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Key House Republicans Almost Get Accounting Control Fraud

By       Message William K. Black, J.D., Ph.D.       (Page 1 of 7 pages)     Permalink

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Reprinted from http://neweconomicperspectives.org/2014/02/key-house-republicans-almost-get-accounting-control-fraud.html#more-7659

To prepare myself for a guest lecture to a class at the University of Kansas I did some research about the House Financial Services Committee, now chaired by Jeb Hensarling (R. TX).  I was pleased to learn that the Committee's home page emphasizes the key role that accounting control fraud played at Fannie and Freddie.  The home page has a "spotlight" section designed to draw the reader's eye to a short series of documents designed to support passage of the Protecting American Taxpayers and Homeowners (PATH) Act, which focuses on eliminating Fannie and Freddie.  The documents largely stress that Fannie and Freddie were accounting control frauds.

Hensarling explains that TBTF bank CEOs have an incentive to commit control fraud

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Hensarling posted his August 13, 2013 keynote address at the George W. Bush Presidential Center.  His central argument is that "Washington promoted moral hazard by protecting Fannie Mae and Freddie Mac, which privatized profits and socialized losses."

That last clause is accurate.  Fannie and Freddie had no explicit government guarantees and they were entirely privately owned.  Their gains went partly to home purchasers, but largely to Fannie and Freddie's shareholders and senior officers.  The moral hazard arises from the fact that Fannie and Freddie's size made them systemically dangerous institutions (SDIs).  Moral hazard can lead to either control fraud or "gambling for resurrection."

Prior to the crisis, America's SDIs were all private.  They consisted of roughly the 20 largest banks, AIG, GMAC, GE, and Fannie and Freddie.  Each of these institutions had an implicit federal subsidy that economic theory claims generates serious moral hazard that can induce widespread accounting control fraud and/or extremely high risk gambles.  The definition of an SDI is that the administration fears that their unconstrained failure could cause a global systemic crisis.

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Every administration since the 1970s has treated the SDIs as "too big to fail" (TBTF).  That phrase is misleading.  It does not mean that the banks did not fail.  In a constrained failure the government ensures that the SDI's general creditors do not suffer losses lest their losses cause "cascade failures" that devastate the financial system.  The sole exception to this policy was the Bush administration's allowing Lehman to collapse in an unconstrained fashion.  That was a deliberate policy change in response to the vitriolic criticism that the Bush administration received from theoclassical economists for preventing the unconstrained failure of Bear Stearns.  Lehman's unconstrained financial collapse did not "cause" the financial crisis, but it triggered a staggering series of cascade failures and the collapse of hundreds of markets.

"Washington" did not make Fannie and Freddie into SDIs.  Their CEOs did that by causing them over several decades to grow enormously.  "Washington" did make them "privatized" -- which is what made their CEOs' incentives so perverse and created the "moral hazard."  Hensarling's account of how Fannie and Freddie grew so large is inaccurate.  He argues that they were:  "private companies awarded monopoly powers by Congress"."  Congress did not give Fannie and Freddie "monopoly powers" and during the run up to the crisis they lost large amounts of market share to competitors, particularly to competitors who purchased vast amounts of nonprime mortgage loans.

Hensarling's speech demonstrates that he almost knows his history.

"We should also never forget that at the dawn of America's history, it was another crony-run Government-Sponsored Enterprise that needed a bailout-- the East India Tea Company -- that sparked a revolution and gave birth to a nation teeming with individuals who decided to take control of their destinies."

Yes, corporations inherently have incentives to leverage their wealth into political power by trying to create crony capitalism.  Adam Smith was well aware of this history.  It prompted his warning against allowing corporations.  The U.K. banned the formation of corporations for many decades.  None of this "sparked" the U.S. "revolution."

Smith explained that their CEOs inherently posed an "agency" problem.  The CEO has the incentive, and the ability, to loot the corporation.  When the CEO was an unfaithful agent he could use the firm's seeming legitimacy and funds to suborn private and public-sector officials -- making them valuable fraud allies.  Hensarling hates the "government" so much that he reinvents that history.

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Hensarling's hypocrisy: SDIs other than Fannie and Freddie = Contributors

Hensarling is right to warn about SDIs.  He is right that they are the beneficiaries of an implicit governmental subsidy that make competitive markets impossible.  He is right that they seek to subvert democratic government into crony capitalism.  We can add to his criticisms -- they are also deeply inefficient.  They are vastly too large to achieve efficiencies of scale.  SDIs pose a global systemic risk when they fail.

We should be fortunate to have Hensarling as the Chairman of the key House committee that can act promptly to pass legislation eliminating the SDIs.  Under Hensarling's logic we should adopt a three-part plan.  The SDIs should be forbidden to grow.  They should be ordered to shrink within five years to a size at which they no longer pose a systemic risk (under $50 billion in total assets).  They should be intensively and extensively examined and supervised by federal banking regulators during the five-year period.

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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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