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William Black, Host:
Ignoring the Elephant in the Room: Control Fraud and the Financial Crisis
A review of Fault Lines: How Hidden Fractures Still Threaten the World Economy
Dr. Raghuram G. Rajan, is a distinguished professor at the University of Chicago’s business school and former chief economist of the International Monetary Fund (IMF). Readers familiar with Chicago school economics will see that the crisis has not led to a fundamental reevaluation of that school’s policy recommendations. The title of his book captures his thesis – Fault Lines: How Hidden Fractures still Threaten the World Economy. Rajan writes clearly and his book is intended for the intelligent lay reader. His book contains no charts, graphs, or equations, doubtless at the urgings of the Princeton University Press. It is an ambitious book, for it seeks to explain the global crisis and different trends in the real economy and the financial sector in many nations.
Brief Synopsis and Primary Themes
Rajan argues that the “rational actor” model explains the crisis – and why future crises are likely: “each one of us did what was sensible given the incentives we faced” (p. 4). He argues that the government can cause individually rational, well-motivated actors to produce results which, collectively, are disastrous. Their actions were disastrous because the government interferes with the economy, “derail[ing]” what would otherwise be “finely incentivized” financial markets (p. 126).
U.S. housing policy caused the crisis. Rajan offers an obligatory passing whack to the Community Reinvestment Act, but his real target is the equally obligatory “government sponsored enterprises” (GSEs) – Fannie and Freddie. Fannie and Freddie were the weapons of mass destruction that perverted the “finely incentivized” financial markets. The “government” is culpable for the making Fannie and Freddie the GSEs that perverted the private incentives. The government did so, inevitably because of the most treasured Chicago school meme – “unintended (negative) consequences.” Rajan speculates (he concedes that he has no evidence) that because U.S. income inequality became so extreme and middle class families’ income stalled, the “government” decided to reduce the inequality through subsidies to housing. In Rajan’s account, income inequality’s great danger becomes the risk that the government will interfere with the economy. Fannie and Freddie prevented “private market discipline” from being effective because they were willing to pay top dollar for “liar’s” loans and securities backed by liar’s loans that were certain to suffer catastrophic losses as soon as the housing bubble stalled. If Fannie and Freddie were the “fool” in the market, then everyone else simply, rationally, skinned them alive. Rajan asserts that Fannie and Freddie made these suicidal purchases because the Congress mandated that they do so. Rajan claims that Fannie and Freddie’s creditors and shareholders did not exert effective private market discipline to prevent the suicide because they (erroneously) expected to be bailed out fully by the Treasury and suffer no losses.
The first part of his explanation for the crisis is globalism and macroeconomics. The fastest growing nations in the East continued to save. U.S. businesses grew by borrowing cheap funds from the East. This led to the high tech bubble and a recession. The Federal Reserve responded to the recession by driving interest rates even lower. This led to the housing bubble because, Rajan asserts, government policies directed credit toward housing credit for low-income buyers. The collapse of the housing bubble triggered the Great Recession – a “child of past crises” (p. 5).
Rajan also addresses why we experienced a banking crisis. He provides his key explanation of the banking crisis (pp. 137-39) is response to his own question: “Why Did Bankers Take on Tail Risk? Searching for Alpha.” This passage is probably the most difficult portion of the book for a non-specialist reader because it involves the interaction of more complex finance and statistical theories, so I will address it in greater detail in the next section.
The Author’s Suggested Reforms
Rajan’s policy remedies are the standard Chicago school proposals. They follow logically from his analysis of the causes of the crisis. The government should withdraw from housing. Deposit insurance should be eliminated. The income tax should be eliminated and replaced by a sales tax (a change from his earlier view that it should be replaced by a tax on wealth). Social Security and Medicare benefits should be cut back and Social Security should be privatized. The Fed should raise interest rates and resist the temptation to try to use easy monetary policies to reduce unemployment even in “jobless recoveries” from recession. Those familiar with IMF austerity policies will recognize the monetary and fiscal policies that Rajan proposes.
Rajan proposes the latest variant in the neoclassical quest to create effective, timely private market discipline in the real world. The idea is to convert creditors into equity positions if the borrower gets in financial trouble, which could increase the creditors’ losses in the event of bankruptcy. With more to lose, the hope is that endlessly predicted, but rarely observed, effective, timely private market discipline will (finally!) emerge. Neoclassical theorists make recurrent efforts to try to create effective, timely private market discipline because the stakes are so high. Absent such discipline, the efficient markets and contracts hypotheses that provide the essential foundation for the entire edifice of “modern finance” and critical aspects of microeconomics fail.
A Critique of the Author’s Explanation of Modern Banking Crisis
Rajan’s explanation of banking crises is inherently complex for general readers. I quote, it at some length, so that the reader can get a feel for what I think is his book’s most important claim. “Alpha” is a financial term of art that refers to the premium return created when the banker’s skills increase investment returns in a manner that does not simply reflect taking greater risk. When Rajan refers to “tail risk” he means the very low risk of an extremely bad event occurring in any particular year.
Why should a manager care about generating alpha? If she wants to attract substantial new inflows of money, which is the key to being paid large amounts, she has to give the appearance of superior performance. The most direct way is to fudge returns. In recent times, some fund managers, like Bernard Madoff, simply made up the numbers, while others who held complex, rarely traded securities attributed excessively high prices to them based on models that had only a nodding acquaintance with reality. But it is easy to track and audit the returns most financial managers generate, so fudging is usually not an option, even for those with consciences untroubled by committing fraud. What then is a financial manager to do if she is an ordinary mortal….?
The answer for many is to take on tail risk. Suppose [she] write[s] earthquake insurance policies but does not tell her investors. As she writes policies and collects premiums, she will increase her firm’s earnings. If the manager does not set aside [loss] reserves … she will be feted as the new Warren Buffett…. The money can all be paid out as bonuses or dividends.
Of course, one day the earthquake will occur, and she will have to pay insurance claims. Because she has set aside no reserves, she will likely default on the claims, and her strategy will be revealed for the sham it is. But before that she will have enjoyed the adulation of the investing masses and may have salted away enough in bonuses to retire comfortably to a beach house in the Bahamas. Failing in a herd rarely has adverse consequences.
I quote this extended passage because it reveals so much about the crisis and why the people that caused the crisis and grew wealthy from it have not been dealt with. Rajan should be applauded for demonstrating that the banking crisis was caused by endemic “accounting control fraud.” In a control fraud the CEO that controls a seemingly legitimate firm uses it as a “weapon” to defraud. For financial firms, for some of the reasons Rajan explains, accounting is the “weapon of choice.” Rajan’s earthquake insurance example confirms the findings of white-collar criminologists and the economists George Akerlof and Paul Romer in their classic 1993 article – Looting: the Economic Underworld of Bankruptcy for Profit – accounting fraud is a “sure thing.” They meant that it produced guaranteed, record (albeit fictional) reported accounting income.
The recipe for a lender to maximize reported short-term (fictional) income was perfected by accounting control frauds decades ago and has been known to competent financial regulators since 1984 (when our “autopsies” of S&L failures revealed the consistent pattern).
1. Grow extremely rapidly
2. Lend to borrowers who will agree to pay a premium yield (this typically means borrowers with high default risks but the ideal is predatory lending – charging extreme yield premiums unrelated to risk to financially unsophisticated borrowers)
3. Extreme leverage
4. Provide only trivial loss reserves
The primary constraint on demand for homes is the unavailability of financing to borrowers that pose serious default risk, so the second ingredient to the fraud recipe leads to a dramatic increase in effective demand. This increase in effective demand, as Akerlof and Romer (and we) explained decades ago, can hyper-inflate real estate bubbles. Credit Suisse reported in 2007 that 49% of mortgage loan originations in 2006 were “stated income” (liar’s loans). Liar’s loans, as the name suggests, are endemically fraudulent. That means that the lenders made millions of fraudulent home loans annually. The resultant epidemic of accounting control fraud, once again, caused a financial bubble to hyper-inflate.
Once we apply the recipe, and its implications, to the facts that Rajan reports we can see why those facts demonstrate that accounting control fraud drove this crisis. We can also explain many of the factual patterns that puzzled Rajan (because they are inconsistent with Chicago school neoclassical theory – which assumes away fraud). Rajan cannot understand why many originators or packagers of liar’s loans held such loans or securities backed by liar’s loans in their portfolios instead of selling them. The answer is yield and compensation. The officers controlling the bank can become wealthy. The bank will fail (unless it is bailed out or allowed to cover up its losses), but the officers can walk away wealthy. This is why Akerlof and Romer’s title emphasizes that the looters profit from bankrupting “their” firm.
Rajan believes that the CEOs of the huge nonprime lenders were among the largest victims of the frauds. He bases this claim on the drop in the value of their stock. This is a common error. The relevant comparison is what their financial position would have been without the fraud. The fraud created the fictional income that drove the run up the bank’s stock price. Rajan writes at several places that the control frauds such as New Century were initially profitable, but in reality their lending had a negative expected value. The stock price of “their” bank would have collapsed if markets were efficient. (Note that the ability to sell the bad assets prior to default does not explain this behavior. Nonprime loan sales overwhelmingly took place with substantial recourse. The sellers of fraudulent liar’s loans (due to falsified applications), for example, typically committed a second felony (actually, a fifth fraud if one includes the related appraisal and securities frauds involved in making and accounting for the loan origination and the fraudulent reps and warranties made to the entity “enhancing” the credit of the CDO) when they sold the loan under false reps and warranties. Such loans can be put back to the seller, so an honest lender would not make fraudulent loans not only because that would be oxymoronic but because it wouldn’t protect them from the inevitable losses. Instead, the CEOs falsely reported that they were highly profitable and this typically successfully deceived enough investors to hyper-inflate the stock price. The same four-ingredient recipe simultaneously maximizes fictional reported short-term income and real losses. The senior insiders cannot capture for their personal benefit all of that run up in stock price because if they sell their shares at the same time the stock price will collapse and their behavior will make the fraud obvious.
Rajan shows why accounting control fraud, by contrast, was “easy” and became widespread. First, take his earthquake insurance example. It is, of course, an obvious case of accounting control fraud. Rajan’s example contains two typical acts of deceit. The CEO “does not tell her investors” that she is taking on a massive insurance liability and the CEO does not provide loss reserves to make it possible for the bank to honor its insurance obligations. The CEO Rajan describes is defrauding the bank’s shareholders, creditors, and insurance customers.
Second, Rajan recognizes elsewhere that banking crisis occurred because hundreds of banks successfully – and massively – overstated nonprime mortgage asset values and returns.
Third, Rajan recognizes elsewhere that accounting control frauds could produce guaranteed, record (albeit fictional) returns by making “liar’s” loans that would produce catastrophic losses not in unlikely (“tail”) circumstances, but rather in any normal circumstances.
Fourth, Rajan’s logic demonstrates that there is no given (exogenous) random distribution of financial events – which means that the entire concept of “tail” events is misleading. When we create criminogenic environments through deregulation, desupervision, and perverse executive and professional compensation we can produce such severe, perverse incentives that we produce recurrent, extreme crises. Rajan recognizes this point later in his book.
Fifth, Rajan’s specific scheme is a real world fraud scheme, but not one that played a material role in the actual crisis. Financial control frauds used superior schemes.
The Crisis was not Caused by Tail Risk
Accounting control frauds typically invest in asset portfolios that are certain to suffer catastrophic losses. Indeed, they deliberately construct their loans and investments in a manner that greatly increases the probability of catastrophic defaults. “Liar’s” mortgage loans create severe “adverse” selection, which creates a “negative expected value.” In English, that means that a portfolio of liar’s loans has an extremely high probability of suffering severe losses. Subprime loans have a particularly high expected default rate. Combining liar’s loans to subprime borrowers, which became common, produces catastrophic default frequencies. The do so because lending on those terms maximizes short-term reported accounting income, which maximizes their income.
Assets that have only a tiny tail risk of going bad are less risky and offer a much lower yield. Conventional, fully underwritten prime mortgage loans are the exemplars of “tail” risk. The historic default rate on such loans is around one percent. The accounting control frauds invariably shifted dramatically away from such loans in favor of nonprime loans with exceptional “layered” risk. Indeed, there was no exogenous risk distribution – the control frauds structured loans to fail because doing so maximized their compensation.
Compensation and Fraud Drove the Disasters at Fannie, Freddie, Lehman, New Century, and Ameriquest
Rajan places primary blame on the “government” purportedly forcing Fannie and Freddie to buy bad loans from poor people for causing the crisis. The effort to force the facts to fit the claim leads to sentences like this:
New Century Financial … was founded in 1995, with about $3 million of venture capital, as government support to the subprime market increased (p. 126).
New Century was created to avoid federal regulation. It was not federally insured. It was not subject to the Community Reinvestment Act. It was a venture capital (VC) initiative, not supported by the government. It chose not avoid regulation because the “government” had recently killed the type of liar’s and subprime loans that New Century made. In 1990-91, several West Coast S&Ls began to make material amounts of liar’s loans. The West Region of OTS, realized that such loans were inherently unsafe and unsound because they were an open invitation to fraud so we used our supervisory powers to end them. Some S&Ls reacted by dropping their federal S&L charter (and deposit insurance) so that they could escape federal regulation and supervision. Roland Arnall converted the California S&L he controlled into Ameriquest, an uninsured and unregulated mortgage banker, to escape our regulation.
Rajan premises his argument on a factual premise that I believe is flawed:
The private financial sector did not suddenly take up low-income housing loans in the early 2000s out of the goodness of its heart, or because financial innovation permitted it to do so – after all, securitization has been around for a long time. To ignore the role played by politicians, the government, and the quasi-government agencies is to ignore the elephant in the room (p. 42).
First, the private sector took up low income housing no later than 1991 and they did it to maximize fictional yields and real bonuses. Second, while “securitization” had been around for a long time, securitization of toxic assets had not been. Securitizing prime assets is relatively straight forward. Securitizing toxic assets is inherently dangerous. Securitizing toxic mortgage product was in fact a (terrible) “financial innovation.” The innovation was led by “private label” entities (not Fannie or Freddie). Fannie and Freddie were private entities engaged in accounting control fraud. Financial regulators were chosen on the basis of their ideological opposition to regulating. Desupervision was endemic. The real elephant in the room was theoclassical economic dogma and perverse (not always) unintended consequences of that dogma which optimized a criminogenic environment in the finance industry.