Many banks set out to defraud, but the authorities continue to turn a blind eye
May 27th, 2010
It is astonishing that none of the bank executives who defrauded their own banks for personal gain before bringing down the financial system have yet been prosecuted — and that many are still working in the financial sector.
Before the crisis, the authorities turned a blind eye to “control fraud” — defrauding one’s own company for personal gain. This was largely because silvery-tongued lobbyists for Wall Street and the City persuaded President George W Bush and Prime Minister Gordon Brown, and indeed their predecessors, that creating a regulatory vacuum would allow banks and hence the wider economy to thrive.
As Nouriel Roubini and Stephen Mihm write in their new book Crisis Economics: A Crash Course in the Future of Finance, economists and politicians allowed themselves to be seduced by:
“Fairy tales about the wonders of unregulated markets and the limitless benefits of financial innovation.”
In fact, the removal of regulatory barriers led to a dystopian “Wild West” where, for example, banks were not stopped from actively encouraging mortgage borrowers to lie about their incomes, before bundling these “liar loans” into opaque securitized parcels and passing them off as ‘Triple A’. In the hellish financial world that was ushered in by Brown and Bush, this and other more extreme forms of skulduggery and corporate crime were deemed perfectly acceptable.
In the above video — which I strongly recommend you watch — William K. Black associate professor of economics and law at the University of Missouri, Kansas City, explains how this was allowed to happen and why the consequent epidemic of fraud that so nearly brought down the financial system has never been properly investigated.
Black says the crisis, which he says was 1,000 times worse than the US Savings and Loan crisis of the 1990s, owes its origins to “calculated dishonesty” by people at the top of banks and other financial institutions. From about 2003 onwards they, for the most part, ran their businesses in ways that delivered maximum bonuses in the short term; but which were bound to jeopardize their business’s long term future.
Black (and the interesting part commences about two minutes into the above programme) says:
“The way that [the CEOs and boards of banks and other financial institutions] do it is to make really bad loans, because they pay better. Then you grow extremely rapidly. In other words you’re a Ponzi-like scheme. And the third thing you do is, we call it leverage, which means you borrow a lot of money.
“The combination creates a situation where you have guaranteed record profits in the early years. That makes you rich through the bonuses that modern executive compensation has produced; it also makes it inevitable that there is going to be a disaster down the road.”
“All of the checks and balances report to the CEO, so if the CEO goes bad, all of the checks and balances are easily overcome. And the art form is not simply to defeat those internal controls but to suborn them; to turn them into your greatest allies and the bonus programs are exactly how you do that.”
Black, a former regulator, teaches white-collar crime, public finance, antitrust, law and economics. He is author of The Best Way to Rob a Bank is to Own One.
Short URL: https://www.ianfraser.org/?p=1163
Posted by Ian Fraser
on May 27 2010. Filed under Blog.
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[…] and The Vavasseur Fraud and The End of Laissez Faire and I also strongly recommend watching Professor Bill Black on US Public Service […]
Well that is just embarassing… Apparently you have managed to ignore the facts:
1) The demand for higher yield, higher rated paper was coming from the buyside, not generated by the sell-side so you are targeting the wrong people here. But they again you are in great company along the hard-core porn experts at the SEC.
2) The demand was so high that these banking CEOs simply were unable to make enough of these loans to satisfy demand – hence the synthetics.
3) The mortgage market is one of the most highly regulated industries out there and the structured products existed solely BECAUSE of regulation not because of a lack of them – ie that the buyside could take a punt on these mortgages because they got a stamp that the regulator recognised.
4) The largest actual frauds – as opposed to what dimwit ignorant journalists are claiming is “fraud” – were easily prosecutable under the law and again happened in the highly regulated fund management business -Madoff – and in the highly regulated orgination business.
5) Bank CEOs who did not ride the CDO and subprime wave were not going to lose their “short-term” bonuses but stood to lose their jobs under pressure from the buyside who owned their shares – look at what happened to John Mack’s predecessor at Morgan Stanley when he tried to take them down the safer agency and IB route.
I know that actually explaining the issues is less fun and more work than blaming “overpaid” bankers but the naive idealist in me likes to think at some point you actually had an interest in the facts.
Danny,
Interesting response, particularly the part about John Mack’s predecessor. I’m sure you’re right that the buyside and its addiction to high-yield junk and obliviousness to the risk of owning this junk merits far greater attention. However, I would contend just because someone is vociferously demanding something, does not mean one has to provide it – particularly if providing it means one is obliged to (1) urge your own borrowers to defraud you (by lying about their capacity to repay their loans etc), (2) sacrifice the long term future of your institution on the altar of short term profits growth.
Ian
Firstly, the “short-term” profits went on for over 5 years. In the corporate world that is a lifetime. Just curious how many investors you personally know who would be able to take 5 years of significantly underperforming their peers? How many CEOs do you personally know who inspire such faith in their investors that they would get no pressure whatsoever if they significantly underperformed?
Secondly, we ALREADY have rules to deal with fraud. It is a criminal offence to lie on these applications. The police should be arresting these people but they are not. Instead reporters are writing stories about how these poor people were “forced” to take these loans out and how they are going to “lose” their homes due to those nasty banks. Politicians are exerting every single sinew to prevent these people be fore-closed on and if possible to be lent more money to. So at one end, the villains are becoming the “victims”.
We then get a load of nonsense about “short-term” bonuses. Again never mind this bubble was over half a decade long. Never mind most of the senior players got paid largely in restricted stock with lock-ins and most of them “lost” hundreds of millions in paper wealth – which we all know is the same as cash, right? – when their companies either crashed or were bought for a song.
Finally, the real villains the buyside, in as far as they get mentioned, are turned into “dupes” who those overpaid, short-termist “crooks” on the sell-side “conned” into buying – in hindsight – instruments they would lose money on. Never mind in a 5 year bubble those “dupes” were earning 2/20 or even 1% AUM. Never mind that banks that were more circumspect got killed and lost their independence – look at JP Morgan, sold out to Chase at a relative discount who then underperformed until the bust. This is at the other end.
So we are now in a world where the people who really caused the financial crisis are the “victims” who need to be protected from the people who actually did lose their shirts. Where short-term is several years – but God forbid you have a couple of quarters of losses. Where people who had zero chance of owning a home before subprime become victims because they “lose” that home that they sucked all the equity out of and never really owned in the first place. Where people who commit financial fraud on their application forms are “victims” but the companies they defraud are “villains”. George Orwell would be proud.
PS The hands down best book for explaining the bubble is Blue Blood and Mutiny. It is about the ousting of Phil Purcell from Morgan Stanley in 2005. Bear Stearns and Lehmans are SPECIFICALLY mentioned by major investors in MS as models for MS. Marvel as Purcell loses Vikram Pandit who is eventually snapped up by Citibank for his fixed income expertise. Cheer as Mack returns in 2005 and takes MS back to its risk-taking roots and in particular storms into the mortgage back securities market.
Every other book is hindsight genius. This book shows the pressure that comes to bear on a CEO who tries to be prudent in a bubble.
1) I know plenty of Edinburgh-based investors – including Walter Scott & Partners and Bruce Stout manager of Murray International Trust – who were aware that all financials in the US and Europe had unsustainable models in 2003-08. They did not invest in them.
2) The line between victim and villain is a grey one. But, in the UK context, I know of executives in companies lent to by HBOS who were effectively coerced into borrowing far more than they needed, to do deals they didn’t want to do …. that’s one of the reasons that HBOS established so many joint ventures, in which the bank owned 50% of the equity; it meant HBOS was in a position to dictate the strategy…
3) You have a somewhat Manichaean view of the buy and sellside universe. Aren’t you capable of acknowledging there’s fault on both sides?? Or is everyone on the sellside ‘whiter than white’? I do agree, however, that far too little attention has been paid by the media etc to the people on the buyside who were pumping up this bubble full of unethical behaviour and fraud.
4) I agree that Orwell would be proud of the contorted logic that applies in some quarters. So would Franz Kafka, Joseph Heller and Jonathan Swift!
5) I’ll take a look at ‘Blue Blood and the Mutiny’. BTW I have heard it said that Fred Goodwin was told by his non-executive directors in circa 2005 that he ought to be emulating what BarCap was doing in financial markets at that time (particularly its profits growth) — hence the decision to embark on breakneck expansion of RBS Greenwich in the CDO arena…
Is it that obvious that i work on the sell-side??
The fact is the sell-side are facilitators and transmission mechanisms not causes. I am not sure how you regulate short-term greed and incompetence but I am sure putting a tougher fiduciary obligation on the buyside will stop this nonsense better than layering more regulation that you and I both know will result in some boilerplate and more work for lawyers and bankers.
The focus with the banks should be liquidity.. Pricing risk and assets is pointless in a fast moving market, the speed at which even the most liquid assets can move in a fast market is far beyond any VaR or accounting reports. What should be published is asset-liability maturity mismatches and funding requirements and horizons. This would far more useful to market participents and far more useful to regulators that some fixed capital requirement or some “counter-cyclical” capital requirement begging to fiddled with by politicians in the good times, especially as they start to end.
And I am not sure credit risk should be singled out for the special treatment it gets now. The discrete tranching is one of the causes of death spirals and the ratings are simply asking to be gamed – there is simply too much incentive to chase yield in boom times.
PS get the book out the library, she isn’t a great writer.
PPS RBS doesn’t surprise me… I remember when Barcap was the unwanted runt end of BZW, how times change.
[…] To read my earlier blog post, ‘Many banks set out to defraud but the authorities continue to turn a blind eye’, based around an interview with William K Black, click here […]
[…] I thought it may have been William K Black, associate professor associate professor of economics and law at the University of Missouri, […]