Financial Fraud

"Actually, fraud is what is preventing total collapse! It just makes the inevitable collapse that much more devastating”

Bill Black: Our System is So Flawed That Fraud is Mathematically Guaranteed

How did we allow things to get this bad?

by Adam Taggart

Peak Prosperity,

26 January, 2013

[Chris lost his voice this week due to illness, so we were unable to record a new podcast. So while Chris recuperates, enjoy this excellent discussion from the archives will Bill Black, recorded a year ago, on the pervasive control fraud within our current financial system. ~ Adam]

“When plunder becomes a way of life for a group of men in a society, over the course of time they create for themselves a legal system that authorizes it and a moral code that glorifies it."  ~ Frederic Bastiat

Bill Black is a former bank regulator who played a central role in prosecuting the corruption responsible for the S&L crisis of the late 1980s. He is one of America's top experts on financial fraud. And he laments that the U.S. has descended into a type of crony capitalism that makes continued fraud a virtual certainty while increasingly neutering the safeguards intended to prevent and punish such abuse.

In this extensive interview, Bill explains why financial fraud is the most damaging type of fraud and also the hardest to prosecute. He also details how, through crony capitalism, it has become much more prevalent in our markets and political system. 

A warning: There's much revealed in this interview that will make your blood boil. For example, the Office of Thrift Supervision. In the aftermath of the S&L crisis, this office brought 3,000 administration enforcement actions (a.k.a. lawsuits) against identified perpetrators. In a number of cases, they clawed back the funds and profits that the convicted parties had fraudulently obtained.

Flash forward to the 2008 credit crisis, in which just the related household sector losses alone were over 70 times greater than those seen during the entire S&L debacle. So how many criminal referrals did the same agency, the Office of Thrift Supervision, make?

Zero.

Similar dismal action was taken by such other financial regulators as the Office of the Comptroller of the Currency, the Federal Reserve, and the FDIC. 

Where is the accountability? you may be asking. Or perhaps, how did we allow things to get this bad?

Fraud is both a civil wrong and a crime, and it's when I get you to trust me and then I betray your trust in order to steal from you. As a result, there’s no more effective acid against trust than fraud, and, in particular, elite fraud, which causes people to no longer trust folks. Economies break down, families break down, political systems break down, and such, if you don’t have that kind of trust. So that’s what fraud is.

But what my work focuses on is, what kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, systemic problems and such, arise when we have what we call in criminology 'control fraud.' And control fraud simply means when you have a seemingly legitimate entity and the person who controls it uses it as a weapon to defraud others. And so in the financial sphere, the weapon of choice is accounting, and the losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.

So for example, in the current crisis, as with the prior ones, if you’re a lender, there’s an easy recipe for maximizing fake accounting income. And it goes like this. You need four ingredients:

Grow like crazy...

...by making really, really crappy loans but at a premium yield (yield just means 'interest rate')...

...while employing extreme leverage, and...

...while setting aside only the most trivial reserves or allowances for the inevitable losses this kind of behavior produces.

George Akerlof and Paul Romer wrote the classic article in economics about this in 1993. And their title really says it all in terms of the dynamic: Looting the Economic Underworld of Bankruptcy for Profit. The idea is, you have a seemingly legitimate entity, and the person at the top is looting it. They loot it by destroying it, but they walk away wealthy. Of course, in the modern era we don’t necessarily – we may bail out the entity. So it may not even fail in that sense.

But here’s what Akerlof and Romer also said that was so critical as an understanding. They said these four steps, these four ingredients: it's just math. It is – and I’m quoting them now – “a sure thing.” So you’re mathematically guaranteed, if you do these four things, to report not just substantial income, but record levels of income. 

The big thing about the seemingly legitimate entity when the CEO is the crook is, first, everybody reports to the CEO ultimately, right? So the CEO is the point failure mechanism where if he or she goes bad, almost everything may go bad as well. So all those things that we call internal and external controls, all report to the CEO, and the CEO therefore can, as I’ll describe, use compensation, hiring, firing, praise, and such to produce the environment that will commit – create allies for his fraud. Now, note that what I’m saying. The CEO, the art of this is not to defeat your controls. The elegant solution, as in mathematics, is to suborn the controls and turn them into your most valuable allies. And therefore, for example, when you’re running accounting control fraud, where your weapon of fraud is accounting and that weapon of choice in finance is accounting, you’re going to want to hire the most prestigious accountants as your outside auditor, because it is precisely their reputation that is most valuable when you can suborn them. And they give you that clean opinion that you just described that will help you deceive other shareholders. So one enormous advantage is, internal and external controls come to the CEO level.

A second incredible advantage is the CEO can optimize the firm as a weapon of fraud. And the CEO can do that. Basically this falls into two big categories. One, you can put it in assets that have no readily verifiable market value, because then it's a lot easier to inflate asset valuations and to hide real losses. And the second thing you do is grow like crazy. And, of course, that is the essence of something your listeners have all heard about, and that is a Ponzi scheme. And so these accounting control frauds have strong Ponzi-scheme like elements, which is why they tend to cause such catastrophic losses.