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The Best Way to Rob a Bank is to Own One

U. Calgary/Haskayne Corruption Forum November 5, 2009

William K. Black Associate Professor of Economics and Law University of Missouri Kansas City

Control Frauds
White-collar criminology theory Person controlling seemingly legit. entity uses it as a weapon Causes > direct $ losses than all other forms of property crime combined Bubbles and market collapses Some control frauds maim & kill Exist in all three sectors

Why CEOs are Unique

Only the CEO can 1. Optimize the rm for fraud 2. Suborn internal & external controls 3. Loot or skim with minimal risk 4. Most audacious make external environment more criminogenic Criminogenic environments cause control fraud epidemics

Recurrent, Intensifying Crises

S&L Debacle Enron, WorldCom, et al. Overall failures California energy crisis The ongoing crisis: driven by fraud Many nations: tunneling, Iceland

Non-regulation Decriminalizes
Decriminalizes accounting fraud Effective regulators essential: Make the criminal referrals Train the FBI Detailed to aid investigations Serve as key witnesses De-supervision = non-regulation

Compensation is Criminogenic
Perverse incentive: accounting fraud Near perfect crime: prots convert rm assets to CEOs benet Greshams dynamic suborns controls Reduces whistleblowing Lose your bonus Peers lose their bonuses Sanctity of contract: unholy mess

Economist as bad criminologists

Economists dont study fraud Dont have a theory of fraud a rule against fraud is not an essential or an important ingredient of securities markets (Easterbrook & Fischel 1991) Greenspan to CFTC Chair B.Born: no need to regulate v. fraud

Optimizing Accounting Fraud

Guaranteed, record prot formula: 1. 2. 3. 4. S&Ls: Extreme growth: avg. >50% Loan to the uncreditworthy Extreme leverage (innite!) Grossly inadequate loss reserves

S&L Debacle Control Frauds

Over 1000 priority convictions The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures. [E]very accounting trick available was used. Evidence of fraud was invariably present as was the ability of the operators to milk the organization (NCFIRRE 1993)

Bad Loans are Best

Accounting abuses also provided the ultimate perverse incentive: it paid to seek out bad loans because only those who had no intention of repaying would be willing to offer the high loan fees and interest required for the best looting. It was rational for operators to drive their institutions ever deeper into insolvency as they looted them. (Pierce 2004)

Not Underwriting is Suicidal

Maximizes adverse selection: loans have negative expected value Reverse Pareto optimality: both principals harmed (agents gain) Creates criminogenic environment for undesired insider & outsider fraud Reduces whistle blowing and morality as best employees leave The rm fails, but the fraud succeeds

Keating Suborns Auditors

[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of "Gresham's Law" in which the bad professionals forced out the good. (NCFIRRE 1993) Criminal referral v. AAs le stufng AY, Jack Atchison, AA & Keating 5 Same dynamic re other professionals

Off the Charts Profits & Losses

S&L control frauds reported extraordinary prots: Vernon & Lincoln the most protable S&Ls Lincoln: $3.4 B loss on $6B in assets Vernon: 96% of ADC loans in default Econometrics perverse: Benston: 0 for 33; Greenspan re Lincoln: no foreseeable risk of loss Fischels 3000 position error

Regulators Must Understand Fraud Mechanisms to Succeed

300 frauds growing at 50% annually Econometrics perverse: autopsied Saw problem: accounting control fraud Found unique pattern optimizing fraud Targeted worst frauds Cut growth their Achilles heel >1000 priority felony convictions Prevented 2000-02 subprime crisis

Reregulated Despite:
Reagan administrations hate for it Majority of House plus Speaker Wright Keating Five Trade association, (#3) in U.S., plus prostitutes for key House member 2/3 of presidential appointees & staff Entire economics profession Media: Mr. Ed (talking horse)

Corruptions Role in the Debacle

S&L debacle & Michael Milken Milkens captive Merchant Princes Milken bribed bond fund managers Prostitutes at Predators Ball Keating and Henkel (& Benston?) Vernons prostitutes: BOD, regulators Speaker Wright/Whip (Coelho) & the Keating Five: FHLBSFs removal

Corruptions Role at Enron

Could tell two opposite tales Among Bushs largest contributors Enron black hole exploited to produce 2001 CA energy crisis Lays enticement to FERC chair Role of Sen. Gramm & Wendy Gramm VP Cheneys secret energy advisors Cheney reads from Lays script

Corruptions Role: Procurement

Boeing scandal: Air Force Pallets of Cash: Iraq Cheney, Halliburton, Water for troops Lethal showers (electrocution) Iraqi police building summed it up Blackwater: above the law Imperial Life in the Emerald City: Inside Iraq's Green Zone (2007) Rajiv Chandrasekaran

Perfect Corruption
Accounting control fraud: perfect crime Compensation as perfect bribe For ofcers: allies & deniability Professionals: allies & blessing Fraud induced v. spontaneous order Few rules, no real regulators & preemption: no bribes necessary Greenspan, Gilleran & Dochow: backdate

War on Regulation
Preemption of state efforts to restrain predatory lending Slashing the FDIC staff with early outs MERIT (non) examination Transferring 500 FBI white-collar specialists to national security Industry = customer; MBA = partner

Mission Accomplished

Intellectual Roots
Ayn Rand: Greenspan: at the bottom of all regulation lies the gun Democracy is illegitimate & corrupt Homo economicus is a sociopath Business schools as fraud factories Hayek: spontaneous order assumes price signals are non-fraudulent Reagan (& Gore): govt is the problem (except for heroes wearing uniforms)

Failed Paradigms
Efcient markets & contracts Private market discipline: perverse Agency cost: shareholders cant stop accounting control fraud Corporate governance: One cant govern control frauds Business ethics: assumes the tone at the top is honest

Its easy to understand why the theoclassical ignore fraud

Control fraud falsies their claims Markets & contracts arent efcient Market discipline is perverse where fraud gives a competitive gain Greshams drives honest from the mkt Reverse Pareto optimality: both parties lose; dishonest agents win Bubble & crisis ruins working class

Add Criminology to Economics

Incentives: the core of economics and white-collar criminology Fraud epidemics arent random The factors that produce criminogenic environments are clear The incentives are perverse, but they have predictable marginal effects Why dont the SEC & FDIC have Chief Criminologists?

Criminologists are the Experts in Dysfunctional Markets

Four key criminology concepts: Criminogenic environment Control fraud Systems capacity Neutralization Mankiw (1993): it would be irrational for operators of the savings and loans not to loot.

Ask the experts how its done

Don'tjustsay:"Ifyouhitthisrevenue number,yourbonusisgoingtobe this."Itsetsupanincentivethat's overwhelming.Youwaveenough moneyinfrontofpeople,andgood peoplewilldobadthings. FranklinRaines:CEO,FannieMae

Do as I say, not as I do
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%.

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 Franks goals. (Mr. Rajappa, head of Fannies internal audit.)

Fannie, Freddie & Ginnie

Disciplined market by defining prime Securitization reduced mortgage rates Privatization of ownership led to huge bonus system at Fannie & Freddie Grew rapidly & took interest rate risk Hedge accounting (SEC restatement) Growth blocked; bonuses at risk Fannie & Freddie turn to extreme credit risk & accounting fraud buy CDOs backed by liars loans

The Coverup Phase

Optimizing by profiting from coverup Hyperinflating & extending the bubble optimizes the coverup Refis defer losses & add to profits Equity stripping & sales allow some borrowers to profit & makes it easier to attract borrowers & grow Supports minimal loss reserves Defeat market discipline & regulators

Massive Losses & Bubbles

The optimization formula explains why large accounting control frauds cause losses > all other forms of property crime combined Optimization means frauds cluster in most criminogenic environment: weakest regulation & best asset for accounting fraud Produces, extends & hyper-inates bubbles and causes crises

Mass Destruction
Maximizes lenders loan losses Bonuses produce Greshams dynamic among professionals & executives Makes market discipline oxymoronic Makes markets inefcient (perverse) Hyperinates & extends bubbles Erode trust and shut markets: frauds create/betray trust: Akerlof/lemons

The Big 8 Fail

S&L control frauds hired only Big 8 The art is to suborn, not defeat, controls; use their reputation and make them best ally Got years of clean opinions blessing extreme prots when insolvent No heroes among audit partners >$1 B in settlements to regulators

Treadway: Almost Right

Treadway: a response to S&L debacle that did not study the S&L frauds Found senior exec involvement in 83% of financial frauds Concluded: frauds occur at smaller corporations with poor internal controls and smaller auditors. SEC enforcement cases=biased sample No (big) problem here

Ignoring (Modern) Criminology

Treadway embraced fraud auditing Relied on old criminology & ignored S&L regulators insights Cresseys fraud triangle v. Sutherlands emphasis on elites Cressey generalized from the most unique fraud to all fraud Goal: show embezzlers=low status Need to think outside the triangle

Modern Criminology: Control Fraud

S&L control frauds audit fees big enough to tempt top tier partners S&L frauds always hired top tier and got clean opinions Regulators recognized accounting control frauds distinctive pattern Regulators targeted Achilles heel Regulators prevented a 2001-02 subprime crisis

Fraud Experts Fooled

Two types of fraud are addressed in this book fraudulent nancial reporting, also known as "Treadway" fraud, usually originating in the top management sector; and "asset-theft" fraud, the more common and more costly type, likely to be practiced by virtually anyone, including outsiders. Treadway fraud is being adequately detected by independent auditors (CPAs) in their annual audits. Accountant's Guide to Fraud Detection and Control, 2nd Edition (March 2000).

Bad Timing (and Analysis)

Enron (2001); WorldCom (2002) Large accounting frauds undetected by CPAs before book published Asset theft is more common than control fraud, but not more costly Audit failures were the norm in the ongoing crisis the difference is that the SEC is even weaker now and banking regulation was gutted Banks political inuence has perverted GAAP (loss recognition)

Mortgage Fraud Epidemic

FBI warned of it, and coming crisis: 9.04 80% of losses induced by lenders FY07; 08: >50K; >62K criminal referrals Investment banks (03-07): 36 referrals Unregulated: 80% nonprime loans Most frauds undiscovered; referrals are exceptionally uneven & biased

If we file it the FBI will come

Nearly 900 ling institutions submitted mortgage loan fraud SARs. Over 700 of those led <5 SARs. <200 them submitted 98% of SARs. The top 10 submitted 57% of all SARs. The top 25 submitted 82% of all SARs. No actions against those that dont refer

FBI Finds Control Fraud

Many of these bankrupt subprime lenders manipulated their reported loan portfolio risks and used various accounting schemes to inflate their financial reports. FBI Report FY07 it would be irresponsible to neglect mortgage fraud's impact on the U.S. housing and financial markets

Dont Ask; Dont Tell

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 01]

Disconcerting Results
The result of the [Fitch loan file] analysis was disconcertingas there was the appearance of fraud or misrepresentation in almost every file. the files indicated that fraud was not only present, but, in most cases, could have been identified with adequate underwriting prior to the loan funding. [Fitch 11.07]

Greshams Grim Dynamic

[I]t was a slippery slope. What happened in '04 and '05 with respect to subordinated tranches is our competition, Fitch and S&P, went nuts. Everything was investment grade. We lost 50% of our coverage [business share]. [Moodys 2007]

Appraiser Coercion = Fraud

Only reason to coerce an appraiser to inate value is fraud 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

The Bankers Knew

Note the dates: 2001, 2004 & 2007 They knew from the beginning The bankers, auditors, attorneys, regulators and rating agencies could all have stopped it Its easy to say no to liars loans and toxic waste No banking heroes, no heroes in the professions

We Can Jail the Frauds

FBI agents investigating mortgage fraud: 120 FY 2007; 180 FY 2008 S&L debacle: 1000 FBI agents and forensic experts: > 1000 felony convictions of high priority frauds Today's financial crisis dwarves the S&L crisis Source: FBI 2.19.09 Dep. Dir. Pistole

Failure is an Option
CEO can profit enormously despite firms failure The firms failure is not a fraud failure Minimal reputation injury Hyperinflated bubbles produce economic crises and provide a ready excuse for firm failure Bailouts & too big to fail immunity

If you dont count it.

Property crime rates in 2007 were at or near the lowest levels recorded since 1973, the first year that such data were available. Property crime rates fell during the previous 10 years (1998-2007) [12.17.08]

Property crime: never higher