This is my second column discussing Federal Reserve (Fed) regulation in the context of the question of who President Obama should appoint to be Ben Bernanke's successor. This column focuses on the sudden discovery by economists (and, purportedly, Obama) that the Fed Chair's most important function is to regulate. (If that sounds like common sense to you, (1) you are not an orthodox economist and (2) you do not understand the Fed's culture.) This column begins the process of explaining why most of the economists and finance scholars (Robert Prasch is the exception) writing to urge that the new Fed Chair be chosen based on their regulatory skills demonstrate that they lack any understanding of the fundamentals of financial crises and supervision (and aiding prosecutions). This column begins my response to Amar Bhide's op-ed entitled "Wanted: A Boring Leader for the Fed."
The Sudden Discovery that the Fed Chair is Supposed to Regulate
There have been a flurry of columns by economists and finance scholars claiming that Obama has decided that the next Fed Chair needs to be a strong supervisor and supporting that decision. Why, when, and how Obama underwent such a miraculous "Road to Damascus" conversion to favor vigorous regulation, supervision, and prosecution given the fact that early in his term he promoted Timothy Geithner and reappointed Ben Bernanke - two of the most spectacular supervisory failures in history - is never explained. Why this zeal for vigorous supervision only applies to the Fed is never explained. Why the economists and finance scholars suddenly (again, with the exception of Prasch) support making tough supervision a top priority of the new Fed Chair is never explained convincingly. Perhaps there was an entire caravan of economist traveling with Obama on the Road to Damascus.
Bhide Bids the next Fed Chair to Go "Boring"
Bhide's advice to Obama is: "Instead of casting about for a new maestro, we need to return the Fed to dullness and its chairman to obscurity."
"Where the Fed must be held more accountable is for its oversight of banks. It is banks, not the government, that effectively create most of the money we use, by extending credit where it is most needed. As we've painfully learned, banks can over-lend and even set off an economic collapse.
Before the crisis the Fed seemingly lost all capacity for the painstaking, boots-on-the-ground supervision of the banks under its purview."
Bhide's remarks reveal his lack of understanding of supervision, why we examine and supervise banks, and why we suffer financial crises. First, the "banks" were only half the problem. The Fed had unique authority under HOEPA (1994) to eliminate the endemically fraudulent "liar's" loans made primarily by non-banks. Second, the problem was not "over-lend[ing]" by the banks. The problems were the twin epidemics of accounting control frauds by the loan originators through liar's loans and appraisal fraud. Those frauds had to propagate through the system given the frequency of secondary market sales and because there is no fraud "exorcist" all the sales required fraudulent "reps and warranties." Control fraud begat additional control fraud and created the perverse incentives that spread "echo" epidemics of control fraud through other professions (loan brokers, appraisers, and auditors) by creating a "Gresham's" dynamic in which bad ethics tends to drive good ethics out of the markets and professions.
Because Bhide ignores the epidemics of "control fraud" at the origination level and in the secondary market and the mortgage derivative products (CDOs), he gets embarrassingly wrong his central point. Bhide thinks that it is "boring" to stop massive epidemics of accounting control fraud by hundreds of lenders (including the largest banks in the world) that are hyper-inflating massive bubbles and leading to a global financial crisis. He thinks it is boring to detect and combat massive money laundering by the largest banks that are aiding the most murderous drug cartels. He thinks it is boring to detect and combat the violation of international sanctions against terrorist organizations that are committed by the largest banks of the world. He thinks it is boring to detect and combat the largest anti-trust cartel (by three orders of magnitude) in history (Libor) when that cartel consists of the largest banks in the world. He thinks it is boring to tell Citi's board of directors they should fire their CEO. He thinks it is boring to tell B of A's board to cut the CEO's compensation by 90 percent and to "claw back" all his past bonuses. He thinks it was boring when Brooksley Born proposed considering whether to adopt rules on financial derivatives.
Only a finance theorist or economist could think that bank supervision is "boring" and that macroeconomics is thrilling. Bhide wrote: "Running what amounts to a hedge fund on steroids is more glamorous and exciting than managing a regulatory bureaucracy." He could not be more wrong. There are three great truths about bank supervision that Bhide misses. First, our key function is to stop the epidemics of accounting control fraud that hyper-inflate financial bubbles and cause our recurrent, intensifying financial crises. Second, these frauds report record profits, blessed by "independent" "experts," during the expansion phase of the bubble and often cultivate immense political power. Our function as supervisors is to expose their frauds, remove them from their positions controlling the banks, and provide the support to the FBI and the Department of Justice (DOJ) (and the constant demand that they take vigorous action) that is essential to prosecute such elite white-collar criminals. The fraudulent CEOs recognize immediately that we pose the greatest risk to them and they unleash unholy hell on the most effective supervisors. That hell will periodically include the senior leaders of one's own regulatory agency, the administration, and the (bipartisan) Congressional leadership. As a bank supervisory one must be prepared to blow the whistle on each of these entities that provide aid and comfort to the frauds. They fraudulent CEOs are great believers in the doctrine that "the best defense is a good offense" so they will use every aspect of their power to discredit and destroy the supervisors they consider most competent. A competent supervisor will never have a boring day.
Third, the most powerful bank CEOs who begin honest can run afoul of the Gresham's dynamic that the control frauds generate that drives good ethics from the markets and professions. The most powerful CEOs, even if they remain honest, are also prone to exceptional arrogance and petulance. They are surrounded by people who tell them how brilliant they are and how tragically underpaid they are when their annual compensation is a mere $20 million. The reality is that their banks are often poorly managed and take grossly imprudent risks that they do not understand. Competent supervisors are the only ones who regularly "speak truth to power" - and the CEOs of the largest banks despise them for doing so. The typical attitude is: "how dare this "bureaucrat" making $75,000 a year tell me how to run my bank!" So, even when we are not dealing with frauds we deal on a regular basis with narcissists of epic proportions who react to criticism by using their immense power to try to destroy our careers. What they really hate is when we prove correct, which is the normal course of events for competent regulators.
Bhide has no excuse for not understanding these realities. He knows that as soon as Brooksley Born took on derivatives the infamous "13 Bankers" appeared in Larry Summers office and successfully enlisted his aid to destroy her ability to protect the Nation. I can assure the reader, having talked to Born, that no aspect of being attacked by the Nation's most powerful lobbyists, the Treasury, the Fed, the Chairman of Senate Banking, and the SEC was "boring." I can assure readers that based on reading Neil Barofsky's accounts he did not find it boring to be the target of Timothy Geithner's obscenities and abuse. I can assure readers based on my reading of the FCIC report and materials that the Fed supervisors did not consider either of the meetings "boring" when Greenspan flayed them for daring to criticize the largest banks' frauds.
Bhide gets every element about supervision wrong because he has no experience with competent supervisors. Competent supervisors are not "obscure" because the fraudulent and narcissistic CEOs use the media to attack us as morons who dare to criticize the great and powerful Oz when the bank is reporting record profits. Bhide thinks that competent regulators are "bureaucra[ts]" who have honed our ability to tolerate the "dullness" of supervising banks. Competent examiners and supervisors have superb technical and people skills, well-tuned "BS detectors," superior analytical skills, a knack for investigation, creativity, and quiet courage. They have an insatiable thirst for knowledge and trying to understand what is really going on. They are the polar opposite of "bureaucrats." But I will let Bhide in on one of the tricks of our trade - we often pretend to be dull. It often works marvelously against the arrogant who are only too willing to believe that we are dull.
Bhide should spend a day with Richard (Dick) Newsom - one of the examiners who brought down Charles Keating. Dick is the real world Columbo.
He should spend the next day with Chris Seefer, our office's top investigative examiner who while working at least 65 hour weeks studied late every night and got his MBA and his J.D. He's now one of the Nation's top securities fraud litigators for plaintiffs.
Bhide should spend the next day with Bart Dzivi, who made one of the most incredible finds in regulatory history when he in the midst of reading thousands of pages of (mind-numbingly boring) loan underwriting documents about Lincoln Savings' junk bond purchases noticed one file where the pagination was not sequential and one file that contained data that should not have been available at the time the bonds were purchased - the file purported to be the contemporaneous documentation of that purchase. From those two incredibly minor and subtle anomalies he pulled on the thread until he learned that every purported underwriting document for Lincoln Savings' $1 billion portfolio of junk bonds was created after the purchase of the bonds and was stuffed into the files for the sole purpose of deceiving our examiners and hiding the fact that Lincoln Savings was a "captive" of Michael Milken and engaged in grotesquely imprudent junk bond purchases at the sole discretion of Milken.
Milken determined the counterparty, the price, and the volume of the sales. He churned Lincoln's portfolio to maximize fees and create phony "market" prices, he used Lincoln and the other captives to ensure that every junk bond issuance would "make" and to arrange agreements for loan modifications to avoid defaults and make it appear that Drexel's junk bonds were stellar (see George Akerlof and Paul Romer's 1993 article - "Looting: The Economic Underworld of Bankruptcy for Profit").
The resultant investigation led by Ann Sobol proved that Lincoln Savings' officials hired Arthur Andersen (AA) as consultants to create the faux junk bond underwriting files. AA was also the company's outside auditors (the kind of naked conflict of interest that was common in that era). Had DOJ acted on our criminal referral against AA arising from this fraud (which was far more severe than its after-the-fact cover up at Enron) there would have been a real chance of deterring the Enron-era frauds.
Sobol's investigation also demonstrated a huge number of forged documents and signatures by Lincoln Savings designed to make it appear that hundreds of millions of dollars in direct investments qualified as "grandfathered" under the direct investment rule and therefore did not violate the direct investment rule. Because Dzivi noticed a small anomaly and recognized its potential significance and at each step we followed up and looked for additional suspicious indicators and pursued those leads we unraveled not one but three massive frauds - Lincoln Savings and Arthur Andersen's effort to defraud the examiners about the (non-existent) underwriting for its junk bonds, Lincoln Savings enormous frauds designed to deceive us about their direct investments, and Milken's use of his "captives" to engage in a series of frauds.
The word that describes competent examiners and supervisors is not "boring," but "relentless." The reaction of the elite frauds we brought down was captured by the famous question Butch Cassidy and the Sundance Kid asked each other when they were pursued by a team of lawmen chosen for their expertise: "Who are those guys?" Boring, hah!
Had any regulatory leader been serious about preventing the most recent crisis they would have talked to Dick, Chris, and Bart (they live within an hour's drive of each other, as does their former leader, Mike Patriarca) and hired them or their counterparts in other OTS regions with orders to tear into the fraud epidemics. Note that even after the crisis made the scope and consequences of the epidemics of control fraud clear to any competent regulator no financial regulatory agency hired the people with a track record of success as examiners, supervisors, and investigators. Their success was essential to the FBI and the DOJ's ability to be successful in their prosecutions during the S&L debacle. The ongoing regulatory failure ensured an epic prosecutorial failure.
The destruction of effective financial regulation by the Clinton and Bush administrations was deliberate. I do not mean that they deliberately sought to create a criminogenic environment. I mean that they viewed effective financial regulation as unnecessary and harmful because they assumed control fraud could not exist. This was, of course, a conveniently absurd assumption. It allowed both administrations to secure large political contributions from corrupt financial institutions while providing deniability to the administration. The administrations assumed that we were experiencing the first Virgin Crisis in which the banks and their controlling officers were innocent victims of depraved working class borrowers. Bhide has proved that Akerlof and Romer were wrong in one regard - economists and finance scholars do not "know better."
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).
Bhide has just witnessed the greatest spree of elite looting in history, but somehow missed it entirely. Had Greenspan and Bernanke understood that deregulation was "bound to produce looting" and given the "regulators in the field" their full support there would have been no financial crisis. Greenspan did not muster even "lukewarm support" for the Fed's supervisors - he attacked them savagely for daring to criticize the banks that were large control frauds. Bernanke appointed two economists as his top (anti) supervisor to ensure he would not suffer their practice of speaking truth to power. A Fed Chair who made it her mission to restore effective supervision would not choose "boring," "dull," or "bureaucratic" people. She would be putting a giant bull's-eye on her back and would ensure that she never have another boring day.