William K. Black
Senators Sherrod Brown (D-OH) and David Vitter (R-LA) have introduced a bill entitled “Terminating Bailouts for Taxpayer Fairness Act of 2013.” It is a miracle of modern staffing that Vitter, who loves polluters as much as his prostitutes, was able to pull himself away from demanding that President Obama’s nominee to run the EPA answer over 600 questions and join Brown in proposing the bill. Under Obama, bipartisan bills have a dismal fate because they Democrats negotiate away key elements necessary to create a good bill and add provisions that make parts of the bill harmful – just to pick up a few token co-sponsors – and then the Republicans kill and good parts of the bill anyway and try to enact the bad parts.
Brown-Vitter (BV) exemplifies all three problems. It would fail to achieve its desirable goals even if it became law. It would help the largest fraudulent banks continue to cripple effective examination. The Republicans will kill the well-meaning parts of the bill and try to enact the bad parts of the bill that are so bad that they are criminogenic.
One of the most essential actions we need to take is to eliminate systemically dangerous institutions (SDIs) (the rough dividing line is any bank with > $50B in liabilities). Dodd-Frank did nothing effective to end SDIs. So BV could be a sensible, even vital reform if it were drafted to end SDIs and if it were enacted. It was not drafted to end SDIs and it will be weakened before it is killed.
BV’s harmful provisions, by contrast, will likely be made worse by amendments. Those harmful provisions may become law.
BV Enshrines Rather than Ends SDIs
The concept of SDIs is that their failures are likely to cause a global, systemic crisis. This is why the “too big to fail” (TBTF) concept developed. TBTF, however, was historically a misnomer. TBTF banks failed in America. The FDIC, however, ensured that when TBTF banks failed their general creditors did not suffer losses. The equity holders and subordinated debt holders were normally wiped out when a TBTF bank failed. The regulatory concern was that if general creditors of an SDI suffered losses when the SDI failed it could cause a “cascade” of bank failures because the SDIs’ largest general creditors are typically other banks.
SDIs create three disastrous problems, any one of which should have been sufficient decades ago to convince Congress to get rid of SDIs.
- SDI’s make a mockery of the phrase “free markets.” The metaphor that a group of conservative NYU scholars use to describe the competitive advantage that the implicit subsidy that arises from bailing out the general creditors provides to SDIs is that it is like “bringing a gun to knife fight.”
- SDI failures risk causing global financial crises.
- SDIs create so much economic power that it inherently translates into dominant political power and cripples our democracy by creating crony capitalism
SDIs also create no desirable advantages. SDIs are so large that they are impossible to manage or regulate effectively. They are inefficient as well as dangerous. We have a classic win-win available. We can make banks more efficient and far less dangerous by getting rid of SDIs.
BV goes off track from the beginning because it does not try to get rid of SDIs. Brown and Vitter’s comments about their bill make clear that they agree about the first two disastrous problems caused by SDIs.
“The truth, according to the markets, is that ‘too big to fail’ is alive and well with the Wall Street megabanks,” Vitter said. “Our number one goal is to protect the taxpayers from financial risks and the best way to do this is by implementing a systemic solution, increasing the minimum amount of capital the mega banks are required to have.”
BV Does Not Get Rid of the SDIs
The first problem with BV is so obvious that the fact that it ignored by the media (and by Brown and Vitter) tells us that SDIs have so insinuated themselves into our psyches that even reformers cannot conceive of a world free of what Brown and Vitter describe as the scourge of SDIs. If their “number one goal” is protect us from SDIs, why don’t Brown and Vitter get rid of the SDIs?
This is how Brown and Vitter began the press release announcing the BV bill.
“WASHINGTON, D.C. – U.S. Sens. Sherrod Brown (D-OH) and David Vitter (R-LA) announced a new plan that would prevent any one financial institution from becoming so large and overleveraged that it could put our economy on the brink of collapse or trigger the need for a federal bailout.”
BV does not do any of things the sponsors claim in this sentence. The SDIs are already large enough that they pose a global systemic risk when they fail. BV does not limit the size of the SDIs or prevent them from growing. Fraudulent SDIs can be massively overleveraged under BV. BV does not eliminate the need for federal bailouts.
Higher Capital Requirements Could Not Make SDIs Safe
Higher capital requirements cannot protect us from the three disasters that SDIs cause. Brown and Vitter’s explanation for their bill contains this telling fact.
“Prior to the crisis, Lehman Brothers ostensibly had a capital ratio of 11 percent, yet its assets were sold in bankruptcy for nine cents on the dollar.”
Brown and Vitter do Not Understand “Capital,” Accounting, or Fraud
Brown and Vitter do not understand the import of the facts of Lehman’s failure. “Capital” is merely an accounting residual: assets – liabilities = capital. Accounting control frauds like Lehman (see my House testimony for details) massively overstate asset values. Frauds also use many scams to dramatically understate liabilities. (Lehman used an accounting scam to substantially understate its debt levels.) There are also scams that directly create fictional capital. See my description in earlier articles of the Icelandic banks’ scams in which they lent money to their shareholders to buy their shares.
Brown and Vitter do not understand the ephemeral nature of capital. “Capital requirements will focus on common equity and other pure, loss-absorbing forms of capital.” Brown and Vitter’s conception that capital can be something that is “pure” and can be counted on to be there when the bank fails to “absorb” “loss” is a dangerous delusion that demonstrates that Brown and Vitter do not understand the most basic and critical concepts of finance, accounting, and regulation. They seem to believe that there is some vault in a bank that holds “capital” and that there is “pure” capital that will remain in the “pure” “capital” vault even after the bank is looted. It is dangerous to believe in such absurd myths.
Brown and Vitter have forgotten recent history, when Congress successfully extorted the Financial Accounting Standards Board (FASB), demanding that they change generally accepted accounting principles (GAAP) so that the largest banks would not have to recognize their massive losses on their loans and toxic derivatives. That accounting travesty remains the rule today, which means that we have systematically overstated bank asset values – which means that we systematically overstate bank capital. Brown and Vitter propose no change to end this travesty. Instead they spread fantasies about “pure” capital.
Brown and Vitter Ignore the Real Problem: Accounting Control Fraud
Lehman provides a chilling example of how much fictional capital an accounting control fraud can create – and how much damage the controlling officers can do by looting “their” firms. George Akerlof and Paul Romer described these frauds in their 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”). I assume for the purposes of analysis the accuracy of Vitter’s claim that Lehman’s asset valuations were overstated by 91 cents on the dollar. At the same time that it was reporting an 11% (positive) capital level its real capital level was in the range of a (negative) 85%.
Lehman could, easily, have reported that it met the 15% capital requirement that BV proposes for “megabanks.” It would have required a few more scam deals, and that would have increased Lehman’s losses. Brown and Vitter show no signs of understanding the basics of accounting control fraud. Here is the fraud “recipe” for officers controlling a lender.
- Grow like crazy by
- Making really crappy loans at a premium yield, while
- Employing extreme leverage, and
- Providing only grossly inadequate allowances for loan and lease losses (ALLL)
Akerlof and Romer agreed with the conclusion of regulators and criminologists that this recipe produces a series of “sure things.” The lender is guaranteed to report record (albeit fictional) profits in the short-run, the controlling officers will promptly be made wealthy by modern executive compensation, and the lender will eventually suffer catastrophic losses. The officers who control a bank and use it as a “weapon” to defraud can easily produce vast amounts of fictional profits that can (partially) be retained so that they produce very high levels of reported capital. A higher capital requirement can slow down a fraud by reducing growth and leverage, but it will not prevent catastrophic losses and, if many controlling officers follow the same strategy, a hyper-inflated bubble that can produce a systemic crisis.
Accounting control frauds are exceptionally adept at suborning the “independent” “professionals” who value assets and liabilities. The fraudulent controlling officers deliberately create a “Gresham’s dynamic” that drives good ethics out of key positions in the professions. Lehman had no difficulty getting a subset of appraisers to overstate home prices and auditors to “bless” even their massively over-valued assets and its preposterously inadequate ALLL. Again, anyone who thinks there is “pure” capital has to believe in “pure” asset and liability valuations. I had not thought, after this crisis, that anyone still believed such a myth, but then came BV. The bottom line conclusion is that BV will fail at precisely the banks where success is most essential – the accounting control frauds. As a group of conservative finance professors were recently forced to conclude as a result of their study, during the recent crisis fraud was “pervasive” at our “most reputable” banks.
Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market. Tomasz Piskorski, Amit Seru & James Witkin (February 2013) (“PSW 2013”).
I have explained their results at some length in a prior article.
The national commission that investigated the causes of the S&L debacle reported that at the “typical large failure” “fraud was invariably present.” The S&L frauds were control frauds. No one doubts that the Enron-era scandals were control frauds. Even conservative scholars that have investigated the most recent crisis have concluded that the SDIs engaged in “pervasive” fraud. The key folks who have not gotten the message about the need to deal with accounting control fraud if we wish to avoid future financial crises are Brown and Vitter. This passage, from their description of the BV bill reveals that they have implicitly assumed fraud out of existence.
“Requiring the largest banks to fund themselves with more equity will provide them with a simple choice: they can either ensure they can weather the next crisis without a bailout or they become smaller.”
No, there is another choice – a choice that the officers controlling the SDIs have often decided was their superior option – accounting control fraud. Fraud is a “sure thing,” and the C suites are filled with officers who love sure things. Again, notice that Brown and Vitter do not understand the import of Lehman’s massive overstatement of assets (and, therefore, capital) that they used as purportedly supporting the desirability of their bill. No capital requirement can “ensure” that a bank will not fail and will not be bailed out.
BV’s Dream of a Regulatory Fusion with Private Market Discipline
Brown and Vitter’s description of their bill contains this dream sequence.
“Regulators may increase capital ratios as banks increase in size. Setting capital levels for the largest megabanks at levels required by the private market, absent government support, will ensure that they have an adequate cushion of equity in the event that the FDIC must put a megabank through orderly liquidation under Title II of Dodd-Frank.”
This passage is another demonstration is that Brown and Vitter do not comprehend the importance of the Lehman fraud and the result catastrophic losses. Once more, they claim that their bill will “ensure” that we will never again have any expense when a “megabank” fails. How can they conceivably say that after Lehman’s failure? We need to go back to basic facts about finance. Lehman was an investment bank so it had no FDIC deposit insurance. Lehman was not treated as TBTF by the markets or the government. It was allowed to fail and its general creditors were not bailed out by the government.
Lehman was not treated by the markets as immune to failure. As a result, it purported to maintain a higher capital level (11%) than did most FDIC insured banks. But that higher reported capital level was a lie – an enormous lie by a grotesquely insolvent investment bank. Its reported capital level was chosen by its management “at levels required by the private market, absent government support.” The twin problems were that the reported capital level was a fiction and that “the private market” failed to spot for years the fact that Lehman was actually deeply insolvent. Lehman proves that one has to be delusional to believe that they can “ensure that they have an adequate cushion of equity” by setting a higher capital requirement. Congress’ role in successfully extorting FASB to hide real losses in order to overstate reported assets and capital also explains one of the several reasons BV cannot “ensure” the attainment of any of its stated goals.
BV Does Not Eliminate the Implicit Federal Subsidy that the Sponsors Decry
I explained why the acronym TBTF was a misnomer. TBTF banks have failed. It actually refers to bailing out the general creditors. Brown and Vitter explicitly criticize the “implicit federal subsidy” enjoyed by the SDIs because they can borrow more cheaply than their competitors. But a close reading of their press release reveals that Brown and Vitter think that the SDIs can borrow more cheaply because the government never permits them to fail. Brown and Vitter do not understand that the implicit subsidy arises because the government ensures when an SDI fails that its general creditors are bailed out. This explains why BV does not ban bailing out a SDI’s general creditors. BV, therefore, would not remove the implicit federal subsidy that SDIs enjoy.
BV Does Not Significantly Increase Capital Requirements for Most SDIs
Note that Vitter did not promise significantly higher capital requirements for SDIs. BV would not substantially increase the capital requirements of most SDIs. Note that Vitter has conflated TBTF with “megabanks.” Megabanks are an important subset of SDIs because their assets are so massive, but most SDIs do not meet the BV definition of “megabank” (assets > $500B). Again, the media has largely ignored this incredible failure by BV to require most SDIs to have substantially greater capital. Even if we were to assume, contrary to fact, that higher capital requirements removed the three disastrous consequences of SDIs, BV leaves a massive loophole. BV only begins to increase a SDIs capital requirement substantially when it attains a size roughly 10 times larger than the ($50B) threshold to become an SDI. BV redefines most SDI’s as “mid-size” and “regional” banks, but calling them that is a pure fig leaf. They are so large that they pose a systemic risk when they fail. BV’s eight percent capital requirement is essentially a return to the status quo before Basel II.
The Only Effective Means to Make Reported Capital Real is Vigorous Examination
I have noted that the officers running accounting control frauds find it easy to create Gresham’s dynamics that allow them to suborn appraisers and auditors who will bless massively inflated asset values while hiding real losses. A lender that follows the fraud recipe has will produce record (fictional) income and can produce very large amounts of (fictional) capital. These results are “sure things” under the fraud recipe. Creditors do not “discipline” accounting control frauds – they fund their growth. Creditors love to loan to firms reporting record profits.
Regulators are the only controls that the fraudulent CEO cannot hire and fire. Only skilled, vigorous examiners backed by tough supervisors have any hope of ensuring that reported bank capital bears any relationship to reality. Brown and Vitter do not appear to understand the import of the Financial Crisis Inquiry Commission’s (FCIC) key finding that the regulators failed to act because of the competition in regulatory laxity, the creation of regulatory black holes, and the regulators’ experience that it was impossible to get the political appointees running their agencies to take action against banks that were reporting high profits (FCIC 2011: 307). The key is for examiners to order banks to recognize losses on bad assets as soon as those assets are impaired – not when the default happens (which can be years later).
In the S&L debacle, we sent shock waves through the frauds when we targeted the S&Ls reporting the highest profits and growth as our top priority for investigation because they were the most likely to be fraudulent. It is essential that we return to that strategy by appointing real regulators.
BV is Criminogenic: It Would Eviscerate Vigorous Examination
Many influential officials try to impair vigorous regulation, which always starts with vigorous examinations. In the S&L debacle, the Reagan administration tried to give the most notorious S&L CEO, Charles Keating (who ran Lincoln Savings), control of the federal agency regulating S&Ls. I blew the whistle on this effort, which led to the resignation in disgrace of one of our three presidential appointees running our agency. A majority of the House co-sponsored a resolution calling on us not to go forward with reregulating the industry. Speaker Wright held the bill to recapitalize the FSLIC insurance fund (so that we would have the funds to close more control frauds) hostage to extort favors for Texas control frauds. Senator Cranston put a secret hold on the same bill at Keating’s behest. Keating used Alan Greenspan as a lobbyist to help recruit the five U.S. Senators who would become known as the “Keating Five” when my notes of the meeting were made public.
OMB threatened to make a criminal referral against the head of our agency, Edwin Gray, on the grounds that he was closing too many insolvent S&Ls. Yes, you read that sentence correctly.
The top guy in Treasury for S&L policy testified against our agency in the challenge to the appointment of a receiver of an insolvent S&L. He opined that it was “arbitrary and capricious” to close S&Ls because they were insolvent. He also testified to Congress that we should simply run a Ponzi scheme by encouraging insolvent S&Ls to grow so that they could use the cash they obtained from deposit growth from new depositors to pay interest to existing depositors.
The Reagan administration and Speaker Wright made a cynical secret deal not to reappoint Gray to a new term. The administration appointed Danny Wall as Gray’s successor. Wall proceeded to meet Wright’s demand that we force out our top supervisor in Texas. Wright’s complaint was that he was gay, but everyone knew that Wright’s real complaint was that he was effective.
Wall immediately ordered an end to our examination and the enforcement investigation of Lincoln Savings. This was Keating’s primary demand because he knew that our examination and enforcement investigation had already discovered a number of his frauds and that his control over Lincoln Savings could not survive our continued examination and enforcement investigation. Wall then removed the jurisdiction of the agency’s San Francisco office over Lincoln Savings because we persisted in recommending a takeover of Lincoln Savings after the Keating Five tried to intervene to prevent us from taking action against Lincoln Savings’ massive violation of the law. This led to a disaster. Lincoln Savings became the most expensive S&L failure and defrauded thousands of widows.
The Texas state S&L commissioner was consorting with prostitutes provided by the Nation’s second worst financial fraud, Vernon Savings (known as “Vermin” to its regulators). The California state S&L commissioner was secretly in business with Keating. The Texas Attorney General announced he was investigating us for discrimination against Texas S&Ls, particularly in our examination process. A couple days later he announced we were guilty without any cumbersome investigation to slow him down.
The COO of one the S&L our San Francisco office regulated threatened our examiner-in-charge. The FBI informed us that organized crime controlled the S&L.
Keating hired private counsel who had recently left a senior position at the Department of Justice (DOJ). They contacted William Weld, one of the most senior DOJ officials. Within days, the FBI was investigating us (the San Francisco office of the federal regulatory agency), rather than Keating.
Keating twice hired private investigators to investigate me. He sued me and a number of regulators, for $400 million in our individual capacities (in a Bivens suit). Keating boasted of spending $50 million to attack our examination report of Lincoln Savings. Keating infamously put in writing his directive to his chief political fixer that his “highest priority” should be to “Get Black … Kill Him Dead.” Keating also created what became known as “the secret file” that supposedly had derogatory information on me and gave it to senior officials of our agency. They refused allow me to read and respond to the file. When I persisted, they gave the file back to Keating to prevent me from getting access to the file.
I note these things to explain several points that are essential to understand about BV. First, regulation can succeed. It is only now, with the experience of the current crisis where effective regulation and regulators were deliberately targeted for removal that we can see that Chairman Gray’s actions in promptly reregulating the industry saved many trillions of dollars by containing a surging epidemic of accounting control fraud in the 1980s. We can also see that our actions in driving liar’s loans out of the S&L industry in 1990-1991 prevented a crisis that also would have cost trillions of dollars to resolve absent effective regulation.
Second, the key is regulatory professionalism, knowledge of accounting control fraud techniques, vigor, and resoluteness. Pushback is inevitable and violent. The accounting control frauds cultivate powerful political allies.
Third, the examination process is the key value that a financial regulatory agency adds. Good examiners do not wait for the assets to blow up in massive defaults. They spot impaired loans early and they spot accounting control fraud schemes early. It is then incumbent on the agency’s leadership to back up the examiners with prompt, vigorous supervision, enforcement, receiverships, and criminal referrals. Akerlof and Romer examined a large amount of materials from our examiners and came to this key insight.
“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).
Fourth, the frauds recognize that the examinations are the key and their effort is always to impair the examination and the ability of supervisors to require prompt corrective action on the basis of the examinations. I mentioned Speaker Wright holding the FSLIC recapitalization bill hostage. The broader story is that the Texas control frauds hijacked the bill and festooned it with “forbearance” provisions designed to allow the frauds to stall the exams and vital supervisory actions.
Fifth, the destruction of effective examination as a result of some of these forbearance provisions and the regulatory race to the bottom proved disastrous during the most recent crisis. Restoring effective financial examination and supervision (and criminal prosecutions) should be a national priority.
Sixth, instead, BV, as introduced, is designed to further impair examination. The Senators’ description of this portion of the bill is disturbingly disingenuous.
“Provide regulatory relief for community banks. By reducing regulatory burdens upon community banks, they can better compete with mega institutions. Because community institutions do not have large compliance departments like Wall Street institutions, this legislation provides commonsense measures to lessen the load on our local banks.
- Creates an independent bank examiner ombudsman that institutions can appeal to if they feel that they have been treated unfairly by their examiner.”
This provision, however, is not limited to “community” (very small) banks. Creating an ombudsman for examination will be a godsend to fraudulent SDIs. Keating ran a $6 billion S&L – and spent $50 million attacking a single examination (roughly our entire budget for a region regulating hundreds of S&Ls). Wait till JP Morgan decides to fight an examination. It will be able to stall the examiners and supervisors for years. The SDIs will hire away the Ombudsman, assuming he sides with the industry, and give him a wonderful sinecure (“revolving door”). The SDIs will lobby to try to ensure that the person selected as Ombudsman is hostile to effective regulation.
Incredibly, BV recreates the worst of Keating’s abuses.
‘‘(e) CONFIDENTIALITY.—The Ombudsman shall keep confidential all meetings, discussions, and information provided by financial institutions.’’
Yes, Keating’s secret files will now become National policy. The bank gets to make ex parte presentations in person and writing with the Ombudsman – who is forbidden by statute from informing the regulatory agency of the charges and giving the examiner and the agency an opportunity to respond. Then, on the basis of ex parte smears, the Ombudsman can issue a report condemning the examiner or the agency.
BV’s Anti-Examination Provisions Will Get Far Worse via Amendment
The grave danger is that one portion of BV will become law – the provisions that will be drafted by the fraudulent SDIs’ lawyer/lobbyists that will expand the assault on any effort to restore what is already a crippled examination process. This is what happened when Speaker Wright was extorting us in 1986-1987. It was only a bit of clever amending by us with the invaluable aid of Representatives Jim Leach and Henry B. Gonzalez that saved the Nation from disaster. I mentioned the cynical deal that the Reagan administration reached with Speaker Wright. The administration promised two things as part of the deal. It would not reappoint Ed Gray as chairman of the regulatory agency and it would not opposed the “forbearance” provisions that the control frauds’ lawyers had drafted to make effective examination and supervision impossible.
Where Does the Obama Administration Stand?
Will the Obama administration oppose this travesty of a bill posing as a reform aimed at the SDIs that would actually be a great boon to the SDIs because they could use it to assure that examination remains impotent? Will the Obama administration support a clean bill with the three provisions below?
- No SDI may grow
- All SDIs must shrink within five years to below $50 billion ($2013) in assets
- All SDIs will be subject to stringent examination and supervision during that five year divestment period