[Congressional Record (Bound Edition), Volume 156 (2010), Part 15]
[Extensions of Remarks]
[Pages 23634-23636]
[From the U.S. Government Publishing Office, www.gpo.gov]




               BLACK: THE DOMINANCE OF UNETHICAL BANKING

                                 ______
                                 

                           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 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

[[Page 23635]]

     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 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

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     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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