EconoMonitor

Great Leap Forward

Why is the Obama Administration Incentivizing Fraud?

Economists are often preoccupied with incentives. The Global Financial Crisis and the ensuing policy response can be analyzed from the perspective of the incentives that produced behavior to bring on the crisis, as well as the incentives created by the bail-out that rescued the miscreants.

Where are we today?

Stoking the fires that created the GFC, of course. We’ve set up the perfect storm of what my colleague Bill Black calls a criminogenic environment—that is, one that promotes, rewards, and sustains fraud. While President Obama’s administration certainly cannot be blamed for all the fraud that led up to the GFC, the policy response on his watch has rewarded the fraudsters.

Many years ago on my first visit to Italy two Italian friends told me of their experience in London. They had stopped on a street and were engaged in a deep and long-winded discussion. After a spell they paused the argument long enough to notice they were standing in the rain near a bus stop. Queued behind them, also in the rain, was a line of polite British folk waiting for the bus. None would dare to move around the Italians to get under the shelter. The Italians, not known for waiting on line in an orderly fashion, recounted this as a hilarious example of British irrationality. Sure enough, when I was leaving the Rome airport some months later, the gate attendants had to halt the boarding process three times as they pleaded with passengers to back off the gate sufficiently to allow boarding to proceed. Passengers had pressed so tightly against the ropes that no one could pass through, and a great roar of laughter emerged from the crowd each time the attendants harangued them to please line up.

My point here is not to criticize the Italian attitude toward queuing (which has changed somewhat over the past three decades) but rather to highlight the role played by custom. The airlines had their rules about orderly boarding, but without willing cooperation the attendants had little hope of enforcing them.

The simplistic economic approach to producing desired behavior is to get the incentives right: rewards for desirable behavior and punishment for bad. The market is supposed to be the best arbitrator. However, more rigorous economic theory and evidence demonstrate convincingly that the market doesn’t operate that way; and psychologists have long known that human behavior is far more complicated than supposed in simple stimulus-response models (something now being recognized by behavioral economics). In truth, even human economic behavior is exceedingly complex, relying on habit, custom, and heuristic methods of problem solving (such as rules of thumb, intuition, educated guesses, myths, and religious beliefs).

Incentives, themselves, are complex and diverse. If you think about the range of incentives facing a top CEO at a big Wall Street bank, it becomes obvious that it is exceedingly unlikely that they necessarily guide the CEO to behave in a manner consistent with the “public purpose” which is also a complex of sometimes complementary but also conflicting sets of objectives. And we see top officials in corporations and government doing things that are awfully hard to explain on the basis of monetary compensation. (Hint: think of poor Bob Rubin—after the hundreds of millions of dollars he sucked out of Goldman and Citi, all he really wanted was some cuddling from young, attractive women: http://www.huffingtonpost.com/iris-mack/bob-rubin-just-wants-to-b_b_557621.html?page=1; we won’t even speculate on the incentives that drove Bill Clinton’s fascination with unusual uses for cigars. OK, cheap shots but you get the idea. Money is one driver of behavior among many.)

In the run-up to the Global Financial Crisis, there was much talk of aligning the interests of the top management of these firms with that of shareholders. This could be consistent with the public purpose, although that is not at all guaranteed. (Before some readers object that the corporation’s only interest should be to maximize shareholder wealth, let me point out that from the beginning, the publicly-provided advantages of incorporation were supposed to be in return for demonstrated public benefits generated by the corporation.) This was part of the reason that top management and other employees were increasingly rewarded with stock options, supposedly linking their fate with that of the stockholders.

We now know beyond any doubt that the result was precisely the opposite: top management ran the biggest banks as control frauds, pumping up stocks through accounting fraud–to hide the fact that trades and other deals guaranteed longer term losses–as they used insider information to bet against their own firms. They sullied the reputation of their firms by pushing trashy assets onto their customers even as they bet on failure. They paid themselves outsized bonuses even as the share prices of their own firms crashed. They walked away from the carcasses of the firms they left behind, with golden parachutes to reward themselves for failure.

So while I am skeptical of a simplistic incentive argument, it does seem to fit reasonably well with the case of the transformation by top management of the biggest financial institutions into control frauds: all the incentives were “aligned” to allow the CEOs to loot them. (See Bill Black’s work at NEP for details: http://neweconomicperspectives.org/)

I’ve already reported the results of studies of the psychological profile of Wall Street’s finest, which find that about 10% of them are psychopaths (ten times the rate of the population at large). There has been some dispute over the findings but really it does not matter whether the actual number is somewhat less (or more). The point is that Wall Street is set up such that psychopaths rule. As Bill Black explains, Gresham’s Law dynamics ensure that the control fraud model dominates. Fraud is always the most profitable strategy available. If the most profitable management and traders are the most highly rewarded, then the psychopaths who are willing to engage in fraud will receive the highest rewards. To remain employed, all others must get on line. We are then off and running to pump and dump, insider trading, rigging municipal bond market bids and LIBOR, and Ponzi schemes.

We’ve got Goldman Sachs and John Paulson as well as JP Morgan and Magnetar creating trash for their customers while betting against it; we’ve got insiders and politicians (Paul Ryan? Nancy Pelosi?) trading on information before it becomes public; we’ve got John Corzine’s MF Global “misplacing” a billion dollars of customer money; and we’ve got London Whales running amuck with investor funds; and on and on and on. Every day another new scandal rises from the muck.

If you were going to run a pyramid scheme, who would you choose as your banker to hold the money you stole from “investors”? You’d want one of the big banks, with a reputation to exploit by an ethically challenged top management. And you’d want one willing to overlook an obvious Ponzi scam as it transferred money from investors to the pyramid. You’d choose Goldman Sachs, of course! That’s exactly what Samuel Israel III did when he needed a “bagman” to hold the money he stole through Bayou Group, a purported hedge fund he founded. As Goldman did the clearing for Bayou it had open access to its books—which clearly indicated a Ponzi scheme (Bayou made no investments). After Goldman lost an arbitration case and two appeals, it was forced to hand over $20 million to investors. Now Goldman claims it is a “creditor” of Bayou and has tied-up the $20 million in a case that most observers say is specious. http://www.nytimes.com/2012/08/19/business/goldman-sachs-still-playing-in-bayous-mud-fair-game.html?pagewanted=1&ref=business

After helping to perpetrate the Ponzi scheme, Goldman has tried to recast its role as hapless dupe. It’s as if the bagman holding the loot for a robber could sue to keep it on the argument that he was the thief’s creditor.

Economists worry a lot about two kinds of errant incentive structures: adverse incentive and adverse selection. Wall Street has both kinds, in spades. Fraud is the surest bet you can make (incentive). So Wall Street selects for those individuals most willing and able to steal (selection).

There is of course one catch: if you want to set up the perfect criminogenic environment: crime must not be punished. If you make crime pay, you’ve done the deed.

As I’ve argued, fraud was and still is absolutely rampant throughout every link in the home finance food chain. It is hard to point your finger at the worst of the lot but I think it is probably MERS. I’ve already written a lot on this blog on this topic, so will just provide a brief reminder. The biggest banksters created MERS to subvert half a millennium of Western property law. No longer would public records be kept so that a homeowner would know who held the mortgage note. Instead, the banksters evaded recording fees by electronically registering mortgages, which were then bought and sold many times before finally getting securitized and sold-on to investors. MERS had only a handful of employees and never bothered to check the accuracy of any of the records. If an employee at one of the banks made a typo when entering an address, the banksters would foreclose and steal the property of the unlucky neighbor whose address had been entered.

And MERS would not allow any homeowner know who held his mortgage—something that is important, for example, if the homeowner wanted a modification. Instead, MERS asserted that the homeowner (as well as the courts) only needs to know who services the mortgage (that is, who should receive the checks). Obviously that is pure nonsense—any bank could come along and tell MERS that it wanted you to send checks to service a nonexistent mortgage. And then, of course, even if you sent the checks, they’d lose them and foreclose so they could steal your house. That is precisely why property law developed, to prevent theft of property. MERS is a conduit for fraud—whether by design or default, it was the perfect vehicle for property theft.

For a long time, the courts just allowed such theft without questioning the thieves. After all, MERS was formed to help speed the upward redistribution of all wealth to the top 1%. And that required that we throw out property law. The orginate-to-distribute securitization model combined with destruction of property records ensured that property wealth would flow to the top, in the greatest redistribution of wealth the world has ever seen.

A little monkey wrench might have been thrown into the redistribution machine, however. Washington State’s Supreme Court has ruled that MERS has no standing in foreclosure cases. “Simply put, if MERS does not hold the note, it is not a lawful beneficiary,” stated the Court’s opinion. I’m not going to go through the details—you can find stories here: http://www.oregonlive.com/business/index.ssf/2012/08/washingtons_highest_court_rule.html

and here: http://livinglies.wordpress.com/2012/08/16/mers-goes-down-in-flames-in-wa-supreme-court-decision/

(This is just the latest in a long line of such rulings, but it is important because a Federal court had referred the case—hence—the ruling’s effects could well spread outside Washington state.)

According to the Court, this casts doubt on all nonjudicial foreclosures—which is the type the banksters prefer. In truth, in most cases no one has the note—not MERS, not the servicer, not the trustee for the securities, not the bankster that claims to be the creditor—because the notes were lost or destroyed, or never properly executed in the first place. (That is why the banksters were using Robo-signers to manufacture fake documents for their judicial foreclosure cases.) As I’ve been saying for several years now, we must presume most foreclosures are theft, plain and simple.

Those who had their homes stolen by banksters now have another ruling in their favor to sue for damages and attorney’s fees. We’re talking very big money here. And even if there is no wave of lawsuits, if banks are stymied in their attempt to do nonjudicial foreclosures, it’s going to get more difficult to continue to steal homes under the noses of increasingly aware judges.

Here’s yet another scandal waiting to be revealed. When the banks securitize mortgages they often take advantage of tax savings by creating a REMIC. The wrinkle is that they only have 90 days after the creation of the trust to move the mortgages into it. They often missed the deadline but took the tax deduction anyway. According to a new study, they might now be liable for a trillion dollars in back taxes. In anticipation of IRS audits, they’ve started putting aside rainy day funds of about $24 billion so far. According the study, it won’t be enough. Read it here: http://www.oppenheimlaw.com/law-review-articles/

Of course, it is not just the hit to the banks’ bottom line, but just the sheer guile displayed by what Oppenheim calls “the dirty dozen” banks perpetrating this scam against the IRS. (As you’d guess, the top four dirtiest banks are JP Morgan, Wells Fargo, BofA, and Citi.)

But you cannot stop fraud through nickel-and-dime judgments against banksters. They’ll happily settle, then ramp up yet another fraud to make sure customers or investors pay the fees.

Need I remind you that the Obama Administration still has not begun a high profile criminal investigation of the top fraudsters? A few low level petty crooks have been prosecuted, and banks have been hit with petty fines. Banksters eat this stuff for breakfast. So far, the Obama Administration has signaled nothing but green lights for speeding fraudsters. Indeed, it has helped to funnel trillions of dollars of bailouts to keep the frauds going.

The incentives are aligned. The fraud will not stop. It does not even need to slow down for a speed bump.

How do you stop it? You target the top 12 dirtiest banks, and choose 10 individuals at each to investigate. It’s easy to know which banks are dirtiest (just take the 12 largest—remember, fraud pays) and which individuals are most culpable (choose ten past and current top management and traders at each institution who reaped the greatest total compensation—remember, fraud pays well). Issue a ceases-and-desist order against all 12 on the day the investigation is announced: no trades, no deals, no sales, no purchases—just routine business operations are permitted. Accumulate enough evidence to bring criminal indictments.

Don’t worry, you’ll find plenty of evidence of fraud since control frauds necessarily engage in fraud. Duh!

Seek Bernie Madoff-style prison terms (long ones). Contemplate RICO Act prosecutions for racketeering by these individuals to enhance penalties and streamline the prosecution. Under RICO you also get to seize assets, which is a bit of poetic justice against banksters that have been seizing homes. Lest you think it is a bit of a stretch to claim racketeering, RICO can be invoked for crimes including: bribery, counterfeiting, theft, embezzlement, fraud, racketeering, gambling, money laundering, embezzling union funds, bankruptcy fraud, securities fraud, and money laundering. See http://www.law.cornell.edu/uscode/text/18/1961.

That reads like the business model for a Wall Street financial institution.

A hundred and twenty investigations would take a real bite outta crime, as McGruff the Crime Dog says. It would send a signal to Wall Street that crime might not pay. Creating some uncertainty would make fraud seem like something less than a sure bet. Start with Bob Rubin and Hank Paulson and see where the roads lead. (Many lead to the NYFed, which could get quite interesting! What did Timmy know and when did he know it? No doubt his knowledge goes way beyond fixing LIBOR rates.)

That gets us back to incentives. Incentives, alone, will not be enough. Nor is financial reform that restores close regulation and supervision of banks. What is necessary is to rebuild the proper culture in which financial institutions actually operate in the public interest. In turn, they must want to comply with rules, regulations, and standards of “good” behavior.

This ain’t easy. It took a Great Depression, nationalization of the financial system, separation of commercial and investment banking, failure of half the banks, (as well as a World War—which ramped up the public sector and favored “industry” over “finance”), and creation of the Pecora commission last time around. Arguably, the problem of control fraud runs much deeper today than it did in 1930.

And our response this time has been precisely the opposite. Instead of going after the fraud, we created the fraud equivalent of a nuclear meltdown–a self-feeding criminogenic environment.

6 Responses to “Why is the Obama Administration Incentivizing Fraud?”

James BAugust 20th, 2012 at 3:33 am

All very logical. Except, the Justice Dept is outgunned. The corps wrote the rules and made them vague enough to make prosecution nigh impossible. The defendants will show up with 10x the lawyers, smarter, and some of them former JD lawyers. We have to fix some other things before we successfully prosecute. Also, going after the financial institutions is political suicide.

Doug SAugust 20th, 2012 at 2:03 pm

So, if you can't prosecute the injustice against the nation and it is obvious that legislation hasn't worked, then the eventual outcome will be a continued spiraling down the drain and an economic collapse. What can't continue, won't. The engine of economic prosperity is the consumer and when the consumer is stripped of the majority of their wealth, then the economic engine sputters and dies. This will all come to a halt when the purchasing power dies and it will as it is mathematically impossible to get blood from a turnip. Or much consumption from overly indebted serfs.

barfAugust 21st, 2012 at 1:08 am

the problem is "the War on Terror" actually. This thing has brought the fraud out into the open…and it's been far from a disenfectant i might add. The mathematical reality however simply overwhelms our hapless fraudsters. the idea that they can keep building better mousetraps forever is simply specious. we're talking the biggest Mafia of them all: the Fed's. They win everytime…plain and simple. Soon "cutting a deal" won't work either. Pay must either rise…and rise substantially or the Fed must "inflate away." The sovereign realities are simply too overwhelming. The State's with all the money have only 1 percent of the population! What about the other 47.5 States in the Union?

RayPhenicieAugust 22nd, 2012 at 1:18 am

The articles by Oppenheim "DECONSTRUCTING THE BLACK MAGIC OF SECURITIZED TRUSTS" and John Atlas "The Conservative Origins of the Sub-Prime Mortgage Crisis" are really excellent in fleshing out an understanding of all of the shenanigans that have been going on in the muckety, muck circles of high finance and the Beltway sewer pit that ends in the Potomac tidewaters.

BonnieGoodellAugust 22nd, 2012 at 2:57 am

I've been thinking about this for awhile. The only thing I can imagine working is a massive class action RICOH civil suit for damages, sponsored on behalf of the 99% by OWS, with some of the foreclosed acting to start it.

1. When the pension funds and hedge funds tried to sue for damages, the banks defense was that those funds were managed by "experienced experts." Who isn't experienced experts? The people at the other end of the deal. The mortgage applicants. The banks' defense makes the case against them.

2. No way will the current or any alternative justice department will go after anyone. They are way too compromised. But, if the bridge falls down because of shoddy construction, who do the victims go after for damages? The contractor who built the "essential infrastructure" and the government regulators who failed to competently oversee the construction and maintenance. Including the Fed. They are always reminding us of how the global financial system is essential infrastructure.

3. The lawsuit should operate in the same manner as the feds use in going after other fraud. Sue everyone and then invite in whistle blowers to make deals. Heaven knows there have been myriad whistle blowers begging to participate. Except these whistle blowers can blow about the regulators and more regulators can be brought and see where that goes.

4. If successful such a lawsuit would bring down the whole financial system. But I agree with Doug and Barf (and Nouriel Roubini for that matter). It is all going to unwind anyway, and the little guys are going to be left holding the bag while the bankers retreat to their fortresses, still blaming the poor no doubt. This way, at least there is a shot at some overdue reparations in order to give a bunch of little guys a grubstake wrung from the moneygrubbers, to fund some bottom-up innovation, by people who would never have been able to get any otherwise.

Dump this applecart right on over.

Mark AtkinsApril 30th, 2013 at 4:10 am

I honestly don't know anymore. I'm as puzzled as the next guy as to why officials seem to be rewarding those who can successfully pull of crimes such as fraud.