Companies, Auditors, Rating Agencies and Regulators All Committed Fraud Which Helped Blow the Bubble and Sowed the Seeds of the Inevitable Crash

Everyone knows that the Fed blows bubbles.

But William K. Black - senior regulator during the S&L crisis, professor of Economics and Law, and an expert on white collar financial crime - says that fraud by many other companies also contribute to the bubble-and-bust cycle.

In a talk Black gave in June entitled "The Great American Bank Robbery" (watch below), he gives the following examples.

Initially, during the S&L, Enron and subprime crises, outside audit firms and appraisers gave their seal of approval and a clean bill of health to the companies, allowing them to commit fraud and blow a giant speculative bubble in toxic assets.

And the three credit rating services also committed massive fraud which helped blow the bubble. For example, an analyst at Standard & Poors was assigned the job of giving a credit risk rating for derivatives backed by subprime loans. He wanted to review a sample of loan file to assess credit risk. His boss (a high-level officer at S&P), gave him the following written response:

Rating Agencies as Vectors.
Any request for loan level tapes is. TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it.
[W]e must produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so. [S&P 2001]

(capitalization and punctuation in original). In other words, he was told to make it up, and then to make up a rationalization.

So the S&P analyst ended up giving AAA rating - i.e. zero credit risk - on something that had immense credit risk.

So the bubble was partly blown because, as Black says,"This was a trillion dollar industry based on don’t ask, don’t tell."

This is nothing new. Black points out that the official investigation into the S&L crisis found that in the typical large failure, fraud was invariably present.

Black also points out that the guys covering up fraud in S&L were promoted to head regulators in the 2000's. These regulators gave a wink and a nod to massive fraud and insane amounts of leverage. So the regulators helped blow the bubble and sow the seeds of the current crash as well.

Fraud By the Banks, Lenders and Financial Service Companies

But the most interesting portion of Black's talk was the role of fraud by numerous businessmen in blowing and then bursting bubbles.

Black explained that fraud by a financial company usually involves the company:

1) Growing like crazy

2) Making loans to people who are uncreditworthy, because they’ll agree to pay you more, and that’s how you grow rapidly. You can grow really fast if you loan to people who can’t you pay you back

and

3) Using extreme leverage.

This combination guarantees stratospheric initial profits during the expansion phase of the bubble.

But it guarantees a catastrophic subsequent failure when the bubble loses steam.

And collectively - if a lot of companies are playing this game - it produces extraordinary losses (more than all other forms of property crime combined), and a crash.

In other words, the companies intentionally make loans to people who will not be able to repay them, because - during an expanding bubble phase - they'll make huge sums of money. The top executives of these companies will make massive salaries and bonuses during the bubble (enough to live like kings even even if the companies go belly up after the bubble phase).

And since honest regulators would stop this fraudulent activity during bubbles, the corruption of regulators ensures wild bubbles and the subsequent crashes.

Of course, the types of fraud described by Black in the S&L, Enron and 2007 meltdowns are not just for the history books. Unless stopped, they will continue and will b of the next crash.

See also Matt Taibbi's discussion of Goldman Sachs.

Watch Black's speech (loads slowly):