[p2p-research] I write to you from a disgraced profession

[Michel Bauwens]

*The following is the text of James Galbraith‘s written statement delivered
a few days ago to members of the Senate Judiciary Committee .*

May 18, 2010

*
http://rwer.wordpress.com/2010/05/18/i-write-to-you-from-a-disgraced-profession/
*<http://rwer.wordpress.com/2010/05/18/i-write-to-you-from-a-disgraced-profession/>

*I write to you from a disgraced profession
*
Chairman Specter, Ranking Member Graham, Members of the Subcommittee,
as a former member of the congressional staff it is a pleasure to
submit this statement for your record.

    I write to you from a disgraced profession. Economic theory, as
widely taught since the 1980s, failed miserably to understand the
forces behind the financial crisis. Concepts including “rational
expectations,” “market discipline,” and the “efficient markets
hypothesis” led economists to argue that speculation would stabilize
prices, that sellers would act to protect their reputations, that
caveat emptor could be relied on, and that widespread fraud therefore
could not occur. Not all economists believed this – but most did.

    Thus the study of financial fraud received little attention.
Practically no research institutes exist; collaboration between
economists and criminologists is rare; in the leading departments
there are few specialists and very few students. Economists have soft-
pedaled the role of fraud in every crisis they examined, including the
Savings & Loan debacle, the Russian transition, the Asian meltdown and
the dot.com bubble. They continue to do so now. At a conference
sponsored by the Levy Economics Institute in New York on April 17, the
closest a former Under Secretary of the Treasury, Peter Fisher, got to
this question was to use the word “naughtiness.” This was on the day
that the SEC charged Goldman Sachs with fraud.

    There are exceptions. A famous 1993 article entitled “Looting:
Bankruptcy for Profit,” by George Akerlof and Paul Romer, drew
exceptionally on the experience of regulators who understood fraud.
The criminologist-economist William K. Black of the University of
Missouri-Kansas City is our leading systematic analyst of the
relationship between financial crime and financial crisis. Black
points out that accounting fraud is a sure thing when you can control
the institution engaging in it: “the best way to rob a bank is to own
one.” The experience of the Savings and Loan crisis was of businesses
taken over for the explicit purpose of stripping them, of bleeding
them dry. This was established in court: there were over one thousand
felony convictions in the wake of that debacle. Other useful
chronicles of modern financial fraud include James Stewart’s Den of
Thieves on the Boesky-Milken era and Kurt Eichenwald’s Conspiracy of
Fools, on the Enron scandal. Yet a large gap between this history and
formal analysis remains.

    Formal analysis tells us that control frauds follow certain
patterns. They grow rapidly, reporting high profitability, certified
by top accounting firms. They pay exceedingly well. At the same time,
they radically lower standards, building new businesses in markets
previously considered too risky for honest business. In the financial
sector, this takes the form of relaxed – no, gutted – underwriting,
combined with the capacity to pass the bad penny to the greater fool.
In California in the 1980s, Charles Keating realized that an S&L
charter was a “license to steal.” In the 2000s, sub-prime mortgage
origination was much the same thing. Given a license to steal, thieves
get busy. And because their performance seems so good, they quickly
come to dominate their markets; the bad players driving out the good.

    The complexity of the mortgage finance sector before the crisis
highlights another characteristic marker of fraud. In the system that
developed, the original mortgage documents lay buried – where they
remain – in the records of the loan originators, many of them since
defunct or taken over. Those records, if examined, would reveal the
extent of missing documentation, of abusive practices, and of fraud.
So far, we have only very limited evidence on this, notably a 2007
Fitch Ratings study of a very small sample of highly-rated RMBS, which
found “fraud, abuse or missing documentation in virtually every file.”
An efforts a year ago by Representative Doggett to persuade Secretary
Geithner to examine and report thoroughly on the extent of fraud in
the underlying mortgage records received an epic run-around.

    When sub-prime mortgages were bundled and securitized, the ratings
agencies failed to examine the underlying loan quality. Instead they
substituted statistical models, in order to generate ratings that
would make the resulting RMBS acceptable to investors. When one
assumes that prices will always rise, it follows that a loan secured
by the asset can always be refinanced; therefore the actual condition
of the borrower does not matter. That projection is, of course, only
as good as the underlying assumption, but in this perversely-designed
marketplace those who paid for ratings had no reason to care about the
quality of assumptions. Meanwhile, mortgage originators now had a
formula for extending loans to the worst borrowers they could find,
secure that in this reverse Lake Wobegon no child would be deemed
below average even though they all were. Credit quality collapsed
because the system was designed for it to collapse.

    A third element in the toxic brew was a simulacrum of “insurance,”
provided by the market in credit default swaps. These are doomsday
instruments in a precise sense: they generate cash-flow for the issuer
until the credit event occurs. If the event is large enough, the
issuer then fails, at which point the government faces blackmail: it
must either step in or the system will collapse. CDS spread the
consequences of a housing-price downturn through the entire financial
sector, across the globe. They also provided the means to short the
market in residential mortgage-backed securities, so that the largest
players could turn tail and bet against the instruments they had
previously been selling, just before the house of cards crashed.

    Latter-day financial economics is blind to all of this. It
necessarily treats stocks, bonds, options, derivatives and so forth as
securities whose properties can be accepted largely at face value, and
quantified in terms of return and risk. That quantification permits
the calculation of price, using standard formulae. But everything in
the formulae depends on the instruments being as they are represented
to be. For if they are not, then what formula could possibly apply?

    An older strand of institutional economics understood that a
security is a contract in law. It can only be as good as the legal
system that stands behind it. Some fraud is inevitable, but in a
functioning system it must be rare. It must be considered – and
rightly – a minor problem. If fraud – or even the perception of fraud
– comes to dominate the system, then there is no foundation for a
market in the securities. They become trash. And more deeply, so do
the institutions responsible for creating, rating and selling them.
Including, so long as it fails to respond with appropriate force, the
legal system itself.

    Control frauds always fail in the end. But the failure of the firm
does not mean the fraud fails: the perpetrators often walk away rich.
At some point, this requires subverting, suborning or defeating the
law. This is where crime and politics intersect. At its heart,
therefore, the financial crisis was a breakdown in the rule of law in
America.

    Ask yourselves: is it possible for mortgage originators, ratings
agencies, underwriters, insurers and supervising agencies NOT to have
known that the system of housing finance had become infested with
fraud? Every statistical indicator of fraudulent practice – growth and
profitability – suggests otherwise. Every examination of the record so
far suggests otherwise. The very language in use: “liars’ loans,”
“ninja loans,” “neutron loans,” and “toxic waste,” tells you that
people knew. I have also heard the expression, “IBG,YBG;” the meaning
of that bit of code was: “I’ll be gone, you’ll be gone.”

    If doubt remains, investigation into the internal communications
of the firms and agencies in question can clear it up. Emails are
revealing. The government already possesses critical documentary
trails — those of AIG, Fannie Mae and Freddie Mac, the Treasury
Department and the Federal Reserve. Those documents should be
investigated, in full, by competent authority and also released, as
appropriate, to the public. For instance, did AIG knowingly issue CDS
against instruments that Goldman had designed on behalf of Mr. John
Paulson to fail? If so, why? Or again: Did Fannie Mae and Freddie Mac
appreciate the poor quality of the RMBS they were acquiring? Did they
do so under pressure from Mr. Henry Paulson? If so, did Secretary
Paulson know? And if he did, why did he act as he did? In a recent
paper, Thomas Ferguson and Robert Johnson argue that the “Paulson Put”
was intended to delay an inevitable crisis past the election. Does the
internal record support this view?

    Let us suppose that the investigation that you are about to begin
confirms the existence of pervasive fraud, involving millions of
mortgages, thousands of appraisers, underwriters, analysts, and the
executives of the companies in which they worked, as well as public
officials who assisted by turning a Nelson’s Eye. What is the
appropriate response?

    Some appear to believe that “confidence in the banks” can be
rebuilt by a new round of good economic news, by rising stock prices,
by the reassurances of high officials – and by not looking too closely
at the underlying evidence of fraud, abuse, deception and deceit. As
you pursue your investigations, you will undermine, and I believe you
may destroy, that illusion.

    But you have to act. The true alternative is a failure extending
over time from the economic to the political system. Just as too few
predicted the financial crisis, it may be that too few are today
speaking frankly about where a failure to deal with the aftermath may
lead.

    In this situation, let me suggest, the country faces an
existential threat. Either the legal system must do its work. Or the
market system cannot be restored. There must be a thorough,
transparent, effective, radical cleaning of the financial sector and
also of those public officials who failed the public trust. The
financiers must be made to feel, in their bones, the power of the law.
And the public, which lives by the law, must see very clearly and
unambiguously that this is the case. Thank you.



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