Partners in Crime

Bill Black-

Black: the dominance of unethical banking

Posted by: Jay Kernis – Senior Producer, Parker/Spitzer

December 20th, 2010, 06:17 PM ET

A credit ratings firm couldn’t give a “AAA” rating (the highest possible – the rating that virtually all these toxic derivatives were given) if it looked at a sample of the loans – so they religiously did not kick the tires on the liar’s loans. So we had the farce of “credit rating” agencies whose expertise was supposedly in reviewing credit quality never looking at that credit quality so that they could make enormous fees by giving toxic waste pristine “AAA” ratings.

The investment banks couldn’t sell the financial derivatives loans to others if the investment bankers (whose supposed expertise was evaluating credit risk) were to actually look at credit quality of the underlying liar’s loans. If they looked, they’d document that the loans were overwhelmingly fraudulent. They’d then have three options.

A. They could sell the CDOs to others by calling them wonderful “AAA” investments – while having files proving that they knew this was a lie. This option is the prosecutor’s dream.

B. They could have sued the lenders that sold them the fraudulent liar’s loans. The investment banks typically had a clear contractual right to force the fraudulent loans to buy back the liar’s loans. But there were fatal problems with that option. The lenders that made liar’s loans typically had minimal capital (net worth). If the investment banks had demanded that they repurchase the loans they would have been unable to do so – and the demand would have exposed the investment banks’ bright shining lie that by pooling liar’s loans they could create “AAA” CDOs. Every CDO purchaser from the investment banks would then demand that the investment banks repurchased their CDOs – which would have caused virtually every large U.S. investment bank to fail.

C. They could have gone to the Justice Department and expose the massive fraud that was destroying the American economy and help the FBI investigate the lenders specializing in making liar’s loans, the corrupt appraisers, and the credit rating agencies. But that would have caused the CDO bubble to burst and the investment banks to fail.

That’s why the industry went with the fourth option – “don’t ask; don’t tell.” It’s like the famous fable of the emperor and the fraudulent designer. The designer tells everyone that he has created clothes for the emperor of such beauty that only the most sophisticated people can even see the clothes. The emperor and his cronies all agree that the clothes are glorious. The fraud only collapses when a boy blurts out: “the emperor is naked.” As long as no one engaged in the frauds pointed out that you can’t make a “AAA” rating out of a pool of massively overvalued fraudulent loans the housing bubble could hyper-inflate and the officers of the investment banks and credit rating agencies could become wealthy beyond their dreams.

The federal government has permitted banks to inflate their reported incomes and “net worth” for the purpose of evading the mandatory statutory duty under the Prompt Corrective Action (PCA) law to close deeply insolvent banks. Congress, at the behest of the Chamber of Commerce, the banking trade associations, and Chairman Bernanke, successfully extorted the Financial Accounting Standards Board (FASB) to scam the accounting rules so that the banks could fail to recognize on their accounting reports over a trillion dollars in losses.

When banks understate their losses massively they, by definition, overstate their net worth massively. The PCA’s provisions kick in when net worth falls, so the accounting lies have gutted the PCA. The accounting lies also allow the banks to (once again) report high fictional income when they are experiencing large, real losses. This accounting scam allows the bank executives to collect hundreds of billions of dollars in bonuses. We should end the accounting scam and enforce the PCA.

Congress Threatens to Sow the Seeds of Our Next Banking Crisis

William K. Black, Huffington Post

December 20, 2010 09:29 AM

Representative Paul’s claims epitomize the triumph of ideology over fact: “The market is a great regulator, and we’ve lost understanding and confidence that the market is probably a much stricter regulator.” No, the “market” is not a “great regulator” and the ongoing crisis is only the latest example of that point. Efficient, non-fraudulent markets would be a very good thing. Inefficient, markets with fraudulent participants can be a catastrophically bad thing.

The “market” also does not deal effectively with externalities (and they can be lethal) and with market power. The neoclassical claim that cartels cannot persist and that potential entry solves prevents all serious ills proved false in the real world. Here, however, I will discuss only why control fraud turns “markets” perverse. Accounting control frauds are guaranteed to report high profits in the early years. This is why Akerlof & Romer (1993) agreed with white-collar criminologists that such frauds were a “sure thing.” I’ve explained why the four-part recipe for optimizing fictional accounting income maximizes executive bonuses — and real losses. In the interest of brevity I will merely mention four ways in which accounting control frauds make markets, and “private market discipline” perverse.

  1. The fictional profits fool creditors and shareholders — they are eager to lend to and invest in firms reporting record profits. Rather than discipline accounting control frauds, creditors and shareholders fund their massive growth.
  2. The fictional profits and the large bonuses they drive create a “Gresham’s” dynamic in which bad ethics tends to drive good ethics out of the marketplace. The CFO that fails to emulate the fraud recipe will report far lower profits in the near term and will fear losing his job. More junior executives whose compensation is based on the firm’s reported income have perverse incentives to engage in accounting fraud to ensure that the firm “hits the number” and have reduced incentives to blow the whistle on frauds.
  3. Lenders engaged in accounting control fraud create “echo” epidemics of fraud. They use their powers to hire and fire and create compensation systems to create perverse incentives in other fields: among their employees, “independent” professionals, and agents (e.g., loan brokers).
  4. When several large lenders follow similar fraud strategies they can hyper-inflate financial bubbles.

Anti-consumer control frauds can also turn markets perverse by creating Gresham’s dynamics. Chinese infant formula provides a good example. Dishonest firms drove honest firms from the market — maiming hundreds of thousands of infants’ health.

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    • on 12/28/2010 at 18:34

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