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The agency problem and how to create a criminogenic environment

By William K. Black

Despite an enviable predictive track record and the success of our policies when they are (rarely) put into practice, white-collar criminologists are overwhelmingly ignored in our core area of expertise by decision-makers whose policies are so criminogenic that they cause the epidemics of “accounting control fraud” that drive our recurrent, intensifying financial crises.

“Control fraud” occurs when the persons controlling a seemingly legitimate entity use it as a “weapon” of fraud.  In finance, accounting fraud is the “weapon of choice.”

I teach a class that focuses on elite white-collar crime.  It can be taken by both law and economics students.  (It could also be taken by criminology students, but none has ever done so because they are almost exclusively interested in criminal justice, a field that ignores the existence of elite white-collar crime.)  My primary appointment is in economics.  I have a joint appointment in law.  I have a doctorate in criminology and I was a financial regulator during the heart of the savings and loan debacle.

I also teach about white-collar crime in my social science and law course, Latin American development, antitrust, and finance courses.  The primary struggle is that economists, lawyers, judges, and even accountants have no theoretical understanding of modern white-collar criminology.  They almost never study fraud mechanisms.  The only field (accounting) in which it is now reasonably common to take a course dealing with fraud and to have a formal literature (GAAS: SAS 99) that discusses criminological theory applies a theory developed 50 years ago (the “fraud triangle”) that has no relevance to accounting/securities fraud.

The problem of not understanding fraud mechanisms is most intense among economists, who typically do not study fraud, do not understand fraud mechanisms, and have a tribal taboo against even writing or speaking the word “fraud.”  Robert Shiller, an eminent Yale economist, exemplifies the field’s failures in his most recent book, Finance and the Good Society (2012).  In the worst simile constructed to date to explain the crisis, Shiller exemplifies the neutralization that adds to a criminogenic environment.

“Certainly, anyone who committed fraud should suffer penalties.  But it is hard to blame the crisis on a sudden outbreak of malevolence.  The situation during the boom that created the crisis was rather more like that on a highway where most cars are going a [sic] just a little too much over the speed limit.  In that situation, well-meaning drivers will just flow with the traffic.  The [Financial Crisis Inquiry Commission (FCIC)] described the boom as ‘madness,’ but, whatever it was, it was not for the most part criminal.

And pursuing this highway metaphor a bit further, we may suggest that automotive designers would best stay focused on how new technology can help us better manage vehicular traffic….” (p. ix).

Shiller wrote his book to try to counter the public’s rage at the “pervasive” fraud committed by the officers controlling our “most reputable” banks.  The quoted phrases are from a recent article by conservative finance scholars.

“[A]lthough there is substantial heterogeneity across underwriters, a significant degree of misrepresentation exists across all underwriters, which includes the most reputable financial institutions” (p. 29).

Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS Market,” Tomasz Piskorski, Seru & Witkin (February 2013).

They are finance professors, so they are not being (deliberately) ironic when they describe the world’s largest frauds as our “most reputable” banks.

Shiller returns briefly to the topic of fraud only near the end of his book to announce that fraud by the financial sector cannot be serious because it would be irrational.  It would harm the banks.  Therefore, if abuses occur they must be minor because the markets self-correct.  This is the dogma that proved (again) in this crisis to be false and destructive.

Shiller’s claim that fraud by banks cannot be material because it would harm the banks suffers from two obvious problems.  First, control fraud often increases bank profits.  Second, Shiller makes the same foundational error that prosecutors now make – they conflate the “bank” with the “CEO.”  This is bizarre.  It ignores history, agency problems, and incentives.  It is startling how little understanding of basic fraud schemes exists today among key leaders in many fields.

“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.”

Sacramento was one of the epicenters of the fraud epidemics that drove the crisis, but the CEOs who led the frauds need not fear prosecution under Wagner, who cannot even keep his pronouns straight in the same sentence.  In fairness, however, the typical law student graduates without ever studying control fraud mechanisms.

Once students are taught the fraud “recipe” for a lender (loan purchaser) they have little difficulty in understanding why, from the controlling officer’s perspective, it optimizes accounting control fraud to cause a lender (purchaser) to make (purchase) bad loans at a premium yield.  We had little difficulty explaining the same concepts to judges and juries during the S&L debacle.  There has been a disastrous loss of understanding won through bitter experience containing prior crises.

Understanding fraud mechanisms is essential to understanding incentive structures and how fraudulent CEOs shape incentive structures to optimize control fraud.  Once students (and policy makers) understand what a Gresham’s dynamic is and how fraudulent CEOs generate such a dynamic they understand how and why they generate “echo” epidemics of control fraud in other fields and professions to aid the central fraud.  Understanding that the controlling officers of both fraudulent lenders and purchasers can simultaneously gain through the fraudulent sale of the underlying fraudulent loans is essential to understanding why the (purportedly) most financially sophisticated firms that under neoclassical economic theory (purportedly) were the optimal source of the (purported) “private market discipline” that (purportedly) ensures “efficient

Understanding fraud mechanisms was essential to our ability as S&L regulators to contain the primary fraud scheme by adopting a rule restricting growth (which struck every accounting control fraud’s Achilles’ “heel”).  It is only in retrospect with the advantage of the current crisis that we can begin to understand how many trillions of dollars the reregulation of the S&L industry saved because it began in 1983.  That was only one year after the key federal deregulatory bill was adopted.  Our reregulation was conducted over the fervent opposition of the Reagan administration and much of the Congressional Democratic Party’s leaders, particularly Speaker James Wright, Jr.

Understanding fraud mechanisms allowed us to identify the control frauds while they were still reporting record profits and to prioritize them for investigation, closure, and prosecution.  It allowed us to bring the most successful enforcement actions in regulatory history.

Understanding fraud mechanisms allowed us to identify and investigate the frauds to be able to make what over time (in what would now be called “continuous improvement”) came to be superb criminal referrals.  We also trained our examiners how to expose and document the fraud schemes, trained FBI agents and AUSAs, detailed our examiners to serve as the FBI’s internal experts in the most complex and highest priority investigations (allowing the examiners access to 6 (e) materials), served as their expert witnesses, and often as their percipient witnesses because our examiners asked the correct questions and documented the answers.

Our agency, OTS, made over 30,000 criminal referrals.  This produced over 1,000 felony convictions in cases designated as “major” by DOJ.  We worked with DOJ to prioritize the prosecutions by creating the “Top 100” list of fraud schemes.  That involved roughly 300 S&Ls and 600 individuals.  Virtually all of them were prosecuted with a 90% conviction rate.

But the most impressive demonstration of the exceptional payoffs to understanding fraud mechanisms occurred in 1990-1991 when a “second front” suddenly erupted during our fight against the S&L debacle.  As with all good U.S. financial frauds it started in Orange County, California.  We (OTS West Region) were the regulators.  We listened to our examiners, the folks closest to the facts.  They told us about loans that are now called “liar’s” loans though the industry did not call them by that revealing phrase in that era.  The S&Ls did not conduct underwriting that was essential to prudent mortgage lending because they did not verify the borrower’s income.  Our examiners explained that this would create intense adverse selection and a “negative expected value” for the mortgage lending.  No honest mortgage lender would engage in such widespread practices.  We drove liar’s loans out of the industry in 1991.  The original and leading originator of liar’s loans was Long Beach Savings.  It also specialized in targeting Latinos and blacks.  It gave up its federal deposit insurance and converted to a mortgage bank from the sole purpose of escaping our regulatory jurisdiction.  Arnall renamed it Ameriquest.  It became the most notorious fraudulent and predatory mortgage lender.

Flash forward to the current crisis.  The mortgage lending industry eventually came to call the loans that Long Beach Savings pioneered “liar’s” loans.  The S&L regulators quickly succumbed to the “Reinventing Government” assault on regulation in 1993 by eliminating the vital rule on loan underwriting and replacing it with a useless guideline that did not expressly require even the most essential underwriting requirements.  Liar’s loans gradually crept back into the S&L industry.  It took many years because we had removed so many of the worst S&L managers from the industry.

By 2006, half of all the loans called “subprime” were also liar’s loans.  The industry’s own anti-fraud experts reported that the fraud incidence in liar’s loans was 90 percent.  By 2006, roughly 40% of the total loans originated that year were liar’s loans.  That means that there were over two million fraudulent loans originated in 2006 alone.  Liar’s loans increased by over 500% from 2003 to 2006 – they were the “marginal” loans that hyper-inflated the bubble.

Liar’s loans were only one barrel of double-barreled fraud “shotgun” that the lenders used to blast the global economy.  The other barrel was appraisal fraud.  The overlapping pattern of fire was devastating.

“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).

Only lenders and their agents can induce large numbers of appraisers to inflate the appraised value of the home by causing a Gresham’s dynamic that drives out honest appraisers.  No honest person would inflate the appraisal.  A national survey of appraisers in early 2004 found that 75% of them reported that they were the subject of attempted coercion designed to inflate the appraisal during the past 12 months.  A follow-up study in 2007 found that percentage rose to 90% and that 67% of appraisers reported losing a client and 45% did not get paid their fee because they refused to inflate the appraisal during the past 12 months.

Note that the petition began in 2000 – before the Enron-era frauds were exposed.  The crisis we are suffering was among the most easily avoidable in history.  The honest appraisers gave us exactly the information we needed with plenty of time to contain the twin fraud epidemics.

Appraisal fraud is a superb indicator of control fraud by lenders.  Juries understand immediately why it provides compelling proof that the lender is engaged in fraudulent lending.  Liar’s loans by mortgage lenders (and their purchase in the secondary market) are obvious fraud markers.  The name itself was an open admission of fraud and it was the lenders and their agents who overwhelmingly put the lies in liar’s loans.

The secondary markets have no fraud exorcist, so originating fraudulent loans for sale to the secondary market inherently required fraud in the sale and  frequently involved fraud in the purchase, pooling, and resale of the resultant mortgage product (MBS and CDOs).

This crisis was even easier to spot and stop than our actions in 1991 that stopped liar’s loans before they could cause any crisis.  There was no analogous petition by appraisers in our era and the loans were not called “liar’s loans.”  Beyond that, everyone in the housing industries and regulatory ranks had the advantage of our successful crackdown on liar’s loans.

What happened instead, however, was that the regulators refused to act against the twin epidemics of accounting control fraud.  The federal regulators were such virulent opponents of regulation that they sought to block state regulators from investigating lenders’ frauds.  The OTS, which was supposed to regulate Countrywide, WaMu, and IndyMac (three of the largest originators of fraudulent liar’s loans and in the case of WaMu infamous for its blacklist of honest appraisers), made zero criminal referrals during the current crisis.  This crisis is roughly 70X the size of the S&L debacle and the extent of control fraud is even greater as a proportion in the current crisis relative to the S&L debacle yet there were zero referrals and zero convictions of the senior leaders of the elite control frauds that drove the crisis.

Without the essential expertise that only the regulatory agencies can provide the FBI/DOJ the FBI felt that it had to go the Mortgage Bankers Association – the trade association of the perps – to gain expertise.  Unsurprisingly, they created a (purported) definition of “mortgage fraud” that excludes fraud by the lender.  To this day, the FBI/DOJ parrot this absurd definition that defines out of existence accounting control fraud.  The FBI/DOJ make no clear statements that only mortgage lenders controlled by fraudulent officers would make liar’s loans and inflate appraisals.

Indeed, the FBI/DOJ seem determined, as we approach the 75th anniversary of Edwin Sutherland’s famous presidential address announcing his concept of white-collar crime, to prove that Sutherland’s new theory was one of the most important scientific advances.  Sutherland understood that there were copious non-elite frauds.  He focused on elite frauds because they were different.  They caused vastly greater damage and often had excellent chances of gaining great wealth and status through fraud without being prosecuted or disgraced.  DOJs and the Brits’ endorsement of the infamous “too big to prosecute” Holder doctrine proves the ever growing importance of Sutherland’s focus on elite frauds, particularly because the epidemics of control fraud drive our recurrent, intensifying financial crises.

We did not have to follow this path.  If we teach our students about fraud schemes they can be effective in countering the cause of much of the economic misery in many nations.

“Now we know better”

That phrase is the key message that the economists George Akerlof and Paul Romer wished to emphasize in their famous 1993 article on “looting.”  The title of their article captures their thesis – “Looting: The Economic Underworld of Bankruptcy for Profit.”  They made this the last paragraph of their article in order to emphasize their central findings.

“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were 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”(Akerlof & Romer 1993: 60).

Notice how strongly they wrote their conclusion – savings and loan (S&L) deregulation was “bound to produce looting.”  The “regulators in the field” “understood what was happening from the beginning” but the economists were “unaware of the concept” of looting.  These are exceptional conclusions coming from prominent economists because their field’s literature constantly derides regulators and praises economists for their superior analytics.  Economists and the industry were the world’s strongest supports of maximum financial deregulation.  Akerlof and Romer wrote their conclusion to make plain their heresy.

Akerlof was made a Nobel Laureate in 2001.  His most famous article, on markets for “lemons” is about another variant of what criminologists term “control fraud” in which the seller deceives the purchaser about the quality of the goods or services (Akerlof 1970).

We cannot afford to suffer another, even more severe economic crisis because our students are “unaware of the concept” of control fraud.  They must stop creating the ever more criminogenic environments that create the perverse incentives that lead to control fraud epidemics.

William Black

About 

William K. Black, J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House Governance Committee on the regulation of executive compensation.