Senate Investigation: Role of Fraud in the Financial Debate

by: Washington

Still on vacation for a bit. Stopping in to note that the Senate subcommittee on investigation just released its massive 650 page report, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse. There’s a lot to go through in this report, headed by Carl Levin (D-MI) and Tom Coburn (R-OK), and I’ve just started it. I’d recommend checking out initial impressions from Jennifer Taub at the paretocommons.

Two quick comments. First, there’s a school of thought that focuses on the linkage between market fundamentalism and the carceral state. By believing that markets naturally self-regulate, we remove the role of government from regulation of markets to the governance of a extra-market penal sphere. The government then redefines the ideal citizen as subjects who are either potential criminals or potential victims of crime and re-conceptualizes its own power as one focused on aggressive crime prevention (see Governing Through Crime, Jonathan Simon, Illusions of Free Markets, Bernard Harcourt). It’s fascinating to contrast the extensive expansion of policing powers focused on the War on Crime/Drugs, on the one hand, against the detailed interactions of the Office of Thift Supervision (OTS) with WaMu, on the other, as shown in the report.

From the introduction of the report:

OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, asset quality, and appraisal practices, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but never did. OTS failed to respond with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually rated WaMu as financially sound.

The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to correct identified problems with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of deference to WaMu’s management, choosing to rely on the bank to police itself in its use of safe and sound practices. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems would be corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results.

Despite identifying over 500 serious deficiencies in five years, OTS did not once, from 2004 to 2008, take a public enforcement action against Washington Mutual to correct its lending practices, nor did it lower the bank’s rating for safety and soundness.

I haven’t read the full thing yet, but this screams that the regulators saw their jobs as to gently nudge the banks they were regulating as partners, as market forces would self-correct these problems. Put that against the expansion of searches, limitations of due process, double jeopardy with regards to property, RICO laws, three-strike laws and general expansion of state powers when it comes to the policing of the poor over the past thirty years.

Fraud as Macro Property.

The placement of fraud in the narratives of the financial crisis is vastly different author by author. Two recent books I’ve read, both excellent on the crisis, could not be more opposed to each other. The Subprime Virus (Engel, McCoy) looks very closely at the securitization chains and points out the places where fraud enters the picture. Balancing the Banks: Global Lessons from the Financial Crisis (Dewatripont, Rochet, Tirole) doesn’t even really mention fraud as an important part of the narrative.

Why is fraud important? The first is obviously the ideal of justice, that those who have been rewarded at another’s expense ought to pay a price. The second is a regulatory issue, to provide disincentives against wrong acts.

The third is the macroeconomic element. How much did the fraud in Wall Street’s misbehavior create and/or sustain the housing bubble? The general narrative looks at a combination of a “global savings glut,” the actions of the Federal Reserve and/or exuberance in the housing market. Wall Street, obnoxious as they may be, is almost a bystander in this narrative. There’s little role for the idea that Wall Street and accompanying parties’ actions, in creating financial instruments they expected to fail, created or sustained the housing and credit bubble in any meaningful, quantitative sense. This is an understudied part of the crisis, and if the Great Depression is any guide, will likely be lost to history.

In that sense, it’s good to see Propublica’s Jesse Eisinger and Jake Bernstein winning a Pulitzer for their work on Magnetar and the rest of the financial crisis. Magnetar is the hedge fund that kept the demand going for subprime mortgage-backed securities when the housing market was originally starting to cool, pumping the bubble that it then bet against. How much of an effect did that have on the overall market? How much less of a recession would we have had if this conflict wasn’t there? We need better numbers here.

We are going to see the idea of prudential regulation of banks extend from a microeconomic concern – one of coordinating behaviors of depositors against runs and towards soundness, etc. – to a macroeconomic concern, one where the lack of regulation of banks has important implications for employment, leverage, crises, price levels, etc. I hope we see movement when it comes to fraud as well.