Yves here. Bill Black flags a new stunning bit of bank propaganda, that risk is an unavoidable natural condition that is futile for regulators to control. There are indeed some risks that can’t be managed, namely exogenous risks, like that of a hurricane or an explosion destroying a major facility at a company in which you’ve invested. But financial institutions also generate risk all on their own, for instance, via Minskian cycles of more and more speculative lending that lead to asset price inflation and eventual busts and bank and investor losses.
As Andrew Haldane of the Bank of England pointed out, in general, following Robert Merton:
Tail risk within some systems is determined by God – in economist-speak, it is exogenous. Natural disasters, like earthquakes and floods, are examples of such tail risk. Although exogenous, even these events have been shown to occur more frequently than a normal distribution would imply. God’s distribution has fat tails.
Tail risk within financial systems is not determined by God but by man; it is not exogenous but endogenous. This has important implications for regulatory control. Finance theory tells us that risk brings return. So there are natural incentives within the financial system to generate tail risk and to avoid regulatory control. In the run-up to this crisis, examples of such risk-hunting and regulatory arbitrage were legion. They included escalating leverage, increased trading portfolios and the design of tail-heavy financial instruments.
By Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Jointly published with New Economic Perspectives
Michael Grunwald has written a column attacking Senator Bernie Sanders. It is entitled “Don’t break up the megabanks.” As Grunwald appropriately discloses, he is Timothy Geithner’s ghost writer and a fervent co-religionist of Geithner’s gospel of adoration of and devoted service to the world’s most fraudulent bankers.
Grunwald gives the reader fair warning that he has no financial expertise and is prepared to say anything to try to defend the banksters and Geithner when he makes his first argument the claim that it is “un-American” to break up banks that pose a global systemic risk. To the contrary, few things could be more American if you are even remotely familiar with American views of megabanks from the founding of our Republic.
I will return to responding to Grunwald’s efforts to prove that Geithner was correct to protect the world’s largest and most criminal banks and banksters from effective regulation and prosecution in a subsequent column. First, however, I will write a series of columns on Grunwald’s heroic effort to convert Geithner (with Alan Greenspan and Bernanke) from one of the Nation’s three worst anti-regulators into a regulatory sage complete with a parable of the “river of risk.” Geithner infamously boasted that he was never a regulator in a rare foray into candor. But the new Geithner is reimagined by Grunwald as a regulatory guru. Grunwald’s effort at sycophancy is in another demonstration of our family rule that it is impossible to compete with unintentional self-parody.
My readers may recall that this is the second effort at rehabilitating Geithner’s regulatory catastrophes. Geithner’s first effort floated a soccer simile. My column explained why the simile demonstrated that Geithner knows as little about soccer as regulation. His simile also lacked gravitas.
I did not get very involved with the emerging concerns about the subprime mortgage market. Ned Gramlich, a Fed governor in Washington, was already leading a process to examine excesses and abuses in the mortgage business serving lower-income Americans. I was impressed by Gramlich’s work, and those issues seemed to be getting a fair amount of attention from the Fed in Washington. I didn’t want us to be like kid soccer players, all swarming around the ball. I wanted us to focus on the systemic vulnerabilities that were getting less attention – starting with our own banks, but looking outside them as well.
A parable is much better on the gravitas dimension that Geithner has always lacked. Here is the Geithner’s gospel of risk and regulation according to Grunwald, complete with the “river of risk” parable.
In retrospect, America’s pre-crisis regulations for commercial banks like JP Morgan and Citi were clearly too weak. But they were strong enough to drive trillions of dollars worth of risky assets into the less regulated “shadow banking system”—investment banks like Bear and Lehman, government-sponsored enterprises like Fannie and Freddie, and insurers like AIG, not to mention off-balance-sheet vehicles that commercial banks like Citi used to dodge their regulatory constraints. Risk has a way of migrating to the path of least resistance; Geithner likes to compare it to a river finding its way around stones. The post-crisis reforms significantly broadened the scope of financial regulation, especially for large institutions, but it’s hard to predict where risk will migrate next. It would be even harder to predict what radically restructuring the industry would do to risk.
What’s safe to predict is that risk won’t go away. The goal should be to monitor and manage it, not to eradicate it. Financial reformers often make grand pronouncements about how this or that reform will eliminate the risk of meltdowns and bailouts, but those risks will remain as long as human beings are susceptible to manias like the one that inflated the credit bubble before the crisis and panics like the one that nearly shredded the system during the crisis—in other words, as long as human beings are human.
Sadly for Grunwald and Geithner, the more they try to float the myth of Geithner as Regulatory Guru the more they reveal their ignorance of finance and Geithner’s abject failure as a regulator. Geithner and Grunwald simply continue to ignore the three most destructive epidemics of accounting control fraud that drove our financial crisis and Great Recession. As I will show (but you already know) it is way too late given all the whistleblowers and admissions for Grunwald and Geithner to pretend that they do not know that the fraud epidemics drove the crisis. Note that Geithner’s ghost, even now, is peddling the nonsense that the housing bubble was inflated by a “mania” and that the crisis stage was simply a “panic.” But that is the subject of my second column in this series.
I will start with the fact that Grunwald/Geithner do not understand “risk.” Grunwald/Geithner suggest that regulation is essentially useless because risk is like a “river finding its way around stones (regulators).” We can all agree that Geithner regulated like an insensate, stationary stone – and that effective regulators are dynamic, but that will be the subject of the third column in my series.
In this column I respond to the Grunwald/Geithner claim that: “The goal should be to monitor and manage [risk], not to eradicate it.” No. Grunwald/Geithner betray their ignorance of the fact that there are many “risks” and they are not equivalent. In particular, it is insane to seek to try to “manage” the risk of fraud rather than to act vigorously and systematically every day to reduce fraud risk. It is true that one can never “eradicate” fraud and that it is too expensive to try to eradicate all minor frauds. With regard to the major frauds led by banksters, however, our mission as (honest) bankers, regulators, investigators, and prosecutors is eternal vigilance against fraud.
Grunwald/Geithner appear to assume that all financial “risks” are the same and that they are akin to credit risk. Honest banks and bankers make their money primarily through taking prudent credit risk. When it comes to credit risk, the bankers’ task is to identify, understand, measure, price, and monitor it. Bankers can develop expertise and experience in each of these vital tasks. The “expected value” of prudent lending by prudent bankers is positive – that is primarily how honest bankers add value and create a profit.
The expected value of taking interest rate or exchange rate is zero, and the bank that takes on substantial unhedged interest rate or exchange risk materially increases its overall risk without creating societal value. A financial regulator, therefore, should act to prevent a firm, much less an industry from taking substantial unhedged interest or exchange rate risk. (And it should ensure that the counterparty on the hedge can pay even if there are extreme movements in interest or exchange risks. So-called “dynamic hedging” is not a hedge and can add to systemic risk.)
The expected value of taking substantial prepayment risk is also zero, but because of “convexity” and the much greater volatility of prepayment rates lenders who take on prepayment risk tend to lose their bet frequently and to lose a lot when they lose the bet. These same characteristics make it technically difficult to hedge prepayment risk.
Basis risk is one of the technical risks of hedging. It too has an expected value of zero and should be minimized.
Taking significant liquidity risk typically has a negative expected value. Banking regulators should be resolute against banks taking material liquidity risk. The downside is vastly larger than the upside.
Fraud risk has a negative expected value. Particularly on large value lending where the money goes out of the bank near the start of the loan – real estate lending – the goal of any honest bankers is to minimize fraud risk. Fraudulent CEOs pose, by far, the greatest fraud risk to banks. Such frauds become epidemic when the environment is made criminogenic. People like Geithner, Greenspan, and Bernanke have been making the environment vastly more criminogenic for decades, refusing “to learn from experience.”
But “fraud risk” is a misleading term when one is talking about “accounting control fraud” or “looting” by the bank’s controlling officers. This is not simply a “risk” – it is an actuality that has caused (in economic terms) loss and it threatens the bank’s survival. One does not “model,” “monitor,” or “manage” such frauds if one is honest and competent. Instead, one seeks to counter and end the fraud on an emergency basis.
Geithner boasts about his ignorance of economics, but he might in his therapy sessions with his ghost/apologist acquaint Grunwald with George Akerlof and Paul Romer’s famous 1993 warning in their famous article “Looting: The Economic Underworld of Bankruptcy for Profit.” They made this the last paragraph of their article in order to emphasize their central findings.
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 Fed – which is to say Geithner, Greenspan, and Bernake – was also warned repeatedly about a series of developing “Gresham’s” dynamics that intensify and spread the criminogenic environment through Geithner’s “river” – creating a tidal bore of elite accounting control fraud (and related corruption) that pollutes the entire river.
George Akerlof used the metaphor to Gresham’s law in his article on markets for “lemons” – another control fraud variant in which the seller uses his asymmetrical information advantage as to the quality of the goods or services being sold to deceive the buyer.
[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).
The Financial Crisis Inquiry Commission (FCIC) described an example of the deliberate creation by the fraudulent officers leading the lenders and their agents the loan brokers of an “echo” epidemic of fraud in the recent crisis.
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 2010:18).
Fed Governor Gramlich warned the Fed – and Geithner concedes (see my prior article on his soccer simile) that he heard the warning in the early 2000s. Geithner dishonestly states that Greenspan acted on Gramlich’s warnings. Even Greenspan admits that he did no such thing.
I have written several columns about Steven Krystofiak’s testimony to the Fed warning them of the coming disaster of endemically fraudulent “liar’s” loans plus appraisal fraud. Tom Miller, the Attorney General of Iowa, described the Gresham’s dynamic in his testimony to the Fed – and explained that it was the lenders and their agents that were overwhelmingly putting the lies in the liar’s loans.
Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete.
[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.
Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007 (Tom Miller, AG, Iowa, August 14, 2007 testimony to Fed.)
I have often written of the MARI’s famous warnings to the industry in early 2006 about liar’s loans and the FBI’s September 2004 warning about the developing “epidemic” of mortgage fraud that it predicted would cause a financial “crisis” if it were not halted. In response to those warnings, and surging early payment defaults (EPDs) the fraudulent lenders poured on more liar’s loans until by 2006 they represented 40% of total loans originated that year.
Regular readers understand the accounting control fraud “recipe” for a real estate lender or loan purchaser. They know that this produces the classic three “sure things” – the antithesis of “risk” as we normally use the term in finance.
Geithner is either so oblivious, or pretending to be, to the three most destructive epidemics of fraud in history that he advises: “The goal should be to monitor and manage it, not to eradicate it.” People who think they can “monitor” or “manage” fraud epidemics are delusional (or lying). One will never “eradicate” fraud, but the regulatory and prosecutorial response to banking fraud epidemics is to break the epidemic as the most urgent priority. Our paramount role as banking regulators is to prevent, or failing that, halt such fraud epidemics before they cause catastrophic systemic harm. Even seven years after the acute phase of the crisis Grunwald/Geithner are either delusional or disingenuous. But Geithner is certainly right that he sat like an inert anti-regulatory rock while massive fraud and corruption polluted the “river” of finance when he was President of the NY Fed.