One Word Explains What Caused the Financial Crisis: Fraud

Last Updated May 5, 2010 5:33 PM EDT

"The best way to rob a bank is to own one." -- William Black
Economist James Galbraith submits what I think is the best theory to explain what caused the financial crisis. It's a doozy, though, so just try to keep up. Here goes: fraud.

Oddly, as the U. of Texas-Austin prof noted this week on Capitol Hill, that simple premise doesn't draw much attention in the corridors of power. Lawmakers furrow their brows. Financial industry folks, summoned to Washington for their opinion, study the middle distance. Adepts of the dismal science whip out incomprehensible charts. It's very complicated.

Except fundamentally it's not. Fraud was, is and will continue to be a central feature of financial crashes, as recent history attests. During the savings & loan crisis in the 1980s, for instance, bankers stripped thrifts down to their skivvies. Twenty years later, boiler-room operators like Jeff Skilling and Bernie Ebbers took the money and ran.

The latest caper was no different. Of course, a full post-mortem requires looking at the many factors that drove the crisis, from reckless lending and securitization, to federal housing policy, to the amplifying effects of leverage and made-to-fail derivatives.

But all these practices are in various ways symptoms of a deeper malaise -- at best, a kind of collective national denial; at worst, a scam. It's clear that participants in the financial system knew that the extraordinary profits and bonuses that flowed during the housing boom were built on a massive falsehood -- that bad loans would come good and home prices keep rising forever. Any analysis that omits this basic truth is inadequate.

As Galbraith told members of the Senate subcommittee on crime:

Ask yourselves: Is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had become infested with fraud? Every statistical indicator of fraudulent practice â€"- growth and profitability â€"- suggests otherwise. Every examination of the record so far suggests otherwise. The very language in use: "liars' loans," "ninja loans," "neutron loans," and "toxic waste," tells you that people knew. I have also heard the expression, "IBG, YBG;" the meaning of that bit of code was, "I'll be gone, you'll be gone."
But not forgotten. During the housing boom, signs of financial fraud abounded, Galbraith said. Industry players grew suspiciously fast; paid lavishly well; and recorded huge increases in profitability, rubber-stamped by auditors. Lenders entered risky markets formerly considered off-limits, shredding their underwriting standards along the way. Crucially, firms figured out how to make a buck while passing along potential losses to others, who took the action on condition they could do the same.

If there was any art to all this, it had to do with creating perceptions. For that, people used math. Mortgage originators built statistical models that suddenly conjured up millions of new customers. Credit rating agencies devised formulas guaranteed to spell "AAA." Banks developed wholly self-referential financial products whose underlying value was based -- presto! -- on themselves.

Said Galbraith:

Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?
Now you see it, now you don't. But such legerdemain has a price. Galbraith argued that this kind of financial fraud poses nothing less than an "existential threat" for the U.S. economy. "Either the legal system must do its work. Or the market system cannot be restored."

It's that simple.

Image from Wikimedia Commons

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    Alain Sherter covers business and economic affairs for