Fraud and Failure: Bo Cutter's Indictment of the Finance Industry (Part 1)

03/18/2010 05:12 am ET | Updated May 25, 2011

Bo Cutter has presented the best possible defense of Treasury Secretary Geithner.

It is a remarkable defense because it is premised on a scathing indictment of Wall Street, theoclassical economics, modern finance, and the sycophants that the financial community installed as anti-regulators. Indeed, Bo's account is sometimes particularly credible because it is a confession. Bo was a managing partner of Warburg Pincus, a major global private equity firm, and led President Obama's Office of Management and Budget (OMB) transition team. His defense of Geithner provides so rich a vein of ore that I will mine it in three installments: (1) Bo's indictment of the finance industry, Greenspan, Geithner, Paulson and Bernanke, (2) the martyrdom of Geithner, and (3) Geithner as Bo's Last Action Hero.

Bo's explanation of Geithner's unique virtues begins the indictment.

It comes down to this: the combination of brains, guts, calmness, and a willingness to act are virtually non-existent in Washington in any era, but particularly in this one. When you find the combination in a significant cabinet level job, you should value it.

[T]his crisis was long in coming and it was a totally integrated failure of intellectual traditions, global macro-economic imbalances, government policy making, regulatory supervision, financial sector greed, incomprehensible boards of directors, absences without leave, and breath-taking management short-sightedness. No one and no institution put together an understanding of the set of factors that triggered this particular debacle. Tim [Geithner] is included in this "no one", but so is everyone else.

I think the last two years have revealed the single largest failure of senior management in the financial sector, and of the board system in American history. I think I am correct in saying that there was not a single independent director in America who stood up on this issue. I do not understand why every board of every institution that failed was not asked to resign immediately.

Bo's indictment is compelling, but his logic proves a deeper failure. There is no reason to restrict his indictment to "the last two years." The senior managers' and directors' failure did not begin with the recession. They failed throughout the expansion of the bubble, the backdating of stock options, after-hours trading, the collapse of the auction rate securities market, the "epidemic" of mortgage fraud by lenders, the massive scandals of the Enron and Worldcom era, and the savings and loan debacle. The financial sector has been in recurrent, intensifying scandals for decades.

Bo's arguments require us to focus on at least the last four years (even if he continues to ignore the FBI's 1984 warning that the mortgage fraud "epidemic" would cause a crisis).

In fact, by 2006 and early 2007 everyone thought we were headed to a cliff, but no one knew when or what the triggering mechanism would be. The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.

By early 2006 -- roughly four years ago -- "everyone" agreed "we were headed to a cliff" and that the banks' "major loans" were "nuttiness of epic proportions." An industry whose claimed expertise is the sophisticated evaluation of risk and value universally failed to come remotely close to valuing either. As Bo emphasizes, these were massive errors. These managers got immensely wealthy because -- not despite -- their willingness to make hundreds of thousands of loans that were certain to crash and burn as soon as the bubble ceased to inflate (which it did in 2006). Bo knows them, and Bo says that every independent (sic) director betrayed their fiduciary duties to shareholders. Every senior officer at the major banks failed. Bo portrays them as incompetents, cowards, and moral failures.

Bo's indictment of his finance peers is even more severe than his portrayal. White-collar criminologists have shown that the lending pattern he describes ("nuttiness of epic proportions" when "everyone" agrees "we were headed to a cliff") demonstrates that the lenders are frauds that have produced an epidemic of accounting "control fraud" (where the persons controlling a seemingly legitimate organization use it as a "weapon"). The FBI began publicly warning of an "epidemic" of mortgage fraud in September 2004, with 80% of the losses occurring when lender personnel were involved in the fraud. The number of criminal referrals for mortgage fraud indicates an annual rate of mortgage fraud in the many hundreds of thousands. The recipe for a lender optimizing accounting control fraud is: (A) grow extremely rapidly, (B) make extremely bad loans, (C) have extreme leverage, and (D) provide minimal loss reserves. (The first two ingredients are related. In a mature product like home mortgages, the optimal way to grow extremely rapidly while increasing yield is to make loans to individuals that cannot repay the loans. The rapidly expanding bubble allows fraudulent lenders to postpone loss recognition by refinancing the bad loans.) Nonprime specialty lenders followed this recipe. The pattern produces guaranteed record accounting profits in the short-term. Because a significant number of lenders follow the same strategy, the result was a hyper-inflated financial bubble followed by an economic crisis.

The accounting fraud optimization pattern that a lender follows, however, creates two weaknesses that we exploited as S&L regulators during the debacle. The lender must gut its loan underwriting standards and suborn its internal controls. Secured lenders must encourage inflated appraisals. Officers must be disciplined for rejecting bad loans and given bonuses for making bad loans. No honest lender would follow such suicidal practices. Bank examiners can easily, quickly, and precisely identify these perversions of honest, normal underwriting practices. We made closing such lenders our top priority -- while they were still reporting record profits and minimal losses (See: The Best Way to Rob a Bank is to Own One). The economists and lawyers thought that this proved we were insane because they were clueless about accounting fraud. The second weakness is that optimizing accounting fraud requires extremely rapid growth. This provided a quick screening device for identifying likely frauds and a means to force their rapid collapse -- by restricting their growth. Regulators could have targeted these same weaknesses and contained the ongoing crisis. Instead, despite the FBI's early warnings about the fraud epidemic, they functioned as anti-regulators. The FBI has put the matter starkly: it is "irresponsible" to purport to explain the crisis without discussing fraud.

This post originally appeared on New Deal 2.0 and New Economic Perspectives.