0:36 Intro. [Recording date: January 24, 2012.] Russ: Bank fraud and what it can tell us about the crisis and what we might learn from it. Tell us to begin with about your background in detecting bank fraud. Guest: It happened, of course, accidentally, like most things in life. I went over to the Home Loan Bank Board, April 2, 1984, as their Litigation Director. Russ: What is the Federal Home Loan Bank Board? Guest: Well, it is two agencies ago. It was the primary Federal regulator of Savings & Loans, agency, the office of Thrift Supervision, which was recently killed by the Dodd-Frank Bill. Russ: And what did you do there? Guest: I did what the title suggested. I was Litigation Director, and we had independent litigation authority. So we didn't use the Justice Department. And so at a very young age I had a docket of 10,000 cases, and then a budget for outside counsel of $100 million dollars, which back in the day was a big deal. But pretty quickly I became heavily involved in two other things--again accidentally. We had a massive run on the largest Savings and Loan (S&L) in America, American Savings; and it was a $6 billion-dollar run. This was not long after Continental Illinois had been brought down by a $6 billion-dollar run. And I ended up on the emergency task force; and so I was working with the business types, and with the field folks; and supervision was really done in the field, not out of Washington, D.C. So, I started learning a great deal about these institutions. And the head of the agency had undergone a remarkable transformation. He was a reasonably close friend of both of the Reagans--appointed head of the agency because of that personal relationship. Very strongly pro-deregulation. But he had changed by this point and had decided to engage in significant re-regulation. And because of the chain of random facts, I ended up being the staff leader of that effort. It's the combination of those things that led me into the anti-fraud efforts. Russ: Going back a little bit to that case you just mentioned, American--what was it? Guest: American Savings, also known as FCA Financial Corporation of America. So, it was a holding company. Russ: And how was that, after that run? It was shut down--is that correct? Guest: No. And indeed that is part of this interesting story of fraud. It was a bit like Lehman Brothers, in that as your listeners may know, the Securities and Exchange Commission (SEC) and the Federal Reserve (Fed) had people in Lehman, in its final months of distress; and the Fed folks were from the credit side of operations. In other words, the potential lenders. Presumably looking at collateral. And the Fed, knowing that Lehman was in desperate shape, sent two people. The SEC did this as well, by the way. We, from our Federal Home Loan Bank of San Francisco sent 45 people. Russ: To look at American Savings. Guest: American Savings; and they worked around the clock, in shifts, going through collateral and made emergency lines available on the basis of reasonable collateral; and actually survived a $6 billion run. But used that leverage to force out [Charles] Charlie Knapp. And in this era the folks were known as the "high flyers"--that was the phrase within the trade--who were doing what was perceived as riskier things. And the perception about Knapp was that he was taking severe interest rate risk. In other words growing very rapidly with a tremendous mismatch, investing very long term, in 30-year fixed-rate mortgages held in portfolio, and financing them with very short-term deposits. Russ: That sounds familiar. Guest: Right. So the key difference is that the Federal Home Loan Bank of San Francisco used its leverage as a lender to force Knapp out and to bring in a new person. And that new person should--you would have thought--have saved the place, because he immediately stopped the interest rate gamble, went to adjustable rate mortgages. Not the modern kind in this crisis, but sort of the good, old-fashioned fully amortizing adjustable rate mortgages. And so he minimized interest rate risk. And they had virtually no defaults on these loans. So, you are thinking: This is great. Right? Russ: Getting back to health. Guest: Right. Wonderful intervention, brought in new folks, saved the place. And what turned out is: Every quarter, the place lost money. And so this made no sense. And what we discovered eventually, when employees started coming forward, was that they had missed entirely the major operation, which is what we call "cash for trash." And when I say "we" call it, as regulators that's the phrase the industry used to describe it; and we simply adopted their phrase.

7:41 Russ: Now, when you say "they discovered," when you said "they missed"--who was "they"? Guest: Yes. In this case it was everybody. So the SEC had prompted the run. I'm not blaming them, mind you--this is a good thing. But they prompted the run by finding a case of accounting fraud by American Savings and forcing it to restate its earnings. But they didn't find the underlying larger fraud. They, the SEC. Nor did the investors. Nor did the regulators. Russ: And what was that fraud? Guest: And that fraud, as I said was called cash for trash. And cash for trash works this way: So, Charlie Knapp didn't simply grow rapidly. He made extremely high-yield, high risk loans. Particularly commercial real estate. And of course, as you might expect with a guy like this, these loans were frequently bad. And that would have caused tremendous loss recognition. So, you come into American Savings, and you've never developed anything; you say: I'd like to borrow a million dollars to create a strip development, put up a 7-11. And the American Savings person would respond, the lender, a loan officer type: Sorry, we won't make you a million dollar loan. But we will make you an $80 million dollar loan. Russ: To a person who has perhaps never developed anything substantial. Guest: Yes. And that would be the norm, and it would be the norm for good economic reasons, because if you are a real developer, even if you have no financial stake in the project--it's a non-recourse loan with no down payment--you still have a reputational interest that can get in the way of what I'm about to describe. Russ: So, this, by the way, is going to be symptomatic of a much larger problem. So, for those of you listening, if you think we are delving into this particular case of American Savings in this peculiar kind of weird transaction, this turns out to be kind of, unfortunately, a template for a wider kind of behavior. So, carry on. Guest: That's exactly right. Russ: So, I'm walking in, I've never built anything in my life; I come to you, American Savings, I say I want to build this development; and I know and you know it's a loser. It's overbuilt already; I don't have much of a track record. And your point was that if I did have such a track record, I wouldn't be so eager to build a lousy development that would hold me back because I want to keep doing this. But if I'm a one-time kind of guy, I walk in and want to borrow a million; you say, no, no--we're going to lend you 80 million. Why wouldn't that be a good idea? Guest: Because I would have previously made a loan for $60 million to somebody else. And they would actually meet your description even more, of deliberately putting up a building that made no sense. And of course it would have gotten into trouble. And so the pesky examiners might either have come in or you fear they are about to come in and say that the $60 million dollar acquisition of development and construction, what's called an ADC loan, is really only worth $30 million, and you have to recognize a $30 million dollar loss. And again, foreshadowing many things we'll talk about, all of these entities have virtually no capital in reality; so a $30 million dollar loss is any amazingly big deal. A few of those and you are gone. So, I don't want to recognize that loss. So, when I do this with a class, I ask: So, what do you do? And after a lot of prompting, they'll say: Well, I loan this new guy, the one who wants to come in that wants to build the 7-11, $60 million dollars. And he buys it for $60 million. And that's the C- answer. Because what you are really going to do, of course, is buy it for $78 million. Russ: So, I'm lost. I got confused there. You've got to prod your bank. You've got one project that went sour. You didn't plan for that one to go sour; it just didn't turn out. Guest: You didn't care. You were fairly indifferent to it going sour. Russ: So, all of a sudden this stream of payments that you might have gotten is now not going to show up. And you are going to end up with a major loss on your hands. You are going to have to grab the property in this half-built building maybe, or building that's been built but it's empty; and the guy says: Sorry, I can't pay the loan, but I guess you'll take my land and my building. Right? Guest: Except that there has never been a stream of earnings. Russ: Right, you've never rented a single office in the building. And now I come in, I'm the second guy, and I say: I want to build a 7-11; I want to borrow a million dollars. And what do you do? Guest: I loan you $80 million. You'll keep $2 million as walking-away money. Russ: So, you are going to give me $80 million dollars. I am going to take $2 million of it to pay my salary of it as developer. Guest: Right, for the risk exposure of committing this fraud. Russ: Yes. And what am I going to do with the other $78 million? Guest: I'm going to purchase the building. Russ: I meaning you or me? Guest: I, the 7-11 developer. Russ: That's me. Sorry. Guest: You are going to purchase the big office building. Russ: Oh! I'm going to use my $78 million that's left over to overpay for the bad thing you already built? Guest: That's right. And I transform, in my hypothetical--which is not a hypothetical--a true $30 million dollar loss--you have an original book value of $60 million. Russ: And now you've got an $18 million dollar profit. Guest: Yes. And you would frequently have what was known as you, the lender, American Savings, would frequently have what was known as an equity kicker. An equity kicker would mean you would get 50% of the net profits if there was a successful sale. Russ: That's really ugly fraught, right, because I'm supposed to take the $78 million you gave me and build the 7-11. You are saying I'm not going to do that? Guest: No, you are coming in for a 7-11; I tell you to forget the 7-11 project. That's not what we are going to do. You are going to get an $80 million dollar loan. You keep $2 million of it as walking around money. Russ: And I take the other $78 million, overpay for your lousy project, and you then, to the regulators on your books, say: We made profit on that first project because we sold it. We sold it to a guy we lent the money to, actually. And of course, I'm going to default on the $80 million dollar loan now. Guest: Eventually, but I'll refinance it three more times. Russ: So, what you've done there is you've pushed the day of reckoning down the road with no hope of ever having it be positive. And in the meanwhile, I've made $2 million; you've made the equity kicker--you pocketed some bonuses maybe and compensation for a good quarter because you say you had a big profit. Is that the idea? Guest: Yes; and I have transmuted a real economic loss into a fictional gain. Remember the pesky examiner who was about to force me to recognize the $30 million dollar loss. He's threatened my ability to survive. Now, when these frauds are done, they don't make lemonade. They make Dom Perignon.

16:00 Russ: It's a Ponzi scheme. Guest: Right. Russ: Essentially. So it falls apart either--I was going to say when you run out of people to participate, but there's always someone. Does the person who takes the $80 million dollar loan and pockets the $2 million, does he go to jail? Guest: Eventually in the old days, yes. In the current system, no. Russ: And he goes to jail because he has willingly participated in a sham transaction? What's the illegality of what he did--what I get in that story? Guest: Excellent question. What you did, because back in the era I'm describing, we had actual rules. And the actual key rule that helped make these prosecutions was very simple. And it was one of those rules that economists could love. Libertarian economists could love. Russ: That's me, Bill. You know that. Guest: It said three things. 1. You must underwrite a loan before you make it. Russ: What does that mean? Guest: Well, it doesn't do you much good if you underwrite it after you've already dispersed the money. Russ: But what does it mean, technically, to underwrite the loan? Guest: Underwriting is the process in this context of determining the risks of the loan, whether it should be made under your risk views, as managers, and what the necessary yield is--the required return in our jargon. Russ: So this is like an assessment. It's the due diligence before you make the loan that complies with the regulatory framework. Is that correct? Guest: No, this is the due diligence that we would do if regulators had never existed. Russ: Oh. Just the idea that you'd want to know what's going on. Guest: Yes. In other words, so to back up, if you don't do due diligence or underwriting in the lending process, we have known for centuries that you create acute adverse selection. And in the context of a mortgage loan, where the money goes out at the beginning, as opposed to credit cards where it goes out in tiny slugs, to engage in significant adverse selection in the mortgage context is to create as a lender an intensely negative expected value. Russ: And by adverse selection, you mean you are going to draw people who are bad credit risks, who are just going to be happy to live in the house for a while and then lose it. Guest: Yes. In this context. You get the worst possible borrowers and because you do not know the risks, because you have not looked, you will underprice. Russ: Okay, so let's get back to your sequence. Guest: You have to underwrite the loan before you make it. Second thing is, through the underwriting process you have to establish that the person has the apparent ability to repay the loan. And third, you have to keep a written record of this process. Russ: Those are pretty simple. Now, the puzzle of course--and we're going to talk about this when we come to the current crisis--the puzzle is: So, why would anyone lend that money? Why would ever I want to create a set of loans that are never going to pay off? That I know in advance are likely to not pay off? Guest: Because, as Akerlof and Romer put it, aptly in the title of their key article in 1993, looting the economic underworld of bankruptcy for profit, accounting control fraud is a "sure thing." Russ: And the sure thing there is the sure thing that's with the Ponzi scheme, right? If I have a bunch of sham investments that I finance by continuing to roll over and attract new investors under a promise of a particular rate of return, say, it's a sure thing until it's not a sure thing. Until I can't find those people any more, in the case of a Ponzi scheme; and then I lose all my money and I go to jail. In the case of a bank, this works for a while; I live a good life in the meanwhile because I've got a lot of cash to play with that I can pay myself with--you've got to be attracting money somewhere along the way so I'm attracting deposits, say, which I'm using to finance these sham transactions and skimming off chunks for myself and other people I lend the money to. But eventually there's a day of reckoning. So, it's not a very attractive sure thing. It's a sure thing until you get caught; and then you go to jail. Guest: Only if you go to jail. And as many economists aptly said, again, it's like all things in risk: You have to make forward-looking views. At the time people were doing this, nobody was going to prison for these things. Russ: In the 1980s, you are saying. Guest: In the 1980s, and of course now, they most assuredly, if they are the elite managers, don't go to prison. They don't even get investigated in the modern era, much less prosecuted. Russ: So, let's go deeper into looting. You just gave a scenario. Guest: Right, you asked me to explain what the crime typically was, and that's why I was explaining the underwriting process. We are back to you, where you are the straw purchaser. Russ: Right; I'm the straw developer. Guest: And the crime is that for an $80 million dollar loan, you are almost certainly going to overstate your income. Russ: Oh, I see. There's going to be a literal fraud. It's not just that I'm faking it and pretending to be a developer. I'm going to have to have filled out some paperwork that shows I'm not who I said I was. Guest: And that's because in that era we had rules, requiring this underwriting. And again, the key on those rules is we didn't go to best practices. We went to minimal practices that any entity that was going to survive as a lender would use. So, there were pretty close to zero economic costs to this regulation. But it created a problem for you if you were to engage in fraud, and so what you would typically do is either put false information in the files or remove honest information from the files that would demonstrate to the examiners that you knew you were making a bad loan. Russ: And that would clearly be the case on my side, as the borrower. And on your side as the lender, you would go to jail for knowingly accepting false documents or removing those things from the file? Guest: You would have been the person, just as in the current crisis who had been encouraging and made basis preparing the false financial statements. You are not going to leave it up to the unsophisticated person who has never been a developer. Russ: To figure out what he needs to lie about.

23:36 Russ: So let's take a brief digression here on ethics, a topic that rarely rears its attractive head. You said that in the profession, in the industry, this was known as cash for trash. At that point, people didn't foresee--many of them, some of them--would go to jail for this procedure. It's not a very nice thing. When you went home at night and talked to your spouse, you'd kind of feel--How was your day? Well, I made another lousy loan, doing great; we're going to Tahiti this summer for a month. How did this become the norm? And it was the norm--we're talking about one particular example, but there were many, many banks in the Akerlof and Romer paper, I remember, very important paper. This wasn't like an isolated thing where someone said: Hey, maybe I could get away with this. It was widespread, correct? Guest: Yes. The inevitable national commission to investigate the causes of the Savings and Loan crisis, the famous phrase is: As the typical large failure, fraud was invariably present. Now, that's the norm within the large failures. It doesn't mean it was the norm within Savings and Loans. There were 3000 Savings & Loans, roughly, depending on the exact date, and we are talking about one tenth of the industry. But 1/10th of the industry is enough to cause catastrophic losses. Russ: And of course, those losses continued to mount. Let me see if I can get the chain correctly. So, I'm a Savings and Loan; I am attracting deposits by offering nice rates of interest. I am taking the money, lending it out along the lines of what we just talked about, aggressively; having good quarter after quarter, by what again seems like a Ponzi scheme; and the people who are ultimately financing it, although they look like the depositors, are not really the depositors. It was the taxpayer. Because the S&Ls were FDIC-insured, the taxpayers were ultimately the funders of this fraud. Is that a correct way to describe it? Guest: Well, first, there was a separate insurance fund in those days, the Federal Savings and Loan Insurance Corporation (FSLIC), as a technical matter. But yes, the government was behind most of it. But don't forget, in terms of key stuff about moral hazard: the government wasn't the only entity. There were shareholders at most of the worst places. And there was subordinated debt at many of the most fraudulent places. And of course in economic theory, it was supposed to be subordinated debt that was the perfect form of private-market discipline. You had the right incentives; you had the sophistication; and you should have done something. But there were zero cases of effective private market discipline by either shareholders or sub-debt holders in the Savings and Loan crisis. Russ: So, let me just review that, because we've talked about this in passing in many different podcasts, many episodes of this show. The debt holders have a fixed upside. They cannot make more than they are promised. Their downside is being wiped out. So in general, they are going to be the watchdogs of risk taking and the enforcers of prudence on the part of the people who they've lent money to through this debt. And what I have been worrying about for a long time, and it's a worry I've learned from Gary Stern's work, is: Well, that's true, that under a market system the debt holders are supposed to be the disciplinarians of risk taking, the watchdogs, but if the bond holders think that they might get their money back even when the firm goes out of business, which happened with Continental Illinois in 1984, you might start to not worry so much about that and be willing to accept a fixed rate of return even when there is a chance that the investment will amount to nothing, because you might get your money anyway. Correct? Guest: True, but not basic enough. In other words, you are quite right that Continental Illinois did a terrible thing and it bailed out sub-debt holders. We never did that in the Savings and Loan. We always wiped out the sub-debt holders. And of course they are supposed to be wiped out. That's the concept of risk capital. Despite that, there was never effective private market discipline; indeed there was no even effort at private market discipline. It failed, by sub-debt holders during that entire crisis. And what I'm explaining with this sure thing and the creation of this record reported income hit the Achilles heel of the private market discipline. So, in the real world, if you are the Chief Financial Officer (CFO) of Enron, and you are reporting record profits, your problem isn't private market discipline. Your problem is that bankers are almost literally trying to break down your office door to get in to you to lend you money. So, as long as you are reporting record earnings, it turns out private market discipline is an oxymoron. The primary entity that loses money, as you aptly pointed out in the Savings and Loan, is not the shareholders--because of the very thin equity. It's the creditors. Now in the Savings and Loan case, yes, the ultimate creditor was the government, in most cases. But that's not true of the Enrons of the world. That wasn't true of the Bear Stearns, Lehman Brothers, Merrill Lynch--in other words, the entities that fund the accounting control frauds are overwhelming the creditors who in theory are supposed to be the ones providing discipline. Instead, what they mostly do is provide cash.

30:36 Russ: Right, so again, the puzzle is: Why? And the answer, it seems to me--there's two answers. One is: they looked at the record profits, the good times, and they were lulled into thinking that they would persist. I find that explanation unpalatable and probably false. Of course it's possible. It's possible that there's this animal spirits of exuberance that gets out of control. But these are savvy people; they've seen a little bit of the world; they do know that prices can go down and assets do fall in value from time to time. And in fact each of these firms has people in them, and that was their sole job--tap the other people on the shoulder and say: Don't forget! And yet they persisted; they continued to fund those investments and eventually when they turned out badly, they should have been wiped out. But they weren't. They got 100 cents on the dollar. They were totally insulated from the market discipline that should have been in place. Guest: Well, it depends on what you are describing. That's certainly not true in the Savings and Loan. Russ: Correct. I'm talking about the current crisis. I'm talking about the Bear Stearns creditors; I'm talking about AIG's, Merrill Lynch--everybody except Lehman. The people who had funded the daily operations that provided the liquidity that let them make the bets they made were insulated from the failure. Guest: Well, again, if you go a little farther back--because again, this theory says: What do I anticipate? We had not been bailing out investment banks. And investment banks had been failing; and by the way they failed primarily because of fraud--and there had been no bailouts. So, if you go on what people supposedly would have anticipated coming into this crisis, I don't buy the argument that they would have been very sure that they would have been bailed out. The banks that facilitated Enron's fraud suffered significant losses. Russ: But the banks that funded the escapades of the Mexican government in the mid-1990s suffered no losses, because the U.S. government stepped in, using the same argument that they would use in this crisis--that there was risk of global instability; that Mexico could not default; no one needs to take a haircut; the U.S. government will guarantee the bonds that the Mexican government would issue to cover its past promises; and it turned out they didn't lose a penny. So it turned out great according to the defenders of that policy. But the investment banks that had bought those Mexican bonds that had issued those, had underwritten those bonds, part of the stream of income that they generated--they were made whole. And I think that's part of the problem. Guest: I agree that that is part of the problem. I would again say they weren't really made whole, except in a very nominal accounting sense. In other words, there were real losses suffered; and Citicorp was next to death's door a number of times. But I think where we'll all end up agreeing is the treatment of systemically dangerous institutions that allows them to hold our economy hostage and produce these bailouts is completely destructive of almost any view of how and economic system should run. Russ: Yes, we're going to agree on that.

34:26 Russ: So, let's get to how the story you just told me about American savings in that era of the Savings and Loan crisis, when banks realized that--Well, let me ask you a different question before we get to the present. How do you get to a world--wouldn't you rather make good loans? Why would you run around trying to make bad loans? Why then? You'd think if this is a good trick, you should always do it. If it's not a good trick, don't do it, if there's a better alternative. Why was it prevalent then? What kicked that looting off? Guest: Well, what kicked it off was almost certainly the first phase of the Savings and Loan crisis, which had nothing to do with fraud. The interest rate crisis. The entire industry ran on a system that exposed it to massive interest rate risk. Paul Volker decided to break the back of inflationary expectations; created the double-digit interest rates; and every Savings and Loan in America was insolvent on a market-value basis; and collectively by mid-1982--of course this wasn't realized for accounting purposes--but in real economic terms, the industry was insolvent to the tune of roughly $150 billion. Russ: So, at this point I'm running a bank and I have made a bunch of loans--basically the idea is to attract new money, which I need, I have to offer a large interest premium. But the money that's coming in from my old loans is very low. This is the mismatch problem, correct? Guest: Yes, although this is where the conventional economic wisdom turns out to be highly incorrect. But it does create lots of pressures; and it creates a unique political opportunity. So, the head of the Federal Home Loan Bank Board, at that point, is Dick Pratt; an academic, very conservative, very libertarian economist/finance expert. And he creates the key deregulatory bill; indeed it was known as the Pratt Bill, informally. It becomes the Garn-St. Germain Act of 1982. And being a good economist, he tries to do it exactly right. And so he asked his economists at the agency, which of the states has the best results? Right? So this is Brandeis-like laboratory experimentation. And they come back and they say: Texas. Texas is the place where the Savings and Loans are reporting the best returns. And so he uses Texas as his model for deregulation--what becomes the Garn-St. Germain Act of 1982. The problem of course that he and his economists didn't understand is that the Texas Savings and Loans were doing what we've been describing in this podcast. Russ: They were the market leaders. Guest: Yes. And as a result they produced over 40% of the total losses in the entire Savings and Loans crisis. And this is the fundamental problem of relying on econometrics during the expansion phase of an epidemic of accounting control fraud. Because you will inherently get not just the wrong answer in terms of public policy--you will get the worst feasible answer. Russ: Yes, it's a destabilizing feedback loop. So, what is--trying to answer my earlier question: This kind of looting or control fraud occurs when I realize that my bank is dead, that my assets are worth less than I had thought, or less than I expected; my liabilities are greater than I expected and it turns out they are much greater than those assets; I realize that my bank is shot. And if an earnest and diligent set of evaluators came in they'd realize this also and I'd be shut down. Instead, I cover up that bad situation with the kind of behavior we talked about earlier, which allows me to sustain a personal lifestyle and package of compensation that's very attractive. Guest: And it's a sure thing and nobody's getting prosecuted. But here's the kicker to what you've just said: That describes 100 shops out of 3000. So, that's your point about ethics. And sociology, mores. If you had been a CEO--these things come from the C-suite--and you had worked at the Savings and Loans for 30 years and you'd risen through the ranks, and you'd hired pretty much everybody who had worked at your shop, this is a much less attractive strategy. Russ: Yes; you've got friends, you are in the community; you don't really want to have people pointing to that grotesque, bad development and say: He did that. Guest: That's right. And you are proud of your place, and you identify with it. And so in fact it was extremely unusual for these folks even though it appeared to be a sure thing. Russ: So most people didn't do that. Guest: And so, Larry White--this is the NYU Larry White, as opposed to your colleague--famously writes about this episode. And he was one of the Presidential employees running the Federal Home Loan Bank Board for several years--saying: The mystery for an economist is why there is so little fraud. Not why there was such extensive fraud. Russ: I understand. Guest: So, the key is entry. Russ: Is 10% half empty or half full? Guest: But the key is entry, which is a wonderfully fine economic concept forgotten by economists in discussing this crisis. So, the fraudsters grossly disproportionately are new entrants. And they are overwhelmingly real estate developers, who have intense conflicts of interest. Russ: Yes, funding themselves. Guest: And they are frequently crummy real estate developers, for the reasons we've discussed. Russ: So, they put out a shingle, start a bank, start collecting some deposits, start lending themselves money for projects that aren't going to make it. And their depositors of course are going to get their money back so long as they are not too large, and sometimes they do anyway.

42:12 Russ: Let's move to the present. Or the semi-present--let's get up to 2008 and go forward. And I want to talk about, if we can, Fannie and Freddie and the investment banks. All of them were doing something similar, sometimes on their own--in the case of investment banks they were origination shops; in the case of Fannie and Freddie, they couldn't originate loans, they could only finance them and fund them and buy them. But both of these groups were grabbing up mortgages, packaging them into securities, and selling those securities, often to each other, often to pension funds and people all around the world. What's the parallel between that period, which is really roughly 2003-2008 when it totally fell apart, between that period of financial activity and the stories we've been telling? Guest: So, what we hadn't finished with the logical link is: Deregulation in the Savings and Loan crisis, the key event that is so fraud-friendly in terms of creating a criminogenic environment, occurs in 1982; and reregulation begins in 1983. So, it begins very quickly and therefore it's done in the face of unbelievably intense political pressure from both parties. So, that's a completely distinct pattern. Now, to understand the current crisis, you actually have to go to 1990, 1991, because that's when liar's loans become significant. And with all good fraud schemes in America, it begins in Orange County, CA. And it begins in large part at Long Beach Savings. And we are the regional regulators by that point. Russ: You? Who is "we"? Guest: We are the Federal Home Loan Bank of San Francisco; and then it becomes the Office of Thrift Supervision, West Region. And we go and we look at we say: Wait a minute. You are not going to do underwriting and that's going to produce immense adverse selection. You are going to have a negative expected value. You have to lose money doing this. This is insane. This can only make sense as a fraud scheme. You can't do it. And so we used normal supervisory means to wipe out liar's loans among Savings and Loans in Orange County in this era. Whereupon, they of course--they being Long Beach Savings--give up their Federal Charter. Give up Federal Deposit Insurance. And become a mortgage banker--for the sole purpose of escaping our jurisdiction. And they changed their name; and they become Ameriquest. And your listeners who are familiar with the story will recognize that name, because it is the first big and infamous maker of liar's loans and other nonprime loans. And on top of that it's a predatory lender that aims at minorities. Whereupon--and by the way, their leading competitor are two people, a husband-wife CEO team at Guardian Savings that we have removed and prohibited from the Savings and Loan industry, so they simply went to mortgage banking. Which is essentially unregulated. Russ: At the time. Guest: So that's where--so you have this era in 1990, 1991 in which you get hundreds of millions of dollars of losses from these loans, but they are pushed out of the regulated industry. There are two more crackdowns involving 49 state attorneys general, plus the Federal Trade Commission (FTC) suing Ameriquest. They settle for $400 million, which at that time was a large amount of money; and we promptly make the CEO of Ameriquest our Ambassador to the Netherlands. Russ: What year was that? Guest: Because, of course, he's the leading political contributor to the President of the United States. Russ: Strangely enough he had a lot of friends. Guest: He had friends again in both party. Russ: Yes, just like Countrywide did, and Fannie and Freddie. Guest: Anyway, so that's what happens: Overwhelmingly this stuff gets pushed, at first, out of the regulated entity. And so it becomes the mortgage bankers; and the mortgage bankers almost exclusively, for the first 8 years, are dealing with the investment banking firms. The Big Five.

47:39 Russ: But I'm confused now. So, in early 1990s, there are some firms who are lending money to people who are not accurately representing their ability to repay the loans. Right? Guest: No. Russ: What's a liar loan? Guest: A liar's loan is--you are correct--involves false statements about income; but it is not the borrowers. It is overwhelmingly the lenders, for the same reasons as in the Savings and Loan crisis. Russ: Well, that's what I don't understand. So, I'm Long Beach Savings, to start with. And I am lending money. We're reversing roles here, Bill. Let's see if you and I can handle it and the listeners can handle it. I'm Long Beach; you have a modest income and you come to me and you want to buy a house. And I say: No, no, no, you don't want to buy that house. Here's a bigger house. And you say to me: Oh, no, but my income. I can't afford it. And you say: Don't worry. I'm going to lend you the money anyway, as if you had the income of 4 times what you actually have. Is that a liar's loan? Guest: That is a liar's loan, but that's not the most typical way that it's going to occur. The typical way it's going to occur, first, is through a broker. So, yet another party has to be introduced to this. So, to skip through: there's testimony in front of the Financial Crisis Inquiry Commission that it was common for the prior job of the mortgage broker to have been literally flipping burgers. So, you are the lender--you are Long Beach. You make the following deal and of course you don't have to have a discussion. You just send out your daily term sheet, starting out with hundreds but eventually tens of thousands of brokers. Communications--it got cheaper. And the term sheets creates an optimization thing that has three components. 1. Higher yield, good. You get a higher yield as a broker; I give you a higher fee. 2. Lower loan-to-value ratio, very good. I give you a higher fee. Russ: So, again, I'm the lender. I'm telling my brokers: Don't ask for much money down; charge them a high interest rate. And is there a third piece? Guest: No, no, no--you missed. It's actually the opposite. A lower loan-to-value ratio. Russ: Oh, sorry, sorry. Guest: You've done a lot. And also 3. A lower debt-to-income ratio. So, those are the three things that we are optimizing as a loan broker. And to skip forward to the current crisis, as you know, home prices in California are often very high. And so what we call a jumbo--a $600-$800 thousand dollar range--you could get as a mortgage broker, a $20,000 fee. For one jumbo. Russ: To bring me the loan that--the borrower that you are going to make the loan to. You are going to get $20,000. Guest: Correct. So you want to incent people to bring you these loans in extraordinary volume with the ultra-high yield; and then these two ratios gimmicked to make it look like the loan is safer. So, the reason, of course, is you are going to resell this loan. Russ: Who am I going to sell it to in 1991? That's what I'm wondering about. Guest: Oh. We're going to sell it to Lehman and--see, all of the investment banks had non-prime entities, at least one non-prime affiliate. Russ: Well, they had their own mortgage originators, too, in the non-prime world. Guest: Well, sometimes. Russ: Bear Stearns did. Guest: They most frequently did exactly what I've described here. So, Lehman Brothers, Aurora, actually had very few loans it made itself, but it made hundreds of thousands of these loans through brokers. Russ: But this is the puzzle. This is what I'm confused about. This is not 2003. You are saying this is 1992. How does Long Beach Savings make any money at this? You say because they are selling them to investment banks? Why would they buy them? They are lousy? Guest: Of course. It's a sure thing. Russ: Well, that's what I don't get. How does this relate to the earlier story where there was a Ponzi-like scheme that let me sustain an unsustainable situation for a while? Why is this a good business model in 1992? Guest: Okay. So, let me tell you the fraud recipe. And for both a lender and a purchaser of these. So, for a lender, it's got four ingredients: grow like crazy, by making really crappy loans but at a premium yield--and those first two things are related--with extreme leverage, and virtually no meaningful allowances for the future losses being recognized currently. Russ: So, how does Long Beach do that? Guest: Through this loan brokerage process that I'm describing. So, I told you the first two elements; the first two ingredients are related. I would, of course, love to grow exceptionally rapidly by making really high-quality loans. Russ: There aren't enough to go around. Guest: Yes; not only that. This is a). not a mature market, this is like iPads, and b). it's a very competitive market. And so what happens--let's do the thought exercise. I want to grow 50% a year, which by the way is what was the average of the accounting control frauds by Savings and Loans until reregulation. That's exceptional growth, as you know. All right. So, if I'm going to grow 50% a year by making extremely good quality loans, what do I have to do? I have to buy market share. How do I buy market share? I have to cut my yield. But in a relatively competitive marketplace, what are my competitors going to do? Russ: Same thing. Guest: They are going to chop their yield. So at the end of the day, is this a good way to create nominal income? No, it's a terrible way. You obviously destroy nominal income through that process. But there are tens of millions of people that cannot afford homes. Russ: They don't have the down-payment, they don't have the credit record, they don't have enough income. Guest: That is correct. I have a huge number of folks that I can lend to. And here's what's even better. As you know, we often have to spend a lot of our time with students explaining the fallacy of composition--that a strategy that's good for one entity can't work typically for an industry. If we all try to sell at the same time, the classic example, of portfolio insurance, it doesn't work really well. Russ: So, go ahead. Guest: But the fallacy of composition works the opposite way; when a bunch of us make bad loans. Because it turns out there are better places to make these loans. And that's going to be a combination of ease of entry, which assets are better for inflating values and hiding real losses, where is the risk of prosecution the smallest, etc. And therefore you get clustering. And you get emulation--what Akerlof and Romer talk about--the mimicking process. It's an easy strategy to emulate, right? Grow rapidly by sending these term sheets out to brokers. Anybody can do it with no brains.

56:22 Russ: But I'm Long Beach, now, and I realize that if I want to have a big institution, I can't just compete like everybody else. I can't just go to the good credit risks. I have to start lowering my standards, lend to people who are not normally going to get a loan, who don't have the income, don't have the credit rating; and I start offering them loans that normally wouldn't get made. So I have two questions. One is: Why do I do that? And is the answer: Because I'm going to look like I'm generating--how do I, why is that good for me as the executive of the bank? Where's the looting? Guest: Sure. So, I create three sure things--again, adapt Akerlof and Romer's phrase. The first sure thing is if I follow this recipe I am mathematically guaranteed in the near term to report not just good profits, but record profits, off-the-chart profits. Two, with modern executive compensation, I will become wealthy. And three, again, if you think about that recipe, I'm actually maximizing real losses, real economic losses. Russ: So, where do I get the money from, to fund this escapade? This is not quite like the earlier story, right? I've got to give money to people who are going to use it to buy houses. Guest: Without deposit insurance, it is harder to hold it in portfolio. You should not assume the impossible. And Ireland should be your cautionary tale, where there was essentially no secondary market and they did very similar things. Because it turns out you can expand, even in the Irish context. Okay, so, but back to your point. How do they get the money? They had an originate-for-sale model. Now, as you've said, they are selling overwhelmingly to surely-private parties. And neoclassical theory says: It's impossible. They will exert private-market discipline. Russ: In theory. Guest: Right. But we ran a real-world test of the theory, and it turns out folks not only will buy it, but they will eagerly buy it. And they will expand. So, what's the formula for accounting control fraud by a purchaser of these entities? Well, it's essentially the same thing. Instead of the first ingredient--sorry, second ingredient--make really crappy loans, I purchase really crappy loans. And I report really nice yields. Now, can this keep going forever? Of course not. Can I keep going for a significant period, as in 8-10 years? Yes. Yes. If these things cluster and we hyperinflate the bubble. Because the saying in the trade is "a rolling loan gathers no loss." Russ: Right. Guest: So, I can refinance the bad loans, and I can hide the delinquencies for a decade. And again, we ran a real world test of that, which showed that's precisely what you could do. Russ: My only defense of neoclassical theory is, again, I think there was the potential expectation that this would not turn out as bad as it looked. But let me just again restate the idea. You are saying that Bear Stearns, Lehman, Citi, etc.--let's forget all the complexities of derivatives and CDOs and all this--I have a temptation to buy up really bad loans, put on my books an expected stream of earnings that probably and almost certainly will not materialize--but that's not known yet. So, I put on my books that I have 30 years of wonderful payments coming in because the historic default rate is a fraction of what it will ultimately be, because that historic rate is predicated on a different set of people borrowing than are actually borrowing now. And, in the short run, which could be a few years, I make really great paper profits; but I'm not really standing over a viable institution. Guest: Right. And to quote someone who has been on your podcast, you also create plausible deniability. Russ: Who are you quoting? Guest: Charles Calomiris. [N.B. quote is not from the podcast but appears in various forms in other material by Calomiris, exact source unknown--Econlib Ed.] "Asset managers were placing someone else's money at risk, and earning huge salaries, bonuses, and management fees for being willing to pretend that these were reasonable investments. They may have reasoned that other competitors were behaving similarly and that they would be able to blame the collapse when it inevitably came on an unexpected shock." And then he says, derisively, "Who knew?" Russ: Sarcasm. Guest: So, Charles is, say from a pretty opposite side of the spectrum from me, and of course has also run a bank; and was perhaps the leading economist in the world, urging internationally that you deregulate banks coming into this crisis. Bo [?] McCallister, who was at Pinkus Warburg, here's what he said: "By 2006 and early 2007, everyone thought we were headed to a cliff. The capital market experts I was listening to all thought the banks were going crazy and that the terms of major loans being offered by the banks were nuttiness of epic proportions." And here are the numbers: After the FBI warned, in September 2004, that there was an epidemic of mortgage fraud and predicted that it would cause a financial crisis if it were not contained, and after the industry--the mortgage, lending industry's own anti-fraud experts issued the following five warnings, in writing, in 2006, to essentially every mortgage lender in the United States: 1. Have you morons forgotten that we've done this before, in 1990 and 1991 and it caused hundreds of millions of dollars in losses? 2. Stated income loans, and I quote, an open invitation to fraudsters. 3. The incidence of fraud in liar's loans is 90%--nine, zero. 4. These loans deserve the phrase that the industry uses behind closed doors to describe them. They are liar's loans. And 5. The banking regulatory agencies--and this is under Bush--are warning against making these loans. The industry massively expanded the number of liar's loans it made, such that by 2006, the best estimates are that 1/3 of all the loans made in that year were liar's loans. And remember, liar's loans and subprime are not mutually exclusive categories. So, by 2006, half of all the loans called subprime were also liar's loans. And now, what is the key difference? I explained to you we used to have rules on underwriting. In 1993. So, this goes way back. Under Clinton. They got rid of that as part of reinventing government. And examiners were instructed to refer to bankers as their clients. And rules were bad, and guidelines were in. So there's now a guideline on underwriting. And a guideline is unenforceable. And so the absolute perfect thing for not creating a perfect paper trail and no longer creating the dilemma about should I put false information in the loan file or should I take out honest information that shows I knew it was a bad loan--the absolute perfect device for fraud, is the liar's loan. Because you don't document. You don't verify. And so the paper trail is much easier for fraud in the current crisis. And then the other key is we eventually developed an incredibly effective means of dealing with the frauds, in the form of criminal prosecutions, administrative enforcement actions, and civil cases. And convicted over 1000 elites--these are not the little cases. Russ: This is in the 1980s. Guest: In the 1980s. And made well over--just our agency--made well over 10,000 criminal referrals. I mean well over 10,000 criminal referrals. Russ: Well, that was unpleasant for those people. Guest: It was. Russ: So, now they found a new way to live. Guest: So, our agency, our same agency in this crisis, the Office of Thrift Supervision, made 0 criminal referrals. And the Office of the Comptroller of the Currency (OCC), depending on who you believe at the OCC, made either 0 or 3. For which you say: [?]. Russ: Which means? Guest: Three is none.

1:07:45 Russ: This is so interesting. Let's try to finish with a conversation about what we agree on and what we don't agree on. So, you and I might disagree about the behavior and the incentives that were in place. We might disagree about the moral hazard. Where we agree is that by failing to prosecute actual fraud and by reducing the incentives for creditors to police risk-taking, we have certainly created an environment right now that is an unbelievably unhealthy situation. And I have to say, and you can correct me if I'm wrong, that when I'm watching a football game, and I do from time to time, and I see an ad for a credit card that offers this glorious rate of interest and all these special, wonderful things that come with it, and all kinds of prizes and rewards, I'm thinking: You know, that reminds me of a S&L situation, where you offer a really high rate of return to your depositors, and then you just take the money and you do some really dumb things with it; and it doesn't really matter. What have we done in the last 4 years other than make this problem worse? And, what should we have done? I'm giving you 5-10 minutes for this, Bill; I know you'd like another hour and a half; maybe we'll revisit it in another podcast. But what do you think we have done to fraud incentives in the last 3-4 years, and what should we have done? Guest: Well, I agree with you fundamentally that we have made the world much more criminogenic. So, I have a doctorate in criminology, and this is what I primarily research--why do you have recurrent intensifying financial crises brought on by these kinds of frauds? And it's a lot of the usual--the unintended consequences. But here are the unintended consequences of doing things like deregulation and modern executive compensation. And of course, I'm not unusual in this. Michael Jensen, the intellectual godfather of modern executive compensation, says that he's created a Frankenstein monster of creating perverse incentives. So, first, deal with the systemically dangerous institutions. And here, the Administration can't even be honest. It calls them systemically important, like they deserve a gold star. But they are vastly beyond any efficiencies of scale. They are inefficient; we would make the world more efficient and we would dramatically reduce systemic risk if we shrunk them to the size that they pose no systemic risk of global collapse. As long as they are this big, they are going to get away with murder. And worse, they will create a Gresham's dynamic. And this is something Akerlof warned about in his famous 1970 article on lemons markets, where cheaters prosper. Bad ethics can drive good ethics out of the marketplace. So, that fundamental task, as financial regulators, is to make market discipline more effective by getting good information out and by removing the cheaters, who create the perverse incentives to match what I'm doing or die. So, that's what we want. We want, a). stop the systemic institutions from growing, because we are making it worse now by making them bigger; 2. We don't tell them how to shrink, but we give them 5 years to shrink. They can use their managerial judgment about how to do that. And 3. is, in the interim, you regulate them much more intensively. Executive compensation is broken. Everybody knows it's broken. Everybody knows that what really happens with executive compensation has nothing to do with what we teach about how to align the interests. In fact, it further misaligns it. And if you want the expert, it's Frank Raines, Fannie Mae, who said famously: If you wave enough money in front of folks, good people will do bad things. And that's exactly what happens. We can't, if you are Enron--think about how Enron works. You can't send a memo to 3000 Enron employees saying: You know what we'd like to do? We'd like to engage in pervasive accounting fraud because then we'll get rich in the interim and we'll walk away from the husk. Russ: Because you could go to jail. Guest: But you could send the same message through your executive compensation, through what GE made famous: rank and yank [?] Russ: Which is? Guest: All you had to do was add one message. And that message will get around the firm within seconds. The message is this: We don't care whether your reported income is real or not. If you create fictional reported income--and Enron did that pervasively--then we will make you rich. So, you've got to fix executive compensation. You've got to restore the criminal referral process--which was essentially eliminated in the regulatory agencies. You have to stop this proposed settlement, at least as it's publicly reported, under which the Justice Department, purportedly, is going to give immunity from criminal prosecution for frauds in the process of making the loans--which is overwhelmingly where the fraud occurred, in vast dollar amounts. So, those things you need to do. You need to reinstate the underwriting rule. Guidelines are the most useless regulatory activity in existence. They are the nattering state. The people that need the rules will utterly ignore at all times your guidelines.