[THS] James K. Galbraith: Why the Experts Failed to See Financial Fraud
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Sun May 16 14:05:50 CEST 2010
James K. Galbraith: Why the 'Experts' Failed to See How Financial Fraud Collapsed
Galbraith to senators: "I write to you from a disgraced profession. Economic theory
... failed miserably to understand the forces behind the financial crisis."
May 15, 2010 |
Editor's Note: The following is the text of a James K. Galbraith's written statement to
members of the Senate Judiciary Committee delivered this May.
Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a
former member of the congressional staff it is a pleasure to submit this statement for
I write to you from a disgraced profession. Economic theory, as widely taught since
the 1980s, failed miserably to understand the forces behind the financial crisis.
Concepts including "rational expectations," "market discipline," and the "efficient
markets hypothesis" led economists to argue that speculation would stabilize prices,
that sellers would act to protect their reputations, that caveat emptor could be relied
on, and that widespread fraud therefore could not occur. Not all economists believed
this but most did.
Thus the study of financial fraud received little attention. Practically no research
institutes exist; collaboration between economists and criminologists is rare; in the
leading departments there are few specialists and very few students. Economists
have soft- pedaled the role of fraud in every crisis they examined, including the
Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com
bubble. They continue to do so now. At a conference sponsored by the Levy
Economics Institute in New York on April 17, the closest a former Under Secretary of
the Treasury, Peter Fisher, got to this question was to use the word "naughtiness."
This was on the day that the SEC charged Goldman Sachs with fraud.
There are exceptions. A famous 1993 article entitled "Looting: Bankruptcy for Profit,"
by George Akerlof and Paul Romer, drew exceptionally on the experience of
regulators who understood fraud. The criminologist-economist William K. Black of the
University of Missouri-Kansas City is our leading systematic analyst of the relationship
between financial crime and financial crisis. Black points out that accounting fraud is
a sure thing when you can control the institution engaging in it: "the best way to rob
a bank is to own one." The experience of the Savings and Loan crisis was of
businesses taken over for the explicit purpose of stripping them, of bleeding them
dry. This was established in court: there were over one thousand felony convictions
in the wake of that debacle. Other useful chronicles of modern financial fraud include
James Stewart's Den of Thieves on the Boesky-Milken era and Kurt Eichenwald's
Conspiracy of Fools, on the Enron scandal. Yet a large gap between this history and
formal analysis remains.
Formal analysis tells us that control frauds follow certain patterns. They grow rapidly,
reporting high profitability, certified by top accounting firms. They pay exceedingly
well. At the same time, they radically lower standards, building new businesses in
markets previously considered too risky for honest business. In the financial sector,
this takes the form of relaxed no, gutted underwriting, combined with the
capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles
Keating realized that an S&L charter was a "license to steal." In the 2000s, sub-prime
mortgage origination was much the same thing. Given a license to steal, thieves get
busy. And because their performance seems so good, they quickly come to dominate
their markets; the bad players driving out the good.
The complexity of the mortgage finance sector before the crisis highlights another
characteristic marker of fraud. In the system that developed, the original mortgage
documents lay buried where they remain in the records of the loan originators,
many of them since defunct or taken over. Those records, if examined, would reveal
the extent of missing documentation, of abusive practices, and of fraud. So far, we
have only very limited evidence on this, notably a 2007 Fitch Ratings study of a very
small sample of highly-rated RMBS, which found "fraud, abuse or missing
documentation in virtually every file." An efforts a year ago by Representative
Doggett to persuade Secretary Geithner to examine and report thoroughly on the
extent of fraud in the underlying mortgage records received an epic run-around.
When sub-prime mortgages were bundled and securitized, the ratings agencies
failed to examine the underlying loan quality. Instead they substituted statistical
models, in order to generate ratings that would make the resulting RMBS acceptable
to investors. When one assumes that prices will always rise, it follows that a loan
secured by the asset can always be refinanced; therefore the actual condition of the
borrower does not matter. That projection is, of course, only as good as the
underlying assumption, but in this perversely-designed marketplace those who paid
for ratings had no reason to care about the quality of assumptions. Meanwhile,
mortgage originators now had a formula for extending loans to the worst borrowers
they could find, secure that in this reverse Lake Wobegon no child would be deemed
below average even though they all were. Credit quality collapsed because the
system was designed for it to collapse.
A third element in the toxic brew was a simulacrum of "insurance," provided by the
market in credit default swaps. These are doomsday instruments in a precise sense:
they generate cash-flow for the issuer until the credit event occurs. If the event is
large enough, the issuer then fails, at which point the government faces blackmail: it
must either step in or the system will collapse. CDS spread the consequences of a
housing-price downturn through the entire financial sector, across the globe. They
also provided the means to short the market in residential mortgage-backed
securities, so that the largest players could turn tail and bet against the instruments
they had previously been selling, just before the house of cards crashed.
Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds,
options, derivatives and so forth as securities whose properties can be accepted
largely at face value, and quantified in terms of return and risk. That quantification
permits the calculation of price, using standard formulae. But everything in the
formulae depends on the instruments being as they are represented to be. For if
they are not, then what formula could possibly apply?
An older strand of institutional economics understood that a security is a contract in
law. It can only be as good as the legal system that stands behind it. Some fraud is
inevitable, but in a functioning system it must be rare. It must be considered and
rightly a minor problem. If fraud or even the perception of fraud comes to
dominate the system, then there is no foundation for a market in the securities. They
become trash. And more deeply, so do the institutions responsible for creating, rating
and selling them. Including, so long as it fails to respond with appropriate force, the
legal system itself.
Control frauds always fail in the end. But the failure of the firm does not mean the
fraud fails: the perpetrators often walk away rich. At some point, this requires
subverting, suborning or defeating the law. This is where crime and politics intersect.
At its heart, therefore, the financial crisis was a breakdown in the rule of law in
Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters,
insurers and supervising agencies NOT to have known that the system of housing
finance had become infested with fraud? Every statistical indicator of fraudulent
practice growth and profitability suggests otherwise. Every examination of the
record so far suggests otherwise. The very language in use: "liars' loans," "ninja
loans," "neutron loans," and "toxic waste," tells you that people knew. I have also
heard the expression, "IBG,YBG;" the meaning of that bit of code was: "I'll be gone,
you'll be gone."
If doubt remains, investigation into the internal communications of the firms and
agencies in question can clear it up. Emails are revealing. The government already
possesses critical documentary trails -- those of AIG, Fannie Mae and Freddie Mac,
the Treasury Department and the Federal Reserve. Those documents should be
investigated, in full, by competent authority and also released, as appropriate, to the
public. For instance, did AIG knowingly issue CDS against instruments that Goldman
had designed on behalf of Mr. John Paulson to fail? If so, why? Or again: Did Fannie
Mae and Freddie Mac appreciate the poor quality of the RMBS they were acquiring?
Did they do so under pressure from Mr. Henry Paulson? If so, did Secretary Paulson
know? And if he did, why did he act as he did? In a recent paper, Thomas Ferguson
and Robert Johnson argue that the "Paulson Put" was intended to delay an inevitable
crisis past the election. Does the internal record support this view?
Let us suppose that the investigation that you are about to begin confirms the
existence of pervasive fraud, involving millions of mortgages, thousands of
appraisers, underwriters, analysts, and the executives of the companies in which they
worked, as well as public officials who assisted by turning a Nelson's Eye. What is the
Some appear to believe that "confidence in the banks" can be rebuilt by a new round
of good economic news, by rising stock prices, by the reassurances of high officials
and by not looking too closely at the underlying evidence of fraud, abuse, deception
and deceit. As you pursue your investigations, you will undermine, and I believe you
may destroy, that illusion.
But you have to act. The true alternative is a failure extending over time from the
economic to the political system. Just as too few predicted the financial crisis, it may
be that too few are today speaking frankly about where a failure to deal with the
aftermath may lead.
In this situation, let me suggest, the country faces an existential threat. Either the
legal system must do its work. Or the market system cannot be restored. There must
be a thorough, transparent, effective, radical cleaning of the financial sector and also
of those public officials who failed the public trust. The financiers must be made to
feel, in their bones, the power of the law. And the public, which lives by the law,
must see very clearly and unambiguously that this is the case. Thank you.
James K. Galbraith is the author of The Predator State: How Conservatives
Abandoned the Free Market and Why Liberals Should Too, and of a new preface to
The Great Crash, 1929, by John Kenneth Galbraith. He teaches at The University of
Texas at Austin.
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