Bill Black: Our System is So Flawed That Fraud is Mathematically Guaranteed
[Chris lost his voice this week due to illness, so we were unable to record a new podcast. So while Chris recuperates, enjoy this excellent discussion from the archives with Bill Black, recorded a year ago, on the pervasive control fraud within our current financial system. ~ Adam]
“When plunder becomes a way of life for a group of men in a society, over the course of time they create for themselves a legal system that authorizes it and a moral code that glorifies it." ~ Frederic Bastiat
Bill Black is a former bank regulator who played a central role in prosecuting the corruption responsible for the S&L crisis of the late 1980s. He is one of America's top experts on financial fraud. And he laments that the U.S. has descended into a type of crony capitalism that makes continued fraud a virtual certainty while increasingly neutering the safeguards intended to prevent and punish such abuse.
In this extensive interview, Bill explains why financial fraud is the most damaging type of fraud and also the hardest to prosecute. He also details how, through crony capitalism, it has become much more prevalent in our markets and political system.
A warning: There's much revealed in this interview that will make your blood boil. For example, the Office of Thrift Supervision. In the aftermath of the S&L crisis, this office brought 3,000 administration enforcement actions (a.k.a. lawsuits) against identified perpetrators. In a number of cases, they clawed back the funds and profits that the convicted parties had fraudulently obtained.
Flash forward to the 2008 credit crisis, in which just the related household sector losses alone were over 70 times greater than those seen during the entire S&L debacle. So how many criminal referrals did the same agency, the Office of Thrift Supervision, make?
Similar dismal action was taken by such other financial regulators as the Office of the Comptroller of the Currency, the Federal Reserve, and the FDIC.
Where is the accountability? you may be asking. Or perhaps, how did we allow things to get this bad?
Fraud is both a civil wrong and a crime, and it's when I get you to trust me and then I betray your trust in order to steal from you. As a result, there’s no more effective acid against trust than fraud, and, in particular, elite fraud, which causes people to no longer trust folks. Economies break down, families break down, political systems break down, and such, if you don’t have that kind of trust. So that’s what fraud is.
But what my work focuses on is, what kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, systemic problems and such, arise when we have what we call in criminology 'control fraud.' And control fraud simply means when you have a seemingly legitimate entity and the person who controls it uses it as a weapon to defraud others. And so in the financial sphere, the weapon of choice is accounting, and the losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.
So for example, in the current crisis, as with the prior ones, if you’re a lender, there’s an easy recipe for maximizing fake accounting income. And it goes like this. You need four ingredients:
- Grow like crazy...
- ...by making really, really crappy loans but at a premium yield (yield just means 'interest rate')...
- ...while employing extreme leverage, and...
- ...while setting aside only the most trivial reserves or allowances for the inevitable losses this kind of behavior produces.
George Akerlof and Paul Romer wrote the classic article in economics about this in 1993. And their title really says it all in terms of the dynamic: Looting the Economic Underworld of Bankruptcy for Profit. The idea is, you have a seemingly legitimate entity, and the person at the top is looting it. They loot it by destroying it, but they walk away wealthy. Of course, in the modern era we don’t necessarily – we may bail out the entity. So it may not even fail in that sense.
But here’s what Akerlof and Romer also said that was so critical as an understanding. They said these four steps, these four ingredients: it's just math. It is – and I’m quoting them now – “a sure thing.” So you’re mathematically guaranteed, if you do these four things, to report not just substantial income, but record levels of income.
The big thing about the seemingly legitimate entity when the CEO is the crook is, first, everybody reports to the CEO ultimately, right? So the CEO is the point failure mechanism where if he or she goes bad, almost everything may go bad as well. So all those things that we call internal and external controls, all report to the CEO, and the CEO therefore can, as I’ll describe, use compensation, hiring, firing, praise, and such to produce the environment that will commit – create allies for his fraud. Now, note that what I’m saying. The CEO, the art of this is not to defeat your controls. The elegant solution, as in mathematics, is to suborn the controls and turn them into your most valuable allies. And therefore, for example, when you’re running accounting control fraud, where your weapon of fraud is accounting and that weapon of choice in finance is accounting, you’re going to want to hire the most prestigious accountants as your outside auditor, because it is precisely their reputation that is most valuable when you can suborn them. And they give you that clean opinion that you just described that will help you deceive other shareholders. So one enormous advantage is, internal and external controls come to the CEO level.
A second incredible advantage is the CEO can optimize the firm as a weapon of fraud. And the CEO can do that. Basically this falls into two big categories. One, you can put it in assets that have no readily verifiable market value, because then it's a lot easier to inflate asset valuations and to hide real losses. And the second thing you do is grow like crazy. And, of course, that is the essence of something your listeners have all heard about, and that is a Ponzi scheme. And so these accounting control frauds have strong Ponzi-scheme like elements, which is why they tend to cause such catastrophic losses.
Click the play button below to listen to Part I of Chris' interview with Bill Black (58m:28s). Part II can be accessed by clicking here.
Chris Martenson: Hello and welcome to another www.PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today, we have the pleasure of speaking with Bill Black, associate professor of economics and law at the University of Missouri, Kansas City, and a former bank regulator and a central figure in prosecuting – there’s a strange work – the corruption associated with the savings and loan (S&L) crisis of the late 1980s. He’s been since a prominent voice against financial and political fraud, and in 2005 authored the excellent book, The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. So I’m sure he has a lot to say about our current situation.
I’m really looking forward to Bill helping us understand why there were nearly two thousand convictions resulting from the S&L crisis but hardly any so far from the mortgage fraud and other criminal activity that caused the 2008 near-system collapse, the one that made the scope of the S&L losses look positively quaint in comparison. Bill, I’m so glad you could join us today.
Bill Black: Thank you.
Chris Martenson: Well, let’s jump right in. For many today, what they’re experiencing is a crisis in confidence, confidence in our entire system, that it's fair and fairly regulated and adjudicated. Perhaps even that if you make both your financial crime, whether large enough or complex enough or both, that you can get away with it. Perhaps maybe paying a fine that’s a fraction of your illicit gain but never facing criminal charges; at least that’s the common experience today. So let’s begin here. What is the basic definition of fraud, and more specifically, what is the form of fraud that we seem to be enmeshed in today?
Bill Black: Well, fraud is both a civil wrong and a crime, and what it is, is when I get you to trust me and then I betray your trust in order to steal from you. And as a result, there’s no more effective acid against trust than fraud, and, in particular, elite fraud, which causes people to no longer trust folks, economies break down, families break down, political systems break down and such, if you don’t have that kind of trust. So that’s what fraud is. But what my work focuses on is, well, what kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, as you said, systemic problems and such, arise when we have, what we call in criminology, ‘control fraud.’ And control fraud simply means when you have a seemingly legitimate entity and the person who controls it uses it as a weapon to defraud others. And so in the financial sphere the weapon of choice is accounting and these losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.
Chris Martenson: All other forms combined – well, I can believe that. I mean I saw what happened with Worldcom, with Enron, it took down Arthur Anderson, I guess, but most of the people that worked there ended up going to work other places. All of the – there seems to be – it's not just the person at the top, the CEO, saying I’m going to really shuffle some deck chairs here and hide what the true state of my operation here is, what my risks are, what my liabilities are, whether I have the assets I claim I have. That requires a willing partner on some level, does it not?
Bill Black: Well, that’s the thing. If you have this person at the top being a crook, they get to choose their partners. And they get to incentivize their partners and, as a result, you’re quite right. They’re very good at spreading frauds. And we call those “echo epidemics.” So for example, in the current crisis, as with the prior ones, if you’re a lender, there’s an easy recipe for maximizing your accounting, fake accounting income, if you’re a lender. And it goes like this, four ingredients. One, grow like crazy. Two, by making really, really crappy loans but at a premium yield. Yield just means interest rate. Three, while employing extreme leverage, and four, while setting aside only the most trivial reserves, allowances for the inevitable losses this kind of behavior produces. So George Akerlof and Paul Romer wrote the classic article in economics about this in 1993. And their title really says it all in terms of the dynamic. It's Looting: The Economic Underworld of Bankruptcy for Profit. So again, the idea is you have a seemingly legitimate entity; the person at the top is looting it. They loot it by destroying it, but they walk away wealthy. Of course, in the modern era we may bail out the entity. So it may not even fail in that sense.
But here’s what Akerlof and Romer also said that was so critical in understanding. They said these four steps, these four ingredients, it is just math. It is – and I’m quoting them now – “a sure thing.” So you’re mathematically guaranteed, if you do these four things, to report not just substantial income, but record levels of income. And that’s when Akerlof and Romer said, now that’s the next thing that comes in that’s really important, and that is modern executive and modern professional compensation. Because with modern compensation, first at the executive level, the CEO level, I can guarantee with modern executive compensation that if I follow this recipe, I will personally be wealthy almost immediately as the CEO. Because I’ll base my compensation as CEO, and that’s the nice thing about being CEO; you get to make the rules for yourself. You’ll base it on short-term reported income, and you’ll make that compensation extremely large for supposed superlative results, in jargon in the industry, “stretch goals.” So you’re going to say, hey, if I double my income in just a few years, which is what the Fannie Mae goal was, then I get an off the charts bonus, huge compensation – except, of course, that goal is easy to meet. You just have to cheat. It is a sure thing.
Chris Martenson: Now Bill, is it possible to follow this four-step prescription and remain within the letter of the law?
Bill Black: No, not within the letter of the law, although it is in places that – it may be –this is the question right now that’s up for grabs – in places where international accounting rules apply. Because under international accounting rules they’re being interpreted by many folks as saying you are not permitted as a lending institution to establish any meaningful allowances for loan losses now, even though it is absolutely certain that – you don’t remember what the ingredient is – the first to grow extremely rapidly by making really, really awful loans at a premium yield. Well, that’s guaranteed to produce massive losses down the road. The international accounting rules – some people are, actually many people are interpreting as you are not permitted to establish any reserves. So that could create the perfect crime in Europe in particular.
Chris Martenson: The perfect crime. Now, so even if you stay within these four though, the parts that get me confused are what happens when say your supposed third-part auditing company comes in and performs their yearly due diligence audit and then signs off on the financial statement. So this company then says these have all been fairly represented and the risks have all been adequately explained and we think this company is fairly representing itself. And then surprise, surprise, like Lucy pulling a football away – I mean, we always seem to be surprised when it turns out that there are glaring, overt, gross material misrepresentations of risk, of assets, of liabilities, of all kinds of things. And somehow that happens again, and again, and again. I’m really interested inwhere the letter of the law is on this. Is there no responsibility here?
Bill Black: Well, the letter of the law in the United States under general accepted accounting principles is that you have to establish the loss reserves now if you make large losses inevitable in the future. So in that if you actually establish the appropriate loss reserves, of course, you would show under this recipe that you are losing money, not making money, and you wouldn’t get any bonus. So under the letter of the law, there’s a fraud in the United States. It turns out there are many frauds in Europe, as well, because people get greedier.
Now, let me approach your more basic question. And your more basic question really has two areas, and that is, so again, why are these control frauds unique? Why are they much more dangerous than regular frauds? And what is this thing that I alluded to, and that is professional compensations? So that’ll bring in your question about the auditor. So if we back up, what’s special when you have a seemingly legitimate entity and the person at the top of the food chain is the crook. The joke that actually many cultures have, like China, is, of course, the fish rot from the head. And that’s designed to capture precisely this point.
So the big thing is about the seemingly legitimate entity when the CEO is the crook, first, everybody reports to the CEO ultimately. So the CEO is the point failure mechanism, where if he or she goes bad, almost everything may go bad as well. So all those things that we call in controls, internal and external controls, all report to the CEO, and the CEO therefore can, as I’ll describe, use compensation, hiring, firing, praise, and such to produce the environment that will commit – create allies for his fraud.
Now, note that what I’m saying. The CEO, the art of this is not to defeat your controls. The elegant solution, as in mathematics,is to suborn the controls and turn them into your most valuable allies. And therefore, for example, when you’re running accounting control fraud, where your weapon of fraud is accounting and that weapon of choice in finance is accounting, you’re going to want to hire the most prestigious accountants as your outside auditors, because it is precisely their reputation that is most valuable when you could suborn them. And they give you that clean opinion that you just described that will help you deceive other shareholders. So one enormous advantage is, internal and external controls come to the CEO level.
A second incredible advantage is the CEO can optimize the firm as a weapon of fraud. And the CEO can do that. Basically, this falls into two big categories. One, you can put it in assets that have no readily verifiable market value, because then it's a lot easier to inflate asset valuations and to hide real losses. And the second thing you do is grow like crazy. And, of course, that is the essence of something your listeners have all heard about, and that is a Ponzi scheme. And so these accounting control frauds give strong Ponzi scheme-like elements, which is why they tend to cause such catastrophic losses.
Chris Martenson: Well, if the fish rots from the head, then you’re talking about a culture issue. and I’m wondering if the head of the largest fish that we could talk about here is what is substantially different about the type of control fraud you’re talking about that’s happening at the corporate level versus, say – oh, I don’t know. What happens when I examine the federal government’s balance sheet and look at its accrual liabilities expanding by four to five trillion dollars per year once you factor in the actual entitlements and the government’s reporting? It's cash balance deficits, which are shocking enough, but on an accrual basis, there’s absolutely no possible chance that we can square this circle. Are companies following sort of a – are we talking about American culture now? Is this something that extends really broadly? I’m really confused.
Bill Black: This is human culture.
Chris Martenson: Human culture – oh, okay.
Bill Black: And it is not limited to corporations. We’ve been focusing on corporations but these frauds occur in the governmental sector, they occur in the non-profit sector, and of course, they occur in combined, in combination. And so crony capitalism is all about the combination of public sector and private sector control frauds working together as cronies.
Chris Martenson: So this is interesting because what you’re saying is something I believe, which is that human nature does not change and it's always human nature to try and game the system, get an advantage, have a free lunch, however we want to put that. And so we’ve known – we’re sophisticated enough that we’ve seen these happen often enough that we know what the dynamic is, you’ve just mentioned this paper, these two gentlemen where there’s four steps. We know what these all are. It is my view that we had tighter regulatory structures that were around the concept of saying listen. These things are going to happen. We’re going to put a basket around this as best we can, and then do what we need to do in order to assure that these things do not flourish. Maybe we’ll have prosecutions. So fast forward, I’m looking at a chart here that shows federal prosecutions for financial fraud are at an all-time low. And my personal perception is that the amount of fraud is probably at an all-time high. They seem potentially correlated, those two pieces of data. Is that true and how did we get here?
Bill Black: Well, you have really interesting phraseology. You said, you talked about we know and you talked about we’re more sophisticated. So this was part of, an important part of, what Akerlof and Romer were talking about in that paper. They chose to include the following paragraph, which I’ll get approximately right from memory. And to make it their last paragraph for emphasis. They said, look, in the savings and loan crisis economists and the public had no theory of this kind of fraud, control fraud. And, as a result they were not in a position to give strong support to the examiners in the field, the regulators, banking regulators, actually savings and loan regulators in the field who recognize from the beginning that this kind of deregulation was bound to create widespread fraud. Now we know better. If we take advantage of this knowledge we need not repeat this kind of crisis. That was written in 1993.
Chris Martenson: Right
Bill Black: And what happened, of course, is right around the same time we did get allegedly more sophisticated in a small part of we. And that small part of we dominated and continues to largely dominate policy. And that small portion of we had exactly the opposite conclusion on the basis of this alleged sophistication. And they said, and this Easterbrook and Fischel. So your listeners need to know that George Akerlof goes on to win the Noble Prize in economics in 2001. So we’ve been talking about one of the most prominent economists in the world. But in the law of economics world a generation of American lawyers has been taught when they study the economics of corporations by a treatise writ in 1991by Judge Easterbrook of the seventh circuit, and Fischel, who was then professor at the University of Chicago Law School, eventually the dean of the University of Chicago Law School. And Easterbrook and Fischel, and again, I’ll get this virtually word for word, say famously, “a rule against fraud is not essential or even particularly important in the securities context.” Now notice how radical a statement that is. It isn’t that we don’t need laws, that we don’t need prosecutors, that we don’t need FBI agents. U.S. attorneys, those kind of folks, we don’t even need a rule against fraud. We don’t need the ability to bring civil suits. We don’t need the securities and exchange commission. Markets, securities markets, are so efficient that they automatically exclude any meaningful accounting control fraud. And we know that they’re efficient because we’ve hypothesized they’re efficient in a wonderful circularity. This was, of course, the efficient market hypothesis that was the centerpiece of all of modern finance theory. And even the weakest version of efficient market hypothesis requires that there be no systematic errors in pricing because if there’s any systematic error in pricing, well, then somebody would correct it. They would make money by correcting it. Therefore, financial bubbles are impossible as well. Fraud is impossible.
Now all of this is insane. And indeed, Fischel was the outside expert for three of the most notorious accounting control frauds of the savings and loan debacle era. Lincoln savings, Michael Milkon at Drexel Burnham Lambert And this incredibly sleazy Florida one as well where the headquarters building was shown in Miami Vice for people who are old enough to know that. And then after he tried his theories in the real world and ended up praising the worst fraud in America, Charles Keating’s Lincoln Savings, as the best saving and loan in America. He wrote those words that I’ve just quoted without ever telling the reader, hey, by the way I tried this in the real world and it was the most embarrassing disaster conceivable. So there’s a strong element of intellectual dishonesty as well that went along with all of this. But anyway, if you believe that fraud’s impossible in the financial sphere, if you believe that markets are inherently efficient and self-correcting, then there’s a clear answer about what you should do about regulation, financial regulation. Financial regulation, A, is unnecessary, and, B, is potentially very harmful because it will potentially stop or interfere, at least, with the self-correcting efficient nature of the marketplace. And therefore, you must be a lead jihad against regulation if you want the country to prosper. and that’s precisely what these folks did.
Well, okay, now that’s academics and, yeah, they’ve trained a generation of lawyers who are now out there in key positions in business and regulation. But surely no one, the adults, right, can’t believe this. But, in fact, they did and, in particular, Alan Greenspan had this view. So he famously, in his first meeting, first person-to-person meeting with Brooksley Born, then the new chair of the commodities future trading commission, invites her over to meet her and says, in the course of the lunch, but of course we’re going to disagree about things. Now, you know, they’ve never had a substantive discussion like this and Brooksley’s wondering what. And he follows up and says because you, for example, believe that fraud provides a basis for regulation, preventing fraud.
Now that’s how extreme and that was, unfortunately of course, the most powerful financial regulatory position in the world was held by someone who believed in this insanity. But it gets worse because Greenspan was also involved, hired by Charles Keating. In fact, Charles Keating hired Greenspan in multiple capacities and one of those capacities was to, as lobbyist, to walk the floors of the senate to recruit the five senators who would become known as the Keating Five. When thirty – I’m sorry, twenty-five years ago on April 9th, 1987, they intervene on Keating’s behalf, those five senators, secretly to try to get us not to take enforcement action against Lincoln savings. Keating also famously put in writing to our agency that Lincoln Savings should be allowed to do hundreds of millions of dollars of these direct investments, which is what we provide the information to do, and they did anyway. That was the violation of rules that the senators were trying immunize by their political pressure. Well, Greenspan opined in writing that we should allow it because, and I’m quoting again, “Lincoln Savings poses no foreseeable risk of loss.” Gosh, he almost got that exactly right except for the fact that it was the most expensive failure of the entire debacle at 3.4 billion dollars, which as you say now, sounds quaint. But back in the day used to be considered a substantial amount of money.
Chris Martenson: Well, if I can turn the phrase around, it looks no bad deed goes unrewarded in this story. And Greenspan is somebody that I’ve been – I wrote about him extensively going, stretching way back because I really, really disagreed with his understanding of risk. He thought the derivatives markets made risk go away. So since you didn’t have risk anymore you could just let people expand their balance sheets and just go hog wild and use that, his view of risk, for as the justification for allowing the sweeps program, which allows banks to effectively hold zero reserve requirements against demand deposits, which I thought was a bad idea at the time. At any rate, so he had some failings, this guy.
Bill Black: But see this is related.
Chris Martenson: Okay, tie it in.
Bill Black: Right, if you believe that fraud is possible then derivatives are a possible problem. If you believe that fraud is impossible and that these people are sophisticated – remember your sophistication illusion again?
Chris Martenson: Yep.
Bill Black: Then it is unambiguous with neoclassical economic theory that the greater the choices the better the results because people will only make good choices for themselves. And as a result, by definition, the purchaser of the derivative will be the one who finds it most valuable and since asset valuation and risk are inversely related it will be the entity that perceived holding that derivative as least risky. In other words, you will get derivatives held by the ideal people for whom they’re in idiosyncratic conditions that reduce the holding, the risk of holding, that derivative for them. And so you will optimize throughout the entire financial symptom the placement of risk in the ideal fashion where the people best situated to have that risk. And not only do you have that advantage, but on top of that it means you will broadly diversify the risk such that there is very little concentration of risk. And therefore, your entire financial system will systemically be far less risky. So they knew all of those things as soon as they started with the assumption that there couldn’t be any frauds.
Chris Martenson: Well, if you’re going to risk that on the efficient market hypothesis there is one other little assumption baked into that, which is that we have even flows of information. There are no information asymmetries. And the very definition of fraud is that it has an asymmetry of information. I can’t square that circle either. There’s an intellectual hole in what you’re describing that’s just gigantic.
Bill Black: Well, enough to drive the world’s largest financial bubble through and the greatest epidemic of the elite fraud in the history of the world, yeah. This is what we call – you know, America is just gone through this recognition that it was being scammed by merchants who were secretly adulterating our hamburgers by adding pink slime, right. And pink slime turned out to be added to a level that maxed out at about fifteen percent. And the reason that it was maxed at about fifteen percent is that it tended to smell and taste bad.
Chris Martenson: Uh-huh
Bill Black: But in the financial end, by the way, pink slime starts out with these ultra-fatty tissues, which are much more susceptible inherently to being, to having strong contamination by e coli, I mean in particular in sense of other things. So they give it an ammonia bath, right, they put Mr. Clean in in gaseous form to try to reduce how infectious pink slime. And it turns out there’s a tradeoff. That’s why it stinks. If you put enough ammonia to really make it close to safe them it really smells and tastes bad. So they don’t put enough ammonia in to really keep it safe. So it's also an unsafe, but it's – I’m not – if you eat a burger you’re not typically going to get sick. In fact, it's quite unusual if you order it at least medium. But that’s not true in finance. In finance it wasn’t a maximum of fifteen percent of some areas were fraudulent. We had whole areas, liars loans, where the fraud incidence, when the people measured it, was ninety percent, nine zero. And we had whole areas like collateralized debt obligations in which the most typical CDO, collateralized debt obligation, was backed overwhelmingly by fraudulent liar’s loads.
Chris Martenson: And we knew about this at the time. There were open articles about ninja loans and this was a very open secret, at least it was to me. I was shorting them of this matter of public record. I was shorting a bunch of mortgage insurers, and homebuilders, and what not, all the way down through this piece because it was so obvious to me that this was a problem. And I’m just an outsider, right. I’m just some guy. I read stuff and I understand a few things. But it was so painfully obvious to me that we had this huge, gigantic issue going on, and it was to insiders too. Michael Lewis and the Big Short details very carefully about how Goldman Sachs with John Paulson went out and handpicked the worst things that were designed to blow up. And, then Goldman Sachs went out and got a so-called independent thirty party’s position saying, hey, this portfolio is randomly selected to succeed when it was actually, I believe, selected to fail. And, then misrepresented that to clients and sold these toxic bundles off because needed somebody on the other side of that trade, often maybe a German bank or somebody like that. So when I look at that, to me that, I can’t find a more clear-cut definition of fraud than that. And yet, I’m not aware of any prosecutions or criminal activity that resulted from that. I believe there might have been a fine but that’s all I can recall at this point. How does that skate through? Did I have the essence of that story right?
Bill Black: Yes, but it goes farther back, so, and there’s a more basic economic problem as well. The definition after all, the defining element about what makes something a liars loan is that you don’t do adequate underwriting, underwriting as a process of evaluating whether you’re going to get repaid when you make a loan. And what are the risks of is so that you can price, decide whether you should make the loan and what conditions and at what price you should do that? And because when you don’t do underwriting on this kind of loan, a mortgage loan, you inherently create something that we call adverse selection. So if you thought of running a health insurance company or life insurance company, and you weren’t going to do any evaluation of your customer’s health or their parents, genetic relatives’ health, you were just going to charge a high price for your insurance to compensate for the risk. Which customers would come to you? Well, obviously, only the sickest. It's the same thing if you couldn’t determine loan quality and you said just charge everybody a high rate of interest as a result, which customers would come to you? Only the worst. And so in this kind of loans, if you create adverse selection you create from the lender’s perspective a negative expected value of making a loan. In plain English that means you will lose money. It's equivalent of betting against the house. And therefore, honest lenders don’t engage in adverse selection. So it's a wonderful natural experiment as to which entities were clearly engaged in fraud, entities making liars loans were clearly engaged in fraud, mortgage lenders doing that.
Okay, so we realized this as regulators in 1990 and 1991. Now let me emphasize those dates again, 1990 and 1991. And America being America, liars loads being the fraud, began most heavily where all financial frauds tended to develop in America and that would be Orange County, California, right. And we were the regional regulators for California, Arizona, and Nevada. And eventually a broader who one-third of the west, one-third of the United States that’s the west. So we looked at these and we said this is insane. These liars’ loans are becoming common. They must lead to fraud. In fact, they only make sense from a lender’s perspective if the lender is engaged in accounting control fraud. And so we use normal supervisory means to drive them out of the savings and loan industry. The leading entity making these liars loans also targeted minorities particularly blacks and Latinos families who couldn’t speak English as well – blacks because they have fewer connections and few choices in the financial industry. So this is a real pernicious place. It was called Long Beach Savings. And we – they were one of the entities we cracked down on. So Long Beach Savings had voluntarily gave up federal deposit insurance, voluntarily gave up his charter to run a savings and loan, and became a mortgage bank for the sole purpose of escaping our regulatory jurisdiction. And as a mortgage bank he was subject to no federal regulation in that era other than active discrimination against minorities, right, this is not community reinvestment act. This is active, I’m out discriminating against minorities, the truth, the fear of lending laws.
Now, his leading competitor is another entity run by a husband/wife team that we removed and prohibited from the savings and loan industry, the gen X. To ease this fraud the head of Long Beach Savings also changes the name of the organization to now mortgage bank and names it Ameriquest. So for people who know this industry they will now be nodding. So Ameriquest becomes the biggest and the baddest, and as it's going out the door we make this referral for discrimination. And the justice department follows up and finds active discrimination. So that’s their second strike, right. The first strike that we went after them for the liars loans, the second strike is the justice department goes after them, and, of course, they make nice, nice, and they promised that they will – they approve things and, of course, the justice department doesn’t bring a criminal action, just a civil action and gets a settlement. Then, of course, Ameriquest does absolutely the same thing targeting blacks, targeting Latinos, outride fraudulent loans, forges people’s signatures, the whole nine yards just completely out of control accounting control fraud, following the recipe that I talked about. And at that juncture, forty-nine state HEs, plus the attorney general of the District of Columbia sued them. Why not the fiftieth? Well, because there was Virginia and at that time Virginia actually had some rules. And so they avoided making mortgages in Virginia. But everybody else sues them, they settle for hundreds of millions of dollars, the biggest settlement of such a kind. Again, no criminal action where upon we make the head of Ameriquest our ambassador to the Netherlands.
Why? Well, because, of course, he was the leading campaign contributor to George Bush. Now that’s politics as usual, the same as I know. But if you want, again, the antecedent of this crisis, two entities rush to acquire Ameriquest from our, now, ambassador or now, about to be, ambassador. Now, again, this place is absolutely notorious. It has a thousand employees, there about, who everyday go in and, if they’re doing substance, what they do is engage in fraud. And, a particularly pernicious fraud where they look for the most vulnerable people in society to defraud. And Citi Corp and Washington Mutual rushed to acquire its operations. And therefore, we are shocked, shocked, that Citi Corp and Washington Mutual made tens of billions in the case of Washington Mutual, hundreds of billions – actually in the case of both of them, hundreds of billions of dollars of fraudulent loans and loan sales. So yes, that just brought us up into the 90s and the early 2000s. So again, we knew in spades, and we not only didn’t bring criminal action we rewarded the frauds, we left them wealthy, we allowed them to sell. They were treated as respectable by the most elite financial institutions in the world, Citi Corp and Washington Mutual being among them. And we discovered our highest honors on the leading frauds. What happens next is by 2004 the FBI warns two things. One, that there is an epidemic of mortgage fraud. Epidemic was their word. And two, warns that it will produce a financial crisis, crisis being their word, if it is not checked, 2004. And here’s a key thing. The FBI person in charge of the effort against mortgage fraud was interviewed by the financial crisis inquiry commission, that inevitable national commission to investigate the causes of this crisis. And he reported that the federal banking regulatory agencies never got in touch with him once either before or after he made this warning about an epidemic of fraud.
Now, can you imagine that? You’re the federal banking regulators, the FBI, publically, and this gets reported all over the place, trade press, general press, says epidemic mortgage fraud is going to cause a financial crisis and nobody in the financial regulatory center says boo, and follows up on it in the least. And here’s a footnote also about the financial crisis inquiry commission. So Eric Holder, the attorney general of the United States of America under Obama, and therefore the head of the FBI as well, in other words, the bureau is part of the justice department, is called to testify in front of the financial crisis inquiry commission. Now what is the most famous thing the justice department/FBI did? Issue this warning in 2004, and Holder’s the head a huge department filled with incredibly bright people who prep him for a testimony like this so the agency looks good. And so Holder looks good, right. That’s your job, prep the guy so he looks good and doesn’t get embarrassed. And what does the first question have to be out of the financial crisis inquiry commission. It's got to be, hey, what did you do in response to your own warning? So that is, in fact, the first question asked to Holder. And Holder, at that point – and Holder is accompanied by his staff and by Lanny Breuer, the head of the criminal division – and his answer is what warning. I’ve never heard of this. Which means nobody up there is passing the note saying I’ll take this Eric. There was no answer. None of them had ever heard of the warning. That’s how big a priority elite financial frauds had in the incoming Obama administration.
Chris Martenson: You know my – this makes my blood pressure rise just a little and I can hear in your voice that you care very much about this too. You know, justice and fair play need to return to our system, and I want to talk about this for a minute because it's very important. The potential corrosive impact this has on society. I had a recent interview with Gretchen Morganson and I asked her about accountability because she’s been, obviously, following this very closely as well. And she had this to say. She said, “the idea that forging signatures, that notarizing very important legal documents really improperly in thousands of cases, maybe millions, the idea that this is somehow going to be allowed to go on with just sort of a penalty of some kind, or a fine, and not prosecuted in the criminal courts, I think is amazing. It really is counter to what we’ve all been led to believe was the course of action in such a case. You have many smaller people, smaller mortgage fraudsters who are in jail. I mean we are talking about the people who are straw buyers for home who defrauded banks. They are in jail for a reason because they perpetrated a fraud. These banks, who’s employees were forging signatures should also have been prosecuted with vigor and they were not. They were simply allowed to negotiate their way out of trouble and negotiate their way with shareholder’s money. They are not paying it out of their own executive’s pockets. They are paying it out of the shareholder’s pockets. There really is no accountability here whatsoever.”
So, in your words, why is accountability, or its lack, so important to each of us? I know some people aren’t even paying attention to this particular issue. To me it's incredibly important because I’m detecting, very powerfully, two sets of rules. I just did my taxes so maybe I have a little ire here because if I don’t follow the letter of the law perfectly there’s a little box on my tax document that says if I sign there and I’m signing with knowing material misrepresentations it's a felony, right. I daily face very serious consequences of my own actions at my level but I’m a little guy. Is that an unfair, sort of summary of this that there might be two sets of rules going on here?
Bill Black: Yeah, and it's what people have always warned about in crony capitalism. So there’s a very conservative French economist, long dead. The name’s pronounced something in French like Bastia, that looks like Bastiat in terms of English spelling and pronunciation, who said – and again, I’ll get pretty close to exact, when plunder becomes a way of life a legal system becomes adopted that legalizes and a moral code is adopted that glorifies it. And so that what crony capitalism, when you fully descend into it, and it's clear that the United States has descended into a version of crony capitalism. So let me tie together this accountability point and these warnings. Let me do the 2006 warnings and the reaction of the industry to both the 2004 and 2006 because that portion that you’re talking about, Gretchen is talking about by far the smallest frauds that the lenders engaged in, which is at the foreclosure stage. But well before the foreclosure stage you have a multiple levels of massive fraud that drive the entire global crisis. So in early 2006, the industry, the lending industries, own antifraud experts, a group called MARI, an acronym, M-A-R-I – issue a report that goes in writing to every member of the mortgage banker associations so thousands of entities, everybody involved. And, says first loans where you don’t underwrite are “an open invitation to fraudsters.” Second when we’ve studied them the incidence of fraud is ninety percent, nine zero, so they’re virtually all frauds. Third, these loans deserve the phrase that the industry itself uses to describe them. They are liar’s loans. Fourth, you apparently have forgotten the experience of the early 90s. Remember when I was telling you about 1990, 1991 when these loans caused hundreds of millions of dollars of losses, hundreds is even more quaint, right.
Chris Martenson: Yep.
Bill Black: And, fifth, the federal banking regulatory agencies – remember this is the Bush era. banking regulatory agencies are warning against making these kinds of loans. Okay, so you have all those warnings from the FBI, you have them the industry’s own experts, you have the fact that inherently in economics you will lose money that this creates adverse selection and that no honest lender would do this. What happens? What’s the industry reaction to hearing all this? Between 2003 and 2006, liar’s loans expand over five hundred percent, and this is the perfect natural experiment. You may have heard this stuff, the claims of this community reinvestment act or that was Fannie and Freddie, the affordable housing requirements that drove the crisis. This is the favorite mime. No, nobody ever required any lender to make or any entity to purchase a liars loan. In fact, Fannie and Freddy were not permitted to count liars loans towards their affordable housing goal. So the reason they did massive amounts of these loans was because of the fraud recipe. Remember, grow ready rapidly by making really crappy loans but at a premium yield. And liar’s loans are perfect for that because in the old days the things we used to prosecute people we had actual rules, and they were really simple rules on underwriting. In essence, they could summarize it in this brief statement. One, before you make the loan you have to underwrite. Two, you have to document that the borrower has the ability to repay the loan. And, three, you have to keep a written record of this underwriting.
Now, if you have those three simple rules, which any honest lender would do if regulators never existed, right. They do all three of those things. So it imposes no cost on the honest portion of the industry. You can see there’s a bind if you want to lie, if you want to do liars loans, right, because if you are going to loan to people who make really crappy loans you’re going to put in your files documentation that you knew you were making bad loans that people couldn’t repay. And if you document that you knew that your regulator is likely to say even under the Bush administration, well, maybe you shouldn’t make those loans and maybe it's my job as a regulator to order you to stop them. Also if you put the – if you try to change the paper trail so that the regulators don’t see that, if you either forge documents or destroy documents, well, that is an additional level of fraud that we can prosecute and we can introduce to show what you’re underlying intent was in making these kinds of loans. So that’s really good for establishing a fraud case. But with a liars loan you don’t have to as the lender document any lies on your part, right, because you don’t do any underwriting so you don’t create a paper trail that shows you knew it was a bad loan because the definition of liars loan is you don’t verify. And so it's perfect device for doing a fraud. All right, so that’s one thing we had done. And by the way, that rule change occurred in the savings and loan industry in 1993 under the Clinton administration and that was part of reinventing government. And I was personally there to witness this, the regulatory regulators were instructed that we were to refer to the industry and to think of the industry as our, in quoting, “client.” There’s no more devastating mindset for ruining regulation than to define the industry you’re supposed to regulate as we’re supposed to serve that industry instead.
Okay, so in response to these warnings the industry massively increased liars loans with nobody requiring and indeed, the federal government warning against it even under the Bush administration such that by 2006 one out of every three new home loans was a liar’s loan. And remember they’re ninety percent fraudulent. And we also know that it was overwhelmingly lenders who put the lies in the liar’s loans, and did so by creating those incentive structures to make sure the mortgage bankers and the mortgage brokers would bring them loans consistent with the recipe, incredible numbers, really crappy, and a premium yield. Okay, so back in the day in the savings and loan crisis, as Akerlof and Romer said, the examiners in the field recognize that this was looting and fraud from the beginning. And so the reregulation of the savings and loan industry begins in 1983. Now that’s really important because the deregulations, the big axe, are 1982 and 1983. 1982 by the federal government, the Garn-St. Germain Act, and then 1983 by California and then followed by Texas. What this created was what we call a regulatory race to the bottom or economists call sometimes a competition in laxity, who can have the weakest rules to attract the industry to come because the industry that’s committing fraud really loves weak rules. And, California and Texas “won”, where obviously won should be in quotation marks, this race to the bottom in the savings and loan crisis. And between just those two states, their savings and loans produced two-thirds of total losses for the entire savings and loan debacle. Think of that. Two states that deregulated the most produce two-thirds of the total losses.