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Posted in New Economic Perspectives - MMT

Three Passages From Akerlof & Romer’s 1993 Article That Should Have Prevented The Crisis

This is a syndicated repost courtesy of New Economic Perspectives. To view original, click here. Reposted with permission.

This is the first installment of a series of articles about the media, finance industry, political, and Department of Justice (DOJ) reaction to Michael Lewis’ new book about high frequency trading (HFT).  The media ballyhooed the book as if it were an amazing revelation of a fact of surpassing importance.  The industry demonized the book and Lewis.  DOJ immediately announced it had begun a criminal investigation and the SEC it had multiple investigations pending.  Whether the industry or Lewis is correct about HFT practices (which he asserts are lawful) is unimportant for some purposes.  My series will focus on the difference between the frenzied DOJ, political, and media reaction to Lewis’ criticism of allegedly lawful HFT practices and the “yawn” reaction of these same groups to the vastly more damaging criminal frauds runs by our elite financial leaders that caused the financial crisis is astronomical, ludicrous, and disastrous.  Similarly, the reaction of these three groups to the finding by multiple investigations that 16 of the largest banks in the world committed crimes by setting LIBOR rates through frauds and cartels (the largest cartel, by several orders of magnitude, in history) was less than a yawn, as I described in prior articles.

 

This installment, however, focuses on detecting loan origination fraud.  Two of the three fraud epidemics that drove the financial crisis were in originations.  The third fraud epidemic was prompted by the twin loan origination fraud epidemics.  I discuss three passages from George Akerlof and Paul Romer’s famous 1993 paper that, had they been read and understood would have prevented the current crisis or, alternatively, would have allowed the regulators, the FBI, and DOJ to identify and prosecute successfully the CEOs who grew wealthy by leading the fraud epidemics.  I begin by describing briefly the three accounting control fraud epidemics.

Appraisal Fraud by the Lenders

By 1998 – a decade before the world recognized the crisis – the honest real estate appraisers were already organizing an effort to warn the U.S. that there was an epidemic of appraisal fraud.  The appraisers warned that the lenders’ controlling officers were deliberately creating a “Gresham’s” dynamic (in which bad ethics drives good ethics from the markets and professions) by blacklisting appraisers who refused to inflate appraisals.  This is the perfect “signal” of accounting control fraud because no honest lender would ever inflate an appraisal.  By 2000, the rival appraiser groups had agreed on, and put on line, a joint petition that they delivered to the relevant federal regulators.  By 2003, a survey of appraisers found that 55% had been personally subjected to extortion to inflate appraisals in that year.  By 2006, a repeat survey, found that percentage rose to 90 percent.  The report of the Financial Crisis Inquiry Commission (FCIC) finds these key facts (the survey data are reported at FCIC 2011: 91).

“From 2000 to 2007, 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).

Liar’s Loans

Similarly, no honest lender would make “liar’s” loans.  The strangest aspect of the current crisis is that a loan that the lenders themselves called “liar’s loans” is treated conclusively as honest lending by the media and DOJ.  Just as we can infer reliably that no honest lender would inflate appraisals or permit them to be inflated we can infer reliably that no honest lender would inflate, or permit the inflation of the borrower’s income.  It is easy for a lender to prevent the inflation of the borrower’s income at trivial cost to the lender.  Lenders fail to verify the borrower’s income because the lenders’ controlling officer wants the borrowers’ income inflated.  Inflating the appraisal and the borrower’s income is certain to cause massive loan losses, but it is also guaranteed to optimize accounting control fraud.  Competent financial regulators have understood this for decades, as George Akerlof (made a Nobel Laureate in Economics in 2001) and Paul Romer explained in their famous 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”).

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: 4-5, 60).

Akerlof and Romer were writing in 1993, but their statement about the “regulators in the field who understood what was happening from the beginning” refers to 1983.  We (the federal S&L regulators) were already good enough by 1984, when our reregulation of the S&L industry reached high gear, to do four key things because we understood the italicized clause.

  • We understood the true nature of the crisis we were facing (an epidemic of accounting control fraud),
  • We understood how to identify and prioritize for closure those frauds even when they were reporting record earnings and minimal losses by looking for S&Ls that gutted their underwriting and internal and external controls,
  • We understood what aspects of the environment were most criminogenic and what rules we should adopt to target the frauds’ Achilles’ “heel” (by restricting growth), and
  • We understood how to prosecute successfully the CEOs that led the frauds.

Those four actions prevented the S&L debacle from becoming a national financial crisis that would cause a recession.

Akerlof and Romer (1993) expressly endorsed our analysis summarized above in the second bullet point, citing my work in footnote 5 of their paper.

“The typical economic analysis is based on moral hazard, excessive risk-taking, and the absence of risk sensitivity in the premiums charged for deposit insurance. This strategy has many colorful descriptions: ‘heads I win, tails I break even’; ‘gambling on resurrection’; and ‘fourth-quarter football’; to name just a few. Using an analogy with options pricing, economists developed a nice theoretical analysis of such excessive risk-takings strategies. The problem with this explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.5 Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem. They were right” (emphasis added, Akerlof & Romer 1993: 5).

5. Black (1993b) forcefully makes this point.

I quoted this lengthy passage because while it was written over 20 years ago it is so obviously and directly applicable to the current crisis that if you understand the passage you will understand the current crisis.  We have a more sophisticated understanding of accounting control fraud today than we did in 1993, but successful analysis of loan origination fraud arises from understanding three key concepts.  It all starts with understanding underwriting and why honest lenders try to do it superbly and why the officers controlling fraudulent lenders deliberately do it so pathetically.  The second concept that needs to be understood is the critical role of underwriting documentation.  The third concept that must be understood is why honest firms treasure effective internal and external controls and why and how fraudulent controlling officers suborn such controls, turning them into valuable fraud allies.

Economists should have little difficulty understanding these three concepts, but they have a primitive tribal taboo about fraud by business elites.  The first two sentences of the quoted passage could have been written today instead of 1993.  Neoclassical and theoclassical economists continue to ignore Akerlof and Romer (and competent regulators and white-collar criminologists).  But Akerlof and Romer made explicit why the “it’s not illegal to take a risk” apology was flat out wrong.  They did so in the italicized portion and in this passage.

“[M]any economists still [do] not understand that a combination of circumstances in the 1980s made it very easy to loot a [bank] 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).

The italicized portion of the quotation should be read with care for it is so obviously the definitive explanation of our current crisis as we read the passage today over decades after it was written.  Akerlof and Romer explained the loan underwriting practices that make it clear that the officers controlling the lender are committing accounting fraud.  Such lenders display:

total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.

How do you spell “liar’s” loans?  Akerlof and Romer are among the rare economists to think closely about why the officers controlling a fraudulent lender would embrace terrible loan documentation and making loans largely to borrowers who were far less likely to repay.

We also have decent data on the frequency of liar’s loans.  By 2006, half (some sources say 60%) of all the loans the industry called “subprime” were also liar’s loans.  By 2006, roughly 40% of all the home loans originated that year were liar’s loans.  At the 90% fraud incidence for liar’s loans found by the lending industry’s own anti-fraud experts (MARI), that means that the controlling officers were causing lenders to make over two million fraudulent loans annually by 2006.  Liar’s loans grew over 500% from 2003-2006 – hyper-inflating the residential real estate bubbles.  Liar’s loans grew rapidly after MARI’s 2006 warnings.

The Epidemic of Fraudulent Mortgage Sales

There is no fraud exorcist and a lender cannot sell a fraudulently originated loan by informing the buyer that the loan is fraudulent.  That means that there had to be an epidemic of fraudulent mortgage sales to the secondary market.  Selling millions of fraudulently originated loans requires millions of fraudulent “reps and warranties” by the lenders to the buyers.  FCIC found that there were an extraordinary proportion of fraudulent reps and warranties in secondary market sales – 46 percent (FCIC 2011: 166).  Because there is no fraud exorcist these frauds propagated throughout the secondary markets.  Like toxic heavy metals, the concentration of these fraudulent loans tended to increase as one went up the financial food chain producing CDOs that were so toxic that they took down the global economy.

The Response to the Three Fraud Epidemics that Drove the Crisis

In the U.S. alone, the financial crisis caused by these three fraud epidemics cost over 10 million Americans their jobs and is projected to cause over $20 trillion in lost production (a trillion is a thousand billion).  How many elite CEOs were prosecuted for leading the three most destructive financial fraud epidemics in history?  None.  But that understates how little DOJ has done.  No elite CEO who became exceptionally wealthy by leading these fraud epidemics has had the wealth they gained through the frauds clawed back.  No elite CEO has even lost his job for leading these frauds at the insistence of DOJ.  But that still fails to capture the true extent of DOJ’s “gone out of business” grant of de facto immunity to the officers that led these three fraud epidemics.  DOJ has not convicted, clawed back, or even forced the resignation of any non-elite CEO for leading these any of these three frauds.  One CEO, Lee Farkas, of a mortgage bank was convicted, but not for fraudulently originating and selling mortgages.  He was prosecuted solely because he tried to defraud TARP (which was created after the crisis).  Even in his case of obvious fraud, Neil Barofsky (SIGTARP) had to take exceptional efforts to get DOJ to prosecute Farkas’ effort to defraud TARP.  DOJ’s failure to enforce the criminal laws against elite bankers even when they grow wealthy through frauds that cause unprecedented harm is epic.

We have expertise about fraud.  Lewis has none.  He virtually never identifies even obvious frauds.  The frauds we document are vastly more damaging than the abuses Lewis identifies.  (And many of us have been warning about HFT for years.)  The media and the DOJ, however, fell all over themselves to trumpet Lewis’ (non-fraud) concerns while ignoring the work of Nobel Laureates in economics, the world’s top criminologists, and regulators with a track record of effectiveness that have extensively documented the three most destructive financial fraud epidemics in world history.  Lewis is a vibrant writer of great talent.  He has never claimed any anti-fraud expertise.

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