Posted below, with kind permission of the author, is the transcript (see note below) of James K. Galbraith’s talk on financial fraud at the 20th annual Levy Institute Hyman Minsky conference at the Ford Foundation in New York City on April 15, 2011.
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James K. Galbraith: Without the rule of law, the financial sector is no use to anyone except those who own it and the politicians they own
In the past month I've attended two meetings as a non-speaker: one at the IMF and the other last weekend at Bretton Woods.
At both I asked the same question, from the floor. How is it possible to have these somber and well-informed discussions of financial supervision, replete with experts and high officials, and not one mention of the word "fraud?"
I received no real answer on either occasion. I trust, in fact that the issue already has been aired at this conference but I wasn't able to be here before today so I don't know for sure.
What is fraud?
William K. Black, the author of the classic work on these matters, entitled, The Best Way to Rob a Bank is to Own One, gives us a definition: Fraud is theft by deception. A control fraud, he writes, quote, "is a company run by a criminal who uses it as a weapon and shield to defraud others and makes it difficult to detect and punish the fraud. Control frauds are financial super-predators that cause vastly greater losses than blue collar thieves. They cause catastrophic business failures. Control frauds can occur in waves that imperil the general economy." He wrote this in a book about the S&L crisis. To use a term from economics, again quoting, "Fraud causes terrible negative externalities because it inflicts injury on those who were not parties to the transaction."
Was fraud present in the run up to this financial crisis? No one denies it. When I asked the question at the IMF, Professor Jacob Frenkel said, "Yes, there was fraud. But it should be treated objectively." He did not say what that meant.
At the INET meeting, Mr. Borio of the Bank for International Settlements said, "Well, yes, there was always some fraud." He didn't seem to think of it as an important problem.
The State Attorneys General, in Minnesota, Iowa and elsewhere, thought differently beginning in 2003.
The FBI thought differently in October, 2004 when it warned, in public, that we could be facing an epidemic—an epidemic—of mortgage fraud.
Fitch Ratings found differently in 2007 when it looked at a bit of mortgage documentation and declared itself startled. There was evidence of fraud, abuse or missing documentation in, quote, "virtually every file."
At the IMF meeting, I had a side conversation with a senior British regulator who said he thought that those who traded the derivatives instruments on these mortgages didn't know. I suggested that the very language of the trade—liars' loans, ninja loans (for no income no job or assets), neutron loans (borrowed from the nuclear lexicon: destined to explode, destroying people but leaving buildings intact), exploding ARMs, toxic waste—that all of this suggested otherwise. Think of a restaurant where the wait-staff refers to the food as scum, muck and sewage.
For details, we have Kathleen Engel and Patricia McCoy, another excellent book, The Subprime Virus, a book whose back jacket declares correctly that it "should be on every prosecutor's must-read list." OK, I confess, I supplied that quotation. Engel and McCoy describe the practices: bait and switch, steering, junk fees, prepayment penalties linked to reset dates, race based targeting of ghetto loans to mud people, padding (a borrower's income or assets), commissioning inflated appraisal, manufacturing fake pay-stubs and W-2s, altering credit reports and creating fictitious checks and investment statements. Want more? Read the book.
Want to see the results? Go to Cleveland, just for example, and drive around. And what for? As Dimitri Papadimitriou asked in the call for this conference, did the market's pursuit of self-interest yield larger societal benefits?
In another excellent book, All the Devils are Here, Bethany McLean and Joe Nocera who is associated with the New York Times and is therefore a completely irreproachable source [Session Moderator was Eric Dash, Banking Writer for The New York Times — s], wrote that 82% of subprime loans were refis and 60% of those were cash out refis. In other words, it wasn't about home ownership as many people claimed. It was about maintaining consumption and meeting costs like education and healthcare.
McLean and Nocera write extensively on Ameriquest, a company they call America's dominant subprime lender whose core product was the 2/28 loan with a 3 year prepayment penalty. One officer later wrote, "my managers and handlers," and I'm quoting from the book, "there taught me the ins and outs of mortgage fraud, drugs, sex and money, money and more money. My friend and manager handed out crystal methamphetamine to loan officers in a bid to keep them up and at work longer hours. A typical welcome aboard gift was a pair of scissors, tape and whiteout."
When Ameriquest settled with 49 state attorney generals for $325 million dollars in January 2006, another company, New Century, wrote that if the guidelines applied to them, quote, "Our revenues, business results of operation and profitability could be harmed." As McLean and Nocera write, this quote "in effect, was an admission that the entire industry had been based on fraud."
An Ameriquest founder, Roland Arnall, in late 2005 was confirmed as United States Ambassador to the Netherlands with the strong support, among others, of one Senator Barak Obama who relied on a letter he had received from one Deval Patrick, who had served earlier on Arnall's board for a fee of $360,000 per year.
You have already heard from Phil Angelides [spoke earlier at the conference —s], so I'll just quote snippets from the conclusions of a final excellent document, an official government document, the Financial Crisis Inquiry Report.
They write of "widespread failures in financial regulation and supervision proved devastating," "dramatic failures of corporate governance and risk management," "systematic breakdown of accountability and ethics," "collapsing mortgage lending standards," "failures of the credit rating agencies were essential cogs in the wheel of financial destruction." And that's just the bold face in the executive summary.
In the text, the words fraud, abuse, egregious, casino, and criminogenic occur time and again. And among many useful passages, I'll just quote one on the question of risk correlation in CDOs. They write, "Imagine flipping a coin to see how many times it comes up heads. Each flip is unrelated to the others [...]. Now, imagine a loaf of sliced bread. When there is one moldy slice, there are likely other moldy slices [...]. As investors now understand, the mortgage-backed securities in CDOs were less like coins than like slices of bread."
I'm pleased, I may say, that this issue, so allergic to high officials who were either negligent or complicit for the most part—and I have to say with the very distinguished exception of our luncheon speaker today [Sheila Blair — s]—this issue is getting some attention. The New York Times, I'll say it again, an impeccable source, two days ago had a long story on the non-prosecution of fraud in this crisis. The Huffington Post, reports yesterday that the Senate Committee on Investigations is considering a criminal referral of Mr. Blankfein related to the Abacus deals. The Financial Crisis Inquiry Commission did make referrals, perhaps someday we'll hear what became of them. As a commenter on one of these stories observed, "If only Attorney General Holder were still alive."
Let me stress though, that this is not about vengeance. It's about accountability. It's about what they call in the Navy "command responsibility." It's about power, legitimacy and public purpose.
Fraud is deceit; the destruction of trust. Restoring trust requires trustworthiness. That has been destroyed. The destruction cannot be papered over by Dodd-Frank or anything else short of rooting out the people and replacing the institutions and structures that were responsible in the first place.
Financial instruments are contracts at law and without the rule of law, the financial sector is no use to anyone except those who own it and the politicians they own.
The question for this panel was whether Dodd-Frank will do the job. I'm tempted to quote Zhou Enlai, his view in particular of the impact of the French Revolution, he said it was too early to tell. But a better evaluation is already in McLean and Nocera who say, "maybe." And I would add, only if the prosecutors and the courts wake up and do their job. Otherwise, not a chance.
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NOTE: Remarks above were transcribed from the audio file at UTIP. All errors are mine. — selise
x-posted at my blog — selise
