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Update: The Best Way to Rob a Bank is to Own One

by William K. Black, New Economic Perspectives


Editor’s note: This is a summary of the writings of Prof. Black over the past several years encompassing the manifest destiny of the political and economic thinking that resulted in the Great Financial Crisis.  The author has called this a “postscript” to his widely acclaimed book.  This editor thinks it is more appropriately called an “update” and has used that word in the title of this article.

A word of advice to readers:  Set aside sufficient time to read this piece.  It is of sufficient length to be a significant part of a book all by itself.  Treat the reading of this article with same dedication of effort as you would to reading a book.  This is one of the most comprehensive pieces Prof. Black has written since the original book was published.


The central questions for a theorist are whether his theory showed strong explanatory power and to what extent it proved useful in diverse settings. A distinguished economist, Dr. Jayati Ghosh, has addressed those questions in an article in which she was explaining to Indian readers that a large fraud, Satyam, was not the product of unique defects in Indian regulation.

But the truth is that instances like Satyam are neither new nor unique to India. Similar — and even more extreme — cases of corporate malfeasance abounded in the past decade, across all the major capitalist economies, especially in the US. And these were not aberrations, rather typical features of deregulated capitalist markets.

Furthermore, there is also quite detailed knowledge about the nature of such criminal tendencies within what are supposedly orderly capitalist markets. Four years ago, at a conference in New Delhi, the American academic William Black spoke of how financial crime is pervasive under capitalism. He knew what he was talking about: as an interesting combination of lawyer, criminologist and economist, he recently authored a best-selling book on the role of organised financial crime within big businesses.

This book — The Best Way to Rob a Bank Is to Own One: How corporate executives and politicians looted the S&L industry — is a brilliant exposé of the savings and loan scandal in the US in the early 1980s.  It received rave reviews, with the Nobel prize-winning economist George Akerlof calling it a modern classic and praise came from all quarters including the then chairman of the US federal reserve, Paul Volcker.

In his book, Mr Black developed the concept of “control fraud” — frauds in which the CEO of a firm uses the firm itself, and his/her ability to control it, as an instrument for private aggrandisement.  According to Mr Black, control frauds cause greater financial losses than all other forms of property crime combined and effectively kill and maim thousands.

Control fraud is greatly abetted by the incentives thrown up by modern executive compensation systems which allow corporate managers to suborn internal controls. As a result, the organisation becomes the vehicle for perpetrating crime against itself.

This was the underlying reality in the savings and loan scandal of the early 1980s that Mr Black used to illustrate the arguments in his book. But it has been equally true of subsequent financial scams that have rocked the US and Europe — from the scandal around the Bank of Commerce and Credit International (BCCI) in the UK in 1991, to the Enron, Adelphia, Tyco International, Global Crossing and other scandals in the early part of this decade, to the Parmalat Spa financial mess in Europe, to the recent revelations around accounting practices of banks and mortgage providers in the US in the current financial crisis.

The point is that such dubious practices, which amount to financial crime, flourish during booms, when everyone’s guard is down and financial discrepancies can be more easily disguised. This environment also creates pressures for CEOs and other corporate leaders to show, and keep showing, good results so as to keep share prices high and rising. The need arises to maximise accounting income and so private “market discipline” actually operates to increase incentives to engage in accounting fraud.

Ghosh identifies several of the concepts I consider central to the theory of “control fraud” and the theory’s predictive and explanatory strength. She emphasizes the importance of the overall “environment.” One group of predictions made in the book addressed what causes a “criminogenic” environment – an environment with incentives so perverse and powerful that it can produce fraud “epidemics.” The book explains the factors that optimize a criminogenic environment.

Criminogenic Environments

Lenders engaged in accounting control frauds will tend to cluster in the most criminogenic environments. The most criminogenic environments have these characteristics

  1. Non-regulation, deregulation, desupervision, and/or de facto decriminalization
  2. Assets that lack easily verifiable market values
  3. The opportunity for rapid growth
  4. The ability to employ extreme leverage
  5. Extreme executive compensation based on short-term reported income
  6. Easy entry
  7. An expanding bubble in the asset category that lacks easily verifiable market values
  8. No enforceable accounting requirement to provide adequate allowances for future loan losses, and
  9. Severe industry losses can spur reactive (v. “opportunistic”) control fraud

The Three “de’s”

Here, I focus on deregulation, desupervision (the rules remain in place, but are not enforced), and de facto decriminalization (what I now refer to as the three “de’s”) and modern executive compensation. I warned in the book that the three “de’s” greatly increase the chance that the CEO will be able to loot with impunity. The book discusses the intense anti-regulatory dogma that was driving the three “de’s.” The book’s warnings about the acute danger that theoclassical economists posed went unheeded. The Bush administration appointed anti-regulators as heads of the financial regulatory agencies.

The OTS – Chainsaw Gilleran and the Return of Darrell Dochow

History is said to repeat itself first as tragedy and then as farce, but OTS proves that the two are not mutually exclusive. Here is the iconic image of the ongoing crisis. The man holding the chainsaw is John Gilleran, the head of OTS. He is accompanied by the three leading bank lobbyists and the deputy head of the FDIC, John Reich, who as Gilleran’s successor will complete the destruction of OTS. These four gentlemen are holding pruning shears. They are poised and posed over a pile of federal regulations, tied together in red tape as a final act of subtlety. The message is that the government and industry are working in tandem to destroy federal regulation and the leader of the pack wants to make clear he intends wholesale destruction in the least possible time. Mission accomplished; criminogenic environment maximized. The anti-regulators were so proud of the photo that they featured it in the FDIC’s annual report for 2003.

The book discusses the hearings that Henry B. Gonzalez (D. Tex.) held when he became chair of the House Financial Services Committee. Gonzalez sought to expose Danny Wall’s cowardice in the face of Keating’s political allies. This was an exceptional act, for the hearings were sure to embarrass the Keating Five, and four of the Senators were Democrats. They could also embarrass Speaker Wright (D. Tex.). The hearings proved explosive. Our (the West Region of OTS) testimony led President Bush to signal that Wall should resign. The hearings also embarrassed Wall’s head of supervision, Darrell Dochow, who led the staff effort to remove our jurisdiction over Lincoln Savings because we refused to change our recommendation that the agency take over Lincoln Savings and end Keating’s frauds.


Editor’s note: Details of the Keating Lincoln Savings & Loan can be read in Prof. Black’s article “Why Was the S&L Crisis not a Systemic Economic Crisis?


Dochow’s position was untenable once Wall resigned. He stepped down and took a position in the field in Seattle, Washington. WaMu was based in Seattle and is it acquired Ameriquest’s fraudulent mortgage operations and increasingly made liar’s loans it began to report exceptional (albeit fictional) profits. Dochow rode WaMu’s “success” back to prominence. The head of OTS, Reich, used Dochow to entice Countrywide to convert from a national bank to an S&L charter that would be regulated by the OTS. Countrywide feared the OCC, which regulates national bank could take an enforcement action against it and was assured by the OTS that it would be welcomed with open arms.

Dochow’s “success” in bringing Countrywide into the OTS system led Reich to appoint him as the head of West Region.   He was now in charge of his old nemesis.  He was also in charge of regulating the largest regulated makers of liar’s loans in the world – Countrywide, WaMu, and IndyMac. He had to resign, however, when the Inspector General found that he had permitted IndyMac to backdate documents to make it appear to be “well capitalized.” (It was, of course, massively insolvent.)

The result of Bush’s anti-regulators control of OTS was that the agency took no effective regulatory action against any of the accounting control frauds specializing in making endemically fraudulent liar’s loans. The OTS took no meaningful enforcement action against any of lenders specializing in making liar’s loans until after they were deeply insolvent. The OTS took no action even as it learned that liar’s loans were endemically fraudulent. The OTS took no action even as it learned that S&Ls were reducing their allowances for future losses even as they made increasingly made loans with a negative expected value. The OTS took no effective action even as it learned that WaMu had a black list – for honest appraisers! The OTS allowed other S&Ls to backdate documents – its senior leadership even recommended that an S&L backdate documents.

Alan Greenspan: Anti-regulator-in-chief

The Financial Crisis Inquiry Commission (FCIC) was appointed to report on the causes of the ongoing crisis. Testimony before FCIC sometimes made public for the first time information that went back many years. Rich Spillenkothen, director of banking supervision and regulation at the Federal Reserve Board (1991 to 2006) testified before the FCIC on May 31, 2010. He testified that the general problems that prevented effective regulation by the Fed included: “a general acceptance of specious conventional wisdom, a philosophical skepticism and ambivalence toward regulation, insufficient attention to the lessons of history….”  He later provided two examples of the specious conventional wisdom and makes clear its roots in theoclassical dogma and the worst pretensions of econometrics. He decries, “the philosophical belief in self-correcting markets held by many economists…” and explained how it led to what the Fed and the industry termed “Fed-lite” regulation. He also reveals that the Fed’s econometricians were the primary authors of Basel II’s worst provisions and states that “Basel II was viewed by its most ardent Fed devotees with a quasi-theological reverence…” Amen.

Spillenkothen reveals that the that Greenspan’s dogmatic belief that regulators invariably identify problems only long after the markets self-correct was studied and falsified by the Fed.

Earlier this decade, in connection with an effort to explore ways to make greater use of public information in the supervision process, an attempt was made to find examples of where the market identified problems before they were noted in supervisory examinations. To the best of my recollection, no examples were found.

Spillenkothen does not make the point explicitly, but the fact that the study disproved Greenspan’s faith-based anti-regulatory creed had no effect on Greenspan’s embrace and propagation of that creed and was never made public until Spillenkothen testified to FCIC.

The Fed was dominated by these theoclassical views.

In the years leading up to this crisis, the culture of the Federal Reserve — an agency dominated by professional economists whose mindset and intellectual biases were to enhance the workings of free markets, not to design regulations — was reinforced by a Chairman who had a strong, deep, and abiding philosophical belief that market and counterparty discipline were more effective in controlling risks than governmental regulation and oversight. This strong institutional orientation toward self-correcting markets and skepticism regarding the efficacy of regulation, often reinforced by industry, public or Congressional expressions of concern regarding regulatory burden, sometimes prevented or slowed the adoption of needed standards or resulted in less robust regulatory requirements.

Spillenkothen then explained how damaging it is when the regulators treat the bank as their “client” and try to protect it. (And fail to see that they are dooming the bank by protecting the CEO that is looting the bank.)

[A]ll banking agencies were wary about information they provided to the regulators of certain nonbank subsidiaries, whose principal mission was enforcement, not prudential supervision. Prior to the crisis, discussions among the banking agencies and the SEC about greater cooperation and information-sharing were controversial and did not proceed smoothly due to differences in supervisory approaches and concern over how information might be used.

It may not be clear what Spillenkothen is saying in this passage. He is admitting that the banking agencies deliberately withheld information from the Securities and Exchange Commission (SEC) about possible securities frauds committed by the banks because they feared that the SEC would take action against the fraud and put the bank at risk of loss.

When Fed supervisors tried to challenge the theoclassical dogma with facts they were smacked down by the ideologues that controlled the Fed. The supervisors were humiliated so vigorously that they refrained from future efforts warn the Fed governors about elite bank fraud. Greenspan and his theoclassical acolytes were never vigorous against the control frauds, but they enjoyed castigating anyone that wanted the Fed to take on the frauds.

A supervision staff presentation to the Board in 2003 or 04 on the role of large banks engaged in complex structured financial transactions with Enron was received coolly by some Board members who seemed clearly unimpressed by staff findings, presumably because, despite the banks’ questionable behavior and risk management lapses, it appeared that no laws were broken and related losses were manageable. The message to some supervisory staff was neither ambiguous nor subtle. In the late 90s, when supervisors were developing policies and regulatory expectations for certain derivatives transactions, senior Board economists (who were actively involved in policymaking and skeptical of the need for additional regulation) cited Enron as an example of a prominent player in the derivatives market that was successfully “regulated” by counterparty discipline, without needing bank-like government oversight. (To be fair, of course, Enron impressed a lot of knowledgeable observers at the time and did not fail until late 2001.)

These reactions and attitudes and the related “body language” were intangible factors. While by definition they cannot be measured, they did foster a climate and tone that were not always conducive to rigorous supervision.

This passage also requires translation. A large number of the world’s largest banks aided and abetted Enron’s fundamental accounting and securities fraud involving its Special Purpose Vehicles (SPVs) and aided Enron’s tax evasion. The reason for the supervisory presentation was to warn the Fed Board that the largest banks had eagerly (the emails are amazing) aided Enron in a massive series of frauds. Enron’s fraud caused tens of billions of dollars of losses. None of the banks approached by Enron to aid the frauds appear to have refused.

Anyone sentient should have been appalled by these facts and would have made anti-fraud efforts the Fed’s top priority. There is an exact historical parallel discussed in detail in the book. Bank Board Chairman Gray was shown a video in 1983 documenting widespread fraud by several relatively small S&Ls in a Texas development. The result is referred to as his “Road to Damascus” conversion. He transformed, because he was open to the facts, from a conventional anti-regulator to a champion of reregulation and the control frauds’ fiercest foe.

But Greenspan and his theoclassical acolytes were made of inferior stuff than Gray. They were enraged at their staff and they went out of their way by word and scowls to make sure the staff knew they were enraged and would never repeat the mistake of suggesting that the Fed should try to counter endemic fraud by the largest banks. The Fed’s attack on its supervisory staff illustrates another danger of DOJ’s failure to prosecute plutocrats – Greenspan was able to pretend that “no laws were broken” solely because DOJ failed to prosecute the long list of elite banks that aided and abetted Enron’s controlling officers’ frauds. Aiding and abetting a securities fraud is a felony. Numerous laws were broken by the banks, and for the worst possible motivations.

Note that Greenspan and the acolytes were not concerned with the huge losses caused to the public by the banks’ aiding and abetting Enron’s fraud. Their sole focus was on the banks, and their losses were “manageable.” The embarrassingly weak policy guidance that the banking regulatory agencies finally released after great delay on aiding and abetting fraud continued this insane and immoral focus on losses to the bank. The guidance treated the issue of aiding and abetting fraud solely as a “risk management” issue for banks – before aiding and abetting a fraud the agencies recommended that the banks do a benefit-cost analysis to consider whether they would suffer excessive reputational and financial losses relative to the potential profits if their criminal acts were exposed and sanctioned.

An Epidemic of Fraudulent “Liar’s” Loans Drove the Ongoing U.S. Crisis

The ongoing U.S. crisis was brought on by a criminogenic environment that exemplified each of these factors. Many of these factors are well known to many readers. The U.S. crisis was driven overwhelmingly by fraudulent “liar’s” loans to purchase homes. I will show that it was overwhelmingly the lenders that put the lies in “liar’s” loans.

In 1990-1991, S&Ls in southern California began to make very large amounts of “liar’s” and subprime loans. Orange County is infamous among white-collar criminologists as the nation’s originator of fraud schemes. Most people writing about the ongoing crisis still refer to it as “the subprime crisis,” but that is misleading. There were never official definitions of “liar’s” loans or subprime loans. The categories are not mutually exclusive. There were many euphemisms for liar’s loans, primarily “alt-a” and “stated income” loans, but the trade often used the term “liar’s” loans when the public was not present. The defining characteristic of liar’s loan is that they are made with little or no meaningful underwriting. A credit score can never be used as a prudent tool for underwriting mortgage lending because it tells one nothing about the borrower’s capacity to repay the loan. Bankers have known for over a century that lenders that make mortgage loans without rigorous underwriting will fail. Failure to underwrite creates strong “adverse selection” and endemic fraud. The “expected value” of making mortgage loans under conditions of adverse selection is sharply negative – the lender will suffer severe losses. Investigations confirm what economic and criminology theory predict – it was the lenders and their agents that put the lies in liar’s loans. No honest CEO of a mortgage lender would make liar’s loans because it would be suicidal for the firm. Making liar’s loans does, however, optimize the fraud recipe. Knowing these facts we realized that cracking down on liar’s loans was an easy call.

Michael Patriarca, the head of OTS’ West Region, led our crackdown on liar’s loans with the support of Tim Ryan. We were so successful that the CEOs of the two of the primary nonprime lenders left the S&L business. Roland Arnall, Long Beach Savings’ CE), gave up its S&L charter and federal deposit insurance in order to form a mortgage bank (which he renamed Ameriquest) that would not be subject to OTS regulation. It was, however, subject to federal laws against lending discrimination and we had made a referral to DOJ based on discrimination against minorities before Long Beach gave up its charter.

Russ and Becky Jedinak owned Guaranty Savings. We “removed and prohibited” them from federally-insured banking, so they formed Quality Mortgage. As a mortgage banker they were not subject to OTS jurisdiction. They became one of Ameriquest’s significant competitors. By 1991, the S&L nonprime lenders were fully contained by normal supervisory means and were in full retreat.

The S&L regulators demonstrated that understanding accounting control fraud could lead to regulatory interventions (e.g., against liar’s loans in 1990-1991) that stopped a crisis from occurring. The current U.S. crisis, largely driven by liar’s loans made and sold by unregulated entities shows the incredible damage that would have occurred in the 1990s in the regulated sphere under the three “de’s.” However, the same incident revealed the danger of allowing “regulatory black holes” where the frauds could move to escape effective regulation.

Too Many of the World’s Most Elite Bank CEOs Embrace Control Fraud

A logical place to begin the story of what led directly to the current crisis is the founding of Ameriquest. Michael W. Hudson has authored the best book on the current crisis (The Monster). It is largely a study of Ameriquest’s frauds and predatory lending. One of my favorite examples is Hudson’s story of Wendell Raphael, Ameriquest’s loan quality officer who wanted to reduce the firm’s endemic appraisal fraud (pp. 162-164). Ameriquest loan officers would call one appraiser after another until they found one who would inflate the appraisal value enough to allow them to close the loan. Raphael had the computer system changed to allow the loan officers only (!?) five chances to find an appraiser willing to inflate the appraisal. His change lasted one morning. The senior loan officers demanded that the change be rescinded so that they could continue to make fraudulent loans that were certain to cause severe losses.

Ameriquest was such a cesspool of fraud and predatory lending that the Department of Justice (DOJ) investigation triggered by the OTS referral for lending discrimination threatened its survival. Instead, a senior Clinton administration DOJ official, Deval Patrick (now Governor of Massachusetts), negotiated a classic modern corporate settlement with Arnall. Arnall – the man leading the fraud and racial discrimination – was allowed to pick the nonprofit groups of African-Americans that would receive charitable donations under the settlement from Ameriquest. From Ameriquest’s perspective the amounts donated represented chump change. The non-profits became great defenders of Arnall and he caused Ameriquest to continue the donations because the support of African-American non-profits, when one is discriminating against African-American borrowers, is priceless.

Arnall needed defenders, particularly prominent African-American defenders, because 49 state attorney generals and the FTC sued Ameriquest for continuing its fraud and predatory lending after Ameriquest falsely promised to clean up its act in its settlement with Patrick. Arnall had morphed from a major contributor to the Democratic Party to the largest contributor to the (second) President Bush. The reason that one state, the Commonwealth of Virginia, did not sue Ameriquest is that Virginia had tougher regulation so Ameriquest avoided defrauding and predating against Virginians. Ameriquest paid hundreds of millions of dollars to settle these lawsuits. Again, no officer was prosecuted for its frauds. The Senate waited for the settlement before confirming Arnall as the U.S. Ambassador to the Netherlands. Remember when Luther thundered at the Catholic Church for selling indulgences to plutocrats for the remission of their sins? Arnall was never indicted. Fraud and predation on minorities made him wealthy, politically powerful, conferred extreme social status on him, and provided him with de facto immunity from prosecution.

Arnall is the key transitional figure and the CEO who demonstrates why criminal prosecutions are essential. We (OTS) were able to stop him from making nonprime loans and we made the appropriate referrals to DOJ during the period when the OTS was a vigorous regulator. DOJ’s failure to prosecute elite financial frauds after 1993 proved disastrous. Civil settlements with Ameriquest were worse than useless. They did not deter fraud and predation on minorities. Arnall treated the settlement fines and donations as an easily bearable license to defraud. The fines weren’t remotely large enough to take the profit out of fraud. The settlements enhanced Arnall’s reputation and left him wealthy and more powerful.

The real Ameriquest scandal – its acquisition by Citi and WaMu

Arnall’s success as a plutocrat is a political scandal that could happen in any nation. The far more telling scandal was what happened when Arnall decided to play Ambassador and put Ameriquest up for sale. Recall that this is an enterprise with an infamous track record for endemic fraud and predation on minorities. Any acquirer will obtain the services of thousands of employees who, dozens of times daily, commit fraud. They make loans that will cause the lender tremendous losses. The government is not imploring any bank to acquire Ameriquest to prevent a financial crisis. The only acquirers that step forward are ones that want to acquire a fraudulent enterprise staffed by fraudulent officers skilled in making loans that generate large amounts of fictional short-term income but will cause large, real losses.

Citi and Washington Mutual (WaMu) were the winning bidders for Ameriquest’s operations, which they split between them in a class “bad bank – bad bank” acquisition. WaMu proceeded to make fraudulent and predatory loans by the tens of thousands. The reader may not be familiar with WaMu, but it is (by far) the largest bank failure in U.S. failure and its fraudulent burnt offerings continue to bedevil its acquirer, JPMorgan Chase.

Richard M. Bowen, III, Business Chief Underwriter for Correspondent Lending in Citi’s Consumer Lending Group testified under oath before the Financial Crisis Inquiry Commission (FCIC), and provided supporting documentation, that 80% of this mortgage product was sold by Citi to others (largely Fannie and Freddie) under false representations and warranties (“reps and warranties”).

Our largest, most elite financial institutions were eager accounting control frauds.

The death of criminal referrals by the banking agencies

The OTS, which had made well over 10,000 criminal referrals in the S&L debacle, made none in the current crisis.

The OCC made, depending on the source, zero or three criminal referrals during the crisis. The Fed apparently made three referrals during the crisis, none of them against a large U.S. bank.

The FDIC apparently made a small number of referrals. None of them has led to a major conviction of a fraudulent senior officer.

I have found that I cannot stress the statement sufficiently to convey its importance to readers who have not been active in efforts to prosecute elite financial frauds. Superb criminal referrals by the banking regulatory agencies are essential if prosecutors are to succeed against the elite frauds in fraud epidemics. I mean the word “essential.” The prosecutors can succeed in a few cases without regulatory support and guidance, but they will fail comprehensively if left on their own against an epidemic of control frauds.

The FBI: a brilliant start followed by misdirection

The FBI deserves immense credit for identifying and publicly proclaiming the existence of an “epidemic” of mortgage fraud at such an early date (September 2004) and predicting that it would cause a financial “crisis” if it were not contained. The FBI did this in open House testimony that was publicly reported by national publications. Thereafter, without the essential assistance of high quality criminal referrals about the accounting control frauds that drove this crisis everything went disastrously wrong.

The two great lessons of investigating fraud in this crisis are:

  1. If you don’t look, you don’t find
  2. Wherever you do look, you will find fraud

Both of these lessons have harmed the FBI. It failed to look for accounting control fraud, so it did not find accounting control fraud. It looked for low level mortgage fraud – and found it in abundance.

The FBI compounded its problems by forming a “partnership” with the Mortgage Bankers Association (MBA) – the trade association of the “perps.” The MBA, predictably, pictured its members as the victims of mortgage fraud and created a preposterous “definition” of mortgage fraud that excludes even the possibility of control fraud. The FBI and DOJ repeat this “definition” endlessly without any analysis.

Because it defined mortgage fraud as consisting overwhelmingly of relatively smaller cases and exclude control fraud it proved impossible for the FBI to get the staff required to investigate even a single large control fraud. The FBI also faced a staffing crisis. In response to the 9/11 attacks the FBI transferred 500 white-collar crime specialists to national security to “follow the money” trail of international terror suspects. That is understandable, but the Bush administration’s refusal to allow the FBI to replace the transferred agents has greatly damaged the prosecution of elite white-collar criminals.

As recently as FY 2007, the FBI had only 120 agents assigned to investigate mortgage fraud. The FBI assigned 1000 agents to investigate the S&L cases. The FBI assigned one-eighth the agents to investigate a fraud epidemic that was roughly 40 times more severe than the S&L debacle. One- hundred-twenty agents might be barely adequate to investigate a single SDI. As a result of the MBA definition and the absurdly inadequate FBI staffing levels the FBI did not conduct a meaningful investigation of any major nonprime lender. It divided it agents in what the military would call “penny packets” – tiny groups of agents incapable of taking on any serious opponent.

“White-collar street crime”

To its credit, the FBI realized by 2008 that continuing to assign its agents to investigate relatively minor cases guaranteed failure. By 2005, there were over one million cases of mortgage fraud annually. A few hundred agents cannot investigate more than a tiny percentage of a million cases. Every year, the FBI was over a million cases farther behind. The FBI’s only chance of success was to investigate the control frauds and their principal allies, the outside auditors and the credit rating agencies. The FBI proposed to create a national task force against mortgage fraud and to reassign its agents to investigate the worst frauds. Bush’s Attorney General Mukasey refused, infamously saying that mortgage fraud was simply “white-collar street crime.” While Mukasey’s statement demonstrates his refusal to understand and take seriously control fraud, one can understand his thought process. He has caused the FBI agents overwhelmingly to be assigned to investigate low priority mortgage frauds. The FBI agents follow their orders and report back what they have found, which must be low priority mortgage frauds. Mukasey reads the reports and finds that they overwhelmingly found low priority mortgage frauds. What Mukasey never understood the circular nature of his conclusion that he was investigating the equivalent of white-collar street crime.

A confusion of pronouns

Mukasey isn’t the only prosecutor who fails to “get it.”

Too Big to Jail?

Not everyone agrees that such a case can be successful. Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. An investor in loans who documents fraud can force a bank to buy the loan back. But convincing a jury that executives intended to make fraudulent loans, and thus should be held criminally responsible, may be too difficult of a hurdle for prosecutors.

“It doesn’t make any sense to me that they would be deliberately defrauding themselves,” Wagner said.

I have more sympathy for Mukasey’s circular error that Wagner’s statement, which is based on the simplest of errors. The context of his statement is that that he was asked to discuss the difficulties of prosecuting the senior officers engaged in looting the banks that they control. His response, at best, represents an inability to understand the meaning of his own incoherent use of pronouns. The key words are “they” and “themselves.” He uses “they” to refer to the CEO and “themselves” to refer to the bank. The problem is that he forgets he is doing so and treats “they” and “themselves” as equivalent when they in fact represent two different entities. It makes perfect “sense” for a CEO to loot the bank. Doing so can make the CEO wealthy and powerful. We were able to explain this successfully to thousands of jurors in the S&L debacle. I have difficulty understanding Wagner’s inability to comprehend that the CEO and the bank are not the same entity. Of course the bank loses money when its controlling officers cause it to make fraudulent loans (that’s the “bankruptcy” part of Akerlof & Romer’s title), but accounting control frauds don’t recognize those losses for years and until that time the fictional income that is a “sure thing” from accounting fraud allows the CEO to loot the bank (that’s the “for profit” part of their title).

Here’s the broader point. If Wagner, a U.S. Attorney in one of the epicenters of mortgage fraud has never heard of control fraud or “Looting: the Economic Underworld of Bankruptcy for Profit” then neither he nor any of his prosecutors has ever received even marginally competent training. During the S&L debacle we made major commitments to ensuring that we trained hundreds of FBI agents and AUSAs on these fraud mechanisms. Something epic has gone wrong at the Justice Department. It is as if they entered the dark ages and lost knowledge that was common to earlier generations before Rome and Constantinople were sacked.

Geithner’s intervention on behalf of the fraudulent plutocrats

The destruction of the criminal referral process by the anti-regulators can explain why the Bush administration failed to investigate and prosecute the elite control frauds. It can explain a delay in the Obama administration bringing cases, but it cannot explain the administration’s failure to make the reestablishment of an effective criminal referral process a top priority for every banking regulatory agency. In terms of what has become public, no government official lost his job, was demoted, or was even criticized for failing to make the vital criminal referrals. No administration official has urged the recreation of the effective criminal referral process. The President and Attorney General have not urged the prosecution of accounting control frauds that drove the crisis and become wealthy through fraud.

What was secret, but has recently become public, is that Geithner intervened with state and federal prosecutors to oppose even the investigation, much less prosecution, of the elite frauds. Here is how I responded to Kai Ryssdal, Marketplace’s business journalist, who asked about Geithner’s rationale:

Ryssdal: What about the argument, though, that the financial system is so fragile still, and these cases so complicated, that we can’t really tear things apart with substantive investigations and prosecutions because it will all fall apart again?

Black: Yeah, that’s an excellent point. We should leave felons in charge of our largest financial institutions as a means of achieving financial stability.

Accounting control fraud drove the U.S. crisis

The nonprime lenders followed the classic recipe for maximizing accounting control fraud

Nonprime mortgage lenders followed the classic accounting control fraud recipe in the current crisis. Growth was extreme.

In summary, the bank in our analysis pursued an aggressive expansion strategy relying heavily on broker originations and low-documentation loans in particular. The strategy allowed the bank to grow at an annualized rate of over 50% from 2004 to 2006. Such a business model is typical among the major players that enjoyed the fastest growth during the housing market boom and incurred the heaviest losses during the downturn (Jiang, Aiko & Vylacil 2009: 9).

Loan standards collapsed. Cutter (2009), a managing partner of Warburg Pincus, explains:

In fact, by 2006 and early 2007 everyone thought we were headed to a cliff, but no one knew when or what the triggering mechanism would be. The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.

Leverage was exceptional. Unregulated nonprime lenders had no meaningful capital rules. Indeed, they had no capital – they were insolvent on any real economic basis because of the large, inherent losses on the fraudulent loans that were always in their “pipeline.”

Honest mortgage lenders would not make liar’s loans because such loans maximize adverse selection and create a negative expected value for the lender. Assuming away these facts solely for the purpose of this discussion, an honest mortgage lender making liar’s loans would establish record high allowances for loan and lease losses (ALLL) pursuant to the requirements of generally accepted accounting principles (GAAP). As these liar’s loans became far riskier (due to “layered” risk) GAAP required the ALLL provisions to grow substantially. The nonprime lenders routinely violated GAAP and did the opposite. “The industry’s reserves-to-loan ratio has been setting new record lows for the past four years” (A.M. Best 2006: 3). The ratio fell to 1.21 percent as of September 30, 2005 (Id.: 4-5). Later, “loan loss reserves are down to levels not seen since 1985” (roughly one percent) (A.M. Best 2007: 1). A.M. Best noted that these inadequate loss reserves in 1985 led to banking and S&L crises. In 2009, IMF estimated losses on U.S. originated assets of $2.7 trillion (IMF 2009: 35 Table 1.3) (roughly 30 times larger than bank loss reserves). U.S. securities registrants must file financial statements that comport with GAAP. The intentional failure to do so, as to any accounting matter that is “material,” constitutes federal securities fraud – which is a felony.

Liar’s loans were endemically fraudulent

Normal underwriting easily detects and prevents this fraud – which is why credit losses on traditional residential mortgages were minimal for nearly 50 years. Fraudulent lenders designed liar’s loans to remove these underwriting protections against fraud. Their fraud-friendly design was so successful that their own industry anti-fraud experts (MARI) denounced their product as “an open invitation to fraudsters” and lived down to the term the industry used behind closed doors to describe them – “liar’s loans” because they were pervasively fraudulent. MARI reported a fraud incidence in liar’s loans of 90 percent.

Lenders and their agents put the lies in liar’s loans

The officers controlling the lying lenders designed and implemented the perverse incentives that produced the intended “echo” fraud epidemics among loan brokers, loan officers, appraisers – and some borrowers. The combination of liar’s loans and the echo epidemics helped the controlling officers produce the first two ingredients of the lender fraud recipe – rapid growth at premium yields. The officers that controlled the lying lenders wanted to be able to make loans to the uncreditworthy – as long as they could do so at a premium yield. Liar’s loans made it easy to do both – and prevented the creation of an incriminating underwriting paper trail documenting that the lender knew the information on the loan application was false when it made the loan. The resultant deniability is implausible to anyone that understands fraud mechanisms, but it does fool the credulous.

Liar’s loans were overwhelmingly sold by the issuers and the fee the issuer could obtain was increased if the issuer could make the loan appear to be less risky. There were two key ratios that could be fraudulently manipulated to make the loan appear to be less risky. By inflating the appraisal, the issuer could make the reported loan-to-value (LTV) ratio appear lower. By inflating the borrower’s income the issuer could make the debt-to-income ratio appear lower. Appraisal fraud, which inherently comes from the lenders and their agents, was the key to producing a more desirable LTV while liar’s loans were the perfect device to inflate the borrower’s income. Because the loan broker’s fee could be much larger with a reduced debt-to-income ratio, loan brokers had a powerful, perverse incentive to inflate the borrower’s income on the loan application.

Investigations, to date, have confirmed this logic. The fraudulent nonprime lenders and brokers typically initiated, directed, and sometimes even directly created the lies on the liar’s loans. The testimony of Thomas J. Miller (Miller, 2007), Attorney General of Iowa, at a 2007 Federal Reserve Board hearing began by describing the Gresham’s dynamic that the interaction of accounting control fraud and modern executive compensation produces:

Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete. Strong regulations will create an even playing field in which ethical actors are no longer punished. (p. 3)

Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007. (note 2)

[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. A review of 100 stated income loans by one lender found that a shocking 90% of the applications overstated income by 5% or more and almost 60% overstated income by more than 50%. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer. (p. 10)

Miller, T. J. (August 14, 2007). Home Equity Lending Market Request for Comment. Docket No. OP-1288.

A small sample review of nonprime loan files by Fitch, the smallest of the three large rating agencies, adds support for the view that fraud became endemic in nonprime mortgage lending. Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files.

The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.

[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools. (Pendley, Costello, & Kelsch, 2007, p. 4)

Fitch did not investigate these loans. It simply reviewed the loan files and servicing files to identify frauds obvious on the face of the documents. They were able to identify likely frauds “in almost every file.” Any honest, mildly competent review of the loan files by the loan brokers and lenders would have prevented these loans from being closed. The logical conclusion is that the lenders and brokers encouraged fraudulent loans.

Hudson also explains the tactics that loan officers use to intimidate borrowers to ensure that they did not read the false disclosures that the officers had fabricated (p. 157).

Recent studies by criminologists show the leading role that lenders and loan brokers took in creating fraudulent loan applications. Tomson H. Nguyen and Henry N. Pontell recently published an article reporting the results of their interviews with lender personnel and loan brokers. (I published the responsive policy essay on their article.)

Appraisal fraud was endemic and it is a “marker” of accounting control fraud

There is no honest reason why a mortgage lender would inflate the appraised value and the size of the loan. Causing or permitting large numbers of inflated appraisals is a superb “marker” of accounting control fraud by the lender because the senior officers directing an accounting control fraud do maximize short-term reported (fictional) income (and real losses) by inflating appraisals and stated income. Lenders and their agents frequently suborned appraisers by deliberately creating a Gresham’s dynamic to try to induce them to inflate market values, leaked the loan amount to the appraisers, drove the appraisal fraud, and made it endemic. A national poll of appraisers in early 2004 found that 75% of respondents reported being subjected to coercion in the last 12 months to inflate appraisals. A follow-up survey in 2007 found that the percentage that had been subjected to coercion had risen to 90 percent. Appraisers reported that when they refused to inflate appraisals 68% had lost at least one client and 45% were not paid for at least one appraisal in the prior 12 months. In 2005, Demos warned of an “epidemic” of appraisal fraud.

As with inflating income in order to minimize the reported debt-to-income ratio, inflating the appraisal allowed everyone with a financial stake in the lies to minimize the reported loan-to-value (LTV) ratio and allowed everyone to pretend that the loan was far less risky because it had such a large (but yet again fictional) equity cushion. Given that we know that appraisal fraud was endemic, that endemic appraisal fraud is impossible without being led or permitted by the lenders and their agents, and that no honest lender would permit or cause widespread inflated appraisals, the logical inference is that the lenders and their agents led both the stated income and the appraisal fraud. Appraisal fraud is particularly pernicious because the borrower does not know it has occurred. He may be told that the home he offered to pay $400,000 to acquire (subject to an appraisal contingency) has a market value of $480,000 when its true market value is $350,000. This constitutes fraud in the inducement.

The New York Attorney General’s investigation of Washington Mutual (WaMu) (one of the largest nonprime mortgage lenders) and its appraisal practices supports this dynamic.

New York Attorney General Andrew Cuomo said [that] a major real estate appraisal company colluded with the nation’s largest savings and loan companies to inflate the values of homes nationwide, contributing to the subprime mortgage crisis.

“This is a case we believe is indicative of an industrywide problem,” Cuomo said in a news conference.

Cuomo announced the civil lawsuit against eAppraiseIT that accuses the First American Corp. subsidiary of caving in to pressure from Washington Mutual Inc. to use a list of “proven appraisers” who he claims inflated home appraisals.

He also released e-mails that he said show executives were aware they were violating federal regulations. The lawsuit filed in state Supreme Court in Manhattan seeks to stop the practice, recover profits and assess penalties.

“These blatant actions of First American and eAppraiseIT have contributed to the growing foreclosure crisis and turmoil in the housing market,” Cuomo said in a statement. “By allowing Washington Mutual to hand-pick appraisers who inflated values, First American helped set the current mortgage crisis in motion.”

“First American and eAppraiseIT violated that independence when Washington Mutual strong-armed them into a system designed to rip off homeowners and investors alike,” he said (The Seattle Times, November 1, 2007).

Note particularly Attorney General Cuomo’s claim that WaMu “rip[ped] off … investors.” That is an express claim that it operated as an accounting control fraud and inflated appraisals in order to maximize accounting “profits.” A Senate investigation has found compelling evidence that WaMu acted in a manner that fits the accounting control fraud pattern.

Pressure to inflate appraisals was endemic among nonprime lending specialists.

Appraisers complained on blogs and industry message boards of being pressured by mortgage brokers, lenders and even builders to “hit a number,” in industry parlance, meaning the other party wanted them to appraise the home at a certain amount regardless of what it was actually worth. Appraisers risked being blacklisted if they stuck to their guns. “We know that it went on and we know just about everybody was involved to some extent,” said Marc Savitt, the National Association of Mortgage Banker’s immediate past president and chief point person during the first half of 2009 (Washington Independent, August 5, 2009).

Inducing endemic appraisal fraud is an optimal strategy for a lender that is engaged in “accounting control fraud.” Accounting control frauds drove the second phase of the S&L debacle, the Enron era crisis, and the ongoing crisis.

Hudson notes that:

One former loan officer and branch manager testified that inflating property appraisals served the “dual purpose of both making sure the loan was approved by the home office as well as making the loan more attractive to sell to investors” (p. 156).

Fannie Mae and Freddie Mac

The SEC explicitly charged that Fannie engaged in the strategy of gambling on interest rates and accounting fraud for the purpose of maximizing the senior officers’ bonuses. What makes the Fannie case particularly piquant is that the Business Roundtable, representing the top 100 U.S. corporations, needed a spokesperson to respond to the Enron era frauds. It chose Franklin Raines, Fannie’s CEO for the role, roughly a year before the SEC discovered Fannie’s frauds. Here is his response to a question from Business Week:

We’ve had a terrible scandal on Wall Street. What is your view?
Investment banking is a business that’s so denominated in dollars that the temptations are great, so you have to have very strong rules. My experience is where there is a one-to-one relation between if I do X, money will hit my pocket, you tend to see people doing X a lot. You’ve got to be very careful about that. Don’t just say: “If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.

Raines was particularly knowledgeable about how CEOs create perverse incentives because, according to the SEC, that is how Fannie’s compensation system worked.

Because DOJ did not prosecute Fannie and Freddie for these frauds and their anti-regulators did not order an end to their criminogenic compensation policies the accounting control frauds continued after the SEC settled its charges and the new CEOs took office at Fannie and Freddie. Indeed, their regulator (then called OFHEO, now FHFA) unknowingly caused them to shift their accounting control fraud scheme by sharply limiting the growth of their portfolio. The new fraud strategy was to use a slight variant on the four-ingredient fraud recipe. Fannie and Freddie could not grow their portfolios very rapidly and they could not make loans, but they could purchase large amounts of bad loans at a premium yield, employ extreme leverage, and provide only grotesquely inadequate allowances for the future losses inherent in following this strategy. Fannie and Freddie had been losing market share to investment banks that purchased massive amounts of nonprime loans. This loss of market share was reversed when Fannie and Freddie shifted their accounting control fraud strategy away from relying on interest rate risk. The change in fraud strategy led to massive losses. The DOJ has failed to prosecute Fannie and Freddie or their senior managers for these new frauds.

Note that Fannie and Freddie went heavily into liar’s loans only after OFHEO restricted their portfolio growth and the accounting control frauds had to change from a fraud strategy based on taking excessive interest rate risk to a slight variant of the accounting control fraud recipe. Fannie and Freddie purchase loans instead of making them so they purchased fraudulent loans and derivatives with a premium yield. Fannie and Freddie had no regulatory requirement to purchase liar’s loans. Liar’s loans greatly inflate the borrowers’ income so they would not be used for purposes of meeting low income loan requirements. Indeed, Fannie and Freddie sought to keep their regulators and investors from knowing the extent of their liar’s loans holdings by calling them “prime” loans. In September 2011, the FHFA sued 17 financial institutions, including many of the largest banks in the world, and provided detailed financial information on fraudulent disclosures that the banks made when selling liar’s loans and CDOs largely “backed” by liar’s loans to Fannie and Freddie.

Modern Executive Compensation Drives the CEOs’ Frauds

Modern executive compensation is criminogenic because it is based largely on short-term reported income (easily inflated by accounting fraud) and is very large. The combination of modern compensation and the three “de’s” allows a fraudulent senior officer to expropriate large amounts of wealth from creditors and shareholders through seemingly normal corporate mechanisms, thereby greatly reducing the risk of prosecution. Modern compensation provides the incentive for the CEO to engage in accounting control fraud and the means to do so in a manner that minimizes the risk of prosecution. The book explains why accounting is the “weapon of choice” for financial firms. The ongoing crisis verifies the accuracy of this observation.

The Accounting Control Fraud “Recipe” for Lenders

The book explains the four ingredients of the fraud “recipe” that maximizes a lender’s fictional short-term accounting income, the CEO’s compensation, and real losses.

  1. Extreme growth through making
  2. Exceptionally bad loans at a premium yield (very high interest rate) while
  3. Employing extreme leverage (the lender has vastly more debt than equity), and
  4. Providing grossly inadequate allowances for future losses inherent in making bad loans

This recipe is why George Akerlof and Paul Romer concluded that accounting control fraud is a “sure thing.” The title of their 1993 article captures the three qualities maximized by these frauds – “Looting: the Economic Underworld of Bankruptcy for Profit.” The accounting fraud maximizes short-term (fictional) reported income, which allows the CEO to “profit” by maximizing his compensation (“looting” the bank), and causes massive losses that can cause the lender to fail (“bankruptcy”).

Accounting Control Fraud and the U.S. Bubble and Crisis

The fraud recipe for lenders has proven itself in the ongoing financial crisis in the U.S. and other nations. Many people still refer to the U.S. crisis as being sparked by “subprime” loans. That is incorrect. By 2006, half of the loans called “subprime” were also “liar’s” loans – loans made without effective underwriting. To this day, there are no official definitions of “subprime” or “liar’s loans” and the categories are not mutually exclusive. By 2006, roughly one-third of total U.S. mortgages issued that year were liar’s loans. That means that there were several million liar’s loans made in 2006.

I have explained how and why we cracked down on liar’s loans in 1990-1991 and drove them out of S&Ls. No honest mortgage lender would make liar’s loans because the expected outcome of making such loans is that the lender will lose money. Unfortunately, liar’s loans are superb “ammunition” for accounting control frauds. That is why it was the control frauds and their agents who put the lies in liar’s loans.

Accounting Control Fraud and the Irish Bubble and Crisis

Here are key excerpts from the Nyberg Report on the Irish financial crisis addressing each of the ingredients of the fraud recipe.

The [compensation] models, as operated by the covered banks in Ireland, lacked effective modifiers for risk. Therefore rapid loan asset growth was extensively and significantly rewarded at executive and other senior levels in most banks, and to a lesser extent among staff where profit sharing and/or share ownership schemes existed.

Targets that were intended to be demanding through the pursuit of sound policies and prudent spread of risk were easily achieved through volume lending to the property sector.

Rewards of CEOs reached levels, at least in some cases, that must have appeared remarkable to staff and public alike (2011: 30).

Nyberg’s report makes it clear that he is unaware of control fraud and was instructed not to look for fraud. His assumption that the bonus “targets” “were intended to be demanding through the pursuit of sound policies and prudent spread of risk” is refuted by the facts he found and by logic. The fraudulent Irish bank CEOs set the bonus targets to appear to be “demanding” but to be “easily achieved” by making extremely bad loans at premium yields – the first two ingredients in the fraud recipe.

The failed Irish banks’ nominal underwriting standards were not real. The banks’ controlling officers made sure that underwriting standards were eviscerated whenever they would impede the ability to follow the first two ingredients of the fraud recipe.

Occasionally, management and boards clearly mandated changes to credit criteria. However, in most banks, changes just steadily evolved to enable earnings growth targets to be met by increased lending. (Nyberg 2011: 34)

The associated risks appeared relevant to management and boards only to the extent that growth targets were not seriously compromised. (Nyberg 2011: 49)

[A]ll of the [failed] banks regularly and materially deviated from their formal policies in order to facilitate rapid and significant property lending growth. In some banks, credit policies were revised to accommodate exceptions, to be followed by further exceptions to this new policy, thereby continuing the cycle.

The first two ingredients made loan quality fall sharply and hyper-inflated the Irish real estate bubble by making increasingly bad loans. They lent into the teeth of commercial real estate glut even after property values fell.

As all banks had effectively adopted high-growth strategies …, the aggregate increase in credit available could not be fully absorbed by good quality loan demand in Ireland (Nyberg 2011: 34).

Thus, banks accumulated large portfolios of increasingly risky loan assets in the property development sector. This was the riskiest but also (temporarily) the easiest and quickest route to achieve profit growth.

Credit, in turn, drove property prices higher and the value of property offered as collateral by households, investors and developers also.” (Nyberg 2011: 50)

The demand for Development Finance was so strong over the Period that bank and individual growth targets were easily met from this sector. Both of the bigger banks continued to lend into the more speculative parts of the property market well into 2008, even though demand for residential property (a major end-user) had begun to decline by the end of 2006 (Nyberg 2011: 35-36).

In order to “easily” achieve the bonus targets that provided the CEOs with “remarkable” compensation, the CEOs suborned the bank’s loan officers by basing their compensation primarily on loan volume while ignoring credit quality. By suborning the loan officers the CEOs ensured that the banks would grow extremely rapidly by making very bad loans, which made record (albeit fictional) reported income a “sure thing.”

Control fraud begets fraud. In Ireland, it suborned loan officers and more senior officers.

Over time, managers known for strict credit and risk management were replaced….

In addition, there were some indications that prudential concerns voiced within the operational part of certain banks may have been discouraged.

The few [personnel] that admitted to feeling any degree of concern at the change of strategy often added that consistent opposition would probably have meant formal or informal sanctioning.” (Nyberg 2011: v)

Anglo’s accounting fraud generated a Gresham’s dynamic that led other controlling officers to mimic Anglo’s fraudulent practices.

Bank management and boards in some of the other [Irish] banks feared that, if they did not yield to the pressure to be as profitable as Anglo, in particular, they would face loss of long-standing customers, declining bank value, potential takeover and a loss of professional respect (Nyberg 2011: v).

Nyberg’s analytics are exceptionally poor and his report reads like it was written by a criminal defense attorney for Irish banks’ CEOs. Anglo was not “profitable” during the bubble while it was making bad loans at a premium yield. It was creating net liabilities (losing money) when it lent – it simply was not recognizing the reality. Its controlling officers were causing Anglo to destroy itself. The relevant “pressure” that the CFOs of Anglo’s rivals faced was the fear that they would be fired if they did not match Anglo’s profits.

As their loan quality fell sharply, the real estate glut grew rapidly, and even as residential property values fell – all factors demonstrating a critical need for higher allowances for future loan losses – the failed Irish banks reduced their allowances.

In the benign economic environment before 2007, the banks reduced their loan loss provisions, reported higher profits and gained additional lending capacity (Nyberg 2011: 42).

Nyberg claims that the banks’ reduction of their allowances for future losses was mandated by international accounting standards (IAS 39). International accounting rules were promoted largely on the basis of their asserted superiority over generally accepted accounting principles (GAAP) and their principal asserted advantage was that they were principles-based. The idea was that the effort to specify and forbid every possible abuse (which was supposedly GAAP’s approach) invariably lead to unmanageable audit standards that could always be evaded. Principles-based audit standards would be far more concise and better prevent abuses because the auditors would be responsible for adhering to those principles rather than pursuing arcane, technical evasions of GAAP.

Criminogenic Interpretations of International Accounting Standard 39

One of the differences between GAAP and the international accounting standards was the treatment of allowances for loan and lease losses (ALLL). The Financial Accounting Standards Board (FASB) and the international standards setting bodies shared a concern about “cookie jar reserves.” A common abuse was to use improperly the ALLL allowances as a reserve that could be called on whenever needed to “make the number” and ensure that the firm’s stock price (and the senior executives’ compensation) not be reduced. The SEC filed a complaint asserting, for example, that Freddie Mac’s engaged in securities fraud by hiding gains in good years through inappropriately increasing its ALLL account and reducing the ALLL allowance in bad years sufficiently to make the analysts’ quarterly predicted earnings per share forecast.

GAAP revised the ALLL provision through a principles-based approach designed to prevent two abuses – cookie jar reserves and the fourth ingredient of the accounting control fraud recipe.

The specific language of IAS 39, the international accounting standards provision dealing with allowances for loan losses, did not discuss explicitly the type of accounting fraud that forms the fourth ingredient in the fraud recipe. Instead, it aimed to kill “cookie jar reserves” as an intolerable abuse. The purpose of the rule was to prevent the officers controlling a firm from manipulating the allowance for losses for the purpose of inflating the share price and the officers’ compensation. Nyberg, without discussion of any alternative interpretation that would actually accord with the anti-fraud principle underlying the international rule, asserts that it must be interpreted to facilitate accounting control fraud. He then asserts that this rule is the reason the Irish banks have inadequate allowances for losses.

As the global crisis developed from mid-2007, the banks were constrained by these incurred-loss rules from making more prudent loan-loss provisions earlier, and the auditors were restricted from insisting on such earlier provisioning.” (Nyberg: 55)

“The composite provisioning level for the covered banks at end 2000 was 1.2% of loans…. If this 1.2% provisioning level had been applied at the 2007 year end by the covered banks, aggregate provisions would have increased by approximately €3.5bn (i.e. from the €1.8bn actual to €5.3bn).” (Nyberg 2011: 43)

“[T]he incurred-loss model [IAS 39] also restricted the banks’ ability to report early provisions for likely future loan losses as the crisis developed from 2007 onwards.” (Nyberg 2011: 42-43)

Nyberg’s interpretation would create the perfect insider bank fraud – throughout most of the world. The international accounting rules, if so interpreted, will create a perfect crime – one that Nyberg aptly called “easy.” It takes no great skill to make bad loans. Nyberg’s interpretation of IAS 39 would destroy the anti-fraud principle underlying the international accounting standard he cites. The international accounting standards setting bodies should promptly and authoritatively reject his interpretation of IAS 39.

Alternatively, if the bodies adopt the principle that IAS 39 should be interpreted in a manner that defeats its underlying anti-fraud principle, then they should change the rule on an emergency basis. The overriding purpose of requiring an allowance for loan losses is to remove the fictional “profit” that comes from following the accounting control fraud recipe. The worst failed Irish banks had allowances for losses of roughly 0.34% and actual losses of roughly 60 percent. Their allowances needed to be approximately 150 times larger to be adequate. Of course, had the allowances been anywhere near 60% the failed Irish banks, from the time they made the bad loans, would have had to report for accounting purposes that making bad loans produced a huge loss, not a gain. That was the economic reality.

The failed Irish banks followed the classic accounting control fraud recipe for lenders. That made it “easy” for them to report record (fictional) short-term accounting profits, maximized executive compensation, and ensured that the banks would suffer catastrophic losses. Because Anglo’s use of the recipe produced a powerful Gresham’s dynamic, many of its rivals followed the recipe. The result was a bubble that was twice as inflated as the U.S. real estate bubble. The bank losses were so great that they destroyed Ireland’s finances and caused a severe recession.

Gresham’s Dynamics and Echo Epidemics: Control Fraud Begets Fraud

The book explained why and how the officers that control fraudulent firms (for the sake of brevity I will call them “CEOs”) create criminogenic environments that suborn individuals and entities that will aid the overall fraud. The Irish and U.S. examples show recent examples of these dynamics. I emphasize that the art is not to “defeat” internal and external controls, but to pervert them into valuable fraud allies. The book shows why the CEO’s unique ability to manipulate the internal and external environments to optimize the underlying control fraud is one of the most important reasons why individual control frauds can cause massive losses and why control fraud epidemics can cause catastrophic damage.

One of the most powerful concepts described in the book, the deliberate creation of a “Gresham’s” dynamic by control frauds, explains why fraudulent CEOs are so effective in spreading frauds. Their unique ability to hire, fire, promote, compensate, and praise or abuse allows fraudulent CEOs to create a Gresham’s dynamic in which bad ethics can drive good ethics out of the marketplace and professions. New York Attorney General Cuomo’s investigation confirmed that elite bank officers at Washington Mutual (WaMu), the largest bank failure in U.S. history, created a Gresham’s dynamic by developing a “black list” of appraisers. WaMu blacklisted honest appraisers who refused to inflate the appraised values of borrowers’ homes. The Seattle Times, November 1, 2007. The book explained that only lenders and their agents could create widespread appraisal fraud and that no honest lender would ever knowingly inflate, or permit its agents to inflate, the appraisal value. Appraisal fraud is a “marker” of accounting control fraud.

The observation and prediction that control frauds can cause greater financial losses than all other forms of property crime – combined – has been confirmed in the crises that followed the U.S. savings and loan (S&L) debacle. The book makes four central points about these financial losses, and modern control fraud confirms each point. Individual control frauds can cause enormous losses. Enron, Worldcom, and their ilk were blowing up as I was completing the original book. They have been followed by enormous frauds such as Indymac, Countrywide, and New Century that made hundreds of thousands of fraudulent “liar’s” loans and suffered losses measured in the tens of billions of dollars. As Ghosh explained, Parmalat and Satyam were classic control frauds in Italy and India.

Control frauds can occur in epidemics, and epidemics of control fraud can cause catastrophic damage by hyper-inflating financial bubbles. The epidemic of S&L control frauds hyper-inflated regional real estate bubbles in the U.S. Southwest. Control fraud epidemics of hyper-inflated enormous bubbles in the U.S., Iceland and Ireland in the current crisis. They may have done so in the UK and Spain as well, but those nations’ refusal to investigate thoroughly the cause of their bubbles makes it impossible to say more than this – the banks that drove these scandals followed the classic “recipe” for maximizing accounting control fraud. Spain’s cover up of the scale of its bubble and its massive losses cannot be sustained. By using the failed Japanese strategy of covering up its losses it is harming its economy so severely that unemployment is at Great Depression levels. When control frauds extend and hyper-inflate financial bubbles they can cause severe financial crises such as the Great Recession in the U.S. The Irish and Spanish bubbles were, relative to the size of their economies, roughly twice as large as the U.S. bubble.

The book explained that bubbles allow the CEO to extend the life of the fraud scheme and greatly increase his looting. The bubble allows the banks to greatly delay loan defaults by simply refinancing the loans. The saying in trade is: “a rolling loan gathers no loss.”

The third key to understanding the enormous losses is the capacity to erode trust and cause markets to fail. At law, the defining element of fraud that distinguishes it from other forms of theft is deceit. The essence of fraud is get the victim to trust the perpetrator – and for the perpetrator to betray that trust. We have also come to understand increasingly how vital trust is to a society. Elite fraud is the worst acid for eroding trust. Long before fraud becomes endemic it can cause markets to fail. If you went to meeting of 100 people each of whom was given a bottle of water – and the audience was informed that one of the bottles was contaminated – how many of us would drink the water? In the ongoing crisis, thousands of markets shut down at times because bankers no longer trusted other bankers.

The fourth injury is the one Akerlof warned of in his 1970 article on markets for lemons. Honest firms and entities are harmed severely when frauds gain a competitive advantage. When regulators and prosecutors act as effective “cops on the beat” and ensure that cheaters do not prosper they make it possible for honest firms to prosper and for markets to become vastly more efficient.

Unfortunately, the book’s observation and prediction that control frauds maimed and killed thousands has been confirmed by subsequent scandals. The Chinese infant formula scandal was a classic anti-purchaser control fraud. It is cheaper to use water and non-milk powder to make counterfeit infant formula than to use milk. China has seen this form of fraud several times, however, and developed a test that assays protein levels in the fluid. The frauds reacted by adding melamine, which spoofs the protein test. The result was a product, for the portion of humanity that most needs nutrition, that had no nutritional value and contained a contaminant that caused kidney stones even in very young infants. At least six children were killed and 300,000 were hospitalized. There are CEOs who will kill your child in order to obtain a few extra dollars.

The Book’s Warnings about the Criminogenic Effects of Econometrics were ignored

Economists relied almost entirely on anti-facts in the expansion phase of the S&L accounting control frauds and the accounting control frauds that drove the ongoing crisis. They used econometric (statistical) techniques to ask whether particular practices were positively associated with higher reported short-term earnings or stock prices (which are largely driven by reported earnings). Econometric studies of this nature inherently provide the worst possible policy advice. Accounting control fraud produces guaranteed, stellar reported short-term income – that is fictional. The fraudulent lending and investment practices must display the strongest positive correlation with short-term reported earnings.

Of course, the economists do not know that the practices are fraudulent, but that is largely because they make no inquiry as to whether the reported short-term income is real or the product of accounting fraud. The book describes an econometric study by a prestigious financial economist retained by Lincoln Savings (the most notorious S&L control fraud) that found that S&Ls that made large amounts of direct investments reported substantially higher short-term income. He concluded that rather than restricting direct investments we should encourage S&Ls to make many more direct investments. Two years later, each S&L he praised because it had made large amounts of direct investments had failed – they were overwhelmingly control frauds.

Similarly, econometric studies in 2004-2007 showed that making “liar’s” loans (endemically fraudulent loans) was positively associated with higher reported short-term income. The banks that made greater amounts of liar’s loans reported earning materially greater short-term income. The reality is that fraud is negatively associated with the lenders’ income, but that reality can be masked for years by accounting fraud. The economists’ conclusions that making more direct investments and liar’s loans increased bank income was an anti-fact – both practices caused catastrophic losses. The fact that the econometricians made the same, obvious error two decades later shows the danger of “theoclassical” economic dogma trumping science.

The largest banks’ and credit rating agencies’ “models” that purported to quantify the price and risk of assets were preposterously wrong in the ongoing crisis because they ignored endemic mortgage fraud by lenders in the form of liar’s loans. The banks and credit rating agencies had powerful compensation incentives to ignore all the warnings and data on the endemic nature of these frauds. The perverse incentives won and the models consistently, and massively inflated the value (and understated the risk) of liar’s loans and derivatives (collateralized debt obligations (CDOs)) “backed” by liar’s loans.

Economists’ Taboo against Considering Control Fraud

In an essay published in the Fall 2009 edition of the NEA Higher Education Journal the economist James K. Galbraith addressed the issue of who got the ongoing crisis correct. His essay was prompted by this passage from an extended essay by the economist (a recipient of the Nobel Prize) and New York Times columnist, Paul Krugman.

Of course, there were exceptions to these trends: a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted and pointed to the long history of financial crises that had devastating economic consequences. But they were swimming against the tide, unable to make much headway against a pervasive and, in retrospect, foolish complacency. —Paul Krugman, New York Times Magazine, September 6, 2009

Galbraith observed a curious fact about Krugman’s essay. It virtually ignored the economists who were right about the crisis. Galbraith notes: “Despite having been right on the greatest economic question of a generation—they are unpersons in the tale.” Galbraith entitled his essay: “Who are these economists, anyway?  Galbraith transforms Krugman’s “unpersons” into the focus of his essay.

And this brings us to an important line of new research, focused on economic behavior and the law, and specifically on the conditions that generate epidemics of financial fraud.

In this area a key references is William K. Black’s systematic study of the savings and loan crisis and his development of the concept of “control fraud” —fraud committed on organizations by those who control them. An effort to bring this to the attention of mainstream economists also exists, in the work of Akerlof and Romer, itself greatly informed by Black’s practical experience as an investigator and whistle-blower in the savings and loan affair.

In the present crisis, the vapor trails of fraud and corruption are everywhere: from the terms of the original mortgages, to the appraisals of the houses on which they were based, to the ratings of the securities issued against those mortgages, to gross negligence of the regulators, to the notion that the risks could be laid off by credit default swaps, a substitute for insurance that lacked the critical ingredient of a traditional insurance policy, namely loss reserves. None of this was foreseen by mainstream economists, who generally find crime a topic beneath their dignity. In unraveling all this now, it is worth remembering that the resolution of the savings and loan scandal saw over a thousand industry insiders convicted and imprisoned. Plainly, the intersection of economics and criminology remains a vital field for research going forward.

One of best tests a reader can perform before deciding whether to purchase a book by economists about the ongoing crisis is to check whether the authors discuss Akerlof & Romer’s 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” Only a small percentage of academic papers and books by economists about the ongoing crisis even mention their classic article or consider fraud as driver of the crisis. Akerlof was awarded the Nobel Prize in 2001, largely for his work on another form of control fraud. His 1970 article on markets for “Lemons” (the term in the U.S. for a car with severe, hidden defects) is largely about fraud in which the nature of deceit is the defective quality of the goods being sold. That article introduced the danger of a Gresham’s dynamic as a result of control fraud. The articles discussion of “asymmetrical information” sparked much of control fraud theory (fraud is the ultimate form of asymmetrical information). Romer is also highly respected as an economist. The economic professions’ continued refusal to discuss control fraud or read the criminology literature on the frauds that drive our recurrent, intensifying financial crises speaks poorly of the field, but ignoring a Nobel prize winner in one of his central areas of expertise constitutes reckless disregard for the truth.

The profession’s primitive taboo against considering fraud by elites is bizarre and crippling. As the passage from Galbraith indicated, Akerlof & Romer worked closely with me when they revised drafts of their article because they realized the need to understand the real fraud mechanisms that financial institutions used. Akerlof & Romer concluded their article with this passage about the criminogenic effects of the S&L deregulation of the 1980s.

Neither the public nor economists foresaw that the [S&L] regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself (1993: 60).

This, of course, is my central disappointment. The ongoing global crisis did not have to occur. We know how to identify accounting control frauds, we know to prevent creating deeply criminogenic environments, we know how to counter an epidemic of accounting control fraud, we know how to burst a bubble that is being hyper-inflated by fraud epidemics, and we know how to prosecute control frauds. The U.S. liar’s loans crisis was particularly easy to prevent. After all, how hard should it be for creditors, shareholders, and regulators to determine that something the trade calls a “liar’s” loan is dishonest? The U.S. Federal Reserve had the unique regulatory authority to ban liar’s loans, but Greenspan and his successor Ben Bernanke refused to use the authority until the key markets had collapsed. Theoclassical economists’ dogmatic hate for regulation and its insistence on ignoring control frauds poses a grave danger to the world. Their ideological creeds and perverse econometric anti-facts lead them to push the policies that create strongly criminogenic environments. No matter how much we deregulate the crisis is always the government’s fault. They create self-fulfilling prophecies of regulatory failure by appointing anti-regulators to head the key agencies.

I was present to hear Bastiat’s warning that those that pander to power will create “a moral code that glorifies [plunder]” come true.  N. Gregory Mankiw, a professor of economics at Harvard who Bush would later make chairman of the president’s council of economic advisers, was a discussant on Akerlof & Romer’s 1993 paper on looting. Mankiw responded that “it would be irrational for savings and loans [CEOs] not to loot.” If a CEO could loot with impunity, his failure to do so would not exemplify a desirable moral compass or his commitment to his fiduciary duties to the shareholders, but demonstrate his “irrationality” and unsuitability to be a CEO. One of our family rules is that it is impossible to compete with unintentional self-parody so I will leave it to the reader to consider the implications for society of “Mankiw morality.”

Related Articles

Analysis Blog articles by William K. Black

Opinion Blog articles by William K. Black:

About the Author

William K. Black is Associate Professor of Economics at University of Missouri, Kansas City. From 1990-1994 Prof. Black was Senior Deputy Chief Counsel, Office of Thrift Supervision, which was formed in 1989 to supervise the thrift industry following the Saving & Loan crisis. He is the author of the widely acclaimed book “The Best Way to Rob a Bank is to Own One.” Full bio here.

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One Response to Update: The Best Way to Rob a Bank is to Own One

  1. Derryl Hermanutz says:

    Bill’s writing and interviews are all over the place all the time. Where does this guy get the ENERGY!? Not to mention the time. He has become so expert in this field and so familiar with his material that he can now rattle off a detailed essay off the top of his head, naming names and reciting dates and sequences of events. This grip on all the facts and the entire recent history of control fraud makes him a devastating debater or witness against the financial criminals and their “theoclassical” acolytes whom he is exposing.

    Before reading this article I hadn’t been aware that Bill originated the term “control fraud”. It’s like any other “meme”: once somebody brings the concept into clear focus and describes it explicitly it feels like we were aware of the phenomenon and knew it all along, because it is so obviously true and so obviously “there”. But plain reality has no effect on the beliefs of theoclassical true believers who see only what they ‘know’ must be there and are blind to what “is” there. I still chuckle, because it is both so apt and so dismissively sarcastic, every time I see the term “theoclassical”: is that another term of Bill’s origination?

    Bill is aware of the difficulty, if not impossibility, of transforming economics from a faith-based authoritarian priesthood to an evidence-based scientific subject of rational inquiry, for reasons Thomas Kuhn made clear in his 1962, “The Structure of Scientific Revolutions”. The egos, careers and social status of the vain high priests who are gatekeepers into the field of economic inquiry cannot bear to admit that they are factually wrong and their life’s work was all in error, so they bar the gate against truth and huddle within the confining but comforting walls of their blind paradigm where they implicitly conspire to agree with one another’s imaginary visions and continue to preach their falsehoods and to reward acolytes who faithfully honor by their rote murmurings those empirically obvious untruths that Bill calls “anti-facts”. In his book Kuhn quotes Max Planck, famous for measuring the boundary conditions of our state of reality in this universe (the Planck limits), regarding the gatekeepers of obsolete intellectual paradigms,

    “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

    Unfortunately the theoclassical economics priesthood happens to serve the interests of the plutocratic financial powers that be in our era, much as Ptolemaic astronomers served the interests of the Church religious powers-that-were who needed to believe for (mistaken) theological reasons that the Earth is literally the cosmological center of creation. When untruth and the anti-facts that support it serve the interests of the ruling powers, it may become practically impossible to unseat the colluding priesthood from the powers-funded academies and replace them with economic “scientists” who base their “observations” on what exists in the world rather than on what exists in their false conception of the world; and who base their theorizing, and test it against, “objectively true” observations about what actually obtains in the real, non-mental, non-imaginary world that exists for all to see outside the opaque walls of the blind paradigm.

    So I’m not sure how much headway economic truth can make against the entrenched powers of objectively false theoclassical imaginings, but there is some reason to hope that “this time is different” and the paradigm shift might be accomplished in decades rather than centuries. Arguably it was Gutenberg’s 1439 A.D. invention of movable type printing (that vastly reduced the time and cost of printing and made widespread Bible reading possible; combined with King James’ translation of the Bible into English, and other contemporary translations of Jerome’s 385 A.D. Latin “Vulgate” into the vernacular languages of the people) that ushered in the era of informed resistance to the ruling religious dogmas.

    But even today academic placement and advancement and status and financial reward, and the peer reviewed economics press, and the mass print media (not to mention TV whose “hot” rapid fire format, as Noam Chomsky and Marshall McLuhan observed, supports parroting of emotion-laden slogans but not “cool” complex analysis) are owned and operated by the plutocratic powers that be who suppress economic truth in support of continued faith in orthodox-but-false theoclassical dogmas, so that it is impossible for heterodox-but-true economics to reach and enlighten a mass audience. Except that today we have the internet, a medium where mass communication has become virtually “free” in terms of time and cost of mass publication.

    I suggest this is why heterodox-but-true economics such as Bill and the UMKC “outlaws” are teaching is finding its way into the mass awareness and moving its way up the economic policy making foodchain. It is difficult for the beneficiaries and preachers of false dogma to retain their credibility against such empirical and theoretical assaults upon their inner sanctum thundering down on them from outer reality, especially when recent global financial tremors have crumbled the imagined walls of their airless castles and the winds of inquiry are searching out coherent and credible explanations of the causes.

    This fortunate confluence of events–the availability of instant mass communication via the internet and the existence of a highly placed, highly motivated and thoroughly informed “revolutionary army” of truth-seeing and truth-telling economists, might just possess the power to finally unseat the self-serving purveyors of ignorance. As an invitation to the innocently deceived victims of the theoclassical faith whose eyes might be opened if they are gently led into the light I offer, “Let us pray.”