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What Inequality has Done to American Conservatives Community of Reason Kansas City: September 16, 2012 William K. Black Associate Professor of Economics.

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Presentation on theme: "What Inequality has Done to American Conservatives Community of Reason Kansas City: September 16, 2012 William K. Black Associate Professor of Economics."— Presentation transcript:

1 What Inequality has Done to American Conservatives Community of Reason Kansas City: September 16, 2012 William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City

2 Conservatives’ & Inequality Responses vary and contradict 1.Growing inequality is a myth 2.Inequality is unimportant 3.Inequality is desirable 4.Inequality reflects culture, not economics 5.Criticizing inequality = class warfare 6.Liberals cause inequality to grow 7.Inequality is due to inferior ethnicity

3 Growing inequality myth Conservatives focus on late : Decreased wealth (v. income) due to stock and real estate losses Decreased income due to reduced bonuses Some job losses in high income jobs

4 Their chart

5 Longer term trend is clear

6 Inequality is unimportant “In the end, however, one has to ask a more basic question. Why do we care about inequality at all?” “Poverty, of course, is a bad thing. But is inequality?” Michael Tanner. Cato (2012)

7 Income jealousy is bad “In what way does someone else's success harm me? Such a viewpoint stems from the misguided notion that the economy is a pie of fixed size. If one person gets a bigger portion of the pie, others of necessity get smaller pieces, and the role of government is to divide up the slices of that pie. In reality, though, the size of the pie is infinite.” Cato 2012

8 Liberals love equality; hate the poor “After all, if we doubled everyone's income tomorrow, we would eliminate an enormous amount of economic hardship. Yet, inequality would actually increase. As Margaret Thatcher said about those who obsess over inequality, "So long as the [income] gap is smaller, they would rather have the poor poorer.“” Cato (2012).

9 Inequality spurs growth But to make it grow, we need people who are ambitious, skilled risk-takers. We need people to be ever striving for more. That means that they must be rewarded for their efforts, their skills, their ambitions, and their risks. Such rewards inevitably lead to greater inequality. But to make it grow, we need people who are ambitious, skilled risk-takers. We need people to be ever striving for more. That means that they must be rewarded for their efforts, their skills, their ambitions, and their risks. Such rewards inevitably lead to greater inequality. Cato 2012.

10 Big $ = essential incentive “[A]s Nobel Prize–winning economist Gary Becker pointed out, "It would be hard to motivate most people if everyone had the same earnings, status, prestige, and other rewards.“” Cato 2012

11 Echelon formation Another Nobel Prize winner, F. A. Hayek, concluded, "The rapid economic advance that we have come to expect seems to be in large measure a result of this inequality and to be impossible without it. Progress at such a fast rate cannot take place on a uniform front but must take place in an echelon fashion, with some far in front of the rest.“ Cato 2012

12 Equality: “who needs it?” We should all seek a prosperous, growing economy, with less poverty, and where everyone can rise as far as their talent and drive will take them. Equality? Who needs itWe should all seek a prosperous, growing economy, with less poverty, and where everyone can rise as far as their talent and drive will take them. Equality? Who needs it? Cato 2012.

13 Inequality increase = “rents” “[T]op performers in their fields—in sports and entertainment as well as business— have enjoyed huge gains in recent decades.” “[E]arnings at the very top of the scale have grown by leaps and bounds over the past generation.” (Cato 2009)

14 Cato (2009): The bad old days “Restrictions on competition in product and capital markets were … reduced during the 1970s and ’80s, to the applause of economists across the ideological spectrum. These salutary developments may have contributed to the rise of income inequality, true enough. But only through the distorting lens of nostalgia can what came before be seen as the “good old days.”

15 Rewards to high skills now huge “The leading explanation that emerges from the literature is one of “skill-biased technical change” (SBTC). [W]ith the explosive growth of information technology in recent decades, rising relative demand for highly skilled “knowledge workers” has resulted in a growing pay gap between those workers and their less-skilled counterparts. (Cato 2009).

16 Superstar compensation “Another distinctive aspect of the inequality picture that seems to need special explanation is the whopping increase in incomes at the very top of the pay scale. How to explain the rise of so-called “superstar” markets?” Cato 2009.

17 Explaining CEO compensation “[C]hief executive officers, investment bankers, [and] elite lawyers[’] big increases in remuneration have come without any corresponding expansion of the “audience” or customer base.” “Paul Krugman and company are well advised to search for additional causal connections [for CEO compensation gains] in the realms of politics and culture.” (Cato 2009)

18 Markets crush plutocrats “And the market economy has repeatedly tried to cut the most politically connected men of wealth down to size, but my critic’s own political hero, Barack Obama, has supported bailing them out. That is not the free market’s fault.” Woods (von Mises site.)

19 The Three “De’s” We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts …due to the widely accepted faith in the self- correcting nature of the markets and the ability of financial institutions to effectively police themselves. [FCIC]

20 Greenspan and HOEPA The Fed had unique statutory authority under HOEPA (1994) to ban liar’s loans made by non-federally insured lenders who made roughly 80% of such loans The Fed knew that liar’s loans were endemically fraudulent and that lenders and their agents put the lies in liar’s loans The Fed knew liar’s loan growth massive Greenspan refused (v. ACORN & NAACP)

21 Greenspan as anti-regulator Greenspan refused to have Fed examiners find facts re nonprime loans after FBI’s 2004 warning that mortgage fraud “epidemic” would cause a financial “crisis” Greenspan & Fed economists attacked Fed supervisors for criticizing nonprime loan Greenspan & Fed economists attacked Fed supervisors for criticizing elite banks for aiding and abetting Enron’s frauds

22 Indifference to looting No banking regulator contacted the FBI in response to its twin 2004 warnings Federal regulators’ “preemption” war v. state regulators stopping fraudulent lenders Death of federal regulatory criminal referrals and even (real) investigations Note that Geithner did not alert the FBI to the Libor frauds: no criminal referral by Fed

23 Bernanke little better Finally succumbed to congressional pressure to use HOEPA to ban liar’s loans on July 14, 2008 – and delayed ban for 15 months lest he discomfit any surviving fraudulent lender When it finally acted the Fed cited the data MARI had sent the industry in 2006 – the Fed did no study of the role of the world’s largest fraud epidemic in driving the crisis

24 MARI’s 5 Warnings (2006) Stated income loans “are open invitations to fraudsters” Study: fraud incidence is “90 percent” “[T]he stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan.’”

25 MARI’s 4 th & 5 th Warnings “It appears that many members of the industry have little … appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses….” “Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans….”

26 U.S. was a liar’s loan crisis Credit Suisse: by 2006: 50% of all loans called “subprime” are also liar’s loans Roughly 40% of all US mortgage loans made in 2006 liar’s loans > 500% growth since 2003 Caused the bubble to hyper-inflate Liar’s loans are the key “natural experiment” to evaluate claims v. CRA and Fannie & Freddie as causing crisis

27 Natural experiment: Liar’s loans “Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not” (FCIC 2010: 125).

28 No government urging “Alt-A mortgages were not generally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from counting toward [Fannie and Freddie’s] affordability goals” (FCIC 2010: 125). Inflating income massively is a poor means to purport to loan to the poor

29 Not so due diligence Clayton’s Potemkin review of mortgage loans for most sophisticated purchasers Found nearly 50% false representations Response: buyers negotiated reduced price to buy (and sell) endemically fraudulent mortgages (Source: FHFA suits) Reduced sampling percentage (2-3%) Passed loans Clayton rejected.

30 Calomiris:“Plausible deniability” “asset managers were placing someone else’s money at risk, and earning huge salaries, bonuses and management fees for being willing to pretend that these were reasonable investments. [T]hey may have reasoned that other competi[tors] were behaving similarly, and that they would be able to blame the collapse (when it inevitably came) on an unexpected shock.” “Who knew?”

31 Conscious Adverse Selection Optimizes accounting fraud & bonuses “[Liar’s loans] are open invitations to fraudsters.” (MARI 2006). Expected value of mortgage lending (and purchasing) under adverse selection is negative – catastrophic losses to firms MBA sent MARI warnings to everyone in 2006 but the response to increase such loans with ever worse quality

32 Negative expected value “owners of the thrift have an incentive to seek out the most unscrupulous ‘developers,’ the ones that it can count on to report grossly overstated interest payments in early years and then to default in subsequent years.” “The development projects that are undertaken in this kind of arrangement would typically have a net present value that was substantially negative.” (Akerlof & Romer 1993: 17)

33 Fraud is a “Sure Thing” “Sure thing” Akerlof & Romer 1993 Finance: accounting = “weapon of choice” Fraud optimization recipe: 1.Grow massively 2.Make (or buy) really bad loans with higher yield 3.Extreme leverage, not “pvt. discipline” 4.Trivial loan loss reserves (ALLL)

34 Lenders knew the recipe “More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan officers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about 10,000 loan originators a year…. (FCIC 2010: 7)

35 Flipping burgers, and homes “His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs ‘flipping burgers,’ he told the FCIC. Given the right training, however, the best of them could ‘easily’ earn millions.” (FCIC 2010: 8)

36 Teaching the Fraud Recipe “He taught them the new playbook: ‘You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.’ He added, ‘I knew that the risk was being shunted off. I knew that we could be writing crap. But in the end it was like a game of musical chairs. Volume might go down but we were not going to be hurt.’” (FCIC 2010: 8)

37 Lenders Add the Rot “Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete.” Miller, T. J. (August 14, 2007). Iowa AG.

38 Only 50,000 rotten apples “Marc S. Savitt, a past president of the National Association of Mortgage Brokers, told the Commission that while most mortgage brokers looked out for borrowers’ best interests and steered them away from risky loans, about 50,000 of the newcomers to the field nationwide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were ‘absolutely’ corrupt.” (FCIC 2010: 14)

39 Lenders Add Rot to Hummler’s Wurst “[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.” [Iowa AG]

40 Appraiser Coercion = Fraud Deliberately created Gresham’s dynamic National study(early 2004): 75% coerced Cuomo 2007 investigation: nationwide 2007 study: 90% coerced Honest appraisers lose: 68 percent reported losing a client and 45 percent didn't get paid for their work when they resisted coercion Demos warned of disaster in 2005

41 Only fraudulent lenders inflate “From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets.”( FCIC: 18)

42 Ask the experts how it’s done Don't just say: "If you hit this revenue number, your bonus is going to be this." It sets up an incentive that's overwhelming. You wave enough money in front of people, and good people will do bad things. Franklin Raines: CEO, Fannie Mae Post-crisis pay: more short-term

43 “Agency cost” = Insanity “By now every one of you must have 6.46 [EPS] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.”

44 The anti-canary “Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.” (Mr. Rajappa, head of Fannie’s internal audit, emphasis in original.)

45 Perverse compensation: big bet? “Compensation systems—designed in an environment of cheap money, intense competition, and light regulation—too often rewarded the quick deal, the short-term gain— without proper consideration of long-term consequences. Often, those systems encouraged the big bet—where the payoff on the upside could be huge and the downside limited. This was the case up and down the line - from the corporate boardroom to the mortgage broker on the street.” FCIC: xix

46 Nyberg’s Irish Incoherence “Targets that were intended to be demanding through the pursuit of sound policies and prudent spread of risk were easily achieved through volume lending to the property sector.” (2011: 30)

47 Gresham’s: Managers “Bank management and boards in some of the other covered banks feared that, if they did not yield to the pressure to be as profitable as Anglo, in particular, they would face loss of long-standing customers, declining bank value, potential takeover and a loss of professional respect.” (Nyberg 2011: v)

48 Punishing Integrity “The few that admitted to feeling any degree of concern at the change of strategy often added that consistent opposition would probably have meant formal or informal sanctioning.” (Nyberg 2011: v)

49 Nyberg’s Incoherence “Over time, managers known for strict credit and risk management were replaced; there is no indication, however, that this was as a result of any policy to actively encourage risk-taking though it may have had that effect.” (Nyberg: v)

50 Ignoring a Nobel Laureate “[M]any economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4- 5).

51 Three sure things Firm will report record (albeit fictional) profit in near term Senior officers will, given modern executive compensation, promptly become wealthy The recipe will cause catastrophic losses to the firm, hence Akerlof & Romer’s title: Looting: the Economic Underworld of Bankruptcy for Profit.

52 Nuttiness of epic proportions Bo Cutter (Warburg Pincus 2009): “by 2006 and early 2007 everyone thought we were headed to a cliff….The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.”

53 Plus one likely thing Accounting control frauds cluster, seeking most criminogenic environments Fraud recipe is perfect for hyper-inflating bubbles – increase lending into a glut A bubble allows accounting control fraud to persist for many years for “a rolling loan gathers no loss” Hyper-inflated bubbles drive great crises

54 Market response to warnings? “Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007.” Iowa AG Note: this is the opposite of what private market discipline is supposed to ensure. The bubble popped in 2006.

55 Faux profits & supervision.1 “Senior supervisors told the FCIC it was difficult to express their concerns forcefully when financial institutions were generating record-level profits. The Fed’s Roger Cole: ‘a lot of that pushback was given credence — Citigroup was earning $4 to $5 billion a quarter. And that is really hard for a supervisor to successfully challenge.’” (Hint: Citigroup was losing $.) FCIC Report 2010: 307

56 Divine right of the SDIs “Supervisors also told the FCIC that they feared aggravating a bank’s already- existing problems. For the large banks, the issuance of a formal, public supervisory action taken under the federal banking statutes marked a severe regulatory assessment of the bank’s risk practices, and it was rarely employed for banks that were determined to be going concerns.” FCIC Report 2010: 307.

57 But if you’re dealing with fraud? “Richard Spillenkothen, the Fed’s head of supervision until early 2006, attributed supervisory reluctance to ‘a belief that the traditional, nonpublic … supervision was less confrontational and more likely to induce bank management to cooperate; a desire not to inject …contentiousness into what was felt to be a constructive or equable relationship with management; and a fear that financial markets would overreact to public actions, possibly causing a run.’” (FCIC Report 2010: 307)

58 The Rot in Hummler’s Wurst Hummler did not recognize the revolutionary nature of his assault on capitalism’s defining metaphor – the butcher we rely on due to his devotion to his self-interest becomes a sociopath Hummler’s butcher sells rotten meat and hides it in opaque sausage casings to deceive and sicken his customers

59 Hummler’s race to the bottom He has described an “agency” problem of the kind Adam Smith believed common at corporations and stated that it will pervert the butcher’s incentives and drive a Gresham’s dynamic among butchers in which rotten sausage becomes the norm as soon as the frauds discover a means of making their crimes opaque. Hummler’s amazing assault on capitalism.

60 Collapse of Ethics “We conclude there was a systemic breakdown in accountability and ethics. The integrity of our financial markets and the public’s trust in those markets are essential to the economic well-being of our nation.” [FCIC]

61 “Echo” Control Fraud Epidemics “[I]t was a slippery slope. What happened in '04 and '05 with respect to subordinated tranches is … our competition, Fitch and S&P, went nuts. Everything was investment grade. We lost 50% of our coverage [business share]….” [Moody’s 2007]

62 Anti-Regulatory Ideology “More than 30 years of deregulation and reliance on self-regulation … championed by …Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry … stripped away key safeguards, which could have helped avoid catastrophe.” [FCIC]

63 Hummler blames government Hummler tries to make the elite perps the victims and the poorer victims the perps Hummler’s story was never sound morally If the government forces you to destroy your bank by making/buying loans to poor blacks you don’t sell fraudulent loans by structuring them to be opaque CDOs. You get out of business or lobby to end the insane rules.

64 Hummler’s empiricism “It is said that the vast majority of insolvent home-owners belong to ethnic minorities.” No citations, no data, but lots of animus.

65 Hummler’s fictional rules Banks always had the political power to prevent rules requiring them to commit suicide by making or buying bad loans. The vast bulk of the fraudulent loans were made by firms not subject to the CRA – and the CRA does not require bad loans. No firm was ever required or encouraged by the U.S. to make or buy liar’s loans. The opposite was true as MARI warned.

66 Good regulation: no U.S. crisis The U.S. crisis was easily preventable “Liar’s loans” lacks subtlety – only anti- regulators blinded by dogma would allow We (S&L regional regulators) ended liar’s loans in in Orange County Ameriquest gives up its federal charter and deposit insurance for sole purpose of escaping our jurisdiction: rise of shadow

67 The U.S. S&L Debacle Widely described then as worst U.S. financial scandal: $150 B ($1993) Federal deregulation (The Garn St- Germain Act of 1982) was a response to state deregulation: model was Texas Prompted a competition in regulatory laxity “won” by Texas and California Intensely criminogenic Those states caused over 60% of losses

68 Competition in Laxity “Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).

69 S&L Fraud Epidemic “The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization” (NCFIRRE 1993)

70 Debacle caused no crisis The S&L debacle would have become a crisis absent reregulation & supervision Garn-St Germain passed in ’82 with only one dissenting vote in each charter Agency began reregulating in ’83 under a conservative Reagan appointee (Ed Gray) Roughly 300 S&L frauds growing at 50% annually when crackdown occurs Immense political push back: CLGs

71 Gresham’s Dynamic v. Morality “[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of "Gresham's Law" in which the bad professionals forced out the good.” (NCFIRRE 1993)

72 Economics Needs a Soul Mankiw (1993): “it would be irrational for savings and loans [CEOs] not to loot.” Moral Markets: “homo economicus is a sociopath” (a triumphal 2008 book)

73 Courage v. Dogma “there was a socio-political context in which it would have taken some courage to seem to prick the Irish property bubble.” “generic weaknesses in [EU] regulation and supervision” Report on the Irish Crisis FCIC dissent claimed deregulation and desupervision could not be a major cause of the U.S. crisis because the crisis also occurred in Europe – proves the opposite.

74 A competition in integrity Needed in finance and regulation: 1.Free ourselves from theoclassical dogma 2.Structure private sector to restore professionalism and self-correction, e.g., return to partnerships & liability 3.Culture of regulatory professionalism 4.Select leaders with spines & integrity 5.End “reinvention” pathologies 6.Refuse to race to the bottom

75 End of 2012 Burgenstock Keynote Presentation The slides that follow are supplemental materials relevant to the crisis.

76 A “Moral Sickness” Supreme Court Justice Lewis Powell’s biographer, John Calvin Jeffries, wrote: “Powell argued that “a root crisis of the crime crisis which grips our country is excessive tolerance by the public generally – a tolerance of substandard, marginal and even immoral and unlawful conduct.” It had reached the point of “moral sickness.”

77 One Minor Exception “The origin of the "white-collar crime" concept derives from a socialist, anti- business viewpoint….This meddling in the law perverts the justice system…. criminaliz[ing] productive social and economic conduct, not because of its wrongful nature but, ultimately, because of fidelity to a long-discredited class- based view of society.” Heritage, 2004.

78 CEO Impunity from the Law “White Collar Witch Hunt: Why do Republicans so easily accept Neobolshevism as a cost of doing business?” Stephen Moore. “[T]he anti-capitalist left … [is] using the criminal law for the endgame purpose of striking down the productive class in American that they so envy and despise….”

79 Conservatives’ Crime Meme Ethics essential Tolerating unethical conduct spurs crime Tolerating crime harms liberty & economy Calls for more police, more vigorous police, certainty of imprisonment, and long jail terms Rights of defendants are excessive and must be reduced

80 Powell: Soft on CEOs’ Crimes Ralph Nader is “the single most effective antagonist of American business.” “He says … that a great many corporate executives belong in prison -- for defrauding the consumer with shoddy merchandise, poisoning the food supply with chemical additives, and willfully manufacturing unsafe products that will maim or kill the buyer.” (Powell/Fortune)

81 “Reinventing Government” Texas Governor Bush & VP Gore initiative Public sector should run like private sector Bank regulators instructed to call, and treat, banks as their “clients” Guidance (barely) OK; regulation is bad Both moves disastrous Bank regulators = “cops on the beat”

82 Hummler’s Key Theses Problem is uniquely American: Problem: Americans borrow too much No deficiency judgments v. homeowners U.S. housing bubble unique Driven by subprime loans “favoring of particular sections of the populace” Investment Commentary No. 262, March 16, 2009

83 Dr. Hummler is an Optimist The crisis is far worse than he thinks It is not uniquely American It is homegrown European, e.g., Basel II It is not unique to the periphery He’s wrong as to causality His remedies don’t address the causes It is his philosophy that is the great threat; crisis is driven by the rich, not the poor

84 Hummler’s Wurst Metaphor Lenders (farmers) sold rotten meat to Investment bankers (butchers) who knew the meat was rotten. They minced it and hid the rot in opaque casings (CDOs) Making Wurst (CDO) buyers sick or dead Buyers swore off sausage, then meat (CDOs, then broader markets failed)

85 Hummler v. Adam Smith Smith said we could trust the butcher never to sell us rotten meat Paradox of self-interest producing simulated altruism for the customer Hummler reverses capitalism’s most sacred and core metaphor Butcher’s greed creates a psychopath Capitalism = criminogenic environment

86 Race explains Obama’s Policy “It is understandable that the Obama administration is inclined to take an accommodating approach to these home-owners, and that appropriate financial help is on its way.” “the obfuscatory approach adopted by Obama, with (again) the favoring of particular sections of the populace” “The righteous are ‘punished’.”

87 Why did banks make bad loans? “sub-prime mortgages in the USA. Encouraged – indeed, driven – by the politicians, who had championed home ownership with the “Community Reinvestment Act” (1977/1995), the banks offered loans to households that would never have been regarded as creditworthy by normal standards.”

88 All to benefit people of color “In terms of property theory, this constellation represented the provision of a subsidy in the form of free guarantees to a certain section of the populace….”

89 Facts are Inconvenient Problem not unique to U.S. Most EU bank losses homegrown Bubbles not unique to U.S.; far worse in Ireland, Spain & Iceland None of these bubbles driven by U.S. Commonalities: key to good analytics EU banks 2X U.S. bank leverage, Basel II

90 Poetry v. Analytics Failure to ask why U.S. banks made massive numbers of fraudulent loans Cheap money is no answer: coffee break metaphor fails Ask why EU and U.S. banks made loans that had to fail w/o perpetual bubble Does anyone in this room believe a bubble can be perpetual?

91 Focus on Incentives & Power The most powerful, elite institutions in the world caused these crises Working class Americans did not It is preposterous and unworthy of elites to blame the crises on the weak/race The class blindness is extraordinary Our top banks’ CEOs decided to make $trillions of bad loans – Ask why?

92 Facts re U.S. Minorities Median white family’s wealth is 20X blacks and 18X Latinos Greatest inequality since we began to study this gap The Great Recession caused the greatest loss of working class wealth in U.S. history – so why do we demonize them?

93 Not due to the CRA Act adopted in 1977 – 30 year delay? Act was weakened in 1999 CRA enforcement gutted under Bush The leading subprime lenders were not even subject to the CRA: roughly 70% None of the nonprime lenders subject to CRA were in trouble with the CRA levels Liar’s loans were the key

94 FBI’s 9/04 Warning Open House testimony & reported in national media Mortgage fraud is becoming “epidemic” and it will cause a financial “crisis” unless it is contained

95 “Liar’s loan” was a Hint “When the stated incomes were compared to the IRS figures: [90%] of the stated incomes were exaggerated by 5% or more. [A]lmost 60% were exaggerated by more than 50%. [T]he stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan’” (MARI 2006).

96 Gresham’s Dynamic “Strong regulations will create an even playing field in which ethical actors are no longer punished.” Iowa AG Consumers and honest lenders are the victims of accounting control fraud Regulation and prosecution are essential to aid making markets efficient

97 Lenders Ignored Fraud Warnings “Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007.” Iowa AG

98 “Disconcerting Results” The result of the [Fitch loan file] analysis was disconcerting…as there was the appearance of fraud or misrepresentation in almost every file. the files indicated that fraud was not only present, but, in most cases, could have been identified with adequate underwriting …prior to the loan funding. [Fitch 11.07]

99 Trivial Loss Reserves Reserves must track risk: GAAP Bank risk was skyrocketing A.M.Best (2/06; 3/07): “new record lows for the last four years.” Matches low in 1985: last disaster Reserve ratio (2005): 1.21% of loans Losses on foreclosed nonprime loans are running >50% for S&Ls Mortgage fraud = accounting fraud

100 Control Fraud v. Eurosystem Control fraud poses existential threats to: National economies EU financial regulation The euro The ECB The European enterprise These are relatively smaller control frauds

101 Leading Cause of Bank Losses Control frauds cause > financial losses than all other property crimes combined Fraudulent CEOs’ pose unique dangers: 1.Suborn all controls 2.Optimize entity for fraud 3.Use normal corporate means to loot 4.Shape external environment to aid fraud: “echo” epidemics/Gresham’s dynamic

102 Recipe for Catastrophe The same recipe maximizes (fake) record profits and (real) catastrophic loss “Criminogenic environments” lead to fraud epidemics & hyper-inflated bubbles Gresham’s dynamic & neutralization “Echo” epidemics: fraud epidemics are criminogenic – cause/permit epidemics Deceit erodes trust: markets can fail

103 Pandering to Power Ethics: “Speaking truth to power” “When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it (Frederic Bastiat).”

104 Control Fraud The persons who control a seemingly legitimate entity use it as a “weapon” In finance, accounting = weapon of choice Accounting control fraud: primary intended victims: creditors & shareholders Akerlof & Romer (1993) “Looting: the Economic Underworld of Bankruptcy for Profit”

105 Size Matters: GDP (2010) U.S. GDP $14.66 trillion (2010 est) Pop. 313,232,044 (July 2011 est.) Ireland GDP $172.3 billion (2010 est.) Pop. 4,670,976 (July 2011 est.) Iceland GDP $11.82 billion (2010 est.) Pop. 311,058 (July 2011 est.) Ireland is 15X Iceland; US is 85X Ireland

106 Iceland as Cato’s Eden Cato praised Ireland & Iceland as models “Iceland’s economic renaissance is an impressive story. [S]upply-side reforms, along with policies such as privatization and deregulation, have yielded predictable results. Incomes are rising, unemployment is almost nonexistent, and the government is collecting more revenue from a larger tax base.” (2007)

107 Ireland: Cato’s 2 nd Eden “It’s Not Luck” “[Ireland] boasts the fourth highest gross domestic product per capita in the world. In the mid-1980s, Ireland was a backwater with an average income level 30 percent below that of the European Union. Today, Irish incomes are 40 percent above the EU average.” Was this dramatic change the luck of the Irish? Not at all. It resulted from a series of hard-headed decisions that shifted Ireland from big government stagnation to free market growth.

108 Saved Ireland from Debt “After years of high inflation, double-digit unemployment rates, and soaring government debt that topped 100 percent of GDP, Irish policymakers began to cut spending in the late 1980s in a desperate bid to recover financial stability.” Cato 2007 Trichet 2004: Ireland is “model” for EU

109 Mother of all Bubbles “GDP growth averaged 6% in , GDP [fell] by over 3% in 2008, nearly 8% in 2009, and 1% in Ireland entered into a recession in 2008 for the first time in more than a decade….Property prices rose more rapidly in Ireland in the decade up to 2007 than in any other developed economy. Since their 2007 peak, average house prices have fallen 50%.”

110 Draconian Budget Insufficient “Faced with sharply reduced revenues and a burgeoning budget deficit, the Irish Government introduced the first in a series of draconian budgets in In addition to across-the-board cuts in spending, the 2009 budget included wage reductions for all public servants. These measures were not sufficient.”

111 Infra (Beyond) Draconian “The budget deficit reached nearly 32% of GDP in 2010 because of additional government support for the banking sector. The government also initiated a four-year austerity plan to cut an additional $20 billion from its budget. A return to modest growth is expected in 2011.”

112 The Definition of Clueless “We have taken bold, decisive and innovative steps to manage our way through this crisis. The Government over the past 18 months has made budgetary adjustments of more than €8 billion for Had we not done so, the deficit would have ballooned towards 20 per cent of GDP.” Fianna Fail

113 The IMF’s Productivity t-shirt* *(One Size Fits All)

114 CIA: Iceland & “Immigration” Settled by Norwegian and Celtic (Scottish and Irish) immigrants during the late 9th and 10th centuries A.D. Yes, and the U.S. was settled by African “immigrants.”

115 Ireland as Santa Claus In 2008 the COWEN government moved to guarantee all bank deposits [sic]…. In late 2010, the COWEN Government agreed to a $112 billion loan package from the EU and IMF to help Dublin further increase the capitalization of its banking sector and avoid defaulting on its sovereign debt.

116 IMF Praise = Proof of Failure “The measures we have taken have been commended by international bodies such as the European Central Bank, the European Commission, the IMF and the OECD and the approval of the international markets.” Fianna Fail

117 The Blind Leading the Blind In December 2008, Fianna Fail in Government launched a five year plan for economic renewal. That plan, by the people who brought you the banking and the budgetary crises – became Ireland’s consensus plan. The IMF loves the Irish plan – and the Irish government thinks that’s a good thing

118 Iceland & Ireland Sagas Hailed as theoclassical icons Existential threat – saved by Fuld Iceland’s Big 3 banks growing at 50% Anglo-Irish grows 35%; biggest RE bubble >10X Iceland’s GDP Massive bank fraud: asset losses = 60% Everyone has a Euro passport Ireland’s biggest export is the Irish

119 The Troika is Here to Help You Servaas Deroose (EC) urged Greece to “sell beaches to develop tourism and the tourism housing market.” IMF mission chief Poul Thomsen also said Greece should “sell land, including the (former) [Athens] airport….”

120 Does Ireland Belong to the Irish? “Greece“Greece must consider a fire sale of land, historic buildings and art works to cut its debts, two rightwing German politicians said today in a newspaper interview that is bound to exacerbate tensions between Athens and Berlin.” Guardian: 4 March 2010.in a newspaper interview

121 German MPs: Sell Greek Islands "Those in insolvency have to sell everything they have to pay their creditors," Schlarmann told Bild newspaper. "Greece owns buildings, companies and uninhabited islands, which could all be used for debt redemption."

122 But not the Acropolis (Yet) Greece's deputy foreign minister, Dimitris Droutsas, was asked about the idea in an interview with ARD TV. "I've also heard the suggestion we should sell the Acropolis," Droutsas said. "Suggestions like this are not appropriate at this time."

123 For what died the sons of Róisín? Will German, French or Dutch Inscribe the Epitaph of Emmet When we've sold enough of Ireland To be but strangers in it For what died the sons of Roisin? Was it greed? [The Dubliners’ Luke Kelly]

124 Kelly’s fear of the highest bidder To whom do we owe our allegiance today? Or her faceless men, who for Mark and Dollar Betray her to the highest bidder To whom do we owe our allegiance today?

125 Ireland should be so lucky Politically-driven privatization is perverse Incentive to sell cheap to cronies Mexico: Corrupt President Carlos Salinas privatizes telecommunications Telmex – monopoly – sold to Carlos Slim

126 Meet the world’s wealthiest man

127 Morgan Kelly is an Optimist He’s right that Ireland can’t repay Ireland is bankrupt – Morgan’s own logic Tell EU: “the bad banks are yours” Delaying the bankruptcy causes far greater pain to everyone Morgan’s budget plan deepens the recession and hurts everyone

128 Export & Tax Strategy Irish plans, even Morgan’s rely on Ireland having lowest taxes and wages That strategy is an enormous gamble – one the Irish cannot control Other nations can & will compete in a “race to the bottom” EU already taking aim at Irish tax rate Ireland on the “Road to Bangladesh”

129 Think Bolder Morgan’s proposal is to default Ireland’s weakness is its strength v. EU Troika cannot afford to bring Ireland down The real bailout is to German banks They’re getting a better deal than they contracted to receive Ireland needs to recover its sovereignty Needs sovereign currency to get out recession w/o becoming Bangladesh

130 Ireland Needs to Reclaim its Soul and Integrity This crisis was driven by elite bank frauds Investigations have instructed reports not to consider fraud Only by holding elites accountable can Ireland break the grip of crony capitalism and avoid recurrent, intensifying financial crises and the death of honest government

131 Nyberg’s Incoherence.2 In addition, there were some indications that prudential concerns voiced within the operational part of certain banks may have been discouraged. Early warning signs generated lower down in the organisation may in some cases not have reached management or the board. If so, the pressure for conformity in the banks has proven to be quite expensive. (Id.)

132 Nyberg’s Incoherence.3a “The mandate of the Commission did not include investigating possible criminal activities of institutions or their staff, for which there are other, more appropriate channels. Under the Act, evidence received by the Commission may not be used in any criminal or other legal proceedings.” (Nyberg 2011: 11)

133 Nyberg’s Incoherence.3a “The Commission has not investigated any issues already under investigation elsewhere. Instead, the Commission used its limited time and resources to investigate, as its Terms of Reference specified, why the Irish financial crisis occurred.” (Nyberg 2011: 11) So fraud cannot explain why it occurred?

134 Nyberg’s Incoherence.4a “Even with the benefit of hindsight, it is difficult to understand the precise reasons for a great number of the decisions made. However, it would appear that they generally were made more because of bad judgment than bad faith.” (Nyberg 2011: 11)

135 Nyberg’s Incoherence.4b “Indeed, a fair number of decision-makers appear to have followed personal investment policies that show their confidence in the policies followed by “their” institution at the time. Such faith usually produced large personal, financial and reputational losses.” (Nyberg 2011: 11)

136 Nyberg’s Incoherence.5a “The [compensation] models, as operated by the covered banks in Ireland, lacked effective modifiers for risk. Therefore rapid loan asset growth was extensively and significantly rewarded at executive and other senior levels in most banks, and to a lesser extent among staff where profit sharing and/or share ownership schemes existed.” (2011: 30)

137 Nyberg’s Incoherence.5c “Occasionally, management and boards clearly mandated changes to credit criteria. However, in most banks, changes just steadily evolved to enable earnings growth targets to be met by increased lending.” (Nyberg 2011: 34)

138 Nyberg’s Incoherence.5d “Rewards of CEOs reached levels, at least in some cases, that must have appeared remarkable to staff and public alike. It is notable, that proportionate to size, the CEOs of Anglo and INBS received by far the highest remuneration of all the covered bank leaders.” (2011: 30)

139 Nyberg’s Incoherence.5e Anglo €2,346 €2,721 €2,354 €3,015 €4,656 €2,129 INBS €910 €1,034 €1,269 €1,836 €2,313 €2,417 AIB €1,399 €1,445 €2,563 €2,436 €2,105 €1,152 BoI €1,594 €1,919 €2,525 €3,998 €2,972 €3,095 EBS € 589 €601 €655 €760 €678 €522 IL&P €946 €1,025 €1,138 €1,335 €1,362 €942 (2011: 31, Figure 2.13)

140 Nyberg’s Incoherence.5f “Financial incentives were unlikely to have been the major cause of the crisis. However, given their scale, such incentives must have contributed to the rapid expansion of bank lending.” (2011: 31) Why?

141 Nyberg’s Incoherence.5g “Nevertheless, it was claimed by a number of bankers that management and staff were not motivated by compensation alone. Most would compete, it was claimed, as they had during the previous period of lower compensation, on the basis of natural competitiveness and professional pride.” (2011: 31)

142 Nyberg’s Incoherence.6a “The core principles, values and requirements governing the provision of credit are contained in a bank’s credit policy document which must, as a regulatory requirement, be approved at least annually by a bank’s board. The policy defines the risk appetite acceptable to the bank and appropriate for the markets in which the bank operates….”

143 Nyberg’s Incoherence.6b “The purpose of such a credit policy is to set out clearly, particularly for lenders and risk officers, the bank’s approach to lending and the types and levels of exposures to counterparties that the board is willing to accept.” (2011: 31)

144 Nyberg’s Incoherence.6c “all of the covered banks regularly and materially deviated from their formal policies in order to facilitate rapid and significant property lending growth. In some banks, credit policies were revised to accommodate exceptions, to be followed by further exceptions to this new policy, thereby continuing the cycle.”

145 Rapid Growth = Bad Loans.1 “As all banks had effectively adopted high-growth strategies (IL&P less so), the aggregate increase in credit available could not be fully absorbed by good quality loan demand in Ireland. Banks had two options to remedy this; diversify their lending into other markets or relax lending standards.” (Nyberg 2011: 34)

146 Rapid Growth = Bad Loans.2 “substantial numbers of new loans were made in Ireland. By implication, credit standards fell. The lowering of standards manifested itself as both a reduction in minimum accepted credit criteria and (more subtly) as an increase in accepted customer and property leverage.” (Nyberg 2011: 34)

147 Endemic Violations “The resulting asset growth meant that internal lending limits (both sector and large exposure limits) were exceeded. Regulatory sector limits in some banks were also exceeded, both prior to and during the Period. Gradually, as such excesses became more frequent, they were viewed with less seriousness.” (Nyberg 2011: 34)

148 Hyper-inflating bubbles “The demand for Development Finance was so strong over the Period that bank and individual growth targets were easily met from this sector. Both of the bigger banks continued to lend into the more speculative parts of the property market well into 2008, even though demand for residential property (a major end-user) had begun to decline by the end of 2006.” (Nyberg 2011: 35-36)

149 Nyberg on ALLL “In the benign economic environment before 2007, the banks reduced their loan loss provisions, reported higher profits and gained additional lending capacity. The banks could no longer make more prudent through-the-cycle general provisions, or anticipate future losses in their loan books, particularly in relation to (secured) property lending in a rising property market.” (Nyberg 2011: 42)

150 Accounting Incoherence “The higher reported profits also enabled increased dividend and remuneration distributions during the Period. All of this led to reduced provisioning buffers….” “the incurred-loss model [IAS 39] also restricted the banks’ ability to report early provisions for likely future loan losses as the crisis developed from 2007 onwards.” (Nyberg 2011: 42-43)

151 Helpless Banks & Auditors “From 2005 the banks’ profits, capital and lending capacity were enhanced by lower loan loss provisioning while the benign economic conditions continued. As the global crisis developed from mid-2007, the banks were constrained by these incurred-loss rules from making more prudent loan-loss provisions earlier, and the auditors were restricted from insisting on such earlier provisioning.” (Nyberg: 55)

152 Pathetic Reserves v. Loss “The composite provisioning level for the covered banks at end 2000 was 1.2% of loans…. If this 1.2% provisioning level had been applied at the 2007 year end by the covered banks, aggregate provisions would have increased by approximately €3.5bn (i.e. from the €1.8bn actual to €5.3bn).” (Nyberg 2011: 43)

153 Perils of not reserving “As a consequence of not making this level of loan loss provisions, increased accounting profits effectively provided additional capital of up to €3.5bn to the covered banks. This, in turn, increased their capacity to lend by over €30bn.” (Nyberg 2011: 43)

154 Nyberg’s Fantasy World “In the competitive market, many property loans were made at margins of less than 1% per annum. A composite year end provisioning level at the 2000 level of 1.2% might have caused the banks to reconsider the amount of low margin property lending and might have led to more appropriate pricing for risk.” (Nyberg 2011: 43)

155 Reported Profit Ruled.1 “High profit growth was the primary strategic focus of the covered banks…. Since the potential for high growth (in assets) and resultant profitability in Ireland were to be found primarily in the property market, bank lending became increasingly concentrated there.” (Nyberg 2011: 49)

156 Reported Profit Ruled.2 “The associated risks appeared relevant to management and boards only to the extent that growth targets were not seriously compromised.” (Nyberg 2011: 49)

157 Hyper-inflated the Bubble Thus, banks accumulated large portfolios of increasingly risky loan assets in the property development sector. This was the riskiest but also (temporarily) the easiest and quickest route to achieve profit growth.” “Credit, in turn, drove property prices higher and the value of property offered as collateral by households, investors and developers also.” (Nyberg 2011: 50)

158 Just Believe One Impossibility “As long as there was confidence that prices would always increase and exit finance was available, an upward spiral of lending and property price increases was maintained.” (Nyberg 2011: 50)

159 Buy Me an Honest CEO Fischel: “The bigger the share of stock held by any particular investor the lower are agency problems… particularly … if the investor is an insider.” “One who buys a controlling block of shares cannot hurt the corporation without hurting himself too. Substantial investment acts as a bond for honest conduct.” Easterbrook & Fischel (1991)

160 Deregulatory Dogma Ireland Report 2010: “Four main failings of supervision: (i) Supervisory culture was insufficiently intrusive, and staff resources were seriously inadequate ….” “On-site inspections were infrequent. Supervisors … imposed no penalties on banks at all.”

161 Irish Desupervision “Ireland’s mounting financial vulnerabilities meant that strong action was called for to over-ride the prevalent light-touch and market-driven fashions of supervision: to call a spade a spade….” “failure to identify, recognise the gravity of, and take tough remedial action to correct such serious governance breaches was a cardinal error of supervision….”

162 Buy me an honest…. “In many popular accounts of the global financial crisis [pay] conjures up images of top management bonuses, or the practice of awarding stock options on a large scale. However, in Ireland at least, one should not neglect incentives set for middle-level bank management and indeed loan officers.” 2010 Ireland Rep. Ask why CEOs created those incentives

163 Gresham’s Erodes Ethics “[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of "Gresham's Law" in which the bad professionals forced out the good.” (NCFIRRE 1993) Control frauds are criminogenic; they can cause “echo” epidemics by creating these perverse incentives

164 Regulatory “cops on beat” Essential for ethical & efficient financial markets – break Gresham’s dynamic Can prevent & reduce crises: 1.S&L debacle “reregulation” nonprime S&L lenders 3.Even in current crisis their guidance was far better than industry on nonprime, CRE, & Basel II capital

165 Regulators & Prosecution Prosecution of elite frauds essential Must start with the regulators S&Ls: >10K criminal referrals, >1K convictions in “major” cases & “Top 100” Current crisis: referrals – OTS: 0, OCC: 0 Convictions of elites: Total: 7 – none from regulatory referrals. Truly elite: 0 Farkas farce: No Fannie referral in 2002

166 Bad Ethics = Bad Economy “Private market discipline” is an oxymoron Banks fund “accounting control frauds” Gresham’s dynamic: bad ethics drives good ethics out of the marketplace CEOs create the perverse incentives Regulatory “cops on the beat” & prosecutors essential to avoid Gresham’s perverse dynamics

167 “Echo” Fraud Epidemics Loan officers/brokers Borrowers: “open invitation to fraudsters” Appraisers: WaMu’s blacklist Auditors Rating agencies Fraud begets fraud. Accounting control fraud is criminogenic.

168 Crony Capitalism Defining characteristics: looting with impunity and subsidies for the cronies It is criminogenic: the “three de’s” – deregulation, desupervision & de facto decriminalization. Loot with impunity. Max moral hazard – fraud = “sure thing” Destroys democracy, ethics, and merit Causes recurrent, intensifying crises

169 Where we look, we find fraud “At the typical large [S&L] failure … fraud was invariably present.” NCFIRRE 1993 The Enron-era accounting control frauds The lenders/agents making “liar’s” loans Iceland: crony “capital” & capitalism Ireland: the “Golden Circle” Elsewhere, we don’t look, e.g., Spain

170 Criminogenic Environment We’re optimizing pro-fraud incentives Elite frauds not investigated/prosecuted Anti-regulators still in charge/promoted CEO pay more perverse CEO still able to create Gresham’s dynamics & “echo” fraud epidemics Assault on regulators’ budgets Gimmicked accounting rules to hide losses

171 The Great Recession there are more than 26 million Americans who are out of work, cannot find full-time work, or have given up looking for work. About four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process…. $11 trillion in household wealth has vanished…. [FCIC]

172 Dissent Focuses on Global The majority says the crisis was avoidable if only the [U.S.] had adopted … more restrictive regulations [and] more aggressive regulators…. This conclusion … ignores the global nature of the crisis. For example: A credit bubble appeared in both the United States and Europe.

173 Search for Common Factors These facts tell us that our explanation for the credit bubble should focus on factors common to both the United States and Europe, that the credit bubble is likely an essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an insufficient explanation of the crisis. [FCIC Dissent]

174 Bad Loans are Best “Accounting abuses also provided the ultimate perverse incentive: it paid to seek out bad loans because only those who had no intention of repaying would be willing to offer the high loan fees and interest required for the best looting. It was rational for operators to drive their institutions ever deeper into insolvency as they looted them.” (Pierce 1994)


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