Columns: How Did Investment Gurus Get Us In This Mess?

Columns: How Did Investment Gurus Get Us In This Mess?

While TV news readers and political pundits continue to scratch their collective heads trying to come up with a 30-second clip to explain the whole thing, while, at the same time, trying not to create a panic among consumers, the causes and ramifications of the economic disaster which engulfs us are actually fairly simple and well known if you do a little research.

While the old media has figured out that some Wall Street guys did some pretty risky and stupid things and, for some reason European banks are now also paying the price for the same stupid and risky behaviour, it is impossible to connect the dots in a 30-second clip. As a result, few average citizens understand what is going on other than the fact that something bad seems to be coming down the pipe.
Because Canada’a chartered banks and financial industry are more regulated and controlled, our exposure to the massive fraud which caused the ongoing economic meltdown was limited. Not due to any political management of the economy by Stephen Harper and Jim Flaherty (who wasted billions of dollars on an Economic Stimulus Package designed to get them re-elected), but due to the conservative and strict regulations on banking in Canada.
With our stimulus billions already wasted, there is precious little Flaherty or Harper can do to protect us against phase two of the worldwide economic meltdown.
One of the interesting questions asked by many average investors, voters and the Occupy movement is this: If what the Wall Street guys did was so bad, why aren’t more than one of them in jail?
The answer will terrify you.
Simple fact: The fraud was so endemic and went from Wall Street right down to the smallest investment broker in the smallest communities in America that to prosecute the fraudsters would involve literally millions of American citizens.
In an enlightening article for Bloomberg Media, University of Missouri associate professor of economics William K. Black explains why.
It is well worth a read.

Why CEOs Avoided Getting Busted in Meltdown

By William K. Black
The defining characteristic of crony capitalism is the ability of favored elites to loot with impunity and the failure of regulators to do their jobs.
We have seen this in the financial crisis that started in 2008 and in an earlier era, when the savings-and-loan industry collapsed.
In the Texas “Rent-a-Bank” scandal of the 1970s, for example, two ringleaders created a fraud network of 50 lenders that caused billions of dollars in losses. The watchdogs removed and sanctioned one of the main culprits, but because the crimes weren’t prosecuted, the same crooks reappeared in the 1980s to do it all over again, only on a bigger scale. Unless you imprison the fraudsters, sophisticated financial scams grow ever more destructive.
It seems as if we have forgotten this lesson.
Take the seven senior officials convicted in the failure of one of the lenders that drove the 2008 credit crunch. All of the cases arose from an investigation of Taylor Bean & Whitaker Mortgage Corp. The first trial occurred last month — 6 1/2 years after the Federal Bureau of Investigation warned publicly that there was an “epidemic” of mortgage fraud and predicted that it would cause a financial crisis if it weren’t contained. The trial and conviction of Taylor Bean’s former chairman, Lee Farkas, occurred nine years after his crimes were suspected.
Taylor Bean was a small Florida mortgage broker before the fraud began as the housing boom took off. Fannie Mae had cited Farkas for multiple violations, but never filed a criminal referral, which would have triggered an investigation. Had it done so, Farkas might have been prosecuted and Taylor Bean shut long before it caused so much damage. Instead, it expanded, then failed, pulling down a bank with it at a cost of $2.8 billion to the Federal Deposit Insurance Corp. Farkas plans to appeal the verdict.
Fraud With Impunity
The Office of Thrift Supervision, the successor to the S&L regulator where I worked, made no criminal referrals in the latest crisis. The Office of the Comptroller of the Currency and the Federal Reserve made less than a handful. Mortgage and investment banks also made very few referrals — and never against their senior officers.
Now it is true that banks made thousands of criminal referrals, but almost all involved low-level figures. The volume overwhelmed the Federal Bureau of Investigation, which failed to devote adequate resources. As late as 2007, the agency assigned only 120 investigators spread among 56 field offices to probe thousands of cases. More than eight times that number probed the S&L frauds, a far smaller epidemic.
Unlike the S&L debacle, there was no national task force and no comprehensive prioritization. This made it difficult to investigate the huge, fraudulent subprime lenders. And since there were no criminal referrals of these firms, the FBI wasn’t even attempting to pursue them.
Two Lessons
The two great lessons to draw from this epidemic of fraud is that if you don’t look for it, you don’t find it and that wherever you do look, you do find fraud. The FBI was concentrating on retail banking, or individual borrowers and smaller lenders. But the big problems were being created in the wholesale end of the business, where loans were pooled, packaged, sold and securitized. Because the FBI only looked at relatively small cases, it found only relatively small frauds.
The FBI has been processing no more than 2,000 mortgage- fraud cases a year. There are two things to consider though: Not only were they the wrong cases to focus on, but they amounted to nothing in light of the estimated 1 million fraudulent mortgage loans made annually during the housing bubble years.
Deserted by Regulators
The FBI — deserted by the banking regulators and undercut by the Justice Department — was so desperate that it formed a partnership with the Mortgage Bankers Association in 2007. The trade association had created an absurd definition of mortgage fraud under which accounting frauds by a lender were impossible and bankers were the victims. By 2009 the financial crisis had become so acute that Treasury Secretary Timothy Geithner discouraged criminal investigations of the large nonprime lenders.
Nobel laureate George Akerlof and Paul Romer wrote a classic article in 1993. The title captured their findings: “Looting: the Economic Underworld of Bankruptcy for Profit.” Akerlof and Romer explained how bank CEOs can use accounting fraud to create a “sure thing” in the form of record short- term income, generated by making low-quality loans at a premium yield while making only minimal reserve allowances for losses. While it lasts, this fictional income allows the chief executive officer to loot the bank, which then fails, and walk away wealthy.
Wealth Destruction In criminology, we call these accounting-control frauds and we know that they destroy wealth at a prodigious rate. There’s no “if” about the losses — the only questions are when they will hit, how big they will be, and who will bear them. The record income produced explains why those involved get away with it for years. Private markets don’t discipline firms reporting record profits. They compete to fund them. Fraudulent CEOs can control the hiring and firing and can create the perverse incentives that produce a dynamic in which bad ethics drive good ethics out of the marketplace.
Sophisticated accounting-control frauds not only sucked in employees who should have known better, but also loan brokers. The result is that the large fraudulent lenders — those making a lot from liar’s loans — produced an echo epidemic of deception.
Fraud, it turns out, begets fraud.

Prfessor William K Black. Photo from laprogressive.com.

William K Black
William K. Black is an associate professor of economics and law at the University of Missouri-Kansas City and the author of “The Best Way to Rob a Bank Is to Own One.”
You can contact William K. Black at blackw@umkc.edu

This column was originally published – May 10, 2011 4:00 PM PT Bloomberg Opinion on Bloomberg.com.