William K Black on Control Fraud 2013

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

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

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

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

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)

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)

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

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.

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.

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

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‖

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

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

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

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

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

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

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

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

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

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

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)

―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).

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

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

FBI‘s twin 2004 warnings
Mortgage fraud becoming ―epidemic‖ and
will cause a financial ―crisis‖ if it is not
contained

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.‘‖

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….‖

―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]

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)

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

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.

“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.‖

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

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)

―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]

Recent mortgage fraud study
Asset Quality Misrepresentation by
Financial Intermediaries: Evidence
from RMBS Market
Tomasz Piskorski, Seru & Witkin
February 2013
http://papers.ssrn.com/sol3/papers.cfm?a
bstract_id=2215422

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.‖

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)

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)

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)

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)

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)

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?‖

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.‖

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

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?

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

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

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

Clayton: Implausible Deniability
http://www.scribd.com/doc/108632731/Ex
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‖

―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.‖

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.‖

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).

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

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.

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)

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.

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‖

―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).

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.‖

But our advances are Ignored by
Fraud examiners
Accountants and their literature
Economists
Judges
Financial regulators
Prosecutors

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

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

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

―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).

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

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.

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.

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.‖

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..

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.

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!

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.

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.‖

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.

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?

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.‖

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.‖

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?

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.

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….‖

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….‖

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.‖

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.‖

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.‖

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

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‖

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‖

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.‖

Assuming Ethical Leaders
―The potential for management override
also increases the need for appropriate
oversight measures by those charged
with governance….‖

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….‖

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).‖

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?‖

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

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

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

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

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

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

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

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

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

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‖

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

―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

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

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

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

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.

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

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

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

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

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”

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.

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

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

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

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

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

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

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

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

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

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

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

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

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.

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]

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

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

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)

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

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

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%.‖

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.)

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

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

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

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

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

―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.]

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

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

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

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

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

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

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.‖

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….‖

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.

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.)

Where We Look, We Find
WaMu
Citicorp
Lehman
Goldman
Rating agencies
Fannie & Freddie
The most elite institutions in the world

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

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.‖

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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

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]

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

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‖?

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

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]
http://www.ojp.usdoj.gov/bjs/pub/press/cv07pr.htm
Reality: Property crime: never higher

William K Black on Control Fraud 2013

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William K Black on Control Fraud 2013