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The Wall Street Journal Pines for the Return of Liar's Loans

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The WSJ also believes that "the [American] government" is the enemy.  This explains the title of their article:  "The Government Won on Financial Reform."  A normal reader might interpret that title as meaning that the United States won on financial reform and view that as a very good thing.  The WSJ knows that "the government" is not a legitimate representative of the American people.  Many progressives share that belief because of the dominance of the SDIs over American politics.  The WSJ, however, views crony capitalism in which "the government" does the SDI's bidding as desirable and is outraged whenever America (episodically) responds to the SDIs' endemic frauds and the resultant financial crises by adopting rules restricting (even modestly) the SDIs' powers.  Under the WSJ's worldview the SDIs rule by divine right and should be immune from any detailed regulatory limitations.

Like Summers, the WSJ's simplistic answer rests on a myth that I have worked to discredit.

"A sensible reform would have been to require more capital as a bumper against losses, and to use a basic definition of capital that can't be gamed."

First, Dodd-Frank did increase capital requirements.  Second, capital requirements were reduced dramatically because of lobbying by the SDIs and the theoclassical economic dogmas worshipped by the Fed's economists.  Third, there is no "basic definition of capital that can't be gamed."  Capital is merely an accounting residual:  A -- L = K (assets minus liabilities = capital).  As long as accounting control fraud exists the bank's officers can game "capital" by overstating assets and understating liabilities.  The accounting control fraud recipe's four ingredients explain how to massively overstate assets, understate liabilities, and overstate capital (and income).

There is one way to make a bank capital requirement dramatically harder to game -- and it requires severe regulatory restrictions on assets and liabilities that would be anathema to the WSJ and Summers' anti-regulatory proposals.  The one way to make it much harder to game a bank's capital requirement is to adopt "narrow banks."  Narrow banks would be allowed to invest in only short-term U.S. government securities that (1) have minimal credit risk (it is easy to game the asset valuation of loans with substantial risk by providing a grossly inadequate ALLL -- the fourth ingredient of the fraud recipe), (2) are routinely traded in "deep" markets that make it harder to inflate "market" values, and (3) are very short term (which tends to reduce interest rate risk).  Narrow banks need rules preventing them from taking currency risks and requiring that they maintain adequate liquidity (the three credit requirements I discussed substantially reduce liquidity crises).  Narrow banks also need requirements to minimize interest rate risk (again, this is greatly eased by the requirement that the assets have very short maturities).  A narrow bank as I have described it is essentially a (well-run) money market mutual fund with deposit insurance.  As Lehman's failure demonstrated, money market mutual funds were allowed to take excessive credit risk by purchasing short-term corporate debt (commercial paper).  When Lehman's commercial paper lost most of its value as a result of its bankruptcy major money market mutual funds that invested in commercial paper experienced losses that "broke the buck" and triggered a multi-billion dollar run on most money market mutual funds that was only stemmed by the emergency provision of federal guarantees and aid.

The key analytical point, which Summers and the WSJ missed, is that the only banking capital requirement that is highly resistant to gaming requires draconian restrictions on bank investment powers.  Narrow banks would not make loans to individuals or firms.  Summers and the WSJ assumed that the opposite was true -- that one can declare a higher capital requirement and make it real while allowing exceptionally broad bank investment powers.  Summers and the WSJ did not even understand that restoring critical loan underwriting requirements, fully adequate loss reserves (ALLL), and prompt, complete loss recognition enforced vigorously by competent regulators who make their priority the prevention, detection, countering, and sanctioning of control frauds and the elite officers who lead the frauds would be absolutely essential even if Glass-Steagall were restored and the Commodities Futures Modernization Act of 2000 were repealed.  The lower the underwriting requirements and the greater the number and variety of assets a bank can invest in the more critical vigorous regulators who understand accounting control fraud and are vigilant in countering it are if we are to prevent future epidemics of control fraud and the resultant financial crises.

Note that increasing the capital requirement does not remove the gaming problem and can intensify it.  Accounting control frauds have routinely demonstrated their ability to get clean audit opinions for financial statements that make deeply insolvent and unprofitable banks appear to have record profits and excess capital.  S&Ls and the Icleandic banks used fraud schemes that directly inflated reported capital.  Neither Summers nor the WSJ would support the U.S. adopting far higher capital requirements than the EU because both have taken the position that the U.S. must not have tougher regulations than the City of London lest our SDIs relocate to the UK.  It is also not credible that a regulator would actually close a bank that failed to meet a 20 percent capital requirement.  The WSJ and Summers have long been virulent opponents of restricting the compensation of senior officers even of failed entities bailed out by the Treasury and the Fed -- they cannot credibly claim that they support slashing the compensation of senior bank officers and "clawing back" prior bonuses as soon as the bank fails to meet, e.g., a 20% capital requirement.  I would be delighted to be proven wrong by them proposing specific capital requirements and specific, mandatory compensation sanctions of the kind I have outlined that automatically come into effect for any bank that fails its capital requirement.  Note, however, that this will increase the CEO's incentive to game the capital requirement.

Even if we created a capital requirement of 100 percent, which one reader recently suggested would end gaming; it would do no such thing.  Indeed, it would encourage gaming because even tiny loan losses could cause the bank to be placed into receivership.  Fraudulent controlling officers could still use the fraud recipe to create fictional income and capital and escape receivership.  Note that a 100% capital requirement for a bank would mean, effectively, that it could not have depositors.  A bank subject to a 100% capital requirement would not be allowed to borrow unless it obtained a new equity infusion at least equal to any deposit it accepted.  That is not workable.  Depositors are bank creditors -- we loan money to the bank.  If banks cannot have depositors then why bother to have banks?  The WSJ, of course, does not want to impose far higher capital requirements on banks.

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Competent financial regulators understand that their paramount task is to prevent epidemics of accounting control fraud and ferret out individual frauds.  Such regulators understand that the single most effective means of making it harder to inflate asset values is to have loan underwriting rules that ban loans that optimize the fraud recipe.  The WSJ is so blind to the lessons of the three modern crises driven by epidemics of accounting control fraud that it demands an end to the most important rule (banning liar's loans) that makes it harder to "game" reported income and capital.

The WSJ is disingenuous about regulators.

"The Dodd-Frank Act's great reform conceit is that the same regulators who missed the last crisis, and who tolerated Citigroup's off-balance-sheet vehicles hiding in plain sight, will somehow prevent the next crisis. It won't happen. Regulators somehow missed J.P. Morgan's "London whale" trades even after they were reported in this newspaper."

The WSJ is correct that it would be absurd to trust "the same regulators who missed the last crisis [to] prevent the next crisis."  But it was the WSJ that applauded the Reagan, Clinton (via ReGo) and Bush II administrations' anti-regulators who inflicted the three "de's" on America (deregulation, desupervision, and de facto decriminalization) that produced the criminogenic environments that drove our three modern crises.  We must, indeed, appoint leaders of financial regulatory agencies because they have a track record of success against epidemics of accounting control fraud.  Instead, we appointed anti-regulators as leaders because they had a track record of failing to spot and prevent such frauds -- and a track record of opposing efforts by others to stop such frauds.  To conclude that regulation cannot succeed because a series of anti-regulators failed to regulate is the ultimate in self-fulfilling prophecies.  Greenspan and many Fed leaders were so vehemently opposed to regulation that they eagerly created the regulatory black hole for derivatives, repealed Glass-Steagall (and turned it into Swiss cheese before the repeal by regulation, interpretation, and refusals to enforce it), sought to eviscerate bank capital requirements through Basel II (the FDIC's heroic rear guard stand against the Fed's economists reduced the catastrophe), attacked the Fed's supervisors when they dared to criticize the SDIs for aiding and abetting Enron's frauds, refused to use HOEPA to stop the mortgage fraud epidemic that drove the crisis, and attacked the Fed's supervisors -- personally -- for daring to provide industry data to the Fed's leadership because it demonstrated the epidemic of fraudulent liar's loans.  It takes chutzpah for the WSJ to claim that leaders who refused to regulate because they shared the WSJ's anti-regulatory dogmas prove that regulation cannot succeed.

I know of several hundred financial regulators with superb track records against the epidemics of accounting control fraud.  I eagerly await the WSJ editorial urging the Obama administration to appoint these financial regulators to leadership roles, but I am not holding my breath.  It is not a rosy hypothetical that these successful regulators would have prevented the mortgage fraud crisis had they been appointed to run the Fed.  They prevented a "second front" liar's loan crisis in 1990-1991 even though they were fighting successfully to contain the S&L debacle and they did so with vastly less information and resources than the Fed had available in 2000-2006.  (The lenders didn't call them "liar's loans" in 1990-1991.  A product that the industry calls a "liar's loans" is a flashing neon signal of accounting control fraud.  As the language I quoted from Akerlof & Romer's 1993 article demonstrates, we understood the concept of "adverse selection" and used it to identify fraudulent practices and S&Ls that were control frauds.  We first used these analytics in 1984.  By 2004, when liar's loans were becoming the dominant means of hyper-inflating the bubble, we had known for two decades why honest lenders would not make liar's loans and why dishonest controlling officers would make liar's loans.

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The epidemic of mortgage fraud that drove the crisis caused over $11 trillion in wealth losses to U.S. households and over 10 million American jobs.  If Mike Patriarca had run the Fed the developing epidemic of liar's loans would have been stopped in its tracks in 2000 or 2001 because we would have used HOEPA to ban liar's loans.  It's not too late to hire him to prevent the next crisis.

The WSJ is partly right, but again disingenuous about the SDIs.  It is true that Dodd-Frank failed to demand that the SDIs shrink to the point that they no longer pose a systemic risk, but the WSJ has refused to support that essential policy.  It is true that the "living wills" are expensive farces.  The WSJ is also correct that the Fed will bail out the SDIs rather than allow another global meltdown.  The WSJ seems to understand that the Fed and the Treasury can make no credible promise not to bail out an SDI given that the Fed and the Treasury believe that the alternative is a global financial disaster.

Unfortunately, the WSJ's answer to the problem that the SDIs pose a global systemic risk and will be bailed out by the Fed (even when Ayn Rand's executor was running the Fed) is to assume the problem out of existence through the fantasy that there is such a thing as a capital requirement that "can't be gamed."  This fantasy demonstrates that the WSJ is clueless about accounting control fraud, capital, and financial regulation.  As I have repeatedly emphasized, Basel II's capital rules are obscenely low and urgently need to be increased substantially and should never be tied to credit ratings.  But it is a dangerous illusion to believe that increased capital requirements will make SDIs (or any non-narrow bank) reliably safe.  Capital requirements are inherently susceptible to being gamed by accounting control fraud.  That is precisely why our paramount task as financial regulators is to create environments in which the perverse incentives to engage in control fraud are minimized and then to make the detection and elimination of control frauds our top priority.  This is also why the most effective work in limiting "systemic risk" is always done by bank examiners.  The least effective, indeed, typically counterproductive work on systemic risk is done by economists.

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http://neweconomicperspectives.org/
William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)
 

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