28 October 2010
William K Black, professor of economics and law at the University of Missouri, and the senior regulator during the US Savings and Loan crisis is, in my view, one of the sharpest commentators on the causes and cures of the financial crisis.
He has an uncanny ability to cut through the crap that keeps emanating from in-denial bankers, regulators, professionals and politicians about what’s really going on — and more particularly what went on — in the banking and financial markets during the credit bubble. Much of what Black says about immoral and amoral US bank behaviour applies, in spades, to the behaviour of UK banks including Northern Rock, Bradford & Bingley, HBOS and RBS.
Last month Black, who I featured in this blog in May, told the US Financial Crisis Inquiry Commission why American banks issued mortgages to borrowers who they knew hadn’t a cat in hell’s chance of repaying their loans. His remarkable testimony is a must-read, but here are some excerpts from the introduction (courtesy of Washington’s blog).
The epidemic of mortgage fraud was so large that it hyper-inflated the housing bubble, which allowed refinancing to further extend the life of the bubble (and the depth of the ultimate Great Recession.
In the cases where there have been even minimal investigations (New Century, Aurora/Lehman, Citigroup, Washington Mutual, Countrywide, and IndyMac) senior lender officials were aware that liar’s loans were typically fraudulent. The lenders could not make an honest business out of selling overwhelmingly fraudulent mortgages.
Liar’s loans were done for the usual reason – they optimized (fictional) short-term accounting income by creating a “sure thing” (Akerlof & Romer 1993). A fraudulent lender optimizes short-term fictional accounting income and longer term (real) losses by following a four-part recipe:
A. Extreme Growth
B. Making bad loans at a premium yield
C. Extreme leverage
D. Grossly inadequate loss reserves
Note that this same recipe maximizes fictional profits and real losses. This destroys the lender, but it makes senior officers that control the lender wealthy. This explains Akerlof & Romer’s title – Looting: The Economic Underworld of Bankruptcy for Profit. The failure of the firm is not a failure of the fraud scheme. (Modern bailouts may even recapitalize the looted bank and leave the looters in charge of it.)
The first two “ingredients” are related. Home lending is a mature, reasonably competitive industry. A lender cannot grow extremely rapidly by making good loans. If he tried, he’d have to cut his yield and his competitors would respond. His income would decline. But he can guarantee the ability to grow extremely rapidly by being indifferent to loan quality and charging weaker credit risks, or more naïve borrowers, a premium yield. In order to become indifferent to loan quality the officers controlling the lender must eviscerate its underwriting.
There is no honest reason for a secured lender to seek or permit inflated appraisal values. This is a sure marker of accounting control fraud – a marker that juries easily understand.
In other words, banks made loans to borrowers who they knew couldn’t really repay because the heads of the banks could make huge bonuses based on high volumes and fraudulent appraisals, and they didn’t care if their own companies later failed.
In short, they looted their companies and the economy as a whole.
Black brings us current to where we are today:
History demonstrates that if the control frauds get away with their frauds they will strike again. By allowing the banks to use their political power to gimmick the accounting rules to permit them to hide their massive losses on liar’s loans we have made it far harder to take effective administrative, civil, and criminal sanctions against the elite frauds that caused the Great Recession. Hiding the losses also adopts the dishonest Japanese approach that cripples economic recovery and public integrity.
Prosecuting the elites control frauds can be done successfully. Create a new “Top 100” priority list and appoint regulators that will make supporting the Justice Department a top agency priority. That’s how we obtained over 1,000 priority felony convictions of elite savings and loan criminals. No controlling officer of a large, non-prime specialty lender has been convicted of running a control fraud. Only one has even been indicted. The FBI has written that any discussion of the crisis that ignores the role of mortgage fraud is “irresponsible.”
Yesterday, the Harvard and Iowa law school professor Katherine Porter sounded a similar call to legal action in her testimony in the Congressional Oversight Panel‘s hearing on foreclosures:
America does not have to continue in a “crisis.” We do not have to tolerate abuse of the legal system, systematic errors, bloated fees, and chaos in the housing and financial sector.
Institutional Risk Analytics’ Christopher Whalen has pointed out that “government sponsored enterprises”, Freddie Mac and Fannie May, fuelled the epidemic of mortgage fraud. Like Black, Whalen has blasted the Obama administration for covering this up:
The invidious cowards who inhabit Washington are unwilling to restructure the largest banks and government-sponsored enterprises. The reluctance comes partly from what truths restructuring will reveal. As a result, these same large zombie banks and the US economy will continue to shrink under the weight of bad debt, public and private. Remember that the Dodd-Frank legislation was not so much about financial reform as protecting the housing government-sponsored enterprises.
Because President Barack Obama and the leaders of both political parties are unwilling to address the housing crisis and the wasting effects on the largest banks, there will be no growth and no net job creation in the US for the next several years. And because the Obama White House is content to ignore the crisis facing millions of American homeowners, who are deep underwater and will eventually default on their loans, the efforts by the Fed to reflate the US economy and particularly consumer spending will be futile. As Alan Meltzer noted to Tom Keene on Bloomberg Radio earlier this year: “This is not a monetary problem.”
The fraud and obfuscation now underway in Washington to protect the too-big-to-fail banks and GSEs totals into the trillions of dollars and rises to the level of treason. And in the case of the zombie banks, the GSEs and the MIs, the fraud is being actively concealed by Congress, the White House and agencies of the U.S. government led by the Federal Reserve Board. Is this not tyranny?