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William K Black on Control Fraud 2013


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"Control Fraud: The Need to Think Outside the Fraud Triangle" 2013 Fraud and Forensic Conference. LSU: July 29, 2013. William K. Black. Associate Professor of Economics and Law. University of Missouri – Kansas City.

Published in: Business, Economy & Finance
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William K Black on Control Fraud 2013

  1. 1. William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City Control Fraud: The Need to Think Outside the Fraud Triangle 2013 Fraud and Forensic Conference LSU: July 29, 2013
  2. 2. Recurrent, Intensifying Crises The two key questions: why do we suffer recurrent, intensifying crises 1st Question: What is the true cause? 2nd Question: What prevents us from learning from our mistakes/successes? Ideology creates dogmatic blinders ―Theoclassical‖ economics is criminogenic Concentration on smaller frauds
  3. 3. What is ―Control Fraud‖? Criminology: The persons controlling a seemingly legitimate entity use it as a ―weapon‖ to defraud. The Best Way to Rob a Bank is to Own One (Black 2005) Big Money Crime: Calavita, Pontell & Tillman (1997) & NIJ Study (1993) Economics (Akerlof & Romer 1993): Looting: Bankruptcy for Profit; NCFIRRE
  4. 4. Control Frauds: Catastrophic Cause greater financial losses than all forms of property crime – combined Hyper-inflate financial bubbles Cause recurrent, intensifying crises Can become epidemic Control fraud begets ―echo‖ frauds Suborns controls & democracy Maim & kill and harm environment
  5. 5. Blind to Accounting Fraud ―In the benign economic environment before 2007, the banks reduced their loan loss provisions, reported higher profits and gained additional lending capacity. The banks could no longer make more prudent through-the-cycle general provisions, or anticipate future losses in their loan books, particularly in relation to (secured) property lending in a rising property market.‖ (Nyberg Report on Irish banks: 2011: 42)
  6. 6. Accounting as ―Weapon‖ Accounting: finance‘s ―weapon of choice‖ Fraud ―recipe‖ for optimizing (fake) income 1. Grow extremely quickly, by 2. Make (buy) bad loans at premium yield 3. While employing extreme leverage, and 4. Grossly inadequate allowances for loan and lease losses (ALLL)
  7. 7. Trivial Loss Reserves Reserves must track risk: GAAP Bank risk was skyrocketing A.M.Best (2/06; 3/07): ―new record lows for the last four years.‖ Matches low in 1985: last disaster Reserve ratio (2005): 1.21% of loans Losses on foreclosed nonprime loans are running >50% for S&Ls Mortgage fraud = accounting fraud
  8. 8. IAS 39: criminogenic ―The higher reported profits also enabled increased dividend and remuneration distributions during the Period. All of this led to reduced provisioning buffers….‖ ―the 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 Right, ―the banks‖ wanted to report higher provisions in Nyberg‘s alternate reality. Listen to the Anglo Irish tapes.
  9. 9. Ireland‘s 0.4% ALLL ―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) Irish banks had twice the leverage, and one- third the ALLL of U.S. banks – and were heavily in CRE. Three strikes; you‘re out.
  10. 10. Accounting Fraud = Sure Thing ―[M]any economists still [do] not understand that a combination of circumstances in the 1980s made it very easy to loot a [bank] with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?‖ (Akerlof & Romer 1993: 4-5
  11. 11. The Recipe‘s Three Sure Things 1. The lender (buyer) will report record income in the near term 2. Modern executive compensation will promptly make the CEO wealthy 3. The lender (buyer) will suffer very large losses because the loans have a ―negative expected value‖
  12. 12. Such Frauds Can Maim & Kill Chinese infant formula + melamine New York inspector: asbestos & lead Turkish/Chinese/Bangladeshi buildings Fake anti-malarial drugs China‘s private coal mines Unlawful disposal of toxic waste and other environmental assaults Lead in toys & antifreeze in cold syrup
  13. 13. Varieties of Control Fraud Classified by primary intended victims • Accounting: creditors & shareholders • Anti-purchaser • Anti-public: tax fraud; environmental • Anti-worker Classified by timing: • Opportunistic • Reactive
  14. 14. Control Frauds‘ Unique Risks Only the CEO can: 1. Suborn all ―controls‖ into allies 2. Optimize firm as fraud vehicle 3. Create ―echo‖ control fraud epidemics 4. Create regulatory ―black holes‖ 5. Loot using ―normal‖ corporate pay
  15. 15. We can prevent fraud epidemics Did so in 1990-1991 in Orange County, CA Long Beach Savings began liar‘s loans No honest firm would make liar‘s loans We had the advantage of OTS underwriting rules for mortgage loans – poses ―trilemma‖ Drove liar‘s loans out of industry Easy call; listened to our examiners
  16. 16. Roland Arnall Flees OTS Gives up federal deposit insurance and becomes mortgage bank for sole purpose of escaping our jurisdiction (Fed given unique jurisdiction: HOEPA ‗04) Changed name to Ameriquest Loans not yet called ―liar‘s loans‖ back then State AGs sue Ameriquest: predatory liar‘s loans targeting minorities + appraisal fraud
  17. 17. Ameriquest foreshadows Bush makes Arnall our ambassador to Netherlands – leading contributor to Bush WaMu and Citi rush to acquire Ameriquest‘s fraudulent lending operations No effective crackdown on Ameriquest‘s frauds – largest nonprime lender It is only in retrospect that we can see the trillions of dollars saved by S&L regulators Fed refuses to use HOEPA to stop frauds
  18. 18. Liar‘s loans = natural experiment Made to exploit minority borrowers Caused them immense losses Lenders put the lies in liar‘s loans No governmental entity every required or pressured any entity to make or buy a liar‘s loans. Made because ideal for fraud recipe and eliminated paper trail of lender fraud
  19. 19. There are real fraud flags Look for control fraud ―markers‖ • Adverse selection = negative value • Appraisal fraud is a fraud & a marker Both markers became endemic Consistent pattern of nonprime lenders and purchasers acting in a manner that was optimal for control frauds and suicidal for an honest firm
  20. 20. Months before Dimon (MBDs) October 1990 2000-2004 June 2006 October 2006 Dimon‘s Conversion Hapless OTS regulators‘ crackdown on S&L non-prime loans: 200+ MBDs Pinko housing activists & State AGs 50+ MBDs JPM Quants: 4MBDs
  21. 21. Creating Perverse Incentives CEO‘s function via shaping incentives Create criminogenic environments Gresham‘s dynamic & endemic fraud Corrupt ―tone at the top‖ Minimizing whistleblowing: art is to suborn Creating deniability Circular reliance – no one responsible
  22. 22. Fraud in the S&L Debacle ―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)
  23. 23. ―Now we know better‖ ―Neither the public nor economists foresaw that [S&L deregulation was] 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‖ (George Akerlof & Paul Romer.1993: 60).
  24. 24. Over 1000 Felony Convictions ―Major‖ S&L cases, not the tellers Over 30,000 criminal referrals ―Top 100‖ priority list Our #2 agency priority: after fraud closure 1000 FBI agents: 90% conviction rate Several thousand enforcement actions; roughly 800 civil & ―freeze‖ actions
  25. 25. Enron era Control Frauds Accounting = weapon of choice Consistently able to suborn ―controls‖ Clean opinions from top tier auditors No deposit insurance, so private market discipline was supposed to make accounting control fraud impossible Concern for ―reputation‖ can increase fraud
  26. 26. FBI‘s twin 2004 warnings Mortgage fraud becoming ―epidemic‖ and will cause a financial ―crisis‖ if it is not contained
  27. 27. MARI‘s 5 Warnings: 2006 • Stated income loans ―are open invitations to fraudsters‖ • Study: fraud incidence is ―90 percent‖ • ―[T]he stated income loan deserves the nickname used by many in the industry, the ‗liar‘s loan.‘‖
  28. 28. MARI Warnings.2 ―It appears that many members of the industry have little … appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses….‖ ―Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans….‖
  29. 29. ―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]
  30. 30. Mortgage Fraud Drove Crisis Liar‘s loans: 40% of 2006 loans (>2MM) (In the UK, they were 45% of 2006 loans) Half of subprime were also liar‘s loans Fraud incidence: 90% Well over a million frauds annually by ‗05 Liar‘s loans hyper-inflated the bubble Great bulk sold to secondary market Collateralized debt obligations (CDOs)
  31. 31. Lenders Ignored Fraud Warnings ―Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007.‖ Miller, Iowa AG The housing bubble burst in 2006 – but lenders increased the growth of liar‘s loans in 2007 until market collapsed
  32. 32. Lenders put the lies in liar‘s loans ―[Many originators invent] non-existent occupations or income sources, or simply inflat[e] income totals to support loan applications. Importantly, our investigations have found that most stated income fraud occurs at the suggestion and direction of the loan originator, not the consumer.‖ Tom Miller, AG, Iowa, 2007 testimony to Fed.
  33. 33. “Alt-A: The Forgotten Segment of the Mortgage Market” (FRBStL 2010) ―[B]etween 2003 and 2006 … subprime and Alt-A [loans grew ] 94 and 340 percent, respectively. The higher levels of originations after 2003 were largely sustained by the growth of the nonprime (both the subprime and Alt-A) segment of the mortgage market.‖
  34. 34. FRBStL (& FDIC) error FRB St. Louis Fed economists made a common error: implicitly assumed subprime loans not also liar‘s loans By 2006, 49% of loans called ―subprime‖ were also liar‘s loans That means that liar‘s loans grew far faster than 340% from 03-06 (>500%) They hyper-inflated the bubble
  35. 35. Lenders Ignored Fraud Warnings ―Despite the well documented performance struggles of 2006 vintage loans, originators continued to use products with the same characteristics in 2007.‖ Miller, Iowa AG The housing bubble burst in 2006 – but lenders increased the growth of liar‘s loans in 2007 until market collapsed
  36. 36. Gresham‘s dynamic: appraisers Art is to suborn, not defeat, ―controls‖ ―From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] ―blacklisting honest appraisers‖ and instead assigning business only to appraisers who would hit the desired price targets.‖( FCIC 2011: 18)
  37. 37. ―Most reputable‖ banks are frauds ―although there is substantial heterogeneity across underwriters, a significant degree of misrepresentation exists across all underwriters, which includes the most reputable financial institutions.‖ [ Id: 29]
  38. 38. Recent mortgage fraud study Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market Tomasz Piskorski, Seru & Witkin February 2013 bstract_id=2215422
  39. 39. Systematic Control Fraud ―You‘re … talking about systematic fraud in the system,‖ Neil Barofsky, the former special inspector general for the U.S. Treasury‘s Troubled Asset Relief Program, said in an interview. ―What this shows is that before the financial crisis, the banks were essentially lying to the purchasers of the mortgages about the quality.‖
  40. 40. Only 50,000 Rotten Apples ―Marc S. Savitt, a past president of the National Association of Mortgage Brokers, told the Commission that while most mortgage brokers looked out for borrowers‘ best interests and steered them away from risky loans, about 50,000 of the newcomers to the field nationwide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were ‗absolutely‘ corrupt.‖ (FCIC 2010: 14)
  41. 41. Dawn of the Loan Brokers ―According to an investigative news report published in 2008, between 2000 and 2007, at least 10,500 people with criminal records entered the field in Florida, for example, including 4,065 who had previously been convicted of such crimes as fraud, bank robbery, racketeering, and extortion.‖ (FCIC 2010: 14)
  42. 42. Volume + Premium Yield = $ ―More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan officers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about 10,000 loan originators a year…. (FCIC 2010: 7)
  43. 43. Flipping Burgers & Homes ―His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs ‗flipping burgers,‘ he told the FCIC. Given the right training, however, the best of them could ‗easily‘ earn millions.‖ (FCIC 2010: 8)
  44. 44. Teaching the Fraud Recipe ―He taught them the new playbook: ‗You had no incentive whatsoever to be concerned about the quality of the loan, whether it was suitable for the borrower or whether the loan performed.‘ He added, ‗I knew that the risk was being shunted off. I knew that we could be writing crap. But in the end it was like a game of musical chairs. Volume might go down but we were not going to be hurt.‘‖ (FCIC 2010: 8)
  45. 45. Calomiris: ―Plausible deniability‖ ―asset managers were placing someone else‘s money at risk, and earning huge salaries, bonuses and management fees for being willing to pretend that these were reasonable investments. [T]hey may have reasoned that other competi[tors] were behaving similarly, and that they would be able to blame the collapse (when it inevitably came) on an unexpected shock.‖ ―Who knew?‖
  46. 46. The Facts: It‘s Control Fraud Bo Cutter (Warburg Pincus 2009): ―by 2006 and early 2007 everyone thought we were headed to a cliff….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.‖
  47. 47. The Questions for Auditors There were myriad warnings of endemic accounting control fraud The frauds were often obvious – appraisal fraud and liar‘s loans are sure signs that the lenders are control frauds The ALLL went in the wrong direction and was farcical There are no audit heroes from this crisis We have seen this before and done better
  48. 48. Making it appear low risk Reduce two ratios via fraud: Loan-to-value (LTV) Debt-to-income (DTI) First series of thought exercises: 1) How would you do this as a broker? 2) Can the borrower game the ratios? 3) What kind of underwriting would be optimal for brokers reducing the DTI?
  49. 49. Maximizing nominal yield Provide only a trivial ALLL Loan to the uncreditworthy Lend to the most vulnerable customers • Limited English language skills • Less experience with banking sector • Early stage Alzheimer‘s
  50. 50. Sutherland Proves Correct Edwin Sutherland: top of his field Knew economics & was empirical Coined term & field: white-collar crime Legitimacy + control + power + status = unique dangers from elite fraud Couldn‘t get the names of corporations violating the law published for 25 years Falsified efficient markets hypothesis 25 years before it was formed
  51. 51. Appraiser Coercion = Fraud Deliberately created Gresham‘s dynamic National study(early 2004): 75% coerced Cuomo investigation: WaMu = norm 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 Demos warned of disaster in 2005
  52. 52. Clayton: Implausible Deniability hibit-15-Whistleblower-Affidavit- Redacted#download The reviewer confirmed what an investigation of Clayton (and the rival firm the same whistleblower also worked at that followed equally pathetic reviews) would have showed about its use of ―compensating factors‖
  53. 53. ―Compensating‖ for Fraud? ―23. When loans did have defects, Clayton and Watterson leads told us to find compensating factors and approve the loan anyway. We often approved loans using compensating factors that I believed were insufficient to overcome the defects.‖
  54. 54. A ―Cheat Sheet‖ for Cheating 24. We often considered as compensating factors items such as the number of years the borrower had been employed], the borrower‘s assets, and the LTV and CLTV ratios. At both Clayton and Watterson, due diligence underwriters … were required to be creative in order to find compensating factors. On many jobs, the leads gave us a cheat sheet of compensating factors to make it easier for us to find them.‖
  55. 55. Audacity is the key ―And, critically: to the degree that a loan was deficient, did it have any ―compensating factors‖ that offset these deficiencies? For example, if a loan had a higher loan-to-value ratio than guidelines called for, did another characteristic such as the borrower‘s higher income mitigate that weakness?‖ (FCIC 2011: 166).
  56. 56. Fraud ―Compensates‖ for Fraud Fraud cannot be ―compensated‖ for Clayton and its ilk used fraud (inflated borrowers‘ incomes and appraisals) to compensate for fraud: a new definition of chutzpah. No one events comments on this insanity
  57. 57. A Method in their Madness ―The due diligence firm would then grade the loan sample and forward the data to its client. Report in hand, the securitizer would negotiate a price for the pool and could ―kick out‖ loans that did not meet the stated guidelines‖ (FCIC 2011: 166). But the sample sizes were so small that they could not ―kick out‖ bad loans – just a ploy to negotiate a lower sales price and reduce EPDs.
  58. 58. Gresham‘s: 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)
  59. 59. Lenders Add the Rot ―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.‖ Miller, T. J. (August 14, 2007). Iowa AG.
  60. 60. Modern Criminology‘s Advances ―Control fraud‖ Criminogenic environment Gresham‘s dynamic Echo fraud epidemics Hyper-inflating financial bubbles Adverse selection: negative expected value ―Systems capacity‖
  61. 61. ―Gresham‘s‖ Dynamic ―[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.‖ George Akerlof (1970).
  62. 62. Swift, J. Gulliver’s Travels ―The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man‘s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.‖
  63. 63. But our advances are Ignored by Fraud examiners Accountants and their literature Economists Judges Financial regulators Prosecutors
  64. 64. Thinking Outside the Triangle ―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. ‗It doesn‘t make any sense to me that they would be deliberately defrauding themselves,‘ Wagner said.‖ ―They‖ ≠ ―themselves‖: CEO loots bank
  65. 65. Two Fields that Have Declined Classical economists: Government must stop fraud by providing rule of law Ayn Rand agreed re fraud Economists became fraud deniers Edwin Sutherland‘s definition of white- collar crime: crime by elites in the course of business White-collar criminologists came to emphasize lower status perpetrators
  66. 66. Criminogenic Theory ―a rule against fraud is not an essential or … an important ingredient of securities markets‖ (Easterbrook & Fischel 1991) Greenspan: no need to regulate v. fraud Claims made after aiding Charles Keating Claims essential to efficient markets and contracts hypotheses Justify 3 ―des:‖ de facto decriminalization, deregulation & desupervision
  67. 67. ―Now We Know Better‖ ―Neither the public nor economists foresaw that [S&L deregulation was] 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‖ (George Akerlof & Paul Romer.1993: 60).
  68. 68. Now we know better?
  69. 69. Think Outside the Triangle Cressey generalized triangle from study of largely pink collar embezzlers Among the most unusual fraudsters Excluded control frauds from his sample Triangle does not describe control frauds But it was adopted by fraud examiners & accounting literature – very damaging Modern white-collar findings ignored
  70. 70. Auditors got Stuck in Past Fraud Triangle – Donald Cressey Cressey: intellectual leader of the ACFE Emphasis on non-elite frauds No concept of control fraud GAAS: Not very useful fraud flags: SAS 99 Treadway/COSO: Control fraud assumed to be a danger posed by small firms Based on SEC enforcement actions, but SEC enforcers pick on the small to rack up numbers.
  71. 71. 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). Ouch! Enron cometh.
  72. 72. SAS 99 & The Triangle.1 ―.07 Three conditions generally are present when fraud occurs. First, management or other employees have an incentive or are under pressure, which provides a reason to commit fraud.‖ Everyone has ―an incentive … to commit fraud,‖ so it‘s useless as a fraud ―flag.‖
  73. 73. SAS 99 and the Triangle.2 ―Second, circumstances exist—for example, the absence of controls, ineffective controls, or the ability of management to override controls—that provide an opportunity for a fraud to be perpetrated.‖ Fraud: only possible when possible. Control fraud is always possible, so flag is useless..
  74. 74. SAS 99 and the Triangle.3 ―Third, those involved are able to rationalize committing a fraudulent act.‖ Only those willing to commit fraud will commit fraud. Second tautology; third useless flag.
  75. 75. SAS and the Triangle.4 ―Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act. However, even otherwise honest individuals can commit fraud in an environment that imposes sufficient pressure on them. The greater the incentive or pressure, the more likely an individual will be able to rationalize the acceptability of committing fraud.‖ Suspect everyone! Let God sort ‗em out!
  76. 76. SAS 99 and Management ―.08 Management has a unique ability to perpetrate fraud because it frequently is in a position to directly or indirectly manipulate accounting records and present fraudulent financial information. Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively.‖ Sadly, ―management‖ also hires and fires the auditor and suborns rather than ―overrides‖ controls, creating fraud allies.
  77. 77. SAS 99: Professional Skepticism ―.13 Due professional care requires the auditor to exercise professional skepticism. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. [P]rofessional skepticism requires an ongoing questioning of whether the information and evidence obtained suggests that a material misstatement due to fraud has occurred.‖
  78. 78. SAS 99: Fraud Risk Factors ―.31 [T]he auditor may identify events or conditions [―fraud risk factors‖] that indicate incentives/pressures to perpetrate fraud, opportunities to carry out the fraud, or attitudes/rationalizations to justify a fraudulent action. Fraud risk factors do not necessarily indicate the existence of fraud; however, they often are present in circumstances where fraud exists.‖ Fraud risk factors are always present due to the risk of control fraud.
  79. 79. SAS 99: Fraud Flags ―.35 [O]bserving that individuals have the requisite attitude to commit fraud, or identifying factors that indicate a likelihood that management or other employees will rationalize committing a fraud, is difficult at best.‖ It is ―difficult.‖ So what do we know about humans when it comes to performing an analytical task that is very difficult and would harm the audit partner‘s self-interest?
  80. 80. SAS 99.36: Death to the Triangle ―[T]he significance of incentives/pressures may result in a risk of material misstatement due to fraud, apart from the significance of the other two conditions. For example, an incentive/pressure to achieve an earnings level to preclude a loan default, or to "trigger" incentive compensation plan awards, may alone result in a risk of material misstatement due to fraud.‖
  81. 81. SAS 99.36 (continued) ―In other instances, an easy opportunity to commit the fraud because of a lack of controls may be the dominant condition precipitating the risk of fraud, or an individual's attitude or ability to rationalize unethical actions may be sufficient to motivate that individual to engage in fraud, even in the absence of significant incentives/pressures or opportunities.‖
  82. 82. SAS 99.37 “The auditor's identification of fraud risks also may be influenced by characteristics such as the size, complexity, and ownership attributes of the entity. [I]n … a larger entity, the auditor ordinarily considers factors that generally constrain improper conduct by management, such as the effectiveness of the audit committee and the internal audit function, and the existence and enforcement of a formal code of conduct.‖ Seriously? A ―code‖ adopted by Ken Lay ―generally constrain[s] improper conduct by management‖? On what planet?
  83. 83. SAS 99.39 ―Certain accounts, classes of transactions, and assertions that have high inherent risk because they involve a high degree of management judgment and subjectivity also may present risks of material misstatement due to fraud because they are susceptible to manipulation by management.‖ [.39 also warns of ―complex accounting principles‖] Control frauds cluster because CEOs cause the firm to operate in these areas that optimize fraud.
  84. 84. Only One Fraud Presumption ―A Presumption That Improper Revenue Recognition Is a Fraud Risk .41 Material misstatements due to fraudulent financial reporting often result from an overstatement of revenues….‖
  85. 85. Management Override Risk ―A Consideration of the Risk of Management Override of Controls .42 Even if specific risks of material misstatement due to fraud are not identified by the auditor, there is a possibility that management override of controls could occur, and accordingly, the auditor should address that risk….‖
  86. 86. SAS 99.54 ―In addressing an identified risk of material misstatement due to fraud involving accounting estimates, the auditor may want to supplement the audit evidence…. (For example, [in] evaluating the reasonableness of management's estimate of the fair value of a derivative), it may be appropriate to engage a specialist or develop an independent estimate for comparison to management's estimate.‖
  87. 87. SAS 99.63: Manager bias ―In preparing financial statements, management is responsible for making a number of judgments or assumptions that affect significant accounting estimates and for monitoring the reasonableness of such estimates on an ongoing basis. Fraudulent financial reporting often is accomplished through intentional misstatement of accounting estimates.‖
  88. 88. SAS 99.65: Make the Number ―[I]nformation coming to the auditor's attention may indicate a risk that adjustments to the current-year estimates might be recorded at the instruction of management to arbitrarily achieve a specified earnings target.‖
  89. 89. SAS 99 Appendix: Fraud Flags c. ―[M]anagement … is threatened by the entity's financial performance [due to]: Significant financial interests in the entity Significant … compensation … contingent upon achieving aggressive target d. [E]xcessive pressure on management or operating personnel to meet financial targets‖ Reactive v. opportunistic control fraud
  90. 90. Fraud flags: Opportunities ―b. There is ineffective monitoring of management as a result of the following: — Domination of management by a single person or small group‖
  91. 91. Fraud flags: Rationalizations ―Known history of violations of securities laws or other laws and regulations, or claims … alleging fraud or violations of laws and regulations • Excessive interest by management in … the entity's stock price or earnings trend • Management failing to correct known significant deficiencies …in internal control on a timely basis‖
  92. 92. Upper Management Flags ―Fraudulent financial reporting by upper-level management typically involves override of internal controls within the financial reporting process. Because management has the ability to override controls, or to influence others to perpetrate or conceal fraud, the need for a strong value system and a culture of ethical financial reporting becomes increasingly important.‖
  93. 93. Assuming Ethical Leaders ―The potential for management override also increases the need for appropriate oversight measures by those charged with governance….‖
  94. 94. Audit Committee Fantasy.1 ―An entity's audit committee also should ensure that senior management (in particular, the CEO) implements appropriate fraud deterrence and prevention measures….‖
  95. 95. Audit Committee Fantasy.2 ―The audit committee … can [deter] senior management [from fraud] by ensuring [that] any attempt by [them] to involve employees in committing or concealing fraud would lead promptly to reports from such employees to appropriate persons, including the audit committee).‖
  96. 96. Broad ethical challenges Traditional business ethics assumes (implicitly) that the CEO is honest Perverse compensation incentives designed to create ethical pressure Increases pressure v. blowing the whistle Degrades professional ethics Will anti-fraud experts take on the CEOs?‖
  97. 97. Conventional Ethics Fails Implicit assumptions are dangerous CEOs assumed to set the right tone Fraudulent CEOs set a corrupt tone Fraudulent CEOs don‘t need to develop a new skill set – managerial incentives Perverse incentives are easier to create Ego, status & money: triumphal trio
  98. 98. Ethical Pressures Target all levels through broad bonuses Target line, controls, professionals & execs Hire, fire, promote, pay, praise & slam Creating a corrupt culture Resistance is futile: bypass the honest Enron: self-selection by personnel – the most amoral people in the room Fraudulent is the new normal
  99. 99. Squash the Whistleblowers Whistleblowers = greatest danger to control frauds Broad bonus programs discourage them It‘s not just their loss of income, it‘s their peers‘ loss of income if they warn CEO can direct the firm‘s full resources v. whistle-blowers: retaliation is inevitable Few famous whistleblowers in this crisis
  100. 100. Degrade the Professionals The art is to suborn, not defeat, controls Professionals = most valuable fraud allies Gresham‘s dynamic Don‘t need to suborn everyone Professional corruption is likely to spread beyond the particular fraudulent firm Highly influential with Congress & juries
  101. 101. Auditors v. Control Frauds? Implicit ethical question rarely asked The CEO poses the central fraud risk No CEO is eager to hire anti-fraud experts who target fraudulent CEOs No firm has me talk about control fraud Auditors rarely emphasizes control fraud Anti-fraud experts emphasizing control fraud puts their career at risk
  102. 102. Speak truth to power Auditors don‘t focus on the worst frauds Does not warn v. criminogenic environment Does not teach how to detect control fraud Does not push for prosecutions Does not push for effective regulation Does not push back v. theoclassical economics
  103. 103. Why no Chief Criminologists? Regulators have huge numbers of economists, lawyers, and accountants They often have no anti-fraud experts Virtually never in senior positions No one thinks about whether they‘re creating a criminological environment No one to train staff to detect control fraud
  104. 104. Perverse Incentives & Dogma Cause: perverse (criminogenic) incentives that create fraud epidemics, hyper-inflate bubbles and drive economic crises Failure to learn: theoclassical ideology Five dogmas: (1) Private market discipline (2) executive pay (3) reputation (4) anti- regulation, and (5) external expert pay These dogmas are our leading export
  105. 105. We face a global fraud crisis We cannot follow business as usual Auditors must be a world leader Auditors are invisible in the global debate The fraud-friendly forces are legion They dominate the regulators globally and both major U.S. parties
  106. 106. Accounting Control Fraud For finance firms accounting is the ―weapon of choice‖ Akerlof & Romer: fraud = ―a sure thing‖ Turns everything you‘ve learned perverse: • Pareto optimality, private market discipline, price signals, econometrics, modeling, performance, reputation, pay, ―income‖, and ―capital‖
  107. 107. Conscious Adverse Selection Optimizes accounting fraud & bonuses ―Stated income and reduced documentation loans speed up the approval process, but they are open invitations to fraudsters.‖ (MARI 2006). Creates ―negative expected value‖ Sure ―marker‖ of accounting control fraud
  108. 108. ―Liar‘s loan‖ was a Hint When the stated incomes were compared to the IRS figures: [90%] of the stated incomes were exaggerated by 5% or more. [A]lmost 60% were exaggerated by more than 50%. [T]he stated income loan deserves the nickname used by many in the industry, the ―liar‘s loan‖ (MARI 2006). 50% of ―subprime‖ was liar‘s loans by ‗06
  109. 109. Appraiser Coercion = Fraud Deliberately created Gresham‘s dynamic National study(early 2004): 75% coerced Cuomo ‗07 finding: WAMU blacklist 2007 study: 90% coerced Honest appraisers lose: 68% reported losing a client and 45% not paid Demos warned of disaster in 2005 Created fake LTV, making sales price of loan higher: lender-side fraud
  110. 110. Lenders Were the Liars Easy for honest lenders to spot/stop lies Fraud recipe optimization via lies No doc = no record we knew lie was bad Investigations: lenders put the lies in liar‘s loans – perverse incentives for brokers Only they knew the magic debt-to-income ratios that would maximize sale price Could make a $20 K fee for lying
  111. 111. Recipe for Catastrophe The same recipe maximizes (fake) record profits and (real) catastrophic loss ―Criminogenic environments‖ lead to fraud epidemics & hyper-inflated bubbles ―Echo‖ epidemics: fraud epidemics are criminogenic – cause/permit epidemics Deceit erodes trust: markets can fail
  112. 112. 1990-91 Nonprime Crackdown California S&Ls led nonprime lending We stopped the abuses in 1990-91 because we knew ―adverse selection‖ That‘s why the nonprime specialists moved out of S&L charters to mortgage banking: Long Beach = Ameriquest. Should have made it easy for our successors to get it right.
  113. 113. Sutherland Channels Bastiat ―When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.‖ • Frederic Bastiat
  114. 114. Sutherland‘s Insights Elite white-collar criminals = unique risks Often engage in crime to gain advantage Greater impunity due to power & status Society ―neutralizes‖ their criminality Perpetrators neutralize their criminality Cause far greater damages Few prosecutions & low penalties
  115. 115. Criminologists as Cassandra Theories tested in the real world Repeatedly worked brilliantly > 25 years Blessed by scholars in multiple disciplines Make markets more efficient Impose minimal costs and achieve staggering net savings Theories also predict conduct globally
  116. 116. Praxis and Prediction Prevent crisis: 1990-91 OTS: nonprime Burst bubble: 1984-87 Bank Board: SW End criminogenic environment: 1983-87 Bank Board ―reregulation‖ Identify & close frauds while they are still reporting profits: 1985-87 Bank Board Convict > 1000 elite S&L felons: 1986-93 Bank Board/OTS/FBI/DoJ
  117. 117. Contrast with Economists Greenspan: Lincoln Savings poses ―no foreseeable risk‖ of loss Fischel: Lincoln and CenTrust best S&Ls Benston: Zero for 33; praises frauds Economists (Dick Pratt) created the criminogenic S&L environment Regulators & prosecutors need a “Chief Criminologist”
  118. 118. Why Did We Get It Right? Recognized ―accounting control fraud‖ Autopsied every failure, identified distinctive fraud pattern. Chief coroner. Understood honest underwriting & lending Recognized fraud ―markers‖ Knew that accounting fraud made econometrics perverse Learned how losses hidden/delayed Knew Gresham‘s dynamic & Lemon mkts.
  119. 119. Too Good To Be True We were one of the rare entities to act on that concept Targeted S&Ls reporting highest income Congress, Reagan administration, industry, economists & attorneys went berserk: asserted we were insane We took conflicts of interest seriously Made stopping the frauds our 1st priority & prosecuting them the 2nd
  120. 120. Actions, Not Words Regulators must serve as ―Sherpas‖ Do the heavy investigative lifting Serve as guides to FBI/DoJ Institutionalized criminal referral process >30,000 SARs. Quality became superb. ―Top 100‖ priority list Trained/detailed/supported/cajoled FBI/DOJ
  121. 121. Unlike Today OCC + OTS: Zero SARs. FDIC: a small number. Fed: unknown. Mortgage/investment bankers: few SARs Insured banks: 25 of them make the overwhelming majority of referrals – massive violation of law – with impunity FBI‘s disgraceful ―partnership‖ with MBA – trade association of the perpetrators that defines control fraud out of existence
  122. 122. Stopped a Catastrophe 300 S&L frauds grew at 50% rate in 1983 Hundreds of new real estate developer entrants annually in California & Texas Pratt praises as ―entrepreneurs‖ Large bubble already in SW CRE No criminal referrals or prosecutions Examination, accounting & supervision weak Enforcement: land of the invertebrates
  123. 123. Preemption Then Texas S&L Commissioner using prostitutes from Vernon (―Vermin‖) S&L – 2nd worst California S&L Commissioner in business with Keating – Worst S&L fraud Asset powers provided by state charter, FSLIC insurance - easy to switch charter Competition in laxity: economists liked it! States bitterly opposed to our preemption
  124. 124. Stopping the Runaway Train Knew Ponzi‘s Achilles‘ heel: growth Limited growth to 25%! Killed every fraud. Used fraud pattern/markers to identify & prioritize – no ―false positives‖ Knew optimizing fraud creates pattern, causes frauds to cluster, inflates bubbles Identified bubble, burst it by stopping frauds
  125. 125. End Criminogenic Environment Stopped entry in California & Texas Cleaned up regulatory accounting scams Restricted growth Huge transfer of examiners to Texas Doubled examination & supervision force OMB threatens to make criminal referral Mandated: fix it or bring enforcement Criminal referrals & prosecutions: priority
  126. 126. Impossible Circumstances S&L trade association: 3rd most powerful Reagan administration: apostates Reagan: George Benston & Lee Henkel OMB: criminal referral v. Chairman Gray Majority of House: co-sponsors Speaker Wright & James Baker‘s deal Senate: ―Keating Five‖ Business press derided Chairman Gray
  127. 127. But Exceptional Results Dramatically reduced growth of frauds Dramatically reduced entry of frauds Dramatically increased closure of frauds Burst the SW real estate bubble Greatest success v. elite white-collar crime Saved > $1 trillion – no Great Recession Facts re fraud create political space for real reform. Annunzio: Jail the S&L Crooks
  128. 128. Met with Initial Praise Three scholarly public administration works use us as exemplar DOJ praised prosecutorial effort Akerlof & Romer (1993) agreed with us NCFIRRE (1993) agreed with us Pontell, Calavita & Tillman agreed with us Lawyers, regulators, public administration, economists & criminologists concurred
  129. 129. Cassandra & Criminogenesis We are not simply ineffective v. control fraud epidemics – we are criminogenic Our economic theories Our economic methodologies Our ideologies Our personnel choices Ignore white-collar criminologists & successful regulators & listen to failures
  130. 130. Criminogenic Methodologies Econometrics: inherently perverse during expansion phase of bubble/fraud The variables that optimize accounting fraud positively associated with income True sign of relationship is negative Econometric analyses recommend the worst possible policies Breed complacency & praise the frauds
  131. 131. Criminogenic Ideology Mankiw (1993): ―it would be irrational for savings and loans [CEOs] not to loot.‖ This was in response to Akerlof & Romer (1993) ―Looting: Bankruptcy for Profit.‖ Bastiat and Sutherland warned us Effective regulation aids market efficiency by countering perverse Gresham‘s dynamics: cheaters must not prosper.
  132. 132. Greenspan v. Brooksley Born ―‗Well, Brooksley, I guess you and I will never agree about fraud‘ [Greenspan] ‗What is there not to agree on?‘ [Born] ‗Well, you probably will always believe there should be laws against fraud, and I don‘t think there is any need for a law against fraud,‘ she recalls. Greenspan, Born says, believed the market would take care of itself.‖ [Genesis of CFMA‘s 2000 black hole]
  133. 133. Private Market Discipline Private market discipline is not failing It is proving overwhelmingly powerful It is simply perverse Works the opposite of the theory so the results are opposite of the theory Markets become increasingly inefficient Funds and aids accounting control frauds & creates echo epidemics
  134. 134. The Hypothetical Pillars Theory: all ―modern finance‖ and much of microeconomics depends on hypos Methodology: all valuation models & most econometric studies depend on hypos Ideology: deregulation, desupervision & de facto decriminalization – which also prevents the frauds from being made public
  135. 135. 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 1994)
  136. 136. Gresham‘s & the 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) Same pattern: credit rating agencies, appraisers & stock analysts
  137. 137. Ask the experts how it‘s 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
  138. 138. 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%.‖
  139. 139. 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, emphasis in original.)
  140. 140. Underling Compensation ―In many popular accounts of the global financial crisis [pay] conjures up images of top management bonuses, or the practice of awarding stock options on a large scale. However, in Ireland at least, one should not neglect incentives set for middle-level bank management and indeed loan officers.‖ 2010 Ireland Rep. But the CEOs created those incentives
  141. 141. Compensation Dogma: CEOs Fischel: ―The bigger the share of stock held by any particular investor the lower are agency problems… particularly … if the investor is an insider.‖ ―One who buys a controlling block of shares cannot hurt the corporation without hurting himself too. Substantial investment acts as a bond for honest conduct.‖ Easterbrook & Fischel
  142. 142. Echo Epidemics Nonprime lenders: primary epidemic Create criminogenic environments Upstream: buy anything; pay for yield Must gut underwriting & suborn controls Necessary & sufficient to cause upstream Necessary, but not sufficient, to cause downstream epidemic of CDOs & CDS
  143. 143. Lying Becomes Endemic Upstream: appraisers, loan brokers Primary: loan officers, auditors Downstream: rating agencies, poolers Financial version of ―don‘t ask; don‘t tell‖ Lying about big things: farblondget Fire the honest; promote the worst Gresham‘s dynamic only needs a minority
  144. 144. Naïve Oxymoron Control frauds turn sources of ―private market discipline‖ into fraud allies They fund the frauds‘ growth They‘re vectors spreading fraud epidemics Caused downstream CDO/CDS epidemic Don‘t ask; don‘t tell – so you can sell Subordinated debt: failed utterly
  145. 145. ―Don‘t Ask; Don‘t Tell‖ Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so. [S&P ‘01, emphasis in the original.]
  146. 146. Criminogenic Environments Extreme CEO pay based on short-term Deregulation, desupervision & decriminalization & source of funds The firm hires the ―controls‖ Bad accounting Creates accounting control fraud epidemics Hyper-inflates bubbles Creates ―echo‖ control fraud epidemics
  147. 147. Ireland & Iceland: Exemplars Small, so hyper-inflated bubbles easier Near total desupervision: optimize fraud Followed the recipe + cruder frauds Cruder frauds prove fraudsters don‘t fear Private market discipline: an oxymoron International accounting rules re ALLL Complete domination by insiders/cronies
  148. 148. Fraud‘s Existential Threat Iceland‘s big three banks‘ liabilities: 10X Iceland‘s GDP: Lehman & Fuld Ireland: developed world‘s largest percentage real estate bubble Losses = $15,000 per capita Big, fraudulent banks growing 50% annually (Iceland) and 35% (Ireland) Debts, mass migration & death of nation
  149. 149. Criminology Explains Bubbles Criminology provides a rational explanation Alternative is mass insanity Accounting control frauds are Ponzi-like Self-reinforcing – extra demand inflates bubbles & bubble allows refinancings that hide the losses & create fictional profits Explains why Ireland and Iceland so bad and regional U.S. variations in housing
  150. 150. Treadway: Control Fraud S&L debacle prompts accountants to study causes of securities fraud Treadway (COSO) Commission reviews non-S&L SEC enforcement actions Frauds overwhelmingly by CEOs & CFOs But SEC skewed sample leads COSO to assume problem is only small firms and lower tier auditors
  151. 151. Enron era Frauds Control frauds: clean opinions-top tier audits Over $6 trillion loss of market capitalization Led to Sarbanes-Oxley law (no input from criminologists, doesn‘t address problem) Experts misled by flawed SEC sample Audit failures hidden by accounting fraud Auditors‘ bad agency incentives > reputation
  152. 152. Deregulatory Dogma Ireland Report 2010: ―Four main failings of supervision: (i) Supervisory culture was insufficiently intrusive, and staff resources were seriously inadequate ….‖ ―On-site inspections were infrequent. Supervisors … imposed no penalties on banks at all.‖
  153. 153. Irish Desupervision ―Ireland‘s mounting financial vulnerabilities meant that strong action was called for to over-ride the prevalent light-touch and market-driven fashions of supervision: to call a spade a spade….‖ ―failure to identify, recognise the gravity of, and take tough remedial action to correct such serious governance breaches was a cardinal error of supervision….‖
  154. 154. Courage v. Dogma ―there was a socio-political context in which it would have taken some courage to seem to prick the Irish property bubble.‖ ―generic weaknesses in [EU] regulation and supervision‖ Contrast to the S&L Debacle: Gray v. a majority of the House, President Reagan, Speaker Wright & the Keating Five. Took them all on simultaneously.
  155. 155. Current U.S. Crisis Ignores Fraud Despite these control fraud epidemics Absurd framing: ―perfect storm‖ FBI (2004) ―epidemic‖ of mortgage fraud Predicted a crisis if fraud increased Anti-regulators triumph No criminal referrals by OCC & OTS 10 convictions of senior lenders of one obscure mortgage bank (Barofsky key.)
  156. 156. Where We Look, We Find WaMu Citicorp Lehman Goldman Rating agencies Fannie & Freddie The most elite institutions in the world
  157. 157. Iceland Looked, Found Fraud SIC found the Big 3 followed the recipe for optimizing accounting fraud 1. Exceptional growth: 50% 2. Bad loans with high yields 3. Essentially infinite leverage 4. Loss reserves were a sick joke Sure thing: record ―profits‖ & losses
  158. 158. But SIC Calls it Bad Luck ―The situation in the international financial markets in the autumn of 2008 has been described as the perfect storm. It was under this situation that the three Icelandic banks, Glitnir, Landsbanki and Kaupthing Bank, collapsed at the beginning of October 2008.‖
  159. 159. Gambling Metaphor As the winter of 2007-2008 progressed, the banks were very dependent of their share prices and largest debtors. Rather than hanging on to their liquid assets, the banks provided substantial amounts as loans for own shares and to support their principal owners. Kaupthing Bank in particular loaned large amounts for the purchase of own shares. The banks were betting everything on life.
  160. 160. Bad Luck Mark Flannery‘s ―Post-Mortem‖ (p. 91): ―Any firm‘s failure reflects some combination of bad luck and bank management.‖ No: Not underwriting = adverse selection Creates negative expected value Fake profits and real losses are certain
  161. 161. Accounting Cover Ups The Icelandic scams are old scams ―Dirt for stock‖: self-funded (fictional – not ―weak‖ capital) Self-funded loans Refinancing: ―A rolling loan gathers no loss‖ Guaranteed ―profit‖ w/o losses
  162. 162. Fraud Epidemics & Bubbles Perverse incentives are the key The most criminogenic environment loses Particularly if entry is easy: regulation Some assets are superior ―ammunition‖ for accounting fraud: ―liar‘s loans‖ Causes frauds to cluster: industry/assets Recipe causes bubbles to hyper-inflate
  163. 163. Adverse Selection Crises began when the loans were made Not underwriting causes adverse selection That causes negative expected value It necessitates accounting fraud: ALLL Honest accounting would show the loans were losses when they were made The firm fails; the fraud scheme succeeds
  164. 164. Perfect Storms & Black Swans Both assume risk is exogenous We spawn the black swans & storms through our perverse market incentives Control fraud creates risk, but ―risk‖ is the wrong lens: record (fictional) profits and (real) catastrophic losses are certain for looting control frauds; the only issues are timing and the magnitude of the loss
  165. 165. Provide Fraud ―Markers‖ Metaphor from pathology: fraud ―markers‖ No honest secured lender would routinely: • Inflate appraisal values • Knowingly permit inflated appraisals • Create severe adverse selection • Create a Gresham‘s dynamic • Reduce ALLL while increasing risk Regulation = easy to prosecute cover ups
  166. 166. Markets Fail Rather than Clear Fraud: create, then betray, trust Fraud is worst ―acid‖ for eroding trust Trust often vital, e.g., in markets Gresham‘s can make fraud endemic What if one bottle in 100 is contaminated? Markets can fail rather than clear Nonprime secondary market
  167. 167. Criminogenic Economists Complacency: we know it can‘t happen Deregulation, non-regulation, desupervision Modern compensation • Executive • Professional • Managerial U.S. exports these failed economic theories that cause recurrent, intensifying crises
  168. 168. Ideology, Methodology & Theory Theoclassical ideology: anti-governmental Efficient contracts/markets hypotheses falsified by criminology 60 years ago Fischel wrote after he‘d worked for frauds Embrace of econometrics, which must get the ―sign‖ wrong in accounting control fraud epidemics, leading to criminogenic policies
  169. 169. The Anti-Regulators Rise Bush‘s ―Wrecking Crew‖ (Tom Frank) If ―the government is the problem‖… And private market discipline is ideal Then appoint anti-regulators to lead Harvey Pitt & ―Chainsaw Gilleran‖ The reanimation of Dochow
  170. 170. Regulatory ―Black Holes‖ Theoclassical economics‘ bipartisan triumph Repeal of Glass-Steagall: Lehman, et alia Commodities Futures Modernization Act Endorsing ―competition in laxity‖ Fed refuses to use HOEPA (1994) authority Preempt state rules v. predatory lending Crippling the OECD initiative v. tax havens
  171. 171. How Did We Succeed? Independent regulatory agency essential Leadership the key: Gray‘s hired those with track record of success & guts Learned via ―autopsies‖: patterns/markers Knew econometrics studies perverse Prioritized the frauds while ―successful‖ Growth limit targets frauds‘ ―Achilles‘ heel‖ Contained nonprime w/o crisis: 1991-1992
  172. 172. Jailed the Control Frauds Regulators recognized control frauds were the key We served as ―Sherpa‖ 1000 FBI agents & top agency priority >1000 priority felony convictions of senior insiders and their accomplices Greatest success v. elite criminals
  173. 173. We Need to Jail the Crooks To deter & to stop Gresham‘s dynamic Investigations produce the facts and change understanding of crisis Turns it from an arcane story to front page Creates the political space for real reform Discredits the crooks & apologists Put a stake in theoclassical economics
  174. 174. 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‖ (FBI: Pistole 2009)
  175. 175. Why Elites Loot with Impunity FY 1992: 2,926 positions (992 agents, 655 attorneys, and 1,279 other); 2,795 FTE; $265M FY 2008: 160 FBI agents Virtually no regulatory criminal referrals Bush‘s AG: mortgage fraud is ―white- collar street crime‖ – don‘t investigate, don‘t indict FBI ―partners‖ with trade ass‘n of perps
  176. 176. Control Fraud Should be Hard Can‘t send a memo to 1000 employees ordering accounting frauds be done CEO can‘t stick his hand in the till A dozen layers of controls v. fraud Private market discipline American tradition of whistleblowers Civil suits Regulators, prosecutors and the FBI
  177. 177. Gresham‘s 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]….‖ [Moody‘s 2007]
  178. 178. Four Failed Paradigms Efficient markets & contracts Private market discipline: perverse Agency cost: shareholders can‘t stop accounting control fraud Corporate governance: One can‘t ―govern‖ control frauds Business ethics: assumes the ―tone at the top‖ is honest
  179. 179. Add Criminology to Economics Incentives: the core of economics and white-collar criminology Fraud epidemics aren‘t random The factors that produce criminogenic environments are clear The incentives are perverse, but they have predictable marginal effects Why don‘t the SEC & FDIC have ―Chief Criminologists‖?
  180. 180. Failure is an Option CEO can profit enormously despite firm‘s failure The firm‘s 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
  181. 181. If you don‘t 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] Reality: Property crime: never higher