Post on 26-Oct-2014
transcript
William K. Black Associate Professor of Economics and Law
University of Missouri – Kansas City
U. Calgary/Haskayne Corruption Forum November 5, 2009
The Best Way to Rob a Bank is to Own One
“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 firm 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: “profits” convert
firm assets to CEOʼs benefit Greshamʼs dynamic suborns controls Reduces whistleblowing • Lose your bonus • Peers lose their bonuses “Sanctity” of contract: un“holy” mess
Economist as bad criminologists Economists donʼt study fraud Donʼt 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 “profit” formula:
1. S&Ls: Extreme growth: avg. >50% 2. Loan to the uncreditworthy 3. Extreme leverage (infinite!) 4. 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 firm 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. AAʼs “file stuffing” AY, Jack Atchison, AA & “Keating 5” Same dynamic re other professionals
Off the Charts Profits & Losses S&L control frauds reported
extraordinary profits: Vernon & Lincoln the most profitable 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”
Fischelʼs 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 Achillesʼ heel >1000 priority felony convictions Prevented 2000-02 subprime crisis
Reregulated Despite: Reagan administrationʼs 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)
Corruptionʼs Role in the Debacle S&L debacle & Michael Milken Milkenʼs “captive” “Merchant Princes” Milken bribed bond fund managers Prostitutes at Predatorsʼ Ball Keating and Henkel (& Benston?) Vernonʼs prostitutes: BOD, regulators Speaker Wright/Whip (Coelho) & the
Keating Five: FHLBSFʼs removal
Corruptionʼs Role at Enron Could tell two opposite tales Among Bushʼs largest contributors Enron “black hole” exploited to
produce 2001 CA energy crisis Layʼs enticement to FERC chair Role of Sen. Gramm & Wendy Gramm VP Cheneyʼs secret energy advisors Cheney reads from Layʼs script
Corruptionʼs 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 officers: 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”
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): govʼt is the problem
(except for heroes wearing uniforms)
Failed Paradigms
Efficient markets & contracts Private market discipline: perverse Agency cost: shareholders canʼt
stop accounting control fraud Corporate governance: One canʼt
“govern” control frauds Business ethics: assumes the
“tone at the top” is honest
Itʼs easy to understand why the theoclassical ignore fraud
Control fraud falsifies their claims Markets & contracts arenʼt efficient Market discipline is perverse where
fraud gives a competitive gain Greshamʼs 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 arenʼt random The factors that produce criminogenic
environments are clear The incentives are perverse, but they
have predictable marginal effects Why donʼt 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 itʼs done
Don'tjustsay:"Ifyouhitthisrevenuenumber,yourbonusisgoingtobethis."Itsetsupanincentivethat'soverwhelming.Youwaveenoughmoneyinfrontofpeople,andgoodpeoplewilldobadthings.
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 Frank’s goals.” (Mr. Rajappa, head of Fannie’s 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 “liar’s 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-inflates bubbles and causes crises
Mass Destruction Maximizes lenderʼs loan losses Bonuses produce Greshamʼs dynamic
among professionals & executives Makes “market discipline” oxymoronic Makes markets inefficient (perverse) Hyperinflates & 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 profits 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 regulatorsʼ insights Cresseyʼs “fraud triangle” v.
Sutherlandʼs 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 fraudsʼ audit fees big
enough to tempt top tier partners S&L frauds always hired top tier and
got clean opinions Regulators recognized accounting
control fraudʼs distinctive pattern Regulators targeted “Achillesʼ heel” Regulators prevented a 2001-02
subprime crisis
Fraud Experts Fooled Two types of fraud are addressed in this
book fraudulent financial 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
Banksʼ political influence 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 filing institutions submitted mortgage loan fraud SARs.
Over 700 of those filed <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 donʼt 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”
“Donʼt Ask; Donʼt 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 ʼ01]
“Disconcerting Results” The result of the [Fitch loan file]
analysis was disconcerting…as 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]
Greshamʼs 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]….”
[Moodyʼs 2007]
Appraiser Coercion = Fraud Only reason to coerce an appraiser to
inflate 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
Itʼs easy to say “no” to “liarʼs 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 firmʼs failure
The firmʼs 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 donʼt 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]
http://www.ojp.usdoj.gov/bjs/pub/press/cv07pr.htm
Property crime: never higher