Why Covering up Fraud Losses Impairs Economic Recovery. Part One.

Part One: The Unbearable Lightness of the Accounting Cover Up Bad bankers, bad regulators, and bad politicians love to cover up losses, fraud, and bank failures. The snake oil peddlers pushing for a cover up scream that if losses are recognized capitalism will collapse. Recognizing losses “causes” bank failures (ponder that “logic”). Bank failures cause other banks to fail. Selling bad assets of failed banks is invariably described as a “fire sale” that causes further falls in asset values, which causes more banks to fail, which causes more assets to be sold, which causes – the end of life as we know it. If the snake oil guys are correct then financial markets aren't fragile, they're friable – a few bank failures away from crumbling. The solution under this logic is to lie about asset values and pretend that insolvent banks are healthy. For a banker, what's not to love about the right not to recognize even massive losses on assets? He gets to keep his job, reputation, and obtain bonuses for blowing up the bank. For a senior regulator whose failures allowed the bankers to cause the “epidemic” of mortgage fraud (FBI 2004), the mother of all bubbles, and the Great Recession a cover up is ideal. Bank failures are supposed to lead to investigations by the Inspector General and can lead to embarrassing congressional oversight hearings. Bankers and bad regulators sell the cover up to legislators as the miraculous “silver bullet” solution that can solve a crisis at no cost. Legislators wish everything they do could be that easy. Among my most painful memories are being in their offices to listen to their explanation of how simple, cheap, and pleasant the cover up will be. Everyone wins, no one loses. It's just like the financial bubble that inflated the fictional asset values. Remember how wonderful the bubble was? The cover up pretends that the bubble prices were real. The cover up strategy says that the answer to a bubble is a bigger, longer bubble. Fiction can be so much more pleasant than reality. Fraudulent bankers' are the biggest winners from the cover up. In addition to maintaining their jobs, reputation, and bonuses they dramatically reduce the risks of being prosecuted and sued. Bank failures are supposed to prompt investigations and severe sanctions against fraudulent and abusive managers. In the (vastly smaller) S&L debacle we obtained over 1000 felony convictions of senior insiders, over 1000 enforcement sanctions, and hundreds of successful civil suits. The S&L CEOs with the greatest political influence were frauds. They led the push to cover up S&L losses. The cover up entered partisan politics during the 2008 presidential campaign. Senator McCain's first big speech on the developing crisis called for changing the accounting rules to prevent loss recognition. Bill Isaac (former FDIC Chair – and leader of the cover up of bank losses during the LDC debt crisis) was invited by the Republican and “Blue Dogs” (conservative Democrats) caucuses considering the first TARP bill to brief them on how to respond to the crisis. He opposed passage, assuring them that if they changed the accounting rules to hide the bank losses they would prevent $500 billion to $1 trillion in losses. This emboldened the Republicans and Blue Dogs to unite and defeat the first TARP bill. McCain had announced that he was suspending his campaign and returning to the Senate to secure passage of the TARP bill. McCain was poorly positioned to counter Isaac's arguments because McCain had proposed the same accounting gimmicks Isaac was proposing. The defeat of TARP I embarrassed McCain and Senator Obama's lead over Senator McCain in the polls increased substantially. Senator Obama, as a candidate, and his administration after the election did not take a public position on covering up the losses. The Chamber of Commerce and bank lobbyists made the cover up of bank losses their top regulatory goal. Their strategy was to get Congress to extort the Financial Accounting Standards Board (FASB) to force a change in the accounting rules so that banks did not have to recognize loan losses. House Financial Services Capital Markets Subcommittee Chairman Paul Kanjorski (D., Pa.) held a hearing in March 2008. The hearing was a bipartisan assault on FASB. Kanjorski demanded the prompt adoption of the cover up. Otherwise, he promised the prompt passage of legislation to remove the FASB's power to se accounting rules. The Chamber, of course, is a fierce opponent of the Obama administration. Nevertheless, the administration took no action to counter the Chamber's unprincipled attack on accounting principles. Bernanke gave open approval to the Chamber's efforts to cover up bank losses. The Obama administration took the exceptional step of nominating Bernanke, a conservative anti-regulatory Republican, for an additional term as Fed Chairman. The administration found the cover up useful to its campaign to use stress tests to restore confidence in the banking system. If the banks had been required to recognize their losses the stress tests would have shown that many of the largest banks were insolvent or on the verge of insolvency. The stress tests were shams based on fictional, grossly inflated asset values. Cover ups make for strange bedfellows. Congress enacted the Prompt Corrective Action (PCA) law in 1991. PCA was adopted because the cover up of S&L and bank losses in the 1980s increased losses severely and left bad and even fraudulent CEOs in charge of federally insured depositories. The PCA was based on theoretical work by conservative economists who feared regulators' perverse incentives to allow banks to cover up losses, but it attracted broad bipartisan support. Its purpose was to constrain regulatory discretion and mandate the prompt correction or closure of failing and failed banks. As we warned its proponents in 1991, however, it had a critical gap that could be exploited to undermine the statutory goal. The PCA is triggered primarily by inadequate capital. Banks fail primarily because they invest in assets whose values fall sharply. Capital is an accounting concept. When a bank overstates its asset values its reported capital is inflated. The PCA was prompted by accounting cover ups of asset losses – but it can be eviscerated by accounting cover ups of asset losses. The Bush and Obama administrations exploited this loophole by refusing to crack down on many enormous banks that grossly inflated their asset values and reported capital. Instead of holding oversight hearings that exposed the Bush and Obama administrations' evasion of the PCA and demanded compliance, prominent members of Congress encouraged it. House Financial Services Chairman Barney Frank (D., Ma.) said: "This is important for all regulators. We need to give you some discretion in how you react to these things. I am asking everyone -- the Office of the Comptroller of the Currency and others -- if anything in the existing legislation deprives you of discretion in how you react ... I insist that you tell us." Congress passed PCA to remove the regulators' discretion to cover up or ignore bank losses. Now, the key House Chair – who once rightly criticized the S&L regulators for not promptly closing insolvent S&Ls – encourages the regulators to employ discretion to cover up or ignore bank losses.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.