1. Accounting Control Fraud Reverses Pareto Efficiency William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City Franklin & Marshall College Economics Department: March 27, 2009

3. Control Frauds as Financial Super-predators Person (typically CEO) that controls a seemingly legitimate firm/agency uses it as a “weapon” to defraud Causes greater $ losses than all other forms of property crime combined Some forms maim & kill (infant formula) Produce, extend & hyperinflate bubbles Deceit erodes trust & closes markets

4. Economics & Criminogenic Environments for Control Frauds Criminogenic environments create perverse incentive structures Control fraud epidemics & bubbles Not random; not “black swans” Conventional economics praxis optimizes criminogenic environment Result: recurrent, intensifying crises

5. Pareto Efficiency Ex ante: we expect voluntary exchanges to make both parties better off Even ex post we expect learning effects to rectify mistakes Positive sum transactions should be the norm Very limited role for government

6. Reverse Pareto Efficiency Both parties are made worse off Nonprime lenders & borrowers Financial bubbles The paradox of falling spreads The “predatory” loan paradox Unfaithful agents gain Immense wealth destruction

7. Akerlof: Lemon’s Markets Every example he uses is an anti-consumer control fraud Deception: quality/quantity Seemingly legitimate fraudsters Gresham’s dynamic: frauds can drive honest from the market Partially dynamic: discusses only honest counter strategies

8. Market Flaw Becomes Triumph Akerlof never used “F” word Literature triumphal – reputation trumps lemons & conflicts Ignored endemic control fraud “ a rule against fraud is not an essential or even necessarily an important ingredient of securities markets” (Easterbrook & Fischel 1991)

9. Signaling Diogenes Three signals only honest can use Hire top tier audit firm Have CEO own stock in firm Extreme leverage Fischel wrote this after he knew it was false: Lincoln & Centrust Each “signal” aids control fraud Mimic. Suborn controls into allies.

10. Economic Praxis Criminogenic Deregulation: good Non-enforcement: good Bad accounting: irrelevant Extreme leverage: good Extreme growth: good Conflicts of interest: good Reliance on auditors/rating: good Huge performance pay: good

11. Optimizing accounting fraud Invest in nominal high yields Extreme leverage Grow rapidly – Ponzi Gut controls & underwriting Suborn controls: allies Comp. based on short-term “Y” Hide losses; tiny loss reserves

12. Produces Paradoxes Making the worst loans, in the worst manner produces record profits during expansion (“sure thing”) Econometric studies praise the worst control frauds’ practices Huge losses certain Competing for growth lowers spread while credit risk skyrockets Bubbles delay loss recognition

13. Gresham’s Dismal Dynamic Control frauds that create competitive advantages: infant formula Accounting control fraud doesn’t Modern compensation has created a Gresham’s dynamic Short-term tenures of CFOs

14. Why Lenders Lose Deliberately making bad loans Perverse incentives to loan officers NINJA = adverse selection = fraud No controls/underwriting exposes lender to unintended frauds Frauds inflate appraisals Lending increases as bubble grows Competing for growth lowers yields Paying excessive compensation

15. Why Borrowers Lose Buy homes near peak of bubble Borrow at rates/amounts = default Harm their credit ratings Strips wealth from working class, particularly minorities

16. Who Wins? Loan officers on commission Appraisers, auditor & rating agency Lender’s executives Shareholders that sell for a gain Borrowers that engage in “equity stripping” or sell for a profit

17. Fraud Causes Inefficiency Mispriced asset values Sends false price signals Bubble expansion & collapse inefficient Poor care of houses = lost value Neighborhood effects of vacancies Systemic risk: failures & deceit erodes trust – mkt. failures

18. Praxis: The S&L Debacle “Autopsies” v. econometrics Recognized that “optimization” created patterns: triage Control frauds were Ponzi scheme Hit their Achilles’ heel: growth Dealt with “systems incapacity” Proving fraud neutralized neutralization Avoid criminogenic environments