Financial Crisis: Mass Delusion, Sure -- but Also a Massive "Control" Fraud
The NYT's Joe Nocera thinks the causes of the housing bubble are to be found not in the actions of bankers or government regulators, but rather in the more mysterious precincts of the human heart. Tear Wall Street down brick by brick, he suggests, and financial manias will still occur. Why? Because people will always fall under the spell of some object of speculative desire, whether tulips, shipping companies, railways or real estate:
I'm all for holding the bad actors accountable, and to the extent the [Financial Crisis Inquiry Commission] has done that, I tip my hat. But mass delusions, alas, are part of the human condition, and no report, no matter how scathing, is going to change that.
And thus the question really isn't whether it will happen again. It's when.That's a curious evasion for a business journalist who has written acutely about the financial crisis. For while it may be true that bubbles are inevitable -- and history suggests they are -- it doesn't follow that we're powerless to counteract them.
Besides, surely it's relevant that the last two bubbles were signed, sealed and delivered by Wall Street, just as other crises have followed periods of financial "innovation." If people have a fatal attraction for games of chance, their impulses need an outlet. If so, then it's hard not to see how tighter regulation of the financial industry, or preferably the break-up of big banks, wouldn't at least help contain the damage when the next frenzy kicks in.
Nocera also ignores his argument's implications. Because if "mass delusions... are part of the human condition," then so is the urge to perpetuate -- and profit from -- them. As the good folks over at Naked Capitalism point out, financial firms in the years leading up to the bust didn't issue and securitize subprime loans because they'd run out of good loans to process -- they cherry-picked bad mortgages because those assets yielded more lucrative rewards for executives:
What happened is that the benefits for originating bad loans exceeded the cost of these negative consequences â€"- someone was paying enough more for bad loans to overwhelm the normal economic incentives to resist such bad underwriting.
The best example of this is John Paulson, who earned nearly $20 billion for his fund shorting subprime. This amount of money was not ever possible or conceivable in the mortgage business prior to that point. The only way it could occur was through the creation of a tremendous number of bad loans, followed by a bet against them. Betting on good loans could never generate this much gain.There's a useful term for such behavior -- it's called a "control fraud." That's how William Black, an economics and law prof at the University of Missouri-Kansas City, describes what happens when "seemingly legitimate entities," like companies, are used by executives to wrongly enrich themselves. In banking, such frauds typically involve lenders using bogus accounting to hide dodgy loans to uncreditworthy borrowers and deploying massive leverage to maximize gains.
Black's concept fits the financial crisis to a tee. Such fraud was visible at virtually every level, from how loans were originated, to the poisonous brew of nonprime CDOs, to banks' spurious bookkeeping for mortgage-related losses. Comp schemes on Wall Street were similarly similarly rigged, as bankers converted corporate assets -- and taxpayer funds -- into bonuses.
It may well be true, as Nocera contends, that the financial crisis sprang from mass delusion. If so, it's also true that various actors sought to exploit those frailties. To think otherwise is itself a delusion.
Images from morgueFile
Related:
- Smoking Loans Prove Wall Street Committed Fraud
- SEC Bribery Probe Opens New Front on Wall Street Corruption
- Moral Hazard: Why Handing Fannie and Freddie to Wall Street is a Lousy Idea
- Reign of Terror: How Subprime Lenders and Wall Street Caused the Financial Crisis
- Street Fight: Time to Send Bankers to Jail