This document summarizes how an epidemic of accounting control fraud caused catastrophic losses in the financial system. It discusses how a lack of regulation, along with factors like securitization and credit rating agencies, created an environment where fraud could thrive. Control fraud at institutions, where CEOs used firms as weapons for fraudulent purposes, optimized accounting to hide losses and grow rapidly in a Ponzi-like fashion. This led to massive losses, economic impacts, and ultimately the shutdown of many financial markets globally.

1. Why Has This Epidemic of Accounting “Control Fraud” Caused Catastrophic Losses? William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City AALS “Hot Topics” Panel on the Financial Crises January 9, 2009

3. Background Staff leader of the successful reregulation of S&L industry Defeats “control fraud” epidemic “Coroner” – autopsied failures Designed the economic studies Fraud: “invariably present” Recognized pattern: triage Achilles’ heel: limited growth Burst SW real estate bubble

6. Focus on Rating Agencies Mortgage bankers were always the mortgage cowboys Constrained by inability to grow Freed by nonprime securitization Which was freed by AAA ratings for “toxic waste”: SIVs & CDOs Created “originate to sell” model

7. Mortgage Fraud “Epidemic” FBI warned of it in 9.04 80% of it induced by lenders Fitch: nonprime incidence >40% FY07: >50,000 criminal referrals Investment bankers (03-07): made 34 referrals Unregulated: 80% nonprime loans 50K is a massive underestimate

8. Epidemic, What Epidemic? “ Sophisticated models, combined with strong risk management, allow lenders to better quantify the credit risk associated with scaling back the verification of a borrower's income and assets.” [Moody’s 11.24.04] Moody’s explanation for weakening its standards on “low doc” loans.

9. Economic Implications Massive direct losses fatal to any lender/buyer – hidden Perverse econometric models Hyper inflate & extend bubble Maximize “adverse selection” and info. asymmetry – Lemon’s Deceit: create & betray trust – cause markets to shut down

10. Securitization Implications Unsafe at any price Why only 34 referrals? No one did any due diligence Don’t ask; don’t tell “Most sophisticated” risk raters ignored the worst credit risk Potemkin models of mendacity Paradox of “predatory lending”

11. Rating Implications Ignored worst underlying risk Ignored fraud epidemic warnings Ignored housing bubble Pineapple v. grenade comparison Ratings were farblondget Toxic waste transformed into AAA Dishonest: CDO credit v mkt. risk Made rating business “lucrative”

12. It’s Not Insane; It’s Fraud 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]

13. See no evil…. “ There's a lot of fraud that's involved there, things that we didn't see. We're on notice that a lot of things that we relied on before just weren't true. [W]e relied on reps and warrantees that no loans were originated in violation of any … law. We know that's a lie.” Moody’s ’07

14. Gresham’s 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]

15. “ Most Investors Don’t Have It” Purchased >$1T nonprime loans During a fraud epidemic Buy liar’s loans w/o fraud checks CDO & CDS: can’t know risks Spreads narrowed – increasingly inefficient, inflated markets Can’t know values , can’t trade

16. Vectors for Fraud Epidemics Didn’t shift risk to best able to bear Concentrated, spread & increased losses Made markets far less “efficient”, the spread narrowed as losses grew Killed our most elite banks: no relevant expertise or data Spread the crisis globally & shut down many markets