Tag Archives: Financial system

The Washington Mutual Wish List: Optimizing a Criminogenic Environment

By William K. Black

(Cross-posted from Benzinga.com)


























The High Price of the President’s Council of Economic Advisors’ Failure to Read Akerlof & Romer

(Cross-posted from Benzinga.com)

By reviewing the annual reports (2005-2007) of President Bush’s Council of Economic Advisors (CEA) I learned that the Council had some interest in fraud, but no understanding of elite fraud and its implications for the economy.  The reports make sad reading.  They deny the developing crisis entirely and they do so for reasons that reflect badly on economics and economists. 

The CEA’s reports’ analysis of the developing fraud epidemics and crisis reveal critical weaknesses in theory, methodology, empiricism, candor, objectivity, and multi-disciplinarity.  Overwhelmingly, the reports ignored the developing crises and their causes.  Worse, as late as 2007, they denied – even after the bubble had popped – that there was a housing bubble.  When the nation and the President vitally needed a warning from its Council of Economic Advisors the CEA did not simply fail to warn, but actually advised that those who warned of a coming crisis were wrong. 

This column does not focus on the CEA’s claims that there was no housing bubble.  Like the National Association of Realtors’ top economist who became known to the trade press as “Baghdad Bob” (the mocking nickname journalists gave Saddam Hussein’s press flack after he denied U.S. troops were in Baghdad), the CEA’s specious bubble denial is an obvious embarrassment.  Their Japanese counterparts did far better in warning of the developing real estate bubble in the 1980s.  The collapse of the twin Japanese bubbles in 1990 and the resultant “lost decade” should have caused the CEA to recognize the gravity of the risk bubbles pose and importance of identifying them promptly.  Instead, the CEA gave in to the temptation to claim that the President’s brilliant policies had produced a wonderful economy.  The reality was that the economy was headed over the precipice.

The focus of this column is on the portion of the CEA’s annual report for 2006 that discussed the theory of financial intermediation and financial regulation.  Indeed, the column focuses on a small subset of the defects in those portions of the report.  I write to emphasize how a theory (“control fraud”) developed two decades ago by regulators, criminologists, and economists could have saved the CEA from analytical and policy errors with regard to financial crises and regulation and led it to identify the crisis and recommend effective measures to contain it.  The tragedy is that the CEA discussion of the theory of financial regulation embraces three of the most useful theoretical insights – adverse selection, lemon’s markets, and the centrality and criticality of sound underwriting to the survival of lending institutions.  These theories are interrelated and they are essential components of control fraud theory.  

Had the CEA understood the true import of these three economic theories it could have gotten the crisis right instead of making things worse.  White-collar criminologists and economists share these three theories (among others) and employ a (limited) “rational actor” model.  (Criminologists never made the mistake of assuming purely rational behavior.  Even neoclassical economists now generally acknowledge that behavioral economics research demonstrates that economic behavior can be irrational in important settings.)  In the 1980s and early 1990s, the efforts of a small group of criminologists, economists, and regulators to understand the causes of the developing S&L debacle led them to develop a synthetic theory that criminologists refer to as “control fraud theory.”  Unfortunately, the typical theoclassical economic treatment of these three theories, exemplified by the CEA’s 2006 report, ignores control fraud.  The result is that the 2006 CEA report misstated the predictions of each of the three theories that it discussed and concluded “no problem here.”  In reality, the three theories predicted that there were epidemics of accounting control fraud 
that were leading inevitably to a catastrophic crisis.

The context of the 2006 CEA report’s discussion of the three theories is a treatise on the theory of financial intermediation and its implications for financial regulation.  The treatise is over the top in its praise of the U.S. financial industry.  The CEA claimed that the U.S. financial deregulation gave its financial sector a “comparative advantage” over other nations.  The CEA cited the financial sector’s rapid growth in size and profits as proof of this comparative advantage and asserted that the financial sector’s rapid growth led to more rapid U.S. economic growth and increased financial stability.  The CEA’s theory of financial intermediation posited that banks exist to minimize the informational difficulties that beset lending and investment.  The CEA concluded that U.S. banks were growing rapidly because deregulation made them ever more efficient in minimizing these informational defects.

Adverse Selection
The CEA addressed three forms of informational defects that banks helped reduce.  The CEA began by discussing “adverse selection.”  Adverse selection was the key to understanding and preventing the developing crisis.  In the lending context, adverse selection arises when a lender’s policies selectively encourage lending to borrowers who pose greater credit risks that are unknown or underestimated by the lender.  Adverse selection can be one of the consequences of “asymmetrical information.”  (Adverse selection also poses a serious risk to honest insurance companies.) 

Because the lender does not know (and therefore is not compensated for) the full extent of the risk of default adverse selection produces a “negative expected value” for lenders.  In plain English, they lose money.  For a residential mortgage lender, adverse selection is fatal because the loans are so large and the loan proceeds are fully disbursed at closing.  It is essential to understand that adverse selection is not equivalent to credit risk.  A mortgage lender makes money by taking prudent credit risks.  Banks “underwrite” prospective borrowers and collateral in order to identify, understand, quantify, and price credit risk.  Prudent underwriting minimizes adverse selection.  Mortgage lenders that fail to underwrite create severe adverse selection and fail.  Honest home lenders would never gut their underwriting standards and create adverse selection.    

The existence of a secondary market does not change an honest home lender’s incentive to engage in prudent underwriting.  Neoclassical theory predicts that the ultra sophisticated investment banks that ran the secondary market would only purchase loans they had prudently underwritten.  A lender that failed to underwrite effectively would be unable to sell its loans in the secondary market.  Neoclassical theory also predicts that the secondary market would only purchase loans sold with guarantees against fraud.  The first prediction, of course, proved false but the second prediction was typically true.  All of the mortgage lenders that specialized in making large numbers of loans under conditions that maximized adverse selection failed even before the cost of the guarantees would have destroyed them because their “pipeline” losses exceeded their trivial (fictional) capital.       

The most severe form of adverse selection is fraud.  The ultimate form of adverse selection is accounting control fraud.  Any experienced banker or insurer knows that adverse selection can lead to fraud.  Fraud maximizes the asymmetry of information because the information provided to the victim contains data that are false and material.  The fraud makes the loan look far less risky than it really is. 

In 2006, MARI, the anti-fraud group of the Mortgage Bankers Association (MBA), reported to MBA members that “stated income” loans were an “open invitation to fraudsters” and that they deserved the term used behind closed doors in the industry, “liar’s loans,” because the incidence of fraud in liar’s loans was 90 percent.  The defining element of liar’s loans was the failure to conduct essential underwriting.  Moreover, fraudulent nonprime lenders typically simultaneously maximized adverse selection and created deniability by creating large networks of loan brokers to prepare the fraudulent loan applications. 

The percentage of nonprime loans made without prudent underwriting is not known with precision because there were no official definitions of stated income, alt-a, or liar’s loans.  Subprime and liar’s loans were not mutually exclusive.  By the time the CEA wrote its 2006 report roughly half of the loans lenders termed “subprime” were also liar’s loans.  Credit Suisse’s March 12, 2007 study (“Mortgage Liquidity du Jour: Underestimated No More”) presented data estimates that roughly 30% of all mortgage loans made in 2006 were liar’s loans.  That frequency produces an annual mortgage fraud incidence of well over one million.  The FBI had put the entire nation on alert about the developing “epidemic” of mortgage fraud in its September 2004 House testimony.  The FBI predicted that the fraud epidemic would cause a financial “crisis” unless the epidemic was contained.  In 2006, no one believed that the epidemic was being contained. 
What everyone, including the CEA, knew in 2006 was that mortgage underwriting standards for nonprime loans were in freefall while other “layered risk” characteristics were multiplying.  This meant that nonprime lenders were dramatically increasing adverse selection while making loans that were ever more vulnerable to losses from adverse selection.  Everyone, including the CEA, knew that the only reason this could occur was the rapid growth of the three “de’s” – deregulation, desupervision, and de facto decriminalization.  Everyone, including the CEA, knew that no one was forcing the nonprime lenders to make liar’s loans.  That should have led the CEA to ask why the senior officers controlling nonprime lenders were deliberately causing the lenders to make loans that created intense adverse selection, endemic fraud, massive (longer-term) losses, and the failure of the lender.  That behavior makes no sense under the theory of financial intermediation advanced by the CEA.  No honest lender CEO would engage in that pattern of behavior.  The nonprime lender CEOs’ behavior only makes sense if they are engaged in accounting control fraud.  The recipe for maximizing fictional accounting income has four ingredients and adverse selection optimizes the first two (rapid growth through making very poor quality loans at premium yields).      
Unfortunately, the CEA’s 2006 report was devoid of any real analytics or facts related to adverse selection.  Indeed, the report’s entire discussion of financial institutions is bizarre because it is not simply removed from any factual context but based on factual assumptions that were contrary to reality and becoming ever more contrary to reality in 2006.  The discussion is a surreal theoretical exercise based on unstated factual assumptions that are the opposite of reality.  The (inevitable) result of its unstated assumptions is the worst possible financial regulatory policy advice that the CEA could give in 2006 – everything is wonderful because our financial intermediaries prevent adverse selection.  The CEA wrote to warn us of the dangers of excessive financial regulation at a time when financial regulation had been eviscerated.
The CEA’s discussion of adverse selection ignored the risk of fraud during what the FBI had aptly termed a fraud “epidemic.”  Instead, it premised its concern on managers of high quality projects being unwilling to seek commercial loans from banks because banks charged excessive interest rates for even high quality projects because of their inability to differentiate bad and high quality business projects.  In reality, interest rates on commercial loans were exceptionally low – even for poor quality business projects.  The CEA’s discussion of adverse selection was premised on an alternate universe.
Lemon Markets
The CEA discussed lemon markets in conjunction with its discussion of adverse selection.  A lemon market reaches its nadir when bad quality products drive good quality products out of the marketplace.  Control fraud theory agrees that lemon market and adverse selection are interrelated theories and provide the keys to understanding why control frauds cause such devastating injury.  George Akerlof was awarded the Nobel Prize in Economics in 2001 for his 1970 article on markets for lemons, which was a pioneering article on fraud and asymmetrical information.  As I have explained, fraud produces the epitome of adverse selection and control fraud is the ultimate form of fraud.  The examples Akerlof provided of sales of goods that posed lemon problems were anti-customer control frauds.
The CEA does not mention Akerlof in its discussion of lemon markets.  This was deeply unfortunate, for it reinforced the CEA’s failure to discuss the epidemic of control fraud by nonprime lenders.  The CEA also failed to explain one of Akerlof’s most important theoretical contributions in his 1970 article, the “Gresham’s” dynamic.  Akerlof used Gresham’s law (bad money drives good money out of circulation in hyperinflation) as a metaphor to explain why market forces became perverse in the presence of asymmetrical information.  The anti-customer control fraud that sells an inferior good through the claim that it is a high quality good gains a large cost advantage over its honest competitors.  If they are driven into bankruptcy or emulate the fraudulent practices good quality goods – and honest sellers – will be driven from the marketplaces by competition.  This happened recently in the Chinese infant formula market, where honest manufacturers were driven out of the market, six infants were killed, and over 300,000 were hospitalized.  The perverse effects of extreme executive compensation largely driven by short-term reported earnings have now created a perverse Gresham’s dynamic in many firms, particularly in the finance industry.  The CEA did not mention the perverse incentives produced by control fraud and modern executive compensation and why markets make the environment even more criminogenic rather than restraining fraud.  Implicitly, however, the CEA recognized that there was some perverse market dynamic that could drive lemon markets to their nadir where “only the worst-quality” good would be sold. 
The CEA compounded its error of not discussing Akerlof’s 1970 analysis of control fraud and the Gresham’s dynamic by failing to address George Akerlof and Paul Romer’s 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”).  Their 1993 article analyzed accounting control frauds.  The CEA’s discussion of financial intermediaries also included a discussion of “moral hazard.”  As with its discussion of adverse selection, the CEA’s discussion of moral hazard implicitly excluded all fraud.  There is no theoretical basis for this exclusion.  Economics (and reality) has long recognized that moral hazard can lead to excessive risk or fraud.  Fraud is often a superior strategy (in terms of expected value – not morality).  As Akerlof & Romer stressed, accounting control fraud is a “sure thing” (1993: 5).  “Gambling for resurrection” is a near sure thing, but in the opposite direction.  The economic theory of how the insolvent or failing bank’s owners maximize the value of their “option” predicts that they will engage in such extraordinary risk that their gamble will nearly always fail. 
But Akerlof & Romer endorsed another point that S&L regulators and criminologists stressed – the manner in which S&Ls purportedly engaged in honest gambling due to moral hazard made no sense for a rational (honest) actor.  Please read their explanation with particular care for its obvious application to our ongoing crisis should be glaring.
“The problem with [economists’ conventional description of moral hazard as an] explanation for events of the 1980s is that someone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending:  maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.*  Examinations of the operation of many such thrifts show that the owners acted as if future losses were somebody else’s problem.  They were right (1993: 4).”
Akerlof & Romer went on to explain that accounting control frauds optimize fictional income by making loans with a negative expected value and by deliberately seeking out borrowers with poor reputations (1993: 17).  Their logic relies implicitly on the deliberate creation of adverse selection by the lender and the creation of a Gresham’s dynamic both among borrowers and those that aid and abet the CEO’s frauds, e.g., the appraisers when they inflate appraisals.

There is no good explanation for why the CEA would cite the Akerlof’s famous theory on lemon markets yet ignore the FBI’s 2004 warning, the experience of the S&L debacle (and the public administration literature on the successful regulatory fight against the control frauds), the Enron era accounting control frauds, Akerlof & Romer’s theory of accounting control fraud, and criminology’s theory of control fraud.  The basic fraud mechanisms had so many parallels that one is forced to the conclusion that the CEA and its staff never read the most important modern economic article on bank failures.  Akerlof & Romer explicitly noted that accounting fraud created perverse “lemon” projects (1993: 29).  It is bizarre that the CEA wrote in 2006 for the express purpose of opposing essential financial regulation and thought that the best way to make its case was to cite theories most closely associated with George Akerlof while ignoring his application of those theories to financial regulation and his research findings on the reality of accounting control fraud.  Note that Akerlof & Romer were writing about precisely the point the CEA was discussing – the role of banks with respect to information asymmetries.  Worse, Akerlof & Romer’s point was that one could not assume that banks acted to reduce information asymmetries because banks engaged in accounting control fraud did the opposite.  Akerlof & Romer also explained how accounting control frauds caused Texas real estate bubbles to hyper-inflate.  If there was one economics article the CEA needed to read carefully it was Akerlof & Romer.  Akerlof was a Nobel Prize winner well before the CEA wrote its 2006 annual report.   
But the CEA could have learned the same vital facts about fraud and financial crises had it read the criminology literature, the regulatory literature on the S&L debacle, or the public administration literature.  The CEA had experienced recently the Enron-era accounting control frauds and the S&L debacle was relatively recent.  The CEA’s failure to even consider the role of fraud in financial crises, particularly after the FBI’s stark warning in 2004, was unconscionable.  Akerlof & Romer went out of their way to warn economists of the dangers of control fraud.
“Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself (1993: 60).”
My criminology colleagues and I sent the same warnings, as did the S&L regulators and public administration scholars.  The FBI sent an explicit warning.  None of us were able to get through to the Clinton, Bush, or Obama administrations.  They have all ignored the epidemic of accounting control fraud that hyper-inflated the real estate bubbles and drove the financial crisis.    
The Necessity and Centrality of Effective Underwriting
The CEA report continues its triumphal “just so” story approach to financial services by explaining how banks develop expertise in evaluating credit risk and use collateral as a means of inducing borrowers to “truthfully” rather than “strategically” release information on the true value of the real estate to the lender.  By 2006, the nonprime industry was notorious for deliberately inflating appraisal values so that it could make more and larger fraudulent loans.  Surveys of appraisers showed widespread efforts by lenders and their agents to coerce appraisers to inflate valuations.  No honest lender would ever coerce an appraiser to inflate a collateral valuation.  Only lenders and their agents can engage in widespread appraisal fraud.  Appraisal fraud is a “marker” of accounting control fraud.  The “strategic” behavior with regard to appraisers was by fraudulent lenders and their agents.  It relied on endemic, deliberate deceit.  Appraisal fraud is particularly egregious in residential home lending because it can lead borrowers to overpay for their home and to fail to understand the risks of purchasing a home. 
The greatest analytical defect in this section of the CEA report, however, is its false dichotomy between economic efficiency and financial regulation.  The CEA was on to something important.  A well run banking system does reduce adverse selection and make markets less inefficient.  A well run banking system does so by engaging in expert underwriting of significant loans such as home loans.  A bank that does not engage in expert underwriting poses a grave danger.  At best, it is incompetent.  Far more dangerously, it is often engaged in accounting control fraud.  A regulation that requires a lender to engage in prudent underwriting imposes no costs on honest banks and it saves society from vast amounts of damage.  When the regulatory agencies gutted the underwriting rules by turning them into guidelines they set us on the road to the Great Recession.  Effective financial regulation begins with mandating prudent underwriting.  Rules mandating prudent underwriting make financial markets far more efficient and stable by blocking the perverse Gresham’s dynamic that otherwise can create a criminogenic environment.  
The CEA was correct in explaining that the raison d’être of financial intermediaries is the provision of exemplary underwriting.  It is, of course, significantly insane that the CEA would implicitly assume in 2006, contrary to known facts, that nonprime lenders, the investment banks packaging CDOs, and the rating agencies were prospering because they were engaged in exemplary underwriting.  The CEA, in the two most important reports it issued in modern times (2005 and 2006), got the developing financial crisis and regulatory policy as wrong as it is possible to get something wrong. 
No economist should be allowed to graduate from a doctoral program without reading Akerlof & Romer.  It would also be salutary to expose any doctoral candidate interested in finance or regulation to the relevant work of criminologists and public administration scholars.  Collectively, our work on control fraud has shown great predictive strength while neoclassical economic work (both macro and micro) and “modern finance” have suffered repeated, abject predictive failures. 

Every financial regulatory agency should have a “chief criminologist.”  The financial regulatory agencies are civil law enforcement entities whose primary responsibility is to limit control fraud, but they virtually never have anyone in authority with expertise in identifying, investigating, and sanctioning control frauds.

* Black (1993b) forcefully makes this point.

Randall Wray Interviewed on KPFK’s Daily Briefing

Randall Wray was interviewed recently on the economics and politics of the banking industry.  The full program can be found here, with Professor Wray’s interview beginning at 39:00.

Investment Banking by Blood Sucking Vampire Squids

By L. Randall Wray

While investment banking today is often compared to a casino, that is not really fair. A casino is heavily regulated and while probabilities favor the house, gamblers can win abut 48% of the time. Casinos are regulated—by the state and presumably by the mob. Top executives who steal funds end up wearing very heavy shoes at the bottom of the ocean.

By contrast, the investment bank always wins, and its customers always lose. Investment banks are “self-regulated” (meaning, of course, they do whatever they want—sort of like leaving your 15 year old at home alone all summer with the admonition to “behave yourself” and keys to the liquor cabinet and the Porsche). Top management rakes off all the funds it wants with impunity. And then the CEOs go run the Treasury to bailout the investment banks should anything go wrong.

This summer I was lunching with a trader who works for one of these investment banks (hint: there are not many left, and he was not with Goldman). Speaking of Goldman he said “those guys are good”. Indeed they are so good, he said, “I don’t know why anyone would do business with them.”

He explained: When a firm approaches an investment bank to arrange for finance, the modern investment bank immediately puts together two teams. The first team arranges finance on the most favorable terms for the bank that they can manage to push onto their client—maximizing fees and penalties. The second team puts together bets that the client will not be able to service its debt. Since the debt cannot be serviced, it will not be serviced. Heads and tails, the investment bank wins.

Note that this is also true of hedge funds and the half dozen biggest banks that are bank holding companies providing a full range of financial “services”.

In the latest revelations, JPMorgan Chase suckered the Denver public school system into an exotic $750 million transaction that has gone horribly bad. In the spring of 2008, struggling with an underfunded pension system and the need to refinance some loans, it issued floating rate debt with a complicated derivative. Effectively, when rates rose, that derivative locked the school system into a high fixed rate. Morgan had put a huge “greenmail” clause into the deal—the school district is locked into a 30 year contract with a termination fee of $81 million. That, of course, is on top of the high fees Morgan had charged up-front because of the complexity of the deal.

To add insult to injury, the whole fiasco began because the pension fund was short $400 million, and subsequent losses due to bad performance of its portfolio since 2008 wiped out almost $800 million—so even with the financing arranged by Morgan the pension fund is back in the hole where it began but the school district is levered with costly debt that it cannot afford but probably cannot afford to refinance on better terms because of the termination penalties. This experience is repeated all across America—the Service Employees International Union estimates that over the past two years state and local governments have paid $28 billion in termination fees to get out of bad deals sold to them by Wall Street. (See Morgenson www.nytimes.com/2010/08/06/business/06denver.html)

Repeat that story thousands of times. Only the names of the cities and counties need to be changed. Analysts say that deals like that pushed onto Denver would never be accepted by for-profit firms. Investment banks preserve such shenanigans to screw the public. Michael Bennet, who was the head of the school district pushing for the deal had worked for the Anschutz Investment Company—so he knew what he was doing. He was rewarded for his efforts—he is now a US senator from Colorado.

Magnetar, a hedge fund, actually sought the very worst tranches of mortgage-backed securities, almost single-handedly propping up the market for toxic waste that it could put into CDOs sold on to “investors” (I use that term loosely because these were suckers to the “nth” degree). It then bought credit default insurance (from, of course, AIG) to bet on failure. By 1998, 96% of the CDO deals arranged by Magnetar were in default—as close to a sure bet as financial markets will ever find. In other words, the financial institution bets against households, firms, and governments—and loads the dice against them—with the bank winning when its customers fail.

In a case recently prosecuted by the SEC, Goldman created synthetic CDOs that placed bets on toxic waste MBSs. Goldman agreed to pay a fine of $550 million, without admitting guilt, although it did admit to a “mistake”. The deal was proposed by John Paulson, who approached Goldman to create toxic synthetic CDOs that he could bet against. Of course, that would require that Goldman could find clients willing to buy junk CDOs. According to the SEC, Goldman let Paulson suggest particularly risky securities to include in the CDOs. Goldman arranged 25 such deals, named Abacus, totaling about $11 billion. Out of 500 CDOs analyzed by UBS, only two did worse than Goldman’s Abacus. Just how toxic were these CDOs? Only 5 months after creating one of these Abacus CDOs, the ratings of 84% of the underlying mortgages had been downgraded. By betting against them, Goldman and Paulson won—Paulson pocketed $1 billion on the Abacus deals; he made a total of $5.7 billion shorting mortgage-based instruments in a span of two years. This is not genius work—an extraordinarily high percent of CDOs that are designed to fail will fail.

Previously, Goldman helped Greece to hide its government debt, then bet against the debt—another fairly certain bet since debt ratings would likely fall if the hidden debt was discovered. Goldman took on US states as clients (including California and New Jersey and 9 other states), earning fees for placing their debts, and then encouraged other clients to bet against state debt—using its knowledge of the precariousness of state finances to market the instruments that facilitated the shorts.

To be fair, Goldman is not alone — all of this appears to be common business procedure.

There is a theory that an invisible hand will guide unfettered markets to perform the public interest. In truth, unregulated Wall Street bets against the public and operates to ensure the public loses. Investment banks are now all corporations (and all have bank charters). Corporations and banks are chartered to further the public purpose. Why do we allow them the screw the public?

Let Banks Choose: Bonuses or Bank Charters?

L. Randall Wray

Now here is the best idea we have seen yet. Britain’s Financial Services Authority has come up with the ultimate response to bank claims that they must pay high bonuses to the geniuses who caused the crisis. Just as Timmy Geithner claimed, while trying to protect his Wall Street handlers, UK banks always say that contracts are contracts and so no matter how repulsive it might be, they have to pay out bonuses as spelled-out in their contracts. The FSA said fine, go ahead, but if you do you will lose your license to do banking in London. In other words, it is the bank’s choice: be a bank, or pay bonuses. You cannot have it both ways (see here).

So here is the deal. President Obama should direct his administration to offer our bankers the same choice: either forgo all bonuses until the US unemployment rate drops below 5%, or lose your bank charter. Indeed, he should go further. Banks are really public-private partnerships, and bank management and other employees should not receive pay in excess of civil servant pay. Assign the appropriate civil servant pay grades to our regulated and protected banking institutions. Any banks that wish to pay higher salaries than that to retain “rocket scientists” can do so, but they will give up their bank charters. They will slip into the dark “shadow banking” sector and will lose all access to government protection.

Then adopt a strict version of the Volcker rule. Should any of those shadow banks find themselves in trouble, they will not be bailed out. Instead, they will be “resolved”—that is, shut down, with creditors paid whatever the government can recover on assets. If that rule had been in place two years ago, no more Goldman Sachs. Instead, Goldman was handed a bank charter, which allowed it to stay in business, to hoover up manufactured profits, to manipulate government policy, and to pay out bonuses using government bail-out money.

As to the complaint that banks will not be able to retain all the geniuses that helped to create the crisis, Obama’s response ought to be: Goodbye and good riddance. Go find jobs in the Caribbean. Banking does not need rocket scientists. It is basically a simple business: assess credit worthiness, make loans that have a high probability of repayment, and issue deposits. It used to be known as the “three-six-three” business: pay three percent on deposits, charge six percent on loans, and hit the golf course at three p.m. That was good banking and it did not need high remuneration. Tens of millions of Americans bought homes, started businesses, and sent their kids to college. It was good enough.

Fixing the Small Banks

By Warren Mosler*

Fixing the Small Banks

The Obama administration has been preaching the importance of fixing the small banks and getting them lending again. This will review what I see as the critical issue and how to fix it.

First, the answer:

1. The Fed should loan fed funds (unsecured) in unlimited quantities to all member banks.

2. The regulators should then drop all requirements that a % of bank funding be ‘retail’ deposits.

Yes, it is that simple. This simple, easly to implement ‘fix’ will immediately work to restore small bank lending from the bottom up by removing unnecessary costs imposed by current government policy.

The current problem with small banks is their too high marginal cost of funds. The only reason the Fed hasn’t expressed an interest in ‘opening the spigot’ and supplying unlimited funding at its target interest rate to any member bank to bring down this elevated cost of funds has to be a lack of understanding of our banking system.

Currently the true marginal cost of funds to small banks is probably at least 2% over the fed funds rate. This is keeping their minimum lending rates at least that much higher, which also works to exclude borrowers who need that much more income to service their borrowings, all else equal.

The primary reason for the high cost of funds is the requirement for ‘retail deposits’ that causes the banks to compete for a finite amount of available deposits in this ‘category.’ While, operationally, loans create deposits, and there are always exactly enough deposits to fund all loans, there are some leakages. These include cash in circulation, the fact that some banks, particularly large, money center banks, have excess retail deposits, and a few other ‘operating factors.’ This causes small banks to bid up the price of retail deposits in the broker CD markets and raise the cost of funds for all of them, with any bank considered even remotely ‘weak’ paying even higher rates, even though its deposits are fully FDIC insured. Additionally, small banks are driven to open expensive branches that can add over 1% to a bank’s true marginal cost of funds, to attempt to attract retail deposits. So by driving small banks to compete for a limited and difficult to access source of funding the regulators have effectively raised the cost of funds for small banks.

It should be clear my solution would immediately lower the marginal cost of funds for small banks. I’ll now attempt to address the usual host of objections to my proposal.

There are always two fundamentals to keep in mind when contemplating banking with a non convertible currency and floating exchange rate:

1. The liability side of banking is not the place for market discipline.

2. The Fed and monetary policy in general is about prices (interest rates) and not quantities.

Disciplining banks on the liability side has been tried repeatedly and always and necessarily fails. First, it’s fundamentally impractical to the point of ridiculous to expect anyone looking to open a checking account or savings account, for example, to be responsible for analyzing the finances of competing banks for solvency, when even Wall Street analysts can’t reliably do this. The US leaned this the hard way when the banking system was closed in 1934, reopening with Federal deposit insurance for bank deposits for the sole purpose of removing this responsibility from the market place. Regulation and supervision on the asset side then became the imperative. And while we have seen periodic failures due to lax regulation and supervision of the asset side of the US banking system, and it’s a work in progress, the alternative of using the liability side of banking for market discipline exposes the real economy to far more disruptions and far more destructive systemic risk.

Those who understand reserve accounting and monetary operations, including those directly involved in monetary operations at the world’s central banks, have known for decades that in banking, causation runs from loans to deposits, with reserve requirements, if any, being merely a ‘residual overdraft’ at the central bank and not a control variable. This includes Professor Charles Goodhart at the Bank of England, who has written extensively on this subject for roughly half a century, endlessly debating the ‘monetarist’ academic economists who spew gold standard and fixed exchange rate rhetoric, and who are unaware of how monetary operations are altered when there is no legal convertibility of a currency. Recall the ‘500 billion euro day’ back in 2008 when the ECB added that many euro in reserves to its banking system, and a week later the monetarists pouring over the data ‘couldn’t find it.’ The fact that they even looked was evidence enough they had no actual knowledge of reserve accounting and monetary operations. And, more recently, the notion that ‘quantitative easing’ makes any difference at all apart from changes in interest rates (it’s always about price and not quantity) reinforces the point that there is very little understanding of monetary operations and reserve accounting. While Professor Goodhart did declare quantitative easing in the UK a ‘success’ he did so on the basis of how it restored ‘confidence,’ making it clear that there was no actual monetary channel of causation from excess reserves to lending. Banks do not ‘lend out’ reserves. Loans create their own deposits. Total reserves are not diminished by lending. This is operational and accounting fact, and not theory or philosophy.

What this means in relation to my proposal of unlimited lending by the Fed to small banks at its target rate, is that any lending by the Fed will not alter anything regarding lending and the ‘real economy’ in any other regard, apart from the resulting term structure of interests per se. (Also, and not that it matters in any event, total lending by the Fed won’t exceed funds ‘hoarded’ by some banks along with the usual operating factors that routinely ‘drain’ reserves.)

In other words, the notion that this policy will somehow result in some inflationary monetarist type expansion is entirely inapplicable with a non convertible currency and floating exchange rate policy.

The other common concern is the risk to the Fed of lending unsecured to its member banks. However, there is none, if you look at government from the macro level. All bank assets are already regulated and supervised, and the banks are continually subjected to solvency tests. This means government has already deemed to the banks ‘safe to lend to.’ Furthermore, functionally, the fact that banks can indeed fund themselves in unlimited size with FDIC insured deposits means the government already lends to banks in unlimited quantities, protecting itself by regulating and supervising the assets, including asset quality, capital requirements, etc. Therefore, the Fed asking for collateral from its member banks is entirely redundant, as well as disruptive and a cause of increased rates to borrowers.

Conclusion: If the Obama administration had the knowledge, they would immediately move to implement my proposals to support small banking.

*First published on Moslereconomics.com

The Point of No Return

Our own Bill Black on bank’s equity and nonperforming loans. Black argued on the Bloomberg article that

“While 5 percent can be “fatal” for home lenders, commercial real estate lenders may be able to withstand higher rates…Commercial loans carry higher interest rates because they’re riskier.”


Click here to read the whole article.

Financial Instability

By L. Randall Wray [via CFEPS]

Economists have long been concerned with the economic fluctuations that occur more-or-less regularly in all capitalist economies. (Sherman 1991; Wolfson 1994) To be sure, there are different kinds of economic fluctuations—ranging from the Kitchin cycle (tied to inventory swings and lasting on average 39 months) to the Juglar cycle (lasting about seven or eight years and linked to investment in plant and equipment) to the Kuznets cycle of twenty years (associated with demographic changes) and finally to the Kondratieff long wave cycles attributed to major innovations (electrification, the automobile). (Kindleberger 1989) Financial factors might play only a small role in some of these fluctuations. Generally, economists studying financial instability have tended to focus on periodic financial crises that frequently coincide with the peak of the common business cycle, although financial crises (especially in recent years) can occur at other times during the cycle. Furthermore, an economy might be financially unstable but manage to avoid a financial crisis. It is best to think of financial instability as a tendency rather than as a specific event, although the typical financial crisis might be the result of unstable financial processes generated over the course of a business cycle expansion. In this essay, we will be concerned primarily with economic instability that has at its roots a financial cause, with less interest in either economic fluctuation that is largely independent of finance or in isolated financial crises that do not spill over to the economy as a whole.

A variety of explanations of the causes of financial instability have been offered. One possible cause could be a speculative “mania” in which a large number of investors develop unrealistic expectations of profits to be made, borrowing heavily to finance purchases of assets and driving their prices to absurd levels. Eventually, the mania ends, prices collapse, and bankruptcies follow. (Kindleberger 1989) The tulip mania of 1634, the South Sea bubble in 1719, or the Dot-com boom of the late 1990s might be cited as examples of speculative manias. Speculative booms often develop, and are fueled by, fraudulent schemes. Recent examples of financial crises in which fraud played a large role include the collapse of the Albanian national pension system (1990s) as well as the American Savings and Loan fiasco (1980s). (Mayer 1990) Other explanations have tended to focus on a sudden interruption of the supply of money or credit that prevents borrowing and forces spending to decline, precipitating a cyclical downturn. The modern monetarist approach attributes financial instability and crises to policy errors by central banks. According to monetarist doctrine, when the central bank supplies too many reserves, the money supply expands too quickly, fueling a spending boom. If the central bank then over-reacts to the inflation this is believed to generate, it reduces the money supply and causes spending to collapse. (Friedman 1982) Others advance a “credit crunch” thesis according to which lenders (mostly banks) suddenly reduce the supply of loans to borrowers—either because the lenders reach some sort of institutional constraint or because the central bank adopts restrictive monetary policy (as in the monetarist story). (Wojnilower 1980; Wolfson 1994) Finally, one could add exchange rate instability and foreign indebtedness as a precipitating cause of economic instability, especially in developing nations since the breakup of the Bretton Woods system. (Huerta 1998)

Other analyses have identified processes inherent to the operation of capitalist economies. (Magdoff and Sweezy 1987) In other words, rather than looking to fundamentally irrational manias or to “exogenous shocks” emanating from monetary authorities, these approaches attribute causation to internal or endogenous factors. Karl Marx had claimed that the “anarchy of production” that is an inevitable characteristic of an unplanned economy in which decisions are made by numerous individuals in pursuit of profit is subject to “disproportionalities” of production such that some of the produced goods cannot be sold at a price high enough to realize expected profits. Key to his explanation was the recognition that production always begins with money, some of which is borrowed, used to purchase labor and the instruments of production in order to produce commodities for sale. If, however, some of the commodities cannot be sold at a sufficiently high price, loans cannot be repaid and bankruptcies occur. Creditors then may also be forced into bankruptcy when their debtors default because the creditors, themselves, will have outstanding debts they cannot service. In this way, a snowball of defaults spreads throughout the economy generating a panic as holders of financial assets begin to worry about the soundness of their investments. Rather than waiting for debtors to default, holders of financial assets attempt to “liquidate” (sell) assets to obtain cash and other safer assets. This high demand for “liquidity” (cash and marketable assets expected to hold nominal value) causes prices of all less liquid assets to collapse, and at the same time generates reluctance to spend as all try to hoard money. Thus, the financial crisis occurs in conjunction with a collapse of aggregate demand. (Sherman 1991; Marx 1990, 1991, 1992)

Some of the elements of Marx’s analysis were adopted by Irving Fisher in his “debt deflation” theory of the Great Depression, as well as by John Maynard Keynes in his General Theory. While Fisher devised a theory of special conditions in which markets would not be equilibrating, in Keynes’s theory these were general conditions operating in monetary economies. Briefly, Fisher attributed the severity of the Great Depression to the collapse of asset prices and the ensuing financial crisis that resulted from an avalanche of defaults. (Fisher 1933; also Galbraith 1972) Adopting Marx’s notion that capitalist production begins with money on the expectation of ending with more money later, Keynes developed a general theory of the determination of equilibrium output and employment that explicitly incorporated expectations. (Keynes 1964) He concluded there are no automatic, self-righting forces operating in capitalist economies that would move them toward full employment of resources. Indeed, he described destabilizing “whirlwinds” of optimism and pessimism, in striking contrast to the Smithian notion of an “invisible hand” that would guide markets toward stable equilibrium. Also, like Marx, Keynes identified what he called the “fetish” for liquidity as a primary destabilizing force that erects barriers to the achievement of full employment. Most relevantly, rising liquidity preference lowers the demand for capital assets, which leads to lower production of investment goods and thus falling income and employment through the multiplier effect.

Hyman Minsky, arguably the foremost twentieth century theorist on the topic of financial instability, extended Keynes’s analysis with two primary contributions. (Minsky 1975, 1986) First, Minsky developed what he labeled “a financial theory of investment and an investment theory of the cycle”, attempting to join the approaches of those who emphasized financial factors and those who emphasized real factors as causes of the cycle by noting that the two are joined in a firm’s balance sheet. (Papadimitriou and Wray 1998) As in Keynes’s approach, fluctuations of investment drive the business cycle. However, Minsky explicitly examined investment finance in a modern capitalist economy, arguing that each economic unit takes positions in assets (including, but not restricted to, real physical assets) that are expected to generate income flows by issuing liabilities that commit the unit to debt service payment flows. Because the future income flows cannot be known with certainty (while the schedule of debt payments is more-or-less known), each economic unit operates with margins of safety, collateral, net worth, and a portfolio of safe, liquid assets to be drawn upon if the future should turn out to be worse than expected. The margins of safety, in turn, are established by custom, experience, and rough rules of thumb. If things go at least as well as expected, these margins of safety will prove in retrospect to have been larger than what was required, leading to revisions of operating rules. Thus, a “run of good times” in which income flows are more than ample to meet contracted payment commitments will lead to reductions of margins of safety. Minsky developed a classification scheme for balance sheet positions that adopted increasingly smaller margins of safety: hedge (expected income flows sufficient to meet principal and interest payments), speculative (near-term expected income flows only sufficient to pay interest), and Ponzi (expected income flows not even sufficient to pay interest, hence, funds would have to be borrowed merely to pay interest).

This leads directly to Minsky’s second contribution, the financial instability hypothesis. Over time, the economy naturally evolves from one with a “robust” financial structure in which hedge positions dominate, toward a “fragile” financial structure dominated by speculative and even Ponzi positions. This transition occurs over the course of an expansion as increasingly risky positions are validated by the booming economy that renders the built-in margins of error superfluous—encouraging adoption of riskier positions. Eventually, either financing costs rise or income comes in below expectations, leading to defaults on payment commitments. As in the Marx-Fisher analyses, bankruptcies snowball through the economy. This reduces spending and raises planned margins of safety. The recession proceeds until balance sheets are “simplified” through defaults and conservative financial practices that reduce debt leverage ratios.

Central to Minsky’s exposition is his recognition that development of the “big bank” (central bank) and the “big government” (government spending large relative to GDP) helps to moderate cyclical fluctuation. The central bank helps to attenuate defaults and bankruptcies by acting as a lender of last resort; countercyclical budget deficits and surpluses help to stabilize income flows. The problem, according to Minsky, is that successful stabilization through the big bank and the big government creates moral hazard problems because economic units will build into their expectations the supposition that intervention will prevent “it” (another great depression) from happening again. Thus, risk-taking is rewarded and systemic fragility grows through time, increasing the frequency and severity of financial crises even as depression is avoided. While there may be no ultimate solution, Minsky believed that informed and evolving regulation and supervision of financial markets is a necessary complement to big bank and big government intervention. Like Keynes, Minsky dismissed the belief that reliance upon an invisible hand would eliminate financial instability, indeed, he was convinced that an unregulated, small government capitalist economy would be prone to great depressions and the sort of debt deflation process analyzed by Irving Fisher.



Fisher, I. (1933), ‘The Debt-Deflation Theory of Great Depressions’, Econometrica, 1, October: pp. 337-57.

Friedman, M. (1982), Capitalism and Freedom, Chicago and London: The University of Chicago Press.

Galbraith, J. (1972), The Great Crash, Boston: Houghton-Mifflin.

Keynes, J. (1964), The General Theory of Employment, Interest, and Money, New York and London: Harcourt Brace Jovanovich.

Kindleberger, C. (1989) Manias, Panics, and Crashes: A history of financial crises, New York: Basic Books, Inc.

Huerta, A. (1998), La Globalizacion, Causa de la Crisis Asiatica Y Mexicana, Mexico: Editorial Diana.

Magdoff, H. and P. Sweezy. (1987) Stagnation and the Financial Explosion, New york: Monthly Review Press.

Marx, K. (1990), Capital: Volume 1, London: Penguin Classics.

—–. (1991), Capital: Volume 3, London: Penguin Classics.

—–. (1992), Capital: Volume 2, London: Penguin Classics.

Mayer, M. (1990), The Greatest-Ever Bank Robbery: the collapse of the savings and loan industry, New York: Charles Scribner’s Sons.

Minsky, H. (1975), John Maynard Keynes, New York: Columbia University Press.

—–. (1986), Stabilizing an Unstable Economy, New Haven and London; Yale University Press.

Papadimitriou, D. and L.R. Wray (1998), ‘The Economic Contributions of Hyman Minsky: varieties of capitalism and institutional reform‘, Review of Political Economy 10, No. 2, pp. 199-225.

Sherman, H. (1991), The Business Cycle: Growth and crisis under capitalism, Princeton, New Jersey: Princeton University Press.

Wojnilower, A. (1980), ‘The Central Role of Credit Crunches in Recent Financial History’, Brookings Papers on #Economic Activity, No. 2: 277-326.

Wolfson, M. (1994), Financial Crises: Understanding the postwar U.S. experience, Armonk, New York and London: M.E. Sharpe.

Do banks need more capital?

By William K. Black (via New Deal 2.0)

Five Unasked Questions About the Stress Tests

1. Why will these (weak) stress tests lead to more realistic evaluations than the (far tougher) stress tests that Congress mandated for Fannie Mae and Freddie Mac?
Congress mandated a purportedly “stringent” stress test for Fannie Mae and Freddie Mac over a decade ago. It required them to have adequate capital to withstand the simultaneous onslaught of severe credit, interest rate and operational risks that continued for 10 years. The current Treasury test concentrates solely on credit risk and assumes it ends after two years. How well did the far more stringent Fannie and Freddie stress tests work? In August 2008, Freddie reported that “even [our] most severe stress tests [show] losses … less than $5 billion.” It failed in September. Actual losses: 20 to 40 times greater.

2. Where else were stress tests used?
Stress tests were used for the Rating Agencies, IndyMac, and AIG. The Rating Agencies’ stress tests gave AAA ratings to toxic waste. Actual losses: more than an order of magnitude greater than those predicted by the stress tests. IndyMac sold over $200 billion of “liar’s loans.” Actual losses: 160 times greater than its tests. AIG (2007): “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [CDS] transactions.” AIG (2008): “Using a severe stress test … losses could go as high as $900 million.” Actual losses: 200 times greater.

3. When did Geithner begin to claim that stress tests were the keys to safe operation?
As president of the Federal Reserve Bank of New York, in a speech in 2004, he first praised stress tests. He was the principal regulator of many of the largest bank holding companies in the U.S. Every large bank has long used stress tests – and Geithner’s Federal Reserve examiners reviewed their stress tests. The big banks’ stress tests on nonprime loans and derivatives failed, and the Federal Reserve examiners consistently failed to understand the failures.

4. How can you conduct a stress test without reviewing the bad mortgage assets’ (missing) underlying loan files?
A Standard & Poor’s (S&P) memorandum recently unearthed reveals the sad truth about how non-prime collateralized debt obligations (CDOs) were purchased, pooled, rated and sold: ”Any request for loan level tapes is TOTALLY UNREASONABLE!!!. … Most investors don’t have it and can’t provide it. … we MUST produce a credit estimate. … It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.” The email message is from a senior S&P manager to the professional rater. The word “investors” means the entity that created the CDOs. One cannot evaluate loan quality or losses accurately without reviewing a significant sample of the underlying loan files. The banks and the regulators virtually never do this. They did not do this during the stress tests. They do not even have access to the files that they need to review.

5. How can you ignore fraud losses during an “epidemic” of mortgage fraud?
The FBI began testifying publicly in September 2004 about the “epidemic” of mortgage fraud. It has also stated that lending insiders participated in 80 percent of mortgage fraud losses. The presence of massive fraud losses means primarily produced by lenders makes it absurd to rely (as Treasury did in its stress tests) on the lenders’ loss evaluations. Stress tests produce fictional results that massively understate real losses and produce complacency.

The Global Reserve Currency

From the Financial Times by Michael Hudson:

“For starters, the six countries intend to trade in their own currencies so as to get the benefit of mutual credit, rather than give it to the US. In recent months China has struck bilateral deals with Brazil and Malaysia to trade in renminbi rather than the dollar, sterling or euros.

Many foreigners see the US as a lawless nation. How else to characterise a country that holds out a set of laws for others – on war, debt repayment and the treatment of prisoners – but ignores them itself?

The US is the world’s largest debtor, yet has avoided the pain of “structural adjustments” imposed on other debtor nations. US interest rate and tax reductions in the face of exploding trade and budget deficits are seen as the height of hypocrisy in view of the austerity programmes that the “Washington consensus” has forced on other countries via the International Monetary Fund and other vehicles. The US tells debtor economies to sell off their public utilities and natural resources, raise their interest rates and increase taxes while gutting their social safety nets to squeeze out money to pay creditors.”