September 15th marked the fifth anniversary of Wall Street giant Lehman Brothers going into bankruptcy, which precipitated the Great Recession that lingers on today — it remains the largest bankruptcy in U.S. history. To date, no executives have faced prosecution for the widespread mortgage fraud that fueled the bubble.
Moyers and Company caught up with a man who knows a lot about fraud — and fraud prosecutions — to explain why that is, and what the possible consequences of letting Wall Street off the hook might be. William K. Black, now a professor of law at the University of Missouri at Kansas City, is a former bank regulator who played an integral role in throwing a number of high-level executives in jail for white-collar crimes during the savings and loan crisis in the 1980s. We spoke with Black by phone. A lightly edited transcript of our discussion is below.
Joshua Holland: To date, a few loan officers — small fish — have been convicted of various offenses related to the financial crash. But none of the big bankers have faced any charges. And it’s not that the government has been losing cases in the courts. There’s simply been no concerted effort to prosecute these guys. Can you contrast that with what happened during the savings and loan scandal of the 1980s, and also give us your sense of why this has been the case?
William Black: Sure. The savings and loan debacle was one-seventieth the size of the current crisis, both in terms of losses and the amount of fraud. In that crisis, the savings and loan regulators made over 30,000 criminal referrals, and this produced over 1,000 felony convictions in cases designated as “major” by the Department of Justice. But even that understates the degree of prioritization, because we, the regulators, worked very closely with the FBI and the Justice Department to create a list of the top 100 — the 100 worst fraud schemes. They involved roughly 300 savings and loans and 600 individuals, and virtually all of those people were prosecuted. We had a 90 percent conviction rate, which is the greatest success against elite white-collar crime (in terms of prosecution) in history.
In the current crisis, that same agency, the Office of Thrift Supervision, which was supposed to regulate, among others, Countrywide, Washington Mutual and IndyMac — which collectively made hundreds of thousands of fraudulent mortgage loans — made zero criminal referrals. The Office of the Comptroller of the Currency, which is supposed to regulate the largest national banks, made zero criminal referrals. The Federal Reserve appears to have made zero criminal referrals; it made three about discrimination. And the FDIC was smart enough to refuse to answer the question, but nobody thinks they made any material number of criminal referrals [either].
And what people don’t understand about the criminal justice system is there are roughly a million people employed in it — and of course, millions incarcerated in it. But of the million employees, 2,300 do elite white-collar investigations. And of those 2,300, you have to contrast that to the number of industries in the United States, which is over 1,300. Notice I didn’t say ‘corporations,’ I said ‘industries.’
So a couple of things should be obvious. First, the FBI agents will not have expertise in the industry. And second, they can’t patrol the beat. They have to wait until a criminal referral comes in, and won’t come from the bank itself. Banks don’t make criminal referrals against their CEOs.
It could episodically come from whistleblowers, but against an epidemic of fraud that can never work. It has to come overwhelmingly from the regulators. So when the regulators ceased making criminal referrals — which had nothing to do with an end of crime, obviously; it just had to do with a refusal to be involved in the prosecutorial effort anymore — they doomed us to a disaster where we would not succeed.
Back in the savings and loan crisis, people like me — and I did this personally a great deal of my time — trained not only our regulators, but also the FBI agents and assistant U.S. attorneys on how to identify fraud schemes, how to respond to them and how to document them. We also detailed our top examiners on the most complex frauds, so that they worked for the FBI as their internal experts, and then people like me testified as expert witnesses. And, again, we had prioritized so we were going against the absolute worst of the worst and most senior of the people. None of those things have happened now.
Because of changes in executive compensation, it’s very uncommon for people to blow the whistle in the modern era. What people often don’t understand is that executive compensation bonuses go down very low in the food chain. And so if I’m a boss and I see a crime being committed, it isn’t just that I risk losing my bonus, it’s that Fred and Mary who report to me — Fred with three kids about to go to college and Mary with a kid that has severe problems — they’ll lose their bonuses as well. And so it’s not even my greed — it’s my altruism that gets in the way.
And then the administration has never — both the Bush and the Obama administrations — made a call for the good people to come forward, the ones who fought against the frauds and were disciplined because they did so. And the Frontline special that investigated this found that as soon as word got out, they were deluged with people giving them information, and the common characteristic Frontline found was that the FBI had never even talked to them.
And of course, the Obama administration has been having an unholy war against whistleblowers.
Holland: It almost sounds like — if I could offer an analogy — if you were trying to prosecute homicides and you had no police on the streets, no homicide detectives and no snitches, your hands would be tied, even if you were a tenacious prosecutor with some ambition.
Black: It’s actually far worse than that, because as a prosecutor of those kinds of cases, I end up with a corpse that has a small entry wound and a large exit wound, and I know there’s been a homicide. I can use forensic evidence to go after those people, even in the absence of witnesses. No such things occur in the elite white-collar sphere. Instead, the lenders were making criminal referrals against the little guys — the hairdressers of the world. And they made hundreds of thousands of them.
So at the peak of the savings and loans crisis — again, one-seventieth the size of this crisis — of those 2,300 total FBI agents, 1,000 of them were working on just one industry, the savings and loan industry, to produce that incredible wave of success that we had. As recently as fiscal year 2007, there were only 120 FBI agents assigned to mortgage fraud, and that’s despite the fact that the FBI itself, in September 2004, warned that there was an epidemic of mortgage fraud — ‘epidemic’ was their word — and predicted that it would cause a financial crisis — ‘crisis’ was their word — unless it was stopped. So what happens instead? You get tens of thousands of criminal referrals about the small fish. And so every single one of those 120 FBI agents was working those cases.
Black: And there was no national task force. They were divided up into what the military would call “penny packets” — two in this office, three in this office, that type of thing. So there was no conceivable way that they would find fraud at the large institutions, because they never looked.
And actually, that same year, in 2007, the FBI forms what it calls a partnership with the Mortgage Bankers Association — the trade association of the perps. The Mortgage Bankers Association set out — imagine the audacity — to con the FBI, and they succeeded! They ginned up this fake definition of mortgage fraud under which the lending institution was always the victim and never a perpetrator. The FBI bought into this hook, line, sinker and the boat they rode out in.
So we have the incredible anomaly of the first African-American president of the United States of America, with an African-American attorney general, Mr. Holder, adopting the tea party definition of the crisis, which says that the banks were pure and this is the first virgin crisis, conceived without sin in the executive suites. Instead it’s those nasty ultra-sophisticated hairdressers who conned the poor unsophisticated bankers from Harvard and Columbia and NYU to cause this crisis.
Holland: Right. Conservatives are convinced that the Community Reinvestment Act played a major role, despite a dozen studies showing that it did not, and it’s like a zombie myth. You can stab it and you can shoot it and it just keeps walking.
Black: Look at liar’s loans — these are the loans where you don’t verify the borrower’s income, and the industry’s own experts said that these loans were 90 percent fraudulent.
Study after study after study has shown that it was the lenders who put the lies in liar’s loans — the lenders and their agents — and nobody ever made a bank make a liar’s loan. It has nothing to do with the Community Reinvestment Act. Because the purpose of it is to inflate the borrower’s income, it takes you out of Community Reinvestment, and no entity — and this includes Fannie and Freddie — was ever required to purchase a liar’s loan. In fact, [liar’s loans] didn’t qualify as credit for affordable housing goals because you didn’t verify the borrower’s income.
So after all these warnings from the industry’s own anti-fraud experts about them being 90 percent fraudulent, and the fact that even the Bush Administration anti-regulators said, “Don’t do these things,” the industry, between 2003 and 2006, increased liar’s loans by over 500 percent. By 2006, 40 percent of all the home loans made that year and half of all the loans called “subprime” were liar’s loans. Remember, there’s a 90 percent fraud incidence in all of this. That means there were over two million fraudulent loans made in 2006 alone.
Now, that’s one way of looking at it, but even more stark is, in the year 2000 — we are talking about over 13 years ago — the group of associations of honest appraisers created a petition and circulated it widely throughout Washington, D.C. and the industry. They went to all the regulators and prosecutors in the industry — it was eventually signed by over 11,000 appraisers. And the appraisers, here’s what they said: ‘There is an epidemic of lenders who are extorting us to inflate the appraisal, and when we refuse to do so, they blacklist honest appraisers and refuse to use them in the future.’ Now, note the date again: 2000. This is over a year before Enron hits. In other words, we got a warning about this crisis before Enron failed.
Okay, so what can we figure out from that? Number one: it’s coming from the lenders. Number two: no honest lender would ever inflate an appraisal, because the appraisal is your great protection against loss. So, three: the lenders are inflating the appraisal for a reason, which is to cover up losses on the underlying mortgage fraud that they’re also engaged in. Number four: these loans are being sold in the secondary market, so we know that the fraud is propagating through the system. And the only way you can sell to the secondary market is by making what we call “representations and warranties.” And of course you can’t make a rep and warranty that says, “Hi, I’m selling you a fraudulent product.”
You can only sell a fraudulent loan through fraud, and there’s no fraud exorcist, so fraud has to go through the system and it has to come out the other end when they sell the CDOs — the collateralized debt obligations — and the mortgage-backed securities.
The Home Ownership and Equity Protection Act of 1994 allowed the Federal Reserve, and only the Federal Reserve, to stop liar’s loans at any time. First Alan Greenspan and then Ben Bernanke refused to use this authority. Bernanke, finally, under congressional pressure, used this authority on July 14, 2008, to kill liar’s loans. But even then, he delayed the effective date of the rule by 15 months, because you wouldn’t want to inconvenience a fraudulent lender.
Holland: Unbelievable. Just unbelievable. Let me ask you this: Up until the dot-com bubble burst in 2000, the size of the financial services industry grew and shrank along with the larger economy. It moved more or less with the business cycle. When the economy was booming, finance grew as businesses needed more loans and people wanted to buy big ticket items. And then when we were in a recession, it tended to shrink. But that never happened after the dot-com bubble burst. Finance was about 8 percent of our economy and it stayed that way until today — it had little ups and downs, but the trend line has been pretty consistent. Bill, finance made up less than 3 percent of our economy in 1950. What does this say about where we are today economically? What does this tell you?
Black: It tells us that the tail wags the dog, and that it wags the dog into recurrent crises. So it’s like a diseased tail. A tail is of course designed for balance and it’s supposed to help things right themselves. This tail throws folks into the ditch.
In addition to the numbers you gave, the percentage of all corporate profits that go to finance is now back up to roughly 40 percent. That is staggering.
It should be small, and you should be trying to minimize it, and it should have very low returns overall in your economy. It’s all about power. And it is not just economic power — it’s political power. This is the modern face of crony capitalism. It is the great threat, not just to our economy, but also to our democracy. That’s particularly true in a Citizens United world, in which these banks can use their political power to drive what we’ve seen.
I could’ve never imagined that in my lifetime an administration would actually say that there were entities too big to prosecute.
Holland: Right. “Too big to jail.”
Black: Right, too big to jail. I actually developed that phrase before this as a way of trying to embarrass the administration. But I’ve given up. They’re beyond the ability to embarrass. They adopted the phrase.
Holland: Bill, let me ask you this — and I guess I’m shifting gears here just a little bit. What does the term ‘moral hazard’ mean, and how do you think the fact that we didn’t prosecute any bankers — and that we bailed out the industry — will affect Wall Street’s behavior going forward?
Black: Moral hazard is a concept that developed originally in insurance and was quickly applied to banking as well. It says when there’s a real asymmetry between risk and reward, you can produce either fraud or wildly imprudent risk, or both, and that either of these things in the banking context can lead to disastrous financial consequences.
Even though we have known for centuries that this produces what we who study criminality now call “control fraud” — when the people who control a seemingly legitimate entity use it as a weapon to defraud — suddenly when they get to moral hazard, neoclassical economists only talk about risk. They ignore the fraud component, which is a leading cause of the most catastrophic bank failures and bank crises.
Holland: And they also only talk about it for the little people defrauding the banks.
Black: Right, the hairdressers.
Holland: The hairdressers. They’re the ones we have to worry about.
Black: Yes, and the FBI and the Justice Department are the brave, virtuous people who are protecting the poor innocent bankers from the blood lust — I am quoting, by the way, the Washington Post — “the blood lust of the public” that wants to go after these poor innocent bankers. And fortunately, we live in a country like America, where the lawyers or the Justice Department are unwilling to be so unjust as to follow the crass prejudices of the public.
The failure to prosecute under any theory of economics and any theory of criminality means that the next crisis is far more likely, and that it’s going to be far larger, because this accounting control fraud recipe is a sure thing that guarantees that you will be made wealthy immediately as the controlling officers, and there will be no risk — zero. Not a single elite banker who caused this crisis is in prison, period. So you have absolutely maximized what we call a “criminogenic environment,” and a key element of that, as you say, is that we have taken moral hazard — the fraud dimension — and maximized it.
Holland: My final question is, very briefly, about the regulatory response we did get following the crash. Dodd-Frank has been hailed as a significant new reform by some; it has been panned as a watered down nothing-burger by others. Does the truth lie somewhere in between, and how much risk remains in this system?
Black: Right now, less risk is apparent because the economy is so crippled. Once we get back to a boom, the bad stuff will reemerge. So the good news/bad news about the weak recovery is that it’s slowing down the next crisis by continuing the current crisis.
Dodd-Frank doesn’t address any of the three central elements that create the criminogenic environment — that produce the recurrent, intensifying epidemics of control fraud that drive our ever-worsening crises. Those three elements are, first, the creation of the systemically dangerous institutions — the so-called “too-big-to-fail” firms. And the administration won’t even begin to be honest about them. It calls them “systemically important,” like they deserve a gold star. But their definition is when — not if, but when — the next one fails, it will, like Lehman, cause a global financial crisis.
These institutions are too big to manage effectively, so there would be a complete win-win-win-win were we to force the shrinkage of the systemically dangerous institutions down to the point where they no longer endanger the global economy. We would, first, reduce global systemic risk. Second, we would make markets far more efficient. Even conservatives say that when there’s a systemically dangerous institution, free markets are a myth, and their metaphor is that it’s like bringing a gun to a knife fight when they compete against anyone else. So we would have better markets. We’d have more efficient banks, because these are too big to manage, and we would remove crony capitalism, one of the leading threats to our democracy. Dodd-Frank doesn’t deal effectively at all with the systemically dangerous institutions. Its idea is to keep them around, which is nuts.
Second big thing is modern executive compensation, which creates the perverse incentive structures and is the means of looting that the CEOs use. That has gotten worse since the crisis and there is nothing effective in Dodd-Frank dealing with either executive or professional compensation.
The third area is what we call the three Ds. These are deregulation, de-supervision and de facto decriminalization. We’ve already talked about decriminalization, so that’s as bad as it can get. No prosecutions.
Deregulation, that’s slightly been reversed. We have banned liar’s loans. We have created a new consumer bureau that, you know, time will tell whether it can be effective. But that’s pretty much it in terms of regulation. There’s stuff on the Volcker Rule, and we still don’t know whether it’s going to get out of the industry’s embrace, but we certainly know they’ll be able to evade it under Dodd-Frank. So, deregulation, a little plus, but nothing to brag about.
De-supervision is still disastrous. We still have the Holders of the world refusing to prosecute, we still have anti-regulators in most of the agencies. So de-supervision? Boy, we’ve still got that in spades.