The economic underworld of bankruptcy for profit - Part 2

In the second part of this series, William Black gives testimony before the Inquiry into the banking crisis in Ireland. He talks from a US perspective, but explains how to tell when banks are behaving recklessly (when their loan books are growing faster than the economy), how bankers have lobbied politicians to get rid of pesky legislation that inhibits their gambling instincts and how they have managed to avoid going to jail. This is fascinating testimony into the dark heart of modern banking.  


Chairman

I thank Professor Black. I noticed in his discourse that he differentiated between “banks” and “bankers”. I know that in our earlier discussion, he just wanted that point noted.

Professor William Black

Yes, particularly for the folks who are going to be reporting on these issues and hearings, almost always when we use the word “banks”, we actually mean “bankers”. It is really important to distinguish which is really being referred to. Banks do not feel; they are not real and they operate through bankers. When you hear “the banks became optimistic”, you should say “No” and always focus on the bankers. The bankers are not the best friend of the banks. Throughout history, the greatest risk to a bank has always been the bank’s CEO. The CEOs are the ones who caused the catastrophic losses throughout history. That does not mean that most bank CEOs are crooks. Do not go from that. Really catastrophic failures are very unusual in banking. When they occur, it is most commonly because of the banks’ CEOs. That is what I was referring to when Deputy John Paul Phelan asked me about the auditors. If a bank could choose, it would choose very conservative and very reliable auditors, but banks do not choose auditors. Bankers do, and bankers want a clean opinion that shows they have record profits and, therefore, should get really big bonuses. Bankers will choose, and characteristically did throughout this entire system.

When there is a Gresham dynamic, you will no longer get just episodic problems with bankers. You can get very widespread problems with bankers, which is why in the United Kingdom, for example, claimants on these products are winning over 80% of their claims. It became absolutely the norm. In fact, the testimony in front of your counterparts is that virtually all the profits that UK banks were reporting came from PPI.

Eoghan Murphy

To come back to the recipe Professor Black was outlining to us earlier, the second step is the making of bad or terrible loans. What is the motivation behind the making of those loans?

Professor William Black

That is a wonderful question. Let us look at the counter-factual. What if you try to grow very rapidly and charge a premium nominal interest rate by making good loans in a relatively competitive industry such as banking with a mature product? In other words, it is not like the invention of the iPad for the first time, when you could sell it to billions of people. If you wanted to grow 50% a year by making really good loans, what would you have to do? You would have to buy market share and reduce your interest rate to be able to get really good borrowers and their business. Good borrowers find it very easy to buy and get loans in normal times. What would your competitors do when you chopped your interest rates?

Eoghan Murphy

They would follow suit.

Professor William Black

They would respond. At the end of the day, do we make more money? We would all make a lot less money. However, in any society there is a significant proportion of people who are not creditworthy, and they will agree to pay a higher interest rate. That higher nominal rate, if you do not establish loss reserves, has to show up as a spread — a very big positive spread. It is just mathematics and accounting at that point, although in this regard I would emphasise something I have not emphasised: the really pernicious part that gets added on is when a lot of this income is non-cash. You have to understand the basics of accrual accounting. Is the difference between accrual and cash accounting familiar? With non-amortising or, at least, non-fully amortising loans — Ireland has had these — banks are booking as income things that they have never received in cash. That is how accrual accounting works. I can agree to do lots of things where I am not actually paying in cash. That is why people make bad loans or why bankers make deliberately bad loans. They will create this phoney income whereas trying to make good loans would produce real losses.

Eoghan Murphy

The point I am trying to come to concerns making bad loans deliberately, with the knowledge they are bad.

Professor William Black

Absolutely.

Eoghan Murphy

What about where people are investing themselves in what their own bank, or banker, is investing in, as we have seen in certain cases? They are losing money in that scenario also.

Professor William Black

Some of this occurs but vastly less than people think. Let us talk about it. One thing is that compensation is often paid in shares. Those concerned say, “Look, how much I lost when the bank failed”, because the share price fell. However, the share price was never real. The only reason the share price reached those kinds of numbers was precisely because of the strategies of the recipe. Therefore, they never lost money because it was not there. Also, even the bankers who are running these schemes do not know when the bubble is going to end; nobody knows. Sometimes people stay too long in the game but frequently, even in those circumstances, you will find it was not really their money but the banks’ money. I would be far less impressed with the line of logic that states those concerned must not have been doing anything deliberately wrong because they, too, suffered some losses in these circumstances. That does not follow logically.

Eoghan Murphy

Let me go back to the prior step in terms of this extreme growth and the role commercial property lending plays for a bank in managing to make that extreme growth, and the relationship with the regulator in that context.

Professor William Black

Again, extreme growth is itself something that should not be allowed by a regulator. We have centuries of experience that tell us that is true. The concentration of risk is something that is insane for a large institution. In other words, small players that cannot reach economies of scale have to have niche strategies, so they will concentrate. That is riskier but they have no great choices. All their choices involve material risk but you do not want a very large financial institution concentrating its risk in a product line like commercial lending. Even if you were going to concentrate on commercial lending, you would never prudently concentrate in a small number of borrowers. The old joke they tell about banking is absolutely true. If you borrow $10,000 from a bank, the bank owns you but if you borrow $100 million from the bank, you own the bank. The banks will extend even bigger loans to you and, as long as new money is coming in, you can keep the thing alive a bit. That is always a bubble disaster. We have known this for many past crises. This was something that was easy for the bankers and for the regulators to figure out. The Irish crisis was one of the most easily preventable crises by either competent bankers or competent regulators.

Eoghan Murphy

I thank Professor Black.

Chairman

I call Senator MacSharry.

Marc MacSharry

Has the Chairman nothing to add himself on this occasion?

I thank Professor Black for joining us and for making the trip over. Just to start things off, he described the guarantee as an insane decision. We have had Governor Honohan from the Central Bank in and we have had Peter Nyberg, as Professor Black is aware. They have said that these were the best of all bad decisions. In Professor Black’s own experience and without the benefit of hindsight, what would he have done?

Professor William Black

That is what I am saying. We are actually saying very similar things. It ends up being an insane decision. It was the worst possible decision that could be made, but in the circumstances one finds oneself – if the bankers are lying to you and the regulators are utterly incapable of seeing reality and, on top of that, are telling you that, tomorrow, the world ends unless you take this action – you are likely to take terrible actions. I think that our testimonies are consistent.

Marc MacSharry

Professor Black may have done the same thing in the same circumstances.

Professor William Black

No.

Marc MacSharry

That is what I am asking. What would he have done?

Professor William Black

Personally, no, because I know banks and I would not have relied on the regulators, but—–

Marc MacSharry

If Professor Black was a politician as opposed to an expert—–

Professor William Black

Yes. A politician is not someone who spent his or her life doing these things and knows that it is too good to be true.

Marc MacSharry

For sure. When I asked Professor Edward Kane, who we had in lately, in the context of Europe’s response to the crisis, he said that, in many ways, Ireland got a hard deal from its European partners in relation to bank debt. In the subsequent reforms that we have seen, does Professor Black think that there has been sufficient reform so far in the eurozone to make sure that a scenario like this does not happen again and to account for the need for a fiscal union?

Professor William Black

No.

Marc MacSharry

Okay. In terms of the likelihood of a repeat, does Professor Black think that the set of parameters that currently exist make it quite likely that it will all happen again?

Professor William Black

Yes, and it will be worse. This is not just Ireland and Europe – this is the United States. There has been no accountability for the bankers and no accountability for the regulators. So, it will take the next boom before this happens again. In the savings and loan crisis, as the committee heard we got over these 1,000 felony convictions. None of those people, to my knowledge, participated in the current crisis precisely because they had criminal records. That is what we call specific deterrence. There will be no specific deterrence out of this crisis. The worst actors who know exactly how to use these four ingredients of the recipe that I told the committee are out there, and what they have learned from this crisis is that it is a sure thing and not much of anything happens to one. That is a really perverse incentive structure. It is critical that one reverses that.

Marc MacSharry

We heard from the Governor of the Central Bank in previous testimony. As to the Governor’s role on the ECB’s Governing Council, does Professor Black believe that this is a flawed construct in the eurozone, where the fiduciary duties of the governor of a state is to the bank and the institution rather than, for want of a better expression, wearing one’s nation’s jersey?

Professor William Black

The Chairman said that everyone should take off one’s jersey. I never had a jersey; I am not from here. Structure matters. Creating conflicts of interest is a bad idea, but all of these structures failed. I spend less time worrying about if it is an FSA consolidated approach or is it from the Central Bank or not from the Central Bank, and far more about whether the people in charge understand the concept. As Professor George Akerlof, the Nobel laureate in economics, said, not understanding the concept, they were helpless to deal with it. If you do not understand the concept, what can you do? It will happen again and you will never even see it.

I focus on leadership. How did it work in the savings and loan crisis? It worked because the chairman of the agency listened to the people in the field, who in business school terms are the closest to the facts. Each month he got 1,000 pages. He actually read and he said that the people in the field were right, and then he went out and he hired the two people in America who had the reputation for being the toughest regulators in America and put them in charge of our two worst areas.

Marc MacSharry

Just very finally—–

Professor William Black

That is just how you do business. Right? If you are a business person, what do you do? You go out and hire some people.

Chairman

I would like to bring Senator MacSharry in for his last question, please.

Marc MacSharry

Last question, and I thank the Chairman. Professor Black’s writings, to me, would seem to suggest that Ireland took the hit for the European banking crisis.

Professor William Black

Absolutely.

Marc MacSharry

Professor Black would agree with that statement.

Professor William Black

Ireland tried to bail out the German banks, basically, and that was never going to work.

Marc MacSharry

Would Professor Black feel that the euro, therefore, is arguably unfit for purpose because of the smaller economies on the periphery like Ireland, which are less than 1% of the eurozone?

Professor William Black

The euro is a disaster. It never made sense in terms of the economic literature on an optimal currency area. My colleague, Professor Stephanie Kelton, who is now the chief economist on the Senate budget committee, is one of a number of scholars who wrote this in advance and their predictions have proven absolutely correct.

Marc MacSharry

I thank Professor Black.

Kieran O’Donnell

I welcome Professor Black. I will just go back. He wrote a blog on 13 November 2013: “Irish fish, and banks, rot from the head”. I want to give him a quote. He said: “The Irish people are distinct, however, in blaming themselves for the crisis.” Can he elaborate on that? What does he mean?

Professor William Black

Yes. I come here frequently for the Kilkenomics festival, in particular, in Kilkenny, Ireland. You get stopped on the street by people, just regular Irish people, who want to talk about economics and such.

Chairman

Does Professor Black charge for it? I know he is coming here for free, but are we—–

Kieran O’Donnell

I am assuming—–

Professor William Black

We are not paid.

Kieran O’Donnell

I assume it is as an economist rather than as a comedian.

Professor William Black

The Deputy can actually check the literature where that has been confused at times. The point is, we get feedback from hundreds of Irish folk over time. I am brought to many other places, like Iceland and such, for the crisis. Ireland is distinctive in the degree to which the average people on the street blame themselves for the crisis.

Kieran O’Donnell

When Professor Black says “blame themselves”, what does he mean?

Professor William Black

“We were too oriented towards home ownership” and “we did not just buy a home – we bought a second, speculative property”.

Kieran O’Donnell

As an objective observer from outside these shores, what is Professor Black’s view as to the view that the Irish people should—–

Professor William Black

In the schema of responsibility, the Irish people are so low on the list that they do not much matter. It is a serious thing. The research on behavioural economics is very, very strong and it is completely ignored by regulatory agencies. Going into this crisis and even afterwards in the United Kingdom, there is all this stuff on consumer education. One cannot try to get everybody in Ireland or the United Kingdom to be able to understand a collared swap, which is what was being pushed for small businesses. I teach courses in this. At the end of a semester-long course for graduate students, if they understand a collared swap I go out and treat myself. The concept that an average person—–

Kieran O’Donnell

It does raise an important question.

Professor William Black

—–would ever understand this is absurd. This attempt to apply the concept of —–

Kieran O’Donnell

Buyer beware.

Professor William Black

That is right—–and in this context produces situations in which one gets an 80% mark-up – a product that no one should ever buy and that should never be authorised, and on which claimants win more than 80% of their challenges saying it is inappropriate.

Kieran O’Donnell

Professor Black made a comment that the Irish crisis could have been prevented. How could it have been prevented?

Professor William Black

Because it followed absolutely the characteristic recipe according to Nyberg. If one looks through the Nyberg report, it states that the banks grew like crazy. In fact, you just read the statistics about it.

Kieran O’Donnell

The former Anglo Irish Bank, one of our banks, grew by nearly 30% per annum over an eight-year period.

Professor William Black

It is not limited that. If you look at the covered banks, which is what his report is on, the growth number is there. You can look at it. The fact that it was extreme leverage is there. The fact that the underwriting was terrible is there.

Kieran O’Donnell

On the four key points Professor Black speaks of, what would have been the antidote to that lethal cocktail to ensure that the Irish banking crisis did not happen?

Professor William Black

When we saw that in the United States, we acted immediately. Within a year of a deregulation law, in our context, which was 1982, there was a full-scale re-regulation of the industry, over the opposition of the Reagan Administration, over the opposition of a majority of our House of Representatives, who co-sponsored a resolution telling us not to re-regulate the industry, and over the opposition of the Speaker of the House, who is the second most powerful elected—–

Kieran O’Donnell

Let us get to the point. What should have been done? What would have prevented it?

Professor William Black

You would have done what we did. You would have restricted growth. You would have said, “You cannot do this terrible underwriting.” You would have investigated the places that were doing it and you would have closed them down.

Kieran O’Donnell

From what year would we have done that?

Chairman

This is the Deputy’s last question.

Professor William Black

Within a year of being appointed, which is when we did it.

Kieran O’Donnell

No, in the Irish context.

Professor William Black

That is what I am saying. You are asking what year, and I am saying we did it as soon as we were appointed.

Kieran O’Donnell

So you would have moved in straight away?

Professor William Black

We would moved straight away.

Kieran O’Donnell

I have a final question. There was lower tier 2 subordinated debt as part of the bank guarantee. To the ordinary person, what is lower tier 2 subordinated debt? It is one feature of our bank guarantee that was very unusual and has never really been properly explained. What is lower tier 2 subordinated debt?

Professor William Black

“Subordinated” means that you come later in bankruptcy priority, and as a practical matter, it means you will essentially never recover if a bank fails. That is what it is supposed to mean. Because of that, the banking regulators actually encouraged the issuance of subordinated debt – because this was supposed to create ideal private market discipline.

It is bought, typically, from a minimum size of $10,000 up to multi-multi-million-dollar slugs, so it pays to exert private market discipline. It is bought by elites – allegedly financially sophisticated people – and because of the subordinated feature, if the bank fails, the argument goes, they will lose their money. You are supposed to get ideal private market discipline and because of that, it is treated as part of your capital to meet your capital requirement. It is expressly defined, therefore, as risk capital. That means it is supposed to be lost if the institution fails – otherwise, all that theory stuff goes out the window. So the one thing you would never, ever bail out or guarantee is subordinated debt.

Kieran O’Donnell

It would make no sense.

Professor William Black

From any perspective, based on even what they knew then, you would never bail out subordinated debt.

Sean D. Barrett

I welcome Professor Black. There are approximately 12 references in Professor Black’s ten-page paper to Gresham’s dynamic. Could he explain that to people watching on television, bearing in mind that here, the Gresham is a very eminent hotel? Even the folks in the hotel may be looking in. Could he explain what he means when he refers to the Gresham?

Professor William Black

It is named after an English economist whose dad was the originator of the idea of creating stock exchanges. It is referred to as “Gresham’s law” in the economic literature, and it says that bad money drives good money out of circulation in hyper-inflation.

Professor George Akerlof, the Nobel laureate in economics, in his most famous article, “The Market for Lemons,” in 1970, used it as a metaphor to describe a Gresham’s dynamic in which bad ethics drives good ethics out of the marketplace. This is because, if you gain a competitive advantage by cheating, markets will become perverse and the cheaters will prevail. It also applies to professions, such as appraisers. This is dealt with in the report published by our analogue to you folks, the Financial Crisis Inquiry Commission, and you can read it.

Sean D. Barrett

I thank Professor Black for that.

Professor William Black

Basically, they extorted appraisers. When I say “they”, I mean the lenders. If you were not willing to inflate the appraisal, they blacklisted you and you could not get a job. No honest banker would ever inflate an appraisal. That is an example of a Gresham’s dynamic. As I say, Swift actually identifies this with the Lilliputians in 1726.

Sean D. Barrett

I expect the people in the hotel will feel much better after that. Could Professor Black explain the concept of PPI abuses – payment protection insurance – and the 80% mark-up for those watching on television?

Professor William Black

PPI is an insurance policy that is sold along with a loan as an allied product. It tries to take advantage of people’s fear of unemployment. It basically says that if you lose your job after a certain period – and only for a very limited period – it will pay some or all of the loan. It is, in United States terms, sort of like a credit life policy. As an undergraduate 40 years ago, I was taught never to buy a product like this. We have known for a very long time that it is a complete rip-off product. On top of that, it was sold to people who were self-employed – who literally could not collect under the terms of the policy.

Sean D. Barrett

One of the things we will be discussing when all the witnesses have gone away is an important recommendation Professor Black makes – that Ireland should not have junked GAAP for IAS 39. It is important for us to understand that change in accounting standards and how Professor Black thinks it contributed to our problems.

Professor William Black

The generally accepted accounting principles, GAAP, rule is that at the time you are making the loans – immediately, in other words – you have to establish loss reserves that are appropriate for the risk you are taking. If you are not underwriting a loan and making it to people with ultra-concentration and such, you have to immediately establish much larger loss reserves. If you had established appropriate loss reserves, the accounting would have shown from day one that the loan was actually a loss.

Sean D. Barrett

I am sure that is something we will come back to. Is there any literature Professor Black has come across that states “No bank should fail”?

Professor William Black

No. Banks should fail. Indeed, our function as regulators is to force them to recognise that they failed a year and a half ago and close them through receivership.

Sean D. Barrett

I have a final question before the Chairman calls this to a halt. Professor Black’s presentation states: “I do not believe any of the purported horrors of increased capital requirements for banks.” What would Professor Black have in mind? What percentage of equity should they bring to the scene?

Professor William Black

I think the proposals to push it up into the 20% range are eminently sensible. I think there is no chance that Basel will do that.

Sean D. Barrett

I thank Professor Black.

Michael D’Arcy

I welcome Professor Black.

With regard to the bank guarantee, Professor Black used the analogy “the worst own goal in history” when referring to subordinated bonds being paid. Was the game fixed against the Irish nation by external players?

Chairman

That is a leading question. The Senator needs to frame his question in a manner that allows the witness to give his own testimony, not to be led by a member of the committee.

Michael D’Arcy

How did the own goal happen? Specifically, I ask Professor Black to address the external factors of the own goal for subordinated bonds.

Professor William Black

There have been subsequent disclosures of the documentation involved stating that there was, in fact, express pressure from the European Central Bank to do these things. I think I have answered the question. The banks provided statements to the Irish Government and the regulators that had no relationship to reality. They were grotesquely inflated in terms of reported capital at a time when the banks were in fact massively insolvent. That is fact one. Fact two is that the banks came and said if you do not give us this guarantee, we will fail and we will fail within hours. Fact three is that the regulators were asked and, by all reports, said something to the effect of “there is no asset problem here, it is just a short-term liquidity”. Fact four is that, for some reason, subordinated debt was not broken out of this explanation. We have gone through that as well in my testimony. Fact five is that, with pressure from the ECB as well, collectively, they said that if there is not an asset problem but there is an imminent liquidity crisis that is going to bring down the banking system tomorrow, we had better give the guarantee. That is how the decision was made.

Michael D’Arcy

What is Professor Black’s opinion on the intervention of the then US Secretary of the Treasury, Timothy Geithner, in regard to subordinated bonds being paid as well?

Professor William Black

I am not personally aware of him taking a role in whether the subordinated debt should be paid in Ireland. I can tell the Senator that I have never run into anyone in any context who thought that this was appropriate. There is unanimity among all the financial experts that this part was simply insane.

Michael D’Arcy

Am I correct in saying that savings and loan in the US equated to the building societies here?

Professor William Black

Yes.

Michael D’Arcy

Can Professor Black expand upon the parallels between savings and loan and what happened in Ireland and how they affected the overall banking scenario in Ireland?

Professor William Black

The most parallel crisis to the Irish crisis, of which I am aware, is the savings and loan debacle. There are many differences, obviously, but it is the closest in that it was same in both cases and it was a bit different from building societies. Because of deregulation in 1982, Savings & Loan institutions were allowed to be essentially universal banks, as the Senator used that parlance, and so they could take equity positions, and unlimited equity positions in the case of the California institutions. They followed the recipe that I talked about and did so not only in residential lending but in commercial lending, and they produced a very large bubble. Our bubbles were regional but we are a much larger country geographically, and those bubbles were of similar magnitude to Ireland, but regional, and compared to our national economy, it was never anywhere near as large.

Chairman

A final question, Senator D’Arcy.

Michael D’Arcy

We are discussing traditional banking and how the traditional banking sector ended up where it has ended up in Ireland. Can I ask about the newer models because Professor Black said he wants to look to the future, and we also want to look to the future? I refer to the newer models of banking such as equity funds which operate in all but name as a bank with their investment in commercial property, and in particular the new disruptive technologies that are disrupting the banking system, as we currently know it, in terms of the tech platforms that have been made available. I refer to what Ana Botín, the chair of Banco Santander has said. These are new challenges that are coming down the tracks rapidly and that are unregulated. What is Professor Black’s opinion on those entirely, or substantially, unregulated sectors that could give rise to catastrophic problems in the future?

Professor William Black

It is a complex mix. The Senator is correct that many technological changes have created rivals to traditional banks and that these rivalries have reduced the profit margins in banks and are likely to do so in the future. There is testimony in the Senator’s counterpart, about which I would be a bit sceptical, of banks claiming that they lose money in traditional activities. Whether or not they are correct, if they have that mindset, it is going to create pressures to find higher yield. There are two ways to create higher yield, one of which I have talked about at length, which is the recipe, but the other one produces large profits and it is basically fleecing one’s customers. That is the PPI model. Both of those are very, very bad things that one would want to prevent. I do not think we are going to be able to prevent technology from changing. It does not particularly upset me that there are private entities that take equity risks as long as they are not bailed out and do not create a systemic risk to the system. If their shareholders want to have an equity fund and win or lose, that is okay by me, but it brings me to the subject we have not mentioned yet, the other grave danger, which is the systemically dangerous institutions, the ones that are so-called too big to fail. One simply should not ever have an Irish champion like that. That is nuts. You cannot bail out Europe in that sense. If one puts oneself hostage to a champion, it is not a champion anymore. As soon as it fails, and it is a question of when and not if, Ireland would be back in a crisis. Do not hitch your star to an institution too big to fail. It will create absolutely perverse incentives.

Chairman

I call Senator O’Keeffe.

Susan O’Keeffe

To return to politicians, faced with a great crisis that is happening all around them, what role could, should or would due diligence play in that scenario?

Professor William Black

Due diligence is underwriting. If one insists on good underwriting, one will find these problems years before, maybe as much as a decade before, as we did with liar loans, and it can be dealt with when it will not cause—–

Chairman

In terms of what Professor Black means by liar loans, are they loans on which people more or less self-assess themselves?

Professor William Black

Yes. It is US business parlance, which was—–

Chairman

When the borrowers self-assess themselves.

Professor William Black

This is how the industry in the United States referred to these loans behind closed doors. In the United Kingdom they are referred to as self-certified loans so—–

Susan O’Keeffe

Should politicians have sought due diligence?

Professor William Black

Right. One of the great stories of the Savings & Loan crisis is the reason we succeeded in those criminal prosecutions is that Congressman Doug Barnard held a hearing, as part of the regular oversight function, and embarrassed the heck out of our agency, the FBI and the Department of Justice. He exposed the fact – this is around 1983 – that there was no effective system for making criminal referrals and for prosecuting people. Yes, vigorous oversight hearings by the Legislature, to use a generic phrase, are critical.

Susan O’Keeffe

No, I am talking about the moment of a crisis when everything is going wrong.

Professor William Black

I am saying before a crisis. The crisis is too late. At that point if a committee started getting involved—–

Susan O’Keeffe

If a decision is going to be made about guaranteeing something, would Professor Black seek at that moment to do some diligence on what he was about to guarantee?

Professor William Black

Absolutely. I would be in a different situation with regard to the ability to do that due diligence even quickly, in terms of it being too god to be true—–

Susan O’Keeffe

Yes.

Professor William Black

—–but politicians are generally not going to be in a position to do that then. But I am saying—–

Susan O’Keeffe

But should they seek it?

Professor William Black

—–well before the crisis, you can be an important part of preventing future crises by holding hearings and bringing in the regulators and asking the tough questions when there is ample time to deal with it, literally years before if you keep in mind the underwriting tell, the Gresham’s dynamic, this recipe, the concept of too good to be true.

Susan O’Keeffe

Could any bank have embarked on this recipe Professor Black has described by accident, or would they know that they were doing what they were doing?

Professor William Black

Again, if I might chide Senator O’Keeffe, that is where we should use the word “banker” as opposed to “bank”.

Susan O’Keeffe

Please do.

Professor William Black

That is my professorial response. No, that is how you distinguish. No honest banker is going to gut underwriting because we have known for centuries if you do that you will lose money. But bankers who want to follow this recipe will do it because it will produce these three sure things, and that is how we got convictions even against top criminal defence lawyers by explaining that to juries. I was the expert witness in a number of these cases. I trained the FBI agents and the assistant US attorneys in precisely how to distinguish. That was among my functions.

Susan O’Keeffe

Would bankers in that recipe scenario know that their own bank was insolvent? Could they have confused it in any way?

Professor William Black

No, they knew and took lots of actions to ensure that did not become public, including the ones in which I have testified at some length in terms of accountants and the creation of the Gresham’s dynamic.

Susan O’Keeffe

Would it be fair to use the term that they were actually creating personal profit centres – that that is what they were at?

Professor William Black

Well, the term used by a Nobel laureate in economics is that this recipe is all about looting. That is a pretty strong term.

Susan O’Keeffe

It is a very strong term. I am very interested to know how the bankers make the money. Professor Black talked about cashing out, the extra shares, the golden handshakes and all of that. How do they actually make the money? Were they taking it out when no one was looking or was it just in their salary? Did they have deals going on?

Chairman

Those questions are leading?

Susan O’Keeffe

What was happening in Professor Black’s experience?

Professor William Black

I can answer a generic question.

Susan O’Keeffe

Based on his experience.

Professor William Black

In my experience and I am answering the question generically not with regard to Irish banks—–

Susan O’Keeffe

Absolutely.

Professor William Black

There are myriad ways to take it out. In fact, if the Senator reads my broad testimony, the national commission that investigated the savings and loan crisis referred to every way possible being used, but the primary way, the cleanest way that reduces the risk of prosecution is to simply take it out through modern executive compensation in which one’s bonus is tied to performance. For the reasons I have stated, it creates a sure thing of high reported profits. That makes one wealthy within months or a year, depending on the situation.

Susan O’Keeffe

What is the myriad of other ways? Can we find them?

Professor William Black

There are all kinds of other ways you can do it. There are many institutions that lend to the senior officer. There are others where they never repay it. There are others where they use that and they take projects. The usurpation of corporate opportunity is the jargon in the United States and probably in Ireland as well.

On lobbying by bankers: In the United States context, these people do not go quietly. If you bring cases against powerful bankers, they will enlist their political allies and they will give very large political contributions to do that. In our context, Alan Greenspan was used to recruit the Keating Five, the five US Senators. He was hired as a lobbyist initially by Charles Keating to recruit those Senators. The United States is not unusual in those terms. If you take on really powerful bankers you will find that you get political push-back. If you do not pick regulators who will stand up to that – this is what I referred to as the Mike Patriarca level – Mike Patriarca was asked by a US Senator, one of the five who was meeting with us, whether he was saying that Arthur Young & Company, then one of the top tier audit firms, would prostitute itself for a client. Committee members, as legislators, know that if they ask that of a bureaucrat what the only possible answer is. When there are five Senators the only possible answer is, “Oh no sir, I would never say that.” The actual answer from Mike Patriarca was “Absolutely, it happens all the time.”

On how to tell banks are gambling: It is absolutely a tell, and it is why the recipe is so dangerous in hyper-inflated bubbles. The first ingredient of the recipe is “Grow like crazy,” and this is met if rents are already declining and there is an abundance of what we call see-through buildings, which are those that have been constructed have no occupants, but the bank keeps on lending. That was exactly the experience in the savings and loan debacle, which is one of the parallels. This is a superb device for hyper-inflating the bubble. It was absolutely done in the United States in the current crisis. We have excellent numbers showing that it was liar loans that grew by over 500% from 2003 to 2006. They became 40% of all residential loans in the United States while conventional lending was falling sharply. We know the marginal loans that hyper-inflated the bubble were these fraudulent loans. We have data showing that 90% of liar loans are fraudulent in the United States. They will be the worst loans, and the lenders will continue to lend even when the stagnation is obvious. Akerlof and Romer talk about that explicitly in their paper. It is a sure tell.

Why underwriting Ireland's subordinated debt was the worst decision made by the country: I do not say it is because of this that it was the worst. It was the worst because it sank an entire nation. It produced a gratuitous fiscal crisis, as it turned out. I distinguish by what you know and when you know it when you make decisions. The inclusion of subordinated debt is simply indefensible and it tells you that you need to look at whoever would have included it. Every regulator in the world should have instinctively said “No” to that. It is contrary to everything we do to include the entire concept of subordinated debt. Remember, precisely because subordinated debt is owned exclusively by people who are considered to be highly sophisticated, they are the ones least likely to run due to liquidity – if it is a liquidity event only and not an asset event – and they cannot run because subordinated debt has a term. It is not like they can take out like a depositor, which is why the number is so low in terms of redemptions at those levels, and you do not have to redeem it after all if you will be paid in full. I add these clarifications to the Deputy’s numbers.

Should banks be allowed to fail? That is precisely what we did in the savings and loan crisis. We would put them into receivership, the subordinated debt would be wiped out and the shareholders would be wiped out. That is what is supposed to happen to risk capital. The insured depositors would be paid in full and the other folks would get a haircut appropriate to what they signed onto – that is, in bankruptcy they take in proportion to whatever is left in those situations. What is different about Ireland is the enormous extent of non-depositor liabilities. That should have been a huge warning flag to your regulators.

Why accountability in banking has died: At this juncture worldwide, and I will talk about the United States, instead of 1,000 plus felony convictions in a crisis (the Savngs and Loians crisis) that was less than 1/100th the size of our current crisis we have zero people convicted who actually were in charge of running the places that made these loans. In a US context, we have scores of lawsuits in which the United States of America and various agencies say, after investigation, that these were caused by fraud but they have failed to bring criminal charges in every case in which they say it was caused by fraud. That is what I mean by the death of accountability in the current system.

How bankers avoid going to jail: When I was an enforcement and litigation director I negotiated these things all the time and here is the key that you need to understand. Bankers make the decision and their priorities are not to go to jail, not to lose their job and not to have their bonuses clawed back. To accomplish those three things they also have a fourth priority to not throw anybody junior to the wolves. In the United States we have much broader plea bargaining powers than exists in most of Europe. If you throw the junior person to the wolves we will flip him which means we will get him to plead and to testify about the more senior people. The committee will note that in all of these major deals in the United States nobody got named, loses their bonus, loses their job or goes to jail and they are happy to trade off fines.

The fines sound large. They are large in absolute terms but relative to JP Morgan Chase, to pick a non-random example, they are literally a few weeks’ revenue so they do not care. Also, bankers do not pay the fines; it is the shareholders. This is the third in a triple whammy hit if you follow the recipe to the extent that the banks have followed this recipe. First, they have caused huge losses to the shareholders directly by making bad loans intentionally. Second, they have taken a whole lot of money that should have gone to the shareholders in the form of bonuses for destroying the institution or at least causing huge losses. Third, they come along and are happy to sign an agreement in which the shareholders pay the fines to make sure that they have no accountability. Therefore, this is an utterly useless exercise in terms of deterrence.

Part 1 of this series can be read here.