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William Black

William K. Black was a federal regulator during the Savings and Loan crisis and appears in Michael Moore's 'Capitalism: A Love Story'

November 2nd, 2009 4:43 PM

Animal House Rules: Treasury Proposes to Use DOUBLE SECRET PROBATION

You can never compete with self-parody, and Treasury and the Fed have mastered the art. The proposed legislation to respond to systemically dangerous institutions (SDIs) reveals that the Fed and Treasury are sowing the seeds for the next crisis. But the bill is also wonderfully wacky. The core of the bill is based on the fantasy that the government can (and should) play by Animal House rules and create a secret list of banks that are on “DOUBLE SECRET PROBATION.” In the movie, the Dean is enraged at the Deltas – the fraternity that is so crazed that it is known as the “Animal House.” His first instinct is to place them on probation.

Greg Marmalard: But Delta’s already on probation.

Dean Vernon Wormer: They are? Well, as of this moment, they’re on DOUBLE SECRET PROBATION!

The Fed and the Treasury propose (1) to create a list of SDIs that (2) will be subject to “heightened prudential standards” and, (3) can receive special federal bailouts when they get in trouble. The bizarre clauses of this proposal are:

(f) NO PUBLIC LIST OF IDENTIFIED COMPANIES. The Council and the Board may not publicly release a list of companies identified under this section.

(b) CONFIDENTIALITY. The Committees of the Congress receiving the Council’s report shall maintain the confidentiality of the identity of companies described in accordance with paragraph (a)(3) and the information relating to dispute resolutions described in accordance with paragraph (a)(4).

I’ll put aside for a later time discussing the obscenity of proposing that the American people be kept from learning which banks are SDIs and can secretly tap the U.S. Treasury and the Fed for unlimited funds. I’ll also mention only in passing the hilarity of Congress proposing that we can successfully create a super secret society of those, including some members of Congress, who will know which banks are on the list – and will never leak.

Here, I want to emphasize the investor. The drafters have forgotten that the SEC mandates the disclosure of material information to investors. The fact that a bank is on the secret list is extraordinarily important to investors. So, the bill as drafted would create a system in which the banking regulators and Congress must keep the DOUBLE SECRET PROBATION list secret – but the banks must publicly disclose that they are on the list. Of course, it’s possible that the Treasury and the Fed – you remember, the folks that tell us constantly about their commitment to “transparency” – are actually so insane that they will propose amending the securities disclosure laws and destroy the entire concept of mandating that publicly traded companies disclose material information to investors.

Substantively, the proposed bill is harmful and disingenuous. It is harmful because (1) it proposes to allow SDIs to continue to operate even though the Treasury and Fed claim that the failure of any SDI is likely to cause a global economic crisis, (2) it would provide the Treasury and the Fed with unlimited authority to use public funds to bail out SDIs, and (3) it would spread rather than contain systemic risk. It is disingenuous in its elaborate provisions for “prompt corrective action” – which current law mandates and Treasury and the Fed refuse to apply to SDIs – and in its repeated assertion that Treasury and Fed would like to do the right things to deal with SDIs but lack the statutory authority to do so.

The Fed and Treasury purport to believe that if any of roughly 20 huge U.S. financial institutions were to fail it would cause a global financial crisis. Let’s assume that their fear is accurate. The essential response is to prevent institutions from posing such a systemic risk. No other response can work in the long run (and can work even in the short-run only if we are fantastically lucky. The SDIs are ticking time bombs, some of which have already exploded and helped produce the ongoing crisis. The solution to the problem is straightforward: (1) stop them from growing any larger, (2) shrink them to the point that they no longer pose systemic risk, (3) remove the perverse incentives caused by (deliberately) badly designed executive compensation programs, (4) require them to review the underlying mortgage loan files (which they have never done) and end their use of accounting gimmicks that hide their losses (which they all do) so that we can learn the true financial condition of these extraordinarily dangerous banks and require them to take prompt corrective action to resolve any problems , and (5) prevent them from investing in assets or engaging in lines of business that pose undue risks.

The Fed and the Treasury and their sister agencies already have ample power to implement each of these five essential responses, but they are doing the opposite. The regulators have sold the largest failed banks to SDIs, causing several of them to grow rapidly. This policy causes SDIs to pose increasingly greater systemic risk. The regulators have not acted to stop perverse compensation systems. The current crisis did not begin a year ago with Lehman’s collapse. Many of the large nonprime lending specialists began to fail in 2006 shortly after housing prices ceased rising rapidly. Well over three years later, only the Fed has even proposed to adopt a regulation with any restriction of executive compensation. (Seven SDIs that are recipients of TARP funds are temporarily subject to statutory rules on executive compensation.) There are no reports that any agency has ordered a bank to review the underlying loan files or purge the accounting gimmicks so that the management, regulators, and the public can determine the bank’s true financial condition. The SDIs are proposing to pay billions of dollars of bonuses on the basis of fictional accounting “income” produced by their political muscle. The FDIC is further inflating this fictional income by encouraging banks to hide their losses on commercial real estate. This is madness. The agencies have allowed SDIs to continue to engage in unsafe lines of business and invest in assets that pose undue risks. The Treasury and the Fed want to recreate the secondary markets in nonprime loans that caused over a trillion dollars in losses and they support legislation that would continue to exempt virtually all of the most dangerous financial derivatives from meaningful federal regulation.

Treasury and the Fed are playing by Animal House rules when they embrace accounting fraud and the recreation of the secondary market in nonprime mortgage paper as the solution to the crisis that accounting control fraud and that secondary market caused. Remember the portion of the movie where the frat brothers ruin Flounder’s brother’s (Fred’s) car during a road trip?

Otter: Flounder, you can't spend your whole life worrying about your mistakes! You [fouled] up - you trusted us! Hey, make the best of it! Maybe we can help.

Flunder [crying]: That's easy for you to say! What am I going to tell Fred?

Otter: I'll tell you what. We'll tell Fred you were doing a great job taking care of his car, but you parked it out back last night and in the morning, it was gone. We report it to the police. Your brother's insurance company buys him a new car. D-Day takes care of the wreck.

Flounder: Will that work?

Otter: Hey, it's gotta work better than the truth.

William K. Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is a white-collar criminologist and was a senior financial regulator. He is the author of 'The Best Way to Rob a Bank is to Own One.'

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