[Original interview published April 21, 2010]
PART ONE: THE BUBBLE & HERR HENKEL / PART TWO: ECONOMIC WARFARE
By Lars Schall
When it comes to White-Collar Crime and Control Fraud, the Roosevelt Institute Braintruster William K. Black is surely the leading expert to ask. In an exclusive interview in two parts, he answers questions related to major causes for the financial / economic crisis, the SEC charges against Goldman Sachs and the importance of drug money for the survival of the international banking system in our times.
William K. Black developed the concept of “Control Fraud” and focuses in his research on the factors of “criminogenic environments” that produce epidemics this dangerous phenomenon.
Who better to ask on matters of economic warfare?
And on a certain German opinion-maker?
PART ONE: THE BUBBLE & HERR HENKEL
Recently I conducted an interview with economist James K. Galbraith and asked him at the beginning:
What caused the crisis?(i)
Mr. Galbraith mentioned “white-collar criminologists”:
“This group had the experience of what happened in the Savings and Loan crisis of the 1980’s, when certain patterns of behaviour, which are relatively standard in criminal financial activity, were very clearly present. These patterns re-emerged in the early 2000’s in the Enron, Worldcom, and Tyco scandals, and they were re-emerging again in the housing sector. To these people it was entirely obvious that a massive problem was developing.”(ii)
Mr. Black, you are a white-collar criminologist. Can you describe for us these “certain patterns of behaviour, which are relatively standard in criminal financial activity” and explain why they occurred?
The fuller question is why we have recurrent, intensifying crises in so many nations. The principal cause is epidemics of “control fraud.” “Control frauds” are seemingly legitimate entities controlled by persons that use them as a fraud “weapon.” (The person that controls the firm is typically the CEO, so that term is used in this article.) A single control fraud can cause greater losses than all other forms of property crime combined. Neo-classical economic theory, methodology, and praxis is optimizing criminogenic environments that hyper-inflate financial bubbles 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 that control fraud cannot exist while recommending legal policies that optimize an industry for control fraud. Its hostility to regulation, endorsement of opaque assets that lack readily verifiable market values, and support for executive compensation that creates perverse incentives to engage in accounting control fraud and optimizes fraudulent CEOs’ ability to convert firm assets to the CEO’s personal benefit have created a nearly perfect crime.
George Akerlof’s famous article about lemons markets (1970) illustrated one of the worst problems that asymmetical information could cause and began the research that led to the award of the Nobel Prize in Economics in 2001. The examples of lemons markets that Akerlof explored in that article were all anti-consumer control frauds in which the deceit hides quality defects in the merchandise. Akerlof explained that this could cause a “Gresham’s” dynamic in which cheaters prospered and market forces drove honest competitors out of the industry.
Neo-classical economics failed to build on Akerlof’s work to develop a coherent theory of fraud, bubbles, or financial crises. Epidemics of control fraud are superb devices for hyper-inflating financial bubbles. The epidemic of mortgage fraud was essential to the creation of the largest bubble in history, the U.S. housing bubble.
Fraud is instrinsically dangerous to markets in another fashion that can cause crises. At law, the defining element of fraud 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 to massively overstated asset values. This can cause bankers to distrust other bankers – which can cause markets to collapse instead of clear.
What are other consequences of Control frauds?
Control frauds can cause enormous losses, while minimizing the risk that controlling officers will be sanctioned because only the CEO can (Black 2005):
-Optimize the firm’s operations and structures for fraud
-Set a corrupt tone at the top, and suborn controls, employees and officers into becoming allies
-Convert firm assets to the CEO’s personal benefit through seemingly normal corporate compensation mechanisms
-Optimize the external environment for control fraud, e.g., by creating regulatory black holes.
These perverse factors were first identified in connection with the S&L debacle of the 1980s. The National Commission on Financial Institution Reform Recovery and Enforcement (NCFIRRE) (1993), report on the causes of the S&L debacle documented the patterns.
The typical large failure was a stockholder-owned, state-chartered institution in Texas or California where regulation and supervision were most lax…. [It] had grown at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very 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 (NCFIRRE 1993: 3-4).
[A]busive operators 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:
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 lcoan 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 (1994: 10-11).
A lender optimizes accounting control fraud through a four-part recipe. Top economists, criminologists, and the savings and loan (S&L) regulators agreed that this recipe is a “sure thing” – producing guaranteed, record (fictional) near-term profits and catastrophic losses in the longer-term. Akerlof & Romer (1993) termed the strategy: Looting: Bankruptcy for Profit. The firm fails, but the officers become wealthy through:
-Extremely rapid growth
-Lending at high (nominal) yield to borrowers that will frequently be unable to repay
-Providing grossly inadequate reserves against the losses inherent in making bad loans.
Nonprime mortgage lenders followed the same recipe. Growth was extreme. Loan standards collapsed. Leverage was exceptional. Unregulated nonprime lenders had no meaningful capital rules.
Honest lenders would establish record high loss reserves pursuant to generally accepted accounting principles (GAAP). “The industry’s reserves-to-loan ratio has been setting new record lows for the 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 and S&L crises. In 2009, IMF estimated losses on U.S. originated assets of $2.7 trillion (IMF 2009: 35 Table 1.3) (roughly 30 times larger than bank loss reserves).
Control frauds, either directly or indirectly through the perverse incentives their compensations systems create for loan officers, loan brokers, and mortgage brokers, cause, encourage, and accede to endemic appraisal fraud.(iii)
Could the 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 crisis to contain successfully than many prior financial crises. The United States had extensive experience with nonprime mortgage lending – and it always ended badly. This is the third nonprime failure in twenty years. Nonprime lending, on its face, is inherently imprudent.
Nonprime lenders suffered huge losses (and many failures) in the late 1990s. These nonprime lenders were also known for their predatory lending practices, which led to serious (but not criminal) sanctions by the Federal Trade Commission. The most disturbing aspect of this series of nonprime failures was that elite commercial banks rushed to acquire the predatory lenders even as they were failing and sued by the FTC. President Bush even appointed the most infamous predatory subprime lender, Roland E. Arnall, to be ambassador to the Netherlands in 2005. Arnall ran Ameriquest Mortgage and was Bush’s largest political contributor since 2002. Ameriquest was the largest subprime lender. It converted from being a S&L to a mortgage banking firm to escape our regulatory restrictions on its subprime lending. It spun off one subprime company that was acquired by WaMu in 1999. In August 2007, Ameriquest shut down its retail lending operations and sold its loan servicing to Citigroup.
The nonprime loans of the current crisis were an order of magnitude worse than in the early 1990s. They were subprime loans with severe credit defects and “no doc” (”liar’s loans“). That produces 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 in 2004, and were supplemented by warnings of endemic appraisal fraud in 2005. “Stated income” loans became known throughout the industry as “liar’s loans” and grew to roughly 30% of total new mortgages by early 2007. Many lenders made liar’s loans their primary product.
The primary epidemic of accounting control fraud by nonprime lenders produced “echo” epidemics of upstream and downstream control fraud. The primary mortgage fraud epidemic created a criminogenic environment that caused the upstream mortgage fraud epidemic. The downstream epidemic consists of those that purchased the nonprime product. The downstream epidemic could not have existed without the endemic mortgage fraud the other two fraud epidemics produced, but the downstream epidemic allowed both 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 them massive quantities of relatively high yield mortgage loans with supporting appraisals, without regard to credit quality. The nonprime lenders created perverse incentives that produced a series of “Gresham’s” dynamics. This did not require any formal agreement (conspiracy), which made it far easier to create an upstream echo epidemic and far harder to prosecute. Traditional mortgage underwriting has shown the ability to detect fraud prior to lending. The senior managers that controlled nonprime mortgage lenders that were control frauds, therefore, had to eliminate competent underwriting and suborn “controls” to pervert them into fraud allies.
When the nonprime lenders gutted their underwriting standards and controls and paid brokers greater fees for referring nonprime loans they inherently created an intensely criminogenic environment for loan brokers and appraisers. The brokers’ optimization strategy was simple – refer as many relatively high yield mortgage loans as possible, as quickly as possible, with applications and made the borrower appear to qualify for the loan. The nonprime lenders, in essence, signaled their intention not to kick the tires and weed out even fraudulent loan applications and appraisals. I call this the financial version of “don’t ask; don’t tell” (a justly maligned U.S. military policy about gays serving in our armed services).
What other problems are associated with the subprime market?
As I’ve explained, the risk of loss rose spectacularly during the decade as loan quality collapsed, fraud became endemic in nonprime loans, and the bubble hyper-inflated. Logically, this should have caused a dramatic increase in loss reserves and should have caused nonprime “spreads” to widen substantially. Instead, the officers controlling the lenders reduced loan loss reserves to ridiculous levels – and spreads narrowed. The first dimension demonstrates endemic accounting and securities fraud. The second dimension demonstrates that markets were not only “inefficient”, but also became increasingly inefficient throughout the growing crisis.
While Greenspan and other failed regulators have claimed that no one warned of the coming crisis; that was truer of the S&L debacle than the current crisis. I’ve shown that there were strong, early warnings of endemic fraud and predictions that it would cause a crisis. Nonprime loans, as I’ve explained, had a consistently bad track record and their problems were sufficiently recent that they should have been well known to both private and public sector leaders. The Enron-era control frauds and New York Attorney General Spitzer’s investigations were fresh in Americans’ minds. Those frauds made clear that:
-The most elite corporations engaged in fraud
-Those frauds were led from the top
-Accounting fraud produced exceptional deception – firms such as Enron that were grossly insolvent and unprofitable purported to be immensely profitable
-The large frauds were able to get “clear opinions from top tier audit firms
-Executive compensation was a major driver of the frauds
-Banks funded the accounting control frauds rather than exerting effective “private market discipline” against them
-Effective regulation was essential to limit such frauds
During the S&L debacle, by contrast, only one economist (Ed Kane) warned publicly of a coming crisis arising from bad assets – and he did not warn about the wave of control fraud. Economists virtually unanimously opposed our reregulation of the industry (Paul Volcker was the leading exception). Economists, including Alan Greenspan, were leading allies of the worst S&L accounting control frauds.
The most difficult aspect of the current crisis to contain was that roughly 80% of nonprime loans were made by entities not subject to direct federal regulation (primarily mortgage bankers). The Federal Reserve (Fed), however, had unique statutory authority to regulate all mortgage lenders under the Home Ownership and Equity Protection Act of 1994 (HOEPA), but Greenspan and Bernanke refused to use it. Finally, over a year after the secondary market in nonprime loans (CDOs) collapsed, and after Congressional pressure to act, the Fed used its HOEPA authority to order an end to some of the most abusive nonprime lending practices. Prior to that time, the federal regulatory agencies acted aggressively throughout the decade to assert federal “pre-emption” of state regulation as a means of attempting to prevent the states from protecting their citizens from predatory nonprime lenders.
All the regulators needed to do to prevent the crisis was to ban lending practices that were rational only for control frauds engaged in looting. The regulators consistently refused to do so because of their anti-regulatory ideology. Traditional mortgage underwriting practices are highly effective against fraud. The regulators knew what reforms would work, but refused to mandate the reforms.
By the time this crisis began economists (Akerlof & Romer 1993), regulators (Black 1993); and criminologists (Calavita, Pontell & Tillman 1997; Black 2003; Black 2005) had developed effective theories explaining why combining financial nonregulation and modern executive and professional compensation produced criminogenic environments that led to epidemics of accounting control fraud. We also explained why these were near perfect frauds and explained how control frauds used their compensation and hiring and firing powers to create a “Gresham’s” dynamic that allowed them to suborn the “independent” professionals that were supposed to serve as “controls” and transform them into allies. (This is similar to HIV’s ability to infect the immune system.)
One of the important practical aspects of control fraud research findings is the existence of fraud “markers.” These can be used to identify the frauds even while they are reporting record profits and minimal losses. The fraud markers also make it possible to prosecute successfully complex frauds because jurors can understand that it makes no sense for honest firms to engage in such practices but makes perfect sense for frauds.
Equally importantly, our research showed how to contain a spreading epidemic of accounting control fraud. These policies were exceptionally effective in containing the S&L debacle. The existence of these research findings and our regulatory record of successful efforts against the accounting control fraud should have made it far easier for our regulatory successors (and any honest bankers) to identify the frauds at an early date and take effective action against them.
During my mentioned interview with Mr. Galbraith, I asked him a few things related to statements given by Hans-Olaf Henkel, an highly influential opinion-maker in Germany:
The first thing he said was that basically no one saw this crisis coming and that he laughs himself to death whenever someone says that this crisis was foreseen.(iv)
Is this true or false?
The claim that no one could have foreseen the crisis is false. Unlike the S&L debacle, the FBI was far ahead of the regulators in recognizing that there was an “epidemic” of mortgage fraud and that it could cause a financial crisis. The FBI warned in September 2004 (CNN) that the “epidemic” of mortgage fraud would cause a “crisis” if it were not contained.(v) The FBI has emphasized that 80 percent of mortgage fraud losses occur when lending industry insiders are part of the fraud scheme. The FBI deserves enormous credit 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 a compendium in 2003 entitled: “Real Estate Fraud: The Housing Industry’s White-Collar Epidemic.” The warnings about appraisal fraud were equally stark – “Home Insecurity: How Widespread Appraisal Fraud Puts Homeowners at Risk” (Demos 2005). The remarkable fact is that the private sector, the regulators, and the prosecutors failed to take effective action despite these warnings. The failure to act is all the more troubling because the nonprime lenders followed the distinctive four-part recipe for lenders optimizing accounting control fraud that regulators, economists, and criminologists had documented and 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) and criminologists and economists (in the 1990s) had identified fraud “markers” (a term borrowed from pathology) that only fraudulent lenders would employ. Gutting underwriting is essential for lenders engaged in accounting control fraud because they have to make massive amounts of bad loans in order to grow extremely rapidly and charge premium interest rates in order to optimize near-term accounting “profits.” Banks (and economists) have known for centuries that gutting mortgage underwriting leads to “adverse selection” (lending to borrowers that will often not be able or willing repay their loans). The “expected value” of adverse selection 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 by inflating appraisals or by ignoring a track record of defaults that no honest lender would commit (Black, Calavita & Pontell 1985; Black 2005).
S&L regulators used these markers to identify and close the accounting control frauds while they were reporting record profits and minimal losses in the 1980s before they could cause a nationwide financial bubble, a general economic crisis, or recession. The most obvious marker is when lenders do not even take prudent steps to prevent fraud, but rather cover it up.
There is no honest reason for deliberately failing to establish adequate loss reserves, yet the typical nonprime lender slashed general loss reserves while risk was surging and GAAP required reserves to increase. That constitutes accounting and securities fraud, but it is also a marker of accounting control fraud. The officers controlling nonprime lenders, by keeping loan loss reserves at trivial levels, maxmized the lenders’ fictional income – and their compensation.
Roughly 40% of U.S. mortgage lending during 2006 was nonprime, evenly split between subprime (known credit defects) and “alt-a” (purportedly high credit quality, but lacking verification of key underwriting data). “Alt-a” loans, by definition, did not conduct traditional underwriting (Bloomberg 2007; Gimein 2008). Almost half of subprime loans, by 2006, did not conduct traditional underwriting. Nearly 30% of total mortgage lending in 2006 lacked traditional underwriting. A small sample review of nonprime loan files by Fitch (2007), found that underwriting had to be eviscerated to permit the endemic fraud that came to characterize nonprime mortgage lending.
Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.
[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.
MARI, the Mortgage Bankers Association (MBA’s) experts on fraud, warned that “low doc” lending caused endemic fraud.
Stated income and reduced documentation loans … are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.
One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.”
The same obvious question (which neither Fitch nor MARI asked) arises: why did lenders fail to use well understood underwriting systems that are highly successful in preventing fraud – even when they knew that fraud was endemic and would cause massive losses? The same obvious answer exists – it was in the interests of the controlling officers to optimize short-term accounting income. Turning a blind eye to endemic fraud helped optimize reported income and their executive compensation.
Criminologists and financial regulators have long warned that the failure to regulate the financial sphere de facto decriminalizes control fraud in the industry. The FBI cannot investigate effectively more than a small number of the massive accounting control frauds. Only the regulators can have the expertise, staff, and knowledge to identify on a timely basis the markers of accounting control fraud, to prepare the detailed criminal referrals essential to serve as a roadmap for the FBI, and to “detail” (second) staff to work for the FBI and serve as their “Sherpas” during the investigation.
The agency regulating S&Ls made criminal prosecution a top priority. The result was over 1000 priority felony convictions of senior insiders and their co-conspirators. That is the most successful effort against elite white-collar criminals. The agency also brought over 1000 administrative enforcement actions and hundreds of civil lawsuits against the elite frauds. One result of this was an extensive, public record of fact that fraud was “invariably present” at the “typical large failure” (NCFIRRE 1993). The Enron-era frauds were accounting control frauds and while the effort against them was too late and weaker than the effort against the S&L frauds it involved scores of 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 from a horrific systems capacity problem. It did not have the agents or expertise to deal with the concurrent control fraud epidemics it faced this decade. Its systems capacity problems became crippling when 500 white-collar specialists were transferred to national security investigations in response to the 9/11 attacks and the administration refused to allow the FBI to hire new agents to replace the lost white-collar specialists.
The most crippling limitation on the regulators’, FBI’s, and DOJ’s efforts to contain the epidemic of mortgage fraud and the financial crisis was not understanding of the cause of the epidemic and why it would cause a catastrophic financial crisis. The mortgage banking industry controlled the framing of the issue of mortgage fraud. That industry represents the lenders that caused the epidemic of mortgage fraud. The industry’s trade association is the Mortgage Bankers Association (MBA). The MBA followed the obvious strategy of portraying its members as the victims of mortgage fraud. What it never discussed was that the officers that controlled its members were the primary beneficiaries of mortgage fraud. It is the trade association of the “perps.” The MBA claimed that all mortgage fraud was divided into two categories – neither of which included accounting control fraud. The FBI, driven by acute systems incapacity, formed a “partnership” with the MBA and adopted the MBA’s (facially absurd) two-part classification of mortgage fraud (FBI 2007). The result is that there has not been a single arrest, indictment, or conviction of a senior official of a nonprime lender for accounting fraud.
One of the most dramatic, and unfortunate differences between the S&L debacle and the current crisis is that the financial regulatory agencies gave the FBI no help in this crisis – even after it warned of the epidemic of mortgage fraud. The FBI does not mention the agencies in its list of sources of criminal referrals for mortgage fraud. The data on criminal referrals for mortgage fraud show that regulated financial institutions, which are required to file criminal referrals when they find “suspicious activity” indicating mortgage fraud, typically fail to do so. There is no evidence that the agencies responsible for enforcing the requirement file criminal referrals have taken any action to crack down on the widespread violations.
The crippling mischaracterization of the nature 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 the Justice Department to create the type of national task force that it did in 2002 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-collar street crime.”
The nation’s top law enforcement official swallowed the MBA’s mischaracterization of the mortgage 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 a self-fulfilling prophecy in which the FBI and DOJ pursued only the “white-collar street crim[inals]” (the small fry) and therefore confirmed that the problem was the small fry. The pursuit of the small fry was certain to fail.
The MBA’s success in causing the FBI to ignore the control frauds reminds me of this passage in the original Star Wars movie where Obi-Wan uses Jedi powers to pass through an Imperial check point with two wanted droids in plain sight:
Stormtrooper: Let me see your 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’re looking 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 by those troops. I thought we were dead.
Obi-Wan: The Force can have a strong influence on the weak-minded.
The FBI isn’t supposed to be “weak-minded” about elite white-collar criminals. It is not supposed to be misled by “Jedi mind tricks” by the lobbyists for the “perps.” It is not supposed to fail to understand the importance of endemic markers of accounting control fraud at every nonprime specialty lender where even a preliminary investigation has been made public.
The FBI, DOJ, banking regulators, SEC, and all the purported sources of “private market discipline” failed to act against (and even praised) the perverse incentive structures that the accounting control frauds created to cause the small fry to act fraudulently. Those incentive structures ensured that there were always far more new small fry hatched to replace the relatively few small fry that the DOJ could imprison. Accounting control frauds deliberately produce intensely criminogenic environments to recruit (typically without any need for a formal conspiracy) the fraud allies that optimize accounting fraud. They create the perverse Gresham’s dynamic that means that the cheats prosper at the expense of their honest competitors. The result can be that the unethical drive the ethical from the marketplace. Had Mukasey been aware of modern white-collar criminological research he would have been forced to ask why tens of thousands of small fry were able to cause an epidemic of mortgage fraud in an industry that had historically successfully held fraud losses to well under one percent of assets. Ignoring good theory produces bad criminal justice policies.
Who else foresaw what was coming?
The economist Dean Baker began warning in 2002 that the housing bubble would cause catastrophic losses. The economist Robert Shiller’s warnings of the housing bubble (he also called the high tech bubble correctly) reached even the general public on August 21, 2005 in a New York Times article about “Mr. Bubble”.
Federal Reserve Board Member Gramlich warned his colleague, Alan Greenspan, of both the bubble and the developing nonprime crisis during the same time period.
My own warnings of the coming crises go back many years. The economist Jayati Ghosh discussed a paper I presented in New Delhi in 2005 (”When Fragile becomes Friable: Endemic Control Fraud as a Cause of Economic Stagnation and Collapse“).(vi)
One interesting aspect is that Shiller, Baker, Gramlich and I all studied or taught economics at the University of Michigan. The University of Michigan long served as an counterweight to the University of Chicago’s claims that the markets were self-regulating and efficient.
Jamie Galbraith has a wonderful article discussing the many scholars and practitioners that warned of the coming crisis that I recommend to your readers.(vii)
Hans Olaf Henkel also said:
…that this crisis was caused by a certain type of “do-goodism” among American politicians who wanted to make sure that every American citizen would have a home of her/his own.(viii)
No, the crisis was caused by “do-badism” led by our most elite financial CEOs. But Henkel perfectly epitomizes a type perfectly familiar to Germans and Americans. He is the one of the most powerful persons in his nation. The anti-regulatory policies he championed helped create the criminogenic environment that produced the epidemics of accounting control fraud that produced crises in Germany and America. He did not warn about the coming crisis. Instead, he served as a cheerleader for the elite business frauds that caused it. Now, in a final disgraceful act, he shirks all accountability, absurdly blames a minority he despises as the cause of the global crisis (in his telling of the tale, working class American blacks ruined the global economy by outwitting 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 business blaming the secretaries for the failure.
Mr. Henkel responded to Mr. Galbraith’s answers by asking him to read:
“Bill Clinton’s own biography in which he boasted (of course before the crisis) the introduction of his ‘National Home Owner’s Strategy’ with the objective to convert ‘two thirds of the Americans to home owners’.”(x)
Is this really necessary for Mr. Galbraith in order to understand the causes for this crisis?
The United States has had a far higher percentage of home ownership than most other nations throughout its history. Conservative economists and political scientists have long argued that this is one of the reasons for American prosperity and the absence of any nationally competitive socialist (or even social democratic) party. They have argued that home ownership leads to substantial positive externalities in terms of care for dwellings and neighbourhoods and to a rejection of populist politics. Henkel’s language makes it appear that that there was some radical plan to “convert” “two-thirds” of Americans from renting to owning. That is silly. Home ownership had long been the norm among American households. Clinton (and Bush) sought to produce a relatively small percentage increase in home ownership. That goal was supported by most conservatives because home ownership is generally good for a nation – not simply the homeowner. The largest governmental subsidy in the U.S. has long been the deductibility of mortgage interest payments for federal income tax purposes. That subsidy is directed principally to middle 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 with the crisis. The CEOs running the nonprime lenders made massive nonprime loans to create huge short-term accounting income and maximize their compensation – not because President Clinton (and the great majority of conservatives) thought greater home ownership 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 Community Reinvestment Act (CRA). To Mr. Henkel’s support, I want to underline that another influential opinion-maker in Germany, Hans-Werner Sinn, President of the ifo-Institute and author of the book “Kasino Kapitalismus”, holds a similar position. What is your take on this argument related to the CRA? Isn’t that at the end of the day what you call in the U.S. a “red herring”?It is such a “red herring” that even conservative members of the industry rarely make this spurious claim. There is zero truth to the claim that the CRA caused the crisis. Consider only the four most obvious problems with the argument:
-Roughly 80% of the nonprime loans were made by entities that were not federally insured and were not subject to the CRA.
-The CRA became law in 1977. It is absurd to claim that, after a 25 year latency period, it suddenly caused a crisis.
-Enforcement of the CRA became substantially weaker during the period leading up to the crisis. The law was weakened near the end of President Clinton’s term. The CRA rules were weakened in the early part of the decade of the crisis. Enforcement of the rules under the Bush administration was far weaker than under the Clinton Administration.
-The CRA never requires a lender to make a bad loan. It requires that banks use some the deposits they gather from a neighbourhood to make loans in that neighbourhood. It does not require lenders to weaken their credit standards.
These facts are known throughout the U.S. industry. When American business people claim that the CRA caused the crisis they know that the facts refute their claims. If they claim that the CRA caused the crisis they are engaged in propaganda. Professor Galbraith made the generous assumption that Herr Henkel and Herr Sinn were less likely to be aware of the facts that demonstrate that the CRA had nothing to do with causing the crisis.
Hans-Olaf Henkel had another suggestion for James Galbraith:
“Or better, Mr. Galbraith should familiarize himself Jimmy Carter’s ‘Housing and Community Development Act’ where in Section VIII Banks were prohibited the practice of ‘red lining’ which until 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 is not 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 to blacks. Herr Henkel has an interesting concept of causality. His “logic” is that blacks, not the denial of home loans, caused “slums.” Banks, naturally, did not loan to blacks because 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 and black neighborhoods (aka, “slums” in Henkel’s world view). The Fair Housing Act of 1968 (passed under President Johnson) outlawed redlining. Under Henkel’s “logic” it, after over a 30-year latency period, caused the global financial crisis. Black borrowers (”slum” dwellers all) destroyed the global economy. And Jews caused Germany to lose World War I by stabbing it in the back.(xii)
Jamie Galbraith gave Herr Henkel the generous presumption 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 the problem is malice rather than ignorance. He wants to blame blacks for the crisis. This is his “logical” chain of reasoning (most of it implicit):
– Bankers can judge the creditworthiness of white loan applicants, but not blacks
– Black borrowers pose enormous credit risk to home lenders
– Because blacks turn neighborhoods into “slums”
– Banks only 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”)
– When President 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 of Herr Henkel’s logic is correct. It is interesting that he asserts that American bankers lacked the ability “to distinguish ‘better living quarters’ and ‘slums’” absent red-lining. Why can’t a lender distinguish “better living quarters” from “slums” and if they cannot do so – how are they supposed to draw the “red lines” that distinguish where they can and cannot lend? There is one obvious answer to this paradox. The answer has the virtue of being historically accurate. The “red lines” 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 areas that were red-lined were not slums. They were the areas the residents were overwhelmingly black – and newly integrated areas.
In his analysis for the causes of the crisis, James Galbraith mentioned:
“…predatory activity directed at a very vulnerable segment of the American population, people who had been renters all their lives, who really couldn’t afford to be moved into houses, who were aggressively moved into them by unscrupulous lenders.”(xiii)
Related to African-Americans and predatory lending, I am familiar with an article by Michael Powell from the “New York Times” of June 6th, 2009: Banks Accused of Pushing Mortgage Deals on Blacks.
How was predatory lending used rather against than to the benefit of African-Americans and working class Americans?
The current crisis caused the greatest financial loss in 80 years to working class Americans. They were victimized in two ways. First, they were put in homes they could not afford at the peak of the housing bubble. Most of their homes are “underwater” – their mortgage is larger than the present market value of their home. Second, many nonprime lenders could have qualified for prime loans. The mortgage personnel, however, received greater commissions if they put their customers in higher cost (nonprime) loans. These lender personnel were more successful steering their less financially sophisticated customers into high cost product even when they would have qualified for less expensive loans.