The Terrible Cost of Not Understanding the Concept of "Looting"
George Akerlof (Nobel Laureate in Economics, 2001) and Paul Romer chose to end their famous article entitled "Looting: The Economic Underworld of Bankruptcy for Profit" with this paragraph in order to emphasize the reason for the deregulatory failure and how to prevent future financial disasters.
"Neither the public nor economists foresaw that the [S&L deregulations] of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself" (1993: 60).
The key words in this paragraph are "concept" and "unaware." Akerlof and Romer were unduly kind to economists in this passage. First, economists who studied banking knew that, historically, elite insider fraud and abuse had long been the leading cause of the most expensive banking failures. Second, economists did not provide "lukewarm support" to "the [S&L] regulators in on the field" who understood the looting "from the beginning." Economists were our most virulent opponents in trying to stop the elite looters. Third, economists did not "learn from [the S&L] experience." They doubled-down on their unrestricted support for the elite bank CEOs.
Failing to understand a critical risk concept (or excluding the concept from public policy formulation through cognitive dissonance) makes it impossible for regulators to take any deliberate safeguards against that critical risk. Ignorance of key risks also leads to regulatory complacency. This is particularly true when the concept that the regulators do not know exists (1) represents the paramount cause of catastrophic individual bank failures, (2) is increasingly likely, due to modern executive compensation, to produce a Gresham's dynamic that can hyper-inflate financial bubbles and spark systemic banking crises, and (3) initially produces exceptional (albeit fictional) reported banking income.
The bank regulator who is unaware of the concept of looting, therefore, creates a regulatory philosophy based on the implicit presumption that "accounting control fraud" does not exist. Implicit assumptions pose unique dangers. Because we do not know that we have made them, we never test their validity. When bank regulators implicitly assume out of existence the paramount risk to banks, the banking system, the public, the economy, and the Treasury they make real the great warning. The great warning is that it isn't the things we don't know that cause disasters -- it's the things we do know, but aren't true. The bank regulators "knew" that the elite bankers were the solution rather than the problem. They could not have made a worse assumption.
Malady #1: The "Recipe's" Four "Ingredients" for a Lender (or Loan Purchaser)
- Grow like crazy
- By making (buying) vast amounts of toxic loans at a premium nominal yield
- While employing extreme leverage, and
- Providing only grotesquely inadequate loss reserves (Allowance for Loan and Lease Losses -- ALLL)
The Recipe Produces Three "Sure Things"
- The firm will promptly report record profits
- The firm's executives will promptly be made wealthy by executive compensation
- The firm will suffer catastrophic losses
Malady #2: The Evisceration of Effective Underwriting
In order to make massive amounts of bad loans the worst bankers have to gut the bank underwriting rules and suborn the supposed "controls." We have known for centuries that this will produce "adverse selection" and cause the loans to have a "negative expected value" at the time they are made. (In plain English, this means that the bank will lose money. The banker maximizes his income by causing the bank to make terrible loans.
Malady #3: The "Gresham's" Dynamic
George Akerlof used the metaphor to Gresham's law in his 1970 article on markets for "lemons," a variety of "control fraud" in which the seller uses his asymmetrical information advantage as to the quality of the goods or services being sold to deceive the buyer. Akerlof was made a Nobel Laureate in Economics in 2001, with the award citing particularly his article on "lemons" (a U.S. term for a car with severe defects).
[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence (Akerlof 1970).
Akerlof's key observation was that market forces became perverse when dishonest officers use the firm's seemingly legitimacy to defraud the firm's customers and gain a competitive advantage over honest rival firms.
The National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) that our Congress and President appointed to study the causes of the savings and loans (S&L) debacle found that the bank officers leading the accounting control fraud epidemic deliberately created a Gresham's dynamic to suborn audit professionals.
[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of "Gresham's Law" in which the bad professionals forced out the good (NCFIRRE 1993).
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