[Congressional Record Volume 156, Number 173 (Wednesday, December 22, 2010)]
[Extensions of Remarks]
[Pages E2252-E2254]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]
BLACK: THE DOMINANCE OF UNETHICAL BANKING
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HON. MARCY KAPTUR
of ohio
in the house of representatives
Wednesday, December 22, 2010
Ms. KAPTUR. Madam Speaker, today I am inserting into the
Congressional Record a recent blog post by Professor William
Black from the Associate Professor of Economics and Law at
the University of Missouri--Kansas City. Professor Black has
focused on white collar crime and routing out of fraud in our
financial system, both in practice and as a field of academic
study. Professor Black's answers on this CNN blog give
direction to our work on cleaning up our financial system of
the criminals while protecting those who follow the law. As
this Congress
[[Page E2253]]
comes to a close and we look to the future, we are faced with
the task of doing more to address the challenges of Main
Street while holding Wall Street accountable. Professor
Black's writing should be one of our guides.
Black: The Dominance of Unethical Banking
(By Jay Kernis)
Only on the blog: Answering today's five OFF-SET questions
is William K. Black, Associate Professor of Economics and Law
at the University of Missouri--Kansas City.
He was the Executive Director of the Institute for Fraud
Prevention from 2005-2007. Black also served as litigation
director of the Federal Home Loan Bank Board, deputy director
of the FSLIC, SVP and General Counsel of the Federal Home
Loan Bank of San Francisco, and Senior Deputy Chief Counsel,
Office of Thrift Supervision. He was also deputy director of
the National Commission on Financial Institution Reform,
Recovery and Enforcement.
You say that fraud by America's major banks plays an
enormous continuing role in the country's financial crisis.
How widespread is the fraud and what are the most serious
charges?
The FBI testified in September 2004 that mortgage fraud was
``epidemic'' and predicted that it would cause an ``economic
crisis'' if it were not contained. Instead of being
contained, FBI data show that it grew enormously after 2004.
The mortgage lending industry's own anti-fraud experts (MARI)
warned in 2006 that ``liar's'' loans deserved their name--
MARI reported a study finding that 80% of such loans were
fraudulent. MARI warned that liar's loans were ``an open
invitation to fraudsters.''
In a liar's loan the lender agrees not to verify the
borrower's income, wealth, job, and debts. The lender and its
agents, loan brokers, can then make up those numbers to make
the loan appear to be only moderately insane and sell the
fraudulent loan to an entity, typically an investment banking
firm or Fannie Mae or Freddie Mac, who will pool thousands of
fraudulent loans together and create a toxic financial
derivative called a ``CDO.'' The rating agencies and
investment bankers knew they had to engage in the financial
version of ``don't ask; don't tell'' on these CDOs because if
they ever really kicked the tires they would all explode--the
frauds in the underlying liar's loans from which the CDOs
were supposed to ``derive'' their value were that obvious and
common.
A credit ratings firm couldn't give a ``AAA'' rating (the
highest possible--the rating that virtually all these toxic
derivatives were given) if it looked at a sample of the
loans--so they religiously did not kick the tires on the
liar's loans. So we had the farce of ``credit rating''
agencies whose expertise was supposedly in reviewing credit
quality never looking at that credit quality so that they
could make enormous fees by giving toxic waste pristine
``AAA'' ratings.
The investment banks couldn't sell the financial
derivatives loans to others if the investment bankers (whose
supposed expertise was evaluating credit risk) were to
actually look at credit quality of the underlying liar's
loans. If they looked, they'd document that the loans were
overwhelmingly fraudulent. They'd then have three options.
A. They could sell the CDOs to others by calling them
wonderful ``AAA'' investments--while having files proving
that they knew this was a lie. This option is the
prosecutor's dream.
B. They could have sued the lenders that sold them the
fraudulent liar's loans. The investment banks typically had a
clear contractual right to force the fraudulent loans to buy
back the liar's loans. But there were fatal problems with
that option. The lenders that made liar's loans typically had
minimal capital (net worth). If the investment banks had
demanded that they repurchase the loans they would have been
unable to do so--and the demand would have exposed the
investment banks' bright shining lie that by pooling liar's
loans they could create ``AAA'' CDOs. Every CDO purchaser
from the investment banks would then demand that the
investment banks repurchased their CDOs--which would have
caused virtually every large U.S. investment bank to fail.
C. They could have gone to the Justice Department and
expose the massive fraud that was destroying the American
economy and help the FBI investigate the lenders specializing
in making liar's loans, the corrupt appraisers, and the
credit rating agencies. But that would have caused the CDO
bubble to burst and the investment banks to fail.
That's why the industry went with the fourth option--
``don't ask; don't tell.'' It's like the famous fable of the
emperor and the fraudulent designer. The designer tells
everyone that he has created clothes for the emperor of such
beauty that only the most sophisticated people can even see
the clothes. The emperor and his cronies all agree that the
clothes are glorious. The fraud only collapses when a boy
blurts out: ``the emperor is naked.'' As long as no one
engaged in the frauds pointed out that you can't make a
``AAA'' rating out of a pool of massively overvalued
fraudulent loans the housing bubble could hyper-inflate and
the officers of the investment banks and credit rating
agencies could become wealthy beyond their dreams.
I cite a study by Fitch, the smallest of the Big 3 rating
agencies later that documents the endemic nature of the fraud
in the nonprime mortgages backing the CDOs. That study does
not contradict the ``don't ask; don't tell'' strategy because
Fitch only published it in November 2007--after the secondary
market that created CDOs collapsed and it would not lose any
fees by asking and telling about the endemic fraud.
The industry sharply increased the number of liar's loans
after MARI's warnings that they were overwhelmingly
fraudulent. Fitch reviewed a small sample of the nonprime
loan and found that there was evidence of fraud in ``nearly
every'' file they reviewed and that the frauds were obvious
on the face of the loan and servicing files and would have
been discovered by any competent loan underwriting process.
Self-reviews by fraudulent nonprime lenders have consistently
revealed pervasive fraud in liar's loans. Reviews by
independent experts demonstrate that fraud was endemic in
liar's loans.
My testimony to the Senate and the Financial Crisis Inquiry
Commission (FCIC) explains why the number of criminal
referrals the FBI receives annually extrapolates to millions
of frauds. There were no formal definitions of an ``alt a''
or ``stated income'' loan (the two most common euphemisms for
liar's loans and, therefore, all the data are best guesses),
but Credit Suisse reported in 2007 that by 2006, 49% of new
mortgage loans in the U.S. were stated income (liar's loans).
If one assumes an 80% fraud incidence--which is the low end
of published studies by independent experts--that translates
into millions of fraudulent loans being made in 2006 alone.
State Attorney Generals' investigations have found that it
was lenders and their agents who put the lies in ``liar's''
loans. The NY AG found, for example, that Washington Mutual
(WaMu), which specialized in nonprime loans, (and is the
largest bank failure in U.S. history) kept a ``black list''
of appraisers. Appraisers got on the black list, however, if
they refused to provide WaMu with inflated (fraudulent)
appraisals. Survey data of appraisers confirms that nonprime
lenders and their agents commonly coerced appraisers to
inflate market values. The borrower has no leverage to coerce
appraisers.
There is no honest reason for a lender to seek, or permit,
appraisals to be inflated. White-collar criminologists and
competent banking regulators recognize that appraisal fraud
is a superb ``marker'' of ``control fraud''--the devastating
frauds in which the senior officers that control a seemingly
legitimate firm use it as a ``weapon'' to defraud. Iowa
Attorney General Miller testified before the Federal Reserve
in 2007 that his investigations found that the lenders and
the agents typically prompted or even directly provided the
false information in nonprime loan applications.
This makes sense because only lenders and loan brokers
would know the key debt-to-income and loan-to-value ratios
that would make the borrowers' application more likely to be
approved and generate the largest fees to the lenders and
their agents. AG Miller even aptly described the
``Gresham's'' dynamic that prevailed in nonprime lending. A
Gesham's dynamic arises in this context when lenders and loan
brokers that cheat gain a competitive advantage over honest
lenders and agents. The result can be a race to the bottom in
which those with no ethics drive the ethical from the
marketplace.
Attorneys General in 50 states are investigating mortgage
fraud and foreclosure fraud. Do you think this was bad
bookkeeping or are banks intentionally doing something
illegal?
I've explained why the data demonstrate that mortgage
fraud, particularly via liar's loans, was endemic,
intentional, and driven by the lenders and their agents.
Lenders and agents engaged in mortgage fraud do not want to
keep accurate records, for those records could provide a
roadmap for prosecuting them. The dearth of records was one
of the key attractions of liar's loans to these lenders and
their agents. That dynamic means that records are commonly
missing at lenders engaged in fraud.
Keeping good records is also a pain for loan officers. It
is a cost--it slows them down from making new (fraudulent)
loans that drive their income. Another marker of loan fraud
is paying loan officers large bonuses based on loan volume
instead of loan quality--everyone in the trade knows this
ends in disaster. But the failure of the lender is not a
failure of the fraud scheme. Here's the four-part recipe for
lenders maximizing fictional short-term accounting income
(thereby maximizing their bonuses). Note that the same recipe
maximizes real losses:
A. Grow extremely rapidly
B. Make very bad loans at high interest rates (``yield'')
C. Use extreme leverage (high debt relative to you equity)
D. Provide grossly inadequate loss reserves
A lender that follows this recipe is mathematically
guaranteed to report record (albeit fictional) income in the
near term--and to cause massive losses in the longer term.
This is why the Nobel prize winning economist, George Akerlof
and his colleague Paul Romer wrote the famous 1993 article
entitled: ``Looting: the Economic Underworld of Bankruptcy
for Profit.'' They describe accounting fraud as ``a sure
thing.'' The lender fails, but the senior officers walk away
wealthy. Since 1993, things have become far worse--we now
often bail out the failed lenders and leave the thieves in
charge.
But a lender making thousands of bad loans has to gut its
``back office'' operations--the folks who are supposed to
document loans and prevent bad loans. We know that this is
exactly what happened. Bank officers and employees of
nonprime lenders
[[Page E2254]]
were reamed out by their superiors if they tried to block the
bad loans. This dynamic is an independent reason why
recordkeeping at the nonprime lenders is often horrific.
Finally, lenders like Bank of America, Citibank, and WaMu
acquired major nonprime lenders that were notorious for their
predatory and fraudulent lending. These banks then often
place the employees they obtained via these mergers in charge
of loan servicing. It was utterly predictable that they would
continue their unethical practices when they functioned as
loan servicers--particularly because the alternative would be
to admit that their loan servicing files were a shambles. Far
better to simply file false affidavits and claim that
everything was in order--which is exactly what many of the
largest loan servicers did ten thousand times a month.
This is one of the reasons that my colleague Randy Wray and
I have called for Bank of America to be placed promptly into
receivership. A minor blue collar thief can go to prison for
life under some ``three strikes'' laws--a huge bank doesn't
even suffer a major loss of reputation when it commits a
hundred thousand felonies. The U.S. now has its own version
of crony capitalism that has produced recurrent, intensifying
financial crises--just as crony capitalism does in many
nations. The difference is that our economy is so massive
that when we have a crisis many nations suffer. When a
nation's elites are able to cheat with impunity the result is
always disastrous.
What should President Obama and Congress be doing right now
to regulate the banks in a meaningful and fair way?
Economists, white-collar criminologists, and regulators
agree that the key is to stop, or at least limit, perverse
incentives. Intensely criminogenic environments lead to
epidemics of control fraud. There are six key components of
what makes an environment dangerously criminogenic.
A. Size matters. A tremendous bubble in the price of
persimmons won't harm the U.S. economy. Real estate bubbles,
by contrast, could cause losses that were a large percentage
of the U.S. GDP. That's how you get a Great Recession.
Accounting control frauds are particularly dangerous because
of they can grow so rapidly and because they tend to cluster
in the assets that are most ideal for accounting fraud. The
combination of clustering and rapid growth means that
epidemics of accounting control fraud can hyper-inflate
massive bubbles. Akerlof & Romer and my work have long warned
specifically about this danger.
The federal regulatory and prosecutorial agencies are
filled with ``chief economists,'' but there are no ``chief
criminologists'', no comprehensive federal data on the most
destructive white-collar crimes, and virtually zero federal
funding for research into the elite financial frauds that
have caused trillions of dollars of losses in the U.S. over
the last 20 years. We need to do the opposite--hire chief
criminologists, keep comprehensive data on the worst frauds,
and fund research so that we can actively identify the
industries at greatest risk of developing the next epidemic
of control fraud. (And this needs to be done not only for
banks. The FDA, for example, needs help in spotting frauds
that maim and kill.) We then need to act, quickly, to stop
those epidemics in their tracks. We did this in 1990-91 as
S&L regulators when we stopped the rapid spread of ``liar's''
loans at several California S&Ls.
B. Deregulation, desupervision (the rules remain in place
but the anti-regulators running the regulatory agencies don't
enforce them) and de facto decriminalization (the three
``de's'') produce the ideal criminogenic environment. The
regulators are the ``cops on the beat'' when it comes to
sophisticated frauds. If you remove the cops of the beat,
cheaters prosper and honest businesses are driven from the
markets. President Obama largely kept in place the failed
anti-regulators he inherited from President Bush. Indeed,
Obama promoted Geithner--an abject failure as a regulator in
his capacity as President of the NY Fed--and renominated
Bernanke, an even greater failure. Obama should fire Attorney
General Holder and Treasury Secretary Geithner and ask
Chairman Bernanke to resign. He should appoint regulators and
prosecutors who have a track record of success.
C. Executive compensation. There is a consensus that
executive compensation should be based on long-term (real)
profitability. In reality, executive compensation is
overwhelmingly based on short-term reported income. (It's
actually worse than that--if the short-term results are bad
corporations commonly gimmick the compensation system to
reward the senior officers' failures.) Everyone agrees that
short-term reported accounting income is easy to inflate
through accounting fraud and virtually everyone agrees that
this creates strong, perverse incentives. Since, the current
crisis began, the percentage of bonus compensation based on
short-term reported income has increased--executive
compensation has become more perverse.
Note that executive compensation also allows the CEO to
convert the firm's assets to his personal benefit using
seemingly normal corporate mechanisms, which makes it far
harder to prosecute the CEO for looting the firm. All bonus
income that takes annual income above $200,000 should be paid
after five years--if the firm's reported income turns out to
be real. There should be ``clawback'' provisions to recover
bonuses even after those five years if they were based on
corporate income inflated by fraud or ``window dressing.''
D. Professional compensation is perverse. Accounting
control frauds deliberately exploit this to create the
Gresham's dynamic that allow them to suborn the outside
professionals--appraisers, attorneys, auditors, and rating
agencies--who are supposed to prevent fraud, but who actually
become the frauds' most valuable allies. Honest professionals
don't get hired, the unethical professionals prosper. This
process creates ``echo'' epidemics of control fraud.
Fraudulent nonprime lenders, for example, shaped financial
incentives to be perverse to create endemic appraisal and
loan broker fraud. The banks should not be able to hire or
fire the appraisers, credit rating agencies, and auditors--
except for fraud or serious incompetence. Those professionals
can only be truly independent if they are assigned to work
for the bank by a truly independent entity.
E. The federal government has permitted banks to inflate
their reported incomes and ``net worth'' for the purpose of
evading the mandatory statutory duty under the Prompt
Corrective Action (PCA) law to close deeply insolvent banks.
Congress, at the behest of the Chamber of Commerce, the
banking trade associations, and Chairman Bernanke,
successfully extorted the Financial Accounting Standards
Board (FASB) to scam the accounting rules so that the banks
could fail to recognize on their accounting reports over a
trillion dollars in losses.
When banks understate their losses massively they, by
definition, overstate their net worth massively. The PCA's
provisions kick in when net worth falls, so the accounting
lies have gutted the PCA. The accounting lies also allow the
banks to (once again) report high fictional income when they
are experiencing large, real losses. This accounting scam
allows the bank executives to collect hundreds of billions of
dollars in bonuses. We should end the accounting scam and
enforce the PCA.
We are also secretly subsidizing banks and hiding their
losses through massive loans from the Federal Reserve backed
by toxic collateral. We should end those subsidies and force
them to post good collateral.
F. Systemically dangerous institutions (SDIs) have often
become far larger and more dangerous since the crisis. The
administration is taking no serious steps to protect us
against the roughly 20 SDIs even though the administration
claims that when one of them next fails it is likely to cause
a global financial crisis. Why are we juggling 20 live
grenades? The only question is when the next pin will drop
out and we'll be blown up.
The good news about the SDIs is that they have reason to
exist. They would be far more efficient if they shrank in
size to levels at which they no longer endangered the global
economy. We should do three things about the SDIs. One, stop
their growth--immediately. Two, order them to shrink over the
next five years to a size at which they no longer are SDIs.
Let them decide what operations to sell. Three, intensively
regulate the SDIs during those five years. That includes
placing any insolvent SDIs in ``pass through
receiverships''--which does not prompt crises.
If there were one questionable banking practice that you
could stop today, what would that be?
The foreclosure frauds.
You have spent decades examining what goes on in banks. Do
think that bankers, either through culture or genetics, are
ethically-challenged?
When you allow a Gresham's dynamic to operate and when
entry to an industry is easy (as it was for loan brokers and
mortgage bankers), you concentrate the least ethical business
leaders in the industry that is most criminogenic. In the
last decade, banking has been severely criminogenic in the
U.S. and much of the world. The unethical banking leaders
became dominant. Their banks, which followed the four-part
recipe for maximizing fictional accounting income, became far
larger and drew the greatest praise from the business
boosters than dominated the financial media. They made their
reputations and their fortunes through fraud.
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