by William K. Black, New Economic Perspectives
The Swedish Central Bank’s (the “Bank”) prize in economics has gone to Jean Tirole. It is always good to test such an award by looking at the writings of the recipient in an area in which the reader has particular expertise. In my case, that would include the Savings and Loan debacle, financial regulation, and control fraud. Tirole’s book: The Theory of Corporate Finance was published on January 1, 2006 during the heart of the three raging epidemics of accounting control fraud that were hyper-inflating the world’s largest financial bubble and about to create the financial crisis and the Great Recession.
As I have long emphasized and will be explaining at greater length in a book about the failures of economics and economists as exemplified by far too many of the recipients of the Bank’s Prize, economics is the only discipline in which the understanding of the field’s subject of study has gone backwards. In particular, the praxis recommended by economists has proven highly criminogenic and is the primary explanation for why we suffer recurrent, intensifying crises, the rise of crony capitalism that cripples democracy and ethics, and spiraling inequality and low growth in the regions that suffer the greatest predation by our parasitical financial centers. Tirole wrote at the ideal time to judge his understanding of corporate finance as it was actively causing these catastrophes.
The Bank’s prize announcement stresses that Tirole was selected because of his “clever” approach to regulation, including financial regulation. So the obvious question is how Tirole, in authoring his book on corporate finance theory and as the exemplar of “clever” approaches to financial regulation missed the crisis, missed the causes of the crisis, missed the causes of past crises, and advance ideas on financial regulation that would not have prevented our banking crises? The subsidiary question, also close to unique in economics, is how he could get so much so wrong by ignoring the work on these crises by a recipient of the Bank’s prize in 2001 (George Akerlof) by savings and loan regulators, white-collar criminologists, and a series of successful civil, administrative, and criminal actions? In other fields, the failure to cite and discuss the relevant work of a recent Nobel Laureate would cause the author to be viewed as an embarrassment to the field.
I want to reemphasize that the book Wesley Marshall and I are authoring on these prize winners chose them because of their intelligence. Tirole is considered particularly clever.
The context of Tirole’s discussion of junk bonds and the savings & loan debacle is that he notes that Drexel Burnham Lambert and Michael Milken, the officer that controlled it (though he was never the CEO), were prosecuted and sued successfully for a wide range of fraudulent actions. In the course of this discussion Tirole notes in passing that a number of S&Ls that were heavy purchasers of these junk bonds failed. His “analysis” of these interrelated matters is relegated to a footnote (p. 44 & n. 88).
“The difficulties faced by the S&Ls did not stem from the junk bonds, but with the interest rate shock of the late 1970s, and several mistakes of prudential regulators in the 1980s. However the S&L disaster added to the general negative feelings about junk bonds.”
It is true that the S&L crisis was not caused by junk bonds. As I wrote in 1993, there were roughly a dozen S&Ls that purchased substantial amounts of junk bonds. “Junk Bonds.” Staff Report 7. San Francisco: National Commission on Financial Institution Reform, Recovery, and Enforcement (NCFIRRE) (April 8) (cited in Akerlof, George and Paul Romer, “Looting: The Economic Underworld of Bankruptcy for Profit” 1993). Each of the S&Ls was a “captive” of Milken. Akerlof & Romer explain how Milken used the captives to suppress the reported default rates on Drexel-issued junk and to ensure that the initial offerings would succeed. These Milken-related frauds caused several billions of dollars in losses, but that represented a small percentage of the total present value cost of $150 billion ($ 1993). Conversely, the interest rate shocks ended up costing roughly $25 billion (NCFIRRE 1993).
The great bulk of the S&L losses were caused by loan defaults, principally through fraudulent commercial real estate loans instigated by the controlling officers of the S&L control frauds. These frauds included the Drexel captives.
We can all agree that there were (more than) “several mistakes of prudential regulators,” but given that Tirole’s claim to fame is largely in the field of financial regulation and he is writing about corporate finance his failure to display any evidence of researching the failures is disappointing. It is difficult to respond to such an amorphous claim about regulatory mistakes, particularly from a scholar who typically (and correctly) emphasizes that closely understanding the specific industrial context is essential to for proper analysis and praxis.
One of the larger “mistakes of prudential regulators” was that Federal Home Loan Bank Board Chairman Edwin Gray wanted to ban S&Ls from purchasing junk bonds, but he was unable to do. He could not act because the agency’s economists told him that the economic literature showed that the default rate on junk bonds was so low, and their yield premium so large, that there was no rational basis for preventing S&Ls from purchasing junk bonds. Given that Charles Keating, who ran the Nation’s most notorious S&L control fraud, was a Drexel captive and was always threatening to sue the agency to strike down our rules, our economists’ position doomed the adoption of any rule. Our economists, as Akerlof & Romer implicitly explain, fell for Milken’s successful use of the captives to suppress the true default rate on Drexel-issued junk bonds.
Had economists not undermined Gray’s determination to stop S&Ls from purchasing junk bonds, the junk bond bubble that Milken generated would have burst years earlier and caused far less harm to the world for the reasons Akerlof and Romer explain in their article on looting. One sad irony is that former senior Bank Board economists now work for Michael Milken.
Similarly, Richard Pratt, Gray’s predecessor, tasked the agency’s economists with exploiting a “natural experiment” provided by the diverse asset powers granted by the states and the federal government. The economists found that Texas-chartered S&Ls reported the highest earnings in the Nation. At that time, the State of Texas had the greatest deregulation of asset investment powers and one of the weakest supervisory staffs in the Nation. Pratt and the economists never considered the reality that the higher reported profits among Texas-chartered S&Ls was produced because its combination of deregulation and desupervision created the most criminogenic environment for S&L control frauds and that such S&Ls were guaranteed to report extreme (fictional) profits on our their commercial real estate loans.
By choosing Texas’ deregulation as the template for federal deregulation he had created an environment that was inherently criminogenic and which also triggered an even more criminogenic regulatory “race to the bottom” that was “won” by Texas and California. S&Ls in those two states produced 60% of total resolution costs for the S&L debacle. When Pratt, an economist, listened to the advice of economists instead of experienced examiners he made a grave regulatory mistake.
Starting from these deep holes dug by the regulators’ mistake in listening to economists, however, the overall supervisory response to the S&L debacle can now be appreciated because it can be contrasted with the conduct of supervision during the recent crisis. S&L reregulation and resupervision began at Gray’s direction within a year of Congress passing the Garn-St Germain Act of 1982. As I have previously explained in detail, Gray took on – simultaneously – the Reagan administration, OMB, a majority of the members of the House, Speaker of the House James (Jim) Wright, the five U.S. Senators who became known as the “Keating Five,” the state S&L commissioners, the industry trade association (ranked number three in the U.S. by some political scientists in terms of national political power), over 300 control frauds growing annually at more than 50 percent, and the media. He stopped cold two of the primary means by which new frauds were gaining control over S&Ls. Gray made the closure of the frauds the agency’s top priority, even though they reported high profitability, and their prosecution the agency’s second-highest priority. Gray adopted a rule raising capital requirements and limiting growth that no only limited losses but struck the Achilles’ “heel” of every accounting control fraud scheme – the need for rapid growth. Gray personally selected and recruited the Nation’s two best financial supervisors to run the Texas and California regions beset by the worst frauds. These two supervisors transformed supervision. Under Joe Selby, the agency deliberately burst a commercial real estate bubble in the Southwest.
In 1990, the examiners working for the top California supervisor, Michael Patriarca, identified a new loan product being offered under the euphemism “low documentation” (“low doc”) loans. Like all good major U.S. financial fraud schemes it began in Orange County, California. Our examiners promptly identified the loan product as inherently fraudulent. Home loans made without prudent underwriting produce severe “adverse selection” which causes a “negative expected value” from making such loans. Despite being in the sixth year of continual mobilization against control frauds in one of the epicenters of such frauds, Patriarca recognized the danger posed by allowing a new accounting fraud epidemic to take root. He broke out a team and we began successfully to drive liar’s loans out of the S&L industry beginning in 1991.
“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).”
In sum, once Pratt, the economist, relinquished control of the agency, the S&L regulators, in circumstances in which it seemed objectively impossible to succeed, acted so successful that a raging epidemic of accounting control fraud was checked before it could cause even a mild recession. Gray’s key supervisory hires outlasted his term of office and prevented an incipient epidemic of what we now call fraudulent “liar’s” loans from causing even a half billion in losses. There was no crisis and no recession arising from liar’s loans in this era.
Tirole knows about the “C’s” of loan underwriting – they’re in his book on corporate finance. Because he has not read, or failed to understand, the relevant literature on the S&L debacle he not only proved that hindsight about that debacle suffered from galloping myopia rather than being 20:20. Effective loan underwriting had to be eviscerated for the epidemics of loan fraud to rage as they were when he wrote and published his book on corporate finance in early 2006. Tirole failed to recognize or understand the criminogenic environments that produced the three epidemics of home lending fraud that were evident at the time he wrote his book. There is no evidence that he understands those three fraud epidemics even today. He exemplifies the tragedy and staggering opportunity costs of economics and economists.