If Obama Thinks the Response to the S&L Debacle Failed...

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If Obama Thinks the Response to the S&L Debacle Failed, Why Is He Adopting It?
William Black
Monday November 1, 2010

President Obama told Jon Stewart that the proof of the administration’s skills in responding to the crisis was holding the costs to the public to below one percent of GDP compared to the 2.5% of GDP cost to the public of dealing with the S&L debacle, which he correctly emphasized was a far smaller crisis than the one he inherited. Our GDP is roughly twice today what it was in 1993, so Obama’s claim is that the respective public costs to resolve the crises were (roughly): $150 billion (S&Ls) v. less than $150 billion (current crisis).

The Bush and Obama administrations have consistently refused to apply any of the successful lessons learned in responding to the S&L debacle – even though the response has been praised by experts in public administration and Treasury Secretaries from both parties for decades. Both administrations refused to even discuss the current crisis with the senior S&L regulators that contained that crisis before it caused a recession. Obama thinks his response to the crisis was brilliant because it did not follow the S&L regulators’ much more expensive strategy. Obama cited the comparison to the S&L debacle as the most telling demonstration he could make of why his administration deserves praise.

It’s a Miracle!

What Obama does not understand is that his “cover up” strategy and his claims of brilliant success are direct steals from Dick Pratt’s playbook. Dick Pratt was the top S&L regulator in 1981-83. When he left (to join Merrill Lynch) he claimed that he had contained the crisis through innovative resolution strategies that slashed the average historic costs (from over 20% to less than 5% of the S&L’s assets). Pratt’s “resolutions” were accounting scams that did not resolve anything. They did, however, transmute real insolvencies into fake assets and create guaranteed (fictional) accounting income. The scam was so crazy that the more insolvent the S&L acquired, the greater the fictional income that the deal created. Pratt did so many of these scam resolutions that they created so much fictional income and capital that the industry reported it had suddenly returned to profitability.

The reality was quite different. There was no miracle, only the cumulative results of multiple accounting scams. Pratt’s resolutions did not resolve failed S&Ls. They were still insolvent.

Regulatory Accounting Scams Create the Ideal Environment for Fraud

Pratt’s cover up strategy is what made the S&L debacle so expensive to resolve. Indeed, it would have caused an economic catastrophe if his successor had not ended the cover up and reregulated. Covering up a banking crisis always has a seductive appeal to politicians. There are always senior officials, close to the bankers, who counsel that covering up the bank losses and providing hidden public subsidies to the failed banks is a “silver bullet” solution that can resolve a banking crisis virtually without cost to the public. Pratt’s cover up cost the public so much because it created a criminogenic environment that caused the second (“control fraud”) phase of the debacle. Interest rate increases ultimately cost the public $25 billion. The second phase of the S&;L debacle cost the public an additional $125 billion (five times the cost of the interest rate phase). If Obama understood any aspect of the S&L debacle accurately he would know that his administration’s response to the current crisis (1) has not resolved the crisis, and (2) reprises the disastrous (and dishonest) regulatory strategy that caused the initial S&L crisis to grow massively and become the debacle.

President Reagan appointed Richard (Dick) Pratt, an academic finance expert, as Chairman of the Federal Home Loan Bank Board (Bank Board) in 1981. Pratt led the response to the first (interest rate risk) phase of the S&L crisis. He gimmicked the accounting rules, cut the number of examiners, and desupervised the industry. This allowed S&Ls to hide real losses and create fictional income. He championed the entry of “entrepreneurs,” primarily real estate developers with intense conflicts of interest.

The administration, Congress, and the media treated these Pratt’s fictional “resolutions” and claims of brilliance as real. By allowing S&Ls to hide real losses and create fictional income, deregulating, desupervising, closing none of the control frauds (which were growing in assets at an annual rate of 50%), and making virtually no criminal referrals (which mean there were no prosecutions), Pratt (and several states that won the “competition in laxity”) created an intensely criminogenic environment that led to the entry of hundreds of control frauds into the S&L industry. As the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) emphasized in its 1993 report, at the “typical large failure” “fraud was invariably present.” The NCFIRRE report also explained how deregulation, desupervision, the lack of prosecutions, the accounting scams that hid real losses and created fictional income, the manipulation of professional compensation for appraisers and outside auditors by the fraudulent S&L executives to produce a “Gresham’s” dynamic in which bad ethics drove good ethics out of the professions, and the perverse incentives caused by modern executive compensation allowed CEOs to create guaranteed, record (albeit fictional) profits and become wealthy by looting “their” S&Ls. (George Akerlof and Paul Romer concurred in their 1993 article. Looting: the Economic Underworld of Bankruptcy for Profit.) Martin Mayer aptly concluded, if one had to pick a single person most responsible for the S&L crisis becoming a debacle it would be Dick Pratt. Indeed, but for Pratt’s successor, Edwin (Ed) Gray’s reregulation of the industry, Pratt’s policies would have caused a Great Recession.

For reasons that only Summers, Geithner, and Obama can know, they chose to adopt Pratt’s disastrous and dishonest anti-regulatory strategy and parrot his dishonest claims of brilliance and success. Congress passed the Prompt Corrective Action (PCA) law in 1991 for the express purpose of outlawing any repeat of Pratt’s refusal to close insolvent banks. Congress, at the behest of the Chamber of Commerce, the American Bankers Association (ABA), and Chairman Bernanke, successfully (and shamefully) extorted the Financial Accounting Standards Board to change the accounting rules so that banks no longer had to recognize losses on their toxic mortgage paper appropriately until they sold the assets. Covering up the losses had three real (carefully unstated) purposes: (1) permitting evasions of the PCA, (2) allowing the banks to remove themselves from the strictures of the TARP program even if they are, in reality, insolvent, and (3) allowing insolvent and impaired banks to pay their senior executives huge bonuses on the basis of the (fictional) income that results when a bank does not recognize its losses. Each of these purposes is unprincipled and indefensible, but taken together they are also dangerous. The stated purpose – that the losses were temporary because of unusual liquidity constraints in the secondary markets) was never credible given the exceptional incidence of fraud by nonprime mortgage lenders and CDO sellers. The secondary market in nonprime paper collapsed three-and-one-half years ago. If we are fortunate, it will never return from the dead.

The administration and its odd bedfellows, the Chamber of Commerce and the ABA, have maximized the perverse incentives that will drive future fraud epidemics, bubbles, and severe recessions. The administration’s embrace of Pratt’s cover up strategy, its breathless self-praise for its own brilliance in resolving the crisis at virtually no cost, its perversion of the accounting rules and the PCA to bail out and make even wealthier the senior officers’ whose frauds drove the current crisis, and both administrations’ failure to prosecute the elite frauds have enraged a broad spectrum of Americans. The Chamber of Commerce and the ABA have rewarded Obama’s tacit support for their dearest dreams with a vicious assault on him. This means that the administration’s banking policies have attained the terrible trifecta: terrible economics, terrible ethics, and terrible politics.
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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.