers to distrust other bankers – which can cause markets tocollapse instead of clear.

What other consequences can Control frauds cause?

Controlfrauds can cause enormous losses, while minimizing the risk that controllingofficers will be sanctioned because only the CEO can (Black 2005):

·       Optimize the firm’s operations and structures forfraud

·       Set a corrupt tone at the top, and suborn controls,employees and officers into becoming allies

·       Convert firm assets to the CEO’s personal benefitthrough seemingly normal corporate compensation mechanisms

·       Optimize the external environment for control fraud,e.g., by creating regulatory black holes.

These perverse factorswere first identified in connection with the S&L debacle of the 1980s.  The National Commission on FinancialInstitution Reform Recovery and Enforcement (NCFIRRE) (1993), report on thecauses of the S&L debacle documented the patterns.

The typical largefailure was a stockholder-owned, state-chartered institution in Texas or California whereregulation and supervision were most lax…. [It] had grown at an extremely rapid rate, achieving high concentrationsof assets in risky ventures…. [E]very accounting trick available was used tomake the institution look profitable, safe, and solvent.  Evidence of fraud was invariably present aswas the ability of the operators to “milk” the organization through highdividends and salaries, bonuses, perks and other means (NCFIRRE 1993: 3-4).

[A]busiveoperators 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 (NCFIRRE 1993: 76).

James Pierce, NCFIRRE’s Executive Director,explained:

Accountingabuses also provided the ultimate perverse incentive:  it paid to seek out bad loans because onlythose who had no intention of repaying would be willing to offer the high loanfees and interest required for the best looting.  It was rational for operators to drive theirinstitutions ever deeper into insolvency as they looted them (1994: 10-11).

A lenderoptimizes accounting control fraud through a four-part recipe.  Top economists, criminologists, and the savingsand loan (S&L) regulators agreed that this recipe is a “sure thing” –producing guaranteed, record (fictional) near-term profits and catastrophiclosses in the longer-term.  Akerlof &Romer (1993) termed the strategy:  Looting: Bankruptcy for Profit.  The firm fails, but the officers becomewealthy through:

·    Extremely rapid growth

·    Lending at high (nominal) yield toborrowers that will frequently be unable to repay

·    Extreme leverage

·    Providing grossly inadequate reservesagainst the losses inherent in making bad loans.

Nonprimemortgage lenders followed the same recipe. Growth was extreme. Loan standards collapsed. Leverage wasexceptional. Unregulated nonprime lenders had no meaningful capital rules.

Honest lenders would establish record high lossreserves pursuant to generally accepted accounting principles (GAAP).  “The industry's reserves-to-loan ratio has been setting new record lows forthe past four years” (A.M. Best 2006: 3). The ratio fell to 1.21 percent as of September 30, 2005 (Id.: 4-5). Later, “loan loss reserves are down to levels not seen since 1985”(roughly one percent) (A.M. Best 2007: 1). It noted that these inadequate loss reserves in 1985 led to banking andS&L crises.  In 2009, IMF estimatedlosses on U.S. originated assets of $2.7 trillion (IMF 2009: 35Table 1.3) (roughly 30 times larger than bank loss reserves).

Control frauds, either directly or indirectly through the perverseincentives their compensations systems create for loan officers, loan brokers,and mortgage brokers, cause, encourage, and accede to endemic appraisal fraud.[iii]

Could this crisis,that we’re going through by now, have been prevented?

Yes, it could have been prevented.  Indeed, in many ways this was an easier crisisto contain successfully than many prior financial crises.  The United States had extensive experience withnonprime mortgage lending – and it always ended badly.  This is the third nonprime failure in twentyyears.  Nonprime lending, on its face, isinherently imprudent.

Nonprime lenders suffered huge losses (and manyfailures) in the late 1990s.  Thesenonprime lenders were also known for their predatory lending practices, whichled to serious (but not criminal) sanctions by the Federal Trade Commission.  The most disturbing aspect of this series ofnonprime failures was that elite commercial banks rushed to acquire thepredatory lenders even as they were failing and sued by the FTC.  President Bush even appointed the mostinfamous predatory subprime lender, Roland E. Arnall,to be ambassador to the Netherlands in 2005. Arnall ranAmeriquest Mortgage and was Bush's largest political contributor since 2002.Ameriquest was the largest subprime lender. It converted from being a S&Lto a mortgage banking firm to escape our regulatory restrictions on itssubprime lending. It spun off one subprime company that was acquired by WaMu in1999. In August 2007, Ameriquest shut down its retail lending operations andsold its loan servicing to Citigroup.

http://www.washingtonpost.com

The nonprime loans of the current crisis werean order of magnitude worse than in the early 1990s.  They were subprime loans with severe creditdefects and “no doc” (“liar’s loans”).  Thatproduces severe adverse selection. Adverse selection is criminogenic. It can produce fraud epidemics.

We will discuss later that the warnings of an“epidemic” of mortgage fraud, which began in 2003, were embraced by the FBI in2004, and were supplemented by warnings of endemic appraisal fraud in2005.   “Stated income” loans becameknown throughout the industry as “liar’s loans” and grew to roughly 30% oftotal new mortgages by early 2007.  Manylenders made liar’s loans their primary product.

Theprimary epidemic of accounting control fraud by nonprime lenders produced“echo” epidemics of upstream and downstream control fraud.  The primary mortgage fraud epidemic created acriminogenic environment that caused the upstream mortgage fraud epidemic.  The downstream epidemic consists of thosethat purchased the nonprime product.  Thedownstream epidemic could not have existed without the endemic mortgage fraudthe other two fraud epidemics produced, but the downstream epidemic allowedboth of the mortgage fraud epidemics to grow far larger.

In order to maximize their (fictional)accounting income, the nonprime lenders needed to induce others to send themmassive quantities of relatively high yield mortgage loans with supportingappraisals, without regard to credit quality. The nonprime lenders created perverse incentives that produced a seriesof “Gresham’s” dynamics. This did not require any formal agreement (conspiracy), which made itfar easier to create an upstream echo epidemic and far harder toprosecute.  Traditional mortgageunderwriting has shown the ability to detect fraud prior to lending.  The senior managers that controlled nonprimemortgage lenders that were control frauds, therefore, had to eliminatecompetent underwriting and suborn “controls” to pervert them into fraud allies.

When the nonprime lenders gutted theirunderwriting standards and controls and paid brokers greater fees for referringnonprime loans they inherently created an intensely criminogenic environmentfor loan brokers and appraisers.  Thebrokers’ optimization strategy was simple – refer as many relatively high yieldmortgage loans as possible, as quickly as possible, with applications and madethe borrower appear to qualify for the loan. The nonprime lenders, in essence, signaled their intention not to kickthe tires and weed out even fraudulent loan applications and appraisals.  I call this the financial version of “don’task; don’t tell” (a justly maligned U.S. military policy about gaysserving in our armed services).

Did the nonprimemarket also made no sense on other dimensions?

As I’ve explained, the risk of loss rosespectacularly during the decade as loan quality collapsed, fraud became endemicin nonprime loans, and the bubble hyper-inflated.  Logically, this should have caused a dramaticincrease in loss reserves and should have caused nonprime “spreads” to widensubstantially.  Instead, the officerscontrolling the lenders reduced loan loss reserves to ridiculous levels – andspreads narrowed.  The first dimensiondemonstrates endemic accounting and securities fraud.  The second dimension demonstrates thatmarkets were not only “inefficient”, but also became increasingly inefficientthroughout the growing crisis.

While Greenspan and other failed regulatorshave claimed that no one warned of the coming crisis; that was truer of theS&L debacle than the current crisis. I’ve shown that there were strong, early warnings of endemic fraud andpredictions that it would cause a crisis. Nonprime loans, as I’ve explained, had a consistently bad track recordand their problems were sufficiently recent that they should have been wellknown to both private and public sector leaders.  The Enron-era control frauds and New YorkAttorney General Spitzer’s investigations were fresh in Americans’ minds.  Those frauds made clear that:

·       Themost elite corporations engaged in fraud

·       Thosefrauds were led from the top

·       Accountingfraud produced exceptional deception – firms such as Enron that were grosslyinsolvent and unprofitable purported to be immensely profitable

·       Thelarge frauds were able to get “clear opinions from top tier audit firms

·       Executivecompensation was a major driver of the frauds

·       Banksfunded the accounting control frauds rather than exerting effective “privatemarket discipline” against them

·       Effectiveregulation was essential to limit such frauds

During the S&L debacle, by contrast, onlyone economist (Ed Kane) warned publicly of a coming crisis arising from badassets – and he did not warn about the wave of control fraud.  Economists virtually unanimously opposed ourreregulation of the industry (Paul Volcker was the leading exception).  Economists, including Alan Greenspan, wereleading allies of the worst S&L accounting control frauds.

The most difficult aspect of the current crisisto contain was that roughly 80% of nonprime loans were made by entities notsubject to direct federal regulation (primarily mortgage bankers).  The Federal Reserve (Fed), however, hadunique statutory authority to regulate all mortgage lenders under the HomeOwnership and Equity Protection Act of 1994 (HOEPA), but Greenspan and Bernankerefused to use it.  Finally, over a yearafter the secondary market in nonprime loans (CDOs) collapsed, and afterCongressional pressure to act, the Fed used its HOEPA authority to order an endto some of the most abusive nonprime lending practices.  Prior to that time, the federal regulatoryagencies acted aggressively throughout the decade to assert federal“pre-emption” of state regulation as a means of attempting to prevent thestates from protecting their citizens from predatory nonprime lenders.

All the regulators needed to do to prevent thecrisis was to ban lending practices that were rational only for control fraudsengaged in looting.  The regulatorsconsistently refused to do so because of their anti-regulatory ideology.  Traditional mortgage underwriting practicesare highly effective against fraud.  Theregulators knew what reforms would work, but refused to mandate thereforms.  

By the time this crisis began economists(Akerlof & Romer 1993), regulators (Black 1993); and criminologists(Calavita, Pontell & Tillman 1997; Black 2003; Black 2005) had developedeffective theories explaining why combining financial nonregulation and modernexecutive and professional compensation produced criminogenic environments thatled to epidemics of accounting control fraud. We also explained why these were near perfect frauds and explained howcontrol frauds used their compensation and hiring and firing powers to create a“Gresham’s” dynamic that allowed them tosuborn the “independent” professionals that were supposed to serve as “controls”and transform them into allies.  (This issimilar to HIV’s ability to infect the immune system.)

One of the important practical aspects ofcontrol fraud research findings is the existence of fraud “markers.”  These can be used to identify the frauds evenwhile they are reporting record profits and minimal losses.  The fraud markers also make it possible toprosecute successfully complex frauds because jurors can understand that itmakes no sense for honest firms to engage in such practices but makes perfectsense for frauds.

Equally importantly, our research showed how tocontain a spreading epidemic of accounting control fraud.  These policies were exceptionally effectivein containing the S&L debacle.  Theexistence of these research findings and our regulatory record of successfulefforts against the accounting control fraud should have made it far easier forour regulatory successors (and any honest bankers) to identify the frauds at anearly date and take effective action against them.

During my mentionedinterview with Mr. Galbraith, I asked him a few things related to statementsgiven by Hans-Olaf Henkel, an highly influential opinion-maker in Germany:

The first thing hesaid was that basically no one saw this crisis coming and that he laughs himselfto death whenever someone says that this crisis was foreseen.[iv]

Is thistrue or false?

The claimthat no one could have foreseen the crisis is false.  Unlike the S&L debacle, the FBI was farahead of the regulators in recognizing that there was an “epidemic” of mortgagefraud and that it could cause a financial crisis.  The FBI warned in September 2004 (CNN) thatthe “epidemic” of mortgage fraud would cause a “crisis” if it were notcontained.[v]  The FBI has emphasized that 80 percent ofmortgage fraud losses occur when lending industry insiders are part of thefraud scheme.  The FBI deserves enormouscredit for sounding such a strong, accurate, and public warning.  Special praise should also go to Inman News,which put out a series of reports about mortgage fraud that culminated in acompendium in 2003 entitled: “Real Estate Fraud: The Housing Industry’sWhite-Collar Epidemic.” Thewarnings about appraisal fraud were equally stark – “Home Insecurity: HowWidespread Appraisal Fraud Puts Homeowners at Risk” (Demos 2005).  The remarkable fact is that the privatesector, the regulators, and the prosecutors failed to take effective actiondespite these warnings.  The failure toact is all the more troubling because the nonprime lendersfollowed the distinctive four-part recipe for lenders optimizing accountingcontrol fraud that regulators, economists, and criminologists had documentedand explained in the S&L debacle, during financial privatization (e.g.,tunneling), and in the Enron-era control frauds. 

S&L regulators (in the 1980s) andcriminologists and economists (in the 1990s) had identified fraud “markers” (aterm borrowed from pathology) that only fraudulent lenders would employ.  Gutting underwriting is essential for lendersengaged in accounting control fraud because they have to make massive amountsof bad loans in order to grow extremely rapidly and charge premium interestrates in order to optimize near-term accounting “profits.”  Banks (and economists) have known forcenturies that gutting mortgage underwriting leads to “adverse selection”(lending to borrowers that will often not be able or willing repay theirloans).  The “expected value” of adverseselection is sharply negative, i.e., the lender will invariably lose money(once the losses become manifest). 

S&L regulators looked for fraud“markers”, such as deliberately lending to uncreditworthy borrowers byinflating appraisals or by ignoring a track record of defaults that no honestlender would commit (Black, Calavita & Pontell 1985; Black 2005).

S&L regulators used these markers toidentify and close the accounting control frauds while they were reportingrecord profits and minimal losses in the 1980s before they could cause anationwide financial bubble, a general economic crisis, or recession.  The most obvious marker is when lenders donot even take prudent steps to prevent fraud, but rather cover it up.

There isno honest reason for deliberately failing to establish adequate loss reserves,yet the typical nonprime lender slashed general loss reserves while risk wassurging and GAAP required reserves to increase. That constitutes accounting and securities fraud, but it is also amarker of accounting control fraud.  Theofficers controlling nonprime lenders, by keeping loan loss reserves at triviallevels, maxmized the lenders’ fictional income – and their compensation. 

Roughly 40% of U.S. mortgage lending during 2006 wasnonprime, evenly split between subprime (known credit defects) and “alt-a”(purportedly high credit quality, but lacking verification of key underwritingdata).  “Alt-a” loans, by definition, didnot conduct traditional underwriting (Bloomberg 2007; Gimein 2008).  Almost half of subprime loans, by 2006, didnot conduct traditional underwriting. Nearly 30% of total mortgage lending in 2006 lacked traditionalunderwriting.  Asmall sample review of nonprime loan files by Fitch (2007), found thatunderwriting had to be eviscerated to permit the endemic fraud that came tocharacterize nonprime mortgage lending.

Fitch’sanalysts conducted an independent analysis of these files with the benefit ofthe full origination and servicing files. The result of the analysis wasdisconcerting at best, as there was the appearance of fraud ormisrepresentation in almost every file.

[F]raudwas not only present, but, in most cases, could have been identified withadequate underwriting, quality control and fraud prevention tools prior to theloan funding. Fitch believes that this targeted sampling of files wassufficient to determine that inadequate underwriting controls and, therefore,fraud is a factor in the defaults and losses in recent vintage pools.

MARI, theMortgage Bankers Association (MBA’s) experts on fraud, warned that “low doc”lending caused endemic fraud.

Stated income and reduced documentation loans … are open invitationsto fraudsters.  It appears that manymembers of the industry have little historical appreciation for the havoccreated by low-doc/no-doc products that were the rage in the early 1990s. Thoseloans produced hundreds of millions of dollars in losses for their users.

One of MARI’s customers recently reviewed a sample of 100 statedincome loans upon which they had IRS Forms 4506. When the stated incomes werecompared to the IRS figures, the resulting differences were dramatic. Ninetypercent of the stated incomes were exaggerated by 5% or more. Moredisturbingly, almost 60% of the stated amounts were exaggerated by more than50%. These results suggest that the stated income loan deserves the nicknameused by many in the industry, the “liar’s loan.”

The sameobvious question (which neither Fitch nor MARI asked) arises:  why did lenders fail to use well understoodunderwriting systems that are highly successful in preventing fraud – even whenthey knew that fraud was endemic and would cause massive losses?  The same obvious answer exists – it was inthe interests of the controlling officers to optimize short-term accountingincome.  Turning a blind eye to endemicfraud helped optimize reported income and their executive compensation.

Criminologists and financial regulators havelong warned that the failure to regulate the financial sphere de facto decriminalizes control fraud inthe industry.  The FBI cannot investigateeffectively more than a small number of the massive accounting controlfrauds.  Only the regulators can have theexpertise, staff, and knowledge to identify on a timely basis the markers ofaccounting control fraud, to prepare the detailed criminal referrals essentialto serve as a roadmap for the FBI, and to “detail” (second) staff to work forthe FBI and serve as their “Sherpas” during the investigation. 

The agency regulating S&Ls made criminalprosecution a top priority.  The resultwas over 1000 priority felony convictions of senior insiders and theirco-conspirators.  That is the mostsuccessful effort against elite white-collar criminals.  The agency also brought over 1000administrative enforcement actions and hundreds of civil lawsuits against theelite frauds.  One result of this was an extensive,public record of fact that fraud was “invariably present” at the “typical largefailure” (NCFIRRE 1993).  The Enron-erafrauds were accounting control frauds and while the effort against them was toolate and weaker than the effort against the S&L frauds it involved scoresof prosecutions and provided substantial public documentation.

Why did the FBI,however, fail to contain the epidemic of mortgage fraud after identifying the epidemic as such?

The FBI suffered froma horrific systems capacity problem.  It did not have the agents or expertise todeal with the concurrent control fraud epidemics it faced this decade.  Its systems capacity problems became cripplingwhen 500 white-collar specialists were transferred to national securityinvestigations in response to the 9/11 attacks and the administration refusedto allow the FBI to hire new agents to replace the lost white-collar specialists.

The most crippling limitation on theregulators’, FBI’s, and DOJ’s efforts to contain the epidemic of mortgage fraudand the financial crisis was not understanding of the cause of the epidemic andwhy it would cause a catastrophic financial crisis.  The mortgage banking industry controlled theframing of the issue of mortgage fraud. That industry represents the lenders that caused the epidemic ofmortgage fraud.  The industry’s tradeassociation is the Mortgage Bankers Association (MBA).  The MBA followed the obvious strategy of portrayingits members as the victims of mortgage fraud. What it never discussed was that the officers that controlled itsmembers were the primary beneficiaries of mortgage fraud.  It is the trade association of the“perps.”  The MBA claimed that allmortgage fraud was divided into two categories – neither of which includedaccounting control fraud.  The FBI,driven by acute systems incapacity, formed a “partnership” with the MBA andadopted the MBA’s (facially absurd) two-part classification of mortgage fraud(FBI 2007).  The result is that there hasnot been a single arrest, indictment, or conviction of a senior official of anonprime lender for accounting fraud.

One of the most dramatic, and unfortunatedifferences between the S&L debacle and the current crisis is that thefinancial regulatory agencies gave the FBI no help in this crisis – even afterit warned of the epidemic of mortgage fraud. The FBI does not mention the agencies in its list of sources of criminalreferrals for mortgage fraud.  The dataon criminal referrals for mortgage fraud show that regulated financial institutions,which are required to file criminal referrals when they find “suspiciousactivity” indicating mortgage fraud, typically fail to do so.  There is no evidence that the agenciesresponsible for enforcing the requirement file criminal referrals have takenany action to crack down on the widespread violations.

The crippling mischaracterization of thenature of the mortgage fraud epidemic came from the top, as the New York Times reported in late 2008.

But Attorney General Michael B. Mukasey has rejected calls for theJustice Department to create the type of national task force that it did in2002 to respond to the collapse of Enron.

Mr. Mukasey said in June that the mortgage crisis was a different“type of phenomena” that was a more localized problem akin to “white-collarstreet crime.”

The nation’s toplaw enforcement official swallowed the MBA’s mischaracterization of themortgage fraud epidemic and economic crisis hook, line, sinker, bobber, rod,reel, and boat they rowed out into the swamp. Because Mukasey refused to investigate the elite frauds he created aself-fulfilling prophecy in which the FBI and DOJ pursued only the“white-collar street crim[inals]” (the small fry) and therefore confirmed thatthe problem was the small fry.  Thepursuit of the small fry was certain to fail.

The MBA’ssuccess in causing the FBI to ignore the control frauds reminds me of thispassage in the original Star Wars moviewhere Obi-Wan uses Jedi powers to pass through an Imperial check point with twowanted droids in plain sight:

Stormtrooper: Let me seeyour identification.
Obi-Wan: [with a small wave of his hand]You don't need to see his identification.
Stormtrooper: We don't need to see his identification.
Obi-Wan: These aren't the droids you'relooking for.
Stormtrooper: These aren't the droids we're looking for.
Obi-Wan: He can go about his business.
Stormtrooper: You can go about your business.
Obi-Wan: Move along.
Stormtrooper: Move along... move along.

Luke: I don't understand how we got bythose troops. I thought we were dead.
Obi-Wan: The Force can have a stronginfluence on the weak-minded.

The FBI isn’tsupposed to be “weak-minded” about elite white-collar criminals.  It is not supposed to be misled by “Jedi mindtricks” by the lobbyists for the “perps.” It is not supposed to fail to understand the importance of endemicmarkers of accounting control fraud at every nonprime specialty lender whereeven a preliminary investigation has been made public.

The FBI, DOJ,banking regulators, SEC, and all the purported sources of “private marketdiscipline” failed to act against (and even praised) the perverse incentive structures that the accounting control fraudscreated to cause the small fry to act fraudulently.  Those incentive structures ensured that therewere always far more new small fry hatched to replace the relatively few smallfry that the DOJ could imprison.  Accountingcontrol frauds deliberately produce intensely criminogenic environments torecruit (typically without any need for a formal conspiracy) the fraud alliesthat optimize accounting fraud.  Theycreate the perverse Gresham’s dynamic that means that the cheats prosper at the expense oftheir honest competitors.  The result canbe that the unethical drive the ethical from the marketplace.  Had Mukasey been aware of modern white-collarcriminological research he would have been forced to ask why tens of thousandsof small fry were able to cause an epidemic of mortgage fraud in an industrythat had historically successfully held fraud losses to well under one percentof assets.  Ignoring good theory producesbad criminal justice policies.

Who else foresaw what was coming?

The economist Dean Baker beganwarning in 2002 that the housing bubble would cause catastrophic losses.  The economist Robert Shiller’s warnings ofthe housing bubble (he also called the high tech bubble correctly) reached eventhe general public on August 21, 2005 in a NewYork Times article about “Mr. Bubble”:http://www.nytimes.com.

Federal Reserve Board MemberGramlich warned his colleague, Alan Greenspan, of both the bubble and the developingnonprime crisis during the same time period.

My own warnings of the comingcrises go back many years.  The economistJayati Ghosh discussed a paper I presented in New Delhi in 2005 (“When Fragilebecomes Friable: Endemic Control Fraud as a Cause of Economic Stagnation andCollapse”).[vi]

One interesting aspect is thatShiller, Baker, Gramlich and I all studied or taught economics at the University of Michigan.  The University of Michigan long served as ancounterweight to the University of Chicago’s claims that themarkets were self-regulating and efficient.

Jamie Galbraith has a wonderfularticle discussing the many scholars and practitioners that warned of thecoming crisis that I recommend to your readers.[vii]

Hans OlafHenkel also said:

…that thiscrisis was caused by a certain type of “do-goodism” among American politicianswho wanted to make sure that every American citizen would have a home ofher/his own.[viii]

No, the crisis was caused by“do-badism” led by our most elite financial CEOs.  But Henkel perfectly epitomizes a typeperfectly familiar to Germans and Americans. He is the one of the most powerful persons in his nation.  The anti-regulatory policies he championedhelped create the criminogenic environment that produced the epidemics of accountingcontrol fraud that produced crises in Germany and America.  He did not warn about the coming crisis.  Instead, he served as a cheerleader for theelite business frauds that caused it. Now, in a final disgraceful act, he shirks all accountability, absurdlyblames a minority he despises as the cause of the global crisis (in his tellingof the tale, working class American blacks ruined the global economy byoutwitting the world’s most elite financial institutions[ix]),and offers no meaningful reforms to prevent future crises.  It’s like the CEO of a failed businessblaming the secretaries for the failure.

Mr. Henkel respondedto Mr. Galbraith’s answers insofar he asked Mr. Galbraith to read:

“Bill Clinton's own biography inwhich he boasted (of course before the crisis) the introduction of his ‘NationalHome Owner's Strategy’ with the objective to convert ‘two thirds of theAmericans to home owners’.” [x]

Is this really necessary for Mr. Galbraithin order to understand the causes for this crisis?

The United States has had a far higher percentage of home ownershipthan most other nations throughout its history. Conservative economists and political scientists have long argued thatthis is one of the reasons for American prosperity and the absence of anynationally competitive socialist (or even social democratic) party.  They have argued that home ownership leads tosubstantial positive externalities in terms of care for dwellings andneighbourhoods and to a rejection of populist politics.  Henkel’s language makes it appear that thatthere was some radical plan to “convert” “two-thirds” of Americans from rentingto owning.  That is silly.  Home ownership had long been the norm amongAmerican households.  Clinton (and Bush)sought to produce a relatively small percentage increase in homeownership.  That goal was supported bymost conservatives because home ownership is generally good for a nation – notsimply the homeowner.  The largestgovernmental subsidy in the U.S. has long been the deductibility of mortgageinterest payments for federal income tax purposes.  That subsidy is directed principally tomiddle and upper class Americans. National American politics have never been dominated by poor Americans.

But the more important point is that this goal had nothing to do withthe crisis.  The CEOs running thenonprime lenders made massive nonprime loans to create huge short-termaccounting income and maximize their compensation – not because PresidentClinton (and the great majority of conservatives) thought greater homeownership was desirable.  Clinton never made a loan or mandated that a loan be made,much less a bad loan.

A crucial point is here with regard to Mr.Henkel’s argument, I believe, the CommunityReinvestment Act (CRA).To Mr. Henkel’s support, I want to underline that another influentialopinion-maker in Germany,Hans-Werner Sinn, President of the ifo-Institute and author of the book “KasinoKapitalismus”, holds a similar position. What is your take on this argumentrelated to the CRA? Isn’t that at the end of the day what you call in the U.S. a “redherring”?

It is such a “red herring” that even conservative members of theindustry rarely make this spurious claim. There is zero truth to the claim that the CRA caused the crisis.  Consider only the four most obvious problemswith the argument:

·       Roughly80% of the nonprime loans were made by entities that were not federally insuredand were not subject to the CRA

·       The CRAbecame law in 1977.  It is absurd toclaim that, after a 25 year latency period, it suddenly caused a crisis.

·       Enforcementof the CRA became substantially weaker during the period leading up to thecrisis.  The law was weakened near theend of President Clinton’s term.  The CRArules were weakened in the early part of the decade of the crisis.  Enforcement of the rules under the Bushadministration was far weaker than under the Clinton Administration. 

·       The CRAnever requires a lender to make a bad loan. It requires that banks use some the deposits they gather from aneighbourhood to make loans in that neighbourhood.  It does not require lenders to weaken theircredit standards. 

These facts are known throughout the U.S. industry. When American business people claim that the CRA caused the crisis theyknow that the facts refute their claims. If they claim that the CRA caused the crisis they are engaged inpropaganda.  Professor Galbraith made thegenerous assumption that Herr Henkel and Herr Sinn were less likely to be awareof the facts that demonstrate that the CRA had nothing to do with causing thecrisis.

Hans-Olaf Henkel had another suggestion forJames Galbraith:

“Or better, Mr. Galbraith shouldfamiliarize himself Jimmy Carter's ‘Housing and Community Development Act’where in Section VIII Banks were prohibited the practice of ‘red lining’ whichuntil then enabled them to distinguish ‘better living quarters’ and ‘slums’.”[xi]

Why should Mr.Galbraith do so, Mr. Black?

Herr Henkel is his own worst enemy.  As I said in an earlier publication: It isnot common to read nostalgia about the good old racist days when the government(the FHA) and businesses worked together to prevent loans from being made toblacks.  Herr Henkel has an interestingconcept of causality.  His “logic” isthat blacks, not the denial of home loans, caused “slums.”  Banks, naturally, did not loan to blacksbecause blacks lived in slums.  They drew“red lines” on maps around “slums” where they would not lend.  Then came what Herr Henkel terms the“do-goodism” among politicians that banned the red lining of integrated andblack neighborhoods (aka, “slums” in Henkel’s world view).  The Fair Housing Act of 1968 (passed underPresident Johnson) outlawed redlining. Under Henkel’s “logic” it, after over a 30-year latency period, causedthe global financial crisis.  Blackborrowers (“slum” dwellers all) destroyed the global economy.  And Jews caused Germany to lose World War I by stabbing itin the back.[xii]

Jamie Galbraith gave Herr Henkel the generouspresumption that he was simply unaware of the facts.  It turns out that Dr. Galbraith erred.  Herr Henkel has no regard for facts.  He is wrong about important facts, but theproblem is malice rather than ignorance. He wants to blame blacks for the crisis. This is his ”logical“ chain of reasoning (most of it implicit):

–       Bankerscan judge the creditworthiness of white loan applicants, but not blacks

–       Blackborrowers pose enormous credit risk to home lenders

–       Becauseblacks turn neighborhoods into ”slums“

–       Banksonly means of staying solvent is to deny lending to all blacks that live in “slums”

–       Therefore,they ”red-lined“ areas where many blacks lived (”slums“)

–       WhenPresident Johnson prohibited “red-lining” (in 1968) it caused a crisis (in 2008)because banks had to loan to ”slums“.

It soils one to even have to try to set out the“logic“ of a racist rant.  No part ofHerr Henkel’s logic is correct.  It isinteresting that he asserts that American bankers lacked the ability ”to distinguish‘better living quarters’ and ‘slums’” absentred-lining.  Why can’t a lender distinguish“better living quarters” from “slums” and if they cannot do so – how are theysupposed to draw the “red lines” that distinguish where they can and cannotlend?  There is one obvious answer tothis paradox.  The answer has the virtueof being historically accurate.  The “redlines” were not drawn on the basis of the quality of the housing stock.  They were drawn based on race.  There is extreme housing segregation in the United States.  The areasthat were red-lined were not slums.  Theywere the areas the residents were overwhelmingly black – and newly integratedareas.

In his analysis forthe causes of the crisis, James Galbraith mentioned:

“…predatory activitydirected at a very vulnerable segment of the American population, people whohad been renters all their lives, who really couldn’t afford to be moved intohouses, who were aggressively moved into them by unscrupulous lenders.”[xiii]

Related toAfrican-Americans and predatory lending, I am familiar with an article by Michael Powell from the “New York Times” of June 6th, 2009:

“Bank Accused of Pushing Mortgage Deals on Blacks”- http://www.nytimes.com/2009/06/07/us/07baltimore.html

How was predatory lending used rather against than to the benefit of African-Americansand working class Americans?

The current crisis caused the greatestfinancial loss in 80 years to working class Americans.  They were victimized in two ways.  First, they were put in homes they could notafford at the peak of the housing bubble. Most of their homes are “underwater” – their mortgage is larger than thepresent market value of their home. Second, many nonprime lenders could have qualified for prime loans.  The mortgage personnel, however, received greatercommissions if they put their customers in higher cost (nonprime) loans.  These lender personnel were more successfulsteering their less financially sophisticated customers into high cost producteven when they would have qualified for less expensive loans.

SOURCES: