by William K. Black, New Economic Perspectives
I was invited back to the give the welcoming keynote address last week to the 33rd SFOA International Bürgenstock Meeting. SFOA is an acronym for the Swiss Futures and Option Association and their meeting (long held at Bürgenstock, Switzerland but now at Interlaken) is the preeminent meeting in Europe on financial derivatives. The meeting attracts industry participants, regulators, and academics from all over the world. I’m writing from the Munich airport, where I get to wait overnight for a flight back to the U.S.
Last year, I squared off with Herr Hummler, a fellow Bürgenstock keynoter, and wrote about the experience in a column entitled: “Who Put the Rot in Herr Hummler’s Wurst?” Hummler ran Wegelin Bank, Switzerland’s oldest private bank (founded in 1741). The subject of my talk this year expanded on our differing views: “Regulatory Races to the Bottom Kill Ethics, Banks and Economies: We need a Competition in Integrity.” I emphasized the revolutionary admission that Hummler made about finance, his failure to understand the import of that admission, and why his admission required a reconceptualization of markets and regulatory and prosecutorial policies. Specifically, he admitted that financial frauds gained a competitive advantage, which made markets perverse and produced a Gresham’s dynamic in which bad ethics drove good ethics out of the marketplace. This was similar to my metaphor – “green slime” – to describe how rotten the financial system became.
When it came to a policy response to this endemic fraud by our most elite financial firms, Hummler championed the perverse competition of the regulatory race to the bottom – destroying the financial regulatory “cops on the beat” who are essential to breaking such a Gresham’s dynamic. Hummler’s policies destroyed not only Western finance, but everything he purported to believe in as a theoclassical economist whose high priest was Herr Hayek (the “Austrian” school of economics). His policies perverted many financial markets into becoming so criminogenic that they drove the epidemics of accounting control fraud that drove the financial crisis and the Great Recession. (His Austrian austerity policies then gratuitously hurled the Eurozone back into recession.)
Hummler’s admission: Bankers defrauded us by putting the Rot in our Wurst
Hummler’s revolutionary admission was that Adam Smith’s reliable butcher, who acts to ensure that we get wholesome meat because his reliable dedication to his self-interest causes him to act as if he cared about our health, had become a sociopath. Smith’s village butcher must cultivate and maintain a reputation for selling wholesome meat or be driven promptly out of business. Smith presents the paradox that the butcher’s incentive to maximize his wealth is so reliable (and, implicitly, long-term) that we count on it to ensure that the butcher serves us only wholesome meat. Conversely, Smith argues not that altruism does not exist, but rather that it is nowhere near as reliable a consideration as the butcher’s self-interest. Smith’s parable of the butcher is capitalism’s defining metaphor.
Hummler’s metaphor subverted Smith’s parable. Hummler admitted that our most elite financial firms had known that they were selling millions of bad home loans and bad financial derivatives, particularly collateralized debt obligations (CDOs), “backed” (not so much) by the bad loans. The elite financial firms, therefore, hid the bad loans from their customers by adopting opaque structures and mixing the bad loans with some less-bad loans. His metaphor was that the most elite banks had disguised what he called “the rot” in the sausages (“Wurst” in German) they sold us. By grinding the meat and serving it an opaque casing, the seller makes it difficult for the customer to discover that the sausage contains rotten meat. Because the fraudulent Wurst seller can buy rotten meat for a much lower price than its honest competitors must pay to purchase wholesome meat, the frauds gain a competitive advantage and the perverted markets drive the honest firms out of the marketplace. (If you are familiar with economics, this is the famous “lemons” market problem first described by George Akerlof in his 1970 article, which led to the award of the economics version of the Nobel Prize in 2001.)
“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” Akerlof (1970).
Economists were not the first to discover how fraud turns markets perverse.
“The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.” Swift, J., Gulliver’s Travels.
In fairness to Smith, he was an intense foe of corporations because he believed that what we now call “the separation of ownership and control” produces a severe conflict of interest in the controlling officers that can lead them to use the corporation as a weapon to loot the customers, creditors, and shareholders (what we now call “control fraud”). He did not assume that the controlling officers of a corporation had a reputational interest that would prevent them from looting. Hummler, however, did not premise his argument as to why elite financial firms engaged in endemic fraud on Smith’s conclusion that corporations are criminogenic. Hummler showed no indication in his talk that he was aware of Smith’s disdain for corporations. Instead, Hummler used Smith’s principal parable of the butcher as his own metaphor – one that turned Smith’s parable on its head and launched a frontal assault on the theories of capitalism embraced by its proponents.
Hummler’s butcher is a sociopath. He knows that the rotten meat will poison us and make us dreadfully ill. He acts to hide the truth from us and to suborn other professionals to “bless” his rotten meat as the epitome of wholesomeness. His corruption of the “Betty Crocker seal of approval” gulls us into purchasing his rotten sausages and allows the butcher to sell millions of rotten sausages for many years. Hummler’s sociopathic butcher becomes wealthy because he is so willing to sell us rotten meat. His more ethical rivals will be driven into bankruptcy because they sell high quality meat honestly. The markets are reduced to the ultimate perverse economic force because they are perverted by a psychopath.
Hummler’s pathetic effort to excuse the financial butchers’ putting the rot in our Wurst
Hummler excuses the elite financial perpetrators
Hummler was a very big deal in Europe when he presented his keynote address at Bürgenstock last year. He sent a bi-monthly newsletter to 100,000 recipients – a “who’s who” of global finance. His newsletter often sparked news stories, frequently sympathetic to his themes. He put full moral culpability for the endemic fraud by bankers on “the government.” Indeed, he placed it on the U.S. government and he made clear that the U.S. government disgusted him. Though the time period of the elite bank fraud made his argument impossible, he made clear that his greatest disdain, hostility, and blame was reserved for President Obama.
Hummler’s moral culpability whitewash for the bankers who put the rot in our Wurst founders on multiple levels.
First, assume (contrary to all fact) that “the government” ordered Lehman, Bear Stearns, and Merrill Lynch (collectively, LBSML) to buy fraudulent bad loans. (I will get to Fannie and Freddie in detail below.) Why would it be moral for them to do so? Why shouldn’t they have used their extraordinary political power to change the governmental mandate to buy fraudulent loans? Failing that, why shouldn’t they cease mortgage purchases entirely rather than buy fraudulent loans? (The reality is that LBSML – and the great bulk of the entities that sold LBSML fraudulent loans – were not even subject to the Community Reinvestment Act (CRA). Further, the CRA never mandated that any entity make or purchase fraudulent loans and the CRA had been in existence for decades and had been greatly weakened by the Bush administration during the period of the mortgage fraud epidemic.)
Second, if the government forced LBSML to buy fraudulent loans, why didn’t they make criminal referrals (something the investment banks did with vanishing rarity)? Those referrals would have produced intense political pressure to remove the (fictional) government mandate that they buy fraudulent loans.
Third, if the government forced LBSML to buy fraudulent loans, why didn’t they put the loans back to the (twice – in the making and the sale) fraudulent sellers of fraudulent mortgages (which they nearly always had a contractual right to do)? This would have
(a) allowed LBSML to avoid crushing losses,
(b) killed the origination of fraudulent mortgages (relieving LBSML of the fictional duty to buy fraudulent loans), and
(c) created intense political pressure to end the fictional governmental mandate to LBSML to buy fraudulent loans.
Fourth, if the government forced LBSML to buy fraudulent loans – why did they sell them to others and, to the extent they held the fraudulent loans and CDO tranches in portfolio, why didn’t they disclose the suicidal nature of purchasing such loans to their shareholders and creditors? Remember, Hummler emphasizes the reality – the originators and purchasers of the fraudulent loans knew that they were fraudulent. Charles Calomiris, a banker and a vociferous academic opponent of financial regulation, describes what the mortgage participants did as the deliberate creation of “plausible deniability.”
“[A]sset 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. [T]hey may have reasoned that other competi[tors] were behaving similarly, and that they would be able to blame the collapse (when it inevitably came) on an unexpected shock.”
The (non) fact that the government mandates that you buy fraudulent mortgage loans provides no moral basis for you to sell the fraudulent loans to others, particularly if such sales do not inform your buyer that the loans you are selling are often fraudulent.
Fifth, Calomiris comments on the managers growing wealthy through putting the rot in the financial Wurst should have led Hummler to discuss the ethics of the officers of the elite banks that put the rot in our Wurst. Assume that LBSML were subject to a fictional government mandate to buy fraudulent loans. Why would the officers of those corporations be willing to stay and commit frauds sure to harm everyone except themselves and their colleagues? They and their colleagues were sure to become wealthy by putting the rot in our Wurst, but they had no mandate or duty to stay at LBSML and commit these frauds. No ethical officer would stay and commit such frauds. (Again, their mass resignations would have killed the fictional mandate.)
Sixth, Hummler’s metaphor includes two realistic elements of the endemic fraud committed by those who created and sold the fraudulent CDO tranches. The fraudulent sellers (a) hid from us the endemically fraudulent nature of the loans used to construct the CDO tranches and (b) suborned “independent” “experts” to certify that the CDOs’ top tranche was so free of rot that it represented the epitome of wholesomeness (“AAA” credit ratings and “clean” opinions from Big 4 auditors). (I would add the purchasers’ cynical use of Clayton’s faux reviews of asset quality to hide the endemic fraud from LBSML’s customers, creditors, and shareholders.) Hummler is describing sociopaths or psychopaths who think cleverly about how to suborn fraud allies while maintaining the twin illusions of exceptional safety of the mortgage loans “blessed” by “independent expertise.”
Seventh, the nearly universal refusal of the elite managers who chose to stay and become wealthy by selling endemically fraudulent loans and CDO tranches to their customers to admit their wrongdoing, return their bonuses, and agree to be held accountable for their frauds demonstrates their moral failures.