Market Overview

Who Put the Rot in Herr Hummler's Wurst?

I write this column as I am flying home from presenting a keynote address Friday to the 32nd annual Burgenstock Meeting (now held in Interlaken, Switzerland). The Burgenstock meeting is one of the top international meetings on financial derivatives and attracts a mixture of senior regulators, market participants, and a scattering of academics. I changed the presentation I intended to make entirely in order to respond to Thursday's famous Thursday keynote presenter, Dr. Hummler, the head of the oldest private bank in Swizerland. Dr. Hummler is famous for his monthly newsletters, which goes out to a select mailing list of 100,000 and often prompt significant discussion. I found his keynote address provocative. I was not adequately aware of his work, so I stayed up until 4:00 a.m. researching his positions and then prepared a new keynote address responding to his central thesis. I discovered in the course of my research that Dr. Hummler's actual thesis is considerably more provocative than the shortened version he presented to us. Dr. Hummler's famous metaphor for the ongoing crisis places principal blame on financial derivatives. I pause to deliver a word of praise for the creator and host of the Burgenstock Meetings, the Swiss Futures and Options Association (SFOA). Many organizations claim to support a robust debate among diverse views, but the SFOA delivers. They featured a speaker, Dr. Hummler, who blames financial derivatives for spreading the global crisis, and me, a strong opponent of the economic orthodoxy, particularly its theoclassical adherents.

Dr. Hummler is a mainstream theoclassical economist. Theoclassical economists are some of America's leading exports. Dr. Hummler received his advanced economics training at one of the University of Chicago's outposts, the University of Rochester. Even within the Chicago school, the UR economists have a reputation for the vigor of their antipathy for even democratic government. Dr. Hummler represents the Austrian wing of Chicago school economics, as slightly modified by the purest of self-interest for a Swiss private banker. He self-identifies as a blunt speaker of truth to politicians. He is strongly hostile to Americans, Germans, the EU, and the euro. His bluntness is exemplified by his acknowledgement that the reason his bank has customers is overwhelmingly the customers' desire to evade taxes through means that are crimes in their home nations, but at most civil violations in Switzerland.

His bank's principal strategic imperative, therefore, is to keep Switzerland a safe place for tax evasion. Accordingly, he requires his customers to have no financial dealings with the U.S., lest the U.S. have jurisdiction to investigate his bank and his personal actions in facilitating what is tax fraud from the U.S. perspective. He fears the U.S. because it is, episodically, the most effective international enforcer of its tax laws. He despises the EU and OECD because he fears their international efforts against tax havens. The Germans are in his dog house because their national intelligence service has shown recent success in cracking down on German tax cheats illegally (under German law) using Luxembourg and Switzerland as tax havens. These factors explain his pugnacious Swiss self-interest component that he adds to his otherwise conventional Austrian and Chicago school views. This fusion of Swiss self-interest and Austrian school economics causes no real intellectual tensions because it is simple under Austrian views of the democratic state as the great danger to freedom to interpret anything, even fraud by the wealthy, that reduces the State's tax revenues as desirable. One must starve the state to preserve freedom. Those that starve the State are, therefore, freedom fighters. Their self-interested actions must therefore be re-conceptualized as representing sacred rights. Dr. Hummler claims that tax frauds with accounts in Switzerland have an unassailable “property right” not to pay taxes.

“[F]oreign clients have so far enjoyed the benefit offered by Switzerland of noncriminalization for simple tax evasion. In terms of property theory, this is a “property right” that had previously been assured; should one wish (or be obliged) to modify it, this amounts to expropriation in the sensitive area of personal integrity.”

Yes, under Hummler's rules Switzerland has a duty to aid and abet what other nations define as tax fraud by their citizens. Hummler joins a classic U.S. moralist, Texas' Governor Bill Clements. Clements became head of Southern Methodist University, after the National Collegiate Athletic Association (NCAA) caught it making unlawful payments to players. SMU agreed to cease the payments and clean up its program. Clements, however, secretly directed that the payments continue, expressing the view that the student-athletes had a property right to receive the unlawful payments. In Texas “a deal is a deal.” SMU had struck a deal with the athletes. They had lived up to their end of the bargain and SMU had a duty to pay them. Sadly, the NCAA lacked SMU's sophisticated understanding of property rights and morality and gave SMU the “death penalty.” As football is god in Texas, this was an act of deicide.

Under Hummler's view of property rights, the democratic State can function only because the non-wealthy lack the wealth and financial sophistication (or they lack the necessary immorality) to emulate the wealthy tax cheats by engaging in tax fraud with impunity. As that great Austrian school sage, Saint Leona Helmsley explained: “only little people pay taxes.” In any other context, of course, Austrian and Chicago school economists would denounce tax fraud – a scheme to receive the benefits of the State, which typically made the tax cheat wealthy, without paying for the benefits – as “rent seeking” and “free riding.” Re-branding the wealthiest tax cheats into freedom fighters represents a triumph of what criminologists refer to as “neutralization” of the moral restraints against fraud. Successful neutralization leads to increased crime.

Hummler's keynote address contained his famous sausage metaphor. Collateralized debt obligations (CDOs) are made by slicing and dicing mortgages. It is easier to observe whether meat is rotten when it is whole. When it is sliced up into tiny pieces, mixed with lots of other meats, and placed in a somewhat opaque casing it is far harder to see or smell that it contains some rot. One only learns that the sausage is rotten after consuming it and getting sick. In the CDO context, Hummler says that the rot was U.S. subprime loans. Once we have been made sick by the rot in the sausage we will stop eating all sausage. Indeed, because we do not know which meat originally contained the rot, we may stop consuming all the meats that go into making sausage. Hummler states that this metaphor explains why large numbers of markets, well beyond the CDO market, collapsed.

Criminology confirms this aspect of Hummler's metaphor. The essence of fraud is deceit. The fraudster gets the victim to trust hi and then betrays that trust. As a result, elite financial frauds are the most powerful acid for destroying trust. When trust fails, markets fail. What happened in this crisis is that the sausage makers at Bank A (one of the largest investment and commercial banks) that were selling each other sausage links began to worry that their counterparties at Bank B were putting as many rotten mortgages into their CDOs as Bank A was putting into its CDOs. Hummler is confirming what criminologists have long known – accounting control fraud can cause extreme negative externalities.

Hummler recognizes that he has to explain why the sausage makers would put rotten meat in their sausages. His metaphor is heretical for a theoclassical economist of either the Chicago or Austrian school. He has reversed the core metaphor of the father of modern capitalism, Adam Smith. Smith's most famous metaphor was that we could safely rely on the butcher (the maker of sausages) and the baker to give us high quality goods without rot not because the butcher and baker really cared about our health, but because they were driven by self-interest. Smith argued that altruism was unreliable, but self-interest was constant because it was continually reinforced by capitalism's inherently positive incentives. The butcher or baker that put rot in our food would immediately be driven out of business by his enraged customers (and all their friends and family who heard their woeful tale of diarrhea and vomit) and his always vigilant competitors. Smith's proud paradox is that it is capitalism's ability to harness productively what he saw as the most widespread and immutable of human characteristics – our relentless pursuit of self-interest – that causes capitalists to act reliably as if they cared about us as human beings. Smith cheerfully acknowledged that this was on some level a mere simulation of morality. His point was that it didn't matter that it was only a simulation – it worked brilliantly and produced a world in which capitalists acted in the best interests of customers.

Hummler is desecrating sacred ground by reversing Smith's central argument in favor of capitalism. He is also exposing one of the central weaknesses in Smith's metaphor – what if the victims do not know they have been defrauded? If I can get away with fraud, and if self-interest is my guide, then Hummler's logic leads to a further great desecration of Smith's metaphor – “Mankiw morality.” N. Gregory Mankiw (Harvard economics professor, and Chairman of President Bush's Council of Economic Advisers when Hummler's sausage was being poisoned, was a discussant when George Akerlof and Paul Romer presented their paper “Looting: the Economic Underworld of Bankruptcy for Profit in 1993. Mankiw responded: “it would be irrational for savings and loans [CEOs] not to loot.” Mankiw morality is that if you can get away with committing accounting control fraud, and fail to do so, you are not a moral CEO – you are “irrational.” It is “irrational” not to breach your fiduciary duties by looting the firm's creditors and shareholders in order to make yourself wealthy.

Mankiw morality proves how correct Bastiat was – and how little human nature has changed since his day. “When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.” (Frederic Bastiat). Hummler's reversal of Smith's defining metaphor of the virtues of capitalism becomes all the more destructive of Smith's thesis when one considers the dynamic implications of control fraud. George Akerlof explained in his classic 1970 article on “lemon” markets that “asymmetrical information” about the quality of a complex product (such as CDOs) allowed sellers of goods and services to defraud their customers. In a world with asymmetrical information, and accounting control fraud by elite financial institutions represents the epitome of asymmetrical information, real morality matters. Indeed, it is essential, for simulated morality will become real fraud. Fraud matters immensely. It is the AIDS of the financial world. Accounting control fraud targets what are supposed to serve as finance's immune system. It does not simply defeat the immune system; it perverts it into a pathogenic environment that spreads the virus particles throughout the system. AIDS allows the virus to function and replicate with a large degree of impunity. Accounting control fraud ensures that markets are inefficient and it is a superb device for causing financial bubbles to hyper-inflate and markets to fail, triggering severe financial crises.

Control fraud can provide cheaters with a competitive advantage in the marketplace. That is clear in the examples Akerlof provided over 40 years in his seminal article on asymmetrical information, anti-customer control fraud, and lemon markets. When a merchant mixes pebbles into the rice that he sells (by weight), he obtains greater profit than does his honest competitor because his cost of goods is materially lower. Akerlof explained in 1970 why, when cheaters prosper, market forces become perverse and bad ethics can drive good ethics out of the marketplace.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” George Akerlof (1970).

Akerlof explained that this perverse effect acted in a fashion analogous to Gresham's law: in hyperinflation, bad money drives good money out of circulation. He warned that the control frauds could produce a similar Gresham's dynamic in which bad ethics would drive good ethics out of the marketplace. It is fitting to give credit to the insights of an Irish genius whose views on the same subject predate Akerlof's, for they were published in 1726 while he was in Dublin.

“The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man's goods from thieves, but honestly hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.”

Swift, J. Gulliver's Travels, London, Penguin (1967) p. 94. See Levi, M. The Royal Commission on Criminal Justice. The Investigation, Prosecution, and Trial of Serious Fraud. Research Study No. 14, London, HMSO (1993) p. 7.

One type of control fraud does not create a competitive advantage for the firm, indeed it does the opposite. The CEOs of lenders typically optimize accounting control fraud by making enormous numbers of bad loans at a premium yield. Making bad loans is suicidal for the firm, but can be extremely profitable for the controlling officers. Neoclassical economic theory predicts that the reaction of a rival bank to a competitor that is committing suicide should be to cheer them on. Unfortunately, modern executive compensation has created a Gresham's dynamic. The accounting control fraud recipe, as Akerlof & Romer warned, is a “sure thing” – it produces record (albeit fictional) short-term income. This maximizes the CFO's and the CEO's bonuses. If a rival (honest) CFO refuses to follow the fraud recipe his bank will report much smaller (albeit real) income. The honest bank may even lose money. (If many control frauds follow the recipe their rapid growth makes it harder for honest banks to make profits because they increase deposit interest rates and depress yields on assets.) CFOs have a realistic, intense concern that they will lose their jobs if they cannot deliver high reported income and maximize their CEOs' wealth. Hummler does not appear to understand how destructive of theoclassical and neoclassical economics' defining metaphor it is to argue that Adam Smith's dependable butcher is now routinely, and deliberately adding meat that he knows is rotten and will make the consumer deathly ill into sausage because he knows that he can deceive the consumer by disguising the filth in an opaque sausage casing. Hummler's butcher is still acting out of greed, but he has discovered that defrauding and sickening or destroying his customer pays. In Hummler's dystopian vision, the capitalist is a psychopath, and capitalism has become severely criminogenic. When he presented his keynote address, Hummler's explanation of why Smith's butcher had become a psychopath was that the U.S. Federal Reserve had set interest rates too low. He stated, “You have all just experienced at the coffee break what happens when something is given away free – you drink it.” That was a silly metaphor on multiple levels. If we gave a bank a trillion dollars for free it would not be indifferent about losing the trillion dollars. The bank would be the pig farmer under Hummler's rotten sausage metaphor. The pig farmer produces the rotten meat and, knowing it is rotten, sells it to the butcher. The metaphor fails to explain why the butcher knowingly buys the rotten pork and adds it to his sausage. Under Hummler's metaphor the butcher is the investment bank creating that purchases subprime loans and creates CDOs. If we gave the butcher a trillion dollars for free to purchase pork it does not follow that the butcher would be losing the trillion dollars. Indeed, the standard neoclassical answer is that providing large, recurrent public subsidies to either the banks or the investment banks would make owning a bank or an investment bank exceptionally valuable to its shareholders. Selling rotten pork or rotten sausages is suicidal for the shareholders' and creditors' interests. The shareholders and creditors should exercise greater private market discipline to preserve their valuable franchise. If they can borrow money exceptionally cheaply the banks and investment banks have no need to take excessive risks to earn a positive spread. We need to step back a moment and consider the “low interest rates cause bankers to become psychopaths” argument. If this is true, then capitalism is doomed. We should also recall that, prior to the crisis; the neoclassical claim was that low interest rates were exceptionally desirable because they reduced the hurdle rate for productive investments in the real economy. Indeed, we were promised that we would enjoy booming real economies due to the lower interest rates and central banks all over the world echoed the claim that it was their unprecedented independence, superior understanding of macroeconomics, and anti-inflationary discipline that produced the low interest rates, low inflation, and low unemployment that characterized “the Great Moderation.” Now many of these same central bankers claim that these conditions cause bankers to become psychopaths. Hummler's admission that banks and investment banks committed massive accounting control fraud was so important, and his explanation for why they did so was so facially absurd that I was intrigued about what Hummler really thought led to the endemic fraud. I junked my planned presentation and researched his positions well into the morning and then created an entirely new keynote presentation responding to his real views. I found Hummler's real views in his Investment Commentary No. 262 (March 16, 2009). Remember, this is a newsletter Hummler indicates goes out to roughly 100,000 recipients. Hummler explained that banks made rotten subprime loans when they started to make loans “favoring … particular sections of the populace.” That, of course, sounded like code. Hummler explains later in his newsletter who he thinks was being favored – and why. “It is said that the vast majority of insolvent home-owners belong to ethnic minorities.” The phrase “it is said” is a sure sign that the author has no reliable information he can cite. It is no surprise that Hummler's demons are “ethnic minorities” in the U.S. Hummler then explains why the U.S. banks suddenly began to make huge numbers of loans to “ethnic minorities.” “[S]ub-prime mortgages in the USA. Encouraged – indeed, driven – by the politicians, who had championed home ownership with the “Community Reinvestment Act” (1977/1995), the banks offered loans to households that would never have been regarded as creditworthy by normal standards.”

Hummler presents the favorite theoclassical explanation of any malady – misplaced governmental efforts on behalf of ethnic minorities led to unexpected negative consequences. Hummler then adds a racial element – President Obama is an ethnic minority.

“It is understandable that the Obama administration is inclined to take an accommodating approach to these home-owners, and that appropriate financial help is on its way.”

“[T]he obfuscatory approach adopted by Obama, with (again) the favoring of particular sections of the populace…” “The righteous are ‘punished'.”

Because the “vast majority” of the people defaulting on their mortgages are “said to be” “ethnic minorities,” it follows that the people who are not defaulting are white and represent “the righteous.” It is “understandable” that Obama is inclined to help “these home-owners” – the ethnic minorities by adopting an “obfuscatory approach” designed to “favor[]” … “particular sections of the populace” [ethnic minorities]. I interpret Hummler as arguing that because Obama is black it is “understandable” that he has adopted policies designed to “favor” ethnic minorities and “punish” primarily whites (aka, “the righteous”).

Collectively, Hummler asserts that these U.S. policies that favor ethnic minorities and punish whites constitute a public subsidy that violates sacred property rights. “In terms of property theory, this constellation represented the provision of a subsidy in the form of free guarantees to a certain section of the populace….”

In fact, the U.S. has not provided “appropriate financial help” to homeowners of any ethnicity under either President Bush or President Obama.

Hummler's baseless assertions that the CRA drove the global crisis by causing banks to make mortgage loans to “ethnic minorities” who “are said to” provide the “vast majority” of insolvent homeowners warrant Charles Black's famous denunciation: “The curves of callousness and stupidity intersect at their respective maxima.” Black wrote that sentence to describe a dishonest, racist statement in the infamous Supreme Court opinion in Plessy v. Ferguson (1896) upholding the constitutionality of racial segregation.

Many of us have explained at length why the CRA argument is nonsense. The Act became law in 1977 so it is a poor candidate for suddenly causing a crisis thirty years later. The only conceivable explanation is that the law or its enforcement (or both) were made much more severe after 2000. The CRA was weakened in 1999 at Senator Gramm's insistence and the Bush administration greatly reduced and weakened CRA examination and enforcement. Home lending, during the key decade, was done to an unprecedented degree by lenders that were not subject to the CRA. Most of the subprime lending specialists were not subject to the CRA. For all these reasons, the CRA had vastly less impact on lending during the key decade when the crisis occurred. For Hummler's argument to have any credibility the opposite would have had to occur.

The CRA never required a bank to make a bad loan. None of the lenders that were subject to the CRA and made very large numbers of subprime loans were in any difficulty with their regulators based on alleged failure to loan to minorities. The lenders, regardless of whether or not they were subject to the CRA, that made large amounts of subprime loans did so in order to grow rapidly by making loans with a premium (nominal) yield.

The CRA did not require loans to be made on the basis of race. The anti-discrimination laws did make red-lining unlawful, but they became law decades earlier. The Bush administration did not produce any great crackdown on the lending discrimination against “ethnic minorities.”

Liar's loans actually drove the crisis, yet Hummler ignored the in the newsletter and his keynote address to us. Liar's loans provide a superb “natural experiment” to test why nonprime lender specialists made vast numbers of nonprime loans. Credit Suisse reported that by 2006 one-half of the loans called “subprime” were also liar's loans. The defining characteristic of liar's loans is the failure to engage in prudent underwriting. In particular, lenders that made liar's loans agreed that the borrower did not have to verify the income stated on the loan application form. I have explained why this produces acute “adverse selection” and that this meant that the expected value of home lenders making liar's loans was deeply negative. In plainer English, that means that that banks that make liar's loans will lose money. Honest banks, therefore, would not make liar's loans backed by home loans.

Herr Hummel‘s horrenden Hausmacher Bank Wurst

I have explained in prior posts why we know that it was the lenders and their agents that typically put the lies in liar's loans. Hummler's rotten sausage was homemade by bankers ranging from elite CEOs to their least presentable mortgage brokers. They put the rot in – billions of dollars of fraudulent and grossly overvalued mortgages – and they sold it and held in portfolio because the premium yield (on purported AAA assets) made their models (which they designed) sing and maxed out their bonuses. The Mortgage Bankers Association's (MBA) anti-fraud specialist (MARI) reported to the entire industry in 2006 that stated income loans were “open invitation to fraudsters,” that the best study of the frequency of fraud in such loans found a fraud incidence of 90%, and that the loans deserved the label the industry used to describe them behind closed doors – “liar's loans.”

Credit Suisse reported that by 2006 roughly one-third of the U.S. mortgages made in that year were liar's loans. That indicates (at a 90% fraud incidence) an annual rate of mortgage fraud greatly in excess of one million. None of this was a surprise. The FBI warned in open testimony in the House of Representatives, reported in the national media, that there was an “epidemic” of mortgage fraud and predicted that it would cause a financial “crisis” if it were not contained. No one claims that it was contained. Instead, many lenders rushed to rapidly increase the number of liar's loans they made after the FBI's 2004 warning. They continued to rapidly increase the number of liar's loans they made after the MBA/MARI's 2006 warning. They continued to do so after repeated warnings that appraisal fraud was becoming common. The government never required liar's loans to be made or purchased. The regulators frequently criticized and warned against liar's loans. Bank CEOs (and, eventually, Fannie's and Freddie's CEOs) caused their firms to make and purchase vast amounts of liar's loans and CDOs because they allowed rapid growth through assets that paid a premium nominal yield and maximized executive bonuses in the near term. (The actual yield, of course was sharply negative because the loan applications and appraisals were so commonly fraudulent.) The senior bank officers that caused their banks to make and purchase liar's loans knew that such loans were endemically fraudulent.

Liar's loans would not be used to make loans to poorer people in order to meet some government mandate. The primary purpose of liar's loans was to inflate income enormously. Inflating income made it appear that liar's loans were made to borrowers with considerably higher incomes than their real incomes, the opposite of what Hummel claims drove bank lending in the U.S. The best available information (there are no official definitions or data) is that half of subprime loans by 2006 were also liar's loans. The fraudulent banks and their agents that drove this crisis systematically overstated borrowers' incomes. Many lenders specializing in making liar's loans did target minorities for predation. Latinos are less likely to understand the complex English used in mortgage documentation. In the U.S., blacks are less likely than whites to have access established banking contacts and less likely to be financially sophisticated. Only lenders and their agents can produce substantial appraisal fraud. Bank employees and agents could cause the appraisal to be inflated substantially and then tell the prospective borrower that he had a guaranteed profit. He was buying the house for “only” $350,000 and the appraisal showed a market value of $425,000. Even if the borrower had trouble making the monthly payments he could always sell the home for a large profit. Many borrowers were told that they could always refinance the loan if they had difficulty making the monthly payments. Many borrowers did not understand the complex “exploding rate” adjustable rate mortgages (ARMs).

Working class Americans were the primary victims of the crisis and within that group blacks and Latinos suffered the worst losses. The median income of white families is twenty times that of blacks and 18 times that of Latinos – the highest disparity ever measured under that data set. It is unworthy of elite bankers, the primary perpetrators and beneficiaries of the endemically fraudulent liar's loans and CDOs, to blame such loans on “the government,” and it is despicable to blame the primary victims of the fraud for the global crisis. Above all, it is imperative that we remove the perverse incentives that have transformed Smith's reliable village butcher (the bank CEO in Hummler's metaphor) into a psychopath. Modern executive and professional compensation, in conjunction with the three “de's” (deregulation, desupervision, and de facto decriminalization) have produced an extraordinarily criminogenic environment so severe that Hummler's wurst was not tainted by rot – it was 90% pure rot. While Hummler wants to talk exclusively about the rotten sausages made in America, plenty of rotten meat (fraudulent loans) were made and purchased by European banks' CEOs. European banks were rarely subject to the CRA, and no one in the U.S. government pressured them to purchase CDOs backed by U.S. liar's loans. European bank CEOs and anti-regulators made their own criminogenic environments by combining the same general types of perverse incentives that drove the U.S. crisis.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

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Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He is a white-collar criminologist. He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He taught previous

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