Financial reform in America “falls short”

William Black of the University of Missouri-Kansas City School of Law speaks to Vanessa Drucker

Q. Responsibilities of the former Federal Savings and Loan Insurance Corporation, where you were deputy director, now rest with the Federal Deposit Insurance Corporation. Are you encouraged by the Dodd-Frank financial reform legislation?

A. Had the Dodd-Frank [Wall Street reform and consumer protection] legislation been in place prior to the crisis, it would not have prevented it and is unlikely to prevent future crises. Its best potential is the creation of a consumer protection agency, although how that will be implemented remains unknown. Elizabeth Warren [now sidelined] would have been by far the best appointee to run it. She warned early on that the housing boom was unsustainable, and she recognised the substantial role of consumer abuse in helping to drive the bubble.

Q. Two years ago, you were saying that many major American banks were insolvent. Is that still the case?

A. Over the past 24 months, nearly every estimate of the recession has proven unduly optimistic, in terms of the deficit, unemployment, housing price declines. The real economy has suffered severe losses and the markets haven’t cleared. Home prices are still falling in California, month to month; depending on housing purchase stimulus programs, we get wilds swings. Fundamentals appear weak. For example, losses at Fannie Mae and Freddie Mac look very severe.

Q. Official policy, however, has been not to look hard at losses. Gimmicky accounting rules are helping to cover them up. The original fair value rule was to recognise losses immediately, other than temporary impairments. The losses arising from the credit crisis were initially characterised as temporary impairments, due to liquidity confidence problems. Temporary? Liquidity confidence supposedly killed secondary market in asset-backed securities back in March 2007?

A. Ben Bernanke [the chairman of the Federal Reserve] gives a critical wink and nod. The White House didn’t say boo, but reappointed Bernanke over substantial opposition, because he was so willing to work with the administration to cover up problems. The government doesn’t want to report the losses they would find if they looked too intensively. Not only are they neglecting the facts, but are relying on gimmicky accounting rules. That’s how they accomplished the phony stress tests. (article continues below)

Q. On the whole what would you have done differently?

A. For over 15 years, Treasury secretaries, whether Republican or Democrat, flew to Tokyo and told the Japanese that what they were doing was self destructive, covering up problems and prolonging their banking crisis. They advised the Japanese to follow the United States’ example during the Savings & Loan (S&L) crisis [of the 1980s and 1990s], of closing failed institutions to allow markets to clear and recover.

Q. We haven’t performed the resolutions. As in Japan, our markets don’t clear, but twist slowly in wind, while other parts of the general economy don’t recover. The real economy weakness feeds back into the lack of recovery in banking.

A. Now that we have gimmicked accounting rules, banks don’t have to recognise losses until they sell bad assets. So there is a strong incentive is not sell assets, but to sit on them. You get a tremendous build up of shadow inventory. Look at delinquencies. Bank of America provides statistics that an average person stays in their house well over 500 days without paying anything, before a bank forecloses. A huge percentage of the homes banks foreclose on are already vacant. A rule of thumb in the trade says that, while vacant, a home loses 1.5% of market value for every month it sits in delinquency. The deterioration in housing stock even extends to entire neighbourhoods, per certain tipping points, like three vacant dwellings per block.

Q. Do you believe large banks should have been nationalised in early 2009?

A. I object to the phrase “nationalised”, which has political overtones. It is amazing how the administration has used the phrase to self neuter itself by setting up a bogeyman. During the S&L era, thousands of receiverships were designed, not to nationalise them, but to put institutions back promptly into the private sector.

Q. Is it the system at fault, or is it the rogues who have been gaming it?

A. System and characters mutually reinforce each other. When plunder becomes large, it creates social belief that praises plunder. One of the reasons frauds pose unique dangers is that the most audacious frauds can change an external environment to make it more criminologic. In criminology, we called these eco epidemics.

We encouraged perverse incentives, allowing excessive executive and professional compensation. Gresham’s Law says bad money drives out the good. By a similar dynamic, we sent business to those people who were prepared to inflate it. Think how we played the credit agencies off against one another. The “elegant solution”, as the mathematicians say, is not to defeat controls but to suborn them.

Q. How can we control that better?

A. [President Barack] Obama left a tremendous opportunity unused. He should have taken on the frauds, as we did during the S&L crisis. Then, we created a top 100 priority list of institutions for prosecutions, targeting over 500 individuals. In the 1990s, we convicted over a thousand felons, and not little junior vice presidents. During the current crisis we have had zero criminal convictions.

Criminal laws serve multiple purposes. One is to brand conduct as socially unacceptable, which is why fraud committed by elites is especially destructive. This time, we have left them in charge, and even given them bonuses. To be biblical, fraud begets fraud. True, recently we have seen a few civil cases and enforcement actions, but not criminal proceedings. The civil actions are pathetic! Angelo Mozilo, that poster child, who was CEO of Countrywide Financial, walked away very wealthy.

Convictions from investigations help create political space for further meaningful action. By obtaining convictions with media coverage, Obama could have done more to change executive and professional compensation, deregulation, de-supervision, and decriminalisation, all of which will establish perverse incentives to produce recurrent intensifying crises.