These numbers as large as they are, vastly understate the problem of fraud.

TO BE NOTED: From Bill Moyers Journal:

"April 3, 2009

BILL MOYERS: Welcome to the Journal.

For months now, revelations of the wholesale greed and blatant transgressions of Wall Street have reminded us that "The Best Way to Rob a Bank Is to Own One." In fact, the man you're about to meet wrote a book with just that title. It was based upon his experience as a tough regulator during one of the darkest chapters in our financial history: the savings and loan scandal in the late 1980s.

WILLIAM K. BLACK: These numbers as large as they are, vastly understate the problem of fraud.

BILL MOYERS: Bill Black was in New York this week for a conference at the John Jay College of Criminal Justice where scholars and journalists gathered to ask the question, "How do they get away with it?" Well, no one has asked that question more often than Bill Black.

The former Director of the Institute for Fraud Prevention now teaches Economics and Law at the University of Missouri, Kansas City. During the savings and loan crisis, it was Black who accused then-house speaker Jim Wright and five US Senators, including John Glenn and John McCain, of doing favors for the S&L's in exchange for contributions and other perks. The senators got off with a slap on the wrist, but so enraged was one of those bankers, Charles Keating — after whom the senate's so-called "Keating Five" were named — he sent a memo that read, in part, "get Black — kill him dead." Metaphorically, of course. Of course.

Now Black is focused on an even greater scandal, and he spares no one — not even the President he worked hard to elect, Barack Obama. But his main targets are the Wall Street barons, heirs of an earlier generation whose scandalous rip-offs of wealth back in the 1930s earned them comparison to Al Capone and the mob, and the nickname "banksters."

Bill Black, welcome to the Journal.

WILLIAM K. BLACK: Thank you.

BILL MOYERS: I was taken with your candor at the conference here in New York to hear you say that this crisis we're going through, this economic and financial meltdown is driven by fraud. What's your definition of fraud?

WILLIAM K. BLACK: Fraud is deceit. And the essence of fraud is, "I create trust in you, and then I betray that trust, and get you to give me something of value." And as a result, there's no more effective acid against trust than fraud, especially fraud by top elites, and that's what we have.

BILL MOYERS: In your book, you make it clear that calculated dishonesty by people in charge is at the heart of most large corporate failures and scandals, including, of course, the S&L, but is that true? Is that what you're saying here, that it was in the boardrooms and the CEO offices where this fraud began?

WILLIAM K. BLACK: Absolutely.

BILL MOYERS: How did they do it? What do you mean?

WILLIAM K. BLACK: Well, the way that you do it is to make really bad loans, because they pay better. Then you grow extremely rapidly, in other words, you're a Ponzi-like scheme. And the third thing you do is we call it leverage. That just means borrowing a lot of money, and the combination creates a situation where you have guaranteed record profits in the early years. That makes you rich, through the bonuses that modern executive compensation has produced. It also makes it inevitable that there's going to be a disaster down the road.

BILL MOYERS: So you're suggesting, saying that CEOs of some of these banks and mortgage firms in order to increase their own personal income, deliberately set out to make bad loans?

WILLIAM K. BLACK: Yes.

BILL MOYERS: How do they get away with it? I mean, what about their own checks and balances in the company? What about their accounting divisions?

WILLIAM K. BLACK: All of those checks and balances report to the CEO, so if the CEO goes bad, all of the checks and balances are easily overcome. And the art form is not simply to defeat those internal controls, but to suborn them, to turn them into your greatest allies. And the bonus programs are exactly how you do that.

BILL MOYERS: If I wanted to go looking for the parties to this, with a good bird dog, where would you send me?

WILLIAM K. BLACK: Well, that's exactly what hasn't happened. We haven't looked, all right? The Bush Administration essentially got rid of regulation, so if nobody was looking, you were able to do this with impunity and that's exactly what happened. Where would you look? You'd look at the specialty lenders. The lenders that did almost all of their work in the sub-prime and what's called Alt-A, liars' loans.

BILL MOYERS: Yeah. Liars' loans--

WILLIAM K. BLACK: Liars' loans.

BILL MOYERS: Why did they call them liars' loans?

WILLIAM K. BLACK: Because they were liars' loans.

BILL MOYERS: And they knew it?

WILLIAM K. BLACK: They knew it. They knew that they were frauds.

WILLIAM K. BLACK: Liars' loans mean that we don't check. You tell us what your income is. You tell us what your job is. You tell us what your assets are, and we agree to believe you. We won't check on any of those things. And by the way, you get a better deal if you inflate your income and your job history and your assets.

BILL MOYERS: You think they really said that to borrowers?

WILLIAM K. BLACK: We know that they said that to borrowers. In fact, they were also called, in the trade, ninja loans.

BILL MOYERS: Ninja?

WILLIAM K. BLACK: Yeah, because no income verification, no job verification, no asset verification.

BILL MOYERS: You're talking about significant American companies.

WILLIAM K. BLACK: Huge! One company produced as many losses as the entire Savings and Loan debacle.

BILL MOYERS: Which company?

WILLIAM K. BLACK: IndyMac specialized in making liars' loans. In 2006 alone, it sold $80 billion dollars of liars' loans to other companies. $80 billion.

BILL MOYERS: And was this happening exclusively in this sub-prime mortgage business?

WILLIAM K. BLACK: No, and that's a big part of the story as well. Even prime loans began to have non-verification. Even Ronald Reagan, you know, said, "Trust, but verify." They just gutted the verification process. We know that will produce enormous fraud, under economic theory, criminology theory, and two thousand years of life experience.

BILL MOYERS: Is it possible that these complex instruments were deliberately created so swindlers could exploit them?

WILLIAM K. BLACK: Oh, absolutely. This stuff, the exotic stuff that you're talking about was created out of things like liars' loans, that were known to be extraordinarily bad. And now it was getting triple-A ratings. Now a triple-A rating is supposed to mean there is zero credit risk. So you take something that not only has significant, it has crushing risk. That's why it's toxic. And you create this fiction that it has zero risk. That itself, of course, is a fraudulent exercise. And again, there was nobody looking, during the Bush years. So finally, only a year ago, we started to have a Congressional investigation of some of these rating agencies, and it's scandalous what came out. What we know now is that the rating agencies never looked at a single loan file. When they finally did look, after the markets had completely collapsed, they found, and I'm quoting Fitch, the smallest of the rating agencies, "the results were disconcerting, in that there was the appearance of fraud in nearly every file we examined."

BILL MOYERS: So if your assumption is correct, your evidence is sound, the bank, the lending company, created a fraud. And the ratings agency that is supposed to test the value of these assets knowingly entered into the fraud. Both parties are committing fraud by intention.

WILLIAM K. BLACK: Right, and the investment banker that — we call it pooling — puts together these bad mortgages, these liars' loans, and creates the toxic waste of these derivatives. All of them do that. And then they sell it to the world and the world just thinks because it has a triple-A rating it must actually be safe. Well, instead, there are 60 and 80 percent losses on these things, because of course they, in reality, are toxic waste.

BILL MOYERS: You're describing what Bernie Madoff did to a limited number of people. But you're saying it's systemic, a systemic Ponzi scheme.

WILLIAM K. BLACK: Oh, Bernie was a piker. He doesn't even get into the front ranks of a Ponzi scheme...

BILL MOYERS: But you're saying our system became a Ponzi scheme.

WILLIAM K. BLACK: Our system...

BILL MOYERS: Our financial system...

WILLIAM K. BLACK: Became a Ponzi scheme. Everybody was buying a pig in the poke. But they were buying a pig in the poke with a pretty pink ribbon, and the pink ribbon said, "Triple-A."

BILL MOYERS: Is there a law against liars' loans?

WILLIAM K. BLACK: Not directly, but there, of course, many laws against fraud, and liars' loans are fraudulent.

BILL MOYERS: Because...

WILLIAM K. BLACK: Because they're not going to be repaid and because they had false representations. They involve deceit, which is the essence of fraud.

BILL MOYERS: Why is it so hard to prosecute? Why hasn't anyone been brought to justice over this?

WILLIAM K. BLACK: Because they didn't even begin to investigate the major lenders until the market had actually collapsed, which is completely contrary to what we did successfully in the Savings and Loan crisis, right? Even while the institutions were reporting they were the most profitable savings and loan in America, we knew they were frauds. And we were moving to close them down. Here, the Justice Department, even though it very appropriately warned, in 2004, that there was an epidemic...

BILL MOYERS: Who did?

WILLIAM K. BLACK: The FBI publicly warned, in September 2004 that there was an epidemic of mortgage fraud, that if it was allowed to continue it would produce a crisis at least as large as the Savings and Loan debacle. And that they were going to make sure that they didn't let that happen. So what goes wrong? After 9/11, the attacks, the Justice Department transfers 500 white-collar specialists in the FBI to national terrorism. Well, we can all understand that. But then, the Bush administration refused to replace the missing 500 agents. So even today, again, as you say, this crisis is 1000 times worse, perhaps, certainly 100 times worse, than the Savings and Loan crisis. There are one-fifth as many FBI agents as worked the Savings and Loan crisis.

BILL MOYERS: You talk about the Bush administration. Of course, there's that famous photograph of some of the regulators in 2003, who come to a press conference with a chainsaw suggesting that they're going to slash, cut business loose from regulation, right?

WILLIAM K. BLACK: Well, they succeeded. And in that picture, by the way, the other — three of the other guys with pruning shears are the...

BILL MOYERS: That's right.

WILLIAM K. BLACK: They're the trade representatives. They're the lobbyists for the bankers. And everybody's grinning. The government's working together with the industry to destroy regulation. Well, we now know what happens when you destroy regulation. You get the biggest financial calamity of anybody under the age of 80.

BILL MOYERS: But I can point you to statements by Larry Summers, who was then Bill Clinton's Secretary of the Treasury, or the other Clinton Secretary of the Treasury, Rubin. I can point you to suspects in both parties, right?

WILLIAM K. BLACK: There were two really big things, under the Clinton administration. One, they got rid of the law that came out of the real-world disasters of the Great Depression. We learned a lot of things in the Great Depression. And one is we had to separate what's called commercial banking from investment banking. That's the Glass-Steagall law. But we thought we were much smarter, supposedly. So we got rid of that law, and that was bipartisan. And the other thing is we passed a law, because there was a very good regulator, Brooksley Born, that everybody should know about and probably doesn't. She tried to do the right thing to regulate one of these exotic derivatives that you're talking about. We call them C.D.F.S. And Summers, Rubin, and Phil Gramm came together to say not only will we block this particular regulation. We will pass a law that says you can't regulate. And it's this type of derivative that is most involved in the AIG scandal. AIG all by itself, cost the same as the entire Savings and Loan debacle.

BILL MOYERS: What did AIG contribute? What did they do wrong?

WILLIAM K. BLACK: They made bad loans. Their type of loan was to sell a guarantee, right? And they charged a lot of fees up front. So, they booked a lot of income. Paid enormous bonuses. The bonuses we're thinking about now, they're much smaller than these bonuses that were also the product of accounting fraud. And they got very, very rich. But, of course, then they had guaranteed this toxic waste. These liars' loans. Well, we've just gone through why those toxic waste, those liars' loans, are going to have enormous losses. And so, you have to pay the guarantee on those enormous losses. And you go bankrupt. Except that you don't in the modern world, because you've come to the United States, and the taxpayers play the fool. Under Secretary Geithner and under Secretary Paulson before him... we took $5 billion dollars, for example, in U.S. taxpayer money. And sent it to a huge Swiss Bank called UBS. At the same time that that bank was defrauding the taxpayers of America. And we were bringing a criminal case against them. We eventually get them to pay a $780 million fine, but wait, we gave them $5 billion. So, the taxpayers of America paid the fine of a Swiss Bank. And why are we bailing out somebody who that is defrauding us?

BILL MOYERS: And why...

WILLIAM K. BLACK: How mad is this?

BILL MOYERS: What is your explanation for why the bankers who created this mess are still calling the shots?

WILLIAM K. BLACK: Well, that, especially after what's just happened at G.M., that's... it's scandalous.

BILL MOYERS: Why are they firing the president of G.M. and not firing the head of all these banks that are involved?

WILLIAM K. BLACK: There are two reasons. One, they're much closer to the bankers. These are people from the banking industry. And they have a lot more sympathy. In fact, they're outright hostile to autoworkers, as you can see. They want to bash all of their contracts. But when they get to banking, they say, ‘contracts, sacred.' But the other element of your question is we don't want to change the bankers, because if we do, if we put honest people in, who didn't cause the problem, their first job would be to find the scope of the problem. And that would destroy the cover up.

BILL MOYERS: The cover up?

WILLIAM K. BLACK: Sure. The cover up.

BILL MOYERS: That's a serious charge.

WILLIAM K. BLACK: Of course.

BILL MOYERS: Who's covering up?

WILLIAM K. BLACK: Geithner is charging, is covering up. Just like Paulson did before him. Geithner is publicly saying that it's going to take $2 trillion — a trillion is a thousand billion — $2 trillion taxpayer dollars to deal with this problem. But they're allowing all the banks to report that they're not only solvent, but fully capitalized. Both statements can't be true. It can't be that they need $2 trillion, because they have masses losses, and that they're fine.

These are all people who have failed. Paulson failed, Geithner failed. They were all promoted because they failed, not because...

BILL MOYERS: What do you mean?

WILLIAM K. BLACK: Well, Geithner has, was one of our nation's top regulators, during the entire subprime scandal, that I just described. He took absolutely no effective action. He gave no warning. He did nothing in response to the FBI warning that there was an epidemic of fraud. All this pig in the poke stuff happened under him. So, in his phrase about legacy assets. Well he's a failed legacy regulator.

BILL MOYERS: But he denies that he was a regulator. Let me show you some of his testimony before Congress. Take a look at this.

TIMOTHY GEITHNER:I've never been a regulator, for better or worse. And I think you're right to say that we have to be very skeptical that regulation can solve all of these problems. We have parts of our system that are overwhelmed by regulation.

Overwhelmed by regulation! It wasn't the absence of regulation that was the problem, it was despite the presence of regulation you've got huge risks that build up.

WILLIAM K. BLACK: Well, he may be right that he never regulated, but his job was to regulate. That was his mission statement.

BILL MOYERS: As?

WILLIAM K. BLACK: As president of the Federal Reserve Bank of New York, which is responsible for regulating most of the largest bank holding companies in America. And he's completely wrong that we had too much regulation in some of these areas. I mean, he gives no details, obviously. But that's just plain wrong.

BILL MOYERS: How is this happening? I mean why is it happening?

WILLIAM K. BLACK: Until you get the facts, it's harder to blow all this up. And, of course, the entire strategy is to keep people from getting the facts.

BILL MOYERS: What facts?

WILLIAM K. BLACK: The facts about how bad the condition of the banks is. So, as long as I keep the old CEO who caused the problems, is he going to go vigorously around finding the problems? Finding the frauds?

BILL MOYERS: You--

WILLIAM K. BLACK: Taking away people's bonuses?

BILL MOYERS: To hear you say this is unusual because you supported Barack Obama, during the campaign. But you're seeming disillusioned now.

WILLIAM K. BLACK: Well, certainly in the financial sphere, I am. I think, first, the policies are substantively bad. Second, I think they completely lack integrity. Third, they violate the rule of law. This is being done just like Secretary Paulson did it. In violation of the law. We adopted a law after the Savings and Loan crisis, called the Prompt Corrective Action Law. And it requires them to close these institutions. And they're refusing to obey the law.

BILL MOYERS: In other words, they could have closed these banks without nationalizing them?

WILLIAM K. BLACK: Well, you do a receivership. No one -- Ronald Reagan did receiverships. Nobody called it nationalization.

BILL MOYERS: And that's a law?

WILLIAM K. BLACK: That's the law.

BILL MOYERS: So, Paulson could have done this? Geithner could do this?

WILLIAM K. BLACK: Not could. Was mandated--

BILL MOYERS: By the law.

WILLIAM K. BLACK: By the law.

BILL MOYERS: This law, you're talking about.

WILLIAM K. BLACK: Yes.

BILL MOYERS: What the reason they give for not doing it?

WILLIAM K. BLACK: They ignore it. And nobody calls them on it.

BILL MOYERS: Well, where's Congress? Where's the press? Where--

WILLIAM K. BLACK: Well, where's the Pecora investigation?

BILL MOYERS: The what?

WILLIAM K. BLACK: The Pecora investigation. The Great Depression, we said, "Hey, we have to learn the facts. What caused this disaster, so that we can take steps, like pass the Glass-Steagall law, that will prevent future disasters?" Where's our investigation?

What would happen if after a plane crashes, we said, "Oh, we don't want to look in the past. We want to be forward looking. Many people might have been, you know, we don't want to pass blame. No. We have a nonpartisan, skilled inquiry. We spend lots of money on, get really bright people. And we find out, to the best of our ability, what caused every single major plane crash in America. And because of that, aviation has an extraordinarily good safety record. We ought to follow the same policies in the financial sphere. We have to find out what caused the disasters, or we will keep reliving them. And here, we've got a double tragedy. It isn't just that we are failing to learn from the mistakes of the past. We're failing to learn from the successes of the past.

BILL MOYERS: What do you mean?

WILLIAM K. BLACK: In the Savings and Loan debacle, we developed excellent ways for dealing with the frauds, and for dealing with the failed institutions. And for 15 years after the Savings and Loan crisis, didn't matter which party was in power, the U.S. Treasury Secretary would fly over to Tokyo and tell the Japanese, "You ought to do things the way we did in the Savings and Loan crisis, because it worked really well. Instead you're covering up the bank losses, because you know, you say you need confidence. And so, we have to lie to the people to create confidence. And it doesn't work. You will cause your recession to continue and continue." And the Japanese call it the lost decade. That was the result. So, now we get in trouble, and what do we do? We adopt the Japanese approach of lying about the assets. And you know what? It's working just as well as it did in Japan.

BILL MOYERS: Yeah. Are you saying that Timothy Geithner, the Secretary of the Treasury, and others in the administration, with the banks, are engaged in a cover up to keep us from knowing what went wrong?

WILLIAM K. BLACK: Absolutely.

BILL MOYERS: You are.

WILLIAM K. BLACK: Absolutely, because they are scared to death. All right? They're scared to death of a collapse. They're afraid that if they admit the truth, that many of the large banks are insolvent. They think Americans are a bunch of cowards, and that we'll run screaming to the exits. And we won't rely on deposit insurance. And, by the way, you can rely on deposit insurance. And it's foolishness. All right? Now, it may be worse than that. You can impute more cynical motives. But I think they are sincerely just panicked about, "We just can't let the big banks fail." That's wrong.

BILL MOYERS: But what might happen, at this point, if in fact they keep from us the true health of the banks?

WILLIAM K. BLACK: Well, then the banks will, as they did in Japan, either stay enormously weak, or Treasury will be forced to increasingly absurd giveaways of taxpayer money. We've seen how horrific AIG -- and remember, they kept secrets from everyone.

BILL MOYERS: A.I.G. did?

WILLIAM K. BLACK: What we're doing with -- no, Treasury and both administrations. The Bush administration and now the Obama administration kept secret from us what was being done with AIG. AIG was being used secretly to bail out favored banks like UBS and like Goldman Sachs. Secretary Paulson's firm, that he had come from being CEO. It got the largest amount of money. $12.9 billion. And they didn't want us to know that. And it was only Congressional pressure, and not Congressional pressure, by the way, on Geithner, but Congressional pressure on AIG.

Where Congress said, "We will not give you a single penny more unless we know who received the money." And, you know, when he was Treasury Secretary, Paulson created a recommendation group to tell Treasury what they ought to do with AIG. And he put Goldman Sachs on it.

BILL MOYERS: Even though Goldman Sachs had a big vested stake.

WILLIAM K. BLACK: Massive stake. And even though he had just been CEO of Goldman Sachs before becoming Treasury Secretary. Now, in most stages in American history, that would be a scandal of such proportions that he wouldn't be allowed in civilized society.

BILL MOYERS: Yeah, like a conflict of interest, it seems.

WILLIAM K. BLACK: Massive conflict of interests.

BILL MOYERS: So, how did he get away with it?

WILLIAM K. BLACK: I don't know whether we've lost our capability of outrage. Or whether the cover up has been so successful that people just don't have the facts to react to it.

BILL MOYERS: Who's going to get the facts?

WILLIAM K. BLACK: We need some chairmen or chairwomen--

BILL MOYERS: In Congress.

WILLIAM K. BLACK: --in Congress, to hold the necessary hearings. And we can blast this out. But if you leave the failed CEOs in place, it isn't just that they're terrible business people, though they are. It isn't just that they lack integrity, though they do. Because they were engaged in these frauds. But they're not going to disclose the truth about the assets.

BILL MOYERS: And we have to know that, in order to know what?

WILLIAM K. BLACK: To know everything. To know who committed the frauds. Whose bonuses we should recover. How much the assets are worth. How much they should be sold for. Is the bank insolvent, such that we should resolve it in this way? It's the predicate, right? You need to know the facts to make intelligent decisions. And they're deliberately leaving in place the people that caused the problem, because they don't want the facts. And this is not new. The Reagan Administration's central priority, at all times, during the Savings and Loan crisis, was covering up the losses.

BILL MOYERS: So, you're saying that people in power, political power, and financial power, act in concert when their own behinds are in the ringer, right?

WILLIAM K. BLACK: That's right. And it's particularly a crisis that brings this out, because then the class of the banker says, "You've got to keep the information away from the public or everything will collapse. If they understand how bad it is, they'll run for the exits."

BILL MOYERS: Yeah, and this week in New York, at this conference, you described this as more than a financial crisis. You called it a moral crisis.

WILLIAM K. BLACK: Yes.

BILL MOYERS: Why?

WILLIAM K. BLACK: Because it is a fundamental lack of integrity. But also because, if you look back at crises, an economist who is also a presidential appointee, as a regulator in the Savings and Loan industry, right here in New York, Larry White, wrote a book about the Savings and Loan crisis. And he said, you know, one of the most interesting questions is why so few people engaged in fraud? Because objectively, you could have gotten away with it. But only about ten percent of the CEOs, engaged in fraud. So, 90 percent of them were restrained by ethics and integrity. So, far more than law or by F.B.I. agents, it's our integrity that often prevents the greatest abuses. And what we had in this crisis, instead of the Savings and Loan, is the most elite institutions in America engaging or facilitating fraud.

BILL MOYERS: This wound that you say has been inflicted on American life. The loss of worker's income. And security and pensions and future happened, because of the misconduct of a relatively few, very well-heeled people, in very well-decorated corporate suites, right?

WILLIAM K. BLACK: Right.

BILL MOYERS: It was relatively a handful of people.

WILLIAM K. BLACK: And their ideologies, which swept away regulation. So, in the example, regulation means that cheaters don't prosper. So, instead of being bad for capitalism, it's what saves capitalism. "Honest purveyors prosper" is what we want. And you need regulation and law enforcement to be able to do this. The tragedy of this crisis is it didn't need to happen at all.

BILL MOYERS: When you wake in the middle of the night, thinking about your work, what do you make of that? What do you tell yourself?

WILLIAM K. BLACK: There's a saying that we took great comfort in. It's actually by the Dutch, who were fighting this impossible war for independence against what was then the most powerful nation in the world, Spain. And their motto was, "It is not necessary to hope in order to persevere."

Now, going forward, get rid of the people that have caused the problems. That's a pretty straightforward thing, as well. Why would we keep CEOs and CFOs and other senior officers, that caused the problems? That's facially nuts. That's our current system.

So stop that current system. We're hiding the losses, instead of trying to find out the real losses. Stop that, because you need good information to make good decisions, right? Follow what works instead of what's failed. Start appointing people who have records of success, instead of records of failure. That would be another nice place to start. There are lots of things we can do. Even today, as late as it is. Even though they've had a terrible start to the administration. They could change, and they could change within weeks. And by the way, the folks who are the better regulators, they paid their taxes. So, you can get them through the vetting process a lot quicker.

BILL MOYERS: William Black, thank you very much for being with me on the Journal.

WILLIAM K. BLACK: Thank you so much."

"inherently requires trying to develop greater mastery of vital questions such as morals and fraud"

Here's a post on Cato Unbound which I basically agree with as well:

"I’m back from Utrecht( TOUGH LIFE ) and eager to rejoin the discussion, which has been aided greatly by the contributions of an anonymous reader who has obviously been in the tranches. Let me first respond to the specific questions my colleagues have posed to me.

Do I argue that agency problems in the private sector are both an important cause of the crises and exacerbated those crises? Yes ( I AGREE. I CALL THIS A HUMAN AGENCY EXPLANATION ). My prior essays and long reply explain why, though I will amplify the answer in my next post.

Do I, Larry White asks, agree with Gerard Caprio, Jr., Aslı Demirgüç-Kunt, and Edward J. Kane (CDK)? “[W]hat prompted the overleveraging and excess risk-taking in the first place? CDK argue that an important contributor was ‘safety-net subsidies,’ i.e., moral hazard from implicit or explicit financial guarantees.” ( I BELIEVE THAT THEY ARE )

No. First, CDK do not provide an explanation of why regulators permitted these activities. One needs to explain why economists’ endorsement of non-regulation and deregulation led to non-regulation and deregulation( IN THIS ONE AREA ). One also needs to examine the ideology of those who appoint the regulators and those appointed as the top regulators( CRONYISM ). As I discussed, when you appoint individuals who believe that regulation cannot succeed, they will prove themselves correct( THEY DID THIS TIME ). You get exactly what we have experienced — desupervision. ( I AGREE )

Second, the great bulk of the crisis was not “excess risk-taking.”( I DISAGREE ) Again, my prior pieces provide substantial analysis and data explaining these points. Mortgage fraud (by lenders) is a “sure thing”( I AGREE ) (Akerlof & Romer 1993; Black 2005) — it is (in combination with rapid growth, high leverage, and minimal loss reserves) mathematically certain to produce extremely high short-term “profits.”( I AGREE ) It is also certain to produce failure — the only question is how soon( I AGREE ). Note that control fraud (rather than “excess risk-taking”) also played the dominant role in prior crises such as the S&L debacle ( TRUE ), Enron/WorldCom and their ilk, Russian privatization, and the travails of the “the Washington Consensus” in Latin America. ( TRUE )

Third, unregulated (or almost entirely unregulated) lenders committed the great bulk of the mortgage. These lenders were not covered by deposit insurance( NOW HERE YOU'RE WRONG. THEY WERE COUNTING ON ANOTHER KIND OF INSURANCE ). If CDK were correct then they should have been subject to far more stringent “private market discipline.” Private market discipline (under their theories) is supposed to ensure adequate capitalization — which is (under their theories) supposed to minimize “moral hazard.”( THAT'S A THEORY. A KANTIAN EXPLANATION. NOTHING MORE. ) Thus, the predictive strength of their model has been tested by the subprime crisis — and falsified by it for mortgage fraud( I AGREE ) (or, if the reader is still in denial about fraud despite the data I provided, which my colleagues don’t even attempt to refute, the “excess risk taking”) was significantly more common in the sector that under their theories had the least moral hazard.

The Enron/WorldCom, et al., scandals had already shown that accounting control fraud did not require explicit or implicit governmental guarantees( WRONG. THEY BELIEVED THAT THEY HAD AN IMPLICIT GUARANTEE ). Fourth, moral hazard theory (as interpreted by CDK) did not explain the S&L debacle even though it took place in an industry with explicit governmental guarantees. They (implicitly) interpret the theory as excluding control fraud. This is an incorrect interpretation of moral hazard theory, which arose in the insurance context and has long recognized that moral hazard can lead to either excessive risk-taking or fraud by the insured ( I AGREE ). For the sake of testing their argument, however, I assume their definition that argues that S&L owners, made insolvent by the interest rate shock of 1979-82, responded by “gambling for resurrection.” These were honest gambles that would only pay off for the CEO or shareholders if the investments succeeded. The troubles with this theory include (1) the purported “rational” strategy (as interpreted by economists) was virtually certain to fail( TRUE ), (2) all of the purported “gamblers” economists asserted followed this strategy (the “high fliers”) first reported exceptional profits and then failed ( TRUE ), (3) as the national commission (NCFIRRE) found, “fraud was invariably present” at the “typical large failure,”( ABSOLUTELY ) (4) the business practices that the purported gamblers followed were profoundly irrational if they were honest, but were optimal as accounting control frauds( YOU ARE CORRECT ), and (5) in fact, there were honest gamblers but they (A) did not act in a manner that economists predicted and (B) they won their bets and substantially reduced the cost of the debacle.( I TEND TO AGREE )

Point 1: economists assert that the optimal “excess risk-taking” strategy for insured banks that are inadequately capitalized or insolvent is to maximize the value of the put option. [1] The means by which one maximizes the put is to take ultra high risk. The optimization is straightforward — the greater the risk, the greater the expected value of the put. The obvious (except to most economists) problem with this concept is that the way to optimize is to take a bet that is so risky that it is virtually certain to fail. Even economists should be able to understand that financial suicide is an unattractive and oxymoronic form of “optimization.” ( NOT IF YOU'VE BEEN HANDSOMELY REWARDED BEFORE THE FALL )

Point 2: The concept of “optimization” I have just explained could explain part of the pattern of outcomes of the “high fliers” and lenders that specialized in nonprime mortgage loans, i.e., universal failure ( I AGREE ). Why S&L subordinated debt holders and other creditors that are not protected from loss by deposit insurance never blocked these suicidal strategies by the “high fliers” is, however, inexplicable under neoclassical economic theory. (Subordinated debt holders, who economists predicted would be the optimal agents of private market discipline because they had large amounts of at-risk funds and were financially sophisticated, also failed to block control fraud — or “excess risk-taking” — at banks, investment banks, and insurance companies.) ( YOU ARE WRONG. THEY BELIEVED THEY HAD IMPLICIT GUARANTEES )

The concept of optimization, however, cannot explain the first aspect of the pattern of outcomes – uniform high, initial profitability. There is no reason why hundreds of S&Ls and scores of nonprime lending specialists (A) should have all specialized in the same small number of activities, and (B) should all have been highly profitable while purportedly engaging in ultra high-risk investments. [2]

What does fit the pattern of outcomes is accounting control fraud( I TEND TO AGREE ). It is a “sure thing.” It produces certain profits in initial years. Unless the fraudulent CEO exercises restraint presumably because the company is well-capitalized and likely to generate long-term profits — which was not the case for any S&L in this era — the optimal strategy was “looting” ( I AGREE )(Akerlof & Romer 1993). Looting is fatal and typically causes catastrophic losses. I term the exercise of restraint in converting firm funds to the CEO’s personal use through accounting fraud “grazing.”( DO YOU NOW? I WONDER WHY, BUT THAT'S ANOTHER QUESTION. I HOPE )

Points 3 and 4: NCFIRRE (1993) found that (A) there was a distinctive pattern to the high fliers’ business practices, (B) the pattern was irrational if they were engaged in honest gambles, (3) the pattern optimized accounting fraud, and, (4) that fraud was “invariably” present at the “typical large failure.” The nonprime lenders meet those four characteristics, as do Enron and its ilk. ( I AGREE )

Point 5: “Traditional” S&Ls did “gamble for resurrection” in 1981-83 by maintaining much of their interest rate risk exposure. This was not consistent with economists’ beliefs about moral hazard theory. Every traditional S&L was insolvent on a market value basis in 1982. Very few of their CEOs (roughly 100 of around 3000) engaged in reactive control fraud due to moral hazard. This restraint is the most significant reason why the debacle did not grow to catastrophic proportions. (Roughly 200 “opportunistic” control frauds entered the S&L industry in 1982-84 through changes of control or opening de novo institutions. The typical opportunist was a real estate developer. He had large conflicts of interest and no ties of loyalty to the S&L or its shareholders, customers, or employees. He was more willing to loot than was the typical traditional CEO that had come up through the ranks over the course of two decades. ( OK )

Moral hazard theory (as taught by neoclassical economists) predicts that traditional S&Ls would dramatically increase their risk exposure through honest gambling in 1982-84. Instead, traditional S&Ls made modest increases in credit risk and modest-to-moderate reductions in their interest rate risk exposure. This behavior was inconsistent with the predictions of moral hazard theory. It was risky. If interest rates had continued to increase throughout 1982 and beyond the overall industry insolvency (on a market value basis) of $150 billion would have increased. Instead, the traditional S&Ls were lucky on interest rates after mid-1982, as rates fell significantly and fairly steadily. Because traditional S&Ls only partially reduced their exposure to interest rate risk, their “underwater” mortgages regained most of their (unrealized) market-value losses. As a result, “only” about $25 billion of that $150 billion was ultimately “realized.” (NCFIRRE 1993). If economists wish to define insolvent S&Ls continuing to take serious, but modestly less, risk as “moral hazard,” then they can conclude that moral hazard significantly reduced the cost of resolving the S&L debacle. ( OK )

Ultimately, CDK’s logic (if not their conclusions) strongly supports the themes I have developed during this discussion. Deregulation and desupervision in the financial sphere can have the unintended consequence of optimizing a “criminogenic environment.” The extension of implicit federal guarantees to every large corporation operating in the United States can exacerbate the problem of control fraud. ( THAT'S IT )

Casey reminds me that he has GDP data (emphasis in the original) that, he argues, demonstrate that there is no “crisis” for the “average” American. Casey is aware that I (and our readers) have data too, and that (unlike lagging GDP numbers) they demonstrate a crisis greater than any of us have experienced in our lifetimes (except for readers who are very long-lived and knew the Great Depression). We know that there have been unprecedented failures of hundreds of markets — globally. We know that but for unprecedented intervention by the Fed, Treasury and other central banks it is the considered judgment of the economic powers that be (here and abroad) there situation would have become catastrophic. We see unprecedented socialism in the United States for our more elite institutions( NOT REALLY ). We see the failure (or “but for” intervention failures) of many of our most elite financial institutions. Now, granted, I was born in Detroit and grew up in Dearborn, so the auto industry probably has lubricants running in my veins, but the “but for” collapse of the entire domestic auto industry is a kind of a big deal. All of this happened not in some “perfect storm” but during the “great moderation.” It is also getting worse, commercial real estate, the PBGC, SIPC and other shoes are waiting to drop. All of these facts are data. They are simply vastly more important data. ( I AGREE WITH HIM AND CASEY, BECAUSE I DAMN WELL CAN )

Brad argues that:

Thus practically every risky asset, all the time, sells for much less than its fundamental value — and does so because financial markets do not do a good job of mobilizing the risk-bearing capacity of society. I don’t think we have any prospect of living in a world in which financial markets do their job of risk-tolerance-mobilization well — nobody should trade or invest in anticipation of such a world. But I don’t think that the idea of “overinvestment” makes a lot of sense: the proper public policy response to every situation that White would characterize as one of “overinvestment” is, I think, one in which the government takes steps to mobilize more of society’s risk-bearing capacity rather than letting asset prices collapse and create massive unemployment.

I have a very different view. Brad believes that financial markets are commonly made deeply inefficient by “lemons markets” problems in a manner that leads to a systematic undervaluing of asset values. Many “risky assets” trade for much more than their “fundamental value” (assuming that this concept can be made meaningful.( ACTUALLY, I DON'T BELIEVE THAT IT CAN ) ) That is precisely why we have epidemics of control fraud. Spreads on nonprime mortgage loans during the last decade have always been grossly inadequate and spreads narrowed when they should have grown over the course of the decade. Moreover, the entire concept of an “adequate spread” for this kind of lending was a misnomer because had the loans been properly priced the spread would have been so large that it would have sent the “adverse selection” problem through the roof (pun intended). ( I TEND TO AGREE )

It follows that we should not seek to initiate government action to inflate housing prices to the point that there were minimal credit losses on existing mortgages. Doing so would misallocate resources further, reward fraud, and make the markets even more inefficient. ( TRUE, BUT...)

Larry, responding to Brad, urges:

In fact, I think economic reasoning about cause and effect (not monkey psychology) helps us to understand what is going on. Economic reasoning does not require the use of, nor have I used, normatively loaded terms like “deserved” or “retribution” or “fecklessness.” To repeat what I wrote on my blog in September:

“This isn’t a morality play. What we’re seeing are the consequences of monetary-policy distortions of interest rates and regulatory distortions of incentives, amplified in some degree by private imprudence, not the consequences of blackheartedness.”

I will offer a different view. There is nothing superior or scientific in avoiding the use of “normatively loaded terms” when such terms are accurate and important. Readers will have discovered that economists have a profound unwillingness to use the “f” word — fraud — to discuss fraud( NOW HERE I AGREE COMPLETELY AND AM GLAD TO READ THIS ). You now see an effort to assert that this weakness is a virtue. Even Brad’s euphemisms are too strong for Larry.

The crisis we are discussing has its roots in a massive fraud, primarily by lenders( BINGO! ). Frauds this severe greatly extend and inflate financial bubbles. This directly causes losses that measure in the trillions of dollars. It indirectly causes systemic risk because (as the anonymous reader agreed) financial systems run on trust( LIKE CREDIT RATINGS AGENCIES. THINK OF ROBERT WALDMANN'S POST ) and there’s nothing like creating and then betraying trust (which is what fraud is) and causing enormous losses through that betrayal, to destroy trust. This is the “transmission mechanism” Brad is searching for that produced the broader crisis. ( TRUE )

Fraud has moral consequences, and morality is central, not peripheral to market efficiency( THIS IS A HUMAN AGENCY EXPLANATION ). Larry’s unwillingness to take fraud seriously, even after my data and analysis dump, is characteristic of what has gone wrong in economics.

For the reasons shown in the earlier discussions, Larry’s claim that monetary policy caused or even contributed greatly to the housing bubble fails( IT'S A SLIGHT CAUSE ). More to the point, if the “solution” were significantly higher short term interest rates the cure would have been far more expensive and harmful than appropriate micro/macro policies (i.e., regulatory restrictions on nonprime lending) that would have killed the bubble at much earlier time with far less collateral damage.

There was no “regulatory” distortion of incentives that caused or even contributed substantially to the bubble( I AGREE, THEY DID HELP IT, BUT NOT CAUSE ). The CEOs that funded these loans did it to create accounting profits. It is naïve (and unsustainable) to claim they made the loans to comply with rules (that in fact did not require making or purchasing nonprime loans).

There was, however, plenty of distortion of incentives by private parties. They distorted those incentives to optimize accounting fraud. They acted in a manner consistent with past control frauds. ( I AGREE )

Economists love to talk about “unintended consequences” and they’re always in the context of social do-gooding gone wrong. Here are two unintended consequences of non-regulation and/or desupervision. (The consequences, of course, are intended by the private parties, but absent corruption, not by the legislators.) First, when you don’t regulate financial activities you de facto decriminalize control fraud because the regulators are the “cops on the beat.”( TRUE ) Second, when you don’t regulate financial activities you make them opaque and you create a situation in which voluntary industry disclosures aren’t verified by a truly independent entity. ( TRUE )

So, no it’s not a fictional medieval “morality play.” It is the real-world economy, the study of which inherently requires trying to develop greater mastery of vital questions such as morals and fraud( I AGREE ). If you are saying that economics and economists are going to continue (1) not to develop a theory of fraud or become cognizant of the findings of other disciplines that specialize in the study of what causes markets to fail profoundly, (2) not to develop a methodology that does not praise accounting control frauds, (3) to recommend praxis that optimizes environments for epidemics of control fraud, (4) to refuse to analyze whether fraud is present, (5) to refuse to call a fraud “a fraud,” and (6) to think that this ignorance and addiction to euphemism is a virtue, then economists need to engage in a fundamental reconsideration of their profession, theories, methodologies, and policy recommendations. ( I AGREE )

As constituted, the economics profession endangers the world economy. As even the triumphalist authors of Moral Markets concede (a book announcing the triumph and moral superiority of “free markets” that had the misfortune of being published this year), our business schools and economics programs too often continue to hold up homo economicus as the ideal — but homo economicus is, to quote that volume: “a sociopath.”( MORE LIKE A FICTION ) The authors, in essence, charge that our business school and economics programs have become fraud academies. Many students will have the moral strength to resist that training, but as economists emphasize, the concern is on the margins. ( I AGREE )

Notes

[1] Note that this subtly removes the “moral” from “moral hazard” and turns an abusive behavior not simply into a neutral activity, but into a desirable activity. This is dangerous because it helps “neutralize” abusive behavior, which increases abusive behavior( I TEND TO AGREE ). As I am about to explain in my discussion of Point 5, “moral” constraints — a broad concept under “moral hazard” theory — can provide some of the most effective constraints against control fraud.

[2] The markets offer far greater yields for honest risk-taking than honestly underwritten subprime loans or direct investments. The reason that mortgage lenders specialized in subprime lending or that S&L specialized in “direct investments” or “ADC” loans has is that these types of investments are superb vehicles for accounting fraud, particularly during a “bubble,” not because the yield is spectacular. ( TRUE )

Now, I disagree about one point, but it's an important point. Many of the actors did not committ fraud, but did engage in other unethical or criminal behavior, which I have listed as fiduciary mismanagement, negligence, and collusion. The implicit and explicit government guarantees to intervene in a financial crisis were necessary for these individuals to take the risks that they did, because these people wanted to remain where they were if everything went sideways. They thought of these guarantees as an insurance policy, which lobbying and networking paid for, and, indeed, these people believe that this is the essence of our system. They do not believe in free markets, but rather favor a version of the welfare state heavily weighted towards their interests. People have an absurd idea of our system when they use words like "socialism" or "free market" to describe what we have. It's a Welfare State. A Government/Private Sector Hybrid. Most people support it, but try and nudge or bribe or convince the government to favor their interests. That's why Interest Groups are so important in our politics.

One final point. Even when people claim that they're Anarchists or Libertarians or Socialists, I tend to doubt that they are. The reason is that until they find out how they would actually do economically, etc., under such a system, I don't believe that they know if they'd support such a system or not. It's a bit like how I feel when people say that they'd like to live in the past. They're always assuming that they'll do all right, while I have my doubts.