Fraud, Free Markets, and the S & Ls

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We choose between the liberty of market exchanges and the government control of production and distribution. In both cases, we want fewer criminals and losses. In both cases, we want policing, adjudication, and enforcement. Low or no criminality is a free market norm. It is not a norm exclusive to government.

We therefore face this question: Which system better controls wrongful behavior and losses? Which system has stronger incentives for people to behave properly?

The savings and loan (S & L) industry was a creation of the New Deal, regulated by the Federal Home Loan Bank Board and the Federal Savings and Loan Insurance Corporation. By 1980 the industry as a whole was insolvent. The government did not want to close down these institutions as the insurer (FSLIC) didn’t have enough money. It did not want to give up its control, and it did not want to fund a bailout. The "solution" it chose contained several elements, detailed by George Akerlof and Paul Romer in their article Looting: The Economic Underworld of Bankruptcy for Profit. The government changed the accounting rules pertaining to net income and net worth. It removed interest ceilings on deposits. It allowed the thrifts to make much riskier investments, including direct real estate and real estate development. It allowed thrifts to concentrate more assets on one borrower. It allowed a single owner to own a thrift. It weakened capital requirements drastically. It allowed land to be contributed as capital. It allowed goodwill created by acquisitions to remain on the books and be depreciated over a 40-year period (as compared with a previous maximum of 10 years.) It removed the limit on the ratio of a mortgage loan to the underlying value, so that loans could be made with no down payments. The FSLIC insurance limit increased from $40,000 to $100,000.

In common parlance, the government deregulated the industry by loosening certain restrictions. The deregulation was far from complete. The government maintained control over rules and much else.

Again, using the language of the critics of deregulation, the government had made the S & L industry much more "free." This way of thinking is actually dead wrong, because an absolutely critical element of a free market was not present, despite all the other regulatory changes.

The one thing that the government did not do, which was essential in view of its other measures, was to remove the government-insured deposits. By retaining government insurance, the government created an extremely weak control structure for these companies, the result of which was that many savings and loans were looted. The government’s insurance of deposits severs the link between those who supply capital and those who use that capital. The suppliers have no interest (incentive) to control how the capital that they supply is used; and the users of that capital (the owners of the S & L) can use that capital without satisfying the suppliers. If the owners can extract more money from the S & L (by deploying the deposits on their own behalf) than its value to them as owners, then they can loot the S & L and personally profit while it goes bankrupt (since they face limited liability.)

The subject of company control structures was not well understood then, and is still not a matter of common knowledge. Those who supply the financing of firms ordinarily put in measures to control its use that have evolved in markets over the centuries. These include extensive bond covenants, loan agreement terms, boards of directors, board composition, the financial structure, limitations on management actions, approval by votes of critical actions, and compensation agreements. If the deposit insurance had been removed, lenders would not have supplied capital to these thrifts without this panoply of financial, operational, and legal safeguards. The thrifts would then have turned into mortgage loan companies, or else into real estate development or some such types of companies. Instead, with deposit insurance left in place, the S & Ls attracted vast amounts of capital from all over the nation in search of high interest rates, capital that knew it was insured no matter what the owners did. The deposit insurance eliminated the role of capital-suppliers acting as controllers of both the owners and the managers. Without these controls, with large cash inflows, and with the possibilities of investing them in land and land development projects whose values are not well-known, the government had created companies that were perfect targets for abuse and fraud.

The result was extensive fraud. Calavita, Pontell and Tillman document and analyze all sorts of S & L frauds and abuses in their book Big Money Crime: Fraud and Politics in the Savings and Loan Crisis. In some states (like Texas), abuses were rampant as S & Ls made various fraudulent deals with dishonest real estate developers and appraisers.

The effects of these deals were felt in widening circles. Some honest real estate developers at the time observed that S & Ls were extending loans to newcomer builders who were overbuilding in the face of high vacancy rates. They withdrew from the market. But other honest developers were enticed into more building because they thought that the building activity and higher prices (often the result of fraudulent sales flipping and appraisals) signaled a greater demand. In this way, the S & L abuses affected the honest market exchanges of honest developers and customers. This led to real estate bubbles, overcapacity, and eventual crashes.

The proponents of the deregulatory changes had exulted in their triumph of deregulation and free markets, not realizing that they had set in motion a catastrophe. They simply did not understand the full economic implications of their partial deregulation. When the S & L industry came totally unglued, they had egg on their face. It was very easy for free market critics to argue for the restoration and maintenance of government control. Indeed, government control did look better than the alternative that the government had (probably unwittingly) created. The solution that was politically unpalatable but correct in these circumstances was to have entirely deregulated, including the elimination of deposit insurance. The lesson to be learned is not that the free market malfunctions, but that the free market cannot be free without being free in its most critical aspects, one of which is that capitalists must have the freedom to control their capital. Whenever the government comes between the supplier of capital and the recipients of capital, it paralyzes and subverts the market. The same happens when the government comes between the producer of income and goods and his disposition of that income and those goods.

Akerlof and Romer note

"Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large banks, student loans, mortgage finance of subsidized housing, and the general obligations of large or influential firms…"

Looting is an apt and succinct term that covers various control frauds and abuses that occur when the owners or controlling interests in a financial (or other) firm use the company corruptly for their gain while destroying the value of the enterprise. Bankruptcy for profit means a perverse economic situation in which owners find it profitable to maximize their cash withdrawals from the company now, which process is enhanced by twisting accounting rules and using fraudulent devices and unprofitable deals that end up bankrupting the company.

The S & L abuses were seen in the market and affected it, but they were not of the market. They were of dishonest persons doing dishonest things as a result of bad government policies that provided incentives to benefit from being dishonest. These facts do not imply that dishonest persons do not do dishonest things in markets that are free from government rule-making. They do. Both free markets and government-control must contend with people doing bad things. But, as I argue next, free markets are less prone to fraud and widespread fraud than government-controlled economies because, for one thing, they provide stronger incentives for wealth-creating behavior and weaker incentives for wealth-destroying behaviors like fraud.

If we understand the incentives built into social arrangements, then we can forecast potential abuses. Some social or contractual arrangements encourage abuses (perhaps inadvertently) or fail to control them, as when S & L owners could aggregate huge amounts of money and dispose of them without effective controls over their spending or by fraudulently bypassing the remaining accounting controls. Millions of property owners turn over vast sums of money to school districts and local governments without a great deal of monitoring and control over how that money is spent, although there is of course some. A rather high degree of official abuse (including waste, incompetence, bureaucracy, poor education, and poor service) is a predictable consequence.

Depositors in S & Ls turned vast sums over to bankers and paid no attention to how that money was used. They did that because they relied on the guarantee of a government agency (the FSLIC) that the money was insured. That reliance, over the course of years and decades, has other major negative effects. There are very few or no innovations in the monitoring of financial institutions, and the monitoring by private persons atrophies. Everyone takes for granted that their money is safe. Meanwhile, unless the investments of the S & Ls are strictly controlled, their incentive is to take on a higher degree of risky investments since losses are shifted to society (the government guarantor) while gains are kept by owners. When the investments are not controlled, the incentive to bankrupt the bank for profit is strengthened.

Who then monitored how these deposits were used when the government deregulated the S & Ls? That lay in the hands of those whom we customarily call government regulators (in this case the FHLBB and state bodies).

The term regulator actually covers six or more distinct functions and responsibilities. They include rule-making, oversight and monitoring (such as inspection and auditing), responding to complaints, policing and detecting rule-breaking, adjudication, and enforcement. We rely on our government agents, the regulators, to do all these tasks when there is no free market. But who regulates the regulators? Who makes the rules for them? Who monitors them? Who polices them? Who controls their behavior and sees to it that they do their jobs? Who brings cases against them when they misbehave and/or respond to political forces and not our welfare? Who controls them when the rules they make cause us to lose? What do we do when the regulators who are supposed to police and enforce fail to do so? What do we do when they make rules that encourage fraud? We pay the price, and it is a very high price.

We the people do not directly control the regulators, and since there are no markets involved for their services, we do not have an impact on them via our market exchanges. Typically our elected representatives control (or attempt to control) the regulators and also make important rules that affect the institutions that they regulate. The politicians find that controlling (regulating) the bureaucracies and agents that they have created is a formidable task. They do so through their staffs, whom they then must control. Both the politicians and their staffs have just as hard a time regulating the regulators as we have regulating the representatives.

Our control system has at least four layers: people control their representatives; representatives control staffs; staffs and representatives control regulators; and regulators control S & Ls. If we bring in the state regulators and federal and state enforcement authorities, then there are even more layers. There is nothing per se wrong with layers, but when the people in each layer fail to have adequate incentives to do their jobs, then the system must deliver poor performance. Voters have almost no incentive to monitor and control their representatives, and most voters do not do so. Huge numbers, who realize the futility of it, do not vote at all. The representatives, who have power, need not be responsive to the voters; but they are responsive to interest groups who feather their nests. Staff members have incentives to control information and access to their bosses. They may, at times, form cozy arrangements with regulators. The regulators, often in secure lifetime jobs, have little incentive to be responsive to the public or to provide full information to politicians. The politicians divide up the oversight of the regulators among themselves, creating fiefdoms, and then they scratch each other’s backs and fail to monitor each other’s behavior.

Business firms often face similar issues, but, in addition to control structures, the important difference is that their customers have an immediate say and large influence on their behavior. The customer directly controls the money that a business gets from him in return for a good, so that the businessman has a direct incentive to satisfy the customer. By contrast, the voter has no direct control over his representative via an exchange of an identifiable good. What’s more, the government takes money from the voter at its discretion, so that it has no monetary incentive whatsoever to satisfy the voter. Furthermore, a business faces competition. People can start up new businesses or expand existing ones when old ones fail to serve public wants efficiently. When is the last time a group of people started up a new government?

The governmental regulatory system would fail miserably if it were not for a good many conscientious and honest people in government who attempt to do their jobs responsibly. Frequently it does fail miserably and, when it does not, the outcomes of this arrangement range from bad to worse. Rarely are we treated to a truly good result. (My opinion is that this system never works to the public’s benefit, but since the public puts up with it, who am I to say that they shall not have the system they prefer? The problem here is that they are saying what system I must live under. They have forced me into their game.)

There are those who set up a straw man version of a free market and then criticize it. They think that freedom means freedom to abuse others, behave dishonestly, and commit fraud. They think that a free market has no monitoring, controlling, policing, adjudicating, and enforcing. They think that freedom means chaos, a dog-eat-dog world, and the liberty to starve. None of this is what proponents of liberty think freedom means. Furthermore, this straw man is a really strange way of thinking, since these same persons often defend what they call "personal" freedom and various rights that are frequently impositions on other people. But freedom does not mean freedom to commit crimes and abuse others. Proponents of free markets want such behavior controlled just as much as do proponents of government, although they have different prescriptions for such control.

We do not have to look far to find those with these sympathies who blame free markets and deregulation for such problems as the S & L failures and now the failures of various financial institutions. They then call for government re-regulation and/or greater government regulation.

As we have seen accusations of deregulation muddy the understanding when deregulation is partial and makes matters worse. Deregulation should be thought of as the complete removal of government controls from an industry. After supposed deregulation, the U.S. financial industries were and still are among the most heavily controlled in our society. Since regulators have six or more distinct functions, deregulation typically means changing some rules and functions, wholly or partly, while leaving others in place. This changes incentives. The overall result may induce more fraud. Similarly, calls for re-regulation are actually calls for changes in some aspects of the existing system of regulation.

Neither deregulation nor re-regulation, as used in conventional discourse, alter the basic government control. Neither one addresses the fact that the existing structure of regulation by government is deeply flawed. We do not have a market system that is controlling, monitoring, policing, adjudicating, and enforcing honest behavior of financial firms. We have the four-layer and more governmental system outlined earlier. When this system of government regulation fails so miserably, as in these cases of financial institution failure, it cannot be blamed on free markets and deregulation.

Akerlof and Romer warned of government guarantees in 1993. Unfortunately, past government guarantees remain in place and new ones have grown up beside them. It is not surprising then to find that fraud or at least abuses of various kinds have played a major role in the most recent financial vicissitudes. There are already numerous reports and investigations of mortgage fraud on the part of borrowers, mortgage brokers, and mortgage companies. As time passes, forensic loan and financial statement audits will probably provide evidence of the involvement of more major lenders as well. The AIG company, which already has a record of fraud, is a reasonable case in point. Its rapid growth, earnings manipulation, and especially its intra-company accounting among its subsidiaries, all make it a prime candidate for further revelations. The entire financial industry of the U.S. has had its capital control incentives distorted by a variety of government measures favoring housing, by deposit insurance guarantees, by past bailouts, by friends in Congress, by campaign contributions, by lobbying efforts, by loose controls over its lending practices, and by creative accounting practices.

Wrongful behavior, abuses, and fraud by officials and people in high positions are serious matters both in markets and in government. When people in high places enrich themselves through criminal and criminal-like behavior, they can impose far greater losses on the general public than the amounts of their own gains. By distorting prices, they can induce honest consumers and producers into mal-investment, causing costly bubbles and crashes. Government has not only not been proven to be adept at controlling these matters, the theory and the evidence tell us that it causes and encourages them. The incentives provided in free markets should prove superior in controlling and mitigating frauds and associated abuses.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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