Keating 5 anniversary: Did McCain just call for more “government-induced accounting fraud”?

The original Keating Five whistleblower says that John McCain’s proposals to deal with the current financial crisis simply replicate the error that led to the S&L meltdown: letting banks lie about their assets.

I don’t know William K. Black, but a colleague describes him this way:

In 1981, William K. Black was counsel to the Federal Home Loan Bank Board. He was the first person to understand the frauds and looting that underlay the savings and loan crisis. In 1987, he was note-taker and then the whistleblower on the Keating Five &#8212 of which McCain, of course, was one. Presently he is Associate Professor of Law and Economics at the University of Missouri, Kansas City. His book on the

crisis is The Best Way to Rob a Bank Is to Own One.

I have Prof. Black’s permission to post this message, which ought to fill every sane American with horror at the thought that John McCain might somehow slip into the White House.

April 2 and 9, respectively, will be the 21st anniversary of the Keating 4 meeting with Bank Board Chairman Gray and the Keating 5 meeting with the Federal Home Loan Bank of San Francisco. Both meetings were designed to pressure the regulators into not taking enforcement action against Lincoln Savings’ $600+ MM violation of the direct investment rule.

By April 1987 the track record of S&Ls making large direct investments was well known — they all failed (and their failures were catastrophic because they were control frauds). The Keating Five’s pressure failed with us, but worked with our successors; producing the most expensive depository institution failure in U.S. history. Something symbolic should be done to note the anniversary.

The national media has failed to note one of the most interesting aspects of Senator McCain’s recent speech on the housing crisis. He called, as what he termed as a matter of the greatest urgency, for the government to meet with the top tier accounting firms to induce them to back off reporting market value losses at banks and other financial

institutions. This would reprise one of the most disastrous public policies of the S&L debacle — accounting forbearance.” His call for government-sponsored accounting fraud (in a speech plainly drafted with substantial input from his economic advisors), was all the more remarkable because he apparently saw no contradiction between calling for accounting fraud and “transparency” and for policies to raise bank capital in the same speech.

Of course, the accounting fraud would be worse than opaque. It would give the illusion of transparency and the illusion of capital adequacy. Like the right side mirror on U.S. cars (“objects in the mirror are closer than they appear”), bank insolvency would be (far) closer than it appears with S&L-style accounting “standards” that

ignored massive losses of market valuation.

A regulatory agency also destroys its own credibility and its ability to take effective enforcement action against control frauds (whose weapon of choice is accounting fraud) when it engages in accounting fraud.

Senator McCain should have been uniquely poised to avoid repeating this S&L mistake. He plainly has not learned the right lessons from the scandal arising from his efforts to help Mr. Keating.

Senator McCain (and his economic advisors) also have a dangerous misunderstanding of the role of econometric models in valuing assets. This is not new and it does not result in understating asset values.

Models have been used pervasively to value assets for two decades &#8212 and they are used to systematically overvalue asset values (by underestimating risk). This should not be a difficult issue for economists &#8212 if we allow businesses to value their own assets using proprietary models they will have strong financial incentives to

overvalue their assets. Basel II compounds this problem by stating that proprietary models are the preferred means of valuing financial assets.

Consider, particularly given federal pay caps and the extraordinary salaries on the Street for those with advanced skills in constructing models, how impossible it becomes for regulators to try to prevent this abuse (even if they had meaningful regulatory authority over investment banks). Consider the practicalities of trying to explain, and prove, to a judge that the properietary model understates risk by assuming a normal distribution when in fact the tails are unusually fat and truncating the distribution at 95% (which is still common with Value at Risk (VAR) models). Then add in trying to explain why the negative convexity of the implied prepayment option in (U.S.) mortgage instruments means that both tails of the distribution pose unusually large risks. Then try to explain how this all ties in to the risk of a sudden loss of all liquidity in specialized financial markets.

The system we have set up is not only unregulated, it is unregulatable absent dramatic revisions. And that is bad for finance, for the ultimate result of using models, particularly while a bubble is hyperinflating, to systematically overvalue financial assets has to be disastrous.

Black writes further:

What lessons did Senator McCain learn from the “Keating Five” scandal and the S&L debacle? Senator McCain stressed this point in his March 25 speech to the Orange County Hispanic Small Business Roundtable on the ongoing financial crises that began in subprime lending.

“When we commit taxpayer dollars as assistance, it should be accompanied by reforms that ensure that we never face this problem again. Central to those reforms should be transparency and accountability.

Krugman’s column today discusses Senator McCain’s speech. Krugman criticizes Senator McCain’s speech for supporting further financial deregulation, which indicates that the Senator has not learned vital lessons from either the past or ongoing crises. Krugman does not note, however, an even more striking portion of the speech that brings to mind disastrous S&L policies.

Deregulation is not the same thing as desupervision. Societies that deregulate their financial institutions often find a need for greatly intensified supervision. In both the S&L debacle and the ongoing crises we deregulated and desupervised. One of the (quite properly) most criticized acts of S&L desupervision was accounting “forbearance”

in which the government debased normal accounting standards so that S&Ls that were, in reality, insolvent could report that they had ample capital. Senator McCain’s speech calls for a return to government-induced accounting fraud.

”But I think we need to do two things right away. First, it is time to convene a meeting of the nation’s accounting professionals to discuss the current mark to market accounting systems. We are witnessing an unprecedented situation as banks and investors try to determine the appropriate value of the assets they are holding and there is

widespread concern that this approach is exacerbating the credit crunch.”

Note the sad irony of this statement being made two days before the release of the report by New Century Financial’s bankruptcy trustee on its massive accounting fraud, aided and abetted by KPMG. New Century was a large subprime lender that used accounting fraud to hide the true scope of its losses so that it could appear to have adequate capital. Senator McCain’s proposal that the government pressure the accounting profession to prevent the recognition of losses &#8212 to adopt New Century-style accounting fraud &#8212 would be disastrous.

The “situation” we are in is not “unprecedented.” Waves of “control fraud” often cause financial bubbles to extend and hyperinflate. The result is massive losses and dramatic falls in asset prices. The proposed “solution” &#8212 covering up the scope of the losses through fraudulent accounting, is not “unprecedented.” Such coverups are

common, e.g., during the S&L debacle and following the collapse of Japan’s “twin bubbles” in 1990. These coverups often cause losses to grow enormously, as in both of the examples I just cited. Senator McCain should have been in a uniquely strong position to avoid repeating the mistaken policies he favored during the S&L debacle.

Note two major internal inconsistencies in Senator McCain’s speech arising from the passage cited above. He does not appear to recognize either inconsistency. Immediately before the passage quoted above, Senator McCain argued:

“‘In financial institutions, there is no substitute for adequate capital to serve as a buffer against losses. Our financial market approach should include encouraging increased capital in financial institutions by removing regulatory, accounting and tax impediments to raising capital.”

The second sentence is the portion Krugman (rightly) criticized. Our banks are failing because desupervision reduced capital requirements and because deregulation and desupervision, together with the perverse incentives maximized by modern executive compensation systems, created a “criminogenic environment” that produced an epidemic of control fraud that hyper inflated the housing boom and caused massive losses.

The first sentence displays a different failure of internal consistency. The accounting fraud that Senator McCain wishes to implement “right away” is designed to help “financial institutions” &#8212 by allowing them to dramatically overstate the value of their assets, which will have the effect (and purpose) of allowing them to report that they have “adequate capital” when they, in fact, have inadequate (or even negative) capital. Fraudulent “capital” is not a “substitute” for adequate capital” and cannot “serve as a buffer against loss.”

Allowing insolvent, or “merely” impaired financial institutions to continue to operate is a prescription for disaster. Government sponsored accounting fraud does that, but it also discredits the regulator and makes effective and timely enforcement action impossible.

The final internal inconsistency is that Senator McCain’s speech continually stresses the need for “transparency.” Transparency is vital; coverups can turn serious problems into catastrophes. Most people think of opaqueness as the alternative to transparency, but opaqueness is benign compared to government-sponsored accounting fraud. If investors have no information (opaqueness) they know that they are undertaking a risky investment. Government-sponsored accounting fraud creates the illusion of transparency through deceit. The investor thinks he is making a low risk investment, but he is really investing in an insolvent financial institution. As a metaphor, think of the right outside mirror on a U.S. car. The illusion of normal vision is so great that we have to be warned: “objects are closer than they appear in the mirror.” Similarly, insolvency is far closer than it appears when accounting fraud makes a financial institution appear healthy.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: