What Inequality has Done to American Conservatives Community of Reason Kansas City: September 16, 2012

1. What Inequality has Done to American Conservatives Community of Reason Kansas City: September 16, 2012 William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City

2. Conservatives’ & Inequality Responses vary and contradict • Growing inequality is a myth • Inequality is unimportant • Inequality is desirable • Inequality reflects culture, not economics • Criticizing inequality = class warfare • Liberals cause inequality to grow • Inequality is due to inferior ethnicity

3. Growing inequality myth Conservatives focus on late 2008-2009: • Decreased wealth (v. income) due to stock and real estate losses • Decreased income due to reduced bonuses • Some job losses in high income jobs

4. Their chart

5. Longer term trend is clear

6. Inequality is unimportant “In the end, however, one has to ask a more basic question. Why do we care about inequality at all?” “Poverty, of course, is a bad thing. But is inequality?” Michael Tanner. Cato (2012)

7. Income jealousy is bad “In what way does someone else's success harm me? Such a viewpoint stems from the misguided notion that the economy is a pie of fixed size. If one person gets a bigger portion of the pie, others of necessity get smaller pieces, and the role of government is to divide up the slices of that pie. In reality, though, the size of the pie is infinite.” Cato 2012

8. Liberals love equality; hate the poor “After all, if we doubled everyone's income tomorrow, we would eliminate an enormous amount of economic hardship. Yet, inequality would actually increase. As Margaret Thatcher said about those who obsess over inequality, "So long as the [income] gap is smaller, they would rather have the poor poorer.“” Cato (2012).

9. Inequality spurs growth But to make it grow, we need people who are ambitious, skilled risk-takers. We need people to be ever striving for more. That means that they must be rewarded for their efforts, their skills, their ambitions, and their risks. Such rewards inevitably lead to greater inequality. Cato 2012.

10. Big $ = essential incentive “[A]s Nobel Prize–winning economist Gary Becker pointed out, "It would be hard to motivate most people if everyone had the same earnings, status, prestige, and other rewards.“” Cato 2012

11. Echelon formation Another Nobel Prize winner, F. A. Hayek, concluded, "The rapid economic advance that we have come to expect seems to be in large measure a result of this inequality and to be impossible without it. Progress at such a fast rate cannot take place on a uniform front but must take place in an echelon fashion, with some far in front of the rest.“ Cato 2012

12. Equality: “who needs it?” We should all seek a prosperous, growing economy, with less poverty, and where everyone can rise as far as their talent and drive will take them. Equality? Who needs it? Cato 2012.

13. Inequality increase = “rents” “[T]op performers in their fields—in sports and entertainment as well as business—have enjoyed huge gains in recent decades.” “[E]arnings at the very top of the scale have grown by leaps and bounds over the past generation.” (Cato 2009)

14. Cato (2009): The bad old days “Restrictions on competition in product and capital markets were … reduced during the 1970s and ’80s, to the applause of economists across the ideological spectrum. These salutary developments may have contributed to the rise of income inequality, true enough. But only through the distorting lens of nostalgia can what came before be seen as the “good old days.”

15. Rewards to high skills now huge “The leading explanation that emerges from the literature is one of “skill-biased technical change” (SBTC). [W]ith the explosive growth of information technology in recent decades, rising relative demand for highly skilled “knowledge workers” has resulted in a growing pay gap between those workers and their less-skilled counterparts. (Cato 2009).

16. Superstar compensation “Another distinctive aspect of the inequality picture that seems to need special explanation is the whopping increase in incomes at the very top of the pay scale. How to explain the rise of so-called “superstar” markets?” Cato 2009.

17. Explaining CEO compensation “[C]hief executive officers, investment bankers, [and] elite lawyers[’] big increases in remuneration have come without any corresponding expansion of the “audience” or customer base.” “Paul Krugman and company are well advised to search for additional causal connections [for CEO compensation gains] in the realms of politics and culture.” (Cato 2009)

18. Markets crush plutocrats “And the market economy has repeatedly tried to cut the most politically connected men of wealth down to size, but my critic’s own political hero, Barack Obama, has supported bailing them out. That is not the free market’s fault.” Woods (von Mises site.)

19. The Three “De’s” We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts …due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves. [FCIC]

20. Greenspan and HOEPA The Fed had unique statutory authority under HOEPA (1994) to ban liar’s loans made by non-federally insured lenders who made roughly 80% of such loans The Fed knew that liar’s loans were endemically fraudulent and that lenders and their agents put the lies in liar’s loans The Fed knew liar’s loan growth massive Greenspan refused (v. ACORN & NAACP)

21. Greenspan as anti-regulator Greenspan refused to have Fed examiners find facts re nonprime loans after FBI’s 2004 warning that mortgage fraud “epidemic” would cause a financial “crisis” Greenspan & Fed economists attacked Fed supervisors for criticizing nonprime loan Greenspan & Fed economists attacked Fed supervisors for criticizing elite banks for aiding and abetting Enron’s frauds

22. Indifference to looting No banking regulator contacted the FBI in response to its twin 2004 warnings Federal regulators’ “preemption” war v. state regulators stopping fraudulent lenders Death of federal regulatory criminal referrals and even (real) investigations Note that Geithner did not alert the FBI to the Libor frauds: no criminal referral by Fed

23. Bernanke little better Finally succumbed to congressional pressure to use HOEPA to ban liar’s loans on July 14, 2008 – and delayed ban for 15 months lest he discomfit any surviving fraudulent lender When it finally acted the Fed cited the data MARI had sent the industry in 2006 – the Fed did no study of the role of the world’s largest fraud epidemic in driving the crisis

24. MARI’s 5 Warnings (2006) • Stated income loans “are open invitations to fraudsters” • Study: fraud incidence is “90 percent” • “[T]he stated income loan deserves the nickname used by many in the industry, the ‘liar’s loan.’”

25. MARI’s 4th & 5th Warnings “It appears that many members of the industry have little … appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses….” “Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans….”

26. U.S. was a liar’s loan crisis Credit Suisse: by 2006: 50% of all loans called “subprime” are also liar’s loans Roughly 40% of all US mortgage loans made in 2006 liar’s loans > 500% growth since 2003 Caused the bubble to hyper-inflate Liar’s loans are the key “natural experiment” to evaluate claims v. CRA and Fannie & Freddie as causing crisis

27. Natural experiment: Liar’s loans “Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not” (FCIC 2010: 125).

28. No government urging “Alt-A mortgages were not generally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from counting toward [Fannie and Freddie’s] affordability goals” (FCIC 2010: 125). Inflating income massively is a poor means to purport to loan to the poor

29. Not so due diligence Clayton’s Potemkin review of mortgage loans for most sophisticated purchasers Found nearly 50% false representations Response: buyers negotiated reduced price to buy (and sell) endemically fraudulent mortgages (Source: FHFA suits) Reduced sampling percentage (2-3%) Passed loans Clayton rejected.

30. Calomiris:“Plausible deniability” “asset 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?”

31. Conscious Adverse Selection Optimizes accounting fraud & bonuses “[Liar’s loans] are open invitations to fraudsters.” (MARI 2006). Expected value of mortgage lending (and purchasing) under adverse selection is negative – catastrophic losses to firms MBA sent MARI warnings to everyone in 2006 but the response to increase such loans with ever worse quality

32. Negative expected value “owners of the thrift have an incentive to seek out the most unscrupulous ‘developers,’ the ones that it can count on to report grossly overstated interest payments in early years and then to default in subsequent years.” “The development projects that are undertaken in this kind of arrangement would typically have a net present value that was substantially negative.” (Akerlof & Romer 1993: 17)

33. Fraud is a “Sure Thing” “Sure thing” Akerlof & Romer 1993 Finance: accounting = “weapon of choice” Fraud optimization recipe: • Grow massively • Make (or buy) really bad loans with higher yield • Extreme leverage, not “pvt. discipline” • Trivial loan loss reserves (ALLL)

34. Lenders knew the recipe “More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan officers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about 10,000 loan originators a year…. (FCIC 2010: 7)

35. Flipping burgers, and homes “His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs ‘flipping burgers,’ he told the FCIC. Given the right training, however, the best of them could ‘easily’ earn millions.” (FCIC 2010: 8)

36. Teaching the Fraud Recipe “He taught them the new playbook: ‘You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.’ He added, ‘I knew that the risk was being shunted off. I knew that we could be writing crap. But in the end it was like a game of musical chairs. Volume might go down but we were not going to be hurt.’” (FCIC 2010: 8)

37. Lenders Add the Rot “Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete.” Miller, T. J. (August 14, 2007). Iowa AG.  

38. Only 50,000 rotten apples “Marc S. Savitt, a past president of the National Association of Mortgage Brokers, told the Commission that while most mortgage brokers looked out for borrowers’ best interests and steered them away from risky loans, about 50,000 of the newcomers to the field nationwide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were ‘absolutely’ corrupt.” (FCIC 2010: 14)

39. Lenders Add Rot to Hummler’s Wurst “[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.” [Iowa AG]

40. Appraiser Coercion = Fraud Deliberately created Gresham’s dynamic National study(early 2004): 75% coerced Cuomo 2007 investigation: nationwide 2007 study: 90% coerced Honest appraisers lose: 68 percent reported losing a client and 45 percent didn't get paid for their work when they resisted coercion Demos warned of disaster in 2005

41. Only fraudulent lenders inflate “From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets.”( FCIC: 18)

42. Ask the experts how it’s done Don't just say: "If you hit this revenue number, your bonus is going to be this." It sets up an incentive that's overwhelming. You wave enough money in front of people, and good people will do bad things. Franklin Raines: CEO, Fannie Mae Post-crisis pay: more short-term

43. “By now every one of you must have 6.46 [EPS] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.” “Agency cost” = Insanity

44. The anti-canary “Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals.”(Mr. Rajappa, head of Fannie’s internal audit, emphasis in original.)

45. Perverse compensation: big bet? “Compensation systems—designed in an environment of cheap money, intense competition, and light regulation—too often rewarded the quick deal, the short-term gain—without proper consideration of long-term consequences. Often, those systems encouraged the big bet—where the payoff on the upside could be huge and the downside limited. This was the case up and down the line - from the corporate boardroom to the mortgage broker on the street.” FCIC: xix

46. Nyberg’s Irish Incoherence “Targets that were intended to be demanding through the pursuit of sound policies and prudent spread of risk were easily achieved through volume lending to the property sector.” (2011: 30)

47. Gresham’s: Managers “Bank management and boards in some of the other covered banks feared that, if they did not yield to the pressure to be as profitable as Anglo, in particular, they would face loss of long-standing customers, declining bank value, potential takeover and a loss of professional respect.” (Nyberg 2011: v)

48. Punishing Integrity “The few that admitted to feeling any degree of concern at the change of strategy often added that consistent opposition would probably have meant formal or informal sanctioning.” (Nyberg 2011: v)

49. Nyberg’s Incoherence “Over time, managers known for strict credit and risk management were replaced; there is no indication, however, that this was as a result of any policy to actively encourage risk-taking though it may have had that effect.” (Nyberg: v)

50. Ignoring a Nobel Laureate “[M]any economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4-5).