Geithner channels Greenspan and Airbrushes Fraud out of our Crises

On April 25, 2012, Treasury Secretary Geithner made remarkable statements about the role of elite financial fraud and greed in producing our recurrent, intensifying financial crises.

In this first installment I focus on the first of five problems with Geithner’s claims: (1) he does not understand the causes of prior crises, (2) he does not understand the causes of the ongoing crisis, (3) he does not understand that if he were correct about the first two points our nation would be in even greater peril and the urgency of Geithner leading a radical transformation of finance and regulation would be greater still, (4) he is not correct that we are prosecuting the elite criminals who drove the ongoing crisis, and (5) the media continues its nine-year pattern of failing to challenge Geithner’s fictions and his failures to lead the radical transformation that he should be desperately seeking given his stated beliefs about the causes of financial crises.

Here are the specifics of what Geithner said about financial crises, fraud, and greed.

"The wheels of justice are turning now," Geithner said at an event in Portland after touring a factory there. "They are not turning as fast as people would like, but we have the best system in the world for making sure we can enforce the laws of the land," he said.

Geithner suggested that holding people accountable for the wreckage caused by the recent housing collapse and the ensuing financial meltdown was not that simple since most crises were not caused by criminal activity.

"Most financial crises are caused by a mix of stupidity and greed and recklessness and risk-taking and hope," said Geithner, who helped tackle the crisis for the Bush administration when he was the head of the New York Federal Reserve and has been urging Europe to act more aggressively to contain its debt problems.

"You can't legislate away stupidity and risk-taking and greed and recklessness. What you can do is make sure when it happens it does not cause too much damage and to do that you have to make sure you have good rules against fraud and abuse, better protections and you force banks to hold more capital against their risk," he said.
 

http://www.huffingtonpost.com/2012/04/25/timothy-geithner-wheels-justice-turning-now_n_1454235.html

Geithner’s first claim is that “most financial crises” are caused by non-criminal acts.  “Stupidity” is the lead cause of financial crises, compounded by “risk-taking and greed and recklessness.”  Fraud does not even make Geithner’s list of contributing factors to financial crises.  The U.S. has experienced three recent financial crises – the S&L debacle (which is the subject of this first installment), the Enron era frauds, and the ongoing crisis.  Accounting control fraud is the leading cause of each of the crises.  “Control fraud” is the term white-collar criminologists use to refer to frauds in which the person controlling a seemingly legitimate entity uses it as a “weapon” to defraud.  Accounting is the “weapon of choice” for elite financial frauds.  Control frauds cause greater financial losses than all other forms of property crime – combined.

Three preliminary comments are in order.  First, Geithner was selected to be the President of the Federal Reserve Bank of New York (FRBNY) in 2003.  The President of the FRBNY has the second most important position in the Federal Reserve System.  It is essential that the FRBNY President study and understand the causes of financial crises.  Geithner had ample time and incentive to conduct such a study.  Second, no one challenged Geithner when he (implicitly) claimed that fraud was not even worthy of mention or consideration as a contributor to financial crises.  Third, even if Geithner were correct that fraud was only a relatively small contributor to the Great Recession that would provide no basis for not prosecuting the elite frauds who made that illegal contribution.

It is useful to expand slightly on the second point.  No one appears to have asked Geithner how he came to believe that “stupidity” is the primary cause of financial crises.  I am flabbergasted at the claim.  The individuals who are principally responsible for the crisis (whether due to their stupidity or fraud) are the CEOs of the largest financial institutions who made, purchased, pooled, and resold as collateralized debt obligations the pervasively fraudulent liar’s loans that drove the crisis.  The enormous extent and growth of liar’s loans and their endemically fraudulent nature is not in dispute.  The green slime that drove the crisis is not at issue. 

The only issue is why the CEOs made and purchased vast amounts of loans they were repeatedly warned were fraudulent and sure to cause catastrophic losses as soon as the housing bubble stalled.  Assume solely for the purposes of analysis that Geithner is correct that they did so because of stupidity rather than fraud.  That assumption requires the CEOs of Countrywide, Ameriquest, Indymac, WaMu, Fannie, Freddie Mac, Fannie Mae, Lehman, Bear Stearns, Merrill Lynch, Wachovia, Bank of America, Citicorp, and all the largest mortgage banks to have been terminally “stupid.”  It also requires the boards of directors of each of these entities to have either been so stupid that they failed to notice that the CEO was stupid or so devoid of integrity and respect for their fiduciary duties that they were indifferent to their CEO’s stupidity.

Geithner’s assertion also requires that the regulators to have been so stupid or so insipid that they could not recognize that the CEOs were terminally stupid or so indifferent to their oaths of office that they did not object to stupid CEOs running the largest financial organizations in the United States.  Since Geithner dealt personally with these CEOs, his assertion, if true, would require him to either be stupid or indifferent to his oath of office. 

That’s a lot of abject stupidity among the most elite CEOs – drawing an average salary of about $10 million annually in compensation for their stupidity.  The boards, the regulators, the media, and shareholders are incapable of recognizing the CEOs stupidity.  Everyone suspended disbelief and emulated the fools in the movie “Being There” who treated Peter Seller’s character’s (Chance the Gardener’s) inane ramblings as profound pearls of wisdom.  If Geithner is correct, big bank CEOs never shave with Occam’s razor – and stupidity is omnipresent in the C-suites.  Geithner also doesn’t seem to view it as particularly alarming that many of most elite CEOs are paid hundreds of millions of dollars as rewards for their surpassing stupidity.

Geithner does not reveal, and the media lacked the curiosity to ask, how he determines the answers to questions as essential to the performance of his duties as “why are we suffering recurrent, intensifying financial crises?”  I will explain how I approached that question when it was essential to the performance of my duties upon becoming an S&L regulator on April 2, 1984.  I decided that it was critical to study what was causing over one S&L per week to fail. 

I was the newly minted Litigation Director of the Federal Home Loan Bank Board (Bank Board) and every failure came across my desk so that I could (1) prepare to defend a legal challenge to our placing failed S&Ls in receivership and (2) determine whether we should sue the failed S&L’s officers, directors, and professionals because acted negligently or fraudulently.  We called the process the “autopsy” and I was the “chief coroner.”   

We decided that the financial autopsies provided us a priceless opportunity to study systematically the causes of the failures and to search for patterns and indicators that we could use to spot the frauds prior to their failures and to prove that they were frauds.  This required us to distinguish between officers who were fraudulent, stupid, or engaged in high risk, but not illegal, “gambles for resurrection.”

To assist our analytics we worked with agency accountants, appraisers, real estate experts, and economists to provide multidisciplinary lenses with which to understand the failures.  We also worked closely with the examiners who best knew the facts about the individual institutions.  The examination reports and supervisory files contained the failed S&Ls’ officers’ explanations and attempted rebuttals of the examiners’ criticisms.

We did not know we were doing it (because no agency has a “Chief Criminologist”), but we had implemented the suggestion of two researchers who studied elite white-collar crimes and proposed two years earlier that investigators develop analogs to CSI-style crime labs to study elite white-collar crime.  Wheeler, S., Rothman, M., 1982. The Organization as Weapon in White Collar Crime.  Michigan Law Review 80, No. 7: 1403-1426. 

We found that there was a distinctive fraud pattern, that the frauds used accounting as their “weapon of choice” (a metaphor that we also developed in parallel to Wheeler and Rothman), and that they followed a fraud “recipe” that was a “sure thing.”  The recipe had four ingredients:

1. Grow like crazy
2. By making really crappy loans at a premium yield
3. While employing extreme leverage, and
4. Providing only trivial allowances for loan and lease losses (ALLL)

The recipe produced three sure things.  The S&L was certain to report extreme (albeit fictional) income in the near term, the CEO would ensure that the S&L adopted a plan of executive compensation that would turn the fictional reported income into real wealth to the CEO, and the S&L was certain to suffer catastrophic losses because the loans had a negative expected value when made. 

These three “sure things” allowed us to understand several things that proved critical in containing the S&L debacle, which was growing rapidly in 1984.  One, we realized that “risk” as we conventionally conceptualize it in finance had nothing to do with the frauds.  Optimizing the recipe, by making loans at a premium yield, caused them to make loans that would have been exceptionally risky for an honest lender, but the risk was irrelevant to the frauds’ decision-making.

Looting is liberating for the CEO.  The frauds weren’t engaged in an honest gamble for resurrection.  They were following a strategy that ensured they could loot the S&L and walk away wealthy when it failed.

Two, we recognized the fraud recipe explained the frauds’ distinctive (reported) performance.  If firms were engaged in honest, extreme-risk gambles for resurrection we should have seen a wide dispersion of results.  There should have been some exceptionally big winners, some mixed, and many abject failures.  Instead, they all reported extreme profits in the short-term, they all failed, and they all suffered catastrophic losses when they failed.  The fraud recipe produces that pattern of (reported) outcomes, honest gambling does not. 

Three, we realized that we were seeing a weapon of mass destruction of wealth.  The fraud recipe was easy to mimic – it is easy to make bad loans.  The frauds clustered where deregulation and deregulation were most extreme – in Texas, Arizona, and California, particularly in state-chartered S&Ls in those states.  We realized that entry was easy because of the desupervision, the creation of “daisy chains” of fraudulent S&Ls that would fund each other’s acquisitions, and the mass insolvency of the industry due to the first phase of the S&L debacle (caused by interest rate risk losses).  This clustering plus the first two ingredients of the fraud recipe meant that the S&L frauds had perfectly perverse incentives to hyper-inflate a bubble.

The fraudulent daisy chain allowed them to refinance each other’s bad loans to greatly delay loss recognition.  The saying in the industry was: “a rolling loan gathers no loss.”  In combination, these aspects allowed the frauds to greatly extend the life of their zombie S&Ls, which allowed ever greater looting. 

We also recognized that the first two ingredients of the formula required fraudulent S&Ls to adopt distinctive operational characteristics that no honest firm would follow.  An honest conventional (as opposed to microfinance) lender has redundant internal and external controls designed to prevent the lender from making bad loans.  Honest conventional real estate lenders engage in excellent underwriting to prevent credit losses.  Historically, home lenders have engaged in such effective underwriting that credit losses were minimal and fraud losses were trivial.  The fraud recipe, however, required the lender to be willing to make enormous amounts of bad loans.  To do so, however, the lender had to gut its controls and underwriting – sure “markers” of accounting fraud. 

For example, an honest lender would never inflate, or permit to be inflated, appraisals of the value of the real estate pledged as collateral for the loan.  Fraudulent lenders often inflate appraisals.  We recognized that the fraudulent lenders were finding means to create perverse incentives to suborn their key controls, particularly the outside auditor and the appraisers, into becoming fraud allies. 

We were familiar with George Akerlof’s already famous article on markets for “lemons” and his warning that if frauds gained a competitive advantage they would produce a “Gresham’s” dynamic in which bad ethics drove good ethics out of the marketplace.  Note that this does not require the frauds to suborn all or even most appraisers and auditors.  A small percentage of appraisers and auditors willing to sign off on inflated asset values is sufficient to permit endemic “accounting control fraud.” 

We used these analytical insights to contain the S&L debacle.  We reconceptualized the nature of the crisis.  It was no longer an “interest rate” or “gambling for resurrection” crisis.  It was becoming a fraud crisis led by the CEOs.  Deregulation, desupervision, ease of entry, and perverse executive and professional compensation were creating an environment that created endemic fraud.  (Criminologists call this a “criminogenic environment,” but we did not know anything about criminology until we met Henry Pontell and his colleagues in 1993.)  We reregulated and resupervised the industry. 

We cracked down further on entry.  Bank Board Chairman Gray had begun the crackdown in November 1983.

We used our knowledge of the fraud recipe to identify the worst frauds while they were still reporting record profits, positive capital, and minimal losses.  Much of the industry went crazy.  Our new strategy caused Keating to put the Keating Five into action to try to block his closure and (soon-to-be) Speaker Wright and a majority of his House colleagues to block reregulation. 

We also realized that the recipe meant that the frauds had an Achilles’ heel – their need for extreme growth.  We restricted growth to 25% annually, a ridiculously high level (it was the only way to get the other Bank Board Members’ to adopt the rule), that still proved fatally low for the frauds.

We made the removal of the frauds from the industry our top priority and their prosecution our second priority.  We trained our staff, the FBI, and the prosecutors to recognize the distinctive accounting control fraud pattern.  We made over 30,000 criminal referrals.  We created over 30 fraud working groups with the FBI and U.S. Attorneys to get continuous feedback on the quality of our referrals so that we could continuously improve our training and quality control to produce superb referrals.  We “detailed” dozens of examiners to serve as internal experts for the FBI on sophisticated investigations.  We worked intensively with FBI and the Justice Department to create the “Top 100” list of the worst frauds that became the highest priority.  We served as fact and expert witnesses for the prosecutions.

I helped shape our criminal referral process, made and edited criminal referrals, provided internal and external training, testified as an expert in court, and testified on behalf of my agency or office a half-dozen times before Congress about the role of fraud in the S&L debacle.  In the course of my written and oral testimony on fraud researched the data on fraud and prosecutions and I studied and often listened to the testimony of other senior regulators and law enforcement officials on the subject.

In 1993, the Department of Justice finally funded criminological research into the S&L debacle.  (One of the great, unknown scandals is that the Justice Department rarely funds research into elite white-collar crime.)  Henry Pontell and Kitty Calavita of UC Irvine and Robert Tillman of St. John’s began to investigate the role of fraud in the S&L debacle.  They interviewed scores of agency officials.  I asked for copies of their final and draft papers and began to add criminological theory into our multi-disciplinary analysis of the S&L frauds.  Their study for Department of Justice, their many academic papers about the role of fraud in the debacle, and their book confirmed the decisive role that senior insider fraud played in driving the crisis.  Calavita, K., Pontell, H., Tillman, R., 1997. Big Money Crime. University of California Press, Berkeley.  

Two additional fusions of knowledge occurred when I served as the Deputy Staff Director of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) the national commission charged with finding the causes of the debacle) where I worked directly and extensively with James Pierce (economics, UC Berkeley).  I produced ten lengthy staff reports for NCFIRRE on a wide range of subjects.  At least five of them dealt materially with fraud.  Dr. Pierce introduced me to his colleagues George Akerlof and Paul Romer, who had been independently studying the role of fraud in the S&L debacle and other crises here and abroad. 

I had developed an extensive piece explaining how to differentiate among potential defendants who were senior lenders based on whether they were acting due to fraud, honest “gambling for resurrection”, or stupidity.  Akerlof and Romer invited me to three academic presentations of their paper, read the staff reports relevant to fraud that I produced for NCFIRRE, and discussed our views extensively.  Their final paper reflects the collegial exchange of views (and, of course, the influence ran in both directions).  The title of their 1993 paper captures their thesis – Looting: the Economic Underworld of Bankruptcy for Profit.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=227162

Ever generous, the first footnote to their paper notes the mutual collaboration.  The passage below adopts the view I had argued about the fact that the operational pattern of the worst S&L failures was optimal for an accounting control fraud but would be insane for anyone engaged in an honest “gamble for resurrection.”

“The problem with this 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.5 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.”

5. Black (1993b) forcefully makes this point.

[This reference was to one of my staff reports that Akerlof & Romer cited.]

Black, WilliamK . 1990." Ending OurForebearers' Forbearances:FIRREAa nd Supervisory Goodwill." Stanford Law and Policy Review 2(1):102-16. .

 1993a. "Junk Bonds." Staff Report 7. San Francisco: National Commission on Financial Institution Reform, Recovery, and Enforcement (April 8).

1993b. "The Incidence and Cost of Fraud and Insider Abuse." Staff report 13. San Francisco: National Commission on Financial Institution Reform, Recovery, and Enforcement (April 12).

(1993 p. 4 & n. 5 and p. 70).

I then returned to school and received a Ph. D in criminology from UC Irvine.  I did my dissertation on the theory of control fraud and its application to the S&L debacle.  I also wrote a book on the subject that remains in print.

I do not know what research process Geithner followed in claiming that fraud was not even worth listing as a material contributor to our financial crises.  I do know that the Obama folks know better because they filmed the heart of a campaign video in our living room here in Kansas City, MO and sent it to six million people.  I took the notes of the “Keating Five” (where we explained to the Senators that they were trying to prevent us from taking a vital enforcement action against a fraud) that led to Senate ethics investigation.  Senator John McCain was one of those Senators.  To no one’s surprise, the campaign video represents the last time the Obama administration has wanted my input.

It is inescapably vainglorious, but it makes sense to explain to the reader that it would have been sensible for the last three administrations to ask for suggestions from my former regulatory and prosecutorial colleagues and me.  Our reregulation of the S&L industry began in 1983.  This was one year after Congress and the Reagan administration enthused over deregulating the industry through the Garn-St Germain Act of 1982, which passed with only one dissenting vote in each chamber. 

Think for a moment of what an “in your face” move that was by “unelected bureaucrats” rejecting the nearly unanimous views of the administration, Congress, the industry, the media, and economists favoring deregulation.  The reregulation and resupervision of the industry stopped a raging epidemic of accounting control fraud that was hyper-inflating real estate bubbles in the Southwest and saved the nation a trillion dollars in losses.  It destroyed the careers of the Bank Board Chairman, Edwin Gray and Joseph Selby, the man Gray personally recruited to serve like a  “Texas Ranger” (their slogan is: “One Riot, one Ranger) who would control the worst real estate fraud hotspot in the nation – Texas.  This was a remarkable success and public administration scholars have been lavish in their praise for our actions, which included repeatedly blowing the whistle on prominent political cronies and regulatory lackeys. 

Our regulatory careers are profiled in Chapter 2 of Professor Riccucci's book Unsung Heroes (Georgetown U. Press: 1995), Chapter 4 (“The Consummate Professional: Creating Leadership”) of Professor Bowman, et al’s book The Professional Edge (M.E. Sharpe 2004), and Joseph M. Tonon’s article:  “The Costs of Speaking Truth to Power: How Professionalism Facilitates Credible Communication” Journal of Public Administration Research and Theory 2008 18(2):275-295.

Similarly, as I will discuss, our combined efforts with the FBI and the Department of Justice to identify, remove, sue, and prosecute elite white-collar criminals remains the most successful program in history in any nation.  We would be happy to explain the things that worked best and the things we felt were unsuccessful.  The last three administrations have wanted no advice from those who succeeded.  None of them has been willing to bear the “Costs of Speaking Truth to Power.”  Indeed, they want nothing to do with us because they know that we will tell them the unvarnished truth as we understand the truth.  They find the truth beyond inconvenient because it threatens their fraudulent big finance contributors.

The question remains how Geithner decided that accounting control fraud was not material in the Enron era frauds and the S&L debacle.  He could have read what experts have termed the definitive book on the S&L debacle.

 Robert Kuttner, in his Business Week column, proclaimed:

“Black's book is partly the definitive history of the savings-and-loan industry scandals of the early 1980s. More important, it is a general theory of how dishonest CEOs, crony directors, and corrupt middlemen can systematically defeat market discipline and conceal deliberate fraud for a long time -- enough to create massive damage.”

George Akerlof called the book “a classic.”  Paul Volcker wrote about my description of how Ed Gray knowingly sacrificed his career to prevent a national catastrophe by standing up for us all:

“Bill Black has detailed an alarming story about financial - and political - corruption.  The … lessons are as fresh as the morning newspaper.  One of those lessons really sticks out: one brave man with a conscience could stand up for us all.”

Does anyone think that Geithner will emulate Gray and sacrifice his career in order to “stand up for us all” against the elite bank frauds and their political cronies? 

Geithner could have learned about the role of fraud in the crisis through other means.  The most obvious means would be to read the NCFIRRE report on the causes of the debacle.  Because the subject is vital and Geithner has an extensive staff he could have them summarize the relevant NCFIRRE staff papers on the fraud, particularly: 

Black, William K., "The Incidence and Cost of Fraud and Insider Abuse." Staff report 13. San Francisco: National Commission on Financial Institution Reform, Recovery, and Enforcement (April 12).   

Or, he could just read one long paragraph in the NCFIRRE report.

NCFIRRE Details how Accounting Control Fraud Drove the S&L Debacle     

The national commission that investigated the causes of the S&L debacle found:

“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization” (NCFIRRE 1993).

“Invariably” present at “the typical large failure.”  The “milk[ing]” by “operators” refers to the CEOs looting “their” S&Ls through modern executive compensation.  Their “weapon of choice” is accounting, which produces enormous, albeit fictional, reported income.  Modern executive compensation turns that fictional income into real, enormous wealth. 

Criminologists Explained Why Fraud, not Stupidity or Risk, Drove the S&L Debacle

There is a peer-reviewed criminology piece that explains how to differentiate among fraud, stupidity, and honest gambles for resurrection.  The article explains why the evidence in the S&L debacle is consistent with accounting control fraud and falsifies the stupidity and gambling hypotheses.

The Savings and Loan Debacle of the 1980's: White-Collar Crime or Risky Business? (Black, William K., K. Calavita and H. Pontell)Law and Policy. Vol. 17, No. 1 (January 1995: 23-55).

As I have explained, criminologists specializing in the study of elite white-collar crimes have published over a dozen articles, two major books, and an official report commissioned by the Department of Justice explaining why the crisis was driven by accounting control fraud.  Of course, if the SEC, the Fed, and Treasury were to hire “Chief Criminologists” they would have known all these things decades ago and we could have prevented the ongoing crisis. 

The U.S. Attorney General explained Fraud’s Major Contribution to the S&L Debacle

Former Attorney General Dick Thornburgh called the S&L debacle “the biggest white-collar swindle in history.” 

http://photo.pds.org:5012/cqresearcher/document.php?id=cqresrre2002101106

In a July 24, 1990 Senate hearing:

“Thornburgh said Justice officials sifted through 18,000 criminal referrals and identified 100 extreme cases for all-out prosecution based on criteria ranging from the degree of the alleged ripoff to the involvement of public officials. The cases involve 310 S&Ls, he said.

Efforts in those cases have yielded 51 indictments and 39 convictions so far, Thornburgh said.

The less severe cases will be prosecuted as time, money and prosecutorial discretion allow, he told the panel.

"With limited resources, we have to concentrate," Thornburgh said. "I'm sorry to tell you ... that these are not all going to be prosecuted by (a U.S. Attorney)."

Note that the “Top 100” list involved 310 S&Ls and hundreds of individual prospective defendants.  Thornburgh testified that it would take DOJ five years to prosecute those cases.  We made thousands of referrals in “major” cases that did not make the Top 100 list and were doomed never to be prosecuted because of a lack of resources. 

http://articles.mcall.com/1990-07-25/news/2760633_1_thornburgh-defends-s-l-probes-justice-department-secret-service

As I explain in my book, in 1993, the incoming Clinton administration deprioritized the S&L prosecutions and shifted resources to health care fraud so many additional elite S&L defendants escaped prosecution.   

The FBI Director Testified that Fraud was a Major Contributor to the Debacle

Here is what a criminal investigator sounds lik