The Bust-Out

On a rainy day in New York last week, a man named William Black stood in front of a roomful of fellow law professors trying to sum up in a minute what had gone wrong with financial regulation over the last two decades. Actually, Black didn't have even a minute. His breathless spiel had (obviously as usual) already gone over its allotted period, leaving Black with just enough time to toss at his audience a number that encapsulated how slipshod and generally crazy-making federal efforts at dealing with fraud in the financial markets had become.

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The number that Black practically shouted out was the grand total of mortgage and securities fraud related convictions the government had managed to secure in the wake of the financial crisis. It was zero. With that startling statistic Black sat down, politely if impatiently waited for the other panelists to finish their brief speeches, and immediately ran off to catch a flight back to Kansas City, trailing a half-open umbrella and a jumble of bags.

Last week, in TBM's roundtable about Michael Lewis' book The Big Short, I wrote about how Wall Street and its financial models were blind to the reality of what was happening in the real world with the no-doc, no-asset, no-nothing loans that drove the subprime mortgage industry. Black explores the other side of the coin: How that same kind of oblivion befogged the work of regulators, who came to believe that fraud rarely happens, doesn't really matter, and wasn't worth pursuing.

How can that be? The work of Bill Black—who spent a decade as a federal bank regulator—is about how bad economic theory has given people whose jobs should be understanding fraud a screwy sense of how fraud works in the real world. One way of seeing this, as Black describes in a terrific article, is to think about the mob “bust-out.”

The bust-out is what happens when the mob moves in to take control of a business that's heavily indebted to a loan shark. As Black tells it, why the heck a mobster would ever want to take over a bar or liquor store in this way is incomprehensible to a classical economist. Why take over the business when you're already getting every cent of profit and more in your weekly vig?

Except that in the real world, things don't work that way, explains Black, a professor at the University of Missouri-Kansas City. The reason to take over the business is to loot it 1,000 ways to Sunday, from buying vast amounts of liquor on credit to, ultimately, torching the place for the insurance money. Prosecutors and mobsters know this. Economists who think the mob operates like a bank that happens to charge high interest rates miss it.

The problem here is that none of the ugly realities of how a business can be stripped of everything valuable make their way into the economic and regulatory theories that have been ascendant for the last two decades. How did we get to this point? Well, here's a story:

Back in the early days of the savings and loan crisis, Bill Black was involved in the efforts of bank regulators to close down two savings and loans, Lincoln Savings—the bank run by Charles Keating, later to become the poster boy for the S&L crisis—and CenTrust Savings. The two S&Ls held massive portfolios of junk bonds issued by the (now long-defunct) investment bank Drexel Burnham Lambert, then the junk bond kings. Black and other regulators believed that Lincoln's and CenTrust's junk bonds and bad loans were a disaster in the making.

To help make the case for their financial stability, Lincoln and CenTrust went to a consulting company called Lexecon, created by Daniel Fischel, a University of Chicago Law School professor and one of the preeminent authorities on the economics of regulation. Lexecon reported that Lincoln and CenTrust were extremely unlikely to fail, and in the (nearly impossible) case that they did, a failure would cost the bank insurance program less than a penny for every $1,000 of deposits.

Lincoln and CenTrust did fail—in the case of Lincoln, at a cost to the government of $3 billion. Daniel Fischel went on to become dean of the University of Chicago Law School. Not long after the Lincoln and CenTrust debacle, Fischel (who defended Keating and his patron Michael Milken in a 1995 book) and his fellow Chicagoan Frank Easterbrook went on to publish The Economic Structure of Corporate Law, the standard text on the intersection of law and economics.

Wait a second, how can a guy who was so utterly wrong in evaluating the economics of the S&L crisis come to be the go-to guy on regulatory theory? Fischel's theories were based on the premise that in the main markets were very good at evaluating the true worth of loans, bonds, and equities, and certainly better at it than regulators. On Fischel's view—a view that Black marvels at, given what the Chicago professor knew about the inner workings of Keating's bank—no fraud could grow too fast or get too big before the markets punished it.

This makes for a very neat economic theory, and a disaster in practice. In the Easterbrook-Fischel world of economic models—the world in which S&Ls don't fail and don't cost much money when they do—even the most cynical subprime lender acts in its own long-term self-interest. In Black's bust-out world, that's not the case at all.

In bust-out world (which means the real world), chief executives pump up their share price and dump as much of it as they can on the market before everyone else has figured out better. Investment banks pocket fees for underwriting bonds and then dump the losers on their captive investment funds. And what's left after it's done, by the time the market exacts its price, is the burnt shell from which every possible profit has been extracted.