Very very very very very dishonest
In Mel Brooks’ brilliant film and Broadway musical The Producers, an over-the-hill Broadway producer, Max Bialystsock and his hapless accountant, Leo Bloom recognise two great truths. It is very hard to produce a hit and very easy to produce a flop – and they can make more money by producing a flop than by producing a hit. Max uses his expertise to ensure that the play flops. He selects the worst play ever written (Springtime for Hitler) – an ode to Hitler, a terrible director, and an awful male lead. Max understands critics’ key role in determining the success of Broadway plays, so he pretends to attempt to bribe the most prominent critic in order to enrage him and make sure that he will pan the play.
Max then (literally) seduces his investors, raising a million bucks from “little old ladies” by selling far more than 100% of the potential profits. If the play fails almost immediately, the investors will not expect to receive any money and Max and Leo can run away to Rio with the investors’ money.
The plot fails, however, because the show turns out to be a hit. It is so excruciatingly bad that the audience assumes it is a clever satire. Bialystock and Bloom land in jail when they are unable to pay over 1000% of profits to the investors. In prison, Max and Leo promptly set out to try the same scam. The story ends there because even Mr. Brooks could not imagine what happened next.
Real-life Bialystocks and Blooms
Not all the CEOs running the fraudulent savings and loans (S&Ls) in California and Texas in the 1980s and 1990s saw The Producers, but all of them could have played Max’s role convincingly. They shared Mr. Brooks’ insight into why the massive frauds use accounting as their “weapon of choice”, structure their efforts to fail, and recruit an accountant as their most valuable fraud ally. The fraudulent CEOs and their accounting allies were the real-life Bialystocks and Blooms. They bankrupted the S&Ls, enriching themselves and their friends along the way, at the expense of stockholders, creditors, and taxpayers.
Fraudulent lenders maximise their (fictional) income by making exceptionally bad loans and growing very rapidly. Borrowers that will frequently be unable to repay their loans are numerous (allowing the lender to grow rapidly) and will pay a higher interest rate (yield). The combination of rapid growth and high interest rates produced guaranteed, record income in the near term during the S&L debacle and the current subprime lending crisis.
During the ongoing subprime mortgage loan crisis, the rating agencies and the top tier audit firms played the real life role equivalent to the critic that Max pretended to try to bribe to make sure that Springtime for Hitler received a terrible review. Unlike the critics, who Max realised he could not succeed in bribing, the rating agencies and the top tier audit firms gave rave reviews to toxic subprime mortgage paper. The rating agencies claimed the toxic waste was pristine “AAA” – the safest of the safe. The elites that we count on to advise us on quality in the real world are more corruptible than the elites in the fictional world that Max and Leo inhabited.
In the words of Professor Paul Romer (quoted from Johnson and Kwak 2010), “Over the last fifty years, the Federal Aviation Administration, the airline manufacturers, and the airlines worked together to make a highly complex air travel system more efficient and much safer… in contrast, our financial regulators and banks have made our financial system less efficient and much more dangerous.”
In time, the regulators and the American justice system caught up with the S&L frauds. More than a thousand priority white-collar felony convictions resulted from the S&L debacle. Also, high-ranking politicians who had aided and abetted the S&L operators and accepted donations from them were driven from office and power, including Jim Wright, Speaker of the House of Representatives from 1987 to 1989. The “Keating Five” were deeply embarrassed for their intervention on behalf of the most notorious fraud, that perpetrated by Charles Keating at Lincoln Savings. One senator was reprimanded by the Senate Ethics Committee, another two were criticised for acting improperly, and two more, while cleared of impropriety, were criticised for poor judgment, including Senator John McCain, the former presidential candidate.
But this is a trick you can pull only once, you might think. Well, a few years later the people in charge at Enron thought they might try something similar, and for a while it looked as if they might succeed. Their fraud was exposed as well, however, and they brought down with them Arthur Andersen, one of the big five accounting firms in the US. And then there was WorldCom, and hundreds of others. Prosecutors were able to arraign only the most notorious of these frauds.
The crisis that started in 2007 also contains significant elements of fraud. The crooks still understand Max and Leo’s scam, but this time the regulators and prosecutors appear to be as clueless as the little old ladies that Max conned.
Perhaps we need to send the regulators and prosecutors to remedial showings of The Producers. Alternatively, we could have them become familiar with modern economics and white-collar criminology. Inspired by the experience of regulators who had dealt with the S&Ls and understood fraud – and perhaps also by Mel Brooks – George Akerlof, the Nobel-Prize winning economist, and Paul Romer published in 1993 a famous article entitled “Looting: The Economic Underworld of Bankruptcy for Profit.” In 2005, the white-collar criminologist, economist, and lawyer William Black published a book entitled “The best way to rob a bank is to own one”. Again, the title says it all. In an appendix, the book reproduces a memo from Charles Keating that reads, in part, “get Black – kill him dead.” In the 1980s, Mr. Keating ran the Lincoln S&L Association, running it into the ground in 1989 at a cost to the federal government of over $3 billion and leaving about 23,000 customers with worthless bonds. Mr. Keating, a generous backer of the five afore-mentioned senators, the “Keating Five”, served four and a half years in jail.
Built to fail
Mr. Black has listed the four main characteristics of fraudulent banks.
- They grow very rapidly;
- They make really bad loans at high yields (because only borrowers who have no intention of paying back will borrow at exorbitant interest);
- They pile up huge debts; and
- They set aside pitifully small loss reserves.
This, in a nutshell, is what many of the failed S&Ls in California and Texas did in the 1980s. The key thing to realise is that such banks are built to fail. The owners and operators of the S&Ls could live lavishly as long as their scam lasted, or longer, as many of them, even after serving time in jail, walked away rich at the expense of innocent bystanders.
At some point, though, the threat of getting caught may lead some to try to subvert the law. As Professor James Galbraith put it in his testimony in the US Senate 4 May 2010, “This is where crime and politics intersect.” This is where law and order enter the picture if financial regulation has failed to rein in the banks as it did before the onset of the current crisis in 2007. The National Transport Safety Board investigates every civil-aviation crash in the US. In Europe, national Civil Aviation Accidents Commissions perform this vital role. Their principal concern is public safety. For reasons of consumer protection and public safety, finance needs to be viewed the same way as civil aviation. When things go wrong, there is a clear need for credible crash analysis to secure full disclosure. If laws were broken, the public has a right to know. Mel Brooks would agree – Bialystock and Bloom went to jail.
Piece originally published at VoxEU.org
Black, William K (2005), The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, University of Texas Press.
Brooks, Mel (1968), The Producers – A Gay Romp with Adolf and Eva at Berchtesgaden, a film written and directed by Mel Brooks starring Zero Mostel and Gene Wilder. Academy Award for best original screenplay.
Brooks, Mel (2001), The Producers, a Broadway musical based on the film. Three Tony Awards, including for Best Musical and Best Book of a Musical.
Brooks, Mel (2005), The Producers, a film adapted from the Broadway adaptation.
Galbraith, James K (2010), “Statement before the Subcommittee on Crime, Senate Judiciary Committee”.
Johnson, Simon, and James Kwak (2010), 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books.
About The Author:
Thorvaldur Gylfason is Professor of Economics at the University of Iceland and Research Fellow at CEPR (Centre for Economic Policy Research) in London and CESifo (Center for Economic Studies) at the University of Munich. He is also a Research Associate at the Center for U.S.-Japan Business and Economic Studies at New York University and a Fellow of the European Economic Association.