The officers controlling the S&Ls used the same means to extort appraisers to inflate the appraised value of the collateral. The report of the Financial Crisis Inquiry Commission (FCIC) appointed by Congress to study the causes of our most recent crisis shows that the lenders reprised the same fraud scheme.
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 2011: 18).
When cheaters gain a competitive advantage, market forces become perverse because of the Gresham's dynamic. As S&L regulators, we were familiar with Akerlof's "lemons" paper, but like virtually all students of economics our professors presented the article solely as a key development of the theory of "asymmetrical information." Our professors had never mentioned the word "fraud" though as one can read in the quotation above Akerlof made clear he was talking about "dishonest dealings." Once we reread the "lemons" article after discussions with the appraisers (the term in the U.S. for the professionals that value real estate) we understood what Akerlof was saying about fraud. Our incorporation of the Gresham's dynamic into the lessons we had drawn as to how fraud could become epidemic proved to be one of the most useful insights.
It took me 20 years after the S&L debacle to learn that a famous non-economist had described the Gresham's dynamic centuries before Akerlof's article. This acute observer was Irish.
The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man's goods from thieves, but honesty hath no fence against superior cunning. . . . [W]here fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage (Swift, J., Gulliver's Travels (1726)).
On February 3, 2015, the U.S. Department of Justice (DOJ) announced a settlement of well over $1 billion with the credit rating agency, S&P. DOJ's civil complaint alleged that S&P engaged in fraud by inflating credit ratings on toxic housing derivatives in order to keep the business of the issuers of those derivatives (who generated a successful Gresham's dynamic by setting the credit rating agencies in competition with each other for laxity.
The Implications of the Three Maladies
These looting strategy creates a serious risk of hyper-inflating a financial bubble. The recipe is easy to copy, and because it maximizes bonuses and raises it creates a Gresham's dynamic that pressures honest bankers to adopt their competitors' strategy of looting.
While a bubble is inflating, it is easy to hide bad loans and their losses by refinancing the bad loans. The saying in the trade is: "a rolling loans gathers no loss."
The lending practices that optimize the CEOs' "sure things" and the nature of the "sure things" mean that the worst failures-in-waiting will follow a characteristic pattern that competent regulators can identify early while the bankers are still reporting that the bank has record profits. They have to gut underwriting, which competent examiners will spot very quickly. They will make loans that are exceptionally risky, but they will report for many years low levels of default and loss upon default because they (or others bankers) will refinance the bad loans. A lender that makes highly risky loans (e.g., commercial real estate loans) and maximizes its risk of loss by gutting underwriting.
It is indefensible folly for regulators to rely on self-regulation, outside auditors, credit rating agencies, reported record bank income or reported capital, bankers' concern for reputation, "efficient markets," or "private market discipline." The recipe is mathematically guaranteed to produce high earnings. "Capital" is simply an accounting residual: Assets -- Liabilities = Capital. The fraud and abuse schemes I have described function by massively overstating asset values (indeed, as I explained, the banks' bad loans are actually net liabilities). On average, every new bad loan causes the bank's losses to grow. If the worst bankers inflate their asset values and/or understate their liabilities (both of which they do routinely) capital will be inflated enormously. Because they report extreme profits it is easy for them to borrow until the collapse is imminent. Governmental regulators are the only "controls" that fraudulent or abusive bank CEO cannot hire and fire. This is why they seek to create a regulatory race to the bottom -- another form of a Gresham's dynamic.
You asked me to comment on capital regulation. Banks need considerably increased capital and that will only happen if capital requirements are increased substantially after Basel II ruined capital requirements for the largest banks and their unreliable models. I do not believe any of the purported horrors of increased capital requirements for banks. I stress that increased capital requirements are a necessary, but not a sufficient change. The accounting fraud schemes I have described and that pose the gravest risks commonly lead to deeply insolvent banks reporting through financial statements blessed by a top tier audit firm that they are highly profitable and exceed all capital requirements. Capital is simply an accounting residual, not a pot of actual money. We cannot simply rely on increased capital requirements to prevent our recurrent, intensifying financial crises.
The very large, unrecognized, credit losses are also likely to cause a liquidity crisis at the bank when the bubble bursts. The losses under the recipe, particularly in the case of a hyper-inflated bubble, are likely to be so large that market-makers fail.
The bad lending practices means that the regulators must intervene -- vigorously -- and very quickly or the losses will surge (but not be recognized for accounting purposes) and the bubble. The regulators must go (as we did in 1984 in the S&L debacle) to an emergency operations basis. The longer the worst banks remain in business, the worse the harm they will create, and losses at the worst banks typically grow more than linearly, sometimes super-exponentially. The bank regulators must not rely on conventional econometric tests and modelling of regulatory decisions. The three "sure things" and the Gresham's dynamic mean that as long as the bubble (or appraisal fraud) is expanding the loan activities that best aid accounting fraud will display the strongest positive correlation with higher reported bank profits.
Modeling. We realized during the S&L debacle based on our understanding of these accounting fraud implications that that the economic models used to quantify various financial risks were unreliable because they systematically and severely understated risk in the presence of accounting control fraud. We also realized the key implications of greatly understating the risk of financial assets: the risk/pricing models must dramatically overvalue assets (and, therefore, the bank's capital) and the models create false complacency. The problem was more basic, and far larger than what is now famous as the "black swan" problem -- the failure to realize that the most extreme portions of the risk "distribution" (the "tail(s)" that would produce the greatest losses) were substantially "fatter" than assumed under a "normal" distribution. The real problem is that all such statistical techniques rely on their being a true, fixed risk "distribution." In statistical jargon, however, there is no true "exogenous" risk distribution. Our regulatory and governance policies (e.g., the virtual elimination of partnerships run by "general partners" with "joint and several liability" for all the partnership's debts -- a characteristic that often created highly prudent decisions), and bank managerial decisions that create a Gresham's dynamic can prove so "criminogenic" that fraud becomes epidemic, even the norm as it did in Libor, Forex, liar's loans, appraisals, and many other banking areas in the United States and the UK.
In such circumstances, the huge risk of catastrophic bank and customer losses due to frauds and abuses led by the banks' CEOs are no longer relegated to the highly infrequent "tails" of the distribution -- they fall within the central tendency. This is why we are suffering recurrent, intensifying financial crises.
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