Market Overview

Cop Out: The Dogma that Broke Stockton, CA now Blames Stockton's Police

I did not know that there is a group that works every day to destroy any respect we have for our local governments and claims to generate 10 percent of the stories nationwide about local and state government.

This is the group’s self-description:  “Franklin Center identifies, trains, and supports journalists working to detect and expose corruption and incompetence in government at the state and local levels.”  I’m hopelessly old fashioned, so I view their description as an oxymoron.  A “journalist,” under my archaic definition, reports facts and analytics.  Journalists are human and they have biases, but their function is not to write only stories that confirm their ideology.  The Franklin Center is relatively new and works closely with Freedom Works (one of the Koch brother’s many entities).

Franklin Center’s vice president for journals, Steven Greenhut, wrote a piece invoking the “broken windows” theory of criminology entitled: “Broken Windows, Broken City.” 

http://www.city-journal.org/2012/cjc0306sg.html

Greenhut is outraged that the “scraggly protesters” of the Occupy movement are not occupying city hall in Stockton, California “where the greed and shortsightedness of the public sector have sent a relatively poor city careening toward insolvency and unraveled its social fabric.”  Greenhut ignores the elite private sector frauds that drove the crisis and broke the windows.  Instead, he blames Stockton’s police officers’ “greed” for causing the broken windows.  The claim that the Stockton police, many of whom lost their jobs due to the budgetary crisis caused by the elite frauds, were morally culpable for breaking Stockton’s windows is akin to blaming a man thrown out a window by a criminal for breaking the class.  Blaming the victims of defenestration for breaking the glass in the windows through which they were thrown is absurd.

Greenhut does not understand how damning the title of his article is of the late James Q. Wilson’s development of his “broken windows” theory.  As I explained in last week’s column:

“In a book entitled, Thinking About Crime, Wilson argued that criminology should focus overwhelmingly on low-status blue collar criminals.

This book [does not deal] with “white collar crimes”….  Partly this reflects the limits of my own knowledge, but it also reflects my conviction, which I believe is the conviction of most citizens, that predatory street crime is a far more serious matter than consumer fraud [or] antitrust violations … because predatory crime … makes difficult or impossible maintenance of meaningful human communities (1975: xx).

I am rather tolerant of some forms of civic corruption (if a good mayor can stay in office and govern effectively only by making a few deals with highway contractors and insurance agents, I do not get overly alarmed)…. “ (1975: xix).       

Notice that Wilson’s explanation is antithetical to his “broken windows” reasoning.  There are, of course, relatively minor white-collar crimes.  Wilson emphasized that it was the willingness of society to tolerate relatively minor blue collar crimes that led to social disintegration and epidemics of severe blue collar crimes, but he engaged in the same willingness to tolerate and excuse less severe white collar crimes.  He predicted in his work on “broken windows” that tolerating widespread smaller crimes would lead to epidemic levels of larger crimes because it undermined community and social restraints. 

The epidemics of elite white collar crime that have driven our recurrent, intensifying financial crises have proven this point.  Similarly, corruption that is excused and tolerated by elites is unlikely to remain at the level of “a few deals.”  Corruption is likely to spread in incidence and severity precisely because it undermines community and the rule of law and it is likely to grow more pervasive and harmful the more we “tolera[te]” it.”  

Greenhut’s arguments and conduct indicate his belief that Wilson made a critical error in refusing to study elite white-collar crime and refusing to apply “broken windows” analyses and policies against less severe white-collar crimes.  Greenhut’s title emphasizes that white-collar crime and corruption can destroy the social fabric and destroy a city and a community.  Greenhut’s work emphasizes the need to expose and condemn every act of corruption the Franklin Center’s personnel can discover in state and local government.      

Greenhut notes that was a “former boomtown” during the housing bubble.  He ignores the fact that the epidemic of mortgage fraud by lenders and their agents hyper-inflated the housing bubble.  Greenhut is selective and counter-factual in his discussion of the “greed” that drove the financial crisis.  As I have documented many times (most recently in my March 7, 2012 testimony before Senate Judiciary), the financial crisis in America (and Stockton) was driven by an epidemic of mortgage fraud.  The fraud was highly concentrated in “liar’s” loans, which grew by over 500% from 2003-2006 (and were surging in 2007 until the collapse came).  The mortgage industry’s own anti-fraud group warned the industry in early 2006 that such loans (1) were an “open invitation to fraudsters,” (2) had a fraud incidence of 90%, (3) deserved the name the industry used to describe them – “liar’s loans”, (4) had caused hundreds of millions of dollars of losses in the early 1990s (before we, the OTS West Region, drove the fraudulent lenders and loans out of the S&L industry) , and (5) federal banking regulators were warning that such loans were dangerous.

No government ever directed that any entity originate or purchase liar’s loan or a collateralized debt obligation (CDO) backed by a liar’s loan.  (No, Fannie and Freddie were never required to purchase liar’s loans.)  This makes liar’s loans the ideal “natural experiment” to evaluate why such a large segment of the mortgage lending and CDO industries made and purchased vast amount of liar’s loans.  They did so because liar’s loans were the best available “ammunition” for accounting control fraud in the United States.   Lenders and their agents overwhelmingly put the lies in liar’s loans.  Liar’s loans inherently create intense “adverse selection” and a “negative expected value” (the lender will lose money).   No honest mortgage lender would make a significant amount of liar’s loans.  No honest investment bank would purchase a significant amount of liar’s loans.

All neoclassical theory taught that it would be impossible to sell such loans, yet lenders were able to sell roughly $1 trillion in such loans – much of it after the warnings that the loans’ fraud incidence was 90 percent – to the (purportedly) most sophisticated evaluators of credit risk in existence, the largest investment banks.  The investment banks should have provided the optimal “private market discipline” preventing the fraud epidemic because doing so made their senior executives wealthy. 

In reality, they funded the epidemic.  These sales were overwhelmingly made with recourse against the seller of the liar’s loans, but such recourse is of course ephemeral when the loans are 90% fraudulent and will cause losses vastly greater than the seller’s capital.  Charles Calomiris, the economist most famous for pushing for global financial deregulation, explained that all the senior managers involved understand the scam (“pretend[ing]” that endemically fraudulent loans were highly valuable assests) and deliberately sought to create “plausible deniability.”

“[A]sset managers were placing someone else’s money at risk, and earning huge salaries, bonuses and management fees for being willing to pretend that these were reasonable investments. [T]hey may have reasoned that other competi[tors] were behaving similarly, and that they would be able to blame the collapse (when it inevitably came) on an unexpected shock.”

            “Who knew?”

George Akerlof and Paul Romer made sure that no economist or senior financial regulator could claim that they did not know better.  They famously concluded their 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”) with this paragraph for emphasis.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).

Congress provided the Federal Reserve with the power to ban liar’s loans through passage of the Home Ownership and Equity Protection Act of 1994 (HOEPA).  Liberals who dealt with housing – including ACORN – repeatedly asked the Fed to use its HOEPA authority to prevent fraudulent liar’s loans.  Greeenspan and Bernanke refused to do so.  Indeed, they refused to even examine bank affiliates involved in making and purchasing liar’s loans to check loan quality.  Their opposition was based on their theoclassical dogma that defined markets as inherently self-correcting and therefore fraud-proof. 

The high priests of this cult were Frank Easterbrook and Daniel Fischel, who infamously wrote that “a rule against fraud is not an essential or … an important ingredient of securities markets” (Easterbrook & Fischel 1991).  That passage was written after Fischel had tried to predict real world events in the savings and loan (S&L) debacle on the basis of this dogma and had ended up praising three of the worst control frauds of the era – a fact that the authors did not feel their readers would find useful to know. 

Bernanke finally used HOEPA to ban liar’s loans in 2008, correctly noting that such loans harmed the lender and the borrower.  He did so under Congressional pressure to act, and even then he delayed the effective date of the rule until 2009.  It took the Fed fifteen years to ban a product so brazenly fraudulent that the industry called them “liar’s” loans.  When one appoints anti-regulators like Greenspan and Bernanke to the most important regulatory position in America one creates a self-fulfilling prophecy of regulatory failure.

So, why did the industry massively increase the sale, and purchase, of loans they knew to be endemically fraudulent and fatal to the firm?  They did so because doing so created what Akerlof and Romer aptly termed a “sure thing.”  Lenders and holders of liar’s loans that followed the “fraud recipe” were mathematically guaranteed to report record (albeit fictional) profits and their senior officers were guaranteed to become immediately wealthy through modern (perverse) executive compensation.   

A study by a Federal Reserve Bank of St. Louis economist documented that the growth of liar’s loans (“Alt-a” is one of many euphemisms for liar’s loans) was so extraordinary that it hyper-inflated the bubble.

 

“[B]etween 2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent, respectively.  The higher levels of originations after 2003 were largely sustained by the growth of the nonprime (both the subprime and Alt-A) segment of the mortgage market.”

 

The growth of liar’s loans was actually far greater than 340 percent.  The author made a common error, thinking that subprime and liar’s loans were mutually exclusive categories.  By 2006, roughly half of all loans called subprime were also liar’s loans.  When one corrects the error the true growth rate of liar’s loans exceeds 500%.

 

Loan standards collapsed.  Bo Cutter (2009), a managing partner of Warburg Pincus, explains:

 

"In fact, by 2006 and early 2007 everyone thought we were headed to a cliff, but no one knew when or what the triggering mechanism would be. The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions."

 

Liar’s loans did not simply become vastly more common in response to the warnings that they were endemically fraudulent.  The loan quality of liar’s loans fell sharply, becoming “nuttiness of epic proportions.”  But such loans are not nutty from the CEO’s perspective.  The first two “ingredients” of a lender’s fraud recipe are growing massively by making poor quality loans at a premium yield.  By 2006, roughly one-third of mortgage loans originated annually was a liar’s loan – indicating that over two million mortgage loans made in 2006 were fraudulent.

Working class Americans, particularly the elderly, blacks, and Latinos, were the greatest victims of fraudulent, high yield liar’s loans.  They were placed in homes they could not afford to purchase, under (negative amortization) loan terms that delayed the delinquencies and defaults, and they were deceived by inflated appraisals into believing that they had gotten a fabulous deal on the home and could always resell it at a profit if they got into a credit or liquidity bind.  (Only lenders and their agents can systematically inflate appraisals and no honest lender would ever inflate an appraisal.)  The result has been the most significant loss of working class income and wealth in 75 years and the poorest minorities and the elderly were special victims within the working class category.  Liar’s loans were certain to cause mass foreclosures. 

So, Greenhut has one fact correct – greed and immorality by financial elites drove the crisis.  Greg Mankiw was the “discussant” (which means his remarks were planned rather than off the cuff) at Brookings when Akerlof and Romer presented their paper on looting.  Mankiw’s response captures perfectly theoclassical economists’ ethics:  “it would be irrational for savings and loans [CEOs] not to loot.”  To Mankiw, CEO’s that pass up a fraudulent “sure thing” are not moral – they are irrational.  President Bush made Mankiw the Chairman of the President’s Council of Economic Advisors.  Akerlof was awarded the Nobel Prize in economics in 2001. 

Greenhut presents no evidence that Stockton’s government officials made liar’s loans.  Stockton’s government had no ability to prevent liar’s loans from being made.  Only the Fed could have done so, and its leaders refused to do so because they embrace the same anti-governmental dogma that Greenhut cherishes.  Stockton’s public employees were victims of the elite frauds. 

Stockton was one of the many indirect victims of the private sector’s epidemic of fraudulent liar’s loans.  Its property and sales tax revenues collapsed as foreclosures surged and home values fell dramatically.

http://stockton.granicus.com/MetaViewer.php?view_id=14&clip_id=3190&meta_id=281232

There was nothing Stockton could do to prevent either of those results.  Stockton grew substantially in population and the needs of its relatively poorer citizens grew sharply as Stockton’s unemployment rate exceeded 20 percent.  The combination was sure to cause a financial crisis absent federal relief.  It also was sure to cause the city to target the unions, particularly public safety unions.  Eighty percent of Stockton’s general purpose expenditures go to public safety compensation.  Id.  That means that as the City is forced to slash expenditures to reduce its budget deficit its largest target has to be its public safety unions.  The City and its police and firefighters are both victims of the elite financial frauds.  Forcing the victims into inherently bitter conflict adds to the injury.      

Stockton’s financial disaster could and should have been avoided.  Everyone knew that state and local finances (particularly outside the oil patch, which was buoyed by the speculative surge in oil prices) would suffer catastrophic damage from the Great Recession.  States and localities in the U.S. do not have their own sovereign currencies.  They must be perceived as running minimal budgetary deficits.  The Obama administration recovery plan, therefore, had a large component of financial transfers to the States (via revenue sharing – a Republican idea) so they could avoid the disaster.  It makes the recession materially worse if states and localities cut back on their spending, employment, and services during a severe recession.  Unfortunately, for reasons that pass all understanding, the conservative “blue dog” Democrats joined the Republicans to demand that that there be no revenue sharing.  Unfortunately, for reasons that pass all understanding, the Obama administration caved on this without a fight.  The result has been a continuing “own goal” in soccer terms.  At the state and local government level we are practicing European-style austerity with European-style (terrible) results. 

Greenhut has particular reason to know about the effects of widespread foreclosure and the Great Recession on city finances because he is a small-time vulture investor.

“Residents share a widespread sense that the city doesn’t respond to problems or do a good job handling basic services. I own two rental houses in Stockton, which I purchased as foreclosures after they lost about 75 percent of their value from the market peak. Overgrown trees entangled with utility wires stand in front of one of my houses. It’s the city’s legal responsibility to provide maintenance for such things, but officials told me they have no plans—let alone a budget—to do so. I see shopping carts abandoned in neighborhoods and trash-strewn parks. When my houses were vacant, preventing break-ins by homeless squatters and copper-pipe thieves was a constant struggle.”

What can we learn from this passage?  (Causality obviously remains a mystery to Greenhut.)  Housing values in Stockton fell dramatically.  When a significant number of homes go into foreclosure, neighborhood values can collapse.  Purchasing houses at foreclosure that had suffered a 75% drop in value seemed like a “sure thing” to Greenhut, but it turned out to be an investment nightmare because Stockton led the nation in foreclosure rates and suffered among the worst drops in market value. 

As the city suffers sharp losses in its own revenues, sharp drops in transfer payments from the State of California, and no relief from the federal level because the conservatives killed revenue sharing, Stockton was forced in a vicious cycle.  It had to slash its city services when they were most needed.  As Stockton cuts services, however, social cohesion starts to fail and housing values fall even more, forcing further budget cuts.  The neighbors in the parts of town where Greenhut purchased foreclosed homes are so desperate that they are squatting in and even stealing copper pipes in unoccupied buildings because speculators had caused copper prices to surge.  Greenhut is mad that a “legal responsibility” of the City to provide necessary services does not magically produce the funds to do so in such a vicious cycle.  The concept that the City is another victim of the fraud epidemic is foreign to Greenhut.

Greenhut has no sympathy for Stockton’s fiscal crisis.  He’s furious that Stockton had to lay off police, which has increased their response times.        

“[D]owntown Stockton, despite its beautiful old buildings dating to the Gold Rush era, is largely a ghost town. An ineffective government, which can’t control crime or even keep the streets clean, is the main source of the problem.”

Greenhut claims that Stockton and Vallejo (another California city forced into financial crisis by the epidemic of fraudulent mortgages) are “are suffering under crime waves as police staffing is reduced….”

Greenhut doesn’t see the irony, but he has just revealed two additional factors that Wilson missed in refusing to study or take seriously white-collar crime or apply “broken windows” theory in that context.  First, Greenhut has just shown how elite white-collar crime can create a crisis in blue collar policing.  Second, what Greenhut is describing is a “systems capacity” problem.  Henry Pontell, of UC Irvine is the criminologist who first formally identified and described the problem, so Greenhut need not go far to draw on real expertise.  One of the things Greenhut would learn is that the systems capacity restraints on efforts against elite white-collar crime are vastly greater than criminal justice systems’ capacity restraints in the blue collar crime sphere.  It was crushing systems capacity problems against elite white-collar crime that produced the severe systems capacity problems against blue collar crime in Stockton.  Greenhut is oblivious to the key failure to regulate, supervise, or prosecute the elite white-collar criminals who “broke” Stockton.

Greenhut is just winding up to the real villains of his piece – police officers.  He blames them for causing Stockton’s financial crisis.    

“[Police] share the blame for the city’s budget disaster. Their salaries and defined-benefit retirements still allow them to retire with 90 percent or more of their final year’s pay. Stockton has lost more than 41 police officers over the past three years. But the city participates in the generous “3  percent at 50” retirement benefit, a formula that allows public safety workers to retire at age 50 with 3 percent of their final year’s salary multiplied by the number of years on the job.”

Greenhut’s “greedy public union” meme follows the usual flawed analysis.  Public sector workers have long negotiated deals with submarket pay but more generous pensions.  The theoclassical meme ignores the first aspect of submarket pay, focuses only on the pension, and demands that the pension be cut without any increase in pay.  But that point has been made in far greater depth by experts in the field, so I urge readers to see those responses.  Note first that the pension funds’ primary problem is the massive investment losses they often took when they purchased fraudulent CDOs (not really) backed by liar’s loans and equities that suffered great losses during sharp drop in the stock market. 

Primarily, however, I emphasize the obvious comparison between the critical role that greed and fraud played in the private sector in making the elite frauds wealthy through illegal acts that drove this crisis.  As (the ultra-conservative) Calomiris emphasized, everybody moderately senior in the liar’s loan food chain knew that it was obvious that loans that were called “liar’s loans” and that had a fraud incidence of 90% were ludicrously overvalued – and that was what was maximizing their compensation.  They got tens of billions of dollars in additional compensation for breaking not just a city (Stockton), but entire countries through a large section of the globe. 

Greenhut makes no criticism of the private sector frauds that grew wealthy by breaking Stockton and large parts of the U.S. and Europe.  Instead, he is livid about the “greedy” police in Stockton.  His first complaint is that they get to retire early at age 50.  Investment and commercial bankers and mortgage brokers could (and often did) retire wealthy in their thirties.  The two jobs are not commensurate.  A police officer’s life is a great deal of boredom broken up by episodic terror and questions such as whether one will try to chase a 18 year old suspect who is jumping fences.  Well before the age of 50 the typical police officer will be incapable of performing some of the physical tasks a patrol job requires in a tough neighborhood.  Many police officers suffer physical injuries on the job.    

Greenhut thinks police pensions are much too high.  The police risk their lives (including when they perform seemingly routine functions like traffic stops and knocking on a door).  They risk their lives for people they typically do not know.  Police officers often cannot know that the person they are interacting with has an outstanding felony warrant and is not willing to go back to prison.  The police officers are innocent victims of the crisis.  The investment and commercial bankers and mortgage brokers that broke Stockton and the world grew wealthy through a “sure thing” (fraud) that required no skill and no risk-taking.  They should be in prison and all of their fraudulently created income – tens of billions of dollars – should be “clawed back.” 

Greenhut believes he has a clever means of dismissing any need to consider the elite private sector frauds that grew wealthy through fraud.  In reality, it is a non sequitur. 

“When private firms don’t provide good services, consumers have choices. When city governments fail to perform adequately because they have squandered their budgets, residents are left waiting, hoping, and eventually moving.”

The “moving” part actually shows some of the limitations of Charles Tiebout’s economic theory that, in a federal system, citizens can “vote with their feet” and find the best site to locate.  Greenhut shows that this can actually add to the vicious cycle destroying Stockton and provides no guarantee that the new home and city will not suffer a new financial crisis.

When private firms provide fraudulent services to their customers consumers are deceived as to their choices.  Indeed, the entire purpose of fraud is to cause the consumer to make a terrible choice that is good for the fraudster and bad for the consumer.  Epidemics of elite accounting control fraud create a Gresham’s dynamic in which bad ethics (think Mankiw) can drive good ethics out of the markets – making market forces perverse.   Greenhut, however, is the kind of anti-journalist who ignores massive frauds by private sector elites and instead blames governmental victims of those frauds.    

There is a hidden story that explains why it is not immediately apparent to every reader that Greenhut has ignored the epidemic of financial control fraud that “broke” Stockton.  Stockton is within the jurisdiction of Benjamin Wagner, the U.S. Attorney for the Eastern District of California.  Wagner has failed to prosecute any of the elite accounting control frauds that drove the crisis because of his inability to understand the concept of looting. 

 

http://huffpostfund.org/stories/2010/05/too-big-jail

 

Too Big to Jail?

Not everyone agrees that such a case can be successful. Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. An investor in loans who documents fraud can force a bank to buy the loan back. But convincing a jury that executives intended to make fraudulent loans, and thus should be held criminally responsible, may be too difficult of a hurdle for prosecutors.

“It doesn’t make any sense to me that they would be deliberately defrauding themselves,” Wagner said.

Wagner has confused himself with his pronouns.  “They” refers to the CEO.  “Themselves” refers to the bank.  The CEO has a “sure thing” – he can grow wealthy very quickly by looting the bank through the accounting fraud recipe.  He is not looting himself.  If Wagner had been prosecuting the frauds and recovering losses that the victims suffered even someone as dogmatic as Greenhut would have to acknowledge that the greed that drove the crisis was not that of the police officers, but the financial sector’s elite frauds.

 

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

Follow him on Twitter: @WilliamKBlack

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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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