William Black on Financial Fraud
Feb 6 2012

William Black of University of Missouri-Kansas City and author of The Best Way to Rob a Bank Is to Own One, talks with EconTalk host Russ Roberts about financial fraud, starting with the Savings and Loan debacle up through the current financial crisis. Black explains how bank executives can use fraudulent loans to inflate the size of their bank in order to justify large compensation packages. He argues that "liar loans" were a major part of the crisis and that policy changes made it easy to generate such loans without criminal repercussions.

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Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Jaime Levine
Feb 6 2012 at 11:08am

I have waited a long time for this interview. Thank you.

Eric Falkenstein
Feb 6 2012 at 12:34pm

I think he trivializes the disincentives. I mean, any transaction could be easy money to someone who commits fraud, assuming he can get away with it. I think he should be more specific about the specific features that make such problems more common for bank owners.

Further, his examples seem to focus on activities from the 1980’s, not so relevant to the mortgage crisis when regulators and investors were not being actively mislead about ‘innovative’ underwriting changes. Everyone thinks it was crazy today, but almost everyone thought these bad underwriting issues were innocuous up to 2007.

Andy Kneeter
Feb 6 2012 at 12:37pm

William Black’s interview was excellent!

The ‘MARKET’ failed, because critical investors weren’t allowed to fail.

There were also too many layers of fiduciaries following regulations. As long as they follow those rules (& they pretty much did), they’ve got an excuse when investments melt down (“It had an S&P investment grade rating, so it’s not my fault it failed”).

Depositors are lenders, but they don’t care about loan quality, because they’re 100% protected by FDIC insurance (it’s greatly underfunded, so taxpayers are on the hook).

Professional investment managers charge big fees, regardless of long term performance. They don’t give them back when investments go bad. When the institutions & investors that give them money to manage lose money on bad investments, so they’ll change the terms of their deals fast.

Our financial system is riddled with misaligned incentives (most of which was the result of government insurance & regulation). Mistakes will always be made in free markets, but allowing repercussions to happen always re-aligns institutions the quickest (particularly for those providing the capital; including the compensation of professional investors & the incentives of the depositors).

Feb 6 2012 at 2:33pm

I think that large short run negatives are to be expected from deregulation, but the long term benefits will be positive. IMO is not useful to regulate the financial industry now, after the crisis, and that showing an unwillingness to let things go unregulated undermines the markets mechanisms that would fill the roles of the regulations.

Chris Cresci
Feb 6 2012 at 5:15pm

Regulators are always good at diagnosing fraud after the fact. Maybe if regulators could be sued for losses to the public within their purview they would be more circumspect with regard to the limits of regulation in general.

Maribel Tipton
Feb 6 2012 at 5:36pm

Loved the interview, very informative and interesting. I have to say that eventhough I am a libertarian (of the Hayekian flavor) I have to wonder whether libertarian economists should get more involved in trying to develop regulations, given the present reality of mixed economy. I understand that from the point of view of a Hayekian claiming to know what regulation would create the right incentives and at the same time that it can be implemented practically given all the political incentives would seem to be sinning of pretence of knowledge. But if you see the “economic ecosystem” composed of “everything”, free people interacting with each other via rules, be it backed by force or just tradition, then regulations are part of the TRIAL AND ERROR PROCESS OF DISCOVERY. So I am saying maybe Hayekians should approach regulations not from the stand that I know exactly what’s going on and how to fix it but more from an empiricists stance, in which you take your best guess and then see how it turns out, trial and error. I don’t know of any other form realistically speaking that the rules that govern our behavior will evolve, but through that interaction, and I would rather see people that love liberty and ultimately prefer localized decision making and understand the knowledge problem trying to come up with basic rules that can addrerss the obvious incentive problems within our framework. It seems like problems like the financial crisis are like the chicken and the egg in terms of what caused what? Why did people behave in this way or that? Is like trying to follow a straigth chain of events that doesn’t exist, the causal relationship is much more complex, more dynamic, more chaotic. So moral hazard alone doens’t explain the behavior since it could make sense for a bank executive to behave in this way even if the FDIC wasn’t around. It seems like in instances were great immediate rewards are possible there is a VERY STRONG INCENTIVE for only concerning ones self with short term performance. A perfect example of that is irresponsible behavior by politicians in the case of the national debt and spending, and entitlement reform, they know it’s unsustainable in the long-term but they want to be in power.

Jeff Boyd
Feb 6 2012 at 10:10pm

Enjoyed the podcast a great deal and thought it a very useful discussion. Having said that I thought Mr. Black tossed around the term “fraud” a little bit too much. The “Cash for Trash” was a clear example of fraud but if I know that a bank is making Liar’s loans and I choose to buy a security backed by that Liar loan I am not a victim of fraud. If I am a Fed bank examiner the bank does not try to hide the nature of the loans, I know exactly what is going on and acquiesce or even encourage the extension of such credits how could it be a fraud?

Really stupid but not fraud. Very depressing but that is the way I see things.

Allan Stokes
Feb 7 2012 at 2:36am

Regulation doesn’t come free, no matter how you do it.

I grew up in the 1970s where the slogan “cancer will be beaten” was repeated endlessly on Canadian TV. But cancer is actually many thousands of little things that go wrong within a vast system of checks and regulatory safe-guards; these little things slowly cascade and reach critical mass. There is no single target. The slogan was hopelessly naive back in the 1970s. After sequencing the human genome and making huge efforts to construct proteomic expression maps, we are still looking at a fifty year campaign.

I don’t believe in disbanding government on an ideological basis. I am up for prying government out of the regulatory business one regulation at a time, having first demonstrated that whatever private-sector mechanism takes over actually works. This I never assume. It has to work, and it has to be embodied with institutional persistence.

As someone who cares to see regulatory effectiveness constructively demonstrated, there’s nothing I like more than a podcast such as this one which lays out what you’re really up against.

Terry Thompson
Feb 7 2012 at 3:48am

Another great guest. I am amazed at the quality of your guests and the diversity of opinion.

What I do not get, is how you can have a guest come on and show you systematically how deregulation was a major cause of this crisis and all you can do is repeat your moral hazard line. It seems to me that you put these people on to try to understand different perspectives. But, for example in this interview, after he makes a compelling argument that lack of oversight and rules were a major cause, you respond by sighting moral hazard like you were having a completely different conversation. At least try to understand his point.

As someone trying to understand your side of this debate, I am not persuaded by you simply asserting your views and not discussing how they relate to the arguments your guest is making. (I listen to your show to try to understand different views) I wish you would engage more on the topic at hand so I could understand how you believe deregulation was not a major cause of the crisis.

He states that the theory of private market discipline has been shown to be false in S&L and Enron cases and that those cases were not moral hazard and you return with well what about Mexico. It does not matter whether some cases could have a moral hazard component. Showing that there is no PMD in the S&L and Enron shows that a theory of Private Market Discipline has flaws. Either change your view or discuss those cases.

Feb 7 2012 at 8:18am

Very interesting interview. I’ve been suspicious that there had to be more corruption in the banking system than is generally acknowledged to lead us into this situation. This interview did a great job of explaining exactly how this form of corruption worked and why it has gotten so bad.

One issue which came up several times in this episode and in some of your past ones as well. Standard economic thinking is that investors and lenders will naturally demand due diligence because they have an incentive to make sure they get a good return on their investment. This leads to the conclusion that we don’t need to regulate many markets and industries, because they will naturally self-regulate. However, it seems time and again we’re finding situations where investors are failing to hold management accountable. Often, in fact, they are turning a blind eye while management engages in all sorts of undesirable practices.

I have some speculative thoughts on the matter, but not more than that. In a world where lenders (and/or capital) is relatively scarce, the lenders hold a lot of power. They are therefore able to require a lot from their borrowers. In our world where wealth has become so much more abundant, the real scarcity is decent places to invest it. In such a situation the investors are willing to give up more oversight for the “privilege” of receiving decent returns.

Another possibility is that, when it comes to the relatively small world of investment bankers and top company management, their interests are more aligned with each other than with the rest of society. Since investment managers often oversee the largest portion of a company’s stock, they hold the most influence over the company’s management. However, since they are personally / socially more aligned with those executives than with their own shareholders, they are more willing to turn a blind eye to practices their shareholders might fight objectionable.

Finally, a cultural observation. We have created the perception of senior management as the new aristocracy. The general impression is that there is something rare and unique about these individuals which makes them deserving of vastly inflated salaries and privileges. Normal individuals are made to feel like they are so beneath them in every way that they shouldn’t deign to judge or criticize their “betters”. Investors have the impression that they are buying special access to the elite world by investing in companies, rather than having true ownership. Essentially its just a mind game, creating the impression that the managers own the company and shareholders should just accept that and not make a fuss.

None of the above is mutually exclusive, and they may all interact with each other. You’ve talked a lot about regulatory capture on your podcast, but I wonder whether you would be able to comment on this phenomenon of “investor capture”. It seems clear to me that something is seriously broken with the free market when investors are not requiring due diligence. Perhaps there are some scholars out there you could interview who’ve studied exactly this phenomenon.

Jennifer Yoon
Feb 7 2012 at 8:45am

Wow, very eye opening. The best talk on the causes of the 2008 crash so far. I have worked on many over $100 million securities litigations before, but only some of them had obvious fraud. Some cases did not seem have any fraud, only poor personal behavior or failure to do their job. It seems the level of fraud had escalated to an unprecedented level by 2007.

It kind of fits. I did not buy the argument that credit rating agencies and financial economists were surprised by the overall housing price decline of 30% (even more now). There used to be a test to achieve a AAA rating; that is, a mortgage pool had to survive the 1930’s experience (defined as a national housing price decline of 30%) and not lose more than 6% of its value. The credit rating agencies actively removed this part of their model around 2000-1. Financial economists had to have also actively remove this test from their housing risk models. I guess the models don’t work when there is extreme fraud. The pricing mis-allocation makes the models look wrong. So the good, honest economists and housing analysts probably lost their jobs in droves while the CEOs were raking it in. FNMA CEO Raines is a very ugly example. Sad.

Mark W
Feb 7 2012 at 11:25am

“A rolling loan gathers no loss…” Great line.

Russ Roberts
Feb 7 2012 at 3:46pm

Maribel Tipton and Terry Thompson,

I’d encourage you to read the Looting paper by Akerlof and Romer listed in the readings above.

Fraud happens in any system, regulated or unregulated. Fraud should be and usually is illegal. The question is how to keep it to a minimum along with the repercussions of fraud.

Without government backing (implicit and explicit) of creditors/depositors/bondholders it is hard to get people to lend you money and buy your bonds if you have little or no money of your own at risk. With government backing, that gets very easy.

I brought up Mexico because Black claimed that investment banks that were creditors hadn’t been bailed out in the past. Not true. The Mexican rescue was a rescue of investment banks and other creditors of the Mexican government.

I think I’ve said on the program that deregulation with bailouts is a horrible idea. So I don’t think deregulation is irrelevant. My claim is that without moral hazard from bailouts, it gets a lot harder to use leverage and the financiers of bad bets via leverage get wiped out rather than receiving 100 cents on the dollar.

Terry Thompson
Feb 7 2012 at 5:23pm

Thank you for your reply.

I understand that you, me and the guest believe that in the case of bailouts, regulation is needed. and even that bailouts are bad. That agreement, however, was not the interesting part of the conversation.

My understanding of Black was that he was arguing that in addition to bailouts there are other reasons for gaming the system rather than looking for success. I.E. the people making the decisions have no belief of getting sent to jail and no long term stake in the game. Thus there is no risk.

The standard view is that the investors with long term interest should impose the discipline. His argument was they just don’t do that, but not because of bailouts, but rather it seems because the people in the investment firms making the decisions got short term bonuses with no risk and when you finally get to the shareholders or pension funds, things are too obfuscated for them to see the fraud several layers down the chain.

This is where the discussion could have been interesting. One side says that it is always because of bailouts or other adverse government intervention and here is a guy saying no, there are other reasons why fraud happens. And thus there is more reason for regulation and oversight.

Patrick R. Sullivan
Feb 7 2012 at 6:58pm

I have to dissent. I’ve been impressed by the quality of the recent podcasts–the one with Simon Johnson being my favorite–but this one was horribly confused.

I’ve seen Saturday afternoon infomercials on TV that were more rigorously logical than Black. Whenever someone has to constantly backtrack, jumps from one time period to another, throws around jargon…that’s a good sign of someone who doesn’t really understand the issue. This guy is no scholar.

Ak Mike
Feb 7 2012 at 10:45pm

Prof. Black went at it backwards. The genesis of bank fraud is the search for high profit loans where the deposits are guaranteed. Because they are high interest (low quality) a percentage go bad. In order the keep the bank alive the bankers start doing those fraudulent loans, leading to a death spiral. The bankers do not start out with fraudulent loans, because those loans will certainly lead to destruction of the bank, which is not really in the bankers’ interest.

The real problem is no risk deposits, which lead depositors not to care where they put their money, except for the interest rate. Speaking as one who has examined many loan files of failed banks, I’m certain that regulators cannot catch many of the fraudulent or ill-advised loans while the banks are still alive. Thus more regulation will not help.

Hudson Cashdan
Feb 7 2012 at 11:02pm

-It is not always clear what commentators- Black in this case- mean by “regulation.” Prosecuting fraud and generally enforcing the rule of law in civil and criminal courts is at the very heart of libertarian values. If that is what Black means by regulation then I am all for it and I suspect so are you. However if he means commissions composed of enlightened bureaucrats who always stay one step ahead of the latest financial “innovation” then I think he is naïve as they will tend towards shutting the barn door after the horse has left the stable. The only way to prevent the damaging financial innovations is to use the blunt force of the bureaucracy to block all financial innovations, the useful and the damaging alike. But even in China, where there is the top-down power will always dwarf that in the U.S., they still cannot reign in their own shadow banking system (Trust Cooperatives), the volume of which exploded when the central government imposed the blunt force of maximum loan quotas on their banks.

-Russ, being sympathetic to the Austrian school I’d think you would pay more attention to micro-level incentives. For instance, executives within a bank often got compensated on volume originated while managers were compensated based on GAAP earnings. Both performance metrics on which their compensation depended were substantially shorter than the duration of the assets they referenced. Thus, many of these people were several jobs removed by the time the chickens came home to roost. I think Bill Black is correct on this point and makes it more forcefully than most commentators.

-But why do the incentive structures at these institutions work for the benefit of management rather than shareholders and creditors? Perhaps shareholder rights law must be strengthened or clarified in some manner? The shareholder is disintermediated from management through a series of fiduciaries, most of whom they have no connection to. How many teachers have discussions with the person managing their retirement money? How is that person compensated? Why are pension and mutual fund managers inclined to do as well of poorly as their peers? Why weren’t these managers actively monitoring the banks risk, especially the holders of the senior credit? Collectively these institutions manage trillions of dollars of capital- surely they can afford a team of risk managers to monitor their holdings. And why haven’t these institutions gone activist to improve the incentive structure, reign in executive compensation, etc.? These are question I have yet to hear asked in a persistent and forceful manner.

-And why not challenge Black on the government regulations themselves that further warped the incentive structure? The rating agencies, for instance, which are a cartel protected by the Federal govt with their product- ratings- written into countless pieces of regulation from banking to insurance to pensions. Regulations go wrong as or more often than they go right. Black’s career seems to be like a detective, identifying and punishing the bad actors after the fact. I’m not sure even he would even claim to be able to craft a set of rules and regulations that would prevent the booms/bust/fraud and keep up with financial innovations.

[typo corrected: “Shutting” by any other vowel might not smell as sweet.–Econlib Ed.]

Mark U.
Feb 7 2012 at 11:37pm

Mr. Black’s, “fundamental point” towards the end is a bit misleading, saying that no government entity encouraged the “liars loans” that the private market was creating, while possibly true, isn’t accurate. Since Fannie&Freddie were making the market much more competitive for private markets to operate, they simply responded with a bit of fraud. Which I believe to be a more fundamental way of thinking about this scenario.

Mort Dubois
Feb 8 2012 at 12:57pm

Ak Mike: “Speaking as one who has examined many loan files of failed banks, I’m certain that regulators cannot catch many of the fraudulent or ill-advised loans while the banks are still alive. Thus more regulation will not help.”

This is what puzzles me when people say that lenders, or small bank depositors, should have skin in the game so that they will keep an eye on their bankers. How, exactly, are they supposed to do it? If experts are fooled by fraud, why would unsophisticated bank depositors do any better? At least someone pays regulators to look at bank records all day – depositors have no such luxury. I run a small business, and the last thing I want is to worry whether my bank will suddenly fail. I have enough to do without investigating my banks’ books on a regular basis to make sure they are playing it straight. I count on regulators and deposit insurance to catch crooks and to keep bank failures from putting me out of business.

So, Ak Mike, I draw the exact opposite conclusion from your statement. If regulators get fooled, let’s have better regulators. Removing the rules, as we have just seen, lets fraud blossom to the point where it destroys the economy.

Russ Roberts
Feb 8 2012 at 1:50pm

Terry Thompson and Mort Dubois,

Long-term investors don’t impose discipline if they are equity investors. It is lenders who impose discipline because they only care about avoiding the downside–they don’t share in the upside. Equity investors don’t want to go broke but they will accept risk because they get a share of the upside. Creditor rescues reduce the incentive for creditors to monitor and enforce risk.

It’s true that it’s hard to know what risks your bank is taking. But under current law, depositors have no incentive to discover that risk. It is natural to assume then that you could no better than regulators so what we need are better regulators. But if there were no regulation, the opacity you are worrying about would make it hard for the bank to attract depositors. They would find a way to make you comfortable risking your money. They found such ways before FDIC insurance existed. There will be more on this on a podcast coming soon.

Mort Dubois
Feb 8 2012 at 4:27pm

“But if there were no regulation, the opacity you are worrying about would make it hard for the bank to attract depositors. They would find a way to make you comfortable risking your money.”

Finding a way to make people comfortable risking their money is common to both legitimate businesses and crooks. In fact, crooks are often better at doing this than anyone else. As was discussed in this podcast, all the performance metrics that were commonly used to evaluate how well an institution was performing were easily gamed, and the fraudulent businesses put tremendous pressure on honest players to cook their books. Your libertarian viewpoint leads you to deplore the costs that regulation impose on the economy. What you fail to realize is that rampant fraud imposes a cost that is probably as large, and unpredictable to boot. It puts a burden on EVERYONE who doesn’t want to keep their cash under their mattress, with special points of pain randomly distributed wherever fraud causes a bank to fail. I suggest you read the Aubrey/Maturin novels by Patrick O’Brian – they are set in England during the Napoleanic wars, and one of the main subplots has to do with the collapse of a bank in which the main characters have deposited all their money. That’s how the world worked for a very long time, until the mass failure of banks in the Depression generated enough political will to change the system. Now the crooks are back in charge. Theoretical notions of how unregulated economies will work have been tested and failed.

So suppose you get things arranged the way you want. Can you picture walking into your local bank and demanding to review the books? Do you think you will uncover any shenanigans that are being concealed by smart, dedicated crooks with plenty of time and motivation? Why wouldn’t they lie to your face? If you think that regulation is something that will magically emerge through crowd-sourcing, you are dreaming.

Yes, regulation imposes some kind of cost on us all. It’s a form of insurance that I am willing to pay for, in order to avoid the possibility that all my money will disappear some day.

Thank you, as always, for a fascinating podcast.

Terry Thompson
Feb 8 2012 at 11:17pm


I think I understand your views. I also understand the other side. I wish you would have flushed out your last statement with the guest. I am not in a position to debate, just learn.

I will look forward to your upcoming podcast. I very much appreciate your show.

Feb 9 2012 at 1:26am

@ Mort DuBois

In your last comment you state:

“Finding a way to make people comfortable risking their money is common to both legitimate businesses and crooks. In fact, crooks are often better at doing this than anyone else.”


“Do you think you will uncover any shenanigans that are being concealed by smart, dedicated crooks with plenty of time and motivation? Why wouldn’t they lie to your face? If you think that regulation is something that will magically emerge through crowd-sourcing, you are dreaming.”

What you fail to realize is that the govt and its regulatory agencies are run by crooks. Regulation doesn’t work for exactly the reasons you cite. With or without regulation, the smart, dedicated crooks will figure out how to take control and fleece the masses. Regulation doesn’t protect you, it merely gives you a false sense of security. This makes it easier for the crooks because you put your trust in the regulators who work for the crooks.

This is the colossal failure of Economists and Economics – they do not understand that the US govt is now, and has been for decades, a tool of organized criminals. So the theoretical arguments are really meaningless since they do not address reality. When these criminals have control of the elected government, the regulatory agencies, the military, and the media, they are in charge. Economic theory and incentives don’t matter anymore. They have this nation and others by the throat and they mean to take all they can.

Russ claims near the end that pressure was brought to bear on the big banks to make loans they would otherwise not have made. So, these giant financial institutions that write the regulations, extort bailouts from taxpayers, fund the Congressional campaigns, then blackmail and bribe the winners, are just going to roll over and do what Barney Frank tells them to do. Wash D.C. doesn’t work that way, Russ. Barney Frank works for the bankers, he does what his owners tell him to do. When he stops doing that or becomes a liability, he is replaced, and he knows that.

History shows that all govt’s will be corrupted, and become a tool by which those with wealth and/or power try to retain their wealth and power. Therefore, we should strive for as little govt as possible and as decentralized as possible. And no private institution should have monopoly control over the money supply.

So, how does one reconcile the testimony of Mr. Black in this podcast with the statement by David Rose two weeks ago

“It’s a problem everywhere, but it’s an especially big problem in countries outside the West. Outside the West, if people feel like they are not hurting anybody, they really feel like they can just do whatever they want as long as they don’t get caught.”

Thank God I don’t live among the heathens in the East.

Russ, thanks for another great interview.

terry thompson
Feb 9 2012 at 2:39am


But, the guest was a regulator, working for government. He was responsible for thousands of people going to jail.

He argued that getting rid of regulation, specifically, getting rid of rules on documentation (underwriting) made it impossible to prosecute the current bunch.

The idea that we should get rid of regulation feeds right into the hands of the crooks, and your position is exactly what they want. You are (probably unwittingly) helping the crooks with your philosophy. Of course they will try to circumvent regulation and pay off lawmakers to change the rules in there favor. The counter to that is not to lay down and get rid of all the rules but rather to fight against it as best we can.

If we eliminate regulation and defund the agencies, we eliminate guys like Black.

Feb 9 2012 at 9:01am


Thank you for continuing to deliver interesting and diverse guests on your podcast.

I thought Mr. Black’s argument was slightly hard to follow. He seemed to be running together different time periods with very different circumstances to try and justify his overriding theme of “deregulation caused everything”.

How is the first example of the shopping center fraud related to a residential ‘liar loan’? One is done by a commercial bank and the other by a mortgage bank – they are two very different entities (portfolio lending v. an origination model), happened in completely different macro-circumstances, and regulated by different agencies. I never quite figured out how/why he tied these two together.

I’ve been in commercial banking since 1987 and have seen/heard first-hand almost all of what he talked about. Although I can’t really remember a period where I felt “deregulated”. Basically, if you are doing well, examiners leave you alone and if you are doing poorly they try and nail you. Everything is done ex post facto, unfortunately that is the downside of regulation (although I still believe it is necessary).

I would love to see Mr. Black back on again to clarify exactly what the “deregulation” is that he’s talking about. I know he mentioned Garn-St Germain (sp?), but blaming that for what happened in the 2000’s seems specious.

Sri Hari
Feb 9 2012 at 7:16pm

I re-listened to the last 3 podcasts. What becomes clear is Fama’s efficient market hypothesis can not withstand the onslaught of fraud & greed.

It is very clear the business practices, which were unlawful before the financial deregulation of the nineties, are no longer so after the financial deregulation.

I am convinced the laws were changed by the lobbyists with fraud in mind and the lawmakers were fooled. The lawmakers are dependent on the contributions by the lobbyist for re-election expenses. The financial contribution by lobbyist to the political system is killing American industry and democracy.

We are lucky in Australia that the lobbyist do not have such influence over the lawmakers. The financial regulatory authorities are still not corrupted by money power. We have a vigilant & knowledgeable electorate thus far. I hope it does not get complacent.


Feb 9 2012 at 8:28pm

Excellent interview. This was one of the most compelling and clear stories I have heard as to the cause of the financial crisis.

Incidentally, with all of the (convoluted) anthropomorphizing done in order to illustrate Long Beach Savings and others, I couldn’t help but wonder to what degree some actual person really did explicitly plan through all the steps. As opposed to many people individually making small (fraudulent) local decisions and the companies and institutions drifting towards a set of solutions that sustained the problem. It seems like a lot had to click into place. It doesn’t matter at one level, but on another it has implications for prevention. And is just interesting. Where does that knowledge and problem really lie, is it more human moral failure or somehow at the level of the whole organization and industry? (usually the answer is both.)

@Travis: I am a bit worried by your comment, though i don’t really know what it means that you have “been in commercial banking since 1987.” Anyway, it seems like you frame the problem nicely yourself: “Basically, if you are doing well, examiners leave you alone and if you are doing poorly they try and nail you.” That was Black’s point. As he said, both the shopping center fraud and mortgage fraud were simply ways to make large commissions while simultaneously appearing to be “doing well.”

Dave A
Feb 9 2012 at 10:32pm

Prof. Black stated that no one asked for Liar’s loans, but this is incorrect. The banks, Fannie and Fredie all had increasing quotas of loans to “under represented groups”, i.e. sub-prime. Liar’s loans were just another way of making a sub-prime loan and the system was under constant pressure to make more of them.

Feb 10 2012 at 8:26am

Black argues that deregulation or lack of regulation underlay the crisis, but how did deregulation make fraud legal? Both the buyers and lenders doing liar loans were either engaging in or complicit in fraud, so I fail to see how regulators could have been unable to do anything to stop them. How about prosecuting a few lenders and borrowers?

Feb 10 2012 at 11:14am


he makes a strong case that moral hazard from bailouts didnt factor in as much as his experience has showed him.

the same ideology that ignored the market failure as the bubble was building and made “free market” and “innovation” defenses r apologizing and deflecting responsibility onto govt again.

Dr. Duru
Feb 10 2012 at 11:52am

This was a *refreshing* follow-up to Fama’s interview. Fama claims that the financial crisis was caused by a recession that made otherwise smart bets by smart people go bad. Black claims that the financial crisis was at least partially caused by fraud conducted by smart people making bets that were smart given rules, regulations, and enforcement principles that facilitated outsized profits from the fraud.

I prefer Black’s story.

Feb 10 2012 at 4:51pm

Great podcast. I wonder what is Mr. Black’s take on “Black Swans” and their importance?

Feb 11 2012 at 2:02pm


One issue I have is the vague concept of regulation. Basically every law is a regulation, murder laws regulate the killing of people, delineating what circumstances someone can kill another, and when they should be punished. Some things have been throughout history considered illegal and our now “deregulated,” such as usury laws.

So the question it seems to me is how much regulation, and what kind of regulations, not this false notion of there being the rule of law on the one hand and government regulation on the other.

The anarcho-capitalist argues that we should deregulate everything, including murder, and that market forces will do a better job of rectifying these issues. I am highly skeptical of this position, even though I find it interesting. The minarchist is somewhat under the illusion that there is some obvious distinction between the proper government functions, and the improper.

If you look at prosecuting people for fraud, it is only because there is a legal requirement (a “regulation”) which compels them to truthfully fill out the information on loan filings.

I go back and forth on the issue, but I personally think smart and well targeted regulation is the ideal. For those libertarians who say that the regulars will just get captured, I would say the same thing is potentially true in almost all systems. Companies regularly use “deregulation” as a way to get free, or underpriced goods from the government. Look at the “deregulation” that lead up to Enron.

Implementing “deregulation” can result in similar, sometimes worse, problems as implementing new legislation can have.

Krzysztof Ostaszewski
Feb 11 2012 at 4:19pm

The incentives of a loan originator are very similar to the incentive of a life insurance salesman. Can anybody say “chargeback”?

Maribel Tipton
Feb 12 2012 at 5:51am

Hi Russ,

Thank you for your response.

I think the free-market has proven to work marvelously, for all the fundamental reasons most libertarians are familiar with. So in the production of most goods I believe the government shouldn’t get involved in any special way. I am skeptical of most government controls of voluntary human activity. Sometimes I get skeptical of large corporations and whether the model works, but I gotta say when I think of most corporations, their managers do what any good entrepreneur does, stay competitive, survive, be profitable, so maybe causes of fraud in Corporations are just part of life, not something intrinsic to incentives within the corp. structure. However when it comes to banking (by banking I mean investment and conventional bank lending), boy this is an area where I get a bit lost as far as trying to apply the same free-market principles to this enterprise, in big part because of the level of government involvement at all different areas of the business, The FED, FDIC, historical precedence (bailouts), and also because it seems like such an unconventional business, you got unprecedented amounts of money $$$$$ managed by a few people, concentration of resources, secondary market for mortgages, maybe the financial crisis was just a bleep in the normal course of human mess ups, and nothing intrinsic to the banking structure or the rules of the game. Is so hard to separate government from non-government, cause and effect. I think this is part of the reason is hard to use moral hazard as a big explanation for the financial crisis, because it’s impossible to know how things would be different if history hadn’t happened, how attitudes would be different today, culture etc. When we judge the moral hazard explanation from where we are today it seems weak, because we can’t conceive how much different banking would really be if we hadn’t bailed out in the past, if we didn’t have the FDIC, if The FED just cared about inflation. Right now it doesn’t feel like the people at the different levels and sides of the transactions that led to all these bad loans being made and then spread around the world would act very differently, it seems like most of the actors didn’t really have the FDIC or bailouts in mind, their view was a lot more myopic, concerned with their immediate surrounding and incentives.

I worked as a loan officer at the peak of the housing bubble in 2005 so I have a different perspective, at least at the peon level of why bad loans were originated. I wasn’t committing fraud, at least not in the sense that I was misleading or lying to my clients in any way. I was just doing my job and my job was 1. To find people that wanted to buy a house and 2. Try to get them qualified for any of the many programs we offered 3. Get my commission. At the mortgage broker level there isn’t much discretion, is pretty cookie cutter. Different lenders would come with their business cards and give you a sheet showing their requirements for the different programs (LTV, FICO SCORE, SAVINGS, CREDIT HISTORY, INCOME for different terms, 30 yr fixed, ARM or whatever). My job was to find the right program for my customer. Each lender has their underwriters which is the person that ensures all docs are good, verifies employment etc. and approves or rejects the loans I am sure on criteria given to them. My mindset was that I was helping people get into homes and when I qualified someone for a 2/3 year ARM I would tell them “OK the interest rate for this loan will adjust after 2 years, right now is all you qualify for, so make sure before that happens to come to me so that we can REFINANCE into a 30 yr fixed mortgage, make sure you pay on time and if you do, you should be able to qualify” hehe never for a moment did I think home prices would go down and they would be stuck with a high payment and underwater! It was the conventional wisdom home prices always went up, appreciation was one of the selling points of home ownership, along with mortgage interest deduction. So at my level I was just a service person doing their job nothing more. I new about the secondary mortgage market in general, Fannie and Freddie, and I just saw it as an interesting piece of trivia. “Hey your lender doesn’t keep your loan, he actually sells it to investors and sometimes just charges for servicing.” So as you go “up the chain” or “up and sideways around the complicated chain” I don’t know if it would be the case that people were just doing their thing in their limited scope and perspective or if at some level you see the “master mind”. For the moral hazard explanation to work at the conscious level this has to be the case, could be, I don’t know, it seems unlikely sometimes.

Sorry for the long comment. I’ll make sure I’ll read the article you suggested soon.

Love your podcast!!! Thanks for bringing people from all perspectives.

Feb 13 2012 at 12:54am

One question that I have had trouble tackling is where is the correlation and causation when it comes to trust of government and government corruption.

It seems to me anti-government ideologies might contribute to worse governments. I have met, read, talked to, and listened to many strongly anti-government people. And especially among the libertarian branch, they are often apathetic, or down right against voting and much active participation in politics on most levels. Obviously this is not true of all, but it would not be too surprising considering the rhetoric (I am not intending “rhetoric” here to have the negative connotations it often has). In addition it seems like it might breed apathy in the form of lowered expectations. People tend to be less outraged when they expect someone to let them down. When people assume politicians are corrupt, liars, and cheats, it seems like it might make the atmosphere more conducive to those very things. It is a lot easier to justify cheating and questionable acts when everyone already assumes you probably are engaging in them.

Jennifer Yoon
Feb 13 2012 at 6:02am

Let us take a concrete example of changed regulation and see if it impacted the level of fraud in the 2007-8 crash. I worked in the financial industry during 1990s to early 2000s. At the time, the underwriting fiducuiary obligation for MBS (pooling of individual residential mortgages into a security) seemed to be taken seriously.

The loan originator had to document the loan, the underwriter (investment bank) had to perform cash flow analysis on the pool, an accounting firm had to write a comfort letter saying it examined the pool for conformity, an insurer (vast majority of times one of the 3 agencies) had to guarantee principal repayment, and a credit rating agency had to rate it as investment grade. Because of joint and several liability, each party to due diligence can be later sued by investors for 100% of loss from fraud. I was hired to double check the work at various parts of these processes by different interested parties. Based on their sharp questions, due diligence seemed like a big deal. The managers said they are always the big pockets that are getting sued after the fact when something goes wrong. Documenting due diligence is their best defense against class action law suits.

One glaring difference from then and now is that the no-doc loans could not comprise more than an insignificant percentage of the MBS. Even if it was fully disclosed, an MBS with 50% no-doc loans will fail all party’s due diligence requirement. Disclosure would not exempt a party from its fiduciary duty of due diligence. A pool that failed any party’s due diligence requirement cannot be securitized and sold. A pool that lacked loan documentation (with proof of income) for 50% of the pool would be a prima facie evidence of fraud.

I still think this is true even for MBS pools underwritten during 2004-2008. All the CMO and CDO created from these faulty MBS will also be frauds. Everyone was doing it, or that was the accepted business practice, is usually a poor defense in securities litigation. So, I am upset that SEC is in no way interested in bringing sweeping fraud charges against the thousands of MBS and CMO originations that occurred during this period. I do not understand the changed behavior at the SEC. The Commission had been exultant when pursuing a high profile case, but now it seems hesitant and worried about making a false move.

The Glass-Stegal was repealed in 2001 and a 2004 law forced SEC to accept investment bank’s own models for calculating net capital, but I am not aware of any changes to due diligence requirement for MBS underwriting. I am told the SEC cannot go after credit ratings agencies, even though they would really like to, because a Supreme Court decision in 2001? stated that the rating decisions are protected under free speech.

And so, even though there were significant deregulation, the lack of prosecution in MBS underwriting seems to come from a new timidity from the primary enforcers of the law. It is not due to shortage of manpower, unlike the FBI financial crimes division as mentioned by Mr. Black. Hum… Any thoughts?

Mirza D
Feb 13 2012 at 11:39am

I enjoyed this interview immensely. It was very educational and clarifying. Would it be possible to have a second interview with Dr. Black? It sounded like you were running out of time and didn’t get to discuss some of the topics as much you wanted.

Feb 14 2012 at 10:20am


g soros makes that argument all the time: 30 yrs of saying govt is bad/incompetent leads to more bad/incompetent govt.

it’s a result of his “reflexivity” principle, which is basically about feedback loops between perceptions of reality and reality itself when agents holding these perceptions act.

his alchemy of finance is a must read.

he does not say govt was great b4 the whole bad govt ideology became mainstream, but it just made it worse.

this makes sense. everyone knows the danger of obsessive negative thoughts on the development/outcomes of people who hold them.

anyhow, it’s easy to see y govt is malfunctioning when people saying this are in govt for nearly 30 yrs ensuring this happens.

it makes the “markets everywhere” solution appear more attractive.

Feb 14 2012 at 4:28pm

I suggest a future podcast on the history of executive compensation. My instinct tells me that Bill Black is correct in that executive compensation is a big part of the story of the financial crisis, but I don’t have a clue how we got here. Was it just corporate greed? Was it changes in the tax code? Was it an unintended consequence of some regulation?

Jonathan Rothwell
Feb 14 2012 at 10:57pm

Thanks Russ for another great podcast. This was a brilliant and informative conversation. Black’s views should be widely disseminated, given his deep knowledge and expertise.

From this, it is hard not to be convinced that this really was a regulatory failure–though not the ones typically cited like Glass-Steagall (I’d like to hear more about the history of the regulatory changes discussed by Black–maybe in another episode). This doesn’t need to be a left-right issue. As Russ implied at one point in the conservation, there is nothing libertarian about refusing to punish crime or fraud.

This is an excellent counter to the podcast with Eugene Fama, who, in an otherwise interesting and cogent series of thoughts, rather stubbornly claimed that we can’t know that the subprime caused the financial crisis.

In his model, people have perfect information. In the real world, some people have limited and inaccurate information–like traders in Norway and Wall Street because of inaccurate models or the mis-understanding of inflated ratings; others have more information–like those making the fraudulent mortgages and consumer advocates, but these groups of people do not communicate with one another, nor do they understand the implications of what they know beyond their narrow perspectives.

In other words, specialization, while great for economic growth, can lead to bubbles, inflated assets, and financial crisis under certain conditions, even if information is widely available in the Fama sense. Black’s narrative, drawn from his experience, shows how easily this can happen in an unregulated market. Market discipline means nothing when the public data is based on fraud.

Jaime Levine
Feb 15 2012 at 4:55pm

One thing not addressed in the podcast is the moral hazard created when powerful players are able to prevent investigations and prosecutions from taking place.

Once we bail out recklessly managed companies, it is more important than ever to pursue bad actors within those companies. Prosecutions of elite frauds could mitigate the moral hazard created by bailouts.

I have summarized much of Professor Black’s message from this podcast: http://www.capitalismwithoutfailure.com/2012/02/bill-black-how-fraud-leads-to-recurrent.html

[broken html fixed–Econlib Ed.]

Feb 15 2012 at 11:35pm

I now see how these enormous corporate bonuses can be paid out to clearly criminal recipients who are turning blind eyes to massive frauds.
If I had any doubt we are rushing headlong into
deoression and global financial ruin, I have none now. Apart from gold and silver, where do we run now? I think we should buy bags of old silver coins that we can at least use for groceries – but they won’t last long!

Roger Meadmore, Australia.

Feb 16 2012 at 3:01pm

I am currently studying for a BA in economics and the one issue that’s nobody pays attrition is the affect crime has on the economy.
there a couple of questions that needs to be answered in this regard :

1) If a bank can easily “print” money, does it mean the fed really don’t complete control over M1?

2) did the “fake” money went just to the banks and it’s employees?
of course not. the effect of the multiplier did it’s work ( to some extent) and some of it did get to other business/private people.
so if you discover the money is fake and you make it “kosher”(bailout the banks) does this mean we are back to 0?

3) does a person that forges $1,000,000 in $20 bills(good quality) and gets arrested receives the same sentence like a banker that makes “liars loan” ?

loved this podcast and this website keep up the good work.


Feb 17 2012 at 2:26am

This was absolutely great interview; Russ, I think you could slightly less push your theories about bailouts creating moral hazard (which I more-or-less share, but still) and more sturdily ask the ‘why do you think it happens? do you think people in general are just negligent/don’t care about their own money etc.’ questions.

What surprised me was the answer as to ‘what should we do’. First, we supposedly have 90% institutions that more-or-less don’t commit crime and 10% that do. All have similar remuneration scheme for their employees; which is to say that it works in 90% of cases. And now we should send a government bureaucrat to all these firms – both honest and dishonest (at least because of presumption of innocence) and start telling the CEO/board/shareholders – “you are doing it wrong, we know what’s the best remuneration scheme for your firm, we are the experts…”… Or, better, the government just imposes this through political process without even going to the affected companies?

If I define ‘regulation’ as ‘forbidding honest voluntary transaction between 2 parties’, I wouldn’t even call e.g. the underwriting process standard a ‘regulation’. I think he is too fast to jump from a reasonably argued position ‘some people are committing fraud and there are ways to detect/minimize it’ to ‘I can run your business better’.

Jay Richardson
Feb 18 2012 at 5:27am


I am a new listener to your podcast, and your interview with William Black was my second.

I don’t have any comment regarding the content of the interview, other than I found both your own opinions and insights were enjoyable, as well as your guest.

Please accept the following criticism in that I would not have bothered if I did not care. I will definitely be listening to future and past episodes.

However, the format of this interview was horrible. As Patrick R. Sullivan above mentions, the interview was a train wreck of chronological confusion, constant interruptions, and erratic behavior. Were you on cough syrup at the time?

You constantly interrupted your guest when you should have let him continue.

You confused the issues and perspectives by role-playing the characters and then messing it up over and over again. Your audience does not need to be babied through this, but it felt like you wanted to dumb-down the issues.

While I appreciate a moderator/interviewer who actively participates in the discussion with thoughtful questions, please don’t destroy the interview by flustering, confusing, and interrupting the guest.

I have listened to William Black on other podcasts, which is how I found yours, so I know the issue isn’t him.

I hope that the quality of the interviews will improve in the future.

Thank you for your public service.

Feb 20 2012 at 2:32pm

Terry Thompson,

Black was picking up crumbs. The scale of the criminal activity I’m talking about is way beyond the level he addressed. Russ used the term pyramid scheme in this podcast. Well, the Federal Reserve, the US Dollar, and the whole fractional banking system of creating money as debt is a pyramid scheme. If you sit down and do the math taking into account the layered system of leveraging which creates debt at multiples of 20 times reserves at each level, you will see there is no way the debt can be paid off – ever. You will also see the imperative to go outside your sovereign borders to try to extract wealth from other nations to support the debt pyramid. This imperative is behind war, the IMF, World Bank, and all the regime change the US has used to steal and extort wealth from those lesser people David Rose talked about two weeks ago.

They prosecute the little fish as sacrificial lambs to divert attention from the big fish. If you prosecute the bag men, but not their bosses, then their bosses will find new bag men and be back in business soon after. We know there was exceedingly high volume of put options purchased on the stock of American Airlines and United Airlines days before 9/11 – totally aberrant activity. Whoever purchased those put options knew about 9/11 in advance. Yet, the parties have never been identified and no one has been prosecuted.

What was it that compelled our elected govt to provide a multi-trillion dollar bailout to banks and other corporate interests? I am not aware of any law or regulation that compelled it, and I am not aware of any Constitutional authority that permitted it. This happened because these corporate interests hold dominion over our elected representatives and regulators, and the govt does not exist to serve the people, it exists to serve these powerful interests. The law just does not matter if the players are powerful enough. You cannot expect a corrupt government to police corruption. We recognize that is true in Mexico and Nigeria, but we don’t recognize it here, primarily because Americans are tragically ignorant of the power structure in the US.

Consider Sarbanes-Oxley, a regulatory response to financial crime. How do large corporations comply with Sarbanes-Oxley? They do it with software, that’s how. Who writes the software? Aye, there’s the rub. If you want the answer, you need to research Richard Grove and Project Constellation. While you’re at it, research Indira Singh and P-Tech, Danny Casolaro and PROMIS, and deepcapture.com The really important prosecutions never take place. And I’m only scratching the surface here.

It’s futile to try to open someone’s mind in this forum. The depth and scale of the corruption in the United States is beyond the imagination and/or comprehension of most Americans. It takes some sort of shock to open peoples’ minds. A generation ago, it was the assassination of JFK. For me it was 9/11. For the rest it will be the conditions of life here after this pyramid collapses. This is the same corruption that swallowed Rome centuries ago. It is not new or unique, it is the timeless endpoint of imperialist empire.

[comment moved from wrong thread to this one–Econlib Ed.]

Yamaha drums
Feb 22 2012 at 7:19pm

Playing the drums and just beating it out – is the reason why these guys ROCK the way they do. You can hardly go past a great Yamaha drums that is without a doubt.

William B
Feb 22 2012 at 9:14pm

Mr. Black’s odd logic goes something like this:

Fraud is committed by banks, and the fraud isn’t punished, therefore we need more regulation to make sure the fraud doesn’t occur.

Since fraud is already illegal, only criminals will commit it in the first place. It would be much more productive to punish the fraud, rather than place burdensome regulations on an entire industry, where people who weren’t doing anything wrong will also be punished.

Feb 24 2012 at 12:25pm

I read Mr. Black’s book “The Best Way to Rob a Bank is to Own One” I thoroughly enjoyed it. I actually picked it up half a year ago since it was the only one that popped up of consequence regarding the S&L crisis.

I kept on thinking to myself, how are we already repeating this stuff a decade or so later. It was quite fantastic. However, the only area I differ is that I think every last one of us had a part to play in this and every other crisis. Either directly or indirectly.


Feb 27 2012 at 11:51am

Bill Black is excellent. This interview exposes something about the host, however; he is too ideological to be a trusted analyst. He cannot contain himself from trying to input his failed past assumptions about how the world works. It did surprise me – given previous EconTalk podcasts.

The crisis has been a great opportunity in terms of exposing compromised thinking. This is a mild case… but given the authority and prominence of the forum, it does make a difference.

Mar 1 2012 at 12:08pm

A very interesting podcast, but I think he is only offering a part of the picture. For example, why were overseas pension funds clamoring for more MBS? Were they also committing fraud? Unlikely. They were chasing yield, because interest rates were super low at the time…and low interest rates also inflate housing prices, which make these frauds more attractive and easier to hide.

The causation is murky, to say the least. And German pension fund managers are not using American compensation models, or there for a short term bonus. Yet they were buying up MBS, too!

I also wonder about the concept that these companies exploited minorities…really? If banks don’t lend enough to minorities they are accused of racism, and if they do lend, its exploitation! Hopefully the next bowl of porridge will be just right.

I think his main point could have been made – we should be able to prosecute fraud for liar loans, and we should have done so vigorously, without much controversy. Prosecuting fraud is accepted even by libertarians.

Jennifer Yoon
Mar 6 2012 at 1:11am

A follow up to my earlier comment. I had dinner in NYC with former SEC lawyers and I asked them about the MBS underwriting fraud and credit rating fraud questions.

On MBS underwriting)
If 100% of the mortgages backing an MBS pool are composed of liar loans, and the investment bank disclosed this in the prospectus, then the only “due diligence” obligation the underwriter has is to prove that 0% of the pool has been fully documented/verified for cash flows. This concept took a while to sink in. So, what I posted on my previous comment is wrong. While it is true that disclosure does not substitute for due diligence, the fiduciary duty applies only to the portion of MBS pool that was stated to be not toxic. If 100% of the pool was said to be poison, and I bought and drank it, then the only fiduciary duty the seller has is to show that the liquid was indeed poisonous.

On First Amendment right and credit rating agency)
Here the two lawyers I talked to diverged on whether credit ratings were protected under the free speech amendment. The Supreme Court decision is said to be an early 1910? period and not a recent decision.

But they agreed that it would be difficult to sue the credit rating agencies because they will claim that the ratings are their opinions. If a seller said he thought it will be sunny tomorrow, and even though I thought it might be cloudy, if I paid the seller for the “Sunny” opinion, I cannot sue the seller if it turns out to be cloudy tomorrow.

That is why SEC is not pursuing these cases. however, I immediately see ways around these points. First, there was a transition period between when liar loan’s could not make up more than a small fraction of MBS pool to when they made up near 100%. During the transition period (2000-2004), the underwriters may very well have skipped due diligence checks on the good portion of the pool. If this could be proved, then lawsuits can still be brought on large number of pools.

Second, for the rating agencies, if it can be shown that the “opinions” were systemetically biased, and not what the best minds at the rating agencies believed to be true, then a lawsut can be successful. throw in conflict of interest on CDO and CDS, a jury outcome will have a good chance of success. From 2000-2003 the credit rating agencies actively destroyed housing price analysis to eliminate all reference to the “1930’s experience”. Prior to 2000, baked into all 3 rating agency’s models was the requirement for any housing related debt instrument to survive the depression era nationwide housing decline with only a modest loss in value (6%) for the debt to receive AAA. When this part of the model was ripped out to allow CDO and CDS to get AAA, experienced credit analysts did not go along quietly. I read news about a number of credit analysts being fired and many others forcefully told to go along, and large numbers of experienced analysts being reassigned. Perhaps some of these disgruntled workers would be willing to testify against top management who rammed the biased model down their throats. If so, a prosecutor may be able to show that the credit opinion was not a fair and unbiased opinion.

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Podcast Episode Highlights
0:36Intro. [Recording date: January 24, 2012.] Russ: Bank fraud and what it can tell us about the crisis and what we might learn from it. Tell us to begin with about your background in detecting bank fraud. Guest: It happened, of course, accidentally, like most things in life. I went over to the Home Loan Bank Board, April 2, 1984, as their Litigation Director. Russ: What is the Federal Home Loan Bank Board? Guest: Well, it is two agencies ago. It was the primary Federal regulator of Savings & Loans, agency, the office of Thrift Supervision, which was recently killed by the Dodd-Frank Bill. Russ: And what did you do there? Guest: I did what the title suggested. I was Litigation Director, and we had independent litigation authority. So we didn't use the Justice Department. And so at a very young age I had a docket of 10,000 cases, and then a budget for outside counsel of $100 million dollars, which back in the day was a big deal. But pretty quickly I became heavily involved in two other things--again accidentally. We had a massive run on the largest Savings and Loan (S&L) in America, American Savings; and it was a $6 billion-dollar run. This was not long after Continental Illinois had been brought down by a $6 billion-dollar run. And I ended up on the emergency task force; and so I was working with the business types, and with the field folks; and supervision was really done in the field, not out of Washington, D.C. So, I started learning a great deal about these institutions. And the head of the agency had undergone a remarkable transformation. He was a reasonably close friend of both of the Reagans--appointed head of the agency because of that personal relationship. Very strongly pro-deregulation. But he had changed by this point and had decided to engage in significant re-regulation. And because of the chain of random facts, I ended up being the staff leader of that effort. It's the combination of those things that led me into the anti-fraud efforts. Russ: Going back a little bit to that case you just mentioned, American--what was it? Guest: American Savings, also known as FCA Financial Corporation of America. So, it was a holding company. Russ: And how was that, after that run? It was shut down--is that correct? Guest: No. And indeed that is part of this interesting story of fraud. It was a bit like Lehman Brothers, in that as your listeners may know, the Securities and Exchange Commission (SEC) and the Federal Reserve (Fed) had people in Lehman, in its final months of distress; and the Fed folks were from the credit side of operations. In other words, the potential lenders. Presumably looking at collateral. And the Fed, knowing that Lehman was in desperate shape, sent two people. The SEC did this as well, by the way. We, from our Federal Home Loan Bank of San Francisco sent 45 people. Russ: To look at American Savings. Guest: American Savings; and they worked around the clock, in shifts, going through collateral and made emergency lines available on the basis of reasonable collateral; and actually survived a $6 billion run. But used that leverage to force out [Charles] Charlie Knapp. And in this era the folks were known as the "high flyers"--that was the phrase within the trade--who were doing what was perceived as riskier things. And the perception about Knapp was that he was taking severe interest rate risk. In other words growing very rapidly with a tremendous mismatch, investing very long term, in 30-year fixed-rate mortgages held in portfolio, and financing them with very short-term deposits. Russ: That sounds familiar. Guest: Right. So the key difference is that the Federal Home Loan Bank of San Francisco used its leverage as a lender to force Knapp out and to bring in a new person. And that new person should--you would have thought--have saved the place, because he immediately stopped the interest rate gamble, went to adjustable rate mortgages. Not the modern kind in this crisis, but sort of the good, old-fashioned fully amortizing adjustable rate mortgages. And so he minimized interest rate risk. And they had virtually no defaults on these loans. So, you are thinking: This is great. Right? Russ: Getting back to health. Guest: Right. Wonderful intervention, brought in new folks, saved the place. And what turned out is: Every quarter, the place lost money. And so this made no sense. And what we discovered eventually, when employees started coming forward, was that they had missed entirely the major operation, which is what we call "cash for trash." And when I say "we" call it, as regulators that's the phrase the industry used to describe it; and we simply adopted their phrase.
7:41Russ: Now, when you say "they discovered," when you said "they missed"--who was "they"? Guest: Yes. In this case it was everybody. So the SEC had prompted the run. I'm not blaming them, mind you--this is a good thing. But they prompted the run by finding a case of accounting fraud by American Savings and forcing it to restate its earnings. But they didn't find the underlying larger fraud. They, the SEC. Nor did the investors. Nor did the regulators. Russ: And what was that fraud? Guest: And that fraud, as I said was called cash for trash. And cash for trash works this way: So, Charlie Knapp didn't simply grow rapidly. He made extremely high-yield, high risk loans. Particularly commercial real estate. And of course, as you might expect with a guy like this, these loans were frequently bad. And that would have caused tremendous loss recognition. So, you come into American Savings, and you've never developed anything; you say: I'd like to borrow a million dollars to create a strip development, put up a 7-11. And the American Savings person would respond, the lender, a loan officer type: Sorry, we won't make you a million dollar loan. But we will make you an $80 million dollar loan. Russ: To a person who has perhaps never developed anything substantial. Guest: Yes. And that would be the norm, and it would be the norm for good economic reasons, because if you are a real developer, even if you have no financial stake in the project--it's a non-recourse loan with no down payment--you still have a reputational interest that can get in the way of what I'm about to describe. Russ: So, this, by the way, is going to be symptomatic of a much larger problem. So, for those of you listening, if you think we are delving into this particular case of American Savings in this peculiar kind of weird transaction, this turns out to be kind of, unfortunately, a template for a wider kind of behavior. So, carry on. Guest: That's exactly right. Russ: So, I'm walking in, I've never built anything in my life; I come to you, American Savings, I say I want to build this development; and I know and you know it's a loser. It's overbuilt already; I don't have much of a track record. And your point was that if I did have such a track record, I wouldn't be so eager to build a lousy development that would hold me back because I want to keep doing this. But if I'm a one-time kind of guy, I walk in and want to borrow a million; you say, no, no--we're going to lend you 80 million. Why wouldn't that be a good idea? Guest: Because I would have previously made a loan for $60 million to somebody else. And they would actually meet your description even more, of deliberately putting up a building that made no sense. And of course it would have gotten into trouble. And so the pesky examiners might either have come in or you fear they are about to come in and say that the $60 million dollar acquisition of development and construction, what's called an ADC loan, is really only worth $30 million, and you have to recognize a $30 million dollar loss. And again, foreshadowing many things we'll talk about, all of these entities have virtually no capital in reality; so a $30 million dollar loss is any amazingly big deal. A few of those and you are gone. So, I don't want to recognize that loss. So, when I do this with a class, I ask: So, what do you do? And after a lot of prompting, they'll say: Well, I loan this new guy, the one who wants to come in that wants to build the 7-11, $60 million dollars. And he buys it for $60 million. And that's the C- answer. Because what you are really going to do, of course, is buy it for $78 million. Russ: So, I'm lost. I got confused there. You've got to prod your bank. You've got one project that went sour. You didn't plan for that one to go sour; it just didn't turn out. Guest: You didn't care. You were fairly indifferent to it going sour. Russ: So, all of a sudden this stream of payments that you might have gotten is now not going to show up. And you are going to end up with a major loss on your hands. You are going to have to grab the property in this half-built building maybe, or building that's been built but it's empty; and the guy says: Sorry, I can't pay the loan, but I guess you'll take my land and my building. Right? Guest: Except that there has never been a stream of earnings. Russ: Right, you've never rented a single office in the building. And now I come in, I'm the second guy, and I say: I want to build a 7-11; I want to borrow a million dollars. And what do you do? Guest: I loan you $80 million. You'll keep $2 million as walking-away money. Russ: So, you are going to give me $80 million dollars. I am going to take $2 million of it to pay my salary of it as developer. Guest: Right, for the risk exposure of committing this fraud. Russ: Yes. And what am I going to do with the other $78 million? Guest: I'm going to purchase the building. Russ: I meaning you or me? Guest: I, the 7-11 developer. Russ: That's me. Sorry. Guest: You are going to purchase the big office building. Russ: Oh! I'm going to use my $78 million that's left over to overpay for the bad thing you already built? Guest: That's right. And I transform, in my hypothetical--which is not a hypothetical--a true $30 million dollar loss--you have an original book value of $60 million. Russ: And now you've got an $18 million dollar profit. Guest: Yes. And you would frequently have what was known as you, the lender, American Savings, would frequently have what was known as an equity kicker. An equity kicker would mean you would get 50% of the net profits if there was a successful sale. Russ: That's really ugly fraught, right, because I'm supposed to take the $78 million you gave me and build the 7-11. You are saying I'm not going to do that? Guest: No, you are coming in for a 7-11; I tell you to forget the 7-11 project. That's not what we are going to do. You are going to get an $80 million dollar loan. You keep $2 million of it as walking around money. Russ: And I take the other $78 million, overpay for your lousy project, and you then, to the regulators on your books, say: We made profit on that first project because we sold it. We sold it to a guy we lent the money to, actually. And of course, I'm going to default on the $80 million dollar loan now. Guest: Eventually, but I'll refinance it three more times. Russ: So, what you've done there is you've pushed the day of reckoning down the road with no hope of ever having it be positive. And in the meanwhile, I've made $2 million; you've made the equity kicker--you pocketed some bonuses maybe and compensation for a good quarter because you say you had a big profit. Is that the idea? Guest: Yes; and I have transmuted a real economic loss into a fictional gain. Remember the pesky examiner who was about to force me to recognize the $30 million dollar loss. He's threatened my ability to survive. Now, when these frauds are done, they don't make lemonade. They make Dom Perignon.
16:00Russ: It's a Ponzi scheme. Guest: Right. Russ: Essentially. So it falls apart either--I was going to say when you run out of people to participate, but there's always someone. Does the person who takes the $80 million dollar loan and pockets the $2 million, does he go to jail? Guest: Eventually in the old days, yes. In the current system, no. Russ: And he goes to jail because he has willingly participated in a sham transaction? What's the illegality of what he did--what I get in that story? Guest: Excellent question. What you did, because back in the era I'm describing, we had actual rules. And the actual key rule that helped make these prosecutions was very simple. And it was one of those rules that economists could love. Libertarian economists could love. Russ: That's me, Bill. You know that. Guest: It said three things. 1. You must underwrite a loan before you make it. Russ: What does that mean? Guest: Well, it doesn't do you much good if you underwrite it after you've already dispersed the money. Russ: But what does it mean, technically, to underwrite the loan? Guest: Underwriting is the process in this context of determining the risks of the loan, whether it should be made under your risk views, as managers, and what the necessary yield is--the required return in our jargon. Russ: So this is like an assessment. It's the due diligence before you make the loan that complies with the regulatory framework. Is that correct? Guest: No, this is the due diligence that we would do if regulators had never existed. Russ: Oh. Just the idea that you'd want to know what's going on. Guest: Yes. In other words, so to back up, if you don't do due diligence or underwriting in the lending process, we have known for centuries that you create acute adverse selection. And in the context of a mortgage loan, where the money goes out at the beginning, as opposed to credit cards where it goes out in tiny slugs, to engage in significant adverse selection in the mortgage context is to create as a lender an intensely negative expected value. Russ: And by adverse selection, you mean you are going to draw people who are bad credit risks, who are just going to be happy to live in the house for a while and then lose it. Guest: Yes. In this context. You get the worst possible borrowers and because you do not know the risks, because you have not looked, you will underprice. Russ: Okay, so let's get back to your sequence. Guest: You have to underwrite the loan before you make it. Second thing is, through the underwriting process you have to establish that the person has the apparent ability to repay the loan. And third, you have to keep a written record of this process. Russ: Those are pretty simple. Now, the puzzle of course--and we're going to talk about this when we come to the current crisis--the puzzle is: So, why would anyone lend that money? Why would ever I want to create a set of loans that are never going to pay off? That I know in advance are likely to not pay off? Guest: Because, as Akerlof and Romer put it, aptly in the title of their key article in 1993, looting the economic underworld of bankruptcy for profit, accounting control fraud is a "sure thing." Russ: And the sure thing there is the sure thing that's with the Ponzi scheme, right? If I have a bunch of sham investments that I finance by continuing to roll over and attract new investors under a promise of a particular rate of return, say, it's a sure thing until it's not a sure thing. Until I can't find those people any more, in the case of a Ponzi scheme; and then I lose all my money and I go to jail. In the case of a bank, this works for a while; I live a good life in the meanwhile because I've got a lot of cash to play with that I can pay myself with--you've got to be attracting money somewhere along the way so I'm attracting deposits, say, which I'm using to finance these sham transactions and skimming off chunks for myself and other people I lend the money to. But eventually there's a day of reckoning. So, it's not a very attractive sure thing. It's a sure thing until you get caught; and then you go to jail. Guest: Only if you go to jail. And as many economists aptly said, again, it's like all things in risk: You have to make forward-looking views. At the time people were doing this, nobody was going to prison for these things. Russ: In the 1980s, you are saying. Guest: In the 1980s, and of course now, they most assuredly, if they are the elite managers, don't go to prison. They don't even get investigated in the modern era, much less prosecuted. Russ: So, let's go deeper into looting. You just gave a scenario. Guest: Right, you asked me to explain what the crime typically was, and that's why I was explaining the underwriting process. We are back to you, where you are the straw purchaser. Russ: Right; I'm the straw developer. Guest: And the crime is that for an $80 million dollar loan, you are almost certainly going to overstate your income. Russ: Oh, I see. There's going to be a literal fraud. It's not just that I'm faking it and pretending to be a developer. I'm going to have to have filled out some paperwork that shows I'm not who I said I was. Guest: And that's because in that era we had rules, requiring this underwriting. And again, the key on those rules is we didn't go to best practices. We went to minimal practices that any entity that was going to survive as a lender would use. So, there were pretty close to zero economic costs to this regulation. But it created a problem for you if you were to engage in fraud, and so what you would typically do is either put false information in the files or remove honest information from the files that would demonstrate to the examiners that you knew you were making a bad loan. Russ: And that would clearly be the case on my side, as the borrower. And on your side as the lender, you would go to jail for knowingly accepting false documents or removing those things from the file? Guest: You would have been the person, just as in the current crisis who had been encouraging and made basis preparing the false financial statements. You are not going to leave it up to the unsophisticated person who has never been a developer. Russ: To figure out what he needs to lie about.
23:36Russ: So let's take a brief digression here on ethics, a topic that rarely rears its attractive head. You said that in the profession, in the industry, this was known as cash for trash. At that point, people didn't foresee--many of them, some of them--would go to jail for this procedure. It's not a very nice thing. When you went home at night and talked to your spouse, you'd kind of feel--How was your day? Well, I made another lousy loan, doing great; we're going to Tahiti this summer for a month. How did this become the norm? And it was the norm--we're talking about one particular example, but there were many, many banks in the Akerlof and Romer paper, I remember, very important paper. This wasn't like an isolated thing where someone said: Hey, maybe I could get away with this. It was widespread, correct? Guest: Yes. The inevitable national commission to investigate the causes of the Savings and Loan crisis, the famous phrase is: As the typical large failure, fraud was invariably present. Now, that's the norm within the large failures. It doesn't mean it was the norm within Savings and Loans. There were 3000 Savings & Loans, roughly, depending on the exact date, and we are talking about one tenth of the industry. But 1/10th of the industry is enough to cause catastrophic losses. Russ: And of course, those losses continued to mount. Let me see if I can get the chain correctly. So, I'm a Savings and Loan; I am attracting deposits by offering nice rates of interest. I am taking the money, lending it out along the lines of what we just talked about, aggressively; having good quarter after quarter, by what again seems like a Ponzi scheme; and the people who are ultimately financing it, although they look like the depositors, are not really the depositors. It was the taxpayer. Because the S&Ls were FDIC-insured, the taxpayers were ultimately the funders of this fraud. Is that a correct way to describe it? Guest: Well, first, there was a separate insurance fund in those days, the Federal Savings and Loan Insurance Corporation (FSLIC), as a technical matter. But yes, the government was behind most of it. But don't forget, in terms of key stuff about moral hazard: the government wasn't the only entity. There were shareholders at most of the worst places. And there was subordinated debt at many of the most fraudulent places. And of course in economic theory, it was supposed to be subordinated debt that was the perfect form of private-market discipline. You had the right incentives; you had the sophistication; and you should have done something. But there were zero cases of effective private market discipline by either shareholders or sub-debt holders in the Savings and Loan crisis. Russ: So, let me just review that, because we've talked about this in passing in many different podcasts, many episodes of this show. The debt holders have a fixed upside. They cannot make more than they are promised. Their downside is being wiped out. So in general, they are going to be the watchdogs of risk taking and the enforcers of prudence on the part of the people who they've lent money to through this debt. And what I have been worrying about for a long time, and it's a worry I've learned from Gary Stern's work, is: Well, that's true, that under a market system the debt holders are supposed to be the disciplinarians of risk taking, the watchdogs, but if the bond holders think that they might get their money back even when the firm goes out of business, which happened with Continental Illinois in 1984, you might start to not worry so much about that and be willing to accept a fixed rate of return even when there is a chance that the investment will amount to nothing, because you might get your money anyway. Correct? Guest: True, but not basic enough. In other words, you are quite right that Continental Illinois did a terrible thing and it bailed out sub-debt holders. We never did that in the Savings and Loan. We always wiped out the sub-debt holders. And of course they are supposed to be wiped out. That's the concept of risk capital. Despite that, there was never effective private market discipline; indeed there was no even effort at private market discipline. It failed, by sub-debt holders during that entire crisis. And what I'm explaining with this sure thing and the creation of this record reported income hit the Achilles heel of the private market discipline. So, in the real world, if you are the Chief Financial Officer (CFO) of Enron, and you are reporting record profits, your problem isn't private market discipline. Your problem is that bankers are almost literally trying to break down your office door to get in to you to lend you money. So, as long as you are reporting record earnings, it turns out private market discipline is an oxymoron. The primary entity that loses money, as you aptly pointed out in the Savings and Loan, is not the shareholders--because of the very thin equity. It's the creditors. Now in the Savings and Loan case, yes, the ultimate creditor was the government, in most cases. But that's not true of the Enrons of the world. That wasn't true of the Bear Stearns, Lehman Brothers, Merrill Lynch--in other words, the entities that fund the accounting control frauds are overwhelming the creditors who in theory are supposed to be the ones providing discipline. Instead, what they mostly do is provide cash.
30:36Russ: Right, so again, the puzzle is: Why? And the answer, it seems to me--there's two answers. One is: they looked at the record profits, the good times, and they were lulled into thinking that they would persist. I find that explanation unpalatable and probably false. Of course it's possible. It's possible that there's this animal spirits of exuberance that gets out of control. But these are savvy people; they've seen a little bit of the world; they do know that prices can go down and assets do fall in value from time to time. And in fact each of these firms has people in them, and that was their sole job--tap the other people on the shoulder and say: Don't forget! And yet they persisted; they continued to fund those investments and eventually when they turned out badly, they should have been wiped out. But they weren't. They got 100 cents on the dollar. They were totally insulated from the market discipline that should have been in place. Guest: Well, it depends on what you are describing. That's certainly not true in the Savings and Loan. Russ: Correct. I'm talking about the current crisis. I'm talking about the Bear Stearns creditors; I'm talking about AIG's, Merrill Lynch--everybody except Lehman. The people who had funded the daily operations that provided the liquidity that let them make the bets they made were insulated from the failure. Guest: Well, again, if you go a little farther back--because again, this theory says: What do I anticipate? We had not been bailing out investment banks. And investment banks had been failing; and by the way they failed primarily because of fraud--and there had been no bailouts. So, if you go on what people supposedly would have anticipated coming into this crisis, I don't buy the argument that they would have been very sure that they would have been bailed out. The banks that facilitated Enron's fraud suffered significant losses. Russ: But the banks that funded the escapades of the Mexican government in the mid-1990s suffered no losses, because the U.S. government stepped in, using the same argument that they would use in this crisis--that there was risk of global instability; that Mexico could not default; no one needs to take a haircut; the U.S. government will guarantee the bonds that the Mexican government would issue to cover its past promises; and it turned out they didn't lose a penny. So it turned out great according to the defenders of that policy. But the investment banks that had bought those Mexican bonds that had issued those, had underwritten those bonds, part of the stream of income that they generated--they were made whole. And I think that's part of the problem. Guest: I agree that that is part of the problem. I would again say they weren't really made whole, except in a very nominal accounting sense. In other words, there were real losses suffered; and Citicorp was next to death's door a number of times. But I think where we'll all end up agreeing is the treatment of systemically dangerous institutions that allows them to hold our economy hostage and produce these bailouts is completely destructive of almost any view of how and economic system should run. Russ: Yes, we're going to agree on that.
34:26Russ: So, let's get to how the story you just told me about American savings in that era of the Savings and Loan crisis, when banks realized that--Well, let me ask you a different question before we get to the present. How do you get to a world--wouldn't you rather make good loans? Why would you run around trying to make bad loans? Why then? You'd think if this is a good trick, you should always do it. If it's not a good trick, don't do it, if there's a better alternative. Why was it prevalent then? What kicked that looting off? Guest: Well, what kicked it off was almost certainly the first phase of the Savings and Loan crisis, which had nothing to do with fraud. The interest rate crisis. The entire industry ran on a system that exposed it to massive interest rate risk. Paul Volker decided to break the back of inflationary expectations; created the double-digit interest rates; and every Savings and Loan in America was insolvent on a market-value basis; and collectively by mid-1982--of course this wasn't realized for accounting purposes--but in real economic terms, the industry was insolvent to the tune of roughly $150 billion. Russ: So, at this point I'm running a bank and I have made a bunch of loans--basically the idea is to attract new money, which I need, I have to offer a large interest premium. But the money that's coming in from my old loans is very low. This is the mismatch problem, correct? Guest: Yes, although this is where the conventional economic wisdom turns out to be highly incorrect. But it does create lots of pressures; and it creates a unique political opportunity. So, the head of the Federal Home Loan Bank Board, at that point, is Dick Pratt; an academic, very conservative, very libertarian economist/finance expert. And he creates the key deregulatory bill; indeed it was known as the Pratt Bill, informally. It becomes the Garn-St. Germain Act of 1982. And being a good economist, he tries to do it exactly right. And so he asked his economists at the agency, which of the states has the best results? Right? So this is Brandeis-like laboratory experimentation. And they come back and they say: Texas. Texas is the place where the Savings and Loans are reporting the best returns. And so he uses Texas as his model for deregulation--what becomes the Garn-St. Germain Act of 1982. The problem of course that he and his economists didn't understand is that the Texas Savings and Loans were doing what we've been describing in this podcast. Russ: They were the market leaders. Guest: Yes. And as a result they produced over 40% of the total losses in the entire Savings and Loans crisis. And this is the fundamental problem of relying on econometrics during the expansion phase of an epidemic of accounting control fraud. Because you will inherently get not just the wrong answer in terms of public policy--you will get the worst feasible answer. Russ: Yes, it's a destabilizing feedback loop. So, what is--trying to answer my earlier question: This kind of looting or control fraud occurs when I realize that my bank is dead, that my assets are worth less than I had thought, or less than I expected; my liabilities are greater than I expected and it turns out they are much greater than those assets; I realize that my bank is shot. And if an earnest and diligent set of evaluators came in they'd realize this also and I'd be shut down. Instead, I cover up that bad situation with the kind of behavior we talked about earlier, which allows me to sustain a personal lifestyle and package of compensation that's very attractive. Guest: And it's a sure thing and nobody's getting prosecuted. But here's the kicker to what you've just said: That describes 100 shops out of 3000. So, that's your point about ethics. And sociology, mores. If you had been a CEO--these things come from the C-suite--and you had worked at the Savings and Loans for 30 years and you'd risen through the ranks, and you'd hired pretty much everybody who had worked at your shop, this is a much less attractive strategy. Russ: Yes; you've got friends, you are in the community; you don't really want to have people pointing to that grotesque, bad development and say: He did that. Guest: That's right. And you are proud of your place, and you identify with it. And so in fact it was extremely unusual for these folks even though it appeared to be a sure thing. Russ: So most people didn't do that. Guest: And so, Larry White--this is the NYU Larry White, as opposed to your colleague--famously writes about this episode. And he was one of the Presidential employees running the Federal Home Loan Bank Board for several years--saying: The mystery for an economist is why there is so little fraud. Not why there was such extensive fraud. Russ: I understand. Guest: So, the key is entry. Russ: Is 10% half empty or half full? Guest: But the key is entry, which is a wonderfully fine economic concept forgotten by economists in discussing this crisis. So, the fraudsters grossly disproportionately are new entrants. And they are overwhelmingly real estate developers, who have intense conflicts of interest. Russ: Yes, funding themselves. Guest: And they are frequently crummy real estate developers, for the reasons we've discussed. Russ: So, they put out a shingle, start a bank, start collecting some deposits, start lending themselves money for projects that aren't going to make it. And their depositors of course are going to get their money back so long as they are not too large, and sometimes they do anyway.
42:12Russ: Let's move to the present. Or the semi-present--let's get up to 2008 and go forward. And I want to talk about, if we can, Fannie and Freddie and the investment banks. All of them were doing something similar, sometimes on their own--in the case of investment banks they were origination shops; in the case of Fannie and Freddie, they couldn't originate loans, they could only finance them and fund them and buy them. But both of these groups were grabbing up mortgages, packaging them into securities, and selling those securities, often to each other, often to pension funds and people all around the world. What's the parallel between that period, which is really roughly 2003-2008 when it totally fell apart, between that period of financial activity and the stories we've been telling? Guest: So, what we hadn't finished with the logical link is: Deregulation in the Savings and Loan crisis, the key event that is so fraud-friendly in terms of creating a criminogenic environment, occurs in 1982; and reregulation begins in 1983. So, it begins very quickly and therefore it's done in the face of unbelievably intense political pressure from both parties. So, that's a completely distinct pattern. Now, to understand the current crisis, you actually have to go to 1990, 1991, because that's when liar's loans become significant. And with all good fraud schemes in America, it begins in Orange County, CA. And it begins in large part at Long Beach Savings. And we are the regional regulators by that point. Russ: You? Who is "we"? Guest: We are the Federal Home Loan Bank of San Francisco; and then it becomes the Office of Thrift Supervision, West Region. And we go and we look at we say: Wait a minute. You are not going to do underwriting and that's going to produce immense adverse selection. You are going to have a negative expected value. You have to lose money doing this. This is insane. This can only make sense as a fraud scheme. You can't do it. And so we used normal supervisory means to wipe out liar's loans among Savings and Loans in Orange County in this era. Whereupon, they of course--they being Long Beach Savings--give up their Federal Charter. Give up Federal Deposit Insurance. And become a mortgage banker--for the sole purpose of escaping our jurisdiction. And they changed their name; and they become Ameriquest. And your listeners who are familiar with the story will recognize that name, because it is the first big and infamous maker of liar's loans and other nonprime loans. And on top of that it's a predatory lender that aims at minorities. Whereupon--and by the way, their leading competitor are two people, a husband-wife CEO team at Guardian Savings that we have removed and prohibited from the Savings and Loan industry, so they simply went to mortgage banking. Which is essentially unregulated. Russ: At the time. Guest: So that's where--so you have this era in 1990, 1991 in which you get hundreds of millions of dollars of losses from these loans, but they are pushed out of the regulated industry. There are two more crackdowns involving 49 state attorneys general, plus the Federal Trade Commission (FTC) suing Ameriquest. They settle for $400 million, which at that time was a large amount of money; and we promptly make the CEO of Ameriquest our Ambassador to the Netherlands. Russ: What year was that? Guest: Because, of course, he's the leading political contributor to the President of the United States. Russ: Strangely enough he had a lot of friends. Guest: He had friends again in both party. Russ: Yes, just like Countrywide did, and Fannie and Freddie. Guest: Anyway, so that's what happens: Overwhelmingly this stuff gets pushed, at first, out of the regulated entity. And so it becomes the mortgage bankers; and the mortgage bankers almost exclusively, for the first 8 years, are dealing with the investment banking firms. The Big Five.
47:39Russ: But I'm confused now. So, in early 1990s, there are some firms who are lending money to people who are not accurately representing their ability to repay the loans. Right? Guest: No. Russ: What's a liar loan? Guest: A liar's loan is--you are correct--involves false statements about income; but it is not the borrowers. It is overwhelmingly the lenders, for the same reasons as in the Savings and Loan crisis. Russ: Well, that's what I don't understand. So, I'm Long Beach Savings, to start with. And I am lending money. We're reversing roles here, Bill. Let's see if you and I can handle it and the listeners can handle it. I'm Long Beach; you have a modest income and you come to me and you want to buy a house. And I say: No, no, no, you don't want to buy that house. Here's a bigger house. And you say to me: Oh, no, but my income. I can't afford it. And you say: Don't worry. I'm going to lend you the money anyway, as if you had the income of 4 times what you actually have. Is that a liar's loan? Guest: That is a liar's loan, but that's not the most typical way that it's going to occur. The typical way it's going to occur, first, is through a broker. So, yet another party has to be introduced to this. So, to skip through: there's testimony in front of the Financial Crisis Inquiry Commission that it was common for the prior job of the mortgage broker to have been literally flipping burgers. So, you are the lender--you are Long Beach. You make the following deal and of course you don't have to have a discussion. You just send out your daily term sheet, starting out with hundreds but eventually tens of thousands of brokers. Communications--it got cheaper. And the term sheets creates an optimization thing that has three components. 1. Higher yield, good. You get a higher yield as a broker; I give you a higher fee. 2. Lower loan-to-value ratio, very good. I give you a higher fee. Russ: So, again, I'm the lender. I'm telling my brokers: Don't ask for much money down; charge them a high interest rate. And is there a third piece? Guest: No, no, no--you missed. It's actually the opposite. A lower loan-to-value ratio. Russ: Oh, sorry, sorry. Guest: You've done a lot. And also 3. A lower debt-to-income ratio. So, those are the three things that we are optimizing as a loan broker. And to skip forward to the current crisis, as you know, home prices in California are often very high. And so what we call a jumbo--a $600-$800 thousand dollar range--you could get as a mortgage broker, a $20,000 fee. For one jumbo. Russ: To bring me the loan that--the borrower that you are going to make the loan to. You are going to get $20,000. Guest: Correct. So you want to incent people to bring you these loans in extraordinary volume with the ultra-high yield; and then these two ratios gimmicked to make it look like the loan is safer. So, the reason, of course, is you are going to resell this loan. Russ: Who am I going to sell it to in 1991? That's what I'm wondering about. Guest: Oh. We're going to sell it to Lehman and--see, all of the investment banks had non-prime entities, at least one non-prime affiliate. Russ: Well, they had their own mortgage originators, too, in the non-prime world. Guest: Well, sometimes. Russ: Bear Stearns did. Guest: They most frequently did exactly what I've described here. So, Lehman Brothers, Aurora, actually had very few loans it made itself, but it made hundreds of thousands of these loans through brokers. Russ: But this is the puzzle. This is what I'm confused about. This is not 2003. You are saying this is 1992. How does Long Beach Savings make any money at this? You say because they are selling them to investment banks? Why would they buy them? They are lousy? Guest: Of course. It's a sure thing. Russ: Well, that's what I don't get. How does this relate to the earlier story where there was a Ponzi-like scheme that let me sustain an unsustainable situation for a while? Why is this a good business model in 1992? Guest: Okay. So, let me tell you the fraud recipe. And for both a lender and a purchaser of these. So, for a lender, it's got four ingredients: grow like crazy, by making really crappy loans but at a premium yield--and those first two things are related--with extreme leverage, and virtually no meaningful allowances for the future losses being recognized currently. Russ: So, how does Long Beach do that? Guest: Through this loan brokerage process that I'm describing. So, I told you the first two elements; the first two ingredients are related. I would, of course, love to grow exceptionally rapidly by making really high-quality loans. Russ: There aren't enough to go around. Guest: Yes; not only that. This is a). not a mature market, this is like iPads, and b). it's a very competitive market. And so what happens--let's do the thought exercise. I want to grow 50% a year, which by the way is what was the average of the accounting control frauds by Savings and Loans until reregulation. That's exceptional growth, as you know. All right. So, if I'm going to grow 50% a year by making extremely good quality loans, what do I have to do? I have to buy market share. How do I buy market share? I have to cut my yield. But in a relatively competitive marketplace, what are my competitors going to do? Russ: Same thing. Guest: They are going to chop their yield. So at the end of the day, is this a good way to create nominal income? No, it's a terrible way. You obviously destroy nominal income through that process. But there are tens of millions of people that cannot afford homes. Russ: They don't have the down-payment, they don't have the credit record, they don't have enough income. Guest: That is correct. I have a huge number of folks that I can lend to. And here's what's even better. As you know, we often have to spend a lot of our time with students explaining the fallacy of composition--that a strategy that's good for one entity can't work typically for an industry. If we all try to sell at the same time, the classic example, of portfolio insurance, it doesn't work really well. Russ: So, go ahead. Guest: But the fallacy of composition works the opposite way; when a bunch of us make bad loans. Because it turns out there are better places to make these loans. And that's going to be a combination of ease of entry, which assets are better for inflating values and hiding real losses, where is the risk of prosecution the smallest, etc. And therefore you get clustering. And you get emulation--what Akerlof and Romer talk about--the mimicking process. It's an easy strategy to emulate, right? Grow rapidly by sending these term sheets out to brokers. Anybody can do it with no brains.
56:22Russ: But I'm Long Beach, now, and I realize that if I want to have a big institution, I can't just compete like everybody else. I can't just go to the good credit risks. I have to start lowering my standards, lend to people who are not normally going to get a loan, who don't have the income, don't have the credit rating; and I start offering them loans that normally wouldn't get made. So I have two questions. One is: Why do I do that? And is the answer: Because I'm going to look like I'm generating--how do I, why is that good for me as the executive of the bank? Where's the looting? Guest: Sure. So, I create three sure things--again, adapt Akerlof and Romer's phrase. The first sure thing is if I follow this recipe I am mathematically guaranteed in the near term to report not just good profits, but record profits, off-the-chart profits. Two, with modern executive compensation, I will become wealthy. And three, again, if you think about that recipe, I'm actually maximizing real losses, real economic losses. Russ: So, where do I get the money from, to fund this escapade? This is not quite like the earlier story, right? I've got to give money to people who are going to use it to buy houses. Guest: Without deposit insurance, it is harder to hold it in portfolio. You should not assume the impossible. And Ireland should be your cautionary tale, where there was essentially no secondary market and they did very similar things. Because it turns out you can expand, even in the Irish context. Okay, so, but back to your point. How do they get the money? They had an originate-for-sale model. Now, as you've said, they are selling overwhelmingly to surely-private parties. And neoclassical theory says: It's impossible. They will exert private-market discipline. Russ: In theory. Guest: Right. But we ran a real-world test of the theory, and it turns out folks not only will buy it, but they will eagerly buy it. And they will expand. So, what's the formula for accounting control fraud by a purchaser of these entities? Well, it's essentially the same thing. Instead of the first ingredient--sorry, second ingredient--make really crappy loans, I purchase really crappy loans. And I report really nice yields. Now, can this keep going forever? Of course not. Can I keep going for a significant period, as in 8-10 years? Yes. Yes. If these things cluster and we hyperinflate the bubble. Because the saying in the trade is "a rolling loan gathers no loss." Russ: Right. Guest: So, I can refinance the bad loans, and I can hide the delinquencies for a decade. And again, we ran a real world test of that, which showed that's precisely what you could do. Russ: My only defense of neoclassical theory is, again, I think there was the potential expectation that this would not turn out as bad as it looked. But let me just again restate the idea. You are saying that Bear Stearns, Lehman, Citi, etc.--let's forget all the complexities of derivatives and CDOs and all this--I have a temptation to buy up really bad loans, put on my books an expected stream of earnings that probably and almost certainly will not materialize--but that's not known yet. So, I put on my books that I have 30 years of wonderful payments coming in because the historic default rate is a fraction of what it will ultimately be, because that historic rate is predicated on a different set of people borrowing than are actually borrowing now. And, in the short run, which could be a few years, I make really great paper profits; but I'm not really standing over a viable institution. Guest: Right. And to quote someone who has been on your podcast, you also create plausible deniability. Russ: Who are you quoting? Guest: Charles Calomiris. [N.B. quote is not from the podcast but appears in various forms in other material by Calomiris, exact source unknown--Econlib Ed.] "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. They may have reasoned that other competitors were behaving similarly and that they would be able to blame the collapse when it inevitably came on an unexpected shock." And then he says, derisively, "Who knew?" Russ: Sarcasm. Guest: So, Charles is, say from a pretty opposite side of the spectrum from me, and of course has also run a bank; and was perhaps the leading economist in the world, urging internationally that you deregulate banks coming into this crisis. Bo [?] McCallister, who was at Pinkus Warburg, here's what he said: "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." And here are the numbers: After the FBI warned, in September 2004, that there was an epidemic of mortgage fraud and predicted that it would cause a financial crisis if it were not contained, and after the industry--the mortgage, lending industry's own anti-fraud experts issued the following five warnings, in writing, in 2006, to essentially every mortgage lender in the United States: 1. Have you morons forgotten that we've done this before, in 1990 and 1991 and it caused hundreds of millions of dollars in losses? 2. Stated income loans, and I quote, an open invitation to fraudsters. 3. The incidence of fraud in liar's loans is 90%--nine, zero. 4. These loans deserve the phrase that the industry uses behind closed doors to describe them. They are liar's loans. And 5. The banking regulatory agencies--and this is under Bush--are warning against making these loans. The industry massively expanded the number of liar's loans it made, such that by 2006, the best estimates are that 1/3 of all the loans made in that year were liar's loans. And remember, liar's loans and subprime are not mutually exclusive categories. So, by 2006, half of all the loans called subprime were also liar's loans. And now, what is the key difference? I explained to you we used to have rules on underwriting. In 1993. So, this goes way back. Under Clinton. They got rid of that as part of reinventing government. And examiners were instructed to refer to bankers as their clients. And rules were bad, and guidelines were in. So there's now a guideline on underwriting. And a guideline is unenforceable. And so the absolute perfect thing for not creating a perfect paper trail and no longer creating the dilemma about should I put false information in the loan file or should I take out honest information that shows I knew it was a bad loan--the absolute perfect device for fraud, is the liar's loan. Because you don't document. You don't verify. And so the paper trail is much easier for fraud in the current crisis. And then the other key is we eventually developed an incredibly effective means of dealing with the frauds, in the form of criminal prosecutions, administrative enforcement actions, and civil cases. And convicted over 1000 elites--these are not the little cases. Russ: This is in the 1980s. Guest: In the 1980s. And made well over--just our agency--made well over 10,000 criminal referrals. I mean well over 10,000 criminal referrals. Russ: Well, that was unpleasant for those people. Guest: It was. Russ: So, now they found a new way to live. Guest: So, our agency, our same agency in this crisis, the Office of Thrift Supervision, made 0 criminal referrals. And the Office of the Comptroller of the Currency (OCC), depending on who you believe at the OCC, made either 0 or 3. For which you say: [?]. Russ: Which means? Guest: Three is none.
1:07:45Russ: This is so interesting. Let's try to finish with a conversation about what we agree on and what we don't agree on. So, you and I might disagree about the behavior and the incentives that were in place. We might disagree about the moral hazard. Where we agree is that by failing to prosecute actual fraud and by reducing the incentives for creditors to police risk-taking, we have certainly created an environment right now that is an unbelievably unhealthy situation. And I have to say, and you can correct me if I'm wrong, that when I'm watching a football game, and I do from time to time, and I see an ad for a credit card that offers this glorious rate of interest and all these special, wonderful things that come with it, and all kinds of prizes and rewards, I'm thinking: You know, that reminds me of a S&L situation, where you offer a really high rate of return to your depositors, and then you just take the money and you do some really dumb things with it; and it doesn't really matter. What have we done in the last 4 years other than make this problem worse? And, what should we have done? I'm giving you 5-10 minutes for this, Bill; I know you'd like another hour and a half; maybe we'll revisit it in another podcast. But what do you think we have done to fraud incentives in the last 3-4 years, and what should we have done? Guest: Well, I agree with you fundamentally that we have made the world much more criminogenic. So, I have a doctorate in criminology, and this is what I primarily research--why do you have recurrent intensifying financial crises brought on by these kinds of frauds? And it's a lot of the usual--the unintended consequences. But here are the unintended consequences of doing things like deregulation and modern executive compensation. And of course, I'm not unusual in this. Michael Jensen, the intellectual godfather of modern executive compensation, says that he's created a Frankenstein monster of creating perverse incentives. So, first, deal with the systemically dangerous institutions. And here, the Administration can't even be honest. It calls them systemically important, like they deserve a gold star. But they are vastly beyond any efficiencies of scale. They are inefficient; we would make the world more efficient and we would dramatically reduce systemic risk if we shrunk them to the size that they pose no systemic risk of global collapse. As long as they are this big, they are going to get away with murder. And worse, they will create a Gresham's dynamic. And this is something Akerlof warned about in his famous 1970 article on lemons markets, where cheaters prosper. Bad ethics can drive good ethics out of the marketplace. So, that fundamental task, as financial regulators, is to make market discipline more effective by getting good information out and by removing the cheaters, who create the perverse incentives to match what I'm doing or die. So, that's what we want. We want, a). stop the systemic institutions from growing, because we are making it worse now by making them bigger; 2. We don't tell them how to shrink, but we give them 5 years to shrink. They can use their managerial judgment about how to do that. And 3. is, in the interim, you regulate them much more intensively. Executive compensation is broken. Everybody knows it's broken. Everybody knows that what really happens with executive compensation has nothing to do with what we teach about how to align the interests. In fact, it further misaligns it. And if you want the expert, it's Frank Raines, Fannie Mae, who said famously: If you wave enough money in front of folks, good people will do bad things. And that's exactly what happens. We can't, if you are Enron--think about how Enron works. You can't send a memo to 3000 Enron employees saying: You know what we'd like to do? We'd like to engage in pervasive accounting fraud because then we'll get rich in the interim and we'll walk away from the husk. Russ: Because you could go to jail. Guest: But you could send the same message through your executive compensation, through what GE made famous: rank and yank [?] Russ: Which is? Guest: All you had to do was add one message. And that message will get around the firm within seconds. The message is this: We don't care whether your reported income is real or not. If you create fictional reported income--and Enron did that pervasively--then we will make you rich. So, you've got to fix executive compensation. You've got to restore the criminal referral process--which was essentially eliminated in the regulatory agencies. You have to stop this proposed settlement, at least as it's publicly reported, under which the Justice Department, purportedly, is going to give immunity from criminal prosecution for frauds in the process of making the loans--which is overwhelmingly where the fraud occurred, in vast dollar amounts. So, those things you need to do. You need to reinstate the underwriting rule. Guidelines are the most useless regulatory activity in existence. They are the nattering state. The people that need the rules will utterly ignore at all times your guidelines.
1:14:43Russ: So, let me give a political economy take on what you've said. I'm going to add a piece to it, and then I'll let you have the last word. Somewhere in the late 1980s or early 1990s, there was a feeling among politicians that America's home ownership rate was not doing what it should be doing. It actually started in the early 1980s. And there was political pressure--and good intentions--to try to get the home ownership rate up. There was of course also political pressure to allow people to expand their businesses in the financial sector; and this is what Bruce Yandle has called a bootlegger and baptist situation, where you have good motives mingling with really pecuniary and not-so-good motives. But I think a lot of politicians managed to convince themselves, in both Parties, that if they could loosen the spigot on money going into the housing sector, they would be able to increase the home ownership rate. And so, the kind of things that you've been talking about, and that we've been talking about in this program for a long time--changes in underwriting, changes in requirements for Fannie and Freddie to purchase loans, changes in how investment banks structure themselves--all these things came together to allow an enormous sum of money to go into housing rather than elsewhere. A lot of people managed to convince themselves that was a good thing, either because they were getting extremely rich--and that includes the builders along with the financial sector that was the greaser of the wheels--or because it was good for America to have more people owning homes than renting. And it blew up. It was an unsustainable strategy. It has created a hideous set of political and economic results. And it seems to me we've barely learned these lessons. What's your take? Guest: I agree with most of the things you say except I think it had almost nothing to do with the crisis. So, it's, I think, really naive to believe that any lender made loans because they thought it made politicians happy. Lenders made loans because it made individual lenders--I don't mean companies, I mean people--much, much wealthier. And they created those incentive structures not because they could care less about people. In fact, of course, the leading victims--and I would guess we both agree on this--have been the working class people, particularly minorities, who after all were put in vastly overpriced houses at the peak of the world's largest bubble, and have had a devastating loss of their net worth. Russ: I've got to interrupt you there. I think there are a lot of tragic individual stories. But many of the people who lost their homes never had any equity in them to start with. So, their wealth was not wiped out. Their credit rating has been wiped out. Many of them didn't have much of a credit rating before. And it's a horrible thing to have to lose your house--of course, there's an enormous emotional toll on folks. But it's not quite as bleak as you are making it out to be. Guest: Actually, I think evidence will show that it is. You are quite right that how much you put into a house matters. But I think you will find even with folks with no down payment--which is sort of the extreme case. Russ: There were a lot of those during this period. Guest: There were many. That they actually make very substantial investments. And you know as a homeowner. It ain't just your down payment, in terms of your exposure. So, these folks--many of them are in states that allow deficiency judgments as well, and we have changed the bankruptcy laws to be much less consumer-friendly, particularly on first homes as opposed to second homes. But let me come back to the more fundamental point. Like you, we are always looking for natural experiments, for what they can teach us. Liar's loans is something where no governmental entity encouraged them. In fact, even the Bush Administration banking regulators, who were not fond of regulating, consistently disparaged those kinds of loans. And nobody ever required Fannie and Freddie to purchase a liar's loan. They chose to do so, and they increased it massively; from 2003-2006 the number of liar's loans increased by over 500%. So, we think this actually is a story, driven overwhelmingly by what we call accounting control fraud; and we think no one much doubts that about the Enron era. And we think there is pretty good consensus on the Savings and Loan crisis as well, because of all the factual record. We had to go up against the best criminal defense lawyers in the world, and we got a 90% conviction rate. Plus, we satisfied the economists that looked. I quoted from the National Commission, which was run by economists, that concluded that at the typical large failure, fraud was invariably present. But if you go and read the economic literature on this crisis, you will find that Akerlof and Romer are cited for example in maybe, generously, 1 out of 100 articles that purport to discuss the causes of the crisis. And you will see that fraud is virtually never discussed as even a potential major contributor. And that is poor; and that is really the tribal taboo that still exists in economics against any serious consideration of the word fraud.