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Those Who Forget the Regulatory Successes of the Past Are Condemned to Failure

Contrasting and analysing the role of regulation and regulators in dealing with two financial crises in the United States brought on by epidemics of control fraud - the us savings and loan debacle of the 1980s and the ongoing financial crisis that first became acute in the us non-prime mortgage sector - this essay argues that there is no substitute for effective regulation. Deregulation, which relies on private market discipline does not prevent or contain such epidemics. On the contrary, it fosters a climate that encourages them.


Those Who Forget the Regulatory Successes of the Past Are Condemned to Failure

William K Black

Contrasting and analysing the role of regulation and regulators in dealing with two financial crises in the United States brought on by epidemics of control fraud

– the US savings and loan debacle of the 1980s and the ongoing financial crisis that first became acute in the US non-prime mortgage sector – this essay argues that there is no substitute for effective regulation. Deregulation, which relies on private market discipline does not prevent or contain such epidemics. On the contrary, it fosters a climate that encourages them.

William K Black ( is with the University of Missouri City School of Law, Kansas City, US. He held several senior regulatory positions during the S&L debacle and is the author of The Best Way to Rob a Bank Is to Own One (2005).

raud has long been the leading cause of bank failures (Pierce 1991). “Control fraud” (Black 2005) is the leading cause of such failures. In a “control fraud” the person who controls a seemingly legitimate business or governmental agency uses it as a “weapon” to defraud (Wheeler and Rothman 1982; Ghosh 2009). Epidemics of bank control fraud are the leading cause of financial crises. This essay contrasts and analyses the role of regulation and regulators in two financial crises brought on by epidemics of control fraud: the US savings and loan (S&L) debacle of the 1980s and the ongoing financial crisis that first b ecame acute in the US non-prime mortgage sector.

The essay argues that effective regulation is essential to prevent and contain such epidemics. If there is a “pathogenic environment”, an epidemic is the natural outcome. An epidemic r equires a reservoir of pathogens, hosts that the pathogens can enter and infect, and “vectors” to spread the pathogen. The anopheles mosquito is infamous as a vector for malaria.

In the financial world we suffer from epidemics of accounting fraud when there is a strongly “criminogenic environment”. Common factors that make an environment strongly criminogenic i nclude non-regulation and non-prosecution, assets that lack readily verifiable market values, and “market” dynamics (that is, compensation systems) that create perverse incentives. The vectors of such epidemics can include rating agencies, accounting firms, and appraisers. The symptoms include financial bubbles, but bubbles are also criminogenic. They aid accounting fraud by making it easy to create fictional income and hide real losses. This feature of bubbles is analogous to infectious diseases. Symptoms (coughing, sneezing, bleeding, and diarrhoea) frequently both spread disease and weaken the human host, making him more susceptible to other infections.

Effective financial regulation is essential to prevent epidemics of accounting fraud. Unfortunately, US economists and finance specialists determine financial regulatory policy and they have operated like faith healers instead of public health specialists. Their policies create, rather than prevent, criminogenic environments. They did so in the S&L debacle, the Enron/WorldCom era scandals, Russian privatisation, and the failures of “The Washington Consensus”.

Economists’ failures are particularly tragic because there was a brief, but vital, period (late 1983 through mid-1987) during the debacle where the regulators did act like public health officials. Their actions prevented the debacle from becoming a financial catastrophe that would have imperiled the general economy. Those actions are largely unknown, as are the successful regulatory and

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Justice Department actions in 1990-92 that produced the largest number of convictions of elite white-collar criminals in US h istory and prevented a sub-prime lending crisis.

The Clinton and Bush administrations seemed unaware of these regulatory successes and the entire concept of criminongenic environments. Their deregulatory policies produced an i ntensely criminogenic environment. Ending effective financial regulation was one of the key steps in producing that environment and delaying the correct diagnosis of the resulting epidemic of mortgage fraud and other forms of accounting control fraud.

1979-82: The Interest Rate Crisis

Overall, regulation played a mixed role during the debacle. The debacle was a tragedy in two acts. Federal regulation made the first act, the interest rate crisis, more severe by banning federally chartered S&Ls from issuing adjustable rate mortgages (ARMs).1 In 1979, Federal Reserve Board Chairman Paul Volcker substantially increased short-term interest rates to end what he viewed as structural inflation.

By 1981, the S&L industry, which specialised in home lending, was insolvent on a market value basis by $150 billion (NCFIRRE 1993: 1).2 That meant that the Federal Savings and Loan Insurance Corporation (FSLIC), which insured S&L deposits, was also massively insolvent. In turn, that meant that the federal budget deficit was $150 billion deeper than reported.

Regulation failed in the first stage of the crisis because congressional pressure prevented the agency from acting in what it believed were the nation’s best interests.

The Disastrous Response

In 1981, President Ronald Reagan appointed Richard (Dick) Pratt, an academic expert in economics and housing finance, Chairman of the Federal Home Loan Bank Board (Bank Board). Pratt believed that excessive regulation, exposure to interest rate risk due to reliance on long-term fixed rate mortgages, and insufficiently entrepreneurial chief executive officers (CEOs) caused the crisis. His proposed solutions were (1) to cover up the industry’s mass insolvency through accounting scams, (2) to decline to close i nsolvent S&Ls, (3) to deregulate asset powers so that S&Ls could invest in other assets less exposed to interest rate risk, and (4) to encourage the entry of “entrepreneurs”.

The first two solutions were imposed by the administration (though Pratt appeared to support them independently). Pratt’s solutions proved to be problems because he did not understand that a new phase of the crisis, an epidemic of control fraud, was emerging and that his policies, particularly when implemented at a time of mass industry insolvency, optimised the criminogenic environment for accounting control fraud. Pratt’s background as an economist also hampered him. Economics had no theory of fraud. The fundamental hypothesis underlying modern finance theory, efficient markets, requires that there not be any material accounting control fraud. Economic methodology, as we will explore, becomes perverse when there is an epidemic of accounting control fraud.

The administration’s response to the interest rate crisis intensified the criminogenic environment that produced the debacle’s

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second, far more costly phase. Its highest priority was covering up the debacle. The cover-up led Pratt to (1) adopt widespread accounting abuses to hide real losses and book fake gains, and

(2) cease closing failed S&Ls (because they would have to recognise their losses). The “innovative” top S&L regulator, however, went well beyond these minimum requirements. Pratt encouraged mergers of insolvent S&Ls to “resolve” the failures. Purportedly pursuant to generally accepted accounting principles (GAAP), merging two insolvent S&Ls transmuted the real insolvency of the S&L being acquired into an asset (“goodwill”). These mergers occurred with no FSLIC financial assistance. The accounting alchemy continued, because the more insolvent the S&L acquired, the greater the net accounting “income” that was produced (Black 2005: 20-29). The typical merger took two deeply insolvent, highly unprofitable S&Ls and combined them to create an entity that promptly reported it was solvent and profitable – all without a single dollar of FSLIC assistance. The fictitious “income” produced by hundreds of these phony “resolutions” was so great that it made the industry report that it had returned to profitability in 1993 (NCFIRRE 1993: 39).

Pratt and the administration compounded the criminogenic environment by deregulating (the Garn-St Germain Act of 1982) at a time of mass insolvency. The economic theory known as “moral hazard” unambiguously predicts that such a strategy will spur fraud and abuse. Why would Pratt, an academic finance e xpert, act in a manner that would cause a disaster? Deregulation had broad, bipartisan support. President Jimmy Carter adopted more substantive deregulation than any US president, for example, in airline and trucking rate-setting regulation. S&L regulation had discredited itself by making the interest rate crisis worse. Economic theory did not expressly warn that deregulation caused any injury. The logic of moral hazard theory predicted that d eregulation would be harmful, but economists did not draw that linkage.

Pratt was also comforted by economic methodology. Economists believe that they are the only social science that uses a truly scientific methodology – econometrics (Stigler 1988). Agency economists tested S&L profitability during the early years of the interest rate crisis. The S&Ls reporting the greatest profits were Texas chartered. Texas led the nation in S&L deregulation. Pratt, therefore, modelled the bill that became the Garn-St Germain Act on the Texas law that deregulated S&Ls. The economists never questioned whether the accounting profits were real.

Pratt also decided to push for deregulation in 1982 because he knew how hard it was to get legislation passed. A crisis provides opportunities for radical legislative change.

Federal deregulation set in motion “a competition in laxity in State regulation” (NCFIRRE 1993: 40). Texas and California “won” by almost entirely ended regulation and, in key time periods, s upervision. The California regulators lost two-thirds of their staff (ibid). The remaining staff worked to approve (there were no rejections) applications for new California charters (“de novos”). This effectively ended state examination and supervision – but generated 200 de novo approvals. Worse, California’s top supervisor was secretly in business with Charles Keating – the most notorious S&L fraud.


The situation was even worse in Texas because fraudulent networks were strongest in that region. Texas’ top supervisor was enjoying the company of prostitutes provided by the second most notorious S&L fraud, Don Dixon (Black 2005: 35-37). Economists knew and approved of the fact that federal deregulation would spark a competition in laxity because they viewed deregulation as the universal antidote.

Texas S&Ls (federal and state) caused over 40% of total S&L losses. Pratt could not have chosen a worse model for deregulation. California S&Ls were the next largest source of loss. The combination of state deregulation and desupervision proved toxic.

Pratt desupervised at the federal level – he cut the number of examiners and he stopped takeovers of failed S&Ls. Even the rules that remained after deregulation were not enforced (NCFIRRE 1993: 48-55). He encouraged new entrants. The great bulk of them proved to be failing real estate developers with s evere conflicts of interest. He was presented with many cases where the examiners found evidence of control fraud, but to an economist such evidence is “merely anecdotal”.

Gray’s Transformation

Edwin Gray was a strong supporter of deregulation and he b elieved, initially, that the industry was recovering. He was soon shocked to learn that one of the new California thrift entrants was a fraud. California’s approval of 200 new charters – even though they had no capacity to regulate them troubled Gray. A lmost all the new charters were real estate developers. Gray d ecided, in 1983, to refuse to grant FSLIC insurance to new state charters unless the state regulators could regulate them effectively. They could not open for business without FSLIC insurance. Neither Texas nor California increased its staff adequately, so Gray blocked all their new charters. Thus he saved the taxpayers many billions of dollars.

In early 1984, Gray was fully transformed by viewing a grainy video of a huge residential housing development in Texas funded by several S&L control frauds. The scale of the losses and the brazen nature of the fraud turned Gray into a strong proponent of re-regulation and re-supervision. This made him an apostate among Reagan administration officials, though he retained the strong support of Federal Reserve Chairman Volcker.

Countering an Epidemic

Gray reconceptualised the crisis, recognising fraud, not interest rate risk, posed the gravest danger. The agency identified the correct problem over the universal opposition of economists by developing a new methodology, reaching the right analytical conclusions from the data provided by the new methodology, r ejecting the conventional theories that form the core of modern finance theory, and developing a coherent theory of control fraud. It used that theory to devise and implement successful praxis. It had to do all of this in a crisis environment in which the agency was overwhelmed with work, beset by internal strife, and subject to powerful, hostile political and industry pressures.

The agency, as it struggled to diagnose and treat the emerging second phase of the debacle in 1983-87, was unaware of Wheeler and Rothman’s recently published (1982) article on how seemingly legitimate corporations could serve as a “weapon”. The agency independently came to the same conclusion, but also adopted variants of their proposed methodology and metaphor.

Wheeler and Rothman urged the systematic study of fraudulent firms to document the distinctive traits of the “weapon” they used to defraud. Their metaphor was that what was needed was a ballistics lab.

The agency called its process “autopsies”. The Litigation Division reviewed each failure to prepare to defend the agency should there be a legal challenge to the takeover and to determine whether the receiver should bring suit. This required the attorneys to determine what caused the major losses.3 An autopsy is a broader inquiry that focuses on the victim, the environment, and any contributors to the victim’s death.

The regulators’ analysis varied from Wheeler and Rothman because it married the autopsy data, modern finance theory’s e mphasis on optimisation, and their knowledge of accounting, governance, and economic (and law and economics) theories about moral hazard, adverse selection, “lemons” markets (asymmetrical information; Akerlof 1970), institutional economics, s ignalling, and “agency cost” to synthesise a multidisciplinary theory of S&L accounting fraud.4

The agency used this synthetic analysis to exceed Wheeler and Rothman’s hopes. First, under Gray’s leadership, the agency produced a coherent theory of the nature of the second phase of the debacle. (Indeed, it identified that there was a second phase.) The agency recognised that it was faced with widespread control fraud and that these frauds were causing the crisis. It realised that the control frauds were primarily responsible (along with perverse incentives created by the 1981 Tax Act) for extending and hyperinflating a bubble in commercial real estate in the Southwest. The agency understood that by hyperinflating that bubble the control frauds were sending false price signals that could deceive honest investors.

Second, the agency found that it could spot such frauds at an early juncture because they followed a distinct operational pattern. Its knowledge of optimisation and accounting, allowed its staff to reconcile two paradoxes. The autopsies documented that the control frauds’ operational pattern was irrational for an honest lender. They found that the worst failures had reported the highest profits, that is, there was a distinct pattern on outcomes.

Once the staff considered how a control fraud would optimise accounting income and the inevitable consequences of that strategy, the paradoxes were resolved. The control frauds lent huge amounts of money to uncreditworthy borrowers without meaningful underwriting or controls. They grew at exceptional rates – over 50% annual growth in 1983. The National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE 1993: 3-4) found:

The typical large failure was a stockholder-owned, state-chartered institution in Texas or California where regulation and supervision were most lax...The failed institution typically had experienced a change of control and was tightly held, dominated by an individual with substantial conflicts of interest...In the typical large failure, every a ccounting trick available was used to make the institution look profitable, safe, and solvent. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organisation through

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high dividends and salaries, bonuses, perks and other means. In short, the typical large failure was one in which management exploited virtually all the perverse incentives created by government policy.5

This operational pattern guarantees large “profits” – and catastrophic failure. Bad borrowers will agree to pay higher fees and interest rates, increasing accounting income. Growing rapidly maximises income. It is far easier to grow rapidly by specialising in making bad loans. Accounting control frauds ruin their underwriting and internal controls because these restraints impair making bad loans. Accounting control frauds cover up the inevitable losses through refinancing devices that hide real losses and create fictional income.

The regulators knew that their fraud theories falsified the core assumptions of modern finance. They knew that neoclassical economic theory provided the exclusive frame for analysing the S&L crisis and that economists would denounce their theory of accounting fraud. Neoclassical economic theory pronounced that individual control frauds were virtually impossible. Economists viewed regulators who believed that there could be substantial control fraud as economically illiterate and politically and ideologically suspect. Larry White, an academic economist expert in finance, and one of the three presidential appointees running the agency, was incensed by the regulators’ theories of accounting fraud. He argued that the regulators should not even study fraud, for doing so would “distract” the agency from the “real causes” of the S&L debacle.6

Successful Praxis

The regulators’ work led to many advances in praxis. First, they realised that accounting fraud was S&Ls’ “weapon of choice” – the overwhelmingly dominant form of fraud. The agency responded by cleaning up many accounting abuses and by adopting rules that allowed examiners to “classify” assets to require recognition of market value losses regardless of their accounting treatment and to post larger loan loss reserves.

Second, they recognised that the wave of fraud was not random, but was caused because deregulation allowed S&Ls (particularly those chartered in Texas and California) to invest in assets that had no readily ascertainable market value and generate substantial amounts of non-cash accounting “income” while hiding real losses. Simultaneously, desupervision (which was also most extreme in Texas and California) and the almost total absence of prosecutions in the early years of the S&L crisis meant that the environment had been optimised for accounting fraud, particularly in Texas and California. The agency responded by attacking this criminogenic environment. It re-regulated (essentially preempting the Texas and California state deregulation statutes), resupervised by greatly expanding the quantity and quality of its examiners and supervisors, created an advanced criminal referral system, and confirmed the wisdom of Gray’s decision to block federal insurance for de novo S&Ls in Texas and California.

Third, they had the insight that optimisation made S&L frauds vulnerable because it created a unique pattern. An honest S&L would never follow that pattern because it involved consistently making loans that made no economic sense – unless one were engaged in accounting fraud in order to loot the S&L. The regulators

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could spot the pattern and target the accounting frauds for closure while they were still reporting extraordinary profits and minimal losses. The pattern proved so distinctive that the regulators did not err by closing any S&L through “false positives”.

Fourth, the regulators realised that the looters optimised accounting fraud by operating as a Ponzi scheme. They had to grow or die. This created an “Achilles’ heel” that the regulators targeted by adopting rules restricting growth. The growth rule forced every high flier to recognise its insolvency within a few years.

Fifth, the regulators realised that the looters’ optimisation strategy involved a trade-off between the “take” from fraud and the risk that their frauds would be detected and punished. A ccounting fraud hides real losses and produces record (albeit fictional) income. This allows the CEO to use normal corporate compensation mechanisms “blessed” by “independent” professionals (auditors and appraisers) and market appreciation of their shares to convert firm and shareholder assets to his personal b enefit, which minimises the risk of the fraud being detected or prosecuted. Indeed, the extraordinary “profits” boost his social status and reputation even as he loots “his” firm. This conversion process is a less “efficient” fraud than embezzlement or causing the S&L to make a loan (that will never be repaid) to a borrower (secretly) controlled by the CEO. In those cases, the CEO would convert the S&L’s entire loss to his gain (less any side payments to the “straw” or “shill”). The “straw” loan is still difficult to detect, but if it is discovered the CEO’s use of a straw will strongly establish the mens rea required for even “specific intent” frauds. A ccounting fraud converts only a portion of the fraud losses to the CEO’s gain, but even if the regulators detect the fraud it is e xtremely difficult to convince the Federal Bureau of Investigation (FBI) and Department of Justice to investigate and prosecute such cases because of the difficulty of proof and the weak “jury appeal” of complicated “paper cases”.

Sixth, the identification of the control frauds demonstrated that Gray had been correct in taking radical measures to double the size of the examination force within 18 months (primarily by hiring experienced examiners), hiring senior regulators from other agencies that had a reputation for vigour, courage, and competence, and demanding that the supervisors ensure that S&Ls promptly fixed problems identified by the examiners or face enforcement actions.

Seventh, Pratt never saw the second phase of the debacle emerging and, therefore, took no steps to contain it. The Bank Board made virtually no criminal referrals, rarely took significant enforcement actions, and the Department of Justice virtually never prosecuted S&L frauds. Gray began to build systems to make criminal referrals and provide agency support for prosecutions (Calavita, Pontell and Tillman 1997). He also revised the “change of control” standards to make it much easier for the agency to bar the entry of CEOs of questionable character.

The regulators’ strategy against the S&L looters was highly successful – in circumstances worse than any other modern US regulatory agency has confronted. The Reagan administration threatened to prosecute Chairman Gray for closing too many fraudulent S&Ls, Speaker Jim Wright extorted the agency for favours on b ehalf of the second worst looter, and the “Keating Five” and


Speaker Wright pressured the agency on behalf of the worst looter, Keating of Lincoln Savings. The agency’s effort against the looters blocked hundreds of them from entering the industry and ensured the collapse of every looter within three years of the adoption of the new rules – even though Gray’s successor ceased targeting S&Ls that followed the accounting fraud pattern for early closure. Restricting growth doomed the Ponzis even after the agency returned to a deregulatory ideology.

The regulators demonstrated that their model had predictive strength – they could identify the environmental factors that bred looting, the entrants most likely to engage in looting, and the S&Ls being run by looters. They also proved that their models allowed them to take individualised and broad regulatory actions that prevented hundreds of billions of dollars of additional losses to the taxpayers. S&L deregulation and desupervision was a disaster, but it would have been catastrophic had the re-regulation and re-supervision of the industry in 1984-85 not proven so effective.

The regulators’ actions against the wave of S&L frauds allowed the agency to demonstrate the wisdom of Wheeler and Rothman’s suggestion that renewed emphasis needed to be placed on the role of corporate crimes and that it was essential to systematically study how these corporate crimes operated if one were to develop effective theories. The regulators added the critical concept of optimisation and developed a health sciences metaphor that proved even more useful than Wheeler and Rothman’s “ ballistics laboratory” analogy.

Those regulatory actions against the epidemic of control frauds, in conjunction with passage of the 1986 Tax Act (which removed key abuses of the 1981 Tax Act) burst the financial bubble in commercial real estate in the Southwest and contained the d ebacle. The regulators correctly “diagnosed” the pathogen, accounting fraud, which was causing the worst S&L failures. The insight into patterns allowed the agency to diagnose the accounting frauds at a stage in which they were reporting record profits and were being praised by economists. The agency used this knowledge to prioritise its interventions.7 The agency also realised that outside experts were the control frauds’ most valuable allies. Outside auditors and appraisers “blessed” fictional income and property values and outside counsel assisted the sham deals that covered up the real losses. The agency realised that these professionals functioned like “vectors” that spread the fraud epidemic.

Gray’s reforms did not simply contain an exploding crisis, burst a financial bubble before it could cause serious damage to the national economy, and lead to the greatest number of convictions of elite white-collar criminals in US history – they also prevented a potential sub-prime lending crisis in the early 1990s. The key senior regulators that Gray had personally recruited realised in the early 1990s that S&Ls were increasingly making imprudent sub-prime loans, for example, “qualifying” borrowers (as having sufficient income to repay their mortgage loans) on the basis of the initial, very low (“teaser”) interest rate rather than the much higher fully indexed rate. The regulators barred the practice and intensively examined S&Ls that had engaged in it. The result was that there was no sub-prime crisis.

Economists Refuse to Learn Lessons of Debacle

The problem for economists was that the regulators’ success exposed the inherent failures of “modern finance” theory, methodology, and policy. Their “solution” was to ignore the regulators’ successes and their own failures. Prominent economists, such as Alan Greenspan, uniformly praised the worst control frauds. This did not, however, harm their careers or their reputations among their peers. Economists ignored accounting fraud and blamed government “intervention” (that is, deposit insurance) for causing the debacle and promoted greater deregulation (ending or severely limiting deposit insurance) as the cure to any ills of deregulation. They put their faith in “private market discipline”, which is akin to relying solely on the immune system to prevent epidemics. They missed the fact that the debacle exposed “private market discipline” as an oxymoron that aided accounting fraud.8

This revisionist history was so effective that the most notorious failure as an economic prognosticator, and the fiercest opponent of regulation during the debacle, Greenspan, was made the most powerful regulator in the world. Keating, the most notorious S&L control fraud, used Greenspan to recruit the five Senators that would become infamous as the “Keating Five”.9 As Chairman of the Federal Reserve, Greenspan reprised his earlier failures during the S&L debacle.

Consequences of Forgetting

It may seem odd to the reader that the story of the failure of US regulation and regulators in the ongoing crisis can be told in far fewer words than were required to explain the S&L debacle, but it can because it is an unremitting story of failure. Every agency and every senior regulator failed. Many made the crisis worse. There are no federal regulatory heroes. There is only one nearhero, Edward Gramlich. He was a member of the Board of Governors of the Federal Reserve. He warned Greenspan that there was a crisis coming in sub-prime and that there was a severe housing bubble and he implored Greenspan to send examiners into the large non-prime lenders to find the problems and stop them. Greenspan refused – and Gramlich (who was in declining health) politely waited until he left office and the crisis had hit to criticise Greenspan.

The Federal Reserve’s failure to act is critical because mortgage bankers (which are not regulated by the federal government) and affiliates of federally insured depository institutions (which are barely regulated by the federal government) made most non-prime loans. The Federal Reserve had unique federal regulatory authority over all home lenders – but Greenspan r efused to use that authority.

By late in the Clinton administration, key officials such as Larry Summers, Arthur Levitt, and Robert Rubin allied themselves with Republicans to pass legislation barring the Commodities Futures Trading Commission (CFTC) from regulating overthe-counter (OTC) credit default swaps (CDS), a variety of financial derivatives.

Contemporaneously, Vice President Gore’s primary role was spreading the “reinventing government” movement, which called for government to be run more like private enterprise. In the financial regulatory context, this meant that the agency should

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view banks as their “customer”. In training (and the author saw this in person), regulators were told that banks, not the citizens of the US, were their customers.

The Bush administration compounded this anti-regulatory c limate by appointing regulatory leaders that did not believe in regulation. They did not believe regulation was desirable or e ffective. The head of the Office of Thrift Supervision brought a chainsaw to a press conference to symbolise his determination to cut a swath through regulation. He succeeded. The deputy head of the FDIC appeared at the same conference with pruning sheers. Three beaming figures, holding pruning shears, stand next to them in the photograph of the conference – the top banking l obbyists (that is, the very satisfied “customers”). The FDIC was so proud of this moment of customer service that they included a photograph of the event, featuring the chainsaw, in their annual report for 2003. They created a self-fulfilling prophecy of regulatory failure.

The Bush appointees cut the number of regulators. The FDIC fell from 23,000 employees in 1993 to a bit over 5,000 employees in 2003 (ibid). The FDIC often used “buyouts”, which encourage higher paid employees to retire early. These employees included the agency’s most experienced examiners, particularly those with skills in investigating complex accounting frauds.

The federal banking regulators took no effective action against the emerging epidemic of mortgage fraud – which the FBI began testifying about in September 2004.10 They took no effective a ction via examination, supervision, regulation, enforcement a ction, or criminal referral. They acted only after banks and S&Ls failed. Even after the secondary market in non-prime loans and the scores of mortgage banking firms that specialised in nonprime loans collapsed early in 2007 they took no effective action.

The Office of Thrift Supervision (OTS) (the Bank Board’s successor agency responsible for regulating S&Ls) continued, for over a full year after the collapse, to purport that its non-prime specialty lenders were “well capitalised”. In fact, they were massively insolvent. The FDIC estimates losses to the taxpayers from IndyMac’s failure, for example, will exceed $9 billion (by far the most expensive failure of a US insured depository in history). I ndyMac specialised in “alt-a” mortgages. Those mortgages were known in the trade as “liar’s loans” because the lenders did not verify the borrowers’ claimed income, job, or assets. Mortgage fraud was common in non-prime lending and lenders initiated the great bulk of it.

The FBI reports that, based on existing investigations, 80% of all r eported fraud losses arise from fraud for profit schemes that involve industry insiders. Fraud for housing is fraud where a borrower perpetrates a fraud in order to acquire or maintain ownership of a house. “This type of fraud is typified by a borrower who makes misrepresentations regarding his income or employment history to qualify for a loan.”11

As hard as it may be to believe, the OTS knowingly permitted a major institution to specialise in making fraudulent (for example, “liar’s loans) loans that it then sold to large commercial and i nvestment banks that created collateralised debt obligations (CDOs) backed by the fraudulent mortgages. In 2006, IndyMac sold $80 billion of “liar’s loans” to other parties. It was a major vector spreading the fraud epidemic.

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Indeed, federal regulators pursued vigorously only one action – pre-empting state officials from taking action against predatory lending by affiliates of insured institutions. OTS reached its nadir when it permitted IndyMac to backdate a financial contribution from its parent company in order to claim that it was “well capitalised” (in reality, it was insolvent by roughly $9 billion).

What went wrong? Bush’s regulatory appointees were selected for ideological loyalty, not competence.12 They knew that the e pidemics of control fraud were impossible because they would falsify the efficient markets and contracts hypotheses. They knew CEOs were customers, not criminals. They had no understanding of accounting control fraud or financial bubbles, so they assumed that the non-prime lenders’ reports of high profits and low losses were accurate. They knew that the large banks that purchased CDOs were not taking any serious risk because the CDOs had “AAA” ratings. “AAA” is supposed to represent that an instrument essentially has no credit risk. The regulators assumed that “performance pay” “aligned the interests” of management and shareholders. The regulators assumed that independent experts such as appraisers, accountants, and rating agencies were independent and reliable. The regulators assumed that the bank’s “sophisticated” risk m odels were accurate.

No evidence has been made public that any senior banking regulatory responded to the FBI’s warnings of an epidemic of control fraud by mortgage lenders by taking any effective regulatory response. There is no evidence that any senior banking regulator seriously examined the Bank Board’s regulatory success in ending a surging epidemic of accounting control fraud and even proposed emulating its measures. Banking regulators have not implemented any of the Bank Board’s proven means to identify, close, or prosecute control frauds.

The Bank Board identified the epidemic while it was still growing and effectively countered it. The Bank Board alerted the FBI to the epidemic of S&L fraud. The current regulators have not identified the epidemic to this day – two years after the nonprime market collapsed and nearly five years after the FBI warning. As a result, they have been constantly surprised by the depth and scope of the losses and the crisis. They have never understood what caused the crisis. They are still engaged in covering up the losses. They have not made public even a single, honest “autopsy” of a large failure. It appears unlikely that they have conducted a single, honest autopsy of a large failure. No CEO of a large US bank has been indicted, much less convicted, for securities fraud in connection with the massive overvaluation of nonprime assets. The Treasury Department states that resolving bank losses will cost trillions of dollars, which means that many large banks must be massively insolvent, yet the large banks r eport that they are well capitalised.

The Bush administration proved that its appointees and policies can cause the systematic failure of financial regulation. It proved that “private market discipline” is an oxymoron where compensation systems create perverse incentives. The outside professionals became the accounting control frauds’ most valuable allies. We now see the catastrophic losses, and the resulting g lobal financial crises that can occur when we ignore the lessons


of the past. We have a successful model of how to build an t echniques) and multidisciplinary analysis to recognise trends, e ffective US financial regulatory body. We have an alternative risks, and fraud mechanisms. model that produces recurrent, intensifying disasters. t OBMZTFTUIFEBUB UPMPPL GPS QBUUFSOTBOEFNFSHJOH SJTLT

The successful model: i ncluding patterns of income that are “too good to be true”.


the public interest seriously and have a track record of i ntegrity. risks.


p roblems.



1 The industry was exposed to severe interest rate risk because it invested in long-term (30-year) fixed rate mortgages funded by extremely shortterm deposits. If interest rates rose sharply, the entire industry would be insolvent. The irony is that the administration, industry, most of C ongress, and the regulators opposed the ban on ARMs, but were blocked from ending it by the power of a single congressional committee chair (Black 2005: 7 n.5).

2 The President and Congress created the National Commission on Financial Institution Reform, R ecovery and Enforcement (NCFIRRE) and appointed its members. Its twin missions, which it completed in 1993, were to report on the causes of the debacle and to make recommendations that would help avoid future crises.

3 As Litigation Director, I was informally referred to as “the chief coroner”.

4 The regulators realised their theory was generalisable. The “weapon” and the “ammunition” would vary depending on what was optimal for the industry involved, but frauds led by the CEO posed a special risk because of the firm’s apparent legitimacy, power, and resources. A leading economist, Jayati Ghosh has recently applied the theory to analyse the Satyam scandal (2009).

5 James Pierce, the author of the NCFIRRE report, asserted that deposit insurance caused the perverse incentives (as did Akerlof and Romer 1993). All three economists believed (then) that the “effi cient contracts hypothesis” required that private market discipline defeat control fraud. Deposit insurance must, therefore, remove the incentive for creditors to exert market discipline. Other N CFIRRE officials challenged Pierce, noting that uninsured creditors (for example, subordinated debt holders) and shareholders never exercised effective discipline against an SL control fraud. Enron, WorldCom and their ilk ended any claim that deposit insurance was necessary to an epidemic of control fraud. Akerlof and Romer changed their views in light of that experience; Pierce did not.

6 White (1991).

7 This is loosely similar to the concept of triage that governs responses to mass emergencies when there are insufficient medical resources to treat everyone immediately. One obvious difference is that the regulators’ top priority when facing overwhelming problems is to identify the insolvent, unprofitable banks and to promptly close them. Triage prioritises patients that can only survive with immediate care.

8 Contrast Easterbrook and Fischel (1991) and Black (2003; 2005; 2007).

9 The Keating Five consisted of Alan Cranston, Dennis DeConcini, John Glenn, John McCain, and Donald Riegle. Each received large political contributions from Keating. They intervened with the regulators at his request in an effort to prevent the agency from sanctioning Lincoln S avings’ massive violation ($615 million) of a rule designed to limit “direct investments” that had proved optimal for accounting fraud. SLs that made large amounts of direct investments invariably led to catastrophic failures. Lincoln Savings cost the taxpayers $3.4 billion, the most expensive failure of the debacle, so the successful political interference of the Keating Five proved disastrous.


p atrons. TJNQMZ FDPOPNFUSJD The failed model did not meet any of these standards.

10 “FBI Warns of Mortgage Fraud ‘Epidemic’: Seeks to Head Off ‘Next SL Crisis’” (CNN) (17 September 2004).

11 “Mortgage Fraud: Strengthening Federal and State Mortgage Fraud Prevention Efforts” (2007). Tenth Periodic Case Report to the Mortgage Bankers Association, produced by MARI.

12 This preference is the agonising subject of recent books by Thomas Frank (2008) and James Galbraith (2008). The consequences are central to the themes of “The Wrecking Crew” and “The Predator State”.


Akerlof, George A (1970): “The Market for ‘Lemons’: Quality, Uncertainty, and the Market Mechanism”, Quarterly Journal of Economics, 84 (3): 488-500.

Akerlof, George A and Paul M Romer (1993): “Looting: The Economic Underworld of Bankruptcy for Profit”, Brookings Papers on Economic Activity, 2: 1-73.

Black, William K (2005): The Best Way to Rob a Bank Is to Own One (Austin, Texas: University of Texas at Austin).

  • (2003): “Re-examining the Law and Economics Theory of Corporate Governance”, Challenge, Vol 46, No 2, March/April: 22-40.
  • (2007): “When Fragile Become Friable: Endemic Control Fraud as a Cause of Economic Stagnation and Collapse” in K Naga Srivalli (ed.), White Collar Crimes: A Debate (Hyderabad: The Icfai University Press).
  • Black, William K, Kitty Calavita and Henry N Pontell (1995): “The Savings and Loan Debacle of the 1980s: White-collar Crime or Risky Business”, Law and Policy, 17: 23-25.

    Calavita, Kitty, Henry N Pontell and Robert H Tillman (1997): Big Money Crime (Berkeley and Los Angeles: University of California Press).

    Easterbrook, Frank H and Daniel R Fischel (1991): The Economic Structure of Corporate Law (Cambridge, Massachusetts: Harvard University Press).

    Frank, Thomas (2008): The Wrecking Crew: How Conservatives Rule (New York: Metropolitan Books).

    Galbraith, James (2008): The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too (New York: Free Press).

    Ghosh, Jayati (2009): “Markets Don’t Regulate, They Abet ‘Control Fraud’”, The Asian Age (27 January). thome/jayati-ghosh.aspx

    National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) (1993): Origins and Causes of the SL Debacle: A Blueprint for Reform, A Report to the President and Congress of the United States (Washington DC: Government Printing Office).

    Pierce, James L (1991): The Future of Banking (New Haven: Yale).

    Stigler, George J (1988): Memoirs of an Unregulated Economicst (Chicago: University of Chicago Press).

    Wheeler, Stanton and Mitchell Rothman (1982): “The Organisation as Weapon in White Collar Crime”, Michigan Law Review, 80, 1403-26.

    White, Lawrence (1991): The SL Debacle: Public P olicy Lessons for Bank and Thrift Regulation (New York: Oxford University Press).


    March 7, 2009

    The Postnational Condition –Malathi de Alwis, Satish Deshpande, Pradeep Jeganathan, Mary John, Nivedita Menon, M S S Pandian, Aditya Nigam, S Akbar Zaidi

    South Asia? West Asia? Pakistan: Location, Identity The Practice of Social Theory and the Politics of Location Reframing Globalisation: Perspectives from the

    Women’s Movement Postnational Location as Political Practice The Postnational, Inhabitation and the Work of Melancholia Empire, Nation and Minority Cultures: The Postnational Moment Nation Impossible Thinking through the Postnation

    For copies write to Circulation Manager

    Economic and Political Weekly

    320-321, A to Z Industrial Estate, Ganpatrao Kadam Marg, Lower Parel, Mumbai 400 013. email:

    march 28, 2009 vol xliv no 13


    –S Akbar Zaidi –Satish Deshpande

    –Mary E John –Malathi de Alwis –Pradeep Jeganathan –Aditya Nigam –M S S Pandian –Nivedita Menon

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