By William K. Black
Sixty Minutes' December 11, 2011 interview of President Obama included the following gem:
KROFT: One of the things that surprised me the most about this poll is that 42%, when asked who your policies favor the most, 42% said Wall Street. Only 35% said average Americans. My suspicion is some of that may have to do with the fact that there's not been any prosecutions, criminal prosecutions, of people on Wall Street. And that the civil charges that have been brought have often resulted in what many people think have been slap on the wrists, fines. "Cost of doing business," I think you called it in the Kansas speech. Are you disappointed by that?
PRESIDENT OBAMA: Well, I think you're absolutely right in your interpretation. And, you know, I can't, as President of the United States, comment on the decisions about particular prosecutions. That's the job of the Justice Department. And we keep those things separate, so that there's no political influence on decisions made by professional prosecutors. I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn't illegal.
That's exactly why we had to change the laws. And that's why we put in place the toughest financial reform package since F.D.R. and the Great Depression. And that law is not yet fully implemented, but already what we're doing is we've said to banks, "You know what? You can't take wild risks with other people's money. You can't expect a taxpayer bailout."
Hallucinations occur at high altitude when you become oxygen deprived. Let's review the bidding on the Bush/Obama record in prosecuting the elite control frauds that drove the ongoing crisis. There are no convictions of the Wall Street elites that made, purchased, packaged, and sold millions of fraudulent liar's loans. There are no federal prosecutions of the major banks that committed over 100,000 fraudulent foreclosures.
There are a few settlements that sound like large dollar amounts, but are merely what even Obama concedes to be the (deeply inadequate) “cost of doing (fraudulent) business.” Fraud pays – it pays enormously and our elites now commit it with impunity as a means of becoming wealthy. We have just witnessed the travesty of Wachovia admitting to criminal conduct in their (grotesquely weak) settlement with the Department of Justice (which has a policy of no longer prosecuting large corporations that commit crimes) – and having the SEC refuse to require Wachovia to make similar admissions in its settlement. All this, the President implicitly or even explicitly concedes.
But the President asserts: “I can tell you, just from 40,000 feet, that some of the most damaging behavior on Wall Street, in some cases, some of the least ethical behavior on Wall Street, wasn't illegal.” Kroft, sadly, did not follow up on this incredible and, if true, extraordinarily important assertion. Obama's statements about fraud and ethics are inaccurate on multiple levels. Obama's factual assertions about the failure to prosecute fraud are unresponsive to the question, false, and logically inconsistent. Note the artful manner in which Obama evaded answering Kroft's question. Kroft asks why there are no prosecutions of the Wall Street frauds that drove the crisis. Obama answers that “some” unethical Wall Street actions were not illegal. Obama's answer implicitly admitted that most Wall Street actions that caused the crisis were criminal. He simply argues that some highly unethical behavior by Wall Street that was not illegal contributed to that crisis.
As David Cay Johnston emphasized in his column about Obama's response to Kroft's question, Obama's answer is a non-answer. Why has he failed to prosecute any of the criminal conduct by Wall Street that drove the financial crisis? The (alleged) fact that “some” destructive Wall Street conduct was highly unethical, but not illegal, obviously provides no basis for not prosecuting what Obama concedes was primarily criminal conduct.
Obama claims that that the purported legality of Wall Street's (unspecified) “least ethical behavior” is “exactly why we had to change the laws.” He then describes the two specific changes in the Dodd-Frank law that he asserts make illegal that “least ethical behavior” for the first time. Obama claims that Dodd-Frank makes it illegal to “take wild risks with other people's money” and for bankers to “expect a taxpayer bailout.” Obama is a lawyer and former law professor, so these are matters as to which he is capable of precision. Dodd-Frank does not make it illegal for bankers to take “wild risks.” Banks inherently take risks “with other people's money” so that that bit of rhetoric is superfluous. Dodd-Frank does not make it illegal for a banker to “expect a taxpayer bailout.” Dodd-Frank does not make it illegal (and could not constitutionally do so) for bankers to lobby for a bailout. We have all seen the success of such lobbying with the Bush and Obama administrations. Both administrations have refused to order an end to the “systemically dangerous institutions” (SDIs) (inaccurately referred to as “too big to fail”). Both administrations asserted that when the next SDI failed it was likely to cause a global systemic crisis. (It is a matter of “when”, not “if” they will fail, or more precisely, when we will admit that they failed.) The SDIs are also too big to manage – they are inefficiently large. We can increase efficiency, dramatically reduce global systemic risk, and reduce the SDI's exceptional political dominance by ordering them to shrink over the next five years to a point that they no longer pose a systemic risk. Instead, the Obama administration continues the Bush practice of referring to the SDIs as “systemically important” (as if they deserved a gold star for putting the world's economy at risk).
The Bush and Obama administrations have allowed, even encouraged, the SDIs to grow larger. That policy is insane. It poses a clear and present danger to the U.S. and global economy and to our democracy. The SDIs will be “bailed out” when they fail. Indeed, they are being bailed out continuously by policies the Fed and Treasury follow that are designed to provide massive governmental subsidies primarily for the benefit of the zombie SDIs that have already failed in real economic terms, e.g., Bank of America and Citi.
“Wild risks” are not remotely Wall Street's “least ethical behavior.” It is impossible, given Obama's generalities and Kroft's failure to probe to know what “wild risks” Obama is talking about, but none of the (supposed) risky loans banks made even approach lenders' “least ethical behavior.” The riskiest loans that banks made were liar's loans to borrowers with bad credit histories. Credit Suisse reported in early 2007 that, by 2006, 49 percent of loans that lenders called “subprime” (because they were made to borrowers with known, serious credit defects) were also liar's loans (loans made without prudent underwriting).
I agree with Obama that making a subprime liar's loan is exceptionally “damaging.” Such loans damaged the lender, the borrower, the purchaser of such loans, and the purchaser of the collateralized debt obligations (CDOs) that were backed by subprime liar's loans. (Of course, “backed” deserves to be in quotation marks.) Such loans would be dumb, but they wouldn't be among the banks' “least ethical” actions if the loans were lawful. Indeed, if making subprime liar's loans were merely risky, one could argue more persuasively that the banks were acting altruistically when they made such loans.
What Obama missed, and Kroft failed to call him on, is that “wild risk” by banks are typically frauds. I have explained these matters at length in previous posts, so I will provide the ultra short version here. Honest home lenders do not make liar's loans. In particular, honest lenders do not make subprime liar's loans. Honest home lenders do not make such loans because they create intense “adverse selection” and create a “negative expected value” (in plain English, they will lose money). No government (here or abroad), required any lender or other entity (i.e., Fannie and Freddie) to make or acquire liar's loans. In fact, the government repeatedly criticized liar's loans.
The FBI warned of an “epidemic” of mortgage fraud in September 2004. The mortgage lending industry's own anti-fraud body (MARI) warned every member of the Mortgage Bankers Association ("MBA") in writing in the 2006 that “stated income” loans were “an open invitation to fraudsters,” had a fraud incidence of 90 percent, and deserved the term the industry used behind closed doors to describe them – “liar's” loans. Despite these warnings, lenders massively increased the number of liar's loans they made.
Home lenders made subprime liar's loans because they were “accounting control frauds.” Subprime liar's loans were ideal “ammunition” for accounting fraud. They reduced the paper trail establishing that the lender knew the loan was fraudulent and they optimized the four-ingredient “recipe” for a lender engaged in accounting control fraud. (Grow rapidly by making bad loans at a premium yield, while employing extreme leverage and providing only grossly inadequate allowances for loan and lease losses (ALLL)).
The CEOs of lenders that made subprime liar's loans as part of this recipe were not taking risks in the conventional manner we discuss in finance (uncertainty). As George Akerlof and Paul Romer explained in their famous 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”), accounting control fraud is a “sure thing.” The lender is guaranteed to report record (albeit fictional) profits in the near term, which makes the CEO wealthy when he uses modern executive compensation to loot the lender. Unfortunately, the same recipe that creates extreme fictional income produces massive real losses.
Making liar's home loans inherently requires lenders to create perverse incentives for widespread mortgage fraud. It was lenders and their agents that overwhelmingly put the lies in liar's loans. The CEOs of the lenders who made subprime liar's loans compounded their initial mortgage origination fraud by making fraudulent reps and warranties to sell the endemically fraudulent mortgages. The growth in liar's loans (roughly half of them were also subprime loans) was so extreme – over 500% from 2003 to 2006 – that it caused the bubble to hyper-inflate.
Making fraudulent loans that placed millions of working class borrowers in loans that they frequently could not afford to repay and were deeply underwater in caused them a massive loss of wealth - and was distressingly unethical. The officers controlling the lenders that made fraudulent liar's loans were even more unethical because they caused this devastation in order to become exceptionally wealthy. The most morally depraved of the CEOs running accounting control frauds sought out the least financially sophisticated borrowers, often minorities, as their victims. Obama has unintentionally proved the accuracy of the plurality of survey responders who concluded that he serves Wall Street's interests at the expense of the public. He cynically evaded responding to the primary reason why the public “gets it” – the abject failure of his administration to prosecute the elite financial frauds that drove the financial crisis and the Great Recession. Obama offered the pathetic (and factually inaccurate) non-excuse that “some” unethical conduct might be legal. It is time for Obama (and Attorney General Holder) to “man up.” If they refuse to do so and are going to continue to be lap dogs for the elite financial frauds they should at least change the name of the Justice Department.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @WilliamKBlack
Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He is a white-collar criminologist. He was the Executive Director of the Institute for Fraud Prevention from 2005-2007.
Link to original at New Economic Perspectives