If this is “Regulatory Capture” May the Lord Smite Us with It – And May We Never Recover!

by William K. Black, New Economic Perspectives

In Fiddler on the Roof, Perchik and Teyve have this exchange:

Perchik: Money is the world’s curse.
Tevye: May the Lord smite me with it! And may I never recover!

I was reminded of this when reading the Wall Street Journal editorial claiming that “regulatory capture” was “inevitab[le]” and that we should therefore replace financial regulation with “simple rules” that “can’t be gamed.”

In my first installment I showed that the WSJ’s “simple rules” not only can be gamed – they are invariably gamed massively in the epidemics of accounting control fraud that cause our recurrent, intensifying financial crises. This installment refutes the “inevitability” of “regulatory capture.” As I promised to explain, I can personally attest that regulatory capture is not “inevitab[le]” even in circumstances that are ripe for capture. Further, “regulatory capture” has no definition and economists use it and the term “rent-seeking” as sloppy swear words to describe regulatory actions that are the opposite of regulatory capture. I conclude by showing that we know how to avoid harmful “regulatory capture,” but the ideologues that oppose effective regulation deliberately chose anti-regulatory leaders who create a self-fulfilling prophecy of regulatory failure. The WSJ editors and neo-classical economists are the jockeys who insure that their horse loses – and then blame the horse.

The savings and loan regulatory agency’s actions during the debacle illustrates each of these points. An economist who was once a senior economist at the Federal Home Loan Bank Board (then the federal regulator of S&Ls (aka “thrifts”) claimed that the Bank Board was the most “thoroughly” “captured” regulatory agency in the Nation.

“[T]he thrift industry has captured its regulatory process more thoroughly than any other regulated industry in the country” [Daniel Brumbaugh, Thrifts Under Siege: 1988: 173].

If the Bank Board was the most thoroughly captured regulator in America then regulatory capture was non-existent in America in the 1980s. Under Bank Board Chairman Edwin J. Gray, the Bank Board reversed the three “de’s” – (deregulation, desupervision, and de facto decriminalization) and implemented what became the most successful financial regulatory, supervisory, and prosecutorial effort in history. Gray did so over the frenzied, simultaneous opposition of the S&L industry, their exceptionally powerful trade association, over 300 S&L control frauds, their political patrons, the Reagan administration, state elected officials in Texas and California, virtually every state regulator of S&Ls, the media (including the WSJ editors), and every economist who spoke or wrote publicly about the issue.

Senior Reagan administration officials were so enraged at Gray’s actions that OMB threatened to make a criminal referral against him – for closing too many insolvent S&Ls! OMB was furious that Gray doubled the number of examiners and supervisors within 18 months and was beginning to close the Nation’s worst frauds. In military terms, the “correlation of forces” made Gray’s efforts against the elite looters and their allies objectively hopeless. But it was the regulators who won, and much of it was due to Gray’s leadership.

Gray’s success is all the more remarkable because he was neither born nor trained to be a regulator, much less a vigorous regulator. He was a passionate supporter of Ronald Reagan and deregulation and a leader of San Diego’s tax revolt. He was not calm in the face of adversity – he lacked that aspect of “the right stuff.” He was not naturally combative. He sought to avoid confrontation. He was his own worst enemy when it came to giving speeches in which he seemed to be comparing himself to people like Winston Churchill. He was, in sum, a flawed human being.

Gray’s actions saved our Nation from catastrophe. First, he redefined, accurately, the agency’s understanding of the problem as one of elite insider fraud and he did so largely by listening to the examiners’ findings and being open to changing his preconceptions.

“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were 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” (Akerlof & Romer 1993: 60).

The S&L regulators were consistently far faster than economists to understand the nature of the crisis. Economists repeatedly championed the most fraudulent S&Ls as purportedly being the best run S&Ls that should be the model for the industry.

Second, Gray blocked the entry of hundreds of newly chartered (de novo) S&Ls in Texas, California, and Florida. The entrants were overwhelmingly badly run real estate investors with intense conflicts of interest and the three states in which Gray blocked FSLIC insurance for the de novos had the most extreme deregulation and desupervision. His actions were based solely on safety and soundness rather than any desire to limit competition.

Third, Gray began to target the worst accounting control frauds for the appointment of conservators even when they were still reporting record (albeit fictional) profits. He spent the entire FSLIC to maximize these closures.

Fourth, Gray – knowing that the Reagan administration refused to admit the need for Treasury to fund the closure of failed S&Ls, developed a program (“FSLIC Recapitalization”) under which the FSLIC would borrow $15 billion (using the capital of the Federal Home Loan Bank system, which was owned by its shareholders, the S&Ls). Gray also doubled the FSLIC insurance premium. Gray’s purpose was to use the extra funds to close the worst remaining frauds. Gray knew that FSLIC Recap would reduce the industry’s reported capital and that doubling the FSLIC premium would reduce their reported income, and both policies would enrage the industry.

Fifth, Gray realized that even with these measures he would lack the funds (and the time before his term ended) to close most of the frauds. He also realized that accounting control frauds have an “Achilles’ “heel” – the need to grow rapidly. Gray adopted a rule limiting S&L growth and raising S&L capital requirements. The growth limit doomed every accounting control fraud.

Sixth, Gray doubled the number of examiners and supervisors within 18 months. Gray realized that the WSJ editorial’s claim that capital requirements “can’t be gamed” was false. Accounting control frauds operate by inflating asset values (and sometimes understating liabilities). Both of these practices inflate reported capital. Akerlof and Romer emphasized this point in their 1993 article on looting – and explained why it was strange that they had to emphasize such an “obvious” point.

“We begin with a point about accounting rules that is so obvious that it would not be worth stating had it not been so widely neglected in discussion of the crisis in the savings and loan industry. If net worth is inflated by … accounting … incentives for looting will be created. *** [E]ach additional dollar of artificial net worth translates into an additional dollar of net worth than can be extracted from the thrift” [Akerlof & Romer 1993: 13].

As Akerlof and Romer explained in their broader discussion of this point, higher capital requirements for S&Ls were needed and desirable, but they would not be sufficient absent vigorous, effective examination and supervision against the looters that led the fraud epidemic that drove the second phase of the S&L debacle. Higher capital requirements for banks are necessary today, but not sufficient, for the same reasons Akerlof & Romer explained two decades ago and Gray understood three decades ago.

It is revealing that the WSJ editors cannot get right one of the most “obvious” aspects of finance. The point is not simply obvious, it has been made repeatedly by a Nobel Laureate in Economics and the world’s top white-collar criminologists. The point was made inescapably obvious in each of the three modern financial crises. What this means is that WSJ editors are either deliberately misleading their readers in order to push their ideology or so blinded by that ideology that they are unable to understand even the most obvious aspects of finance and the most obvious facts that caused each crisis. Each of the crises was defined by the massive “gam[ing]” of asset values and capital that the WSJ editors claim “can’t” occur.

Seventh, Gray put in place the criminal referral process and made the agency’s support of prosecuting the elite criminals its second highest priority. (The highest priority was removing the frauds from control of open S&Ls, typically through the appointment of a conservator or receiver). The criminal referral system was continued and enhanced for seven years during the debacle by the criminal referral coordinators that were first appointed under Gray. The system produced over 30,000 criminal referrals and lead to the successful felony prosecution of over 1,000 insiders and co-conspirators in cases designated as “major” by the Department of Justice (DOJ). This remains the greatest prosecutorial success against elite white-collar defendants.

Eighth, taken together, these measures stopped a raging and rapidly growing epidemic of accounting control fraud. By 1983, there were 300 S&Ls growing at over 50% annually. The number of these accounting control frauds was growing rapidly due to the entry of hundreds of real estate developers annually and the rate of entry by new frauds was rapidly accelerating. By 1983 there was already a substantial commercial real estate bubble in Dallas. Within a few years even larger bubbles would have been hyper-inflating in many large cities, particularly in the states that most fully embraced the three “de’s.” The extreme growth in the number of S&Ls controlled by looters and the growth of their assets would have meant that the frauds would soon have dominated the entire industry and that the industry would be growing at a rate that would increasingly converge with the obscene growth of the accounting control frauds. Against this onslaught the agency’s examiners and supervisors were grotesquely outnumbered and out-resourced. Charles Keating, for example, bragged that Lincoln Savings spent $50 million opposing our 2006 examination – roughly the entire annual budget of its regional supervisors.

The fraud epidemic had an enormous head start as shown by the number of frauds and their terrifying growth rate in 1983. The state of Texas’ S&L Commissioner was sleeping with prostitutes provided by the most notorious Texas control fraud – Vernon Savings (known as “Vermin” within our agency). The state of California’s S&L commissioner was in business with an affiliate of Lincoln Savings. The Commissioner approved roughly 200 de novo charters. California “won” the regulatory race to the bottom and had the greatest deregulation of any jurisdiction – a California-chartered S&L could invest 100% of its assets in anything with the approval of that ultra-accommodating Commissioner.

The Bank Board was not permitted to pay competitive salaries for its examiners. We were not simply prohibited from paying salaries that were competitive with the private sector, we were not permitted to pay salaries competitive with other federal banking regulators’ examiners. The competitive gap was very large between the Bank Board and its sister agencies was very large so it was difficult to recruit and retain examiners, particularly the best examiners. Gray developed a plan (RIF the examiners and have them rehired by the Federal Home Loan Banks) to evade that pay differential and OMB’s limits on hiring to double the number of examiners in 18 months and materially increase their skills.

Ninth, Gray deliberately targeted the Dallas commercial real estate bubble. His goal was to burst the bubble. He achieved that goal by closing many Texas frauds and adopting the rule restricting growth.

Tenth, Gray personally chose and recruited Michael Patriarca and Joe Selby to be the lead supervisors for our two largest problem regions – California and Texas. Gray succeeded brilliantly in these hires because he first did due diligence. He asked dozens of people which supervisors had the best reputation for competence, integrity, vigor, and courage. Selby and Patriarca did stellar work under Gray, but their work and leadership continued long after Gray’s term ended. It was Selby who stood up to Speaker Wright and Patriarca who stood up to the combined weight of Wright and the five U.S. Senators who became known as the “Keating Five.” Consider this excerpt from my notes of our April 9, 1987 meeting with the five senators.

DECONCINI: Why would Arthur Young say these things? They have to guard their credibility too. They put the firm’s neck out with this letter.

PATRIARCA: They have a client. The $12 million in earnings was not unwound.

DECONCINI: You believe they’d prostitute themselves for a client?

[I hope we can all agree that Senator DeConcini phrased his question to leave Patriarca with only one possible answer – “no.”]

PATRIARCA: Absolutely. It happens all the time.

Capture? Not so much.

Tenth, consider two examples of Patriarca’s achievements after Gray’s term ended. Patriarca’s jurisdiction over Lincoln Savings was removed in an unprecedented action by Gray’s successor, Danny Wall, in response to threats by Speaker Wright and the “Keating Five.” These are, of course, precisely the threats brought directly against Gray (on April 2, 1987) and Patriarca (on April 9, 1987) by Keating’s political allies. Wall removed our jurisdiction over Lincoln Savings because we refused to rescind our recommendation that Lincoln Savings be taken over through a conservatorship that would remove Keating from control. Ultimately, our testimony before the House of Representatives led Wall to resign in disgrace.

All good U.S. financial frauds start in Orange County, California, which Patriarca had jurisdiction over. In 1990, while we were overwhelmed dealing with the S&L debacle. Our examiners recognized immediately (decades before the industry) in 1990 that “low documentation” loans (the industry did not yet use the term “liar’s” loans) were inherently fraudulent and would not be made by honest lenders. We drove these loans out of the industry beginning in 1991. Remember, these loans were brand new at this time.

Eleventh, Gray and the regulators were attacked in a series of ways that regulators understand but were never considered by George Stigler when he derided regulation and regulators. Keating tried to remove Gray as a supervisory barrier by offering him a job with a huge salary increase. An ally of Keating tried to hire Patriarca’s wife (a skilled attorney) at a generous salary. Keating twice hired private investigators to try to find dirt on me. Keating sued Gray and me for $400 million in our individual capacities. Prominent politicians allied with the leading frauds sought (successfully) to get Gray’s successor to fire Selby and me. And then there was Keating’s written order to his chief political fixer to make his “highest priority” the effort to “GET BLACK … KILL HIM DEAD.” [Keating was an “all caps” kind of guy.]

Here’s a hint: they don’t work so hard to bribe, bully, and bash you, if you’re “captured.” Regulatory capture is not inevitable.

Any President who wants regulatory (or prosecutorial) success can easily achieve it. You simply do what Gray did in picking Selby and Patriarca. Indeed, today, with the record of our success any President could easily reach out and hire people like us who would make capture impossible and success exceptionally likely. We know how to achieve financial regulatory success.

I’ll leave you with one additional point about another regulatory malady that “public choice” theorists tend to present as inevitable. I worked closely for years with my three colleagues (each of who was also a friend) who attended with me the Keating Five meeting. To this day I have no idea what political affiliation – if any – they held or hold. Party was irrelevant to us. I am a Democrat (and not a “Democrat for Reagan”). I was instrumental in helping to bring down Speaker Wright and the Keating Five. Four of those five politicians were Democrats.