(Please welcome William Black, author of The Best Way To Rob A Bank Is to Own One in the comments — jh)
William Black is not the guy you want to talk with for an hour and a half on a Friday night if you want to sleep well knowing all is right with the world. He’s white-collar criminologist and former financial regulator who teaches at the University of Missouri-Kansas City School of Law, and he’s written many of the canonical pieces on the role of mortgage fraud in the financial crisis. For starters, check out his Two Documents Everyone Should Read To Better Understand the Crisis.
I asked Bill here tonight for a couple of reasons. One, Rob Johnson told me to, and wise people always do what Rob says. Two, Geithner will be testifying before House Financial Services on re-regulation on Thursday. But mostly because, as we’ve been saying for a while, continuing to shovel more money into a broken financial system without regulating it first is a dangerous proposition. Other countries are extremely concerned about putting up more funds until the US fixes its banking system, and will certainly be aggressively pushing both Geithner and Obama about re-regulation at the upcoming G20.
Yesterday, I sent Bill a New York Times article on the administration’s intention to increase oversight of executive pay. I was interested to know what he thought, because perverse incentives in the compensation structure were a huge factor not only in the mortgage bubble but in the larger financial crisis we find ourselves in the midst of. This was his response:
The specifics matter enormously, so discussing this on the basis of a sketchy newspaper article has to be approached with caution.
I have intense concerns with the Fed as regulator.
Regulators are deeply inferior within the institution. "Real men" at the Fed are economists and they do monetary policy. They dine with top bankers on fine china. They play squash on the Fed squash courts. Fed regulators have no power within the institution and the institution is inherently hostile to vigorous regulatory action against the big banks.
Economists in general, and Fed economists in particular, are a major cause of the financial crisis. Their philosophies and theories shaped deregulation and desupervision. They promised that "private market discipline" and "efficient markets" would produce growth and safety. The Fed’s economists’ research during the run-up to the crisis (A) ignored everything important, e.g., it denied the existence of a bubble, (B) praised the worst possible practices, e.g., Greenspan’s praise of subprime lending and financial derivatives and his article lauding "equity stripping", (C) was full of undeserved self-praise, e.g., re "the Great moderation" that Fed policies (and neo-classical economics) had purportedly created, and (D) proved no practical assistance to Fed examiners/supervisors to deal with the crisis. Its mono-methodological reliance on econometrics produced the inevitable results — econometric studies, during the inflation phase of an epidemic of accounting control fraud must find that the worst possible practices (e.g., (A) exploding rate ARMs originated with no verification, no meaningful underwriting, no internal controls, and perverse executive compensation systems, (B) sold to others for pooling into CDOs, (C) extreme leverage, and (D) extreme growth are positively correlated with the increased "profit" and share prices. It is only after the bubble collapses that the true sign of the relationship will reverse. Economic theory teaches that regulation must fail. It creates a self-fulfilling prophecy.
The Fed’s regional offices (the FRBs) have strong conflicts due to the pervasive role of the industry in running the FRBs. Many of the FRB presidents were picked because of their ideological opposition to regulation.
The FRB has consistently failed as a regulator.
The FRB continues to fail to understand and respond effectively to the crisis two years after the nonprime market collapsed.
The FRB has been particularly weak in dealing with systemic risk. It prates endlessly about it and its economists are almost obsessed with studying esoteric potential systemic risks, but there’s a huge kicker — they were utterly clueless to the enormous systemic risk crushing the global economy. They weren’t simply useless; their policies were critical to the creation of the criminogenic environment that produced the systemic crisis.
financial derivatives clearininghouses are a good idea if you’re going to allow derivatives, but they would not have prevented or significantly reduced the current crisis. They are deliberately being oversold as making financial derivatives safe. Many financial derivatives, and a large number of purposes for which derivatives are actually used (as opposed to the hypothetical usages economists employed to support the desirability of financial derivatives), should be prohibited. I see no willingness of the administration to enact such prohibitions. Everything seems to be designed to recreate the failed financial derivatives markets.
The truly obscene part of the proposal (if the article is accurate) is the desire to recreate nonprime financial derivatives (and not even to regulate them more in the near term lest we discourage such derivatives). We need to make the next point in the starkest terms: the nonprime secondary market existed for only roughly eight years. The norm is that no such market exists. The norm was the norm because nonprime loans do not even come close to meeting the minimum requisites for a prudent MBS. Among the very last things in the world we should be doing is trying to recreate the nonprime secondary market. It is inherently unsafe and wealth-destroying.
As to executive compensation:
The right way to do executive compensation is (as the proposal awill apparently require) to require that best practices be followed for compensation (rather than to set dollar limits). No performance compensation should be paid except that based on long-term profitable performance.
Contrast this NYT article with the one about Geithner’s new asset disposal system. It too is obscenely bad. It suggests that the administration is eager not to apply executive compensation limits to purchasers of assets, particularly hedge funds. This seems inconsistent with this article, which implies the limits should apply to hedge funds.
The idea (endorsed by Geithner in prior proposals) that executive compensation should be increased if the shareholders approve it is very dangerous. It is part of the same efficient markets ideology that produced the global crisis. It is easy for the worst CEOs to get shareholder approval of the most destructive practices.
It is vital to deal with compensation in every publicly traded corporation. Modern executive compensation programs (along with the compensation mechanism for outside professionals: appraiser, auditors, and rating agencies) have created the perverse incentives that produced the global crisis. Even Michael Jensen, the father of performance pay, has concluded that it has become a Frankenstein monster.
As a side note, he also says that "The key, unreported, news from Geithner re: compensation is that. by joining this program, hedge funds, etc., can also secure immunity from future statutory reforms dealing with comp. and governance."
Well, that ought to give you plenty of fodder for questions.
Other articles by William Black: