In testimony, May 4, 2010, from Jamie Galbraith before the Subcommittee on Crime on the role that fraud played in the financial crisis, Mr. Galbraith said sub-prime mortgage was a “license to steal.” He said, “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.:
Galbraith said, “At its heart, the financial crisis was a breakdown in the rule of law in America.” And he warns, “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.”
Galbraith recommends: “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.”
Other Excerpts:
- 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.
- 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.
- 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.
- 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. … 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.
- 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.”
- 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?
- 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.
Written By Mike Bock
Mike, you are spot on. I advocate the death penalty for those engaged in massive frauds. We need to insist that the political parties drop partisan wrangling for common sense reform. It makes me livid when I see the likes of Dodd and Frank act like angels when they act like they had nothing to do with the problem.
Unfortunately, “fraud” is a term of art in the law, different than the popular understanding of cheating. It requires proving intent to deceive, false statements of fact, reliance on the statements, and perhaps most importantly, a right to rely on the statement. Not surprisingly, fraud is rarely proven against reasonably sophisticated perpetrators, particularly those who have studied psychological market research about how people make decisions. In sales of homes, for instance, a defect that could be seen by an expert who knows where to work is considered something a buyer is expected to see. In a complex instrument like a mortgage, key surprises can be hidden in piles of documents where they will be missed. The social setting, particularly the fact that people often rely on relationships of trust that can be abused easily, and sign documents in situations where detailed study is discouraged, are generally not considered. For most transactions, the laws of “fraud” were found to be inadequate long ago, and better consumer protection laws have been passed. However loopholes in these laws are often discovered or purchased from legislators in exchange for contributions, or are unintended consequences of past crises. (Much of the predatory lending of the 90s and 2000s resulted from abuse of innovations created to cope with the inflationary 1970s.) To the extent that lenders were regulated, it was often by competing institutions at different levels of Americans federal system, which created a race to the bottom dynamic. The problems are exascerbated when things change hands quickly, with remedies often disappearing after sale to a new party.
Galbraith speaks not of fraud in the technical legal sense but the common sense sense, with a marketplace that is unregulated, without remedies, and can not be trusted. Combine this with the lack of solidarity we see people have for their neighbors who are victims, often blaming the victims for their plight and at the same time congratulating themselves for their good fortune in not becoming a victim themselves. One problem is that people expect a justice system to be more effective than it actually is in practice. If people know how little trust they should have in the financial system, they may put their money under a mattress, which is not good for the overall system. They say people are happy with their health insurance until they get sick and need to make a claim. Similar people have been happy with the civil justice system and financial regulatory system until it fails miserably, as it has done. The purpose of a justice system is justice, so that people can go about their business in the marketplace in relative safety. As Galbraith points out, this is not the first time in recent memory that this system has failed. We need to get serious about restoring integrity to the marketplace.