GAO: Cost of financial meltdown: $22 trillion

And, as Elizabeth Warren pointed out, nobody has gone to jail for it. Because it was caused by stupidity and greed.  I mean, it was the business cycle. No, wait, it was Fannie Mae and Freddie Mac! Yeah, that's the ticket....

Financial Crisis Cost Tops $22 Trillion, GAO Says

By Eleazar David Melendez

February 14, 2013 | Huffington Post

URL: http://huff.to/WsgcIk

Laffer up to his old tricks again

As if we needed more proof that Laffer sucks at drawing curves...

Popular views on the effectiveness of fiscal stimulus v. austerity measures will likely determine the outcome in November's elections.  That is why GOP hack economist Art Laffer is deliberately muddying the waters with his latest WSJ op-ed.  It's not surprising that this facile analysis came from the same guy whose claim to fame is scribbling an arc on a napkin for Dick Cheney.

Anyway, his only real data here is the relation between spending from 2007-09 and rate of GDP growth over the same period.  The rest is a lot of noise you'd see in, say, one of Thomas Sowell's lazy, phoned-in editorials.

This data tells us there is a weak negative correlation, -0.23, between governments' spending and their rates of GDP growth.  That is, as one tended to decrease, the other tended to increase, and vice-versa.  However, any statistician will tell you can't take two variables and draw conclusions about causality, especially with such a low correlation coefficient.  

Indeed there are some big, unexplained outliers like Hungary, that increased spending only 0.7 percent but saw its rate of GDP growth decline by 9.9 percent.  That's a greater decline than in the U.S., which increased spending 7.3 percent.  Or take Israel, which cut spending 0.9 percent but still saw its rate of GDP growth decline 6.2 percent.  Or Switzerland, which also cut spending 0.2 percent and still lost 7.1 percent of GDP growth rate.  

Laffer doesn't even try to explain these outliers because he can't; or if he did try, he'd have to admit that many more variables played a role, for instance (just thinking logically here), the percent of each country's pre-crisis GDP represented by banks and financial services.  

Next, all these economies were going to shrink with or without stimulus spending.  It was a question of how much.  Furthermore, it is entirely reasonable to suppose that economies that were going to suffer the worst from a financial crisis, for example, those more dependent on the financial sector, knew they had to spend more on stimulus.  

Finally, there is a timing problem here:  three years is a long time and some economies tanked very quickly, whereas stimulus wasn't passed as a reaction until later.  For instance, the U.S. recession started in December 2007 but Obama's ARRA (stimulus bill) wasn't passed until February 2009.  Laffer's GDP analysis stops in 2009... effectively blocking out the effect of Obama's stimulus bill.  Official data from the BEA shows us that U.S. GDP growth was negative in 2009 but then roared back 3.8 percent in 2010 and 4 percent in 2011 after the stimulus bill (adjusted for current dollars).  

The truth is, we will never know how much worse it would have been without stimulus and automatic stabilizers to workers' income.  We certainly would not want to find out firsthand.

The Real 'Stimulus' Record

By Arthur Laffer

August 5, 2012 | Wall Street Journal

URL:  http://online.wsj.com/article/SB10000872396390444873204577537244225685010.html?mod=WSJ_Opinion_LEADTop

Yves Smith: PBS whitewashed crisis, bailouts

If this is how the "liberal media" (PBS) takes on America's corrupt bankster-regulator nexus, then the conservative media can relax.  The fix is already in.  History has been re-written by the victors.

Frontline's Astonishing Whitewash of the Crisis

By Yves Smith

April 27, 2012 | Naked Capitalism

URL:  http://www.nakedcapitalism.com/2012/04/frontlines-astonishing-whitewash-of-the-crisis.html

Obama too lazy to fake keeping his SOTU promise

Is this how a crypto-Marxist behaves?  Obama can't even be bothered to fake a half-hearted investigation into banks' criminal behavior!

Face it: when it comes to placing Obama on the political spectrum, the Left is in denial, and the Right is in Fantasy Land.

Yet Another Obama Big Lie: Mortgage Fraud Investigation Not Even Staffed

By Yves Smith

April 18, 2012 | Naked Capitalism

URL:  http://www.nakedcapitalism.com/2012/04/yet-another-obama-big-lie-mortgage-fraud-investigation-not-even-staffed.html

German linguists can't do without 's**tstorm'

You're welcome, Germany.

But German speakers are not alone; even we English speakers sometimes find that "shitstorm" is the only word that will do.

I humbly submit this slight variant to the lexicon: "shitastrophe."

UPDATE (07.09.2013): Here's the latest on shitty German lexicography: "The German Dictionary Has A New Fun Word, Thanks To The Internet And The Eurozone Crisis."  Apparently shitstorm (Scheißesturm?) is one of Merkel's favorite words.

'S**tstorm' Chosen By German Linguists As Top New Addition To Language

By David Moye

February 14, 2012 | Huffington Post

URL: http://www.huffingtonpost.com/2012/02/14/shitstorm-top-new-german-word_n_1274503.html

Stiglitz: Austerity is a 'suicide pact'

Stiglitz says European austerity plans are a 'suicide pact'

By Malcolm Moore

January 17, 2012 | The Telegraph

Imposing austerity measures as countries slow towards recession is a fundamentally flawed response, said Mr Stiglitz, who won the Nobel prize in 2001 for his work on how markets work inefficiently.

"The answer, even though they see over and over again that austerity leads to collapse of the economy, the answer over and over [from politicians] is more austerity," said Mr Stiglitz to the Asian Financial Forum, a gathering of over 2,000 finance professionals, businessmen and government officials in Hong Kong.

"It reminds me of medieval medicine," he said. "It is like blood-letting, where you took blood out of a patient because the theory was that there were bad humours.

"And very often, when you took the blood out, the patient got sicker. The response then was more blood-letting until the patient very nearly died. What is happening in Europe is a mutual suicide pact," he said.

Keynesian economics, which require governments to help sustain demand, suggests that austerity measures should be imposed when an economy is booming, not waning.

Mr Stiglitz pointed out that 700,000 public sector jobs had been cut in the United States in the past four years, removing demand from the system as unemployment spikes. The UK is set to lose a similar number by 2017.

Instead, Mr Stiglitz argued the best economic medicine is infrastructure spending, especially on transport and energy projects. He pointed to China as one country that had successfully combatted financial crises with stimulus packages.

On Monday, George Osborne had told the same forum that the UK's fiscal austerity measures, which have been in place for a year and under which the economy has begun to tip into recession, were the only way to convince the market of the UK's economic credibility.

"When you have a high budget deficit, if you do not have a [disciplined fiscal] plan then you will not have sustainable growth because investors will be worried about investing in your country," the Chancellor said.

However Mr Stiglitz argued that austerity in the UK and elsewhere would not boost confidence. "There will not be a restoration of confidence as long as economies keep falling, and that will continue until [politicians] change economic course. And I do not think that is likely," he said.

Mr Stiglitz said economists are now not debating if the Euro will break up, but how and when it will happen.

"Among economists the discussion is about the best way to end the euro. It could be civilian upset that does it. Youth unemployment in Spain has been over 40pc since 2008. How much longer will they tolerate that? The policies of the new government are for more of the same medicine, except worse.

"The other way it may end is when the European Central Bank refuses to be the lender of last resort for some countries, precipitating a crisis. We can be sure that markets will be highly volatile and the end of the Euro will be a very severe disruption to the global economy," he said.

However, he compared the strictures of the single currency to the gold standard, and noted that countries which had abandoned the gold standard early had recovered more quickly.

"When the Euro was founded, most economists were skeptical," he said, noting that the single currency was a political project that had not satisfied the optimum conditions for a currency bloc. "They hoped they would be able to finish the project over time, but the politics was not strong enough," he said.

Mr Stiglitz also said that while he was critical of the ratings agencies, a decision to downgrade the European Financial Stability Fund (EFSF) on Monday was reasonable. "The EFSF was trying to leverage something out of nothing, and that was never going to work, and they were just saying that it wasn't going to work," he said.

Krugman: Romantic dreamers posing as 'technocrat' economists

Boring Cruel Romantics

By Paul Krugman

November 20, 2011 | New York Times

There's a word I keep hearing lately: "technocrat." Sometimes it's used as a term of scorn — the creators of the euro, we're told, were technocrats who failed to take human and cultural factors into account. Sometimes it's a term of praise: the newly installed prime ministers of Greece and Italy are described as technocrats who will rise above politics and do what needs to be done.

I call foul. I know from technocrats; sometimes I even play one myself. And these people — the people who bullied Europe into adopting a common currency, the people who are bullying both Europe and the United States into austerity — aren't technocrats. They are, instead, deeply impractical romantics.

They are, to be sure, a peculiarly boring breed of romantic, speaking in turgid prose rather than poetry. And the things they demand on behalf of their romantic visions are often cruel, involving huge sacrifices from ordinary workers and families. But the fact remains that those visions are driven by dreams about the way things should be rather than by a cool assessment of the way things really are.

And to save the world economy we must topple these dangerous romantics from their pedestals.

Let's start with the creation of the euro. If you think that this was a project driven by careful calculation of costs and benefits, you have been misinformed.

The truth is that Europe's march toward a common currency was, from the beginning, a dubious project on any objective economic analysis. The continent's economies were too disparate to function smoothly with one-size-fits-all monetary policy, too likely to experience "asymmetric shocks" in which some countries slumped while others boomed. And unlike U.S. states, European countries weren't part of a single nation with a unified budget and a labor market tied together by a common language.

So why did those "technocrats" push so hard for the euro, disregarding many warnings from economists? Partly it was the dream of European unification, which the Continent's elite found so alluring that its members waved away practical objections. And partly it was a leap of economic faith, the hope — driven by the will to believe, despite vast evidence to the contrary — that everything would work out as long as nations practiced the Victorian virtues of price stability and fiscal prudence.

Sad to say, things did not work out as promised. But rather than adjusting to reality, those supposed technocrats just doubled down — insisting, for example, that Greece could avoid default through savage austerity, when anyone who actually did the math knew better.

Let me single out in particular the European Central Bank (E.C.B.), which is supposed to be the ultimate technocratic institution, and which has been especially notable for taking refuge in fantasy as things go wrong. Last year, for example, the bank affirmed its belief in the confidence fairy — that is, the claim that budget cuts in a depressed economy will actually promote expansion, by raising business and consumer confidence. Strange to say, that hasn't happened anywhere.

And now, with Europe in crisis — a crisis that can't be contained unless the E.C.B. steps in to stop the vicious circle of financial collapse — its leaders still cling to the notion that price stability cures all ills. Last week Mario Draghi, the E.C.B.'s new president, declared that "anchoring inflation expectations" is "the major contribution we can make in support of sustainable growth, employment creation and financial stability."

This is an utterly fantastic claim to make at a time when expected European inflation is, if anything, too low, and what's roiling the markets is fear of more or less immediate financial collapse. And it's more like a religious proclamation than a technocratic assessment.

Just to be clear, this is not an anti-European rant, since we have our own pseudo-technocrats warping the policy debate. In particular, allegedly nonpartisan groups of "experts" — the Committee for a Responsible Federal Budget, the Concord Coalition, and so on — have been all too successful at hijacking the economic policy debate, shifting its focus from jobs to deficits.

Real technocrats would have asked why this makes sense at a time when the unemployment rate is 9 percent and the interest rate on U.S. debt is only 2 percent. But like the E.C.B., our fiscal scolds have their story about what's important, and they're sticking to it no matter what the data say.

So am I against technocrats? Not at all. I like technocrats — technocrats are friends of mine. And we need technical expertise to deal with our economic woes.

But our discourse is being badly distorted by ideologues and wishful thinkers — boring, cruel romantics — pretending to be technocrats. And it's time to puncture their pretensions.

For the last time: Fannie did NOT cause financial disaster

Gee, I'm sure this well-researched article will put an end to the false belief that the FMs caused the financial crisis, which has become an article of faith among many, especially on the Right.

I'm doubly sure that those who refute this article will come back with statistics or studies or something checkable to support their false claim that the FMs/GSEs caused the financial crisis.

Yep, I'm absolutely sure, because we're all reasonable, fact-based thinkers.

Did Fannie Cause the Disaster?

By Jeff Madrick and Frank Partnoy

October 27, 2011 | New York Review of Books

Amid the current financial turmoil, the causes of the crisis that just preceded it—the bursting of the housing bubble—are being badly distorted. Some analysts, including the authors of the book under review [Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, by Gretchen Morgenson and Joshua Rosner], are arguing that the housing and financial crises of 2007 and 2008 were the direct result of federal guarantees of mortgages, a program first created in the 1930s, and therefore less so the result of the aggressive creation of mortgages by private business than has been widely reported.

In particular, the authors accuse two quasi-public but profit-making companies, Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), of adding risks to the mortgage markets that resulted in disaster. Much the same criticism has been made by Peter Wallison, a fellow of the American Enterprise Institute, who wrote an angry dissent to the findings of the Financial Crisis Inquiry Commission (FCIC), which was appointed by Congress to investigate the causes of the crash. Contrary to Wallison, the nine other members of the commission, including three others appointed by Republicans, concluded that Fannie and Freddie were not the main causes of the crisis.

Along with many other experts, the nine members pointed to considerable evidence that, despite large losses, these government-sponsored enterprises (GSEs), as they are known, bought or guaranteed too few highly risky loans, and did so too late in the 2000s, to cause the crisis. But in their new book, Reckless Endangerment, the New York Times reporter Gretchen Morgenson and mortgage securities analyst Joshua Rosner try to revive the issue of their responsibility.

The book boldly and passionately asserts that the risk-taking of Fannie Mae and Freddie Mac was a major element in causing the housing bubble. In particular, the authors blame the crisis on the goals set by the Clinton administration in the early 1990s to make lending "affordable" to more middle- and low-income home buyers. These goals were raised several times over the next dozen years so as to include more people, with the result that loans became cheaper. The authors write, "The homeownership drive helped to plunge the nation into the worst economic crisis since the Great Depression." They add, "How Clinton's calamitous Homeownership Strategy was born, nurtured, and finally came to blow up the American economy is a story of greed and good intentions, corporate corruption and government support."

This bold claim, however, is not substantiated by persuasive analysis or by any hard evidence in the book. The GSEs did generate large losses, but their bad investments in housing loans followed rather than led the crisis; most of those investments involved purchases or guarantees made well after the subprime and housing bubbles had been expanded by private loans and were almost about to burst.

Even then, the GSEs' overall purchases and guarantees were much less risky than Wall Street's: their default rates were one fourth to one fifth those of Wall Street and other private financial firms, a fact not made clear by the authors. A further review of other literature shows that Clinton's goals to increase "affordable lending" had little to do with the risks the GSEs took. The FCIC, for example, argued that in several years these goals were largely met by the GSEs' standard loans with traditional down payments.

Although they were set up originally by the federal government, the GSEs have been private companies for roughly the last forty years. They are traded on the stock market and were on a hunt for profits like much of Wall Street, in part because their executives' bonuses were linked to earnings per share. Even so, by comparison with other companies they restrained their risk. Private firms on Wall Street and mortgage companies across the nation, uncontrolled by adequate federal regulation, unambiguously caused the crisis as they expanded in the 2000s. They were the ones who "came to blow up the American economy."

This is not to say that the GSEs' way of doing business was sensible or that their losses—up to $230 billion—can be justified. The hybrid business model of a quasi-public but profit-making company, whose bonds were treated in the financial markets as if they were guaranteed by the federal government, was likely to lead to abuse and careless investment. Financial markets assumed that the GSEs were relatively safe partly because they were regulated by a federal agency, the Office of the Federal Housing Enterprise Oversight (OFHEO) and were subject to a web of rules. They also had a long record of backing safe mortgages. The authors describe well how, beginning in the 1990s, Fannie in particular betrayed its responsibilities. It aggressively minimized federal regulation of its activities and it fought off attempts to tax its profits, partly through extravagant favors to influential lawmakers. This is a story that needed telling. Reform of the GSEs should be an urgent part of a new federal housing agenda.

But the book's unjustified thesis that Fannie and Freddie were major causes of the financial crisis is being used by politicians and pundits to soften criticism of private business and by lobbyists and others who would water down the new regulations passed by Congress under the Dodd-Frank Act. The book is also being exploited by those who believe the federal government should have little if anything to do with support for the mortgage market, a view we find unfounded.

Reviving the housing market was a high priority for Franklin Delano Roosevelt when he took office in 1933. In 1934, he created the Federal Housing Administration, which guaranteed mortgage payments, and provided insurance for savers' deposits in the thrift institutions that then were the nation's leading mortgage writers. He had also created a government bank, the Home Owners' Loan Corporation, to make new loans to distressed home owners and buy bad mortgages from failing financial institutions. Finally, in 1938, he established Fannie Mae to guarantee mortgages that met adequate standards or buy them outright from private financial institutions; it issued its own debt to major investors to support its practices. The goal was to maintain a stable mortgage market with reasonable borrowing rates in all regions of the country.

For roughly fifty years, Fannie Mae did its job. Home ownership rates rose from about 40 percent in the 1920s to about 60 percent and, in contrast to earlier, far more volatile history, the mortgage market was mostly stable. Freddie Mac was created in 1970 as a private company to package mortgages into securities that could be sold to institutional investors like pension funds.

That the GSEs were private began to draw increasing criticism as they grew larger. The implied federal guarantee of the debt of these private, profit-making companies, which lowered their borrowing rates, made it easier for them to grow and make new and riskier loans. Some urged that the GSEs be fully privatized and stripped of any advantage they might have because of federal regulation. Wall Street and mortgage firms wanted for themselves the business Fannie and Freddie were doing, including the packaging of mortgages into securities.

In the early 1990s, Congress recognized that Fannie and Freddie, which were growing rapidly, required closer regulation. President Clinton and Congress also were eager to channel more loans to lower-income Americans. Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which established a new agency to oversee the GSEs and set affordable lending goals.

From the beginning, the new oversight agency—OFHEO—was weak. And this is essentially where Reckless Endangerment begins, with sordid details about how James Johnson, Fannie's chief executive and an influential Democratic insider, fended off control by OFHEO during its first seven years. Johnson established an expensive twelve-person lobbying office, gave campaign money to powerful politicians, and made contributions to the favorite charities of influential congressmen. He opened local development offices in congressional districts as a public relations campaign to show how congressmen were helping their local constituents get mortgages.

By means of such measures, Johnson won congressional support and repeatedly resisted attempts by a handful in Congress to rein Fannie in, as did his successor in 1999, Franklin Raines, President Clinton's former budget director. Perhaps most important, Johnson tied his own CEO bonuses and those of other executives to the earnings of the company.

Morgenson and Rosner make a strong if one-sided case against Johnson. We never hear from any of his defenders, and he refused, the authors write, to be interviewed. But as they make clear, Johnson, partly by his egregious self-promotion, made Fannie virtually untouchable politically. Above all, he exploited the Fannie mandate to lend to lower-income Americans in order to expand the company's reach, and in the process increase both its earnings and his personal wealth.

They also note that Democrats ranging from Congressman Barney Frank, who got his partner a job with Fannie, to former Clinton adviser Lanny Davis were strong supporters of Fannie Mae. William Daley, a high-level adviser to President Obama, was on Fannie's board. They cite Republicans who were Fannie supporters or executives as well, including Newt Gingrich, Senator Christopher Bond, and Robert Zoellick, legal counsel of Fannie and currently head of the World Bank.

The authors make no serious charges of outright fraudulent corruption on the part of these people, however. The one potential exception is Angelo Mozilo, the flamboyant head of Countrywide Financial, the nation's largest mortgage originator, who offered beneficial mortgage rates to some influential politicians. But the authors add nothing new here. The "friends of Mozilo," who got cut-rate VIP loans, included Johnson, Senators Chris Dodd and Kent Conrad, and the late Ambassador Richard Holbrooke, among others. But while Mozilo did favors for them, Morgenson and Rosner cite no specific favors returned to Mozilo by Dodd, Conrad, Holbrooke, or the others mentioned.

In these and other cases, the authors tar with a broad brush. They write that they conducted interviews over more than a decade and amassed a "mountain of notes," but many sources quoted are anonymous and the book does not cite references in footnotes so there is no way to assess many of their assertions. They almost never deal with counterarguments to their many claims, if only to show them wrong.

They make some odd errors as well, such as stating that Walter Mondale was "sitting out" the 1980 presidential election, when as vice president he ran again as Jimmy Carter's running mate. Their scathing criticism of a Federal Reserve Bank of Boston study published in 1992, which demonstrated prejudice against minorities in the distribution of mortgages in the Boston area, is an especially disturbing example of their one-sided reporting. They assert that this study, which they say influenced Congress's adoption of affordable lending goals, was deeply flawed. They mock the primary author of the study, the economist Alicia Munnell, and state that the Boston Fed made "a fool of itself."

But they don't point out that the Boston Fed's study was later subject to a stringent peer-review process and was published in 1996 in the respected American Economic Review. Indeed, few research papers have been as closely scrutinized. The published results, which corrected some methodological errors, showed persuasively that there was in fact a bias in the mortgage markets. In 1998, another peer-reviewed paper—also ignored by the authors—analyzed the criticisms of the Boston Fed study, as well as other research on mortgage bias, and concluded that the study was fundamentally correct. "The bottom line is that the results related to race are extremely robust," wrote the author.

The one claim that Morgenson and Rosner depend upon most for their extreme conclusions about Fannie and Freddie is especially poorly documented. Fannie, they write, started influencing the private sector in damaging ways beginning in the 1990s, when the GSEs reduced the down payments required for mortgages in order to help poorer Americans acquire housing loans. Fannie's lower standards "set the tone for private-sector lenders across the nation." In support, they cite two quotes from one unidentified former Fannie executive. They offer no empirical evidence, or even telling illustrations or anecdotes. A more recent paper by economist Edward Pinto offers more supposedly illustrative anecdotes about reduced down payments but remains unpersuasive. In fact, the loans guaranteed by Fannie in those years were always privately insured.

But the key point—which is largely missing from Reckless Endangerment —is that private lenders made far riskier loans than GSEs bought or guaranteed, especially during the 1990s, when subprimes issued to borrowers with low income and poor credit were relatively new. You will not read in Reckless Endangerment that the GSEs bought very few subprimes in these years. Rather than leading the way, Fannie's market share of the low-income home buyers fell behind private industry's far riskier lending to poorer home owners and others.

The increased risk-taking of the GSEs during the 1990s, far more modest than what was to come in the 2000s in the private sector, had no bearing on the financial crisis of 2007 and 2008. The authors make it seem as if it did, however. They write:

Clinton's public-private partnership was ramping up…. To meet the goals Fannie and Freddie had to buy riskier mortgages, such as those defined as subprime….

Some $160 billion in subprime mortgages would be underwritten in 1999, up from $40 billion five years earlier. And in another four years, that figure would jump to $332 billion.

Many of those loans wound up in Fannie's and Freddie's portfolios. By 2008, some $1.6 trillion of toxic mortgages, or almost half of those that were written, were purchased or guaranteed by Fannie and Freddie.

As noted, the GSEs bought very few subprimes in the 1990s. But it might especially surprise the inexpert reader to know that the GSEs did not own almost half of the "toxic mortgages" written by private companies, a remarkable exaggeration on the part of the authors. As usual, no source for the estimate is given, but it is likely based on the analysis of Pinto, who was a former Fannie official and is a colleague of Wallison's at the American Enterprise Institute. To make the claim, Pinto radically redefined what qualified a mortgage to be subprime or an Alt-A, for which mortgage-holders were often not required to document their income, rejecting the conventional and widely accepted definitions. In his analysis, almost any mortgage held by Fannie and Freddie with modest above-average risk was categorized, to use Morgenson and Rosner's term, as "toxic."

If so, one would presume the delinquency rates suffered by the GSEs during the crisis would have been very high. But David Min, an analyst with the Center for American Progress, shows that the after-crisis delinquency rates on the large additional portion of GSE mortgages that Pinto claimed were high risk, and that was termed "toxic" by Morgenson and Rosner, was roughly 10 percent, far lower than the 25 to 30 percent default rate of true subprimes. In fact, the rate of delinquencies for all GSE securities in 2004 was 4.3 percent, compared to a delinquency rate in private industry of 15.1 percent of mortgages. In 2005, the GSE rate was 7.8 percent compared to 28.7 percent, and in 2006 and 2007, the rates reached 13.2 and 14.9 percent in the GSEs and 45.1 and 42.3 percent in the private market. None of these figures are cited in Reckless Endangerment. In fact, losses as a proportion of mortgages guaranteed or bought by the GSEs were far lower than in private industry.

When Wall Street was taking more and more risk in the 2000s, as the housing bubble expanded, the GSEs were, relatively speaking, sitting it out. Johnson had left Fannie at the end of 1998 with a $21 million pay package, joining the board of Goldman Sachs and eventually running the Brookings Institution and becoming a key adviser to Senator John Kerry in his run for the presidency. But serious accounting irregularities under Raines, perhaps initiated under Johnson, left Fannie subject to immense pressure years later to get its books straightened out. Overall mortgage debt grew by 11.9 percent a year from 2003 to 2007, but the amount funded by the GSEs grew by only 7.6 percent a year. The GSE market share fell from over 50 percent to 40 percent.6

The GSEs did buy subprime mortgages in the 2000s, but contrary to the impression given by Morgenson and Rosner, their purchases were always a distinct minority of those sold by Wall Street. As Jason Thomas and Robert Van Order of George Washington University further point out, the subprimes the GSEs bought in these years were from the safer triple-A tranches of basic mortgage-backed securities, i.e., the highest quality of groups of mortgages rated by their risk of default. The GSEs never bought the far riskier collateralized debt obligations (CDOs) that were also rated triple-A and were the main source of the financial crisis. (The triple-A classifications of some of those CDOs were conferred on them very dubiously by the credit-rating agencies, Standard & Poor's and Moody's.) It turned out that subprimes accounted for only 5 percent of the GSEs' ultimate losses, according to Thomas and Van Order.

Some, like Alan Greenspan, argued that the GSEs' purchases of subprimes, nevertheless, helped hold down mortgage rates and therefore pushed up demand for housing and housing prices. But Thomas and Van Order strongly dispute that as well, showing that there was so much demand for the healthier triple-A tranches the GSEs bought that the purchases of subprimes made virtually no difference.

What then caused the losses of up to $230 billion by the GSEs that required the Treasury to put them into conservatorship in September 2008—they are now run by the Federal Housing Finance Agency—and a federal bailout of up to $150 billion in capital? It had little to do with pursuit of the original goals of "affordable lending." The GSEs were far more concerned to maximize their profits than to meet these goals; they were borrowing at low rates to buy high-paying mortgage securities once their accounting irregularities were behind them. For example, they started aggressively buying Alt-A loans that did not generally meet affordable lending goals because they were made to higher-income individuals. This was irresponsible. Most disturbing about the GSEs, they refused to maintain adequate capital as a cushion against losses, despite demands from their own regulators that they do so.

The GSEs never took nearly the risks that the private market took. Still, when housing prices collapsed so sharply, even modestly risky and traditionally safe mortgages produced losses. The risky lending was not driven by the affordable lending goals; nor did it cause the crisis. Thomas and Van Order write convincingly that the downfall of the GSEs "was quick, primarily due to mortgages originated in 2006 and 2007. It…was mostly associated with purchases of risky-but-not-subprime mortgages and insufficient capital to cover the decline in property values."

After devoting roughly two thirds of their book to Johnson and the GSEs, Morgenson and Rosner comment, "Of all the partners in the homeownership push, no industry contributed more to the corruption of the lending process than Wall Street." The assertion is jarring, coming so late in the book and after so much blame has been leveled at the GSEs. The authors do not really try to prove their point. They do not seriously address the derivatives market—the highly leveraged securities based on other securities that were at the core of excessive risk-taking. They mostly present a random collection of examples of wrongdoing, and their points have largely been made elsewhere.

But they add some useful details. Earlier in the book, they tell very well the story of NovaStar Financial, a mortgage originator that began doing business in the 1990s and exploited home owners still more in the 2000s. The company's history can serve as a quintessential example of regulatory failure. Respected Wall Street firms fed NovaStar and other dubious mortgage-writing companies with more money than they could wisely use. The authors also show how Goldman Sachs supplied mortgage money to Fremont, which they call "one of the nation's most wanton mortgage originators." Goldman, however, was only one of the pack, and many Wall Street investment banks owned their own aggressive mortgage originators.

The authors, moreover, explain clearly how the prices of collateralized debt obligations were driven up by credit-rating agencies. They show how some banks used off-balance-sheet accounting that permitted them to stuff risky assets into hidden "Special Purpose Vehicles," or SPVs. But here they mix up SPVs with more complex "Structured Investment Vehicles," or SIVs, which resemble CDOs but have shorter-term debt. Both the book and its index mislabel SIVs as "Special Investment Vehicles." They incorrectly write that Citigroup's large losses were due to problems in their SIVs. The big bank's losses actually came from the highly rated parts of CDOs they retained as well tens of billions of dollars of guarantees they made to those who bought the CDOs they underwrote, known as liquidity puts.

Clearly, the GSEs must be reformed and, if they are allowed to have the advantage of a presumed government guarantee, their practices and profits must be controlled and limited. A federal presence in the mortgage market is required to maintain liquidity and adequate access for home buyers. As for poorer families, a system of mortgages based on affordable lending goals is not necessarily the most efficient way to enable them to purchase homes. Direct vouchers might be a better alternative. Finally, there is the larger and more controversial question of whether many people, and the financial system itself, might be better off if more homes were rented, not bought.

But these are different debates than the one this book has provoked. Contrary to many commentators on Reckless Endangerment, and to its chief claims, it was Wall Street, not the GSEs, that fundamentally caused the 2007–2008 crisis, which was driven not merely by a headlong pursuit of easy profit but also by ethically dubious practices. Morgenson and Rosner discuss a handful of these practices and raise appropriate questions about why Wall Street participants were not criminally prosecuted. We will turn our attention to this important issue in a second article.

—This is the first of two articles.

Black: Ireland and Iceland were models to follow?

Black asks if anybody cares to remember how Ireland and Iceland were trotted out by EU and US neo-liberals as great successes to follow in their deregulation, privatization of public assets, and budget cuts, particularly to the social safety net.

And yet budget surpluses and supply-side growth didn't save Iceland or Ireland from the financial crisis.

ECB President Trichet Praised Ireland as the Model for the EU to Follow
By William K. Black
June 7, 2011 | New Economic Perspectives

URL: http://neweconomicperspectives.blogspot.com/2011/06/ecb-president-trichet-praised-ireland.html

Taibbi: Feds should prosecute Goldman Sachs

If Goldman Sachs hadn't given so much damn money to Obama and everybody else in DC, we might get a federal prosecution case out of this, at the very least for perjury during Goldman exec's' Congressional testimony. As Taibbi describes, a Congressional panel has laid the prosecution's case in the government's lap.

Here's the meat of it:

"[Goldman Sachs mortgage chief] Sparks followed up that [December 14, 2006] meeting [about lowering Goldman's exposure to mortgage loans] with a seven-point memo laying out how to unload the bank's mortgages. Entry No. 2 is particularly noteworthy. 'Distribute as much as possible on bonds created from new loan securitizations,' Sparks wrote, 'and clean previous positions.' In other words, the bank needed to find suckers to buy as much of its risky inventory as possible. Goldman was like a car dealership that realized it had a whole lot full of cars with faulty brakes. Instead of announcing a recall, it surged ahead with a two-fold plan to make a fortune: first, by dumping the dangerous products on other people, and second, by taking out life insurance against the fools who bought the deadly cars.

"The day he received the Sparks memo, Viniar seconded the plan in a gleeful cheerleading e-mail. 'Let's be aggressive distributing things,' he wrote, 'because there will be very good opportunities as the markets [go] into what is likely to be even greater distress, and we want to be in a position to take advantage of them.' Translation: Let's find as many suckers as we can as fast as we can, because we'll only make more money as more and more shit hits the fan.

"By February 2007, two months after the Sparks memo, Goldman had gone from betting $6 billion on mortgages to betting $10 billion against them — a shift of $16 billion. Even CEO Lloyd 'I'm doing God's work' Blankfein wondered aloud about the bank's progress in "cleaning" its crap. 'Could/should we have cleaned up these books before,' Blankfein wrote in one e-mail, 'and are we doing enough right now to sell off cats and dogs in other books throughout the division?'"

Shorting the mortgage market was/is not a crime, but Goldman misled its clients to buy these crap mortgage-backed assets while Goldman itself was making massive bets against them. Broker-dealers like Goldman are required by the SEC to disclose "material adverse facts" to their clients which includes among other things Goldman's "adverse interests" in selling off these bad assets.

The People vs. Goldman Sachs:

A Senate committee has laid out the evidence. Now the Justice Department should bring criminal charges

By Matt Taibbi

May 11, 2011 | Rolling Stone

URL: http://www.rollingstone.com/politics/news/the-people-vs-goldman-sachs-20110511

Ratigan: Financial reform law is 'window dressing'

Wall Street 'Reform' in a Nutshell: The Politicians Lied, Media Applauded, and We Americans Will Suffer

The same Washington spinsters who have driven our country into the ground seemed to be out in full force proclaiming an empty 'victory.'

By Dylan Ratigan

June 26, 2010 | AlterNet

The same Washington spinsters who have driven our country into the ground seemed to be out in full force on Friday, claiming that their latest policy "victory" is the most "sweeping change" of our financial regulatory since the Great Depression.

Actually, it is nothing more than window dressing.

The real sweeping change of our financial system took place over the past 20 years. The irresponsible repeal of Glass-Steagall in 1999. The Commodities and Futures Modernization Act of 2000 by Larry Summers and Bob Rubin -- the one that legalized the most destructive financial instruments of all, derivatives. The leverage exemption at the SEC in 2004, asked for (in person) and received by Hank Paulson and friends.

Of course, there are small victories here -- there is better investor protection and, most importantly, an awakened citizenry.

What's not fixed?

- The Cops (regulators and ratings agencies) working for the crooks.

- Banks still Too Big To Fail.

- Banks gambling with your deposits.

- Banks allowed to "mark to myth" and use off-balance sheet accounting to bonus themselves into the atmosphere, with the taxpayer taking the fall.

- Banks getting trillions from the Fed, Fannie and Freddie -- AKA you, the future and present taxpayer.

What does it mean for us?

It means that the same people who brought you these horrible changes -- rising wealth discrepancy, massive unemployment and a crumbling infrastructure -- have now further institutionalized the policies that will keep the causes of these problems firmly in place.

Meanwhile, all involved in the facade try to pretend that this should be considered a success because, gosh, real financial reform is just too hard and those crafty banksters will just outsmart us anyhow. Many in the media are either too complicit, too confused or too lazy to contradict this spin, but the rest of us shouldn't buy that BS. Real and lasting financial reform is actually quite easy to implement -- and the last time we had a crisis of this magnitude, we kept the banksters in check for 70 years.

Time and time again in America, they don't win -- we do.

And I believe as we head towards election time with leaders whose only plan for creating new jobs is a few more workers manicuring soon-to-be even bigger Bankster bonus-fueled estates coupled with a few more government handouts, this lesson will be learned once again.

James Galbraith's must-read Senate testimony on financial fraud

Galbraith: The Role of Fraud in the Financial Crisis

May 5, 2010 | Economist's View

Recent testimony from Jamie Galbraith before the Subcommittee on Crime on the role that fraud played in the financial crisis:

Statement by James K. Galbraith, Lloyd M. Bentsen, jr. Chair in Government/Business Relations, Lyndon B. Johnson School of Public Affairs, The University of Texas at Austin, before the Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010: Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including "rational expectations," "market discipline," and the "efficient markets hypothesis" led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on, and that widespread fraud therefore could not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft- pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble. They continue to do so now. At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word "naughtiness." This was on the day that the SEC charged Goldman Sachs with fraud.

There are exceptions. A famous 1993 article entitled "Looting: Bankruptcy for Profit," by George Akerlof and Paul Romer, drew exceptionally on the experience of regulators who understood fraud. The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financial crime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: "the best way to rob a bank is to own one." The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle. Other useful chronicles of modern financial fraud include James Stewart's Den of Thieves on the Boesky-Milken era and Kurt Eichenwald's Conspiracy of Fools, on the Enron scandal. Yet a large gap between this history and formal analysis remains.

Formal analysis tells us that control frauds follow certain patterns. They grow rapidly, reporting high profitability, certified by top accounting firms. They pay exceedingly well. At the same time, they radically lower standards, building new businesses in markets previously considered too risky for honest business. In the financial sector, this takes the form of relaxed – no, gutted – underwriting, combined with the capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles Keating realized that an S&L charter was a "license to steal." In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.

The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. In the system that developed, the original mortgage documents lay buried – where they remain – in the records of the loan originators, many of them since defunct or taken over. Those records, if examined, would reveal the extent of missing documentation, of abusive practices, and of fraud. So far, we have only very limited evidence on this, notably a 2007 Fitch Ratings study of a very small sample of highly-rated RMBS, which found "fraud, abuse or missing documentation in virtually every file." An efforts a year ago by Representative Doggett to persuade Secretary Geithner to examine and report thoroughly on the extent of fraud in the underlying mortgage records received an epic run-around.

When sub-prime mortgages were bundled and securitized, the ratings agencies failed to examine the underlying loan quality. Instead they substituted statistical models, in order to generate ratings that would make the resulting RMBS acceptable to investors. When one assumes that prices will always rise, it follows that a loan secured by the asset can always be refinanced; therefore the actual condition of the borrower does not matter. That projection is, of course, only as good as the underlying assumption, but in this perversely-designed marketplace those who paid for ratings had no reason to care about the quality of assumptions. Meanwhile, mortgage originators now had a formula for extending loans to the worst borrowers they could find, secure that in this reverse Lake Wobegon no child would be deemed below average even though they all were. Credit quality collapsed because the system was designed for it to collapse.

A third element in the toxic brew was a simulacrum of "insurance," provided by the market in credit default swaps. These are doomsday instruments in a precise sense: they generate cash-flow for the issuer until the credit event occurs. If the event is large enough, the issuer then fails, at which point the government faces blackmail: it must either step in or the system will collapse. CDS spread the consequences of a housing-price downturn through the entire financial sector, across the globe. They also provided the means to short the market in residential mortgage-backed securities, so that the largest players could turn tail and bet against the instruments they had previously been selling, just before the house of cards crashed.

Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?

An older strand of institutional economics understood that a security is a contract in law. It can only be as good as the legal system that stands behind it. Some fraud is inevitable, but in a functioning system it must be rare. It must be considered – and rightly – a minor problem. If fraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails to respond with appropriate force, the legal system itself.

Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning or defeating the law. This is where crime and politics intersect. At its heart, therefore, the financial crisis was a breakdown in the rule of law in America.

Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had become infested with fraud? Every statistical indicator of fraudulent practice – growth and profitability – suggests otherwise. Every examination of the record so far suggests otherwise. The very language in use: "liars' loans," "ninja loans," "neutron loans," and "toxic waste," tells you that people knew. I have also heard the expression, "IBG,YBG;" the meaning of that bit of code was: "I'll be gone, you'll be gone."

If doubt remains, investigation into the internal communications of the firms and agencies in question can clear it up. Emails are revealing. The government already possesses critical documentary trails -- those of AIG, Fannie Mae and Freddie Mac, the Treasury Department and the Federal Reserve. Those documents should be investigated, in full, by competent authority and also released, as appropriate, to the public. For instance, did AIG knowingly issue CDS against instruments that Goldman had designed on behalf of Mr. John Paulson to fail? If so, why? Or again: Did Fannie Mae and Freddie Mac appreciate the poor quality of the RMBS they were acquiring? Did they do so under pressure from Mr. Henry Paulson? If so, did Secretary Paulson know? And if he did, why did he act as he did? In a recent paper, Thomas Ferguson and Robert Johnson argue that the "Paulson Put" was intended to delay an inevitable crisis past the election. Does the internal record support this view?

Let us suppose that the investigation that you are about to begin confirms the existence of pervasive fraud, involving millions of mortgages, thousands of appraisers, underwriters, analysts, and the executives of the companies in which they worked, as well as public officials who assisted by turning a Nelson's Eye. What is the appropriate response?

Some appear to believe that "confidence in the banks" can be rebuilt by a new round of good economic news, by rising stock prices, by the reassurances of high officials – and by not looking too closely at the underlying evidence of fraud, abuse, deception and deceit. As you pursue your investigations, you will undermine, and I believe you may destroy, that illusion.

But you have to act. The true alternative is a failure extending over time from the economic to the political system. Just as too few predicted the financial crisis, it may be that too few are today speaking frankly about where a failure to deal with the aftermath may lead.

In this situation, let me suggest, the country faces an existential threat. Either the legal system must do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power of the law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case. Thank you.

Simon Johnson & James Kwak on breaking up the U.S. oligarchy

I'm including only this semi-optimistic excerpted quote from 13 Bankers co-author, BaselineScenario.com co-creator, and MIT business professor Simon Johnson, in order to give some much needed historical perspective on the crisis we find ourselves in today.

Bill Moyers Journal

Interview with Simon Johnson and James Kwak

April 23, 2010 | PBS

[...]

Bill Moyers: But we can't compete with those lobbying dollars. We can't compete with this interlocking oligarchy that you say. That's a fact.

Simon Johnson: Bill, in 1902, when Theodore Roosevelt took on the industrial trusts, nobody knew what he was doing. Nobody thought he could win. The Senate was called the Millionaires Club for a reason. And it wasn't even any theory. The antitrust theory, everything we know and believe about monopoly, why monopoly is bad for society, didn't really exist, certainly not in the mainstream consensus, when Roosevelt decided to take on J.P. Morgan, okay?

Ten years later, the mainstream consensus has shifted completely. People understood from the debate and from the struggle, from the fact- from the way the trusts fought back and the way they spent their money, they began to understand this was profoundly dangerous, politically and socially. 1912, everyone agreed that breaking up Standard Oil was a good idea. Had to be done. They broke into 35 companies, most of them did well. The shareholders actually made money. It's a very American resolution, Bill. And it's very clear that we've had this confrontation before in American history: Andrew Jackson against the Second Bank of the United States in the 1830s, Jackson won, barely; Theodore Roosevelt, the beginning of the 20th Century; FDR in the 1930s.

The American democracy was not given to us on a platter. It is not ours for all time, irrespective of our efforts. Either people organize and they find political leadership to take this on, or we are going to be in big trouble, okay?

More heroic testimony from Rambo-regulator Bill Black

More amazing testimony from former bank regulator Bill Black. You can watch it here:

http://www.pbs.org/moyers/journal/04232010/watch.html

or read the following transcript:

Bill Moyers Journal

Interview with Bill Black

April 23, 2010

BILL MOYERS: You probably heard the President speaking in New York yesterday, stumping for more regulation of Wall Street:

You've also probably heard about the government's charge that Goldman Sachs committed a highly sophisticated fraud. The claim is that this kingpin of Wall Street made a bundle by packaging mortgage debt as exotic investments some in the firm knew would fail.

That word "fraud" pops up more and more as we dig deeper into Wall Street's outrageous behavior during the run up to the great collapse of 2008. We heard it right here on the Journal, one year ago.

WILLIAM K. BLACK: Fraud is deceit. And the essence of fraud is, "I create trust in you, and then I betray that trust, and get you to give me something of value." And as a result, there's no more effective acid against trust than fraud, especially fraud by top elites, and that's what we have.

BILL MOYERS: That was Bill Black, who's no stranger to bank investigations. He was a senior regulator for the Federal Home Loan Board who cracked down on banking during the Savings & Loan crisis of the 1980s.

Just this week, he was on Capitol Hill testifying about another failed financial firm, Lehman Brothers.

WILLIAM K. BLACK Lehman's failure is a story in large part of fraud. And it is fraud that begins at the absolute latest in 2001.

BILL MOYERS: Bill Black is with me now. One of the country's leading experts on crimes in high places he teaches economics and law at the University of Missouri-Kansas City, and wrote this book, THE BEST WAY TO ROB A BANK IS TO OWN ONE.

Welcome back to the JOURNAL.

WILLIAM K. BLACK Thank you.

BILL MOYERS: What did you think of the President's speech late this week?

WILLIAM K. BLACK It's a good speech. He's a very good spokesman for his causes. I don't think substantively the measures are going to prevent a future crisis. And I was disappointed that he wasn't willing to be blunt. He used a number of euphemisms, but he was unwilling to use the F word.

BILL MOYERS: The F word?

WILLIAM K. BLACK: The F word's fraud in this. And it's the word that explains why we have these recurrent, intensifying crisis.

BILL MOYERS: How is that? What do you mean when you say fraud is at the center of it?

WILLIAM K. BLACK: Well, first, when you deregulate or never regulate, mortgage bankers were never regulated, you effectively have decriminalized that industry, because only the regulators can serve as the sherpas, that the FBI and the prosecutors need to be able to understand and prosecute these kind of complex frauds. They can do one or two or maybe three on their own, but when an entire industry is beset by wide scale fraud, you have to have the regulators. And the regulators were the problem. They became a self-fulfilling prophecy of failure, because they, President Bush appointed people who hated regulation. I call them the anti-regulators. And that's what they were.

BILL MOYERS: This hearing that, where you testified this week, looking into the bankruptcy at Lehman Brothers, had something on this.

TIMOTHY GEITHNER: And tragically, when we saw firms manage themselves to the edge of failure, the government had exceptionally limited authority to step in and to protect the economy from those failures.

BEN BERNANKE: In September 2008, no government agency had sufficient authority to compel Lehman to operate in a safe and sound manner and in a way that did not pose dangers to the broader financial system.

ANTON VALUKAS: What is clear is that the regulators were not fully engaged and did not direct Lehman to alter the conduct which we now know in retrospect led to Lehman's ruin.

BILL MOYERS: The regulators were not fully engaged. I mean, this is an old story. We all know about regulatory capture where the regulated take control of the regulators.

WILLIAM K. BLACK Yeah, but this one is far worse. That's not very candid testimony on anybody's part there. The Fed had unique authority. And it had it since 1994 to regulate every single mortgage lender in America. And you might think the Fed would use that authority.

And you might especially think that, if you knew that Gramlich, one of the Fed members, went personally to Alan Greenspan and said, there's a housing bubble. And there's a terrible crisis in non-prime. We need to send the examiners in. We need to use our regulatory authority. And Greenspan refused. Lehman was brought down primarily by selling liar's loans. It was the biggest seller of liar's loans in the world.

And when we look at these liar's loans, we find 90 percent fraud. 90 percent. And we find that most of the frauds are not induced by the borrower, but they're overwhelmingly done by the loan brokers.

BILL MOYERS: And liar's loans are?

WILLIAM K. BLACK A liar's loan is we don't get any verified information from you about your income, your employment, your job history or your assets.

BILL MOYERS: You give me a loan, no questions asked?

WILLIAM K. BLACK No real questions asked. Certainly no answers checked. In fact, we just had hearings last week about WaMu, which is also a huge player--

BILL MOYERS: Washington Mutual--

WILLIAM K. BLACK --in these frauds. Washington Mutual, which used to make, run all those ads making fun of bankers who, because they were stuffy and looked at loan quality before they made a loan. Well, WaMu didn't do any of that stuff. And of course, WaMu had just massive failures. And who got in trouble at WaMu? Who got in trouble at Lehman? You got in trouble if you told the truth. They fired the people who found the problems. They promoted the people that caused the problem, and they gave them massive bonuses.

BILL MOYERS: I watched the testimony where you were present the other day in the Lehman hearings. And there was a very moving moment with a former vice-president of Lehman Brothers who had gone and tried to blow the whistle, who tried to get people to pay attention to what was going on. Take a look.

MATTHEW LEE: I hand-delivered my letter to the four addressees and I'll give a quick timeline of what happened, May 16th was a Friday, on the Monday I sat down with the chief risk officer and discussed the letter, on the Wednesday I sat down with the general counsel and the head of internal audit, discussed the letter. On the Thursday I was on a conference call to Brazil. Somebody came into my office, pulled me out, and fired me on the spot with out any notification. I stayed, sorry.

BILL MOYERS: Matthew Lee, vice-president of Lehman Brothers, fired because he tried to blow the whistle. What does that say to you?

WILLIAM K. BLACK Well, it tells me that they were covering up the frauds, that they knew about the frauds and that they were desperate to prevent other people from learning.

BILL MOYERS: Matthew Lee told the accounting firm Ernst & Young what was going on. Isn't the accounting firm supposed to report this, once they learn from somebody like him that there's fraud going on?

WILLIAM K. BLACK Yes, they're supposed to be the most important gatekeeper. They're supposed to be independent. They're supposed to be ultra-professional. But they have an enormous problem, and it's compensation. And that is, the way you rise to power within one of these big four accounting firms is by being a rainmaker, bringing in the big clients.

And so, every single one of these major frauds we call control frauds in the financial sphere has been-- their weapon of choice has been accounting. And every single one, for many years, was able to get what we call clean opinions from one of the most prestigious audit firms in the world, while they were massively fraudulent and deeply insolvent.

BILL MOYERS: I read an essay last night where you describe what you call a criminogenic environment. What is a criminogenic environment?

WILLIAM K. BLACK A criminogenic environment is a steal from pathology, a pathogenic environment, an environment that spreads disease. In this case, it's an environment that spreads fraud. And there are two key elements. One we talked about. If you don't regulate, you create a criminogenic environment because you can get away with the frauds. The second is compensation. And that has two elements. One is the executive compensation that people have talked about that creates the perverse incentives. But the second is for these professionals. And for the lower level employees, to give the bonuses. And it creates what we call a Gresham's dynamic. And that just means cheaters prosper. And when cheaters prosper, markets become perverse and they drive honesty out of the market.

BILL MOYERS: You also wrote that the New York Federal Reserve knew about this so-called three-card monte routine. But that, the man who led it, at the time, Timothy Geithner, now the treasury secretary, testified that there was nothing he could do.

TIMOTHY GEITHNER: In our system the Federal Reserve was a fire station, a fire station with important, if limited, tools to put foam on the runway, to provide liquidity to markets in extremis. However, the Federal Reserve, under the laws of this land was not given any legal authority to set or enforce limits on risk-taking by large financial institutions like the independent investment banks, insurance companies like AIG, Fannie and Freddie, or the hundreds of non-bank financial firms that operated outside the constraints of the banking system.

BILL MOYERS: Now, what I hear is the gentleman who was then chairman of the New York Fed, saying, I, we had this job to do, but we didn't have the authority to do it.

WILLIAM K. BLACK Yeah.

BILL MOYERS: We were the fire truck, but we didn't have any water in our hose.

WILLIAM K. BLACK Yeah, this was pretty disingenuous, because other portions of his testimony, he explained why there was this gap. And he said it was because we repealed Glass-Steagall. Well, the Fed pushed for the repeal of Glass-Steagall.

BILL MOYERS: Glass-Steagall was the act that was repealed in the late nineties that separated regular banks from investment banks, right?

WILLIAM K. BLACK Correct. So this is a deliberately created regulatory black hole, created by the Fed. And then the Fed comes into the hearing, eight years later, and said, we were helpless. Helpless to do anything, because of a black hole we designed.

BILL MOYERS: Well, it doesn't stop there, because as I listened the other day, I heard that the Securities and Exchange Commission knew that Lehman was repeatedly ignoring its own risks, but it did nothing. Here's what the new chairman of the SEC, Mary Schapiro, had to say the other day, about why the commission fell down on the job. Take a look.

MARY SCHAPIRO: The SEC didn't have the staff, the resources, or quite honestly, in some ways, the mindset to be a prudential regulator of the largest financial institutions in the world. It was such a deviation from our historic disclosure-based and rules-based approach to regulation to come in and be a prudential supervisor. The staff was never given the resources. This program peaked at 24 people for the entire universe of the five largest investment banking firms in the world.

WILLIAM K. BLACK Well, this is another example, the self-fulfilling failure. This wasn't done under Mary Shapiro's watch.

BILL MOYERS: Right--

WILLIAM K. BLACK: This was Chris Cox, who was Bush's appointment. And he's the one who decided, we're only going to send 24 people to deal with all of the largest investment banks in the world. Now that's a farce. And everybody knows it's a farce. He didn't want effective regulation. We both spent time, considerable time, in Texas. And you know, the joke, one riot, one ranger, right?

BILL MOYERS: Texas ranger, right.

WILLIAM K. BLACK Treasury Secretary Geithner testified that in the circumstances they were dealing with at Lehman, "We were on the brink of the destruction of the entire global financial system." And then Chairman Bernanke testified how many people the Fed sent to Lehman to prevent us on the brink of global collapse.

BILL MOYERS: And how many?

WILLIAM K. BLACK: Two. They have a staff of thousands. This is criminal negligence except, because he's a federal employee, we can't charge him with a crime.

BILL MOYERS: Let's talk a moment about the government's allegations against Goldman Sachs. I mean, I get dizzy just reading about it. But the Wall Street Journal reporters did a terrific job this week of trying to sort it out. And they say, "It centers on a deal Goldman Sachs crafted, so that the hedge fund king, John Paulson, could bet on a collapse in housing prices." Is that your reading of it?

WILLIAM K. BLACK Yes, I mean, the complaint actually focuses on lying to investors. So it's a very traditional securities fraud complaint.

BILL MOYERS: Not about Paulson, by the way. He's not mentioned in the complaint.

WILLIAM K. BLACK No, but that's really interesting. And as to whether he will be mentioned eventually in this complaint, because Paulson has lots of potential liability on this one. John Paulson was allowed by Goldman, indeed encouraged by Goldman, to create a "Most Likely to Fail" list. So he took, within a particular category, the absolute worst stuff, because he wanted to bet that the stuff would fall in value. And they were certain to fall in value in terms of the economics.

BILL MOYERS: Wasn't he betting that people wouldn't be able to pay their mortgages?

WILLIAM K. BLACK Not even necessarily that, because most of these are liar's loans, again. And they will not pay, right? It's not an issue of liar's loans, will it work or will it not work. It's only when will it blow up. A liar's loan will blow up. If housing prices keep going up for three years hugely, then they will blow up in the fourth year.

But they will blow up. So he was betting against something that he knew was going to blow up. He didn't necessarily know the timing, but he proved to be right about the timing, because we know from the SEC complaint that he was in a rush to get this. He knew that the housing collapse was imminent. And he had to get this deal done right away. And Goldman Sachs felt the same thing. So they went and they got themselves a dupe, ACA. And they told the -- ACA is a group that puts together and supposedly checks the quality of mortgages. Not very well, as it turned out, of course. An investor would obviously want to know that this portfolio was picked to fail. Instead, they were told, according to the SEC complaint, "No, no, no, no. There's no John Paulson out there. There's only ACA, and it's in your corner. And it's picking a portfolio most likely to succeed." Now if John Paulson knew that Goldman was making those representations, then John Paulson knew those representations were false. And that could make him an aider and abettor.

BILL MOYERS: So tell me where the fraud might be in there, if the government proves its case.

WILLIAM K. BLACK Well, the fraud is, I'm representing to you, the potential investor, that a competent professional independent firm, ACA, looking after your interests, has picked this portfolio because they believe it's most likely to succeed. When in fact, the portfolio was selected overwhelmingly by Paulson and was selected because it was deliberately chosen to fail.

BILL MOYERS: The complaint names only one person, Fabrice Tourre, if I get the name correct.

WILLIAM K. BLACK That is correct.

BILL MOYERS: Who was 27 at the time. Would he have been acting without supervision on a deal of that enormity?

WILLIAM K. BLACK Oh, not even close. And this was-- this was part of a package of about 18 deals as well. So as big as this package was, and it was huge, the overall package was absolutely the type of thing that received personal attention of the leaders, the absolute top leaders at Goldman Sachs. So it's very curious to me that the SEC has failed to name the higher-ups.

BILL MOYERS: Why did it take so long for the Securities and Exchange Commission, the SEC, to kick into gear on this? I mean, have they kicked into gear?

WILLIAM K. BLACK Well, they haven't kicked into gear fully, or they'd be naming Blankfein and other senior leaders of Goldman. And they've, as you just mentioned, they've only gone after a junior person. And there would be, if they were really in gear, there would be criminal charges here. And if they were really in gear, there'd be a broad investigation, not just of Goldman, but of all of these major entities.

In the last three weeks, we have finally done a half-baked investigation, mind you. Not -- nothing like we did in the Savings & Loan days -- of Washington Mutual (WaMu), Citicorp, Lehman, and Goldman. And we have found strong evidence of fraud at all four places.

And we have looked previously at Fannie and Freddie and found the same thing. So the only six places we've looked, at really elite institutions, we've found strong evidence of fraud. So where are the other investigations? Why are there no arrests? Why are there no convictions?

BILL MOYERS: Well, Bill, where are the other investigations? Why have there been no arrests? Why have there been no convictions?

WILLIAM K. BLACK Because we have still Bush's wrecking crew in charge of the key regulatory agencies. Why are they still in place? They have abysmal records as major causes of this crisis.

BILL MOYERS: You talk about the Bush appointees still being there, but Goldman's former lobbyist, his treasury secretary, Timothy Geithner's chief of staff, the head of the Commodity Futures Trading Commission, Gary Gensler, who may soon have new power over derivatives, worked for Goldman.

So did the deputy director of the White House National Economic Council, the under Secretary of State is a former Goldman employee. Goldman's hired Barack Obama's recent chief counsel from the White House on his defense team. I mean--

WILLIAM K. BLACK Don't forget Rubin.

BILL MOYERS: Robert Rubin, whose influence is all over the place, who used to be--

WILLIAM K. BLACK It's his protégés that are in charge of economic policy, under Obama.

BILL MOYERS: So is this administration, which still has some Bush holdovers in it, and now has a lot of Goldman people in it, is this administration going to be able to pass judgment on Goldman Sachs?

WILLIAM K. BLACK Well, so far, they haven't been able to do it. They can't even get themselves to use the word fraud.

There's a huge part that is economic ideology. And neoclassical economists don't believe that fraud can exist. I mean, they just flat out -- the leading textbook in corporate law from law and economics perspective by Easterbrook and Fischel, says -- I'll get pretty close to exact quotation. "A rule against fraud is neither necessary nor particularly important." Right?

Notice how extreme that statement is. We don't need laws. We don't need an FBI. We don't need a justice department. We don't even need rules like the SEC. The markets cleanse themselves automatically and prevent all frauds. This is a spectacularly naïve thing. There is enormous ideological content. And it fits with class. And it fits with political contributions.

Do you want to look at these seemingly respectable huge financial institutions, which are your leading political contributors as crooks?

BILL MOYERS: TheHill.com website says Goldman Sachs is uniquely positioned to fight this case, that it spent $18 million over the last decade lobbying members of Congress, and put millions more in their campaigns. I mean, you've said elsewhere. That's smart business, right, to invest in the politicians who are going to be investigating you?

WILLIAM K. BLACK I would tell you, the Savings & Loan crisis, our phrase was, "The highest return on assets is always a political contribution."

BILL MOYERS: Well, all right. You're a member of Congress. The Supreme Court has said, "Goldman Sachs can spend all it wants in November to defeat you." Are you going to take them on?

WILLIAM K. BLACK Absolutely, but I would never be elected to Congress because of that. So let me -- in terms of that Supreme Court decision, if corporations are going to be just like people, let me tell you my criminologist hat. Then let's use the three strike laws against them. Three strike laws, you go to prison for life, if you have three felonies. How many of these major corporations would still be allowed to exist, if we were to use the three strike laws, given what they've been convicted of in the past?

And in most states, they remove your civil rights when you're convicted of a felony. Well, let's take away their right to make political contributions that they're found guilty of a violation.

BILL MOYERS: Bill, are you describing a political culture, that is criminogenic?

WILLIAM K. BLACK It's deeply criminogenic. And this ideology that both parties are dominated by that says, "No, big corporations wouldn't cheat. Fraud can't happen. Market's automatically excluded," is insane. We now have the entitlement generation as CEOs. They just plain feel entitled to being wealthy as Croesus with no responsibility, no accountability. They have become literal sociopaths. So one of the things is, you clean up business schools, which right now are fraud factories at the senior levels, right?

They create the new monsters that take control and destroy massive enterprises and cause global economic crises, cause the great recession. And very, very close to causing the second Great Depression. We just barely missed that. And there's no assurance that we've missed it five years out.

BILL MOYERS: This brings us back to what the president said this week. He said the crisis was born of a failure of responsibility from Wall Street to Washington. You've just described that. That brought down many of the world's largest financial firms and nearly dragged our economy into a second Great Depression. But he didn't name names. He doesn't say who specifically was responsible. You have. But the president doesn't name names.

WILLIAM K. BLACK No, and one of the most important things a president has is the bully pulpit. We have not heard speeches by the president demanding that the frauds go to prison. We have not heard speeches from the attorney general of the United States of America, Eric Holder. Indeed, we haven't heard anything. It's like Sherlock Holmes, the dog that didn't bark. And that's the dog that is supposed to be our guard dog. It must bark. And it must have teeth, not just bark.

BILL MOYERS: Bill Black, thank you for being back on the Journal.

WILLIAM K. BLACK: Thank you.

MIT economist Simon Johnson on breaking up TBTF banks

Simon Johnson: Wall Street's Stranglehold on Our Democracy Must Be Broken

The progressive economist talks about the fight to reform Wall Street, what Robert Rubin should do with his money, and why Jamie Dimon is the most dangerous man in America.

Interview with Simon Johnson by Zach Carter

April 17, 2010 | AlterNet

Simon Johnson is the former chief economist for the International Monetary Fund, and co-founder of the Baseline Scenario, a blog about the financial crisis and financial reform. He is a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. Johnson's latest book, 13 Bankers (co-authored with Baseline Scenario co-founder James Kwak) is a detailed examination of Wall Street's political and ideological power and the devastating economic results. AlterNet's economics editor Zach Carter recently talked with Johnson about the U.S. banking system.

Zach Carter: Your push to break up the largest banks into smaller banks that can actually fail without wreaking havoc on the economy has been very well-received by progressives. But historically, the IMF and the Federal Reserve are not exactly hotbeds of progressive thought. How did you and Paul Volcker become the vanguard of the economic left?

Simon Johnson: The ideas that we're advancing both in Baseline Scenario and in the book should appeal to people on the right, the center and the left. There's an article by Arnold Kling that we wrote about on Baseline Scenario. He's a libertarian, which I am not, but he's come around to our way of thinking about the banks. If you think about it from the right, our financial system is just monstrously unfair. It's not in any way a market economy to have these banks who are so big that the government can't let them fail. They have funding advantages over other banks, and those advantages only encourage them to get bigger. That's just not reasonable.

The left—which coincides more with my own views than the right—is very uncomfortable with the power structure that is inherent in that imbalance. And the center--which I would also say characterizes my own views, I'm a center-left person—the center is very concerned about the effects of giant banks on efficiency and the interworkings of the economy. You can see the spectrum of appeal from the blurbs on our book.

ZC: Sen. Jim Bunning, R-Kentucky, is a fan.

SJ: I thought we just had to include Jim Bunning, because what else would these people agree on? You can't list five other words in the entire English language that Bunning and Alan Grayson would agree on outside of financial reform.

ZC: But doesn't the broad appeal of your argument run counter to the basic idea? Your point is that Wall Street has taken over the economic ideology in Washington, D.C., but just by looking at the cover, we can see several economists and politicians who agree with you that what is good for Wall Street is often bad for society.

SJ: The ideological capture was complete through 2005 and 2008. I think now there's been some push-back against it. I think this is an ideological debate. I think it's a debate about doctrines and the real nature of a market economy. So there are now people who are pushing back. But I can assure you, Wall Street still has a fantastic grip at the top levels of this administration and on Capitol Hill.

We are in the fight, at least, and we have some people on our side, but it is very, very lopsided. Did you see Chris Dodd told Don Imus that he's reading 13 Bankers? I was quite amazed by that. So we're at the table, but it's going to be an uphill battle for some time.

ZC: You've been making this argument for more than a year now, that there's no way to fix our financial system without breaking up the big banks. But watching the debate over financial reform, Congress really hasn't seriously considered the idea. Is this something we can hope to enact with this reform bill, or are you geared up for a longer fight?

SJ: It's a longer fight. There is a slim chance—maybe it's five percent, maybe it's ten percent—that in this legislative cycle, the White House will change its position. And I think after they got a pretty good final outcome on health care, all things considered, a re-energized President Obama saying, "Anybody who opposes us is on the side of the too-big-to-fail banks, and here's how we're going to make them smaller" would have a tremendous effect. That's a very powerful message, and that's what we're telling the White House.

The political side of the White House, I think, finds that very appealing. The economic side of the White House, of course, is in a very different place, which is why the odds are about 90 percent against us. But that's just in this legislative cycle, and this is not a one-cycle debate. It took 10 years for Theodore Roosevelt and the people who came after him to change the consensus around big business in the U.S. at the beginning of the 20th century. [i.e. the Progressive Era movement - J] I think we're in a five- to ten-year fight to change and reshape the consensus. And I think the response to the book is very encouraging.

Not that Chris Dodd will suddenly change his mind and we'll see a sudden legislative shift, but that we'll have a good chance of moving the entire mainstream thinking on this—including mainstream left and mainstream right—away from support for this oligopoly. People currently think, 'Oh my gosh, we cannot allow a monopoly on an industrial product." After a hundred years, that's a mainstream view. But what people don't get is that massive banks are incredibly dangerous, too.

I would point to J.P. Morgan Chase CEO Jamie Dimon's letter to his shareholders this week as an indication of what we're up against. He says they should be allowed to get as big as they want, and that's how the free market works. Well no, Jamie, that's not a free market. That is the result of unfair competition and an implicit government subsidy.

ZC: He also completely ignores all of the egregious things his bank did over the past decade, particularly the $30 billion subprime operation. But it does seem like there has already been some positive ideological movement. When you were pushing this idea a year ago, a lot of people viewed it as crazy. That doesn't seem to be true any more. Lots of people still disagree with you, but your views have become an acceptable part of the dialogue.

SJ: I think that's true. But you also saw the Volcker rule in January, which turns out, I admit, to be rather tepid. Nevertheless, seeing the president say, "If these guys want to have a fight, let's have a fight," was very important. And to see Treasury willing to take on the financial lobby, even the Chamber of Commerce, is noteworthy, although it's only been over consumer protection. Treasury official Neal Wolin gave a pretty good speech recently where he said, "Look, you're spending $1.5 million a day on lobbying and employing four or five lobbyists per member of Congress. This is totally unacceptable, and you're not even representing the interests of all your members."

ZC: And Wolin is a former lobbyist for the financial industry.

SJ: Yes! If you gave me the opportunity, I would hire some of those people, too. In the U.K. there is an expression, I don't know if it works in the U.S., but it's "Hire poachers and turn them into gamekeepers."

ZC: The first SEC Chairman was Joe Kennedy, and he wasn't exactly a shining example of business integrity.

SJ: It takes one to know one, right?

ZC: Let's talk about the revolving door, though. A lot of people from Wall Street leave to work in Washington, and then go right back. The top bank regulator in the country used to be one of the top bank lobbyists, and he hasn't done a very good job as a regulator. How do you exploit the expertise of the financial sector without succumbing to its excesses?

SJ: Well yes, the revolving door is obviously out of control, and I didn't mean to say you should exclusively employ poachers, that doesn't go well. What you need is a very strong set of incentives and guidelines, and you need people at the top of the regulatory chain who truly believe that the bad aspects of the financial sector need to be curtailed. We haven't had that for a very long time. You saw just last week, a guy left Barney Frank's staff to become a financial lobbyist. Not to pick on that one guy, but it's a perfect illustration of how the whole culture between Wall Street and Washington is just totally out of whack.

You probably need to come in with some overly draconian initial restrictions, like banning anyone from revolving through the door for a period of five years. Once the cultural perceptions about Wall Street change, you can maybe relax those rules a bit. But right now it's just so massively out of control, it really does need strong action.

ZC: I want to ask you some smaller-bore economic questions. At a certain point, there was a lot of public debate on executive compensation, which has subsequently disappeared from the reform push. What role did executive compensation play in the crisis, and do people have a right to be angry about it?

SJ: Yes, people have a right to be angry about it. I think it's a symptom of a deeper problem. I don't think you can just fix executive pay by itself, because people will find other ways to compensate themselves that get those restrictions. But a lot of pay that rewards short-term performance is undoubtedly a reflection of the dangerous incentives in our financial system.

There was a very nice write-up in the Washington Post going through how people are being paid, and the executives of big banks, most notably John Stumpf, head of Wells Fargo, are getting just huge cash payouts. And those payouts are absolutely not in line with what the administration asked them to do.

I think this shows two important things. First, when you ask bankers nicely to do something, they just don't do it. Second, when Wells Fargo was pressed on why Stumpf was getting paid so much, his spokesperson said, "Well, we had a really good year in 2009." I'd say that, actually, no, you didn't have a good year, you were saved like all of the other big banks by the government. That is not a good year from a social point of view, it's not a good year if you're trying to run a bank well, and paying this much cash is completely inappropriate. It reflects how deep we are in this mess. We haven't gotten out of it.

ZC: So would you say that too-big-to-fail and excessive Wall Street pay are connected?

SJ: Yes, I would say they are two sides of the same coin. But I would caution that if you fix too-big-to-fail, I wouldn't have a problem with the compensation. Then I think it's an issue for shareholders and corporate governance that the company's owners can either take on or ignore.

If some hedge fund, for example, makes a lot of money and pays its guys a lot of money, I don't really have a problem with that, so long as they aren't creating systemic risk. I'm an entrepreneurship professor at M.I.T, I like people who take risks. What I don't like is people who play with house money, which in this case is the taxpayers' money.

ZC: Your background is with the IMF. Drawing on that experience—do financial crises of the size and scope of what we've just experienced take place without widespread fraud?

SJ: It's a good question. You never know how much fraud there is unless big banks actually collapse. You can see this around Lehman. We knew Lehman was a sharp operator, we knew Lehman was really skating along the edge in many ways, but we didn't know they were engaged in outright fraud. And in fact, even after the revelations about their Repo 105 plan to hide assets from investors, we still don't know if that behavior can be proved fraudulent in a court of law.

They certainly bent the rules massively. They certainly misrepresented things to their investors and to the market. Whether they can be held accountable for that is another question, unfortunately.

But you never really find out about fraud until the company collapses, because after that, nobody wants to do business with them anymore, and nobody wants to cover for them. Nobody thinks, "If I get tough on Lehman, they won't give me any more good trades," because Lehman is gone.

This is what protects the big guys right now, the J.P. Morgans, even Citigroup, which most people on Wall Street really dislike and regard as very poorly run. Even Citi is immune from some level of criticism because there are hedge fund people and people on Wall Street who are very knowledgeable and want to do business with those companies going forward. As long as a company stays in business, the public will never know what was fraudulent and what was not.

ZC: So what's the difference between an Enron-style scandal where people go to jail and what we just lived through?

SJ: I think there are a lot of parallels. With Enron, we never found out about anything until the firm collapsed. After that, there were prosecutions. So we should wait and see how things play out. But the rules that apply to the financial sector are very loosey-goosey, and much more open to interpretation and exploitation than the rules that apply to other companies. Enron was sort of a weird hybrid that committed many financial infractions, but they weren't a bank, and they didn't have the kind of protection that you get from being a bank and being regarded as central to the credit system.

ZC: But they were involved in the derivatives market, and they did engage in accounting hijinks.

SJ: Right, although by today's standards, of course, they were small-scale and primitive.

ZC: But shouldn't that scandal have sounded an alarm somewhere? Shouldn't there have been some broader federal response after Enron?

SJ: Well, the big alarm bell was the failure of the Long-Term Capital Management hedge fund in 1998. And the extraordinary thing, which we point out in 13 Bankers, is that Brooksley Born actually rang the alarm bell before the Long-Term Capital Management crisis, and she was ignored, marginalized and attacked for it.

I think Enron was actually misconstrued, because people dismissed it, saying it was just fraud, they just failed to disclose important things to shareholders. And we did get the Sarbanes-Oxley Act out of it, and I don't think that was a bad idea. But the response did not cut to what now appears to be the heart of the problem.

ZC: You've done a very good job emphasizing the conflict between big banks and the broader economy. But there are also conflicts between the managers of companies and the shareholders who own them. How do you align those incentives to prevent executives from looting their own firms, as thousands did during the savings and loan crisis?

SJ: That's a very tough problem and it gets to the heart of our modern economy. The central problems in the economy today are these agency problems, the phenomenon in which the people who run companies are controlled only very indirectly by shareholders or anyone else. And in big, complex enterprises, its easy to hide a lot of stuff. Remember even small banks are relatively large and complex compared to other businesses.

The savings and loan crisis was very much about regulatory failure, and about regulators being encouraged to look the other way by the executive branch and by Congress. At the end of the day, though, I would emphasize that the savings and loan crisis resulted in more than 750 people going to jail and more than 2,000 institutions going out of business—all without bringing down the global economy.

You cannot expect for there to be zero fraud in a country like the United States, with its dynamic culture and its complexity. It's just part of the way we are. What you want to make sure is that the economic structures you create cannot be completely destroyed by the actions of one, two, or thirteen bankers who engage in things you and I would consider fraudulent. That's obviously not where we are today.

ZC: In a recent column in the New York Times Paul Krugman argued that breaking up the big banks won't solve all of our problems, that the bank crash of the 1930s was mostly small banks, and the government made a mistake when it allowed them all to fail. Do you have a response to that?

SJ: The 1930s obviously taught us a very important lesson, particularly the need for deposit insurance. I would not want us to have small banks fail in the context where you had removed federal deposit insurance, but that's not going to happen. That's never going to happen. That aspect of a retail panic run is something people have to take away from the '30s experience.

Now, when you've prevented that, you've introduced a distortion into the system, because people now have protected sources of money, so they won't pay much attention to how the institution is governed. That means you have to have substantive regulations.

I'm not suggesting that we forbid or outlaw crises. That's impossible. But ask yourself this question. If Citigroup had failed in 2008—this is a little funny because of course they did fail, and we saved them—but in 2008, they had a total balance sheet of about $2.5 trillion. That's 17 percent or 18 percent of the U.S. economy. If they had been a $5 trillion bank, or a $10 trillion bank. If they'd been on a scale relative to the U.S. economy of what we saw in Ireland or the U.K.—in the U.K., Royal Bank of Scotland peaked at 1.75 times the U.K. economy, by our calculations. So let's say Citigroup was a $20 trillion bank. Would our problems today be better or worse?

That's question number one. Question number two is, are the incentives for the banks now to become bigger or smaller? Jamie Dimon's letter to his shareholders is very clear on this. He thinks if you do well, you should be allowed to get as big as you want. That is incredibly dangerous.

Actually, Jamie Dimon may be the most dangerous person in America today. He's dangerous because he's good. I fear the collapse of Citigroup, and I find Goldman Sachs more entertaining than anything else. They really help us because they aggravate so many people. But Jamie Dimon is smart. Jamie Dimon keeps his head down, and Jamie Dimon keeps getting bigger. Even if you think Jamie Dimon is a fantastic guy, and a savvy businessman, whatever the president said about him, which I'm not taking a side on. Jamie Dimon will not be running J.P. Morgan Chase forever. He's already lining up his successor, in fact. Whatever you think of John Reed and Sandy Weill at Citi, the fact is, they were succeeded by Chuck Prince, who was a disaster.

Every business eventually falls into the hands of somebody who doesn't know what they are doing. That is particularly true in finance, and it is particularly true at big financial institutions. So I think it's safe to say Jamie Dimon is the most dangerous man in America.

ZC: There is a very strong culture of hero worship in finance, not just on Wall Street but in the Federal Reserve. People view the Fed Chairman as this great golden god who descends from the clouds to speak to the monetary multitudes.

SJ: Yes, he's like the adventure hero in some King Kong movie.

ZC: At least with Alan Greenspan, and the way his reputation has changed so dramatically in the last three years, is it safe to say that this idolization is a bad thing?

SJ: This is sort of a secondary point to our main theme, but Federal Reserve reforms are very important. There should be term limits on the Fed Chairman and the Fed Governors, and you should change the Sunshine Act to the extent that it applies to the Fed. The Sunshine law says that if you have more than three Fed Governors meeting at any time, it has to be subject to public notification.

Over the past few years, Ben Bernanke, Donald Kohn, and Kevin Warsh were the inner core, and everyone else was basically ignored, and to be honest, not that important. That's a mistake. It feeds into this whole policymaker-as-hero idea which is very dangerous in a democracy.

ZC: You've mentioned Citigroup a few times. What should Robert Rubin do with all of his money?

SJ: Robert Rubin is the most interesting person and the most important character for the country to understand in this crisis. What he thought, when he thought it, why he pursued these deregulatory policies when he was at the Treasury during the 1990s, what he was doing or dreaming about when he was supposedly in charge of governance at Citi. The way he viewed the world, and the way Greenspan viewed the world, is largely responsible for what just happened. How that has changed, if at all, is very important.

ZC: I'm not a fan of his policies at Treasury, but whatever you think of them, he was one of the few people who stayed on at Citi for the entire mess.

SJ: And a figure who has slipped below the radar. But here's what he should do with his money. My kids love Colonial Williamsburg. And I think Rubin needs to take a page from John D. Rockefeller here and go out and restore some historic banking place and create a living museum where people can go around and learn about and wear the clothes of people from this crazy era. I'm being a little facetious here with Williamsburg, but my daughters like to wear the clothes of 18th-century Virginians. But some place where you could wear the clothes of 1990s American bankers, and play in financial markets and make them crash. That'd be wonderful.

ZC: But this lesson about financial crashes seems to get unlearned every few years. One of the more obnoxious things Jamie Dimon said before the Financial Crisis Inquiry Commission was that remark about how financial crises happen every five to seven years, and we should stop being surprised by it and stop trying to prevent or contain it. But why does it keep happening? Why can't people remember that markets often get out of control and crash?

SJ: Oh that's hooey; they remember. The problem is that they have incentives to do it again. The Chuck Prince quote that we all make fun of--"While the music is playing you've got to get up and dance"--is actually 100 percent correct. It totally encapsulates what is wrong with Wall Street now and what was wrong with Wall Street before. Remember, he said that in July 2007 just as the wheels were starting to come off the bus. The insanity couldn't continue forever, but everybody was getting rich by pretending it could.