As the financial reform bill wends its way through the Senate, one has to wonder whether lawmakers understand the true nature of the massive fraud that was perpetrated on this country. They should be listening to William Black.
Black, a former senior banking regulator during the S&L crisis and now a professor of economics and law at the University of Missouri-Kansas City, has been speaking out over Wall Street's culture of criminality. He wrote the book The Best Way to Rob a Bank is to Own One and knows all the white-collar criminal tricks from the inside.
To illustrate just how rotten the investment banks had become during the last decade, Black laid out in prepared testimony before Congress last month the way now-defunct Lehman Bros. was able to loot huge sums for executives, even as it was writing its own death warrant that would ultimately wipe out its shareholders.
A central part of Lehman's business was making and selling "liar's loans" under its Aurora subsidiary. It was a suicidal enterprise. These kinds of loans, where borrowers have an incentive to inflate income or assets, are set up to fail. Black estimates that every dollar lent on a liar's loan loses 50 to 85 cents.
In the short term, making these loans produces significant apparent but fictional income — and correspondingly huge bonuses for executives. Only later do the loans create real catastrophic losses for those holding them.
Lehman was the world leader in originating these loans. In the first six months of 2007, Aurora was lending more than $3 billion a month of subprime and liar's loans. This guaranteed senior management extraordinary paydays. Even as the fall was becoming evident, the firm's CEO and chairman, Richard Fuld, was awarded $40 million in total compensation for 2007. (Much of it in stock that later became worthless.)
Undoubtedly, the firm's top executives knew that making fraudulent loans was its primary source of income. But Lehman assiduously attempted to hide that fact, classifying its liar's loans as "prime" loans in disclosures, Black says. Had Lehman disclosed the true nature of the loans it was selling, no one would buy them and the firm would have been found out as insolvent.
To various degrees this kind of deceit was the business model of every player in the subprime mortgage lending and securities market: every bank that loaned money without documenting a borrower's credit worthiness, every firm that securitized loans without examining the lender's loan files, every accounting and law firm that helped fudge disclosures, and every credit rating agency that rated a mortgage-related security as safe without sampling the underlying loans.
It was a game of "financial don't ask, don't tell" as Black dubs it, that at its core was an epidemic of corruption.
Why was this allowed to continue even though the FBI warned as early as 2004 that mortgage fraud was massive? Because, Black says, officials at the Federal Reserve and Securities and Exchange Commission were ideologically opposed to fulfilling their regulatory role.
This recurring problem of regulators cozy with the industry they regulate means that financial reform must go beyond giving regulators more power and tools. It needs to impose clear legal duties on the financial sector with stiff consequences, which don't currently exist, for failure.
Two amendments offered by Sen. Arlen Specter of Pennsylvania would do just that. The first would impose a fiduciary duty on broker-dealers to act in the best interest of their investor customers, with criminal penalties for willful violations. The second would make those who aid and abet securities fraud civilly liable, a way to hold accountable all the professionals — appraisers, lawyers, accountants and others — who help cover the tracks of fraud.
Despite the recent swipe at Goldman Sachs by the SEC and a possible federal criminal probe, there has not been enough focus on the gross criminality infecting huge swaths of the financial sector. The economic meltdown was caused by deceivers, swindlers and defrauders who, in a just world, would be trading their pinstripes for prison stripes. If only.