Debate
by Marshall Auerbach, William K. Black, Jack Blum, Gary Dymski, Barkley Rosser, Jr, Paul Davidson
Paul Davidson
I have two points: one is about Bill Black’s account of fraud, which obviously is correct. Just think about this: Economists do not make their own data, they rely on accountants to provide them. Nowb what does that tell you about econometric studies, particularly of GNP, GDP, etc? If it’s pig iron production or something like that, where they measure tons, I assume they don’t lie about the number of tons. Barkley, I was with you until you mentioned the Glass-Steagall Act at the very end. The reason why Glass-Steagall Act was enacted in the first place is that banks had been underwriting all sorts of strange things during the 1920s and before and selling them off. Remember, with a 5 percent margin, every individual was a hedge fund at that time. You put down 5 percent and you borrow 19 times that; that was one of the reasons the market eventually collapsed. And the Glass-Steagall Act said: “if you’re a financial institution, you have to decide whether or not you’re going to make loans”. These loans were illiquid assets and had to be carried on the books till the person either paid off the mortgage or defaulted. Before making a loan, the banker checked the classical three C’s: collateral, credit history and character of the borrower. When you securitize mortgage you don’t care about the risk, because you’re going to pass it off. You can choose to be either a banker, and make these illiquid loans and hold them until the end because you couldn’t sell them, or to be an underwriter. The very purpose of this was to create a secondary market for mortgage loans. You pointed out the 1960s but the real start of the shadow banking system was in the 1970s, when we allowed money market accounts to create checking deposits. Then, in 1987, the Federal Reserve permitted bank holding companies to have up to 25 percent of their revenues in collateralized loans. And finally the dam broke in 1999, when Glass-Steagall Act was repealed. At that time, nobody thought they had to hold a mortgage for more than 30 days and that’s what created our problems. Who is responsible for repealing the Glass-Steagall Act? We usually blame the Senator Phil Gramm. But as The Wall Street Journal recently pointed out, he didn’t have enough votes to get it repealed, and so he told a Citibank lobbyist to call Sandy Weill9 and ask him to call the White House. Three days later Clinton twisted Democrats arms, and we got repeal. Who in the White House did that? We don’t know, but Robert Rubin resigns the next week and takes a job at Citibank.
Bill Black
Let me just add to this that bankers have been trying to get out of the banking business for at least the last 40 years. The problem is that being a banker is a lousy business. You have to do real loan underwriting. You have to figure out if the borrower will repay the loan. You have to check his books, and half the time you’re going to say no. It’s expensive, time-consuming. And then, how much can you charge? If it’s a really well underwritten loan you’re not going to make a lot of profit. Routine banking business is computerized, and it’s commodity, nobody makes any money on it. So, sometime around the 1970s, bankers got the following advice from business consultants: “The only way for you to increase your earnings is to get out of this business. Let other people do the underwriting. What you do is give them a line of credit so they can make the loan, and then you securitize and sell off”. Following this advice, banks literally got out of the banking business. I learned this in 1974, at a meeting in San Francisco where the treasurer of the Bank of America was explaining to me how brilliant their strategy was. Before the 1970s, the Bank of America was a community banker. They made loans on houses and really dealt with ordinary people. But as explained by the treasurer, this was far too expensive. “What we’re going to do is lend to developing countries. We all know they never default. And the beauty of dealing with developing countries is that we can put together a bank syndicate and lend them $500 million or a billion at once. It’s one shot, there’s no underwriting cost, and we get much better return on that than we do making all these local loans”. So one by one, all of the banks that did the banking job got out of the business, to the point where they didn’t even bother doing the intermediary function, because they farmed out their treasury operations to institutional money market funds. So what we have is banks rejecting their social function and a society that’s now stuck with the fact that nobody did the underwriting, that the people who did the underwriting made money by cooking the books, the people who bought it had no idea what they were buying, and the banks are collecting outrageous fees for doing this. That has to stop.
Barkley Rosser
Let me respond to Paul, and this is partly a follow-up on Jack’s comments. I think the problem isn’t so much the nature of the investment banks; the problem is elsewhere, in low margin requirements, in lack of good supervision of such things. If you have a highly unregulated banking system like ours, then yes, you have a problem. I would suggest something like Canada or Germany – Canada in particular – where you put all banks together and apply more serious regulations. Now maybe that’s not going to work in the U.S., but in fact, they are already back together, which means that we’re basically going in that direction anyway. Frankly, I prefer to see Morgan Stanley and Goldman in commercial banking roles rather than doing what they were doing until now.
Bill Black
But who, in the regulatory world, has a clue about what they’re doing and has the possibility to regulate them? All it does is putting a fig leaf over what’s going on. That doesn’t help anyone, on the contrary: it gets the federal government deeper in trouble.
Barkley Rosser
Will reinstituting the Glass Steagall system resolve that problem?
Bill Black
No, we’re talking about a much broader problem and that’s why I said we have to look at the world as it is and look for the holes, and what has to be done to fill them. I’m not asking for a reinvention of the wheel, I’m not asking for creation of mega-agencies; what I am saying is that we really must take a look at where the regulations have been undercut, what’s wrong with the current regulatory system, why the people in charge of risk management can’t actually manage risk.
Gary Dymski
Let me make a couple of comments and then ask a question to the entire panel. Barkley, I was going too fast to clearly indicate that I was talking about shared appreciation mortgages. The counter-party could be either the government or a private party, but it’s something to look at. And local governments could, were they positioned and given the capacity, maybe with some kind of infrastructure fund backing, take charge of housing in their own neighborhoods. They know the cost of abandoned subdivisions, they know what it means when the police force can’t take care of the problems in the neighborhood. Secondly, when Nation’s Bank bought Bank of America, the first thing they did was to eliminate something called the Bank of America Community Development Bank, which had been fought for by community activists over many years. It makes one wonder that there’s an offloading of this core banking function, how we need to really envision that in this rethinking. Now to my question. It seems that there’s some kind of squareroot law at work: the more locations there are to do activities, the more kinds of activities you can do, the more assets you can trade. And the more things you can do with these assets, the more fraud can be perpetrated. So if we focus on simplifying activities, on reducing the number of locations of markets and so on, what direction should we take, given your experience and your frustration over what you see as years of fraud? Where should we begin if we want to cut down the fraud?
Bill Black
In terms of cutting down fraud and dealing with bubbles, I think we’re one of the unusual entities that did deliberately target a bubble. We targeted it through the years 1984-87. It was a commercial real estate bubble. I shouldn’t be the one saying this but I will argue that we were extraordinarily successful, and that it’s a far better tool than monetary policy. What we realized, of course, was that the bubble was built on Ponzi schemes. That’s how you optimize an accounting fraud. And if you put a series of Ponzis together, they will hyper-inflate and extend a financial bubble, and they will also send false price signals. This is pretty standard economics and finance. So one of the best things to do is to look for the Achilles heel – and the Achilles heel, every time you deal with Ponzi, is growth. So we restricted growth, and that killed every single one of the Ponzi schemes. There were roughly 300 of them. We did it through a requirement that directly restricted growth. Because if you make it against capital, they simply inflate the capital through the accounting and you don’t achieve your goal. The other thing you do is to look for perverse incentive structures. I’m a white-collar criminologist, and it’s very similar to economics. We think in terms of what we call criminogenic environments, environments that lead to crime. So where do we look? You look for assets that have no readily verifiable market value, because it’s far easier to inflate them, to create phony accounting income and hide real losses. So it is not true that they use just about anything for making fraud. Typically, fraud is not about the risk. These methods are not risks in any conventional sense. These are sure things in terms of accounting fraud, sure in both senses: you know for sure that you’ll report record profits, and you know for sure that you will fail. Jack Blum I want to turn our conversation to commodities. Most of you probably don’t know how commodities contracts work; but before a contract can start trading, the Exchange has to approve it, the Commodity Futures Trading Commission (CFTC) has to sign off on it. And when a contract is traded, the selling firm is responsible for insuring the contract. And then, would that firm fail, the whole exchange is responsible. Some people started then to move commodities trading into an unregulated offshore arena, and that gave us companies like Refco, which went bust. It gave us unregulated oil contracts, traded offshore, which allowed the most amazing manipulation by people like Bernie Kornfeld or some Russians speculators, which is why we got to $140 a barrel and why, just a few months later, we’re back down to $60. And nobody, absolutely nobody wants to look at it; because as long as I’ve known the Commodity Futures Trading Commission, you got the job by a letter of recommendation from one or another of the brokerage firms to say you’re a good guy.
Barkley Rosser
I’m not sure what the disagreement is. I think one way to get at this, and I think this is relatively easy, is simply to outlaw certain kinds of financial instruments like interest-only mortgages or negative amortization mortgages. I understood that the housing bubble was about to blow when I read in The Washington Post, in early 2005, that a majority of the mortgages that were being issued in the metropolitan area were interest-only. This showed that things have gotten out of control. But we know from economic experiments that even when people know that the bubble is going to blow, they still like to go on because, while they go on, people are making money, and that is very pleasurable.
Marshall Auerback
On the question of fraud, I think it’s interesting to note that the FBI seems to be examining Fannie and Freddie a little bit more closely – and as we know from the history of Watergate, once the FBI gets involved, a law of unintended political consequences comes in and sometimes things actually get done. So I wonder what you think the impact of that investigation might be. My second question is to Barkley Rosser, and it’s about the mark-to-market debate. I’ve seen how some of these derivatives work, and I think the analogy generally used is the Latin American crisis in the 1980s. You say you hold the bond on the bank’s book until maturity and thereby avoid the problematic issue of marking it to market. But we’re dealing with something which is much more complex. We’re dealing in many cases with derivatives of derivatives. There’s no real definable cash flows for these products, so I’m not sure how you can value it as a hold-to-maturity proposition either. That, I think, is the real problem you get into when you use that as a solution. So I’m interested in hearing your thoughts on that.
Barkley Rosser
Marshall, I’m not quite sure whether you were asking me whether altering mark to marketing was difficult, or whether mark to marketing itself is difficult. I would certainly agree that these exotic derivatives are very hard to value. We know that even some of the people who have issued them don’t know how to value them. So there are very difficult problems, and I don’t really have the answer.
Jack Blum
Let me answer the first question: I was an expert witness for the entity that was supposed to regulate Fannie and Freddie in the administrative enforcement action against the former senior management. It was a classical case of accounting control fraud, run from the top. The Securities and Exchange Commission did not investigate it in terms of going after the senior leadership. It looked at it and said that the accounting is all wrong, but it did not move at all vigorously. The FBI, as I noted, has treated this as a retail problem. It has focused on people ripping off. And it does some 600 cases a year of that; it’s like throwing sand into the ocean. Had they created task forces early on, they might have identified the real problem. Maybe we can’t put undercover agents in Al-Qaida but it’s easy to put FBI agents in firms like WaMu.
Bill Black
Believe it or not but it’s worse than you think. The FBI actually had a mortgage fraud squad working in northern Virginia for several years. I know it because I handled the case involving a totally falsified mortgage where they tricked non-English-speaking immigrants into signing all the papers. We brought the agent in and gave him all the information. He rolls his eyes. I ask him, “You must have seen these cases before. Why haven’t these people been prosecuted?” Because he even knew the people who were doing it. And he said: “no prosecutor would pick up the case because no one had lost any money. I can’t sell that to a jury”. The other part of it is that the FBI pulled most of its agents of white-collar crime to do counter-terrorism. And let me put it like this: the ones left are like a group of sumo wrestlers doing needlepoint.
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