1. The Best Way to Rob a Bank is
to Own One
U. Calgary/Haskayne Corruption Forum
November 5, 2009
William K. Black
Associate Professor of Economics and Law
University of Missouri – Kansas City

2. “Control Frauds”
White-collar criminology theory
Person controlling seemingly legit.
entity uses it as a “weapon”
Causes > direct $ losses than all other
forms of property crime combined
Bubbles and market collapses
Some control frauds maim & kill
Exist in all three sectors

3. Why CEOs are Unique
Only the CEO can
1. Optimize the firm for fraud
2. Suborn internal & external controls
3. Loot or skim with minimal risk
4. Most audacious make external
environment more criminogenic
Criminogenic environments cause
control fraud epidemics

4. Recurrent, Intensifying Crises
S&L Debacle
Enron, WorldCom, et al.
Overall failures
California energy crisis
The ongoing crisis: driven by fraud
Many nations: “tunneling”, Iceland

5. Non-regulation Decriminalizes
Decriminalizes accounting fraud
Effective regulators essential:
• Make the criminal referrals
• Train the FBI
• Detailed to aid investigations
• Serve as key witnesses
De-supervision = non-regulation

6. Compensation is Criminogenic
Perverse incentive: accounting fraud
Near perfect crime: “profits” convert
firm assets to CEOʼs benefit
Greshamʼs dynamic suborns controls
Reduces whistleblowing
• Lose your bonus
• Peers lose their bonuses
“Sanctity” of contract: un“holy” mess

7. Economist as bad criminologists
Economists donʼt study fraud
Donʼt have a theory of fraud
“a rule against fraud is not an
essential or … an important
ingredient of securities
markets” (Easterbrook & Fischel
1991)
Greenspan to CFTC Chair B.Born: no
need to regulate v. fraud

8. Optimizing Accounting Fraud
Guaranteed, record “profit” formula:
1. S&Ls: Extreme growth: avg. >50%
2. Loan to the uncreditworthy
3. Extreme leverage (infinite!)
4. Grossly inadequate loss reserves

9. S&L Debacle Control Frauds
Over 1000 “priority” convictions
“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)

10. 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 2004)

11. Not Underwriting is Suicidal
Maximizes adverse selection: loans
have negative expected value
Reverse Pareto optimality: both
principals harmed (agents gain)
Creates criminogenic environment for
undesired insider & outsider fraud
Reduces whistle blowing and morality
as best employees leave
The firm fails, but the fraud succeeds

12. Keating Suborns 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)
Criminal referral v. AAʼs “file stuffing”
AY, Jack Atchison, AA & “Keating 5”
Same dynamic re other professionals

13. Off the Charts Profits & Losses
S&L control frauds reported
extraordinary profits: Vernon &
Lincoln the most profitable S&Ls
Lincoln: $3.4 B loss on $6B in assets
Vernon: 96% of ADC loans in default
Econometrics perverse: Benston: 0 for
33; Greenspan re Lincoln: “no
foreseeable risk of loss”
Fischelʼs 3000 position error

14. Regulators Must Understand
Fraud Mechanisms to Succeed
300 frauds growing at 50% annually
Econometrics perverse: “autopsied”
Saw problem: accounting control fraud
Found unique pattern optimizing fraud
Targeted worst frauds
Cut growth – their Achillesʼ heel
>1000 priority felony convictions
Prevented 2000-02 subprime crisis

15. Reregulated Despite:
Reagan administrationʼs hate for it
Majority of House plus Speaker Wright
Keating Five
Trade association, (#3) in U.S., plus
prostitutes for key House member
2/3 of presidential appointees & staff
Entire economics profession
Media: “Mr. Ed” (talking horse)

16. Corruptionʼs Role in the Debacle
S&L debacle & Michael Milken
Milkenʼs “captive” “Merchant Princes”
Milken bribed bond fund managers
Prostitutes at Predatorsʼ Ball
Keating and Henkel (& Benston?)
Vernonʼs prostitutes: BOD, regulators
Speaker Wright/Whip (Coelho) & the
Keating Five: FHLBSFʼs removal

17. Corruptionʼs Role at Enron
Could tell two opposite tales
Among Bushʼs largest contributors
Enron “black hole” exploited to
produce 2001 CA energy crisis
Layʼs enticement to FERC chair
Role of Sen. Gramm & Wendy Gramm
VP Cheneyʼs secret energy advisors
Cheney reads from Layʼs script

18. Corruptionʼs Role: Procurement
Boeing scandal: Air Force
Pallets of Cash: Iraq
Cheney, Halliburton, Water for troops
Lethal showers (electrocution)
Iraqi police building summed it up
Blackwater: above the law
Imperial Life in the Emerald City:
Inside Iraq's Green Zone (2007)
Rajiv Chandrasekaran

19. Perfect Corruption
Accounting control fraud: perfect crime
Compensation as perfect bribe
• For officers: allies & deniability
• Professionals: allies & blessing
• Fraud induced v. spontaneous order
Few rules, no real regulators &
preemption: no bribes necessary
Greenspan, Gilleran & Dochow: backdate

20. War on Regulation
Preemption of state efforts to restrain
predatory lending
Slashing the FDIC staff with “early outs”
“MERIT” (non) examination
Transferring 500 FBI white-collar
specialists to national security
Industry = “customer”; MBA = “partner”

21. Mission Accomplished

22. Intellectual Roots
Ayn Rand: Greenspan: at the bottom of all
regulation lies the gun
Democracy is illegitimate & corrupt
Homo economicus is a sociopath
Business schools as fraud factories
Hayek: “spontaneous order” assumes
price signals are non-fraudulent
Reagan (& Gore): govʼt is the problem
(except for heroes wearing uniforms)

23. Failed Paradigms
Efficient markets & contracts
Private market discipline: perverse
Agency cost: shareholders canʼt
stop accounting control fraud
Corporate governance: One canʼt
“govern” control frauds
Business ethics: assumes the
“tone at the top” is honest

24. Itʼs easy to understand why the
theoclassical ignore fraud
Control fraud falsifies their claims
Markets & contracts arenʼt efficient
Market discipline is perverse where
fraud gives a competitive gain
Greshamʼs drives honest from the mkt
Reverse Pareto optimality: both
parties lose; dishonest agents win
Bubble & crisis ruins working class

25. Add Criminology to Economics
Incentives: the core of economics and
white-collar criminology
Fraud epidemics arenʼt random
The factors that produce criminogenic
environments are clear
The incentives are perverse, but they
have predictable marginal effects
Why donʼt the SEC & FDIC have “Chief
Criminologists”?

26. Criminologists are the Experts in
Dysfunctional Markets
Four key criminology concepts:
• Criminogenic environment
• Control fraud
• Systems capacity
• Neutralization
Mankiw (1993): “it would be
irrational for operators of the
savings and loans not to loot.”

27. Ask the experts how itʼs 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

28. 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%.”

29. 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.)

30. Fannie, Freddie & Ginnie
Disciplined market by defining “prime”
Securitization reduced mortgage rates
Privatization of ownership led to huge
bonus system at Fannie & Freddie
Grew rapidly & took interest rate risk
Hedge accounting (SEC – restatement)
Growth blocked; bonuses at risk
Fannie & Freddie turn to extreme credit
risk & accounting fraud – buy CDOs
backed by “liar’s loans”

31. The Coverup Phase
Optimizing by profiting from coverup
Hyperinflating & extending the bubble
optimizes the coverup
Refis defer losses & add to “profits”
“Equity stripping” & sales allow some
borrowers to profit & makes it
easier to attract borrowers & grow
Supports minimal loss reserves
Defeat market discipline & regulators

32. Massive Losses & Bubbles
The optimization formula explains why
large accounting control frauds
cause losses > all other forms of
property crime combined
Optimization means frauds cluster in
most “criminogenic environment”:
weakest regulation & best asset
for accounting fraud
Produces, extends & hyper-inflates
bubbles and causes crises

33. Mass Destruction
Maximizes lenderʼs loan losses
Bonuses produce Greshamʼs dynamic
among professionals & executives
Makes “market discipline” oxymoronic
Makes markets inefficient (perverse)
Hyperinflates & extends bubbles
Erode trust and shut markets: frauds
create/betray trust: Akerlof/lemons

34. The Big 8 Fail
S&L control frauds hired only Big 8
The art is to suborn, not defeat,
“controls”; use their reputation and
make them best ally
Got years of clean opinions blessing
extreme profits when insolvent
No heroes among audit partners
>$1 B in settlements to regulators

35. Treadway: Almost Right
Treadway: a response to S&L debacle
that did not study the S&L frauds
Found senior exec involvement in
83% of financial frauds
Concluded: frauds occur at smaller
corporations with poor internal
controls and smaller auditors. SEC
enforcement cases=biased sample
No (big) problem here

36. Ignoring (Modern) Criminology
Treadway embraced fraud auditing
Relied on old criminology & ignored
S&L regulatorsʼ insights
Cresseyʼs “fraud triangle” v.
Sutherlandʼs emphasis on elites
Cressey generalized from the most
unique fraud to all fraud
Goal: show embezzlers=low status
Need to think “outside the triangle”

37. Modern Criminology: Control Fraud
S&L control fraudsʼ audit fees big
enough to tempt top tier partners
S&L frauds always hired top tier and
got clean opinions
Regulators recognized accounting
control fraudʼs distinctive pattern
Regulators targeted “Achillesʼ heel”
Regulators prevented a 2001-02
subprime crisis

38. 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).

39. Bad Timing (and Analysis)
Enron (2001); WorldCom (2002)
Large accounting frauds undetected
by CPAs before book published
“Asset theft” is more common than
control fraud, but not “more costly”
Audit failures were the norm in the
ongoing crisis – the difference is
that the SEC is even weaker now
and banking regulation was gutted
Banksʼ political influence has
perverted GAAP (loss recognition)

40. Mortgage Fraud “Epidemic”
FBI warned of it, and coming crisis: 9.04
80% of losses induced by lenders
FY07; 08: >50K; >62K criminal referrals
Investment banks (03-07): 36 referrals
Unregulated: 80% nonprime loans
Most frauds undiscovered; referrals are
exceptionally uneven & biased

41. If we file it the FBI will come
Nearly 900 filing institutions submitted
mortgage loan fraud SARs.
Over 700 of those filed <5 SARs.
<200 them submitted 98% of SARs.
The top 10 submitted 57% of all SARs.
The top 25 submitted 82% of all SARs.
No actions against those that donʼt refer

42. 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”

43. “Donʼt Ask; Donʼt 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 ʼ01]

44. “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]

45. Greshamʼs 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]….”
[Moodyʼs 2007]

46. Appraiser Coercion = Fraud
Only reason to coerce an appraiser to
inflate value is fraud
National study(early 2004): 75% coerced
Cuomo 2007 investigation: nationwide
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

47. The Bankers Knew
Note the dates: 2001, 2004 & 2007
They knew – from the beginning
The bankers, auditors, attorneys,
regulators and rating agencies
could all have stopped it
Itʼs easy to say “no” to “liarʼs loans”
and “toxic waste”
No banking heroes, no heroes in the
professions

48. We Can Jail the Frauds
FBI agents investigating mortgage
fraud: 120 FY 2007; 180 FY 2008
S&L debacle: 1000 FBI agents and
forensic experts: > 1000 felony
convictions of high priority frauds
Today's financial crisis dwarves the
S&L crisis
Source: FBI 2.19.09 Dep. Dir. Pistole

49. Failure is an Option
CEO can profit enormously despite
firmʼs failure
The firmʼs 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

50. If you donʼt 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
Property crime: never higher