When it comes to White-Collar Crime and Control Fraud, the economist William K. Black is surely the leading expert to ask. In an exclusive and comprehensive interview in two parts, he answers questions related to some major causes for the financial / economic crisis, the SEC charges against Goldman Sachs and the connection between drug money and the survival of the international banking system.
PART TWO: ECONOMIC WARFARE
Mr. Black, Lehman Brothers, founded in 1850, failed in September of 2008. What broke its neck after all those years?
The bankruptcy examiner conducted an investigation of Lehman Brothers. The report reveals that Lehman Brothers was engaged in large scale accounting and securities fraud by failing to recognize losses so large that it had failed as an enterprise. Lehman’s senior executives sought to cover up its failure with a series of very large ($50 billion) quarter end REPO transactions. Curiously, the report puts no emphasis on the underlying fraud that drove the fraud concentrates on the second-stage REPO cover up.
What are your thoughts on Goldman Sachs facing serious difficulties with the SEC related to fraud? Is this what you get when you do “God’s Work on Earth”?
We have learned from the SEC charges related to Goldman Sachs that it should be added to the list of elite financial frauds. It is a tale of two (unrelated) Paulsons. Hank Paulson, while Goldman’s CEO, had Goldman buy large amounts of collateralized debt obligations (CDOs) backed by largely fraudulent “liar’s loans.” He then became U.S. Treasury Secretary and launched a successful war against securities and banking regulation. His successors at Goldman realized the disaster and began to “short” CDOs. Mr. Blankfein, Goldman’s CEO, recently said Goldman was doing “God’s work.” If true, then we know that God wanted Goldman to blow up its customers.
Goldman designed a rigged trifecta: (1) it turned a massive loss into a material profit by selling deeply underwater, toxic CDOs it owned, (2) helped make John Paulson (CEO of a huge hedge fund that Goldman would love to have as an ally) a massive profit – in a “profession” where reciprocal favors are key, and (3) blew up its customers that purchased the CDOs. Paulson and Goldman were shorting because they believed that the liar’s loans were greatly overrated by the rating agencies. Goldman let John Paulson design a CDO in which he was able to pick the nonprime packages that were most badly overrated (and, therefore, overpriced). Paulson created a CDO “most likely to fail.” Goldman constructed, at John Paulson’s request, a “synthetic” CDO that had a credit default component (CDS). The CDS allowed John Paulson to bet that the CDO he had constructed (with Goldman) to be “most likely to fail” would in fact fail – in which case John Paulson would be become even wealthier because of the profit he would make on the CDS.
Now, any purchaser of the “most likely to fail” CDO would obviously consider it “material information” that the investment was structured for the sole purpose of increasing the risk of failure (and getting rid of Hank Paulson’s worst investments). The SEC complaint says that Goldman therefore defrauded its own customers by representing to them that the CDO was “selected by ACA Management.” ACA was supposed to be an independent group of experts that would “select” nonprime loans “most likely to succeed” rather than “most likely to fail.” The SEC complaint alleges that the representations about ACA were false.
Also, I’d add a fourth advantage to Goldman from the Abacus scheme. When you’re shorting (and its critical that both Goldman and John Paulson were shorting the same thing) you want more shorting. So Goldman and Paulson were a mutual aid society.
The obvious question is: did John Paulson and ACA know that Goldman was making these false disclosures to the CDO purchasers? Did they “aid and abet” what the SEC alleges was Goldman’s fraud? Why have there been no criminal charges? Why did the SEC only name a relatively low-level Goldman officer in its complaint? Where are the prosecutors?
And there is the key question that we (Eliot Spitzer, Frank Partnoy and I) asked in our December 19, 2009 op ed in the New York Times – why haven’t the AIG emails and key deal documents been made public so that we can investigate the elite control frauds? (I have called for the same disclosures of Fannie and Freddie’s key documents. ) Goldman used AIG to provide the CDS on these synthetic CDO deals and Hank Paulson used our money to bail out Goldman when AIG’s scams drove it to failure.
Mr. Black, can you put the crisis we’re going through into an international perspective?
Finance has become a parasite in most developed nations. It is supposed to serve the “real economy as an “intermediary.” Its function is to move capital to its most valuable use at the lowest possible cost. Instead, it creates massive bonuses and crises when it works badly. When it works “well” it misallocates capital and funds speculative attacks on commodities and national currencies. It is particularly harmful to workers in Europe and the U.S. None of this requires any conspiracy. Finance is not run in the interest of financial firms. It is run in the interests of the senior officers that control the financial firms. They simply maximize their income (often through accounting control fraud). They enter into tactical coalitions, but they have no permanent alliances. They are not loyal to the nation or the firm. They represent the closest thing to “homo economicus” – the rational, selfish, ethics-free, and wealth-maximizing economic agent that neoclassical economists imagined. As authors in the triumphal book about market economies (Moral Markets) conclude, “homo economicus is a sociopath.” Increasingly, our most elite business leaders (and this gives them great political power as well) are sociopaths. This is a recipe for recurrent, intensifying crises and increasing inequality.
One of the most distressing elements of the crisis, which is true in both Europe and the United States, is the death of accountability of our financial elites. Europe went overwhelmingly to anti-regulation. Strict regulation was the evil. It smacked of retributive American approaches. Elite bankers were the solution, not the problem. The Brits called the approach “softly, softly.” Regulation was not delegitimized. Markets were inherently self-regulating. It was all very clubby. Germany and France emulated the Brits. The Eastern European nations never had serious regulatory capacity and they generally followed the lead of the two European financial centres – the UK and Germany.
President Bush picked regulators designed to signal his administration’s intent to end effective regulation. He chose Harvey Pitt to head the SEC precisely because Pitt was infamous as the leading opponent of serious securities law enforcement. Pitt’s first major speech continued this symbolism. He spoke to a meeting of accountants and bemoaned the fact that the SEC had not always been a “kinder and gentler” place for accountants. He blamed this on his agency – not the top tier firms that consistently gave clean audit opinions to the financial statements of massively insolvent accounting control frauds that falsely purported that the firms were highly profitable.
This regulatory rot began in the U.S. under President Reagan (who demonized regulation and regulators), was reduced under the first President Bush, and began to decay again under President Clinton. Europeans’ first thought when they hear the name “Gore” is probably global climate change, but when he was Vice President his priority was “reinventing government.” The premise of reinventing government was that it needed to be fundamentally changed to more closely resemble a private corporation and to partner with private firms. Financial regulators were instructed to refer to the banks and S&Ls they were supposed to regulate as their “customers.”
Former OTS Director John Reich, who served from 2005 to 2009, referred to WaMu Chief Executive Kerry Killinger as “my largest constituent” in a 2007 e-mail.
Reich also appears in the signature photo of the U.S. contribution to the global crisis. The star of the photo is “Chainsaw Gilleran” (then the OTS Director). (The OTS is supposed to regulate S&Ls.) He is holding a chainsaw. The next three individuals are the top U.S. banking lobbyists, and Reich, then Deputy Chair of the FDIC, rounds out the group. They are all grinning. Everyone but Gilleran is holding pruning shears. They are posed over a pile of federal regulations and the message they are sending is that the industry/anti-regulator partnership will work together to destroy financial regulation. Well, “Mission accomplished!” The anti-regulators were so incapable of shame that they were proud of this tableau (which most resembled Soviet agitprop) and placed it in the 2003 annual report of the FDIC, which your readers can access online. It is no surprise that the federally regulated (sic) financial institutions which produced the worst frauds (or, at least, the worst we know of at this point) were S&Ls.
How long will it be economic warfare? Are we heading into a major war as a Last Exit Strategy?(xiv)
No one knows. The next severe economic crisis could be substantially worse than the Great Recession. I don’t think there is any grand conspiracy of financiers or that financiers as a group are eager to produce a war.
In your analysis: What is Germany’s role in all of this? Do you agree with Chancellor Merkel’s proposals do deal with the crisis?
Germany was a typical weak financial regulator. German banks are far larger than in many nations, and more integral to the economy, so they caused severe damage to the German economy. Germany played a significant role in the U.S. decision to terminate one of the most successful Great Depression-era U.S. reforms – the Glass-Steagall Act. Glass-Steagall required a separation between commercial and investment banking because of the inherent conflicts of interest of combining both operations in the same entity. (And everyone knows that “Chinese Walls” fail when they are most needed.)
U.S. opponents of Glass-Steagall (our largest banks) argued that we had to do away with Glass-Steagall to end their competitive disadvantage vis a vis German “universal” banks. This was dangerous nonsense (there are no economies of scale to the German banks – and the conflict endangers the bank), but it also kept alive a perverse dynamic, the “competition in laxity.” This dynamic creates incentives to weaken continuously financial regulation to the point that it will fail. This was the goal of the anti-regulators. They made regulatory failure a self-fulfilling prophecy. The Fed, through Patrick Parkinson, made the same “race to the bottom” argument in favour of passage of the Commodities Futures Modernization Act (which banned all regulation of credit default swaps). He claimed that if the U.S. regulated CDS the major players would move to the City of London and New York and the U.S. would be the losers. We should have been so lucky! Americans would have been overjoyed had AIG run it CDS scams out of a corporation in the City of London.
Germany is playing a negative role in responding to the crisis. The Euro stability pact is inherently unsound. Nations facing serious recessions make things far worse when they respond with “austerity.” Even conservative economists – even the IMF – had come to a general understanding that the IMF austerity strategy made crises worse. Germany, of all nations, should understand that demanding the economic (not moral) equivalent of “reparations” from Iceland or Greece cannot work. It will make the regional economic crises worse (and harm German exports). Germans can understand what the reaction of any Greek has to be to a suggestion from German leaders that Greece should sell its land (islands in this case) to other nations. Merkel seems to have backed off some of her strongest demands against the Greeks, but she has been leading the charge for IMF austerity policies. Absent the (U.S.) Fed’s interventions on behalf of nations like Switzerland (or, more precisely, its banks), the EU banks would have had to engage in massively greater bailouts of their banks.
What is your opinion on Mr. Bernanke being Time’s Man of the Year 2009?
Bernanke is a failed regulator that ignored every warning and refused on ideological grounds to act under HOEPA to stop the fraud epidemic. If he had any moral strength he would resign. Your readers need to know that he remains an active force against the public. He appointed, in late 2009, another failed economist, Patrick Parkinson, to run all examination and supervision at the Fed. Parkinson has no experience as an examiner or supervisor. He is notorious for taking the lead at the Fed in the successful effort to destroying Ms. Born’s efforts to protect the nation by regulating financial derivatives, particularly CDS, in 1999 and 2000.
Bernanke also took the lead in encouraging the banks to use their lobbing power to induce Congress to extort the Financial Accounting Standards Board (FASB) (the professional group that determines U.S. GAAP accounting standards) to change GAAP so that banks would not have to recognize currently the great bulk of their losses on bad assets (including those financial derivatives that Bernanke, Parkinson, and Greenspan championed). This unprincipled power play was successful. The ability to hide the massive losses has been attractive to the Obama administration (which regularly trumpets the false claim that it has resolved the crisis at virtually no ultimate cost to the taxpayers) and to bank officers. Overall, if the banks had to recognize their losses the bank bonuses could not be paid at many banks.
I am frank enough to ask one question that many people in the world have: Shouldn’t the Federal Reserve, as it exists today, being abolished for the sake of humanity?
It depends on what one means by “as it exists today.” My colleague Randy Wray is the expert on this. He makes the persuasive point that the Fed’s essential operations are extremely limited and not terribly complex. There is also no reason to keep so many of their operations opaque.
A first step to “The Fed’s End As We Know It”, I assume, could be the Audit the Fed bill. Do you support the House Resolution 1207 Federal Reserve Transparency Act of 2009?
Yes, I’m one of the signatories of a letter supporting that audit.
A colossal problem in this crisis are derivatives in the global financial system of at least 600 trillion US-dollars (xv). How was this mess created? How can this mess can be fixed? Isn’t a collapse of the system inevitable?
It exists because it is unregulated and (a very few) financial firms exploit this regulatory black hole to benefit their senior officers. Exchange traded derivatives can be valuable and pose little risk, but they are a tiny percentage of the outstanding derivatives. The overwhelming bulk of derivative transactions produce no value to the real economy. They are, however, capable of creating immense damage to the real economy. They are a ticking time bomb (except those that have already blown up.)
That derivatives will cause – as Johnny Carson would put it – “a really, really BIG” problem was predicted from early on, like Adam Hamilton did, when he wrote on September 7, 2001 about “The JPM Derivatives Monster“(xvi). How could it be that this problem was allowed to grow for years and years – and is there anybody out there responsible for it? No, there is literally no one in charge. Greenspan, Bernanke, Geithner, Summers, Rubin, and Parkinson all got their way in eliminating any protection for the public.
Short selling is not inherently evil, but it is at best a “second-best” solution. Consider accounting control frauds like Charles Keating’s Lincoln Savings and Loan. Some market participants decided that Lincoln Savings’ purported profits were fraudulent. They entered into “short sales” in which they would gain if the share price of Lincoln Savings’ parent company fell. Such sales could serve to signal regulators that there was something suspicious happening at Lincoln Savings. (In reality, the causality ran the opposite direction. The regulators’ concerns prompted the short sales.) The best solution would be to fix what ails regulation (which is primarily appointing anti-regulators as leaders) and have the bank regulators and the SEC attack the underlying accounting control fraud directly.
The SEC action against Goldman confirms one of the reasons we should be concerned about short selling. According to the SEC complaint, John Paulson (who runs one of the world’s large hedge funds), wanted to “short” nonprime loans in mid-2007. Note that this is far too late to provide the vital price signal that such loans were massively overvalued. By mid-2007, the secondary market in nonprime loans had already collapsed. Mortgage brokers were going bankrupt every week. Housing prices were declining. So, at best, Paulson was speculating in a manner that could not contain the crisis. Paulson’s actions were despicable. If he knew that Goldman was making false securities disclosures his actions could even be criminal. But they did not cause the decline in nonprime prices. The collapse in CDO prices was because CDOs were backed by nonprime mortgages that were endemically fraudulent and were made near the peak of the largest bubble in history because the epidemic of mortgage fraud hyper-inflated the bubble.
What kind of damage caused Naked Short Selling during the last years? Shouldn’t it be illegal rather today than tomorrow?
That is hotly contested. We have too few facts because data on short selling, and most other securities transactions is often not collected and was rarely subject to competent, critical examination by aggressive regulators. You can’t make short selling illegal today. One can construct credit default swaps (which remain unregulated) that create the economic equivalent of shorting a security. Again, this is why Eliot Spitzer, Frank Partnoy, and I have called for the release of the AIG emails and the relevant pricing models and data on CDS and other financial derivatives (and why I’ve called for the same public release by Fannie and Freddie). We should not have to guess about these matters. The facts should be made public.
I know that you pay close attention to what’s going on at A.I.G. Bob Chapman from “The International Forecaster” wrote not so long ago on the hearings before the House Oversight and Reform Committee:
“Each day brings more revelations of efforts of the NY Fed and Goldman Sachs to hide the details of the criminal conspiracy of the AIG bailout. . . . This is a real crisis on the scale of Watergate. Corruption at its finest” (xvii).Is this an exaggeration or an understatement?
Well, “each day” is an exaggeration. It is also hard for federal officials to commit a crime through bad regulation unless they are actually bribed or commit perjury. But the heart of claim is correct. Put aside for a moment any focus on criminal law and ask whether a nation can long prosper under crony capitalism. Crony capitalism is inherently corrupt and corrupting. It leads to terrible business decisions. It creates massive inequality and resentment. Our crony capitalism is a different model than Suharto. It is not based on family.
But it is built on connections and Goldman has exploited its connections to an unprecedented degree. The key problem is that there is not a U.S. consensus that Goldman’s role is a national disgrace and a grave threat to our economy, democracy, and souls. Hank Paulson engaged in such a blatant conflict of interest, and cost the American people such large amounts of money by bailing out Goldman (and many others) that he should have been persona non grata among his peers. But he lacks any moral compass and the elites no longer make even a pretence of having norms demanding civilized behaviour.
Can you discuss the importance of liquid cash flow generated through drug trafficking within and without the U.S.A. for banks primarily based in New York City and London via their off-shore connections (sic!)? A.I.G. seems to be also heavily involved in drug money – at least for sure in the past (xviii). And the UN-chief on drugs, Antonio Maria Costa, stated that “liquid investment capital” generated from drug trafficking helped to keep the financial system going in 2008. He said:
“In the second half of 2008, liquidity was the banking system’s main problem and hence liquid capital became an important factor … Inter-bank loans were funded by money that originated from the drugs trade and other illegal activities … There were signs that some banks were rescued that way” (xix).
Isn’t that a little bit of an embarrassing problem for the global financial system?
Yes, but I repeat that we do not know (and Mr. Costa does not know) the facts. There are two “first-best” solutions. One, we should legalize drugs. (For the readers who are about to stop reading; please continue a bit. First, I am 58 and I have never tried an illegal drug. I don’t even drink. I do not think drugs are good. I think they do awful things to people. Second, my policy advice is shaped by my experience as a criminologist, regulator, and teacher of economics. I’m with Milton Friedman on this issue.) We should legalize drugs because our policy of criminalizing it has failed – and will fail. That failure is catastrophic. The price of drugs gives us excellent market evidence on the success of our current policies. Drugs are generally cheaper now. I don’t care how many photo ops we stage of drug busts – the drug war has failed.
Our current policies make rich the worst, most dangerous people in the world and caused tragedy in nations like Columbia and Mexico (a tragedy spreading to the U.S.). We do not know how much money really goes to the druggies, terrorists, and corrupt politicians, but the number is large. We could defund many of the people out to harm our nation if we end this failed effort at Prohibition.
The other first-best solution is to get the facts and to seize as many billions as possible of those funds from the cartels, Taliban, and corrupt officials. The way to do that is to (1) end the tax havens (which are also havens for the scum of the earth), (2) to use undercover investigators and electronic surveillance against financial institutions with suspicious cash flows, and (3) to seize the existing proceeds.
The OECD launched an initiative against the tax havens. The Bush administration blocked the initiative because it wanted to create a “race to the bottom” of taxation by encouraging tax evasion through the use of tax havens. After the 9/11 attacks (which were funded through tax havens), the administration allowed a weakened version of the OECD initiative to proceed. The Obama administration should, with the aid of the OECD (Germany would likely be very supportive on this given its intelligence services’ recent initiatives on your neighbouring tax haven), should lead a campaign to end all tax havens. The U.S. has the economic power, even if had to act unilaterally without OECD support, to end the tax havens. The Fed could use its leverage for something constructive!
Antonio Maria Costa said furthermore, that drug money is by “now a part of the official system.” Is this naïve or deceptive to say that from Mr. Costa’s side? It is widely known that the Pakistani bank BCCI for example was involved with drug money during the 1980’s and then-Secretary of Treasury, James Baker III, did nothing against it “because he thought a prosecution of the bank would damage the United States’ reputation as a safe haven for flight capital and overseas investments.” So my question is: Nothing New in the West, is it?
Yes, BCCI (informally, and accurately, known as the “Bank of Crooks and Criminals, International”) was a massive control fraud. Yes, there is nothing fundamentally new about fraud schemes. The U.S. has long been complicit in refusing to crack down on the tax havens. The deal it made with UBS was scandalous. We have to end the “race to the bottom.” We can end it. It would do enormous good for the world in a wide range of spheres – and it would be immensely political popular. It would, however, enrage the richest Americans who evade taxes (but make political contributions).
From a criminological point of view: it’s the criminalized status of drugs that makes this whole business possible, right?
Yes, as I just explained, that is the key. Prohibition “sells” in politics, but it fails in the real world.
One last question, Mr. Black. Does John Lennon’s 1968 expression of the illness of our society apt today?
“Our society is run by insane people for insane objectives…. I think we’re being run by maniacs for maniacal ends … and I think I’m liable to be put away as insane for expressing that. That’s what’s insane about it” (xxi).
We face recurrent, intensifying economic crises (and economic stagnation for the working and middle class in the developed West) because our financial elites are unworthy. They are too often outright criminals – control frauds. They have no sense of accountability, no sense of duty to the nation (or community or world). Herr Henkel demonstrates how pathetic they have become. Their anti-regulatory, pro-greed ideology triumphed and produced a global Great Recession. But for government intervention and bailouts they would have caused a second Great Depression worse than the original. And what do our elites do? They blame the least powerful citizens for the crisis the elites designed, implemented, and grew rich on. Herr Henkel even descends to the last refuge of a modern scoundrel – racism.
Thank you very much for taking your time, Mr. Black!
(Sources listed here).