by William K. Black, New Economic Perspectives
Raj Chetty has written an op ed in the New York Times designed to counter the abuse the Sveriges Riksbank (Sweden’s central bank) rightly received for its latest embarrassment. Economics does not have a true Nobel Prize, so a central bank decided to create a near-beer variant. The central bankers have frequently made a hash of it, often awarding economists who got it disastrously wrong and inflicted policies that caused immense suffering. This year, not for the first time, the central bankers decided to hedge their bets – awarding their prize to economists who contradict each other (Eugene Fama and Robert Shiller). The hedge strategy might be thought to ensure that the central bank’s prize winners were right at least half the time (which would be an improvement over the central bankers’ batting average in their awards), but that is a logical error. It is perfectly possible for both of the prize winners to be wrong. I’ll explain why I think that is the case in a future article.
In this article I respond to Chetty’s effort to defend economists from the ridicule that the most recent Riksbank award prompted. Chetty is professionally embarrassed by that ridicule.
The first words of his article are: “CAMBRIDGE, Mass. – THERE’S an old lament about my profession: if you ask three economists a question, you’ll get three different answers.” Chetty’s “old lament” is accurate, but incomplete. The “economist’s lament” has many verses.
- If you ask three economists a question, you’ll get three different answers
- The three answers will be opinions driven by the economists’ ideologies
- The answers will ignore the relevant multidisciplinary literature
- The answers will ignore the relevant economics literature that challenges the answers
- The answers will arise from studies that fail basic requisites of the scientific method, e.g., they will implicitly assume that alternative causes do not exist
- The empirical methodology used to support the answers will often be so biased that it seems to support answers that are the opposite of reality
- The economists frequently water board their data until they seem to confess the answer that comports with the economist’s dogmas
- All three answers are wrong, horribly wrong
- The policies that the economists recommend on the basis of their ideologies and tortured data are often destructive and they breed complacency by assuming away critical risks
- The policies that the economists recommend often produce unanticipated consequences that prove even more destructive
- The economists are blind to conflicts of interest and eagerly seek out such conflicts to enrich themselves
- The economists are blind to ethics, even disdainful of it
- The economists will rarely admit that they were wrong and reconsider their dogmas
Chetty’s effort to defend economists was less than robust. He did not defend the answers economists reach as being the product of science. Instead, he argued that economists should not be mocked by real sciences because economists would really, really like to be scientists.
“But the headline-grabbing differences between the findings of these Nobel laureates are less significant than the profound agreement in their scientific approach to economic questions, which is characterized by formulating and testing precise hypotheses. I’m troubled by the sense among skeptics that disagreements about the answers to certain questions suggest that economics is a confused discipline, a fake science whose findings cannot be a useful basis for making policy decisions.”
Chetty thinks critics who point out that economists don’t achieve science even though they purport to aspire to it are “unfair and uninformed.”
“That view is unfair and uninformed. It makes demands on economics that are not made of other empirical disciplines, like medicine, and it ignores an emerging body of work, building on the scientific approach of last week’s winners, that is transforming economics into a field firmly grounded in fact.”
Again, Chetty’s idea of a defense reads more like a petulant confession of failure. We are supposed to be impressed that, in late 2013, economics is seeking to “transform” itself “into a field firmly grounded in fact.” A science does not have “transform” into a science. Economists could have modeled the scientific method for well over a century. A large minority of economists continue to urge us to inflict austerity in response to a Great Recession – the equivalent of pre-scientific “medicine” bleeding sick patients.
Chetty then tells us what he believes is the core problem with economics and why economists are finally “transforming” economics into a reality-based field.
“As is the case with epidemiologists, the fundamental challenge faced by economists – and a root cause of many disagreements in the field – is our limited ability to run experiments.
(Surely we don’t want to create more financial crises just to understand how they work.)
Nonetheless, economists have recently begun to overcome these challenges by developing tools that approximate scientific experiments to obtain compelling answers to specific policy questions.”
Chetty’s parenthetical says it all, for economists have “create[d] more financial crises” precisely because they do not “understand how they work” yet they dogmatically insist on policies that prove ever more criminogenic. Economists would understand how they work if they actually followed the scientific method.
Chetty’s statement that economics is “transforming” into a “science” based on “facts” because economists have “begun” to study “natural experiments” is as bizarre as it is inaccurate. I was taught over 40 years ago by my economics and statistics professors to study natural experiments and none of my teachers suggested that the methodology was novel. I was taught the same thing in criminology 20 years ago. As regulators we successfully used natural experiments for “testing precise hypotheses.” In analyzing the causes of the current crisis I have repeatedly emphasized the usefulness of the natural experiment provided by “liar’s” loans for “testing precise hypotheses.” As I explain below, neo-classical economists studied natural experiments 30 years ago during the S&L debacle. The difference is that the economists’ dogmas caused them to implicitly constrain the range of alternative hypotheses to exclude accounting control fraud as a candidate explanatory variable. As regulators, we did not arbitrarily constrain potential explanatory variables by excluding fraud. The result is that we got it right and the economists got it as wrong as it is possible to get something wrong.
Testing natural experiments is a fine idea that all social sciences embraced decades ago. It is bizarre and inaccurate for Chetty to claim that it is novel and that it produces “science.” It can help and it can hurt depending on how well it is conducted. It is one important methodology, not the holy grail of scientific methodology for economics or criminology.
I will discuss several examples of why Chetty’s “scientific experiments” have repeatedly produced what economists assured us were “compelling answers to specific policy questions” that were disastrously wrong. It turns out that the scientific method that economists purport to embrace is frequently the thinnest of fancy veneers hiding a core composed of the cheapest pressboard. Economists who study fields beset by financial frauds, for example, are overwhelmingly betrayed by ideology and conflicts of interest.
Economists do not study fraud. They have a primitive tribal taboo against using the word. This, of course, is because economics is assuredly not “firmly grounded in fact.” Ignoring fraud is a pure ideological construct that requires economists to ignore fraud, particularly private-sector “control fraud.” Economists do not study the criminology literature on elite white-collar crimes. Economists do not study and do not understand sophisticated financial fraud schemes.
I will briefly mention five examples during the savings and loan debacle. Richard Pratt, an academic economist who was Chairman of the Federal Home Loan Bank Board, exploited a series of natural experiments to study which state-chartered S&Ls reported the highest income. The answer was Texas. Pratt, the architect of the deregulation bill that became law as the Garn-St Germain Act of 1982, used Texas’ deregulation law as the model for the Garn-St Germain Act.
Alan Greenspan, having studied the natural experiment provided by S&Ls following different investment strategies praised Charles Keating’s Lincoln Savings as the exemplar that should be the model for the industry because Lincoln Savings reported record profits. Greenspan assured the federal regulators that Lincoln Savings “posed no foreseeable risk of loss.”
Daniel Fischel, exploiting a similar natural experiment, praised Lincoln Savings as the Nation’s best S&L. He also praised CenTrust as a superb S&L. In each case the basis for his conclusion was the extreme income reported by the S&L.
George Benston used a natural experiment by studying state-chartered S&Ls that had made large amounts of “direct investments” that the federal regulators were proposing to restrict. He found that such S&Ls reported substantially higher income than other S&Ls.
James Barth studied a natural experiment provided by failed S&Ls and concluded that their owners must have been honestly gambling for resurrection because as the S&Ls approached failure they increasingly invested in high risk assets. Barth was the regulatory agency’s head economist.
The common denominators in these five examples are that the economists implicitly assumed accounting control fraud out of existence and as a result their conclusions were false. The “recipe” for accounting control fraud by a lender has four ingredients.
- Grow extremely rapidly by
- Making enormous numbers of bad quality loans at a premium yield while
- Employing extreme leverage and
- Providing only trivial allowances for loan and lease losses (ALLL)
The recipe produces three “sure things.” The lender is guaranteed to report record income in the near term, the senior officers will be made immediately wealthy by modern executive compensation, and the lender will eventually suffer severe losses. Texas led the Nation in accounting control fraud because it deregulated and desupervised, so its S&Ls reported the highest (fictional) profits and suffered the worst losses. Pratt’s use of Texas as the model for deregulation was the worst possible choice and caused catastrophic harm.
Greenspan’s assurance that Lincoln Savings posed no foreseeable risk of loss proved incorrect – it caused the largest loss to a federal deposit insurance fund in history. It was impossible for Greenspan to make a larger error when writing about a single institution.
Fischel praised the worst, most fraudulent S&L in the Nation as the best S&L. He made a 3,000 position error in an industry with 3,000 positions. It is impossible to get it more wrong. CenTrust was also a massive accounting control fraud that caused roughly $1 billion in losses.
Benston praised roughly 33 S&Ls that made large amounts of direct investments – they all failed. They were overwhelmingly accounting control frauds. It is impossible in a sample size of 33 to bat worse than 0 for 33. Greenspan, Fischel, and Benston shared another characteristic that helps explain the astonishing extent of their errors – Lincoln Savings paid for their research.
Barth did agree that control fraud existed, but he missed the fact that firms following the fraud recipe will invest heavily in high risk assets but they will do so in a manner that demonstrates that they are engaged in accounting control fraud rather than honest gambles. George Akerlof and Paul Romer’s 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”) explained this point in detail.
“[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?”
[S]omeone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications” (Akerlof & Romer 1993: 4-5).
Akerlof and Romer made this passage their concluding paragraph in order to gives special emphasis to the message to their field.
“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 Romer1993: 60).
Economists overwhelmingly supported the deregulation of S&Ls. Larry White’s famous phrase was that there were “no ‘Cassandras'” in his field who warned that deregulation would produce a disaster. Economists overwhelmingly and vociferously opposed our reregulation of the S&L industry (claiming we were economically illiterate). Economists did not provide us with “lukewarm support” – they were our leading opponents in our successful effort to contain the epidemic of accounting control fraud that drove the crisis. Chetty denied the problem, but the “facts” are what demonstrate that economists as a field performed during the S&L debacle as “a fake science whose findings cannot be a useful basis for making policy decisions.” In every case the policies that proved disastrous were based on precisely the econometric practices that Chetty claimed were “transforming” his field into a “science.”
George Akerlof received the Riksbank award in 2001. The Akerlof work that the award committee singled out for praise was his 1970 article on markets for “lemons” in which he explained anti-purchaser control frauds in which the seller deceives the purchaser about the quality of the goods or services. Akerlof (1970) and Akerlof and Romer (1993) both studied natural experiments.
Chetty’s article disses economists who are theorists and praises quants. He mentions two theorists, Paul Krugman and Janet Yellen (both of whom have done extensive quantitative research) in a manner that implies that they are primitives who have missed the field “transforming” into a “science” based in “facts” – Paul Krugman and Janet Yellen. Krugman is another recipient of the Riksbank prize and Yellen is President Obama’s nominee to run the Federal Reserve (and Akerlof’s spouse). If Chetty’s dichotomy between theorists and scientists were true we would have to wonder why economics continues to bestow its top honors on economists whose work is not scientific because it is not “firmly grounded in fact.” But Chetty’s dichotomy is false. He is simply engaged in the highly scientific practice of a Harvard prof dissing his more prestigious peers who have taught at Princeton and Berkley.
Akerlof and Romer exposed the most fundamental problem with Chetty’s theory of the scientific method. Fact and theory are both vital. If economists’ dogmas and mono-disciplinary blinders prevent them from understanding that control fraud exists then Chetty’s supposed recipe for science – “formulating and testing precise hypotheses” – will consistently produce failed empirical studies that economists will interpret as supporting policies that cause our recurrent, intensifying financial crises. Good theory is essential to constructing good empirical studies.
Akerlof and Romer worked closely with a financial regulator (me) in drafting their famous article. That meant that they had the advantage of being firmly grounded in fact and a wealth of multi-disciplinary learning (including white-collar criminologists whose work I was drawing on) – an advantage that Akerlof and Romer enthusiastically welcomed. Note that Akerlof and Romer rightly stressed other forms of learning that proved far superior to “scientific” economists precisely because the examiners exemplify the concept of learning that is “firmly grounded in fact.” Akerlof and Romer praised “the regulators in the field who understood what was happening from the beginning….”
Chetty has conflated “data” with “facts.” Accounting control fraud produces fraudulent accounting data that economists and finance scholars treat (implicitly) as facts. During the expansion phase of a bubble or an expanding epidemic of accounting control fraud the traditional econometric study will lead the “scientific” economist to support the worst possible policies that most aid accounting control fraud. Whatever practices best facilitate the creation of fictional income will show the highest positive correlation with the firm’s reported income (or stock price). The true (negative) “sign” of the correlation will only emerge after the bubble bursts or years after the fraud epidemic begins. By then, of course, it is too late to prevent the crisis brought on by the “scientific” economists’ disastrously bad policy recommendations.
Note how pernicious this methodological failure is when combined with neo-classical economists’ insistence that it be made unlawful to adopt regulations until the regulators can produce data demonstrating that the benefits of the new rule would outweigh the costs. The D.C. Circuit, controlled by ultra-conservative law and economics devotees is using this as the pretext to block the SEC from adopting vital regulations. The D.C. Circuit has effectively resurrected the discredited anti-regulatory “substantive due process” abuses that the judiciary abused 80 years ago.
Chetty is a mono-methodologist. Only quant work is “scientific.” Other social sciences that use multiple research methodologies, e.g., criminology must not be “scientific.” Chetty’s view of the scientific method represents dogma and personal predilections rather than science.
Competent bank examiners never forget that accounting data can be the product of accounting control fraud. Examiners produce the equivalent of hundreds of detailed case studies that can be examined rigorously for common characteristics. It was our “autopsies” of every failed S&L that led to our development of the concept of control fraud and the subset we now call accounting control fraud. The autopsies led to our identification of the fraud “recipe” for a lender. We consistently studied natural experiments to test precise hypotheses in order to formulate the radical policy changes that contained the epidemic of accounting control fraud that drove the second phase of the S&L debacle. But we did more that test hypotheses – we formulated theories such as the concepts of control fraud and accounting control fraud and the fraud recipe.
We synthesized a theory of control fraud, building it from economics, law, criminology, accounting, governance, and political science. We built in many economic concepts that proved immensely useful. We stressed the perverse incentives arising from “agency” problems in corporations and how modern executive compensation aggravates the incentives, allows the CEO leading the control fraud to signal other officers on the practices they should follow to aid the fraud, and serves as a means to loot the firm. We realized that the decline of financial partnerships with “joint and several liability” greatly increased agency problems by eroding “private market discipline.” We understood how the CEOs manipulated professional compensation to create a “Gresham’s” dynamic that drove good ethics from professions and markets. The art was for the CEO to suborn purported “controls” and pervert them into fraud allies. The professionals’ reputation aided the fraud scheme. We understood that markets were frequently deeply inefficient because the fraud recipe made reporting record profits a “sure thing.” Banks do not create private market discipline – they fund the massive growth of firms that report record profitability due to the fraud recipe. We realized that lenders following the recipe had to gut their underwriting standards and suborn their internal controls. We used this to identify the frauds while they were still reporting record profits. We understood that these practices created intense “adverse selection” and meant that the lending had a “negative expected value” at the time they were made. We determined that the recipe was a superb means of hyper-inflating a financial bubble and realized the significance of the industry expression “a rolling loan gathers no loss.” We developed a superior understanding of “moral hazard” and the nearly universal practice of economists implicitly assuming control fraud out of existence and assuming that moral hazard led solely to honest gambles.
Understanding the recipe allowed us to identify the worst accounting control frauds at an early point while they were still reporting record profits. The recipe also allowed us to target the frauds’ Achilles’ “heel” – the need to grow extremely rapidly. Our rule restricting growth doomed even the S&L control frauds we could not close promptly because we lacked the funds.
As S&L regulators, we made our top supervisory priority the S&Ls reporting the highest income. Economists viewed this as proof that we were economically illiterate. Charles Keating famously sent a letter to much of the Nation’s political leadership on July 8, 1986 that specifically attacked us for this prioritization. The letter calls us “Nazi” and then cheerfully mixed its sensational similes by concluding that our policy was “like Jupiter eating his children.”
Bank Board Chairman Edwin Gray began S&L reregulation in 1983 – the year after the Garn-St Germain Act implemented federal deregulation and triggered a regulatory “race to the bottom” among state regulators. By 1984, there were 300 S&L control frauds growing at an average annual rate of 50 percent. It is only with the benefit of hindsight informed by our experience with the current crisis that we can now understand how incredibly valuable it was that Gray began the reregulation of the industry so promptly. The reregulation was done in the teeth of vicious opposition from the Reagan administration, James Wright, Jr., the Speaker of the House, a majority of the members of the House, the five U.S. Senators who became known as the “Keating Five,” every outside economist who expressed an opinion, the industry, and the business media. It soon rendered Gray unemployed and unemployable for over two decades. Absent that prompt reregulation, resupervision, and beginning criminal referrals and prosecutions the S&L debacle would have become vastly more damaging. In retrospect we can see that good regulatory theory saved trillions of dollars and that bad economic studies that followed Chetty’s claims of proper scientific method would have led to terrible policies that would have added trillions of dollars of losses had we (the S&L regulators) not countered the studies and followed the opposite policies.
The advantages of good theory were demonstrated in 1990-1991 during the S&L debacle when the control frauds opened a second “front” in Orange County, California (where all good U.S. financial fraud epidemics begin). The primary “ammunition” used for accounting fraud during the debacle was commercial real estate loans. Orange County control frauds began to make significant amounts of what are now called “liar’s” loans. They had no such warning label in this era. We were the regional regulators with jurisdiction over Orange County S&Ls and we listened to our examiners. Our examiners stressed that no honest mortgage lender would make such loans without underwriting key information such as the borrower’s income. Absent such underwriting, a mortgage lender creates severe adverse selection and the lending has a negative expected value. In plainer English, the lender will lose money. Liar’s loans do, however, make sense for an accounting control fraud. We drove liar’s loans out of the S&L industry. We did this while heavily occupied dealing with the overall S&L debacle. It was one of the easiest supervisory calls we ever made.
Again, the current crisis, which was driven principally by an epidemic of fraudulent liar’s loans, allows us to understand for the first time how much this regulatory crackdown on liar’s loans in 1990-1991 saved the Nation and the world trillions of dollars in losses. The current crisis could not have grown to such epic proportions absent the anti-regulatory studies and theories of economists that regulatory leaders adopted under the Clinton and Bush administration. These theories implicitly taught that control fraud did not exist because markets must be self-correcting to be efficient. The crisis could not have occurred without ignoring the findings and experience of competent regulators, industry experience, criminologists, and Akerlof and Romer.
The tragedy, however, is that economists’ anti-regulatory, pro-corporate biases have proven so all-consuming that most economists are so anti-scientific that they have refused to learn from the control fraud epidemics that drive our recurrent, intensifying financial crises. The industry and the regulators during this crisis had the advantage of our crackdown on liar’s loans and the fact that the industry was now calling the loans “liar’s” loans. There was no subtlety to this first aspect of the loan origination fraud epidemic. No government agency or law required or recommended that lenders make liar’s loans. But economists also had the advantage of Akerlof and Romer’s 1993 article about “looting.” Akerlof and Romer’s general point that accounting control fraud existed and could drive crises and the admonition that now we (economists) know better and that if we learn from the looting we need not suffer a recurrence of the crises should have alerted every economist to the danger. Even better, the article specifically warned that we could recognize the frauds by looking for lenders that failed in “maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications.” They warned their field against the specific fraud scheme that drove the current crisis – a full decade in advance. Their article also warned about fraudulent lenders exploiting loan brokers’ perverse incentives to originate bad loans and then sell the loans in the secondary market (1993: 29, 46). Economists did not simply fail to warn about the fraud epidemics – they recommended doubling down on the criminogenic policies (the three “de’s” – deregulation, desupervision, and de facto decriminalization) that Akerlof and Romer warned were “bound to produce looting.” Economists, in the rare cases where they mentioned fraud, claimed that fraud posed no risk in “sophisticated” financial markets. Complacency is one of the most destructive mindsets a regulator can have.
I have explained in depth the lead role that fraudulently originated liar’s loans played in driving the crisis. The brief summary is that the incidence of fraud in liar’s loans, according to the industry’s own anti-fraud experts was 90 percent. The massive expansion of liar’s loans caused the bubble to hyper-inflate. Liar’s loans grew by roughly 500% from 2003-2006. By 2006, roughly half the loans that the industry called “subprime” were also liar’s loans (the two categories are not mutually exclusive) and about 40% of all home mortgage loans originated in 2006 were liar’s loans. In 2006 alone, the industry originated over two million fraudulent liar’s loans.
The other aspect of the loan origination fraud epidemic, appraisal fraud, was even more blatant.
“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).
The petition was corroborated by two surveys of appraisers. A survey in 2003 found that 55% of appraisers reported being coerced to inflate at least one appraisal that year. A repeat of the survey in 2007 found that the percentage that had experienced coercion that year had risen to 90 percent. Sixty-eight percent of appraiser reported having lost a client and 45% reported that they were not paid for their work when they resisted coercion. Demos published a study in 2005 that reported that appraisal fraud had become “epidemic.” Then New York Attorney General Cuomo reported that his investigation had confirmed that Washington Mutual (WaMu) had blacklisted appraisers who refused to inflate appraisals and that this practice was the norm for the industry.
The mortgage lending industry and the regulators could have figured out everything necessary to prevent the crisis had they understood accounting control fraud and the import of the petition. Here are the key conclusions that the industry and regulators should have drawn.
- Lenders and their agents are causing inflated appraisals
- Appraisal fraud had become epidemic
- No honest lender would inflate appraisals or allow them to be inflated
- The lenders’ strategy is to generate a Gresham’s dynamic and suborn appraisers
- Only rational if covering up underlying mortgage fraud, i.e., liar’s loans
- There is no fraud exorcist, so the fraudulent loans are sold fraudulently
- The MBS and CDO are backed by fraudulently inflated appraisals
Individually, each of the three control fraud epidemics (liar’s loans, appraisals, and secondary market sales through fraudulent “reps and warranties”) would have represented the most destructive financial frauds in world history. Collectively, they caused catastrophic, global damage and unprecedented fraudulent enrichment of the officers that led the control frauds.
As remarkable as the near total failure of economists to “know better” about twin loan origination fraud epidemics that we had seen, and successfully suppressed before, the truly remarkable demonstration of how self-destructive economists’ dogmas are of their ability to go beyond a shambolic parody of the scientific method is their work after the crisis that purports to explain what caused the crisis. In virtually all cases (1) they never consider the possibility of accounting control fraud, (2) they do not discuss or even cite Akerlof and Romer 1993, and (3) they do not discuss the relevant criminology literature. They purport to use natural experiments “testing precise hypotheses” but they implicitly exclude accounting control fraud as a possibility. Because the exclusion is implicit, it is not supported by reasoning. Indeed, it is unlikely that the researchers consciously know that they have excluded control fraud. Ideology and mono-disciplinary blinders consistently trump the scientific method. We have the worst of all worlds because the researchers believe they are the very model of the modern scientific economist while the reality is that they are in thrall to their dogmas, which implicitly censor out alternative theories of causation that would falsify their ideologies. To gleefully mix Gilbert and Sullivan tunes, the economists that Chetty praises became the equivalent of admirals in their field because they stuck close to their desks and never went to sea to battle the three most devastating epidemics of financial fraud in world history.
I’ll end with one such example, of over a hundred. I picked it because it explicitly discusses liar’s loans at one of the large accounting control frauds, Bear Stearns (Bear). It is a 2009 study entitled “Taking the Lie Out of Liar Loans.”
The researchers studied loans made by Bear and its affiliates. They explain that Bear’s mortgage loan originations became increasingly dominated by liar’s loans. The authors do not attempt to explain why Bear’s leadership chose to increasingly originate overwhelmingly fraudulent loans that the industry called “liar’s” loans. The article exemplifies economists’ tribal taboo about the frightening power of the “f” word. An article focused on fraudulent loans never uses the word “fraud.” The article never cites Akerlof and Romer (1993), the relevant criminology literature on control fraud, or the fact that the other two modern financial crises (the S&L debacle and the Enron-era scandals) were driven by epidemics of accounting control fraud. It ignores our 1990-1991 experience with liar’s loans.
The article implicitly assumes that accounting control fraud by lenders cannot exist – even when lenders employ a type of loan that they know will produce endemically fraudulent loan originations. Indeed, Bear massively increased its liar’s loans knowing that they were frequently fraudulent.
The authors’ seemingly sensible, but actually bizarre presumption underlying the article is that they are developing a proposed means of underwriting to reduce the fraud incidence of inflated borrowers’ incomes in liar’s loans. The obvious, except to economists, analytical point that explains why the authors’ presumption is bizarre is that lenders have known for centuries how to underwrite home loans in a manner that reduces fraud by borrowers to trivial levels. The officers controlling fraudulent home lenders created the perverse compensation systems of loan officers and loan brokers and enthusiastically embraced endemically fraudulent liar’s loans because they did not wish to engage in effective underwriting. Effective underwriting would prevent them from attaining the “sure things” offered by the fraud recipe. The authors’ crude underwriting substitute could not reduce fraud remotely as effectively as real underwriting. Neither fraudulent nor honest officers would use the authors’ underwriting substitute. The fraudulent officers did not want to exclude bad loans and honest officers would have found the authors’ underwriting substitute grossly inferior to real underwriting.
Using euphemisms for fraud, the authors repeatedly confirm the endemic inflation of the borrower’s income in liar’s loans. In no case, however, do they even consider that the officers controlling the lender could have been engaged in accounting control fraud. The closest they come was to note that a journalist assumed that liar’s loans were actually profitable to the lender because “lenders may have incentives to encourage brokers to solicit stated-income loans because such loans may produce ‘excessive rates and penalties.'” The authors did not bother to analyze the journalist’s claim.
The authors also implicitly assumed appraisal fraud out of existence because they rely uncritically on reported “loan-to-value” (LTV) ratios. In one case the authors note the possibility that the “the borrower (and/or broker) may have exaggerated income to qualify for a loan that is greater than they can really aﬀord.” The possibility that the officers controlling the lender knew that brokers and loan officers would encourage or even directly cause the inflation of the borrower’s income pursuant to the fraud “recipe” was ignored. In eight places in their article the authors assumed that it was solely the borrowers who must be inflating their incomes and implicitly assumed that the lender’s controlling officers would have been determined to prevent such frauds. The authors ignored all the investigators who testified that it was lenders and their agents that put the lies in liar’s loans and all the warnings to the lenders that liar’s loans were endemically fraudulent (I have detailed these in prior articles).
The mono-disciplinary authors emphasize that they were the first to study the effect of liar’s loans on loan defaults (by which they mean the first economists to study). Consider how crazy that is for a field that pretends to science. The biggest development in real estate, by far, was the rise of nonprime loans, particularly liar’s loans and most particularly subprime liar’s loans. The context was that even many economists were warning about a massive housing bubble. The rise in liar’s loans was so rapid from 2003-2006 that they were the marginal loan driving the bubble to hyper-inflate. The Federal Reserve’s supervisors were so worried about the spread of non-prime loans that, despite Greenspan’s disapproval they conducted an exceptionally limited inquiry into the largest banks’ origination of non-traditional mortgages.
“Sabeth Siddique, the assistant director for credit risk in the Division of Banking Supervision and Regulation at the Federal Reserve Board, was charged with investigating how broadly loan patterns were changing. He took the questions directly to large banks in 2005 and asked them how many of which kinds of loans they were making. Siddique found the information he received ‘very alarming,’ he told the Commission.
In fact, nontraditional loans made up 59 percent of originations at Countrywide, 58 percent at Wells Fargo, 51 at National City, 31% at Washington Mutual, 26.5% at CitiFinancial, and 28.3% at Bank of America. Moreover, the banks expected that their originations of nontraditional loans would rise by 17% in 2005 to 608.5 billion. The review also noted the ‘slowly deteriorating quality of loans due to loosening underwriting standards.’ In addition, it found that two-thirds of the nontraditional loans made by the banks in 2003 had been of the stated-income, minimal documentation variety known as liar loans, which had a particularly great likelihood of going sour.
The reaction to Siddique’s briefing was mixed. Federal Reserve Governor Bies recalled the response by the Fed governors and regional board directors as divided from the beginning. ‘Some people on the board and regional presidents . . . just wanted to come to a different answer. So they did ignore it, or the full thrust of it,’ she told the Commission.
Within the Fed, the debate grew heated and emotional, Siddique recalled. ‘It got very personal,’ he told the Commission. The ideological turf war lasted more than a year, while the number of nontraditional loans kept growing….” (FCIC 2011: 20-21).
The Fed is dominated by neo-classical economists. What was the reaction of many of the Fed’s senior economists to the facts of mortgage lending? They were enraged at their own supervisory messengers. It was just data – supplied by the biggest banks – yet because it was counter to their dogmas the reaction was “emotional” and “heated” and directed against the supervisors rather than the banks. The telling phrase about dogma is that opponents of supervision “wanted to come to a different answer. So they did ignore [the data].” The Fed is supposed to be the high temple of the quants that Chetty claims are transforming economics into a science.
But here is the real takeaway about economists and their pretensions to be scientists. The Fed employs hundreds of economists who are supposed to study important economic developments. There were no more important micro-foundational developments than the three mortgage fraud epidemics and the hyper-inflated bubble that they produced. The Fed’s economists, according to the authors of the study I have been discussing, failed to study the four developments that were about to cause a catastrophe. To make it worse, only the Fed had the authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to ban all liar’s loans and the Fed held a series of hearings mandated by Congress at which there was extensive testimony about liar’s loans. The Fed’s economists, therefore, should have made studying the three mortgage fraud epidemics and the resultant bubble their highest research priority. That’s what scientists would have done.
But those studies would have produced results that would have devastated the dogmas that rule the Fed’s economists. The effectiveness of those ideological blinders in preventing serious research on the frauds by the Fed’s economists continues to this day. This is a very old story. Michael Jensen, when he was the managing editor of the Journal of Financial Economics, discovered that no proposed article could get through peer review if it challenged the efficient market hypothesis. Jensen was a strong supporter of EMH, but he was appalled by this triumph of dogma over science. He published an “anomalies” volume, though as he noted in the first volume each of the contributors professed belief in EMH.
The strength of Jensen’s endorsement for EMH, even when he discovered that his colleagues were ruled by their dogmas should be a cautionary tale with regard to Chetty’s claim that this time it’s different, this time economists will behave like scientists. Jensen stated: “I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.” If he is correct, then the costly collapse of EMH suggests that all other economic propositions rest on even shakier foundations built on friable dogma rather than bedrock facts.