If Not Now, When?

There was a strange debate about financial regulation in connection with various annual meetings of the international finance bodies in Washington, D.C. this weekend. The nominal debate was between the supposed hawks and doves on regulatory capital requirements. The most vocal doves spoke at the Institute of International Financial (IIF) meeting. Joseph Ackermann, Deutsche Bank's CEO, is the IIF chairman. Germany, of course, at the behest of its banks, led the opposition within the Basel III process to raising capital requirements. Germany prevailed in the Basel III process, leading to a lengthy delay (until 2019) in returning nominal capital requirements to pre-Basel II levels. (Basel II reduced capital requirements in Europe to farcical levels. Even those levels were fictional because most large banks massively overvalued their mortgage assets.) Ackermann decried proposals to require systemically dangerous institutions (SDIs) to hold additional capital and proposals to speed up Basel III's proposed increases in nominal capital levels. He argued that Lehman's failure proved that interconnectedness, not simply size, contributed to causing global systemic risk. That is true, but his argument strongly supports requiring the SDIs to shrink to a level at which they would no longer pose systemic risks. IIF released an interim study in June 2010 claiming that Basel III's higher capital requirements would reduce signatory nations' GDP by three percent. These studies are easy to create. If one assumes (1) that banks will be (really) profitable (as opposed to creating fictional accounting income and real losses) and (2) that the banks' incentives and real successes will be unaffected by even exceptional leverage, then it follows that the greater the leverage the greater the bank lending and profitability. If one then assumes that greater bank loans will fund productive investments, thereby causing greater real growth (as opposed to inflating asset bubbles, which reduce real growth) and that this relationship is continuous (e.g., the more commercial real estate we finance in Atlanta the faster Atlanta's economy will grow -- forever), then extraordinary bank leverage must expand GDP. The optimal bank capital requirement is no requirement. None of these assumptions, conclusions, or predictions is valid, and we have just seen that the opposite can be true, but theoclassical economists' dogmas have proven impervious to reality. The capital hawks promptly responded to Ackermann. Kansas City Federal Reserve Bank President Thomas Hoenig argued that higher bank capital requirements were necessary for sustained economic growth. Hoenig's remarks took aim at the central premise of self-regulation by markets – the concept of “private market discipline.”

"It [the markets] didn't, it can't and it won't, [self-regulate]. The industry's structure and incentives are now inconsistent with the market being the disciplinarian."

The problem with this debate is that it has little to do with reality. The banking industry, in alliance with the U.S. Chamber of Commerce, with Bernanke's blessings (and with no opposition from the Obama administration), succeeded in using Congress to extort FASB to change the accounting rules so that banks do not have to recognize their real estate losses until they sell their bad assets. This makes the entire debate about nominal capital requirement surreal. Capital requirements are accounting concepts. If you pervert the accounting rules you render the capital requirements meaningless. This was done deliberately to subvert the Prompt Corrective Action law and to allow the continued payment of bonuses to bank senior officers. There is no meaningful capital requirement for the SDIs with enormous holdings of toxic mortgage assets. The Fed's “stress tests” deliberately ignored the losses on these assets. There are no real hawks at the Fed on capital requirements. Not a single senior Fed supervisor has the spine to even find the truth, much less close an insolvent SDI. Bernanke's claim that they would have placed the huge, insolvent investment banks in receivership in 2008 if the Fed had possessed such resolution authority is preposterous. The banking regulators had ample authority to place insolvent federally insured banks that were SDIs in receivership but lacked the courage and integrity to do so. The housing market stalled in mid-2006 and the uninsured mortgage bankers began failing in late 2006. The secondary market in nonprime mortgages collapsed in spring 2007. Years later, we have covered up the causes and extent of the crisis. This must end. GMAC's, Fannie's, and Freddie's managers, the Federal Housing Finance Agency (FHFA), and the GAO should conduct three studies using data available at those enterprises and the Fed. First, what is best estimate of the market value losses on liar's loans, subprime loans, and CDOs held by Fannie, Freddie, and as collateral by the Fed? To what extent have those losses been recognized by the entities holding the assets? To what extent are Fannie, Freddie, and the Fed under collateralized? The Fed should demand additional collateral to ensure that it is not exposed to any loan losses. Second, examine a sample of those assets' loan and servicing files to determine the incidence of likely fraud that can be spotted simply through file reviews. This second study should determine the lender on each fraudulent loan and the professionals involved (e.g., the investment bankers that created the CDOs, the appraiser, the outside auditor, and the rating agency). This list should be used to prioritize administrative, civil, and criminal investigations. The list of likely fraudulent loans should be cross checked against list of criminal and SEC referrals to determine which entities are failing to make referrals. The GAO should formally alert the relevant regulatory agencies about which entities are not making adequate referrals. The entities conducting the study should make criminal and SEC referrals where others have failed to do so. Fannie and Freddie should be directed by FHFA to put back fraudulent mortgages to the lenders/CDO packagers. Third, review the loan and servicing files of a sample of GMAC's mortgage servicing portfolio and its foreclosures during the first half of 2010. Determine the extent of likely mortgage fraud for the mortgages serviced by GMAC (and follow the steps recommended above). Determine the extent of GMAC files that lack adequate documentation to ensure the ability to conduct a valid foreclosure. Review a sample of the loan and servicing files for mortgage instruments that the Fed has taken as collateral. Determine the extent to which the file deficiencies would pose difficulties for the Fed if it sought to foreclose on mortgage assets it holds as collateral. Review a sample of GMAC foreclosures to determine the extent to which such foreclosures were invalid, unethical, or unlawful because of defects in the files or foreclosure processes used by GMAC or its agents. If the sample reveals material problems direct GMAC to cure any defects or abuses. The fact that four years after the onset of greatest financial crisis of our lives neither the industry nor the regulators have systematically studied these basic facts essential to addressing this crisis and avoiding future crises is a demonstration of how destructive the cover up has been. We should not be forced to spell out and mandate the studies that any competent, honest decision maker would have begun nearly four years ago. The fact that Treasury Secretary Geithner, a co-architect of the cover up (with Paulson and Bernanke), is engaged in a successful propaganda campaign premised on the facially absurd claim that the entire banking crisis was resolved at a taxpayer cost of roughly $50 billion is a testament to the continued debasement of not only the Department of the Treasury, but also too much of the financial press.

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.