Fiat Justitia Ruat Caelum

(Let Justice be done, though the Heavens Fall)

By William K. Black

It is one of the paradoxes of life that the most practical means to ensure that the system does not collapse is to insist on justice for all and to ignore demands for special treatment premised on claims that justice places the system at grave risk of collapse. Nietzsche argued that the ubermensch (generally translated as “Superman”) transcended the normal rules. The elites claim impunity from normal rules on the basis of their purported superiority and because they claim that they are so important that applying the normal rules to them will harm society. Some pigs are more equal than others. What any competent financial regulator learns is that the best way to destroy a financial system is to refuse to hold the elites accountable. Regulators that insist on doing justice prevent the heavens from falling.

Gretchen Morgenson and Louise Story authored a column addressing one of our national scandals – the elite banking frauds who caused the Great Recession through their looting have done so with impunity. Not a single one of them has been convicted. This is the hallmark of crony capitalism.

Gretchen and Louise’s reporting exposed for the first time two underlying scandals that produced the overall scandal. In 2008, the FBI, belatedly, realized that it had improperly targeted relatively trivial mortgage frauds while ignoring the massive lenders that specialized in making fraudulent mortgages. The FBI developed a plan to reorient its resources towards the “accounting control frauds” that always should have been its priority. We now know that the Department of Justice (DoJ) deliberately, and successfully, sabotaged this effort to investigate the major frauds. We need additional investigative reporting to discover why DoJ did so.

The second underlying scandal that their column disclosed is that two key members of what Tom Frank aptly termed Bush’s “Wrecking Crew” – Geithner and Bernanke – who President Obama chose to promote and reappoint and make his anti-regulatory leaders sought to discourage or limit federal and state prosecutions, enforcement actions, and suits. Geithner’s express rationale was that the financial system extreme fragility made vigorous investigations of the elite frauds too dangerous.

Here is how I responded to Kai Ryssdal, Marketplace’s business journalist, who asked about Geithner’s rationale:

Ryssdal: What about the argument, though, that the financial system is so fragile still, and these cases so complicated, that we can’t really tear things apart with substantive investigations and prosecutions because it will all fall apart again?

Black: Yeah, that’s an excellent point. We should leave felons in charge of our largest financial institutions as a means of achieving financial stability.

Ryssdal: See, that’s funny because I was expecting you to come back with — I don’t know, JPMorgan earned $5 billion last quarter. How shaky can they be?

In retrospect, that interchange should have been a warning to me – Ryssdal actually thought Geithner’s position favoring immunity for elite felons was acceptable when financial conditions are “shaky.” Sure enough, Matthew Yglesias wrote a column on April 14, 2011 embracing the Geithner immunity doctrine. He titled it: “The Fraud Free Financial Crisis” – and it proves our family rule that it is impossible to compete with unintentional self-parody.

Here is Yglesias’ position:

[T]he key sentiment underlying the whole thing is that the Obama administration felt it was important to restabilize the global financial system. That meant, at the margin, shying away from anxiety-producing fraud prosecutions. And faced with a logistically difficult task, that kind of pressure at the margin seems to have made a huge difference. There simply was no appetite for the kind of intensive work that would have been necessary.

I’m not as persuaded as, say, Jamie Galbraith is that the failure to do this is a key causal element in our economic problems. Indeed, I’d say that if you look at the situation literally, Tim Geithner’s judgment was probably correct.

Yglesias believes that “Geithner’s judgment was probably correct” because investigating the accounting control frauds that caused the economic crisis would have been “anxiety-producing.” Geithner’s overriding goal was to “restabilize the global financial system,” so he was correct to discourage the fraud investigations of the elite bankers. Yglesias obviously believes that Geithner “restabilize[d] the global financial system.”

I’ve noted the brief answer that I gave on Marketplace. Here’s the expanded answer. This was not a “fraud free financial crisis.” It is a prosecution free financial crisis for the elites whose frauds caused the crisis. Historically, “control frauds” – frauds run by the senior officers who control seemingly legitimate banks and use them as “weapons” to defraud creditors and shareholders – drive serious financial crises. That was true of our two most recent financial scandals. The national commission investigating the causes of the S&L debacle found that at the typical large failure “fraud was invariably present.” The major Enron era frauds were all control frauds. This current crisis was driven by accounting control frauds. We have known, for well over a century, how to make home loans in a manner that limits fraud to negligible levels. We have known for centuries that if bankers do not underwrite the inevitable results are massive losses, endemic fraud, and failure. Honest mortgage lenders do not make liar’s loans. No one ever forced a banker to make liar’s loans. Only fraudulent mortgage lenders make material numbers of liar’s loans. My prior columns have explained that it was the lenders that overwhelmingly put the lies in liar’s loans.

The FBI warned in House testimony in September 2004 that there was an “epidemic” of mortgage fraud and predicted that it would cause a “financial crisis” if it were not stopped. It was not contained. Everyone agrees that the mortgage fraud epidemic expanded massively after the FBI warning. Here’s the four-part “recipe” for a fraudulent lender optimizing fictional accounting income and real losses:

1. Grow massively
2. By making awful loans at a premium yield
3. While employing extreme leverage, and
4. Providing only grossly inadequate loss reserves

Deregulation and desupervision are more extreme in some industries and regions and certain assets provide superior “ammunition” for accounting fraud. If entry is relatively easy (and it was ridiculously easy for mortgage banking and loan brokers), then accounting control frauds will cluster in particular asset categories, industries, and regions. Clustering, extreme growth, and the fact that accounting control frauds rapidly increase their lending even when they know that they are lending into the teeth of a massive bubble are all factors that make accounting control fraud epidemics uniquely dangerous devices for hyper-inflating financial bubbles. All other factors being held constant, the more a bubble hyper-inflates the greater the economic inefficiency and losses and the greater the risk that it will cause a severe recession. The second ingredient in the fraud recipe – lending to borrowers who will often be unable to repay their loans – also plays a major role in causing bubbles to hyper-inflate. There are tens of millions of Americans who cannot afford to purchase homes and therefore are normally unable to obtain loans to purchase homes. When accounting control frauds lend to the uncreditworthy they make it possible for millions of additional Americans to purchase homes – but not to repay their loans. In economics jargon, this shifts the demand curve to the right. Shifting the demand curve for housing to the right will increase the price of housing and hyper-inflate the bubble.

How much of the bubble was driven by the accounting control fraud? We don’t know the precise amount. Data on the frequency of liar’s loans are uncertain. The three major categories of home loans: prime, subprime, and “alt-a” (aka: “stated income” or “liar’s loans) had no formal definition and no standard reporting. The loan categories are not mutually exclusive. The best information we have is that by 2006 one-half of subprime loans were also liar’s loans. The most reliable estimates of the total number of liar’s loans made in 2006 are that they represent between 25 and 49% of home loans. That is a disturbingly wide range of estimates. Even the lower bound estimate represents over a million loans. Independent studies of the incidence of fraud in liar’s loans run from 80 – 100%. That means that the annual number of mortgage frauds arising from liar’s loans alone is likely to be roughly one million. (Extrapolating the likely number of frauds from the number of criminal referrals leads to a similar estimate of the annual number of mortgage frauds.) Expanding the number of home purchasers by loaning to those who would often prove unable to repay their home loans caused a major right shift in the demand curve – providing somewhere between 25 and 50% of the total home purchasers in 2006. Losses do not increase in a linear fashion when a bubble hyper-inflates. A 25% increase in the bubble could produce a 100% increase in the ultimate losses. We do not know how rapid the rise in losses will be when a bubble hyper-inflates, but our experience with the collapse of massive bubbles is generally dire.

We could have far better data if the administration heeded our requests that we sample the Fed’s and Fannie and Freddie’s massive holdings of mortgage instruments to determine the facts. Instead, the FDIC and OTS have created a “data base” of mortgages that is worse than useless. It treats prime, subprime, and alt-a as mutually exclusive categories and defines alt-a not by the lack of underwriting but rather by FICO score. Both of these practices are not only obviously wrong, but indefensibly wrong. These errors will irretrievably cripple meaningful research and fact-based policies if senior FDIC officials fail to intervene.

These facts about the current crisis and prior crises led prominent economists such as George Akerlof (Nobel Prize, 2001), Paul Romer, and James Galbraith to warn that accounting control fraud epidemics posed critical dangers to our economy. Yglesias, who is not writing in an area in which he has any experience or expertise, offers a bare conclusion – he’s “not persuaded” by the economists, criminologists, or regulators who have made a specific study of the causes of the crises. He apparently believes that the FBI’s prescient 2004 warning that the fraud epidemic would cause a financial crisis was fanciful – even though it proved correct. Among the factors that Yglesias fails to consider is the first rule of investigating accounting control fraud – if you don’t look; you don’t find. The people that look have to understand accounting fraud mechanisms and they have to work intensively with serious commitments of expert personnel. Geithner blocked the investigations. It is clear from the FBI’s own numbers that it never provided remotely adequate staff to conduct a serious investigation of any major failed bank. We know that there were no serious investigations by the regulatory agencies. Contrast that with the S&L debacle where our regulatory investigations led the agency to make well over 10,000 criminal referrals. It’s easy to be “not persuaded” when no one is investigating and making public the persuasive facts. We’ve had to rely on a Senate committee and the Financial Crisis Inquiry Commission to do a literal handful of investigations because the banking regulatory agencies (1) had their budgets and staff’s shredded and (2) were led by anti-regulators who ended the entire criminal referral process and institutions that we built up despite their proven success. It is bizarre that Yglesias uses the paucity of publicly available data – caused by the anti-regulators’ refusal to conduct meaningful investigations and make criminal referrals – to justify his skepticism that bankers who wear nice suits could be criminals.

Liar’s loans are not “complicated.” The huge commercial real estate (CRE) loans that were the dominant “ammunition” used for accounting fraud during the S&L debacle were very complicated. We were able to get over one thousand felony convictions in “major” S&L cases (with a conviction rate of over 90%) despite the complexity of CRE deals.

I end on the fundamental problems with Geithner’s immunity doctrine and Yglesias’ support for it. The policy represents the intersection of the curves of injustice and stupidity at their respective maxima. Those curves have intersected to produce Secretary Geithner’s policy of protecting from prosecution the elite C-suite criminals who caused the financial crisis and the Great Recession. It is stupidity of truly epic proportions to leave felons in charge of banks. Doing so cannot stabilize a financial system – it is certain to cause recurrent, intensifying crises. When I was a regulator during a financial crisis our agency’s top priority was to prevent frauds from controlling S&Ls. Our second priority was to support the prosecution of those fraudulent leaders.

The injustice of Geithner’s “elite frauds go free” doctrine is every bit as extreme as the stupidity of believing that giving fraudulent CEOs de facto immunity is the road to financial stability. It is a travesty that I have to defend the importance of integrity and justice. No nation can be great if it allows its elites to loot with impunity and prosecutes its whistleblowers. Geithner is destroying the things that made America great. He did so as part of Bush’s wrecking crew and he is doing so now as part of Obama’s wrecking crew.

Geithner’s “elite frauds go free” plan is not new. Speaker Wright demanded that my colleagues and I go easy on fraudulent Texas S&Ls to save the Texas economy (which the S&L frauds were savaging – but he assumed they were salvaging). The five senators that became known as the “Keating Five” told us that Lincoln Savings was critical to the health of Arizona’s economy. In reality, it was the worst threat to Arizona’s economy. One of my agency’s presidential appointees, Bank Board member Roger Martin, argued that if Keating was a fraud and had made Lincoln Savings insolvent by looting the S&L it was all the more important to keep him in charge so that he could use his exceptional political power to get zoning changes that would reduce losses. He opposed any closures of insolvent, fraudulent Arizona S&Ls on the grounds that the Arizona economy was fragile. Here’s the difference. We, the professional regulators, explained in excruciating detail why leaving frauds in charge of S&Ls would massively increase losses and harm regional economies. Only one of the three Board members (Larry White) listened to us – the other two (Martin and Bank Board Chairman Danny Wall) took the unprecedented action of removing our jurisdiction over Lincoln Savings because we refused to withdraw our recommendation that it be promptly taken over and Keating removed. We told the Keating Five to their faces that they were intervening on behalf of a fraud. Even before Wall and Martin removed our jurisdiction over Lincoln Savings they expressly ordered us to cease our examination of Lincoln Savings, to cancel the upcoming examination (nominally, they ordered us to postpone it indefinitely), and ordered that the formal investigation of Lincoln Savings (which had produced the admissions of fraud) be terminated (nominally, suspended). The result was that Lincoln Savings became the worst S&L failure. Losses increased substantially after our examination, investigation, and supervision of Lincoln Savings were halted. All of this became a national scandal when House banking chairman, Henry B. Gonzalez, over the opposition of the Democratic leadership, conducted a series of intense oversight hearings that exposed the Bank Board’s capitulation to the political extortion of the Keating Five and Speaker Wright. Danny Wall resigned in disgrace as a result of those hearings.

For those readers who doubt that regulators can ever be trusted let me note several facts about the Keating Five meeting (which occurred 24 years and one week ago). Four of the Senators were Democrats, one was a Republican. Speaker Wright was a Democrat. Four of us from the Federal Home Loan Bank of San Francisco met with the Keating Five. To this day, I have no idea what the political affiliations, if any, of my colleagues were. It was irrelevant to us. We detested the frauds and their political allies. Our job was to protect the public. We were constantly abused, sued for hundreds of millions of dollars, investigated, and threatened with being fired. We prioritized the most elite, most destructive frauds for removal from the industry, enforcement actions, civil suits, and prosecutions. We persevered.

In 1990-91, as the nation entered a recession, and the banking agencies were accused of preventing the recovery of the fragile economy through excessively strict regulation, suits, and prosecutions we ignored those accusations and used normal supervisory means to end a developing wave of nonprime lending by California S&Ls. Our supervision prevented any nonprime crisis in that era. Indeed, we were so effective that the fraudulent S&L leaders of that era “voted with their feet” and left the S&L industry to escape our supervision. For example, the most notorious nonprime lender of that period, Roland Arnall, the head of Long Beach Savings, gave up his federal charter and created a mortgage banking firm (Ameriquest) so that he would not be subject to our supervision. One of his primary mortgage banking competitors was controlled by a married couple we removed and prohibited from a California S&L they controlled.

Competent financial regulators understand that good ethics makes for good regulation. As soon as you depart from the justice and integrity and attempt to save elite bankers from “anxiety” you become a grave threat to the public. I have no hopes about Geithner. What distresses me is Yglesias’ casual willingness to give up on justice because Geithner believed it might cause “anxiety” among his cronies. Justice must not occupy a very high position in either man’s values if they are so willing to abandon it. Powerful bankers commonly press regulators to abandon justice as soon as we find that they have violated the law. These pleas are far more common than threats, and they are more insidious because they are far more likely than threats to be effective. A regulator who gives in to the plea can feel great – he saved the entire system. A regulator that gives in to a threat knows that he has violated his duty and exhibited cowardice.

Yglesias substitutes faux violence for integrity in his vision of how to respond to the massive frauds that caused the Great Recession and cost 10 million Americans their jobs. He muses about the desirability of Nancy Pelosi slapping a bank CEO. His every instinct is wrong. He trivializes the crimes and the concepts of justice and accountability. The web has the opposite extreme – jokes about executing the senior bank frauds. This is the not a mindset of effective regulators or white-collar criminologists. My boss, Michael Patriarca, famously directed us to “cut square corners” in all our dealings with Lincoln Savings even though we knew it be a fraudulent operation engaged in the vilest of tactics against us and the public. Justice, not punishment, is the key.

Effective regulators are the cops on the beat who are essential to defeating the Gresham’s dynamic that arises when frauds gain a competitive advantage. As regulators, we know and deal regularly with a large number of honest bankers. When we leave criminals in place as CEOs by discouraging even investigations of their fraud we endanger their honest competitors, our economy, and our democratic system. Geithner’s path is the coward’s retreat from imagined fears. If he really believes that the fraudulent bank CEOs are essential to the “success” of our economy then he must believe that our economy is fatally flawed and he should be leading the charge to radically transform it.

[Please note: my phrase about the intersection of the curves is a variant of Charles Black’s famous denunciation of a dishonest, racist statement in the infamous Supreme Court opinion in Plessy v. Ferguson upholding the constitutionality of racial segregation: “The curves of callousness and stupidity intersect at their respective maxima.” I am surprised that Paul Krugman has not used Charles Black’s classic phrase (or a variant such as “callousness and mendacity”) to describe Representative Ryan’s budget plan.]

This article first appeared at New Economic Perspectives, a blog representing economic ideas from the University of Missouri-Kansas City where Bill Black is an Associate Professor of Economics and Law. Bill is a white-collar criminologist, a former senior financial regulator, and the author of The Best Way to Rob a Bank is to Own One.