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”

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): 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