by William K. Black, New Economic Perspectives
This article was prompted by William Galston’s review of Tyler Cowen’s new book Average is Over. Galston’s column worries about the huge, permanent underclass that Cowen envisions will grow in the United States. I write to challenge Cowen’s assumption that winners will prevail through a process of “hyper-meritocracy.”
Cowen’s embrace of Social Darwinism assumes that the winners have a selective advantage that arises from “merit” – which Cowen conflates with the ability to create wealth. This is passing strange as we are still suffering from an orgy of wealth destruction led by the “winners.” The people who grew wealthiest were often the people most responsible for the largest destruction of wealth in history. In this first of several articles I show that it is the most anti-meritocratic system. We do not live in a “winner-take-all” Nation. We increasingly live in a “cheater-take-all” system.
What Cowen has missed is the famous (but nearly famous enough) warning sounded by George Akerlof and Paul Romer in 1993 in their classic article “Looting: The Economic Underworld of Bankruptcy for Profit.”
“[M]any economists still [do] not understand that a combination of circumstances in the 1980s made it very easy to loot a [bank] with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4-5).
The result of these perverse incentives is the epidemics of accounting control fraud that drive our recurrent, intensifying financial crises. In the savings and loan debacle, for example:
“The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used…. Evidence of fraud was invariably present as was the ability of the operators to ‘milk’ the organization” (NCFIRRE 1993).
The large Enron-era frauds were all accounting control frauds.
The people who grew wealthiest were often the people most responsible for the largest destruction of wealth in history.
Worse, when cheaters prosper market forces become perverse because of the “Gresham’s dynamic” in which bad ethics drives good ethics out of the markets and professions. George Akerlof explained this in his most famous article on “Lemons” in 1970.
“[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 was not the first expert to understand the dynamic.
“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: 1726).
The mortgage fraud crisis occurred because the fraudulent CEOs whose banks created the twin epidemics of mortgage origination fraud and deceptive securitization deliberately generated a series of Gresham’s dynamics that produced an unethical race to the bottom in the professions that aided and abetted the loan origination fraud. The earliest warnings of this were made by honest appraisers in 2000.
“From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets”( FCIC 2011: 18).
A national survey of appraisers conducted in early 2004 found that 75% of appraisers had been urged within the prior 12 months to inflate an appraisal. A 2007 survey found that the percentage of appraisers reporting that they had been urged to inflate an appraisal within the past 12 months had risen to 90% and honest appraisers were forced to pay a high price for refusing to give in to the coercion: 68% reported losing a client and 45% did not get paid for their work. Note that a Gresham’s dynamic does not have to drive all the honest professionals out of the field to produce epidemic levels of fraud. Even if only a small percentage of the appraisers are suborned they can inflate all the appraisals required.
in early 2004 … 75% of appraisers had been urged within the prior 12 months to inflate an appraisal.
New York Attorney General (now, governor) Cuomo investigation of Washington Mutual (WaMu) found that it had blacklisted honest appraisers. Cuomo described WaMu as typical of nonprime lenders.
Similar Gresham’s dynamics have been documented in many crises and professions.
“[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of “Gresham’s Law” in which the bad professionals forced out the good” (NCFIRRE 1993).
Modern executive compensation is also a superb device for enlisting the aid of hundreds or even thousands of employees and officers and suborning internal controls. It also reduces whistleblowing.
“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.’ It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things” Franklin Raines: CEO, Fannie Mae.
Raines’ analysis was correct, which explains why the bonus system he put in place was so successful in turning Fannie Mae into one of the world’s largest and most destructive accounting control frauds.
“By now every one of you must have 6.46 [earnings per share (EPS)] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.
Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.” (Mr. Rajappa, head of Fannie’s internal audit, emphasis in original.)
The second epidemic of loan fraud by lenders created the epidemic of fraudulent “liar’s” loans. The liar’s loan epidemic interacted with the appraisal fraud epidemic to hyper-inflate the real estate bubble and created a financial catastrophe. The fraudulent leaders of nonprime lenders deliberately created a Gresham’s dynamic among their loan officers and their loan brokers. Loan brokers did most of the dirty work (giving the lenders deniability) of inflating appraisals and putting the lies in liar’s loans.
“More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan officers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about 10,000 loan originators a year…. (FCIC 2011: 7)
“His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs ‘flipping burgers,’ he told the FCIC. Given the right training, however, the best of them could ‘easily’ earn millions.” (FCIC 2011:
“He taught them the new playbook: ‘You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.’ He added, ‘I knew that the risk was being shunted off. I knew that we could be writing crap. But in the end it was like a game of musical chairs. Volume might go down but we were not going to be hurt’” (FCIC 2011: 8).
“I knew that we could be writing crap.” Under the incentive structures deliberately created by the officers controlling the lenders the loan officers “had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.” To ensure that their new loan officers understood and responded to the perverse incentives the fraudulent lenders hired people like Christopher Cruise to train them to understand and act in accordance with those incentives.
Loan brokers did most of the dirty work (giving the lenders deniability) of inflating appraisals and putting the lies in liar’s loans.
The general reader may be confused as to why the CEOs leading the fraudulent lenders were deliberately creating incentives to make enormous numbers of bad loans. The fraud “recipe” for an accounting control fraud optimizing fraudulent income by making (buying) bad loans has four ingredients.
- Grow extremely quickly by
- Making (buying) bad loans at premium yield
- While employing extreme leverage, and
- Providing grossly inadequate allowances for loan and lease losses (ALLL)
This is the recipe that produces what Akerlof and Romer aptly described as a “sure thing” and that hyper-inflated the bubble and drove the crisis. The recipe produces three sure things: the lender (purchaser) of “crap[py]” loans will immediately report record income, the controlling officers will promptly be made wealthy through modern executive compensation, and the firm will suffer severe losses.
It is simple to follow the recipe. No skill is required. The fact that the recipe can be employed simultaneously by the originator/seller and the buyer of the fraudulent loans explains why the secondary market followed the financial version of “don’t ask; don’t tell.”
Even the former head of the professional association of mortgage brokers, while trying to minimize the success of the Gresham’s dynamic, actually conceded its critical importance.
“Marc S. Savitt, a past president of the National Association of Mortgage Brokers, told the Commission that while most mortgage brokers looked out for borrowers’ best interests and steered them away from risky loans, about 50,000 of the newcomers to the field nationwide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were ‘absolutely’ corrupt” (FCIC 2011: 14).
Ameriquest was not some random lender. It was the fraudulent lender that first developed liar’s loans and it was for many years the largest originator and seller of fraudulent loans. Its CEO, Roland Arnall, was made wealthy by the fraud – wealthy enough to make the large political contributions that got him appointed our Ambassador to the Netherlands after the fourth time Ameriquest was subject to government sanctions. It was Ameriquest that WaMu and Citicorp rushed to acquire even though Ameriquest was the most notorious lender in America.
Sadly, Savitt’s estimate of fraudulent loan brokers was far too low. When entry is easy – and becoming a mortgage broker was simple – and the financial incentives to commit fraud are powerful, the result is horrific.
“According to an investigative news report published in 2008, between 2000 and 2007, at least 10,500 people with criminal records entered the field in Florida, for example, including 4,065 who had previously been convicted of such crimes as fraud, bank robbery, racketeering, and extortion” (FCIC 2011: 14).
A loan broker could make $2,000 to $20,000 by getting a single bad loan approved. But he got nothing if the loan was not approved.
…between 2000 and 2007, at least 10,500 people with criminal records entered the field [as mortgage brokers] in Florida … including 4,065 who had previously been convicted of such crimes as fraud, bank robbery, racketeering, and extortion
The brokers knew that that if they put the borrower into a liar’s loan the broker would receive a higher fee because such loans had a higher interest rate (which increased the broker’s compensation). The brokers knew that the lender would not verify the borrower’s reported income on a liar’s loan. If the broker inflated the borrower’s income the lender was far more likely to approve the loan. The broker, but not the borrower, knew how much to inflate the borrower’s stated income.
“[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.” Tom Miller, AG, Iowa, 2007 testimony to Fed.
It was the lenders and their agents that put the lies in “liar’s” loans and that used coercion to inflate appraisals. No honest lender would create the perverse incentives sure to lead to fraudulent epidemics of liar’s loans and inflated appraisals.
The constants present in each of our three modern financial crises (the S&L debacle, the Enron-era scandals, and the mortgage fraud crisis) were that the crises were driven by epidemics of accounting control fraud and that during the expansion phase of each crisis neo-classical economists praised the worst frauds as brilliant innovators who understood the importance of technological advances. The economists assured us that the massive compensation that the fraudulent CEOs awarded themselves was the just result of an emerging meritocracy. The reality was the opposite.
“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).
Cowen does not discuss financial fraud, Akerlof and Romer’s findings, or the Gresham’s dynamic in his book even though they are central to his purported thesis. He simply assumes that the financial frauds were made wealthy because they were more “productive.” They were the opposite of productive. Cowen has adopted, implicitly, the label that Christopher Cruise, the lead training official that the fraudulent lenders chose to train their loan officers, used.
“Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs ‘flipping burgers,’ he told the FCIC. Given the right training, however, the best of them could ‘easily’ earn millions.” (FCIC 2011:
Cruise and Cowen simply assume that whoever can “earn millions” represents the “best” of Americans. It can, but it can also represent the worst of us. Finance has become dominated by the worst of us, which is why we have recurrent, intensifying financial crises driven by their fraud epidemics. Cowen looks at the results of our hyper-anti-meritocracy system of finance, a gaudy whorehouse bedecked with red neon lights. Cowen concedes in his book (though it does lead to any analytical inquiry) that finance executives are currently the largest winners in gaining wealth despite causing the massive loss of societal wealth in the ongoing crisis. Without even discussing fraud or why the people who are the leading destroyers of wealth were the largest beneficiaries and experienced the greatest growth in wealth since 2009 Cowen describes finance as if it were a temple of meritocracy. Cowen has demonstrated that when Akerlof and Romer said of economists – twenty years ago – that “now we know better” about fraud and financial crises they were far too optimistic about their profession.