Friday, February 10, 2012

Bill Black: How Fraud Leads to Recurrent, Intensifying Financial Crises, and Steps We Must Take To Stop that Cycle

The selected notes below do not encapsulate the entire conversation between Russ Roberts and Bill Black. The audio of the 73 minute conversation is provided below this text.

William K. Black's Regulatory Background: On April 2, 1985, William K. Black became the Litigation Director of the Federal Home Loan Bank Board - the primary federal regulator of Savings and Loan Associations. That agency subsequently became the Office of Thrift Supervision. Black ultimately had a docket of 10,000 cases and an outside-counsel budget of $100M. Soon after his appointment, there was a $6bn run on the largest S&L in the USA - American Savings. Bill Black was made staff leader of the emergency task force set up to handle that crisis. This led to his anti-fraud efforts.

Comparing the Fed's efforts at Lehman to how American Savings was handled: The SEC and the Fed sent staff into Lehman in its final months of distress. The Fed, knowing that Lehman was in desperate shape, sent 2 staff members. Black's team had sent 45 people to American Savings. Those 45 worked around the clock in shifts going through collateral. They made emergency lines of credit available on the basis of reasonable collateral. American Savings survived the run. Black's team used their leverage as a lender to force out Charlie Knapp

The Fraud at American Savings and other S&L's: The major fraud was initially missed by the SEC and by investors. Ultimately, it was discovered that they were engaging in what the industry termed "cash for trash".

Illustration of "Cash for Trash": A borrower would come in to the bank seeking a $1m loan for a project such as a strip mall. The S&L would instead lend the borrower $80m on condition that $78m of that loan would be used to buy a project that the S&L had previously financed and which was not fiscally viable.
The borrower would keep $2m and would vastly overpay ($78m) for the failing investment. The lender would often have an "equity kicker", meaning that the lender would get 50% of the profit at the time of a successful sale. The result would be the transformation of a real economic loss into a fictional gain. "When these frauds are dealt lemons, they don't make lemonade; they make Dom Perignon."

On what made this possible: Back in the 80's, there were rules that stated: 1. You must underwrite (determine the risks of the loan and the required yield) a loan before you make it, 2. You must establish that the borrower has the apparent ability to repay the loan, and 3. You must document 1 and 2. Note that these rules just codify what any prudent lender would do as good business practice - as in "rules that libertarian economists could love". There were arguably zero economic costs - in that any prudent lender would be doing this anyway.

On what happens when underwriting is not done: In the mortgage context, not underwriting creates an intensely negative expected value. Not underwriting will result in acute adverse selection; it pulls in the worst possible borrowers, and results in underpriced debt.

On what the crime was: At the core of it, the borrower would have documented income that did not exist. However, it was overwhelmingly the lender that would be encouraging, and in many cases preparing, the false documentation. This was true during the S&L crisis, and is also the case now.

On why it was done: As George Akelof and Paul Romer stated in Looting: The Economic Underworld of Bankruptcy for Profit, "Accounting control fraud is a sure thing." At the time people were doing this, no one was going to jail.

On moral hazard and market discipline: In economic theory it is supposed to be the subordinated debt-holders who enforce market discipline. They have the right incentives and are sophisticated actors. There were zero cases of effective private market discipline by either shareholders or subordinated debt holders in the S&L Crisis. More recently, the creditors in Enron, Bear Stearns, Lehman, Merrill Lynch were all private creditors. In theory they are supposed to provide discipline. But they do not.

On bailing out mismanaged banks:  The treatment of Systemically Dangerous Institutions that allows them to hold the economy hostage and produce bailouts is completely destructive to any theory of how an economic system should run.

On how Dick Pratt's deregulation exacerbated the problem: By mid-1982 the S&L industry, in the wake of Paul Volcker's interest rate hikes, was insolvent. Dick Pratt, the conservative head of  the Federal Home Loan Bank Board, created the key deregulatory bill - the Garn–St. Germain Depository Institutions Act of 1982. Pratt asked economists at the agency which state had the best results. Texas was where S&L's were showing the best returns. He used Texas as the model for deregulation. The problem was that the Texas S&L's were market leaders and innovators - in fraud. Pratt's deregulation was the key fraud-friendly event. (This is the fundamental problem with relying on econometrics during the expansion phase of an epidemic of accounting control fraud.)

On the progression of fraud from then to now:  Liars loans became significant in 1990-1991. It began in large part at Long Beach Savings. Black was part of the regional regulator at that point. They determined that Long Beach Savings was not going to be doing requisite underwriting, would be creating immense adverse selection, and were setting themselves up to lose money doing it. It only made sense as a fraud scheme. Black and his team wiped out liars loans in Orange County using normal supervisory means in the region. Long Beach Savings then gave up their federal charter and federal deposit insurance and became a mortgage banker for the sole purpose of escaping Black's jurisdiction. They changed their name to Ameriquest. It was the first big and infamous producer of liars loans and other nonprime loans, and was also a predatory lender. Ameriquest ultimately was sued by 48 state attorney generals and the FTC. They settled for $400m. Bush then appointed the CEO of Ameriquest to be the Ambassador to the Netherlands.

On how liars loans became prominent: Lenders would send out "term sheets" to brokers with the following optimization: 1. Higher yield => bigger fee for the broker, 2. Lower loan to value ratio => higher fee for the broker, 3. Lower debt to income ratio => bigger fee for the broker. In California you could get a $20,000 fee for doing a single jumbo loan. They incentivized brokers to bring in "optimized" loans in as high a volume as possible. Because they were "no doc" or "liars' loans", the brokers were able to gimmick the paperwork to make it fit those parameters.

The Fraud Recipe for lenders:  1. Grow like crazy by making crappy loans at a premium yield, 2. With extreme leverage, and 3. With virtually no meaningful allowances for losses. But the mortgage market is a mature market with many competitors. In order to grow like crazy - the average growth was 50% per year -  they must open up the field to borrowers who cannot afford homes.

On what can be achieved by following the Lender Recipe for Fraud: If you follow the above recipe for fraud, you create three things: 1. You are mathematically guaranteed to report record profits, 2. With modern executive compensation, you will beceome wealthy, and 3. You will maximize real economic losses.

On the fraud recipe for a purchaser of debt: 1. Grow like crazy by purchasing crappy loans at a premium yield, 2. With extreme leverage, and 3. With virtually no meaningful allowances for losses.

On how long it can last:  The fraud can go on for 8 to 10 years if these things cluster and we hyperinflate the bubble. The saying in the industry is, "A rolling loan gathers no loss." Bad loans can be refinanced and delinquencies can be hidden for a decade.

On the regulatory change that enabled liars loans: In 1993, under Clinton, they got rid of the Underwriting Rule. It was changed from a Rule to a Guideline - which is unenforceable. That made the liars loan the perfect vehicle for fraud.

On the enforcement effort following the S&L Crisis vs. our current enforcement effort: Ultimately, Black's team developed an extremely effective means to deal with the frauds. Their agency alone made well over 10,000 criminal referrals - which resulted in over 1,000 convictions. The same agency made ZERO criminal referrals after our more recent crisis.

On what we have done by ignoring fraud and bailing out Systemically Dangerous Institutions: We have made the world much more criminogenic. Why do we have recurrent, intensifying financial crises, brought on by these kinds of frauds? They are unintended consequences of deregulation and modern executive compensation.We have created perverse incentives.

On what we must do to stop the recurrent, intensifying financial crises: First, we must diminish the size of Systemically Dangerous Institutions. The current administration calls them systemically important institutions - as if they deserve a gold star. But they are inefficient and dangerous. We would make the world more efficient and dramatically safer if we shrunk them to the size where they posed no systemic risk of global collapse. As long as they are this big, they are going to get away with murder. And worse, they will create a Gresham's Dynamic (see George Akerlof's The Market for Lemons): where cheaters prosper, bad ethics can drive good ethics out of the marketplace.

Second, we must restore the criminal referral process which has been essentially eliminated in the regulatory agencies.

Third, we must stop any settlement in which the Justice Department will give immunity from criminal prosecution for fraud in the process of making loans. It is in the process of making loans in which the fraud overwhelmingly takes place.

Fourth, we must reinstate the Underwriting Rule. Guidelines are a useless regulatory activity. Anyone that needs the rules will ignore guidelines.

On the appropriate role of financial regulators: The fundamental task of financial regulators is to make private market discipline more effective - by removing cheaters who create perverse incentives.

On the role of government leading to the crisis: Lenders made bad loans because they made individuals in their industry much wealthier. No one told those companies to issue liars loans. Even the Bush Administration, which was not fond of regulation, consistently disparaged those kinds of loans. No one ever required that Fannie and Freddie purchase a liar's loan. Private entities created the incentive structures to grow their businesses as quickly as possible.

On the five-letter F-word: This is a story driven overwhelmingly by accounting control fraud in private industry - just as in the Enron era and during the S & L Crisis.  But fraud is now almost never discussed. Fraud is the tribal taboo that still exists in economics.

Audio of Russ Roberts' interview of William K. Black:

Link to original post at EconTalk:

Summary by Jaime Falcon

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