Author: William Black

[Welcome Simon Johnson, and Host William Black,  author of, The Best Way to Rob a Bank is to Own One ]

[As a courtesy to our guests, please keep comments to the book.  Please take other conversations to a previous thread.]

Thirteen Bankers: The Wall Street Takeover and the Next Financial Meltdown

The authors begin their book with two quotations that implicitly raise the question of why we are suffering recurrent, intensifying crises. You have to love a book that begins with an excerpt from Fitzgerald’s The Great Gatsby.

They were careless people, Tom and Daisy – they smashed up things and creatures and then retreated back into their money or their vast carelessness, or whatever it was that kept them together, and let other people clean up the mess they had made.

The first chapter begins with a quotation from President Obama’s remarks to the thirteen bankers on March 27, 2009 at a meeting to seek their support for his recovery plans.

My administration is the only thing between you and the pitchforks.

The authors note that President Obama then made the plea: “Help me help you.” [In a Freudian keyboard slip, I originally typed “Help us help you.” But Obama personalized his plea.] President Obama came into office emphasizing his intent to look forward, not backward. The authors show us the high cost of this failure to even understand the concept of accountability. Accountability is essential to a just world. The authors also show it is essential to an honest and competent financial sector that does not careen from crisis to crisis.

President Obama instinctively sees holding elites accountable to be a vile thing that calls forth our lesser angels. Those who believe in justice are dangerous populists. They are mobs wielding “pitchforks.” The proper role of the President is to protect “Tom and Daisy” from justice. He will “clean up the mess they had made” of the economy (with our money). The citizens’ function is to “help” the thirteen bankers. The authors rightly emphasize that the most fundamental way in which big finance dominates both political parties is not through their massive political contributions, but through the triumph of the industry’s ideology. The standard Reagan jest about government applies far better to the big banks: “I’m from Goldman Sachs, and I’m here to help you.” But that is not how the political elites frame the issue. They accept the big finance’s ideological trinity: (1) massive financial firms are essential to fund the real economy, (2) “financial innovation” brings efficiency and growth while excluding fraud, and (3) financial regulation cannot succeed, but can make things far worse.

Tom Frank (who has a doctorate in history), has tried to correct many of these fictions about populism in his books (What’s the Matter with Kansas and The Wrecking Crew). People hate elites that abuse their power to enrich themselves through fraud and crony capitalism. They particularly hate it when the elites do so with impunity. Effective Presidents throughout our history have channeled this outrage and demand for justice (accountability) to create the political space that led to passage of many progressive measures that are so much a part of our world today that we no longer even recall that their opponents once claimed they were the vanguard of Marxism.

The authors show how President Obama squandered his opportunity to create the political space for reform when he embraced big finance and sought to protect its leaders from justice. They also demonstrate that this is not a new phenomenon. Rubin led President Clinton’s administration down this same rabbit hole. His protégés, particularly Larry Summers, are President Obama’s principal economic advisors.

And so, despite what the FBI has rightly called an “epidemic” of mortgage fraud, with 80% of the losses arising when industry insiders are involved in the losses, not a single senior officer of a major nonprime lender has been arrested (much less convicted) of mortgage fraud or securities fraud. Despite bailing out with federal funds every major bank, the regulators did not insist that any of the CEOs lose their jobs or return the massive bonuses they obtained via false accounting. Indeed, the administration stood by silently while, with Ben Bernanke’s encouragement, the Chamber of Commerce and the banking lobbyists induced Kanjorski to extort the Financial Accounting Standards Board (FASB) to (successfully) intimidate it into dropping honest accounting rules so that the banks could avoid recognizing their losses. Absent this dishonest accounting the banks could not have paid most of the massive bonuses because the banks would have been reporting losses instead of profits and many would be reporting that they were insolvent.

The regulators have even failed to bring civil suits and administrative actions for restitution against the officers of the massive banks that drove the financial crisis. No prominent banker complicit in the nonprime scandals has even been “removed and prohibited” from the industry.

The authors make the essential point. If you don’t hold the bankers accountable even when they blow up the world economy, but instead reward them for doing so, you create a situation in which the two most relevant questions are: (1) when will the next global crisis strike and (2) how horrific will it be?

The authors show how dangerous the financial oligarchy is to democracy and to the global economy. Their answer is the one that I think is the only workable answer – no bank should be allowed to become (or remain) a systemically dangerous institution (SDI). They end, as they began, with the effort by the Rubin wing of the Democratic Party to label and dismiss any position in favor of effective reform as naïve and “pitchforky.” The authors’ proposed reform is the product of sound analytics and common sense. The Rubin wing of the party is the land of the economists that claimed that big finance was benign, self-regulating, and immune from fraud. That’s naïve with a capital “N.” They are even proud of not holding the financial oligarchs (who make them rich and powerful) accountable. They think the American peoples’ desire for justice is naïve and dangerous and that their function is to protect the oligarchs from the people. This makes them not simply naïve but enablers of elite criminality and enemies of democracy.

 

[Welcome Joseph Stiglitz, and Host William Black.] [As a courtesy to our guests, please keep comments to the book.  Please take other conversations to a previous thread. – bev]

Freefall:America, Free Markets, and the Sinking of the World Economy

By Joseph E. Stiglitz (Nobel Laureate, Economics 2001)

William K. Black, Associate Professor of Economics and Law, University of Missouri – Kansas City

This book is about a battle of ideas, about the ideas that led to the failed policies that precipitated the crisis and about the lessons we take away from it (p. xii).

Anyone seeking to explain this “battle of ideas” must address three questions:

1. What “ideas” are producing environments in so many nations that create the perverse incentives that have led to recurrent intensifying crises in many nations?
2. Why did these ideas become dominant in so many nations?
3. Why have these ideas become more dominant even as they have produced greater crises?

Stiglitz’ answers to these questions are:

1. Neoclassical economics has become ferociously anti-governmental.  Financial markets, absent effective regulation, generate perverse incentives that cause crises.
2. The United States, through our universities and through institutions such as the International Monetary Fund (IMF), exports neoclassical economics and economists to the world and gives them the power to set policy in most nations.
3. Stiglitz suggests several reasons why economists have become ever more married to their models as they fail spectacularly.  Self-interest and power are part of the answer (p. 42).  Neoclassical economists are useful to big finance because they are willing to give the wrong answers.  The more that reality falsifies their models, the more valuable neoclassical economists are to big finance in fending off regulation, in creating models that overvalue assets (allowing huge bonus payments), and in claiming that the prices their own models generate after the crisis should be disregarded because the problem isn’t asset quality, but rather liquidity and market confidence (p. 48).  Economists have become financial holocaust creators and deniers.

But Stiglitz’s primary argument is that anti-regulatory economists have remained intellectually dishonest for the saddest of reasons – they lack the courage to admit that their theories have been falsified and that the policies they have championed caused the crises (p. 48).

Stiglitz documents America (and much of the world’s) descent into crony capitalism (pp. 41-42, 122).  He explains that while other bankrupt firms settle claims on credit default swaps (CDS) at 13 cents on the dollar, Paulson and the Fed pressured AIG to pay favored systemically dangerous institutions (SDIs) such as Goldman Sachs 100 cents on the dollar – with the public bearing the cost of this secret subsidy (p. 49).  His broader point is that the neoclassical triumph in the battle of ideas (and its triumphalism about winning the battle) led not to the promised utopia of efficient, stable markets and growth, but rather to economic stagnation for the middle class, a catastrophic fall for the working class, and recurrent crises.

Stiglitz emphasizes that none of this is due to bad luck.  The Great Recession was not analogous to the “100 year flood.”  Crises have happened in a broad range of nations because when finance becomes unregulated it becomes vastly too large and too powerful and uses its power to corrupt or evade restraints on its power.  This means that crony capitalism is a severe danger and will often occur.

Their victory over America was total.  Each victory gave them more money with which to influence the political process.  They even had an argument:  deregulation had led them to make more money, and money was the mark of success.  Q.E.D. (p. 10).

Stiglitz emphasizes that finance can become hyper-dominant in a broad range of political settings throughout the world.  One of his most candid themes is that the Obama administration continued Bush’s policy of crony capitalism (pp. 46-49).

This book is weakest in providing a concrete explanation of the mechanism that caused this, and prior, crises.  Stiglitz appropriately identifies three aspects of why the ideas he criticizes produce an environment that causes crises:

• Deregulation, (and, even more, desupervision)
• Modern compensation (executive and “agents”, e.g., outside auditors, rating agencies, and appraisers)
• Accounting.  Criminologists recognize that accounting is the “weapon of choice” for financial frauds and that the first two elements interact to optimize an environment for accounting fraud.

The tension is that Stiglitz refers primarily to “risk” and views the difference between “gambling” and fraud as being a “fine line” (p. 125), using the S&L debacle as his example (p. 125) and citing Ed Kane and George Akerlof and Paul Romer, respectively, for this proposition.  But this misreads what Akerlof & Romer wrote and it misses the fact that they wrote later than Kane with the benefit of dramatically better data that disproved Kane’s hypothesis that the debacle was primarily caused by (honest) “gambling for resurrection” by already insolvent S&Ls (Black 2005).   As the national commission into the causes of the S&L debacle found, at “the typical large failure” “fraud was invariably present.”  (“Traditional” S&Ls did engage in honest gambles for resurrection by only moderately reducing their exposure to interest rate risk in 1983-86.  They won those gambles when interest rates fell sharply, which sharply reduced the cost of resolving the debacle.  Note that they reduced rather than expanded their risk exposure – contrary to the “gambling” hypothesis.)

Akerlof & Romer’s title says it all:  “Looting:  Bankruptcy for Profit.”  They agreed with the insight that regulators and criminologists had reached about the debacle – fraud is a “sure thing.”  A lending institution that follows the classic four-part strategy for optimizing accounting fraud is mathematically guaranteed to report record profits:

1. Grow rapidly
2. Make loans regardless of the borrower’s ability to repay (this is essential to being able to grow rapidly while charging a premium yield)
3. Extreme leverage
4. Grossly inadequate loss reserves

The “typical” large nonprime lender failure during this crisis fits this pattern.  The first three parts of the strategy are well known, but loss reserves have been ignored in discussions of the crisis.  Overall, loss reserves fell to “record lows” for four straight years even as (1) the FBI warned in September 2004 that there was an “epidemic” of mortgage fraud (and predicted that it would produce an economic crisis if it were not contained), (2) underwriting standards disappeared (which is deliberate and essential to part two of the optimization strategy), and (3) warnings of the housing bubble became common and strident.  Each of these factors should have led to far larger loss reserves, collectively they should have led to loss reserves so large that the lenders would have had to report that nonprime lending was (in economic reality) unprofitable.  Instead, loss reserves virtually disappeared.  Again, this is not an issue of a “fine line.”  We are talking about loss reserves that were two orders of magnitude too small.

So I would add another reason why economists have been so blind to the causes of these crises – they have been taught from their freshman year that accounting doesn’t matter (efficient markets must “see through” accounting) and that no rational person would base a business decision on accounting.  In reality, accounting fraud routinely cons financial markets and accounting is the primary driver of decisions by financial firms.

The biggest story in the bailout is barely known because it is an accounting story.  The big banks, with Bernanke’s support, used their political muscle to cause Congress to extort FASB to gut the accounting rules so that lenders did not have to recognize their loan losses.  Absent that rule change, the banking “profits” would have been losses and they would not have been able to pay themselves over a$100 billion in executive bonuses.