The Best Way to Rob a Bank is
         to Own One


U. Calgary/Haskayne Corruption Forum
            November 5, 2009



 ...
“Control Frauds”
White-collar criminology theory 
Person controlling seemingly legit.
   entity uses it as a “weapon” 
Cau...
Why CEOs are Unique
Only the CEO can
1.  Optimize the firm for fraud
2.  Suborn internal & external controls
3.  Loot or sk...
Recurrent, Intensifying Crises
 S&L Debacle
 Enron, WorldCom, et al.
   
Overall failures
   
California energy crisis
 Th...
Non-regulation Decriminalizes
 Decriminalizes accounting fraud
 Effective regulators essential:
 •  Make the criminal refe...
Compensation is Criminogenic
 Perverse incentive: accounting fraud
 Near perfect crime: “profits” convert
    firm assets to...
Economist as bad criminologists
  Economists donʼt study fraud
  Donʼt have a theory of fraud 
   “a rule against fraud is...
Optimizing Accounting Fraud

Guaranteed, record “profit” formula:

1.    S&Ls: Extreme growth: avg. >50%
2.    Loan to the ...
S&L Debacle Control Frauds
Over 1000 “priority” convictions
“The typical large failure [grew] at an
   extremely rapid rat...
Bad Loans are Best
“Accounting abuses also provided the
   ultimate perverse incentive: it paid
   to seek out bad loans b...
Not Underwriting is Suicidal
Maximizes adverse selection: loans
   have negative expected value
Reverse Pareto optimality:...
Keating Suborns Auditors
“[A]busive operators of S&L[s] sought
    out compliant and cooperative
    accountants. The resu...
Off the Charts Profits & Losses
  S&L control frauds reported
     extraordinary profits: Vernon &
     Lincoln the most pr...
Regulators Must Understand
Fraud Mechanisms to Succeed
  300 frauds growing at 50% annually
  Econometrics perverse: “auto...
Reregulated Despite:
Reagan administrationʼs hate for it
Majority of House plus Speaker Wright
Keating Five
Trade associat...
Corruptionʼs Role in the Debacle
  S&L debacle & Michael Milken
  Milkenʼs “captive” “Merchant Princes”
  Milken bribed bo...
Corruptionʼs Role at Enron
Could tell two opposite tales
Among Bushʼs largest contributors
Enron “black hole” exploited to...
Corruptionʼs Role: Procurement
  Boeing scandal: Air Force
  Pallets of Cash: Iraq
  Cheney, Halliburton, Water for troops...
Perfect Corruption
Accounting control fraud: perfect crime
Compensation as perfect bribe
•  For officers: allies & deniabil...
War on Regulation
Preemption of state efforts to restrain
   predatory lending
Slashing the FDIC staff with “early outs”
“...
Mission Accomplished
Intellectual Roots
Ayn Rand: Greenspan: at the bottom of all
   regulation lies the gun
Democracy is illegitimate & corrup...
Failed Paradigms
Efficient markets & contracts
Private market discipline: perverse
Agency cost: shareholders canʼt
    stop...
Itʼs easy to understand why the
    theoclassical ignore fraud
 Control fraud falsifies their claims
 Markets & contracts a...
Add Criminology to Economics
 Incentives: the core of economics and
    white-collar criminology
 Fraud epidemics arenʼt r...
Criminologists are the Experts in
     Dysfunctional Markets
   Four key criminology concepts: 
   •  Criminogenic environ...
Ask the experts how itʼs done

Don't
just
say:
"If
you
hit
this
revenue

   number,
your
bonus
is
going
to
be

   this."
I...
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 ...
The anti-canary
“Remember, Frank has given us an
   opportunity to earn not just our
   salaries, benefits, raises, ESPP, ...
Fannie, Freddie & Ginnie
Disciplined market by defining “prime”
Securitization reduced mortgage rates
Privatization of own...
The Coverup Phase
Optimizing by profiting from coverup
Hyperinflating & extending the bubble
   optimizes the coverup
Refi...
Massive Losses & Bubbles
The optimization formula explains why
   large accounting control frauds
   cause losses > all ot...
Mass Destruction
Maximizes lenderʼs loan losses
Bonuses produce Greshamʼs dynamic
   among professionals & executives
Make...
The Big 8 Fail
S&L control frauds hired only Big 8
The art is to suborn, not defeat,
   “controls”; use their reputation a...
Treadway: Almost Right
Treadway: a response to S&L debacle
   that did not study the S&L frauds
Found senior exec involvem...
Ignoring (Modern) Criminology
 Treadway embraced fraud auditing
 Relied on old criminology & ignored
    S&L regulatorsʼ i...
Modern Criminology: Control Fraud
  S&L control fraudsʼ audit fees big
    enough to tempt top tier partners
  S&L frauds ...
Fraud Experts Fooled
Two types of fraud are addressed in this
   book fraudulent financial reporting, also
   known as "Tre...
Bad Timing (and Analysis)
Enron (2001); WorldCom (2002)
Large accounting frauds undetected
   by CPAs before book publishe...
Mortgage Fraud “Epidemic”

FBI warned of it, and coming crisis: 9.04
80% of losses induced by lenders
FY07; 08: >50K; >62K...
If we file it the FBI will come

Nearly 900 filing institutions submitted
   mortgage loan fraud SARs.
Over 700 of those fil...
FBI Finds Control Fraud
“Many of these bankrupt subprime
     lenders manipulated their
     reported loan portfolio risks...
“Donʼt Ask; Donʼt Tell”
Any request for loan level tapes is
   TOTALLY UNREASONABLE!!! Most
   investors don't have it and...
“Disconcerting Results”
The result of the [Fitch loan file]
   analysis was disconcerting…as
   there was the appearance o...
Greshamʼs Grim Dynamic
“[I]t was a slippery slope. What
     happened in '04 and '05 with respect
     to subordinated tra...
Appraiser Coercion = Fraud
Only reason to coerce an appraiser to
   inflate value is fraud
National study(early 2004): 75% ...
The Bankers Knew

Note the dates: 2001, 2004 & 2007
They knew – from the beginning
The bankers, auditors, attorneys,
     ...
We Can Jail the Frauds
FBI agents investigating mortgage
   fraud: 120 FY 2007; 180 FY 2008
S&L debacle: 1000 FBI agents a...
Failure is an Option

CEO can profit enormously despite
   firmʼs failure
The firmʼs failure is not a fraud failure
Minima...
If you donʼt count it….
Property crime rates in 2007 were
   at or near the lowest levels
   recorded since 1973, the firs...
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William Black The Best Way to Rob a Bank is to Own One!

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William Black The Best Way to Rob a Bank is to Own One!

  1. 1. The Best Way to Rob a Bank is to Own One U. Calgary/Haskayne Corruption Forum November 5, 2009 William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City
  2. 2. “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
  3. 3. 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
  4. 4. 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
  5. 5. 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
  6. 6. 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
  7. 7. 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
  8. 8. 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
  9. 9. 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)
  10. 10. 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)
  11. 11. 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
  12. 12. 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
  13. 13. 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
  14. 14. 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
  15. 15. 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)
  16. 16. 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
  17. 17. 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
  18. 18. 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
  19. 19. 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
  20. 20. 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”
  21. 21. Mission Accomplished
  22. 22. 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)
  23. 23. 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
  24. 24. 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
  25. 25. 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”?
  26. 26. 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.”
  27. 27. Ask the experts how itʼs done 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.
 Franklin
Raines:

CEO,
Fannie
Mae

  28. 28. 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%.”
  29. 29. 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.)
  30. 30. 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”
  31. 31. 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
  32. 32. 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
  33. 33. 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
  34. 34. 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
  35. 35. 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
  36. 36. 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”
  37. 37. 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
  38. 38. 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).
  39. 39. 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)
  40. 40. 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
  41. 41. 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
  42. 42. 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”
  43. 43. “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]
  44. 44. “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]
  45. 45. 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]
  46. 46. 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
  47. 47. 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
  48. 48. 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 

  49. 49. 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
  50. 50. 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

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