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THE FINANCIAL CRISIS, THE US ECONOMY, AND
INTERNATIONAL SECURITY IN THE NEW ADMINISTRATION
New School University
New York City
November 14, 2008
2:30 – 4:00 Session III: A New Domestic Financial Architecture
Dimitri Papadimitriou (Moderator):
I also want to thank the Bernard Schwartz Center of Policy Analysis. The Levy Institute had something to do with this conference—little, but something. And I do want to say that in this particular session the focus is on the new domestic financial architecture.
Someone asked me earlier—You know, financial architecture has something to do with Hymen Minsky, why is it that people talk about Hymen Minsky. Well, I would hope that by the end of the conference something will be said about Hymen Minsky. If I were to say it, I think it would be self-serving, and so I will not say very much about it.
Clearly we know that the former, and perhaps the current maestro of the financial architecture had advocated the self-correcting mechanism of the financial markets. Of course we know what that took us. It ran the economy off the cliff, and it took us with it. So I would hope that the panelists will have particular views. I know they have different perspectives because they come from different training.
We have a former regulator who is at the present not here; that’s Bill Black, who now has decided to become an academic at the University of Missouri at Kansas City. We have Jack Blum, who is a lawyer and works in compliance for banks and brokers, and also—and don’t be frightened—has worked for the IRS. And then we have Richard Medley, who’s not here, who apparently has been doing very well under this financial meltdown, and perhaps he’ll tell us something about that. Or at least he’ll tell us what the financial architecture should be so that things should become normal. And then finally we have Barclay Rosser, who is a true academic. He is a professor at James Madison University.
Since Bill is not here, I think I will ask Jack to be the first speaker.
Again, fifteen minutes, so there is enough time for discussion.
Jack Blum:
I feel particularly privileged to be here. I have a confession to make: I have never taken a formal course in economics, which makes me a rather unusual speaker for this kind of meeting.
DP:
[When you went to college we didn’t teach economics?]
Jack Blum:
That’s true, that’s true. Before there was a Levy Institute.
But what I have had is 40 years of experience investigating financial crime and fraud. And I’m going to shock you: The first time I investigated sub-prime mortgage fraud—bundled the instruments, sold off to people they didn’t know what they were buying—was 1969. Sixty-nine! 1970. A hundred-and-some-odd people went to jail. What was happening was Senator Hart, then chairman of the anti-trust sub-committee, asked me to figure out why center cities were being hollowed out, and why homes were going into foreclosure and being burned. We found out that banks were dumping conventional mortgages, trying to convert them to FHA mortgages, which would then be bundled and sold off to Fannie Mae and Freddie Mac. Lo and behold, Freddie Mac and Fannie Mae sold securities to brokerage firms, and many of those firms went bust because those instruments became known as pass-throughs, and the brokers later, after they were unemployed, called pass-outs.
Now, you would say, 1969—why didn’t you fix it if you knew it then? And of course the answer was that the strongest lobby in Congress was the local real estate agents, mortgage bankers, and builders. The prospect of getting reform through the banking committee was zero.
Now this story would be interesting, historical, whatever, except for the fact that one of the firms we put out of business was called Eastern Services Corporation, owned by a husband and wife named Bernstein, and they had an adult son who escaped prosecution. One day I’m reading The New York Times in 1989—okay, we’re now 20 years later—and I read that the son is being prosecuted for the same damn thing, only this time it’s regulatory, and he’s taken it up an order of magnitude. The Times story has a complete recounting of the earlier episode.
So of course when I pick up The New York Times, and I see stories about the housing foreclosure, and they show a street in Boston, I’m practically nauseated; because it’s the same damn street I stood on for the anti-trust sub-committee in 1969. Everything in the current financial mess has been out there in plain sight for everybody to see for the last 20 years minimum; and if you were looking carefully, for a lot more than that. I’m sorry, but the excuses for not looking are so monumental that you’re amazed, you’re astonished. Long-term capital management—that was a bad apple, an aberration. Russian geckoes and the carry trade—oh my god, that was an aberration; we can’t solve that problem. I could go on and on and on. Only that’s pointless.
What I’m going to do is, instead of recounting all the different ways we were warned that this was coming in full detail, talk about what has to be done, and talk about what’s going on in the regulatory structure, and why everyone of you who’s interested in a solution has to get into the nuts and bolts of these institutions, how they work, and what’s wrong with them.
How can I best put this? First of all, we have a globalized economy. In this globalized economy, there are some 90 jurisdictions who have no laws, no accounting laws, corporate laws that allow you to incorporate with no responsibility whatsoever, where the directors have no fiduciary responsibility, where the directors have no idea what the business of the corporation is or any records of what the corporation is doing.
These jurisdictions give every financial institution in the world a place to go hide the crap, to be blunt about it. And they do. Many of these institutions operate in ways that put off their balance sheets what’s really going on. So for example, right now, if credit markets are frozen, it’s because every financial institution knows what they have hidden, and they know that all their counter-parties have hidden the same kinds of things in the same places. The problem is that they don’t know what the counter-parties have. So they won’t deal with the counter-parties.
Now it’s just a simple fact: You can’t run a regulated banking system without knowing what’s going on, and that requires regulators to be able to see through and actually get an idea of a world-wide position of an institution. We don’t have a system that’s capable of doing that. You would think after Enron—and again, this is another one of the many warning signs that things had run amok, when we discovered 300-and-some-odd offshore entitites--that somebody might have said, You can’t have ‘em. But no, nobody said that, and the banks looked at it and said, this is a terrific idea. So we come up with SIVS. And I thought SIVS—that was a perfect acronym. The money went right through it.
This to me is an intolerable situation. You can’t solve any of these problems through regulation if what you have is a system where the players can arbitrage the rules of jurisdiction and figure out where there is no regulation, and put their most toxic stuff where there’s no regulation, and get away with it. That does not work.
There’s a second part to this problem which is equally obnoxious, and that is that by moving it all offshore, they took whatever speculative stuff that was going on and actually injected steroids in it by the fact that it’s all tax-free. And not report it. So if you have any doubt about the dimension of tax evasion, if you saw yesterday’s Wall Street Journal, the most senior official in private banking at UBS was indicted, and he was indicted because UBS had 19,000 undeclared accounts for Americans. I really urge you to read the indictment, because they wrote a level to all their people saying, We’re so politically connected in the US, you don’t have to worry about pressure from the US government to get the information.
Well, you think that that was an overstatement. Let me put that in immediate context. UBS, the same bank—these 19,000 accounts? $20 billion dollars in them. $200 million a year in fees to UBS. Put it in perspective. UBS turned up with dollar obligations outstanding, four times the GDP of Switzerland. UBS needed $40 billion- worth of cash to keep going—US dollars. This Swiss central bank could no more provide US dollars than it could provide green cheese—and Switzerland makes lots of cheese. It has to go to the Fed because if it tries to go to the open market, a Swiss franc would be worth about what a year’s Kleenex on a New York City subway platform would be worth. So they go to the Fed, and instead of the Fed saying, “Guys, turn over the names,” or, “Tell us what’s really going on under the sheets in this place,” the Fed says, “Here, take the money on a swap. We do that. We’re central bankers. We don’t regulate anything.” This doesn’t work. It can’t be, and it has to change.
I want to talk about something else, and this is how regulation works inside financial institutions. Every financial institution has a risk-management department. These people are supposed to do either risk management, risk oversight—they’re supposed to know what’s going on in the place. Some of them know what’s going on; but they also know that you don’t tell anybody else in the place, and you most certainly don’t tell your boss not to do it, because you know that’s a very career-disruptive move. The job that the people in compliance and risk management tend to have is akin to the people in the circus who follow the elephants sweeping up the droppings. And unless government absolutely reinforces through regulation the role of those people, they’re there as window dressing.
So the question is: where is the government?
To that I answer: in very deep anesthesia.
Take a look at the last four election cycles - it’s easily available on the Web - at the largest contributors to both political parties and all presidential campaigns. Then remind yourselves—and I’m sure you all know this—that the stuff that’s going on is so complicated, average people have no idea of what it really means or how it works. The average Congressman is slightly better than that, but not much; therefore when they’re told by the people who’ve just given them this wad of money that there are no problems, who are they to argue? Because what they want the money for is commercials to talk about happy stuff, or to run down their opponent.
We have to get them out of deep anesthesia. And the only way we’re going to do that is by going back to something that happened in the 1930s, when a commission was set up, and a judge, Ferdinand Pecora, put in charge of it. There was subpoena power, and people could dig into the detail of what had occurred: who did what to who, how things were manipulated, and what the real problems were. Out of that we got very specific legislation. We need the same thing [now], because without that kind of public understanding and without real disclosure of the depth of the manipulation, the nonsensical instruments, the 400-page prospectuses that didn’t mean anything, that weren’t vetted by the SEC because somebody ruled they weren’t financial instruments—all of that stuff has to be put out in public and discussed so we see where we go.
My time is a little bit limited here, so I’m just going to talk about another aspect of this, which is the weakness of the regulators in the face of the complexity and the size of the institutions. These regulatory agencies hire kids fresh out of law school, out of accounting school, some of your finer students, and they have no idea how the institutions they’re looking at work, and they have no idea how the instruments that they’re supposedly looking at work. Now how can I say this? Well, I’ve been on the other side of their trying to figure out what’s going on, and I’ve watched them spun; what’s really depressing is how easily they’re spun. The bad news is, just about at the point where they can figure out what’s really happening, they get a much better job. This is not a working regulatory system.
We also have a business of chipping away at the law. This goes on in the tax law all the time, where ingenious lawyers figure out how to put together code sections, or write opinions, and all of this sort of sneaks something past the current understanding and rules of IRS, which then has to be corrected. It’s sort of an ongoing game. This has been going on in the securities industry for 40 years. You explain to me how a credit default swap isn’t an insurance policy, and I’ll take you back to a whole series of quiet opinion letter and interpretations; and lo and behold, it’s not regulated, it’s not that. Well, if its not that, maybe a financial instrument that needs a certain kind of prospectus and review. But then again, we have another bunch of stuff that takes it out from under the law. There is so much of that that’s gone on, you really have to be in the business to understand it.
I would argue that we can all discuss economy theory from now to the end of time. If we don’t get into those nuts and bolts; if we don’t start looking at the globalization arbitrage problem, that is, the arbitraging of different jurisdictions and different national laws, and get some idea of what’s really going on through accounting, so this off-the-books, contingent liability, we-don’t-know-what-we-owe-anybody is gone; and change the system so the guys who are risk managers and who are the ones who are supposed to be saying no get more than a shovel and a broom, we’re never going to fix it. Thank you.
Dimitri Papadimitriou (Moderator):
Bill, you have an extra minute. Better jump up and get it now. Sixteen minutes exactly.
Bill Black:
I was asked to talk about architecture; but if you’re going to talk about architecture, everybody who is an architect understands that it only makes sense in terms of the environment where you’re going to put that architecture. So I’m going to broaden that discussion of architecture to include the environment as well. And I’m going to suggest the old saw is the best saw here, and that is, it’s not the things that you don’t know that produce disaster; it’s the things that you do know that aren’t true that produce disaster.
Let me suggest three things that we knew that were critical in shaping the environment so that all of these institutions that I’m going to talk about, or are this architecture, worked within this environment. I’ll attempt to show how destructive it was, and how vital it is to change that environment.
The first part was that of course fraud couldn’t happen. So even in a meeting like this, where it’s not so much the old fogies, the f-word is almost never used. We have Akerlof’s famous article on lemons market, every single example of which is a fraud; but the word fraud is never used. We have Akerlof coming back in 1993 with his article on looting, and he then of course goes on to win the Nobel Prize; and that article is virtually never sited by people discussing these crises, even though it is the most relevant single piece in the conventional economics literature.
Instead we have a theory where we know fraud cannot occur. We know fraud cannot occur because if there were substantial fraud, markets wouldn’t be efficient; and since markets are efficient, there can’t be fraud. And we have just proved that, right? Because we show the circle. Let it be unbroken.
So the small little fact that there were over a thousand insider convictions, senior insider convictions, in the savings and loan debacle is no particular reason to revisit that issue; nor the fact that since September of 2004 the FBI has been testifying that there is an “epidemic” of mortgage fraud developing; nor the fact that only 20 percent of the folks who make home loans are required to make criminal referrals, and that 20 percent made over 50,000 referrals for mortgage fraud. Or the fact that the FBI says that 80 percent of mortgage fraud is induced by the companies, not by the borrowers.
And by the way, we don’t find most frauds; so you have to multiply not just by 5 to get the total number, but probably more like 10. That tracks Fitch and others that have looked at small samples and find in sub-prime an incidence of fraud of over 40 percent; indeed, typically 40-60 percent. So we have a massive problem which we don’t talk about, and we certainly don’t provide resources. We have 200 FBI agents chasing roughly a half-million frauds a year. We can talk about architecture all you want; but that’s the environment. You can have any architecture you want; it’s not going to work in those circumstances.
So first, we knew that fraud couldn’t occur; so even when we knew fraud was occurring, and knew it was occurring in massive amounts, we don’t even bother to put that in the literature. You can look at article after article in SSRN, and you may find a footnote buried about, and there maybe could be a little fraud, too—with no numbers, typically.
All right. Beyond that, our standard means, our methodology that we are so proud of, econometrics, produces in the expansion phase of a bubble the worst possible policy advice conceivable, and it must do so whenever there is a substantial amount of accounting fraud. Because whatever practices are most associated with accounting fraud, will have to show the strongest R-squared, positive R-squared, with profitability, and that flows through earnings per share and such in terms of stock market. Why the worst possible? Because the way you optimize accounting fraud, and these are accounting frauds, is to loan to the worst possible borrowers. Why? Because they’ll agree to pay the highest fees and interest rates. Note that I stress the word agree. It’s not actual cash flow, folks. There are ways to scam that as well, through refinancings, and that is the story and has been the story in this crisis and in other crises. It’s quite true that California and Detroit are quite different. It’s also quite true that in both of them you have extraordinary degrees of accounting fraud through mortgage fraud.
And by the way, who did the FBI decide to make its strategic partner in dealing with mortgage fraud? The Mortgage Bankers Association, the organization of perks. Can you imagine that happening in the blue-collar sphere? Right? It is the apparent legitimacy that makes these white-collar crimes so devastating.
So the first thing that we knew was true, but wasn’t true, was that you couldn’t have fraud. And it certainly couldn’t be important to anything like an economic variable, something like a bubble. The second thing that we knew was that regulation couldn’t work. So it became a self-fulfilling prophesy. You have people in charge that believe that regulation won’t work. By god, they’ll succeed in proving that it doesn’t work, and all the appointees in this administration succeeded in doing that.
The third—and it’s wonderful that it was an example in an earlier panel- It is the mindset that as long as you can think of any conceivable place where some aspect of this might be beneficial, you shouldn’t ban. Because that would be throwing out—the other clichés, right? So the fact that that net, it helps produce the largest economic disaster of our lifetimes isn’t sufficient reason to say no, we’re not going to do this activity.
And by the way, when people say CDOs haven’t defaulted, [whispering] they’re structured so they don’t default. That doesn’t mean they don’t lose their economic value. Of course, if you structure it so it doesn’t default, you simply have the right to whatever the first bit of cash is, and then it’s tiered. It won’t default because by its terms it doesn’t require any payment. That doesn’t mean it doesn’t lose virtually all its economic value; and in many cases that’s precisely what’s happened.
Okay, Bill Cosby is, as on many things, excellent for the next part of this. Bill Cosby said there are a lot of things in life that are absolutely inexplicable unless you assume there was a coin toss and that somebody lost it. You remember the joke that General Washington and General Cornwall had a coin toss at the beginning, and obviously Washington won. And [Cornwall] said, “You have won the toss; what do you choose?” And [Washington] said, “We will have rifle barrels, and we’ll have camouflage, and we’ll stand behind trees, and we’ll shoot you, and you have to stand in long red lines with muskets and get shot.” You need something like that to understand the architecture that was set up for regulation—which is, of course, essentially non-regulation in all of this.
First, standard economics, or at least classical economics: Reputation trumps all, and therefore conflicts of interest are irrelevant. Indeed, the literature became that it’s a good thing to usurp corporate opportunities, because that gives it to the highest and best use, and it just reduces overall compensation, and it’s really a great thing. It was a good thing that outside auditors would also be consultants, because then they’d be so much more knowledgeable, and they could bring those efficiencies and such. Alan Greenspan was the leading purveyor of this view. Go back to his speeches, which are on the website at the Federal Reserve, and you will see these odes to reputation and how reputation conquers all.
Second, private market discipline removes any need for regulation. Indeed, it means that regulation is counter-productive, because regulation will commonly reduce the incentives for private market discipline, and therefore it’s bad.
Third, a specific example of that: therefore we should encourage subordinated debt and rely on subordinated debt as one of our principle forms of regulating bank institutions. How many people here have actually been financial regulators? And how many people have actually investigated directly things? There’s always a handful in these kinds of groupings. I’ve never been able to find anyone who can show me where a subordinated debt holder prevented a single one of these frauds. This is many groupings that I’ve raised this with.
Executive compensation—extreme executive compensation is good because it aligns the interests, and therefore we needn’t worry about incentive incompatibility. The agency problem has been dealt with. All is good. You see again this theme that all is well, and therefore we don’t much need regulation.
International competition as a driver means we must respond by progressively weakening our regulation. We must get rid of Glass Steagall because we have to compete with the universal banks of the Germans.
Prompt corrective action has dealt with any additional, remaining problems, because now, as soon as there’s a problem, bam, we mandate by statute, the regulators are in there, and WaMu, and Wachovia, and Indymac, and such, and everybody else are closed before there are any significant losses. Of course, it forgets all about accounting fraud. So we have prompt corrective action, but driven off of numbers that are created through accounting fraud. And what happens when you engage in accounting fraud? You use it to look a little profitable? No! You make sure that you’re one of the most profitable institutions in the country, because that’s what allows you to pay that very large compensation. In a way that dramatically reduces the risk of prosecution, you are able to convert firm assets to your personal benefit through normal corporate mechanisms--dividends, stock appreciation—all those good types of things.
In addition, the theory was we had backup regulation. We had the FDIC. But it turns out the FDIC backup regulation only kicks in after you’re failing your capital requirements, which comes back to accounting fraud, which makes it look like you have extraordinary unprofitability.
President Bush yesterday said that the problem was we had old-fashioned regulation that didn’t have sufficient capital requirements. No. Basel II was designed specifically to reduce capital requirements, and specifically capital requirements for those holding large amounts of mortgage assets. It specifically encouraged the largest banks to use proprietary models to value their assets, even though everybody knew that that was a recipe for disaster. So it’s not just the United States. Basel II is not simply the United States writ large in terms of direct control. It is [that] we have infected the rest of the world with a deficient economic understanding. In the United States, we have the competition and laxity among the federal regulator agencies that constantly pushed towards the weakest control at the federal level. And we decided to preempt any states that were vigorous in trying to enforce against things like predator lending.
Control frauds, the most audacious ones, were able to create regulatory black holes. The famous one is Enron, and the one that Enron exploited to create the California energy crisis through its cartel operation. Note what happened then. Who did we take our policy advice from to deal with the California energy crisis? Anyone remember? Ken Lay was able to get a meeting with the vice president of the United States of America giving talking points, opposing any efforts to deal with the price rise. And Vice President Cheney, the next day, read pretty much from those talking points, encouraged the Federal Energy Regulatory Commission to take no action on behalf of California, and added a gratuitous slam at a bunch of tree-hugging Californians.
I took the notes at the Keating Five meeting. Where was the intervention in that case? Again, the apparent legitimacy of the entities, and the fact that they report record profits—Lincoln Savings reported it was the most profitable savings and loan in America. It’s easy if you’re going to engage in accounting fraud.
In addition to all these forms of deregulation, do not forget de-supervision. You can have all the rules in place you want; if you put in leaders who do not believe in regulating, you will get completely ineffective regulation. Here are the classic examples, was the head of OTS, first appointed by President Bush, who came to the press conference with a chainsaw and the federal register to demonstrate his commitment to destroy all regulation.
Again, think more broadly than just the regulatory structure. When you deregulate a financial industry, de facto you decriminalize it. The FBI cannot make these cases on its own. I spend a huge amount of my time doing this at the agency. We are the people that make the criminal referrals. We are the ones who make the substantial criminal referrals. We are the ones who put together who are the leading purveyors, where are the weak points, the Achilles heels in these systems. We are the people that train the FBI agents. We detail our staff to serve on the grand juries if they’re going to be effective; we serve as their expert witnesses. I did this on a number of occasions. When those things do not exist, de facto it’s decriminalized. Nobody calls the Houston Police Department and says, I think there’s a problem at Enron. Could you come on over and look? It seems absurd to even think of that.
Similarly, we have gutted the ability of plaintiffs to bring civil fraud suits. We have put in place in the Securities and Exchange Commission frequently people who did not believe in doing it at all; instead of the other thing that you do when you deregulate or de-supervise, is that you make an area opaque. So one of the enormous problems the Treasury and Fed have had to deal with is they simply didn’t even know who the counter-parties were. They didn’t know within $5 trillion what the notional amount of CDS was. Plus or minus $5 trillion is a little off.
And we got this too-big-to-fail wrong on both ends. Lehman shouldn’t have been allowed to go down in that fashion, and others who[m] we bail out— I would say to Marcellus, I would offer a metaphor that might be even better: It’s not that they grabbed somebody and kidnapped; it’s Blazing Saddles. I can’t say the line out loud, those of you who remember it; but the sheriff turns the gun on himself and threatens to shoot. And that’s very much what AIG has done, turned the gun on itself and threatened to shoot. Thank you very much.
Barclay Rosser:
I’m basically going to talk about five different things, and maybe a little bit of a difference tone from the previous two, which has been catching crooks, and I’m all for catching crooks. I’ll say what they are, and then I’ll do them.
One has to do with how much should we spend time worrying about new institutions. Another has to do with battling bubbles. Another has to do with the infamous mark-to-marketing issue. Another has to do with what should we do about housing. And the last is a kind of a, thinking briefly at least, about an interesting example, the safest banks in the world, the Canadian banks.
So the first one: If I had put up my [power point], it would have said, “No new institutions!” Now I don’t really believe that, but I want to raise a cautionary point here. We have this glorious moment of crisis. We’re all enjoying it to some degree, those of us who haven’t gone broke, and partly that’s because there’s this chance to do all sorts of new things. But even in a situation like this, there is, as they say, a limited amount of political capital. What do you focus your political capital on? I would say that what you need to focus it on is getting good rules, good regulations, and good people in it—not so much on trying to create new bodies or new institutions. I don’t want to pick on any; there have been quite a few thrown out here. We need this kind of a thing, we need that kind of a thing. Many many of the things that have been proposed—I should say, the activities—can be done through existing institutions. As Jamie Galbraith pointed out, we have all array of institutions that were created in the New Deal and the Great Society. Many of them have been sort of moribund or not very active; they’ve had bad leaders, or corrupt leaders. But many of these institutions with better leaders and new rules can do many of the very desirable things that have been proposed today by many people.
An example in my mind of bad organizational activity—and I fear the Democrats are maybe more prone to this; the Democrats like to create new government entities—I’m just thinking about the Homeland Security Department. This was supposed to solve our problems. There was this huge restructuring, and we pull all these agencies, and we stick them under it, and we discover that, what have we done, we’ve created a new level of bureaucracy which is focused on keeping out terrorists from abroad. And the next thing that happens is we have hurricanes hitting New Orleans, and FEMA is under the Department of Homeland Security, and the Department of Homeland Security couldn’t give a hoot about hurricanes, and where are we. So you can really mess things up.
I understand there was a conference yesterday that Joe Stiglitz organized, and I heard from a couple of the people here who were there that in fact this is a big argument, that practically the central bankers were saying, Don’t do much. Tweak the existing institutions. Some others are saying, Let’s create new institutions. But I think you can have really new policies and really major reform, and focus on that rather than let’s create this entity, or let’s create that entity.
Now that doesn’t mean—I’ve been sort of thinking about it—I’m totally against creating some new entities. Two that are kind of in my mind - although I think at least one of them we might be able to fit into an existing entity, is Paul Davidson’s Homeonwers Loan Corporation, HOLC. I suspect we could probably put that activity into the Housing and Urban Development Department, which of course was created in the’60s. HOLC was a creation of the ‘30s. So I think, again, this is, I think, a very good activity, we need something like that; but I think we could probably do it in existing institutions.
If there’s another one, that maybe is the brand new one, and this hasn’t been brought up, and it may be more international, although I think there’s been some move in the US. But again, this one might be able to be done with existing institutions. There’s been some talk, especially for credit default swaps, what we need to do is have a central exchange and stop having them being over the counter. This is a way in which we will have transparency, know how much of them are out there—I mean, this looks to me like something we really really really really need to have. But it may well be that we can do that through the Commodity Futures Trading Corporation, or something else. But maybe we have to set up a brand new entity, I don’t know.
The fewer new entities we’re creating, I think the better off we are. We should be focusing on the actual policies, the actual new activities, and getting people into these places that have the right attitudes and are committed to doing something. My bottom line on that is that the institutional structure that we get out of this should lean and clean and mean.
Number two: Now this one hasn’t really been spoken about, although I think buried in Allen Sinai’s report were sort of some vague comments, and some of this is something that Paul Davidson has talked about. This is the question about battling bubbles. I’ve talked about some of the things I’m talking about today to a number of colleagues, some of whom are very pro-free market. This is the one that really gets them upset. They start [makes tight growly noises]. I’m also going to give warnings about this. This is a very difficult one. In fact, let me note the warnings up front, and then I’ll suggest what we should do.
We’ve had some efforts to do this in the past, and some of them were really really disastrous. Here’s who I don’t think should be doing it, or the tool that shouldn’t be done: using interest rates, having the Federal Reserve use interest rates to battle bubbles I think is an overly blunt instrument. What is the great awful example? 1929 and 1930. Why did the Federal Reserve not have an expansionary monetary policy when the Stock Market crashed in 1929? Well, there have been a lot of allegations about anti-Semitism, and this and that; but the major thing that was going on, at least on the surface, was they were trying to squeeze the bubble out of the stock market. Well by gosh darn it, they succeeded, and we also got the Great Depression. So an overly blunt instrument against bubbles can way way bomb.
Then there’s this other problem, and a lot of people have laughed about it, but in fact it’s a very serious problem: It’s the question of when is there a bubble? How do you know there is a bubble? Alan Greenspan resisted trying to battle bubbles precisely on this. Some people laughed and said, Ah, he should have seen it. Why didn’t he do something? I think he should have done something. In fact, you know, a lot of people have forgotten that he made a vague effort to do something about the Stock Market bubble, and he made a complete fool of himself. It was his famous line about irrational exuberance, right? It warned against irrational exuberance in 1996. Well, I think the market dropped the next day, and then it turned around and went roaring off; and I’m not sure that the dollar has ever been back down that low again. Greenspan is somebody—maybe he’s the big villain, or whatever; but he really doesn’t like being caught and made to look silly. And he looked silly. I’m tempted to tell you about a cartoon that I have outside my door, but I think I’ll skip that. If somebody can ask me in the question-and-answer session, I’ll tell you about the cartoon I have on my door. It’s about the irrational exuberance.
But in any case, after that he was burned. He said, “I don’t want to get into this business.” There are huge theoretical arguments here that I’m not going to get into. But here’s what I think: I think that the body that ought to keep track of this actually is the Council of Economic Advisors. Oh, by the way, I think that one body we don’t need is the National Economic Council. Clinton created this; I don’t know what it does. What the Council of Economic Advisors is, get rid of the NEC. It’s look like Obama wants to do it again. This is a Robert Rubin thing. Yech! Get rid of it. Anyway, let the CEA be the body that sits around and tries to figure out, are there bubbles in certain markets.
Here’s what I think about responding. I think what you have to think about is a variety of flexible policies and actual agencies that carry it out. It depends on the bubble Different bubbles go different ways. Some go up, and then they suddenly crash—you see that more in commodities--; some go up gradually and come down gradually—that’s housing; and others do the period of financial distress—this, by the way, is the most common. It goes up, kind of declines for a while, and then it crashes. That’s what it looks like happened with the credit and financial derivatives market. It peaked in August of 2007, crashed on September 17, thirteen months later. If you go read Kindleberger’s great book, Manias, Panics, and Crashes, you have Appendix B, fourth edition, 47 historical bubbles; 37 of them look like that.
Part of what you want to do depends on what kind of a bubble it is, what is its pattern? You can attack them in different ways. I think what you need is innovative approaches. Margin requirements are an obvious thing for certain kinds of markets, restricting certain kinds of lending practices, and housing, building housing—Gary’s talked about this. Paul Davidson has talked about buffer stocks. We had an oil bubble earlier that was tough. We shouldn’t have been adding a strategic petroleum reserve. Sell oil out of the strategic petroleum reserve. I could tell a story about Joe Stiglitz and that issue, but he’s not here, so I won’t.
In any case, what I see is particular bubbles, you use particular bodies that deal with what the bubble is. If it’s an agricultural commodity, you go through USDA, and be very precise—not some blunt instrument that hits the whole economy. I realize that this is something that’s very very difficult and probably the most controversial. I think it should be attempted.
Mark-to-marketing accounting: We’ve had a little bit of discussion of this. Let me throw out a couple of things on this. I don’t think I need to go through the argument of why this is destabilizing. What’s happening? We forced banks to sell off assets to raise capital. When the value of the assets goes down, well, of course, the selling itself pushes these values further. So we know that this has a bad tendency to destabilizing.
This is actually a fairly complicated issue. The mark-to-marketing thing has come in from the Basel II accord, combined with capitalization requirements; and this is something that took a very very long time to be done. I’ve talked to a number of accountants, and they really don’t want to see mark-totmarketing got rid of. I can see that there’s a very valid argument for using mark-to-marketing. So you don’t get rid of it. What you do is you kind of come up with ways to kind of go around it. One of these I read about, and another one I just heard about at lunch, which came from that conference yesterday. So one of them is what they’re doing in Germany. These two are kind of variations on each other; they’re ways to kind of relax the mark-to-marketing. I think the SEC is apparently thinking about this matter, so they may be the body that could actually do this. Apparently what is being done in Germany now is that if a bank promises to hold an asset to maturity, well then you allow them to value it at what they bought it for, or what it’s going to be paid in for—whatever. You don’t make them mark to market, so that sort of removes some assets, potentially moves some assets from mark-to-marketing rule without getting rid of the whole system. Now, some people have pointed out, well what do you do about—You’ve got to make them promise. How do you hold them to those promises? That can be kind of tough.
Now another proposal, actually John Eatwell was telling me about this at lunch; it came up yesterday. This is one where you look at, in fact, the nature of the funding; because a lot of the mark-to-marketing is a day-to-day evaluation. Let’s say you’re being funded by longer-term securities; then you can base it on that. In any case, what it boils down to is that there are probably ways to in effect tweak the mark-to-marketing system to smooth things out, and not force this very volatile jumping around.
Housing. There’s a whole bunch of things that have been proposed, and really a lot of them I’m very supportive of. Let me just mention two things that I haven’t heard mentioned yet. One of them is a proposal that I think David [Pollander?] came up with. Maybe the HOLC, or the entity in HUD that becomes the HOLC, or does that function, could do this. This a proposal of foreclosure vouchers. There are some problems probably with this, but I think it’s kind of an interesting idea. So what you do is you issue these vouchers based on income, so poorer people will get more of them. And basically you can use them either to help pay a mortgage if you’re in danger of being foreclosed, so this helps avoid foreclosures, keeps people in their homes. There’s been a lot of discussion about how can we help keep people in homes, poor people who are in danger of losing their homes. We’d rather not have these houses being dumped on the market in a forced way, and so on and so on. Or you can sell it to somebody who’s going to do that. Or you can just sell them in a secondary market. Now, I have some questions about this, but I think it’s sort of an interesting idea that people should think about.
Another one is the so-called shared appreciation mortgage. This is apparently something that had been done in the past where, in effect, you renegotiate a mortgage with the lender, you get a lower principle. In effect what happens is that the lender is able to share in any appreciation of the housing value that might occur. This presumably allows or would encourage lenders to allow some renegotiation of a mortgage to a lower amount.
Apparently this is on the books. And what’s happened, one of the advocates said this could be done with a stroke of a pen by the US Treasury secretary. Apparently what’s happened is that these are not being done because the IRS decided that there was some problem about the definition of debt and equity, and they said, “This is too complicated,” and they’ve put a hold on it. But the treasury secretary, any treasury secretary, could simply say, Not a problem. Bing. And we could have these again.
Let me make a further comment about housing: There’s a real deep conflict here. A lot of people, including people like Martin Feldstein, have been arguing—and I have a good deal of agreement—that as long as housing is going down in value, and if Case and Shore are right, we’re probably only about halfway down from the bubble; we’ve got some ways to go. It took us two years to get from the top to where we are now, so if you want a rough estimate of how long it’s going to take us to get down, another two years. And of course this has been driving the sub-prime mortgage crisis. What has happened is we’ve had this giant house of cards built on ultimately bad sub-prime mortgages that are blowing up. As long as housing prices keep going down, we’re going to have more of these things blowing up. So until those things stop going down, we’re in this danger of more and more toxic waste popping up from who knows where? So a lot of people are going, “We’ve got to stop the housing crisis going,” and there’s certainly a very strong argument for this.
But I guess I’m in the camp of saying, “Well, we really actually do have to get the housing prices down.” Some of this is, who likes expensive housing? Well, people own their own house, and they want to use it to borrow against to buy stuff, fine. I want a home equity loan to send my kid to college with. I’ve got children who are thinking about buying housing in California. It’s very expensive, and lower-cost housing is a good thing for people trying to get in the market. People say, “Oh, we have these people who can’t afford their mortgages,” but if the housing prices aren’t too high, then they can afford the mortgages. I mean, part of this whole sub-prime and exotic mortgage thing was trying to get people in these overblown bubble-priced houses that they couldn’t afford. Oh, well, we’ll give you this interest-rate-only and negative amortization mortgage. But I think we need to have a lot of mechanisms to help people and try to keep them in their houses while all this process is worked out.
My final example: today the best banks in the world by far the safest—none of them have failed—is the Canadian banking system. They’re very heavily capitalized, they’re very conservative. Mac Robertson over here was telling me, Eh, they’re boring!—but they aren’t failing. They’re clean and lean and mean. The regulations are pretty simple, but they work.
One final comment here—I’m going to finally have some disagreement; disagree with Bill Black. I’m not for reviving Glass Steagall. In fact, one of the things in Canada, was that all of the investment banks have been under the commercial banks, which means they’ve been under the regulations of the commercial banks. In fact, we’ve sort of have had that happen here in the US now. We don’t have any investment banks. Goldman Sachs and Morgan Stanley have suddenly turned themselves totally into commercial banks, which has the virtue of bringing them under the regulatory framework, and I think that’s a good thing. Paul’s shaking his head. Anyway, so I’m going to stop there. Thank you.
DP:
I don’t know Richard Medley, but I don’t think he’s here. So I guess we’ll open the floor for questions. But before we do so, I can’t resist, I’m going to ask about the cartoon of the irrational exuberance.
Barclay Rosser:
Okay, I’ll tell the irrational exuberance story. This cartoon came out right after he married Andrea Mitchell. They had their wedding and reception at the Inn at Little Washington, which is this very very famous, very fine, very expensive bed and breakfast outside of Washington, often rated as the best restaurant in the entire Washington metropolitan area.
The cartoon shows this hallway, and you see “Honeymoon Suite” on a door. And it says, “Mitchell Greenspan” above the “Honeymoon Suite.” And you see this bubble with a voice coming out and it says, “Alan, please, not another speech about the dangers of irrational exuberance!”
DP:
Just in case you thought this session wasn’t going to be exciting. Paul
Paul Davidson:
I thought he was going to say that she was very disappointed because he turned out to be anti-inflation.
Two points: One is Bill Black’s point about accounting fraud, which obviously is correct. Just think about this: Economists do not make their own data. They rely on accountants to provide the data. Now what does that tell you about econometric studies, particularly of GNP, GDP, etc. If it’s pig iron production, or something like that, where they measure tons, I assume they don’t lie about the number of tons. Maybe they do, I don’t know. But it says something about, even if you have a Council of Economic Advisors, can you trust them, can you trust any of these models?
Barclay, I was with you until you got to Glass Steagall. You mentioned Pecora, which of course is the reason what Glass Steagall was enacted. What the Pecora Commission found out was that banks were underwriting all sorts of strange things during the ‘20s and before, and selling them off. And remember, with a 5 percent margin, every individual was a hedge fund. You put down 5 percent, and you borrow 19 times that; so that was one of the reasons the market collapsed. Glass Steagall said, if you’re a financial institution, you have to decide whether you’re going to make loans, which were illiquid assets, had to be carried on the books ‘til the person either paid off the mortgage, or defaulted. And therefore the banker knew—He checked three things, the three C’s were collateral, credit history, and character. And you didn’t make a loan unless you knew this person.
When you securitize, you don’t care, because you’re going to pass it off. So you can either be a banker, and make these illiquid loans and hold them until the end because you couldn’t sell them, or you can be an underwriter, the purpose of which was to create a secondary market for these things. The real starting of the shadow banking system was in the ‘70s, when we allowed money market accounts to create checking deposits. Then the Federal Reserve in 1987 permitted bank holding companies to have up to 25 percent of their revenues in collateralized loans, and so on. And finally—and by the way, Paul Volker voted against it; he was the only one on the Federal Reserve board to vote against it. And finally the dam broke with Glass Steagall. What happens then is that nobody thinks they have to hold a mortgage more than 30 days, and that’s what creates the problem.
I should point out one other thing: Who is responsible for ending Glass Steagall? Well, we usually blame Phil Graham. But The Wall Street Journal points out that he didn’t have enough votes to get it repealed, and so he told a lobbyist of Citibank to call Sandy Weil up and have somebody call the White House and get Clinton. Three days later comes out and twists Democrats arms, and we get repeal. Who in the White House did that? We don’t know, but Robert Rubin resigns the next week and takes a job at Citibank. So…
Jack Blum:
The thing that I didn’t say when I spoke is that bankers have been trying to get out of the banking business for at least the last 40 years. The problem is that if you’re a banker, it’s a lousy business. You’ve got to do real loan underwriting. You’ve got to figure out, can the guy repay the loan? You’ve got to check his books, and half the time you’re going to say no. So it’s expensive, time-consuming. And then, how much can you charge? Because if it’s a really well-underwritten loan you’re not going to make a lot of profit. Routine banking business—your checking account, all the stuff you do—that’s all computerized, and it’s commodity, and nobody makes any money on it. So somewhere around the 1970s, bankers got advice from business consultants, who said, “The only way you’re going to have earnings increases is to get out of this business. Let other people do the underwriting. What you do is give them a line of credit so they can make the loan, and then you securitize and sell off.” So banks literally got out of the banking business.
Now I learned this in ’74 at a meeting in San Francisco where the treasurer of the Bank of America-- Lee [Prusher?] was his name, and he was explaining to me how brilliant their strategy was. Now, if you know the Bank of America before the ‘70s, it was a community banker. They made loans on houses. They really dealt with average people. He comes along, and he says, “Look, that was way too expensive. What we’re going to do is lend to developing countries.” And in this interview he says, “And we all know they never default. And the beauty of dealing with developing countries is we can put together a syndicate, and we can led them $500 million or a billion. It’s one shot, there’s no underwriting cost, and we get much better return on that than we do making all these local loans.” So one by one, all of the banks that did the banking job got out of the business, to the point where they didn’t even bother doing the intermediary function, because they farmed out their treasury operations to institutional money market funds. The institutional money market funds were doing treasury operations for banks. So what we have is banks rejecting their social function and a society that’s now stuck with the fact that nobody did the underwriting, that the people who did the underwriting made money by cooking the books, the people who bought it had no idea what they were buying, and the banks are collecting outrageous fees for doing this. That has to stop.
Barclay Rosser:
Let me respond to Paul, and this partly maybe is a follow-up on Jack’s comments. I think the problem isn’t so much the nature of the investment banks; it’s a lot of these other things, that you had low margin requirements, that you didn’t really have good supervision of these things. In some sense, what you have is this very unregulated banking. So if you have this very unregulated banking, then yes, you have this big problem. But I think what we’re looking like is I’m suggesting something like Canada, or Germany—Canada in particular—where you put them together, you make sure they’re together, and you apply more serious regulations to the whole operation. Now maybe that’s not going to work in the US. Well, they are back together, and we’re basically going there anyway. Frankly, I just as soon see Morgan Stanley and Goldman be in commercial banking roles than out there flying around doing who knows what.
Jack Blum:
But who in the regulatory world has a clue about what they’re doing and has the possibility of regulating them? I will tell you, based on my own experience, there isn’t anybody. So, that they get under the Fed’s regulation is an absolute waste of energy. Nobody will be able to regulate them, and all it does is put a fig leaf over what’s going on. That doesn’t help anyone. All it does is get the federal government deeper in trouble—
Barclay Rosser:
But would reinstituting Glass Steagall resolve that problem?
Jack Blum:
No, we’re talking about a much broader problem, and that’s why I said we have to revisit and look at the world as it is in a Pecora kind of study, so we know where the holes, and what has to be done, and who can pick up the pieces. I’m not asking for a reinvention of the wheel, I’m not asking for creation of mega-agencies; what I am saying is we’ve really got to take a look at where we’ve come, where the regulations have been undercut, what’s wrong with the regulatory system we have, why it is that the guys who are in charge of risk management can’t manage risk. That’s the stuff.
DP:
Before I ask you to speak, Gary, I want to recognize President Bob Kerrey, who is here from The New School, and I want to ask him whether he wants to make any comments.
Bob Kerrey:
I didn’t know about this event until too late to schedule a very long appearance. All I really want to do is come and thank the participants and apologize for not being able to be a part of it longer. I hope that some of the smart things that you all are trying to figure out make their way either into the lame duck session, about which I’m not terribly hopeful, I’m sad to report to a grateful nation, but at least it will make it into what I think is going to be a very very, I would say historic first session of the Congress in January. I think even prior to the State of the Union you’re apt to see the new Congress come into session and take fairly significant action, unfortunately a bit too late. But as they say, better late than never. So I think this next Congress is apt to accomplish more good, if you’re a Democrat, than maybe any Congress in the history of the country. There’s going to be a lot of good things done, I think, and I hope that some of the ideas that are percolating around here today make their way down to Washington; because there’s no question that the law is to be changed. The question is how. And there’s no question that the economy globally is in very serious condition. Some combination of John Maynard Keynes and Adam Smith needs to be applied pretty vigorously to get the darn thing back on track.
Anyway, I apologize for kind of a hit-and-run appearance, and I thank particularly the participants, and all of you in the audience, for gathering and having this discussion.
DP:
Thank you very much, and thank you very much for your hospitality.
BK:
You’re welcome.
Gary Dimsky:
I appreciate that. A couple of comments and then a question for the entire panel, including you, Dimitri, if you don’t mind. First, Barclay, I was going too fast to clearly indicate that what I was talking about in part was shared appreciation mortgages, which in my view could be held by—the counter-party could either be the government or a private party; but it’s something to look at. And possibly local governments, were they positioned and given the capacity, maybe with some kind of infrastructure fund backing, to take charge of housing in their own neighborhoods, because they know the cost of abandoned subdivisions and all that, and the police forces that they’re having to cut that can’t take care of the problems out in the neighborhoods, and all of that.
Secondly, Bank of America. When the Nation’s Bank bought Bank of America so that they could turn back into Bank of America, the first thing they did in California, the homeland of that organization, was to eliminate something called the Bank of America Community Development Bank, which had been fought for by community activists over many years as kind of the structural response to the Community Reinvestment Act needs that were no longer being met except through that entity. So that was kind of the reply to California. It makes one wonder, as you’re noting, that there’s an offloading of this core banking function, how we need to really envision that in this rethinking.
Now to my question: We have here—First of all, Barclay is one of the people who really knows a lot about chaos in economics, and so Barclay, you qualify, because from what we understand from our regulator friends here, chaos is very much one of the key themes that they’ve encountered and dealt with through their careers. And Dimitri, you’ve heard so many regulators, as well as participants over the years. So one question: If we take all that you say as true, it seems that there’s some kind of square-root law at work, where the more locations there are to do activities, and the more kinds of activities you can do, the more assets you can trade, and the more things you can do with them, and whether the not they’re over the counter or exchange-traded, the more fraud that can be perpetrated and the more bad things that can be done. So if we have to focus on simplifying activities, or reducing the number of locations of markets and so on, what direction, based on experience and your frustration over what you see as years of fraud, how would we begin to move to make more sense out of this, to cut down the fraud?
Bill Black:
In terms of cutting down fraud and dealing with bubbles, I think we’re one of the unusual entities that did deliberately target a bubble. We targeted it in 1984 through 1987. It was a commercial real estate bubble. I shouldn’t be the one evaluating it, but I will argue that we were extraordinarily successful, and that it’s a far better tool than trying to use monetary policy to try to deal with those kinds of things. What we realized, of course, was that these were Ponzi schemes. That’s how you optimized an accounting fraud. And if you put a bunch of Ponzis together, they will hyper-inflate and extend a financial bubble, and they will also send false price signals. This is pretty standard economics and finance, and by the way, it’s in the Akerlof and [Romer?] article in ’93 as well, the false price signals portion. One of the best things to do is to look for what is the Achilles heel. The Achilles heel, anytime you’re dealing with Ponzis, is growth. So we restricted growth, and that killed every single one of the Ponzis. There were roughly 300 of them.
Q [Gary Dimski?]:
Through leverage […?]
Bill Black:
Through a requirement that directly restricted growth. Because if you make it against capital, they simply inflate the capital through the accounting, and you don’t achieve your goal.
But the other thing that you do is, again, look for optimization. I’m a white-collar criminologist, and it’s very similar to economics. We think in terms of what we call criminogenic environments, environments that lead to crime; and it’s through perverse incentive structures. So where do we look there? You look for assets that have no readily verifiable market value, because it’s far easier to inflate those kind of values, it’s far easier to create phony accounting income, and it’s far easier to hide real losses. So it isn’t just everything. And it typically, by the way, isn’t risk. Economists, finance types--almost entirely the discussion is in terms of risk. These are not risks in any conventional sense. These are sure things in terms of accounting fraud, sure things in both senses: Sure things that you’ll report record profits, and sure things that you will fail.
Jack Blum:
I want to turn that conversation to a different area: commodities. I represented an exchange at one point. Most of you probably don’t know how commodities contracts work; but before a contract can start trading, the Exchange has to approve it, the CFTC has to sign off on it. And when a contract is traded, the firm that sells you the contract is responsible for insuring it. Then, if that firm fails, the whole exchange is responsible.
Now, what started to happen was the guys decided, the hell with this, we’re going to move this whole business of commodities trading into an unregulated offshore arena. And that brought us to companies like Refco, which went bust. It brought us to unregulated oil contracts, trading offshore, which allowed the most amazing kind of manipulation by Bernie Kornfeld and a bunch of crazy Russians, which is why we got to $140 a barrel, and why, in a matter of months later, we’re back down to $60. And nobody, nobody, but nobody, wants to look at all of that; because as long as I’ve known the Commodity Futures Trading Commission, you got the job by checking in with the head of the Chicago Merc [Chicago Mercantile Exchange], and you got a letter of recommendation for one or another of the brokerage firms to say you’re a good guy, and then you could get on the commission. And then when it came time to actually put a break on some of this offshore lunacy—Then of course there was a whole business of, Oh gee, Brooksly Born decides this, my god, this is out of control, we’ve got to do something. And she’s visited by Rubin and Greenspan, who say, Oh my god, it will be the end of the world if we actually regulate this stuff.
Now, indeed, it’s been the end of the world, but they got it backwards.
Q:
[…?]
Bill Black:
Yeah. This is the kind of stuff, this isn’t rocket science. We had a plan in place. There was a system for it. But when you allow the Exchange to appoint the regulators, and then you allow people to open up a whole lead [bate in it?], nothing works.
Q:
[…?]
Jack Blum:
Phil Graham’s wife, yeah.
Bill Black:
Let me also do just 20 seconds on, you can’t simultaneously crack down on accounting fraud and be sponsoring it. And so the cover-up through not recognizing market losses is always seductive. It is always sold as the silver bullet. It happens every time, every time, and people I don’t think in this room know that it’s happened every time, and that not always, but typically, it ends really badly, for all the reasons you would expect from moral hazard theory. This is another area where we do disagree, and we disagree very strongly.
Barclay Rosser:
I’m not sure what the disagreement is. Two quick comments on Jerry: One is, I think one way to get at this—I mentioned it, but I reemphasize it—is—and I think this is relatively easy—simply to outlaw certain kinds of financial instruments: interest-only mortgages—What were we ever doing with negative amortization mortgages? When I knew that the housing bubble was about to blow was when I saw in The Washington Post in early 2005, a majority of the mortgages that were being issued in the metropolitan area were interest-only or these kinds of things. The thing has gone out of control.
One final thing is, by the way, it’s very hard to fight—We know from economic experiments that even when people know they’re going to blow, they really like to do them because, while they’re going on, people are making money, and it’s very pleasurable.
Jack Blum:
On the mortgage business, there was regulation of that in the 1930s which required amortizing mortgages to be the mortgages; and then got blown off.
Bill Black:
And we brought it back in ’91 in regulations, because there was a problem developing in the same kind of instruments; and we stopped it in ’91.
DP:
Gary, that was a very good question, but maybe we should take another one.
Marshall Auerback:
I’ll be relatively quick with mine. One is directed towards Bill and one is directed towards Barclay. Just on the question of fraud, I think it’s interesting to note that the FBI now seems to be getting involved in examining Fannie and Freddie a little bit more closely, and I think, as we know from the history of Watergate, once the FBI gets involved, a law of unintended political consequences comes in, and sometimes things actually get done because you start entrapping people in the political class that prevents these sorts of regulations from what Jack Blum was talking about. So I’m just first of all asking what you think might be the impact of that investigation.
And my second question is to Barclay Rosser. It’s really to do with the mark to market issue. I’ve seen some of these derivatives, and I think the analogy that’s generally used is the Latin American crisis in the 1980s. So you say, Okay, you hold the bond on the bank’s book until maturity, and thereby avoid the problematic issue of marking it to market. Really now we’re dealing with something which is much more complex. We’re dealing in many cases with derivatives of derivatives. There’s no real definable cash flows for these things. So I’m not sure how you actually value it as a hold-to-maturity proposition either. That, I think, is the real problem you get into when you use that as a solution. So I’m interested in hearing your thoughts on that. Those are the questions. Thank you.
Bill Black:
Answer to the first one: I was an expert witness for Ohayo, the entity that was supposed to regulate Fannie and Freddie in the administrative enforcement action against Frank Raines and the former senior management. It’s a classic accounting control fraud run from the top. The SEC did not investigate it in terms of going after the senior leadership. It looked at it and said yes, the accounting is all wrong, but did not move at all vigorously. The FBI, as I noted, has treated this as a retail problem. It’s focused on people ripping off. And it does all of 600 cases a year of that, and it’s like throwing sand into the ocean. Had they created task forces early on, identified the problem—We can’t put undercover agents in Al Qaida, but it’s real easy to put FBI agents in WaMu. We don’t even have to phony up anything. They just leave the FBI, they get a job there, and within days they’d know that the internal control environment was completely destroyed.
Jack Blum:
It’s, believe it or not, worse than you think. The FBI actually had a mortgage fraud squad working in northern Virginia for several years. I know it because I handled the case involving a totally falsified mortgage where they tricked a legal but non-English-speaking immigrant into signing all the paperwork. And we brought the agent in, and gave him all the stuff. He rolls his eyes. And as we’re walking out, I ask him, “You’ve obviously seen these cases before. Why haven’t these people been prosecuted?” Because he even knew the people who were doing it. He said, “Well, until now, no prosecutor would pick up the case because no one lost any money.” And he said, “I can’t sell that to a jury.”
Now, the other part of it. The FBI pulled most of its agents of white-collar crime to do counter-terrorism. And let me tell you, the ones that are left—I was asked about, What do you think of the quality of their white-collar crime financial group as it sits? I said, It’s like a group of sumo wrestlers doing needlepoint.
Bill Black:
Seriously, you have to understand this: If you bring FBI agents who specialize in white-collar crime into a case like this, and you sit them down in front of files—70 file drawers—they will stare at you and go, “What the ___ do you expect me to do?” It isn’t going to happen unless you have an agency showing the way.
Barclay Rosser:
Marshall, I’m not quite sure whether you were asking me whether altering mark-to-marketing was difficult, or whether mark-to-marketing itself is difficult. I would certainly agree that these very very exotic derivatives are very very hard to value. We know from what people are saying that some of the people who’ve issued themselves don’t know how to value them. Somebody made a wisecrack, the people who were committing the fraud don’t even know they’re committing them. So there are very very difficult problems. And again, one of the signs of this is these things were supposed to be insured. And then they wake up and discover that the counter-party isn’t there, and of course that’s why we have a problem with AIG, who is reinsuring these insurance things. So I don’t really have an answer on that one.
Bob Larick:
I wanted to thank you all for your presentations. And I think what you brought up was really collusion. And getting back to what Mr. Schwartz was saying about the human failures, this is also very—not only humiliating, but, to say these least, these corporate officers lost a fortune, as well as their companies, and there’s something wrong with what we’re doing. So the question is, shouldn’t we be thinking about what did we do wrong in terms of our culture-a-go-go, our over-confidence, as well as, I think as you brought up, the sense of entitlement by not only Enron, but UBS, and some of these others in terms of political connections. And even in fairness to Mr. McCain, I think he said there’s corruption in Washington at the highest levels. And don’t we need to be able […?] to the issues of accountability and responsibility, and what type of world are we leaving our children unless we really go back and evaluate this type of global competition and cutthroat competition, and what type of family life and values are we really leaving for our children?
Bill Black:
This is led by our elite and by what became our most prestigious elites, right? Finance was where it was.
Jack Blum:
One of the indicia of this is that people stopped going to graduate school in economics to go to business school because they could make more money. There’s a whole collection, a whole generation of people who have gone worshipping at the church of the failed religion, and there’s still a whole bunch of them kneeling in that church chanting along with the people who gave them the failed religion. My son at the moment is in a business school program, and he came back to me, and he said, This is a terrible program. No professor of mine has yet discussed the current financial crisis. That’s Johns Hopkins Business School.
Bill Black:
The Chinese saying is that fish rot from the head.
Dimitri Papadimitriou:
I have been asked to end this session at 3:45, so the next one can begin at 4:15. And since the person who asked me is the higher authority, I have to listen to him. So thank you very very much.
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