"Formula For Fraud"
How To Become A Billionaire
Guns and Butter, Broadcast April 4, 2012
here’s the key question: How many of you are bankers? Not
many, right? How much brains does it take to make a bad loan?
I think we could all do that. So, all the mediocre bankers have
no way to make money with honest competition. But they have a
sure thing, if they’re willing to follow the fraud recipe.” —William
“We’ve been asked to do our talks in four parts. So, unlike
Gaul, my speech is divided in four parts. This talk
will be about why we suffer recurrent, intensifying, financial
crises. Then, I’ll explain how theoclassical
economic dogma produces these disasters. The
third part will be to explain why our response to the crisis has
made it worse. And I actually will end on an
optimistic note. The fourth part is how we have
succeeded in some places at some times and why you can do the
(c. 9:59) “So, what did we know out of that savings and loan crisis, that was widely described at the time as the worst financial scandal in U.S. history? And we have a history rich in scandal. Here is what the national commission that investigated the causes of the crisis reported:
"'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 organisation.'
(c. 11:04) "That means to loot the organisation. But, speaking of milk, [Applause] the frauds I’m describing are in no way limited to the Unites States; they exist in every country. And they are common enough to explain; and they are old enough to explain what Balzac was saying because many of the wealthy become rich through precisely the scandals, the fraud, I will describe.
“In criminology, we call them financial super predators when we’re being lyrical. When we’re writing journals, we call them ‘control frauds,’ which is boring. Control fraud occurs when the person who controls a seemingly legitimate entity, like Parmalat, uses it as a weapon to defraud. And they can often use this weapon with impunity. In finance, accounting is the weapon of choice. And these accounting frauds cause greater losses than all other property crimes combined, yet economics, again, never talks about it. Worse, when many of these frauds occur in the same area, they hyperinflate financial bubbles, which is what causes financial crises and mass unemployment. It makes the CEOs wealthy, produces Balzac scandals, and destroys democracy.
(c. 13:10) “In criminology, we talk about criminogenic environments, long words, simple concept. When the incentives are extremely perverse, you will get widespread fraud. So, what makes for perverse incentives? The ability to steal a lot of money and not go to prison and not having to live in disgrace. In practice that means, in English, the three Ds: deregulation, desupervision, and de facto decriminalisation. Deregulation, you get rid of the rules. Desupervision, any rules that remain, you don’t enforce. Decriminalisation, even if you sometimes sue them and get a fine, you don’t put them in prison. So, that’s the first area—deregulation. The second area is executive compensation.
“And what is ideal for accounting fraud?
Really high pay based on short-term reported income with no way
to claw it back, even when it proves to be a lie. Those are the
most important, but it’s also good, if your assets don’t have a
readily verifiable market-value ‘cos then it’s easy to inflate
the asset prices and it’s easy to hide the real losses. And, if
you want a true epidemic of fraud, if entry into the industry is
very easy then you’ll get much more fraud.”
William Black: “So, this is what you were waiting for, at least from me. This is the recipe, only four ingredients, that bankers in many parts of the world use to become billionaires. And, again, it’s one that Akerlof and Romer agreed with. So, first ingredient: grow massively. Two: by making really, really crappy loans, but at a higher interest rate. Third ingredient: extreme leverage—that just means a lot of corporate debt. Fourth ingredient: set aside virtually no loss reserves for the massive losses that will be coming. By the way, in Europe, this last ingredient is mandated by international accounting rules, which are incredibly fraud-friendly. And everybody knows that, in accounting; and nobody has changed it. If you do these four things, you are mathematically guaranteed to report record short-term income. This is why Akerlof and Romer referred to it as a sure thing—it’s guaranteed.
(c. 17:11) “There are actually three sure things. The bank will report record profits. The profits, of course, are fictional. The CEO will promptly become wealthy and, down the road, the bank will suffer catastrophic losses. Again, if many banks do this, you will hyperinflate a bubble. This recipe helps explain why bankers hate markets, why bankers hate capitalism, why they hate anything like an effective market.
“So here’s a thought exercise: What if you were a CEO of a bank and you wanted to grow exceptionally rapidly? The first ingredient to the fraud recipe, that means 50% a year. And that’s realistic; that’s what the banks in Iceland, that’s what many of the banks in Europe—continental Europe—and the U.S. also did. How would you do that if you were honest? You’re in a market that’s competitive. The only way to grow that rapidly is to charge far less money, a lower interest rate, for your loans. But if they’re a real market what would your competitors do? They would match your price reduction. You wouldn’t end up making anymore loans; and all the banks would be loaning at a lower interest rate. So, here’s the question? Is that a good way to make money as a bank? It’s a terrible thing for a bank, right? So, all the bankers would lose. And that’s why they hate markets. And that’s why banks are the biggest proponents of crony capitalism and the leaders worldwide in crony capitalism.
(c. 19:26) “And that leads us to a discussion of why bad loans are so perfect for bank fraud; you can charge a much higher rate to people who can’t get loans because they can’t repay the loans. And there are millions, tens of millions, of such people. So, you can grow very rapidly. You can charge a higher interest rate. If your competitors do the same thing, it’s actually ‘good’ for you because it hyperinflates the bubble. And the bad loans, you just refinance them and you hide the losses for many more years.
(c. 20:22) “So, the CEO takes no risk; all of this is a sure thing. And here’s the key question: How many of you are bankers? Not many, right? How much brains does it take to make a bad loan? I think we could all do that. So, all the mediocre bankers have no way to make money with honest competition. But they have a sure thing, if they’re willing to follow the fraud recipe. I’m now gonna quote from the person, the economist [James Pierce, NCFIRRE's Executive Director], who led the national investigation of the savings and loan crisis. And he called this dynamic I’ve just explained, 'the ultimate perverse incentive.' So, this is what he said:
"‘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’—that’s CEOs—‘to drive their
banks ever deeper into insolvency, as they looted them.’
“We already established you’re not bankers. So, imagine all of
you run Competent Honest Bank and you do underwriting.
And you can tell can tell high-risk and low-risk borrowers. Low
risk borrowers you charge 10%. High-risk borrowers you charge
20%. I run Bill’s Incompetent Bank, I can’t tell
risk. So, I charge everybody 15%. Which borrowers come to me?
Only the absolute worst borrowers. No good borrower would come
because they could borrow at your bank at 10%. So, this is not
like a usual risk. In economics, we call this
adverse selection. And it means
that a bank that makes loans this way must lose vast amounts of
money. No honest banker would operate this way. And the
banks that engage in these frauds also create
criminogenic environments themselves to recruit fraud allies.
For example, the people that value homes, if they won’t inflate
the value, the dishonest banks won’t use them. Do they need to
corrupt every person that values homes? No. 5% of the
profession would be fine. They just send all their business to
the corrupt—we call them—appraisers in America. And
this is called a
Dynamic; and it means that cheaters prosper and bad
ethics drives good ethics out of the marketplace.
“And that was
Raines, the head of
which is now insolvent by about $500 billion dollars. How did
Frank Raines know about this perverse incentive? Because he
used it at Fannie Mae to produce the frauds that made him
wrong with his sentence, though?
(c.30:30): “You’re listening to lawyer,
academic, author, and former bank regulator William K.
Black. Today’s show: ‘Formula for Fraud.’
I’m Bonnie Faulkner. This is Guns and Butter.”
“As I said economics is particularly awful when it gets into the
concept of morality. In my first talk, I read you a quotation
from the economist who conducted the investigation of the
loan crisis. And he pointed out that it was ‘rational’
for looters to make bad loans. Well, here is the reaction of
Greg Mankiw, to hearing the work of that national commission
and of that Nobel Prize winner-to-be, George Akerlof.
He listened to their story and he said—and this is not an
off-hand comment; he was the official discussant; he had the
paper a week in advance; he thought about these remarks—he said:
"They assured us that because of bankers’ interest in their reputations and auditors and appraisers, that they would never commit a fraud and never assist a fraud.
"They predicted that massive financial derivatives would stabilise the economic system.
"They told us, even when the bubble had reached proportions larger than any in the history of the world, that there was no housing bubble in the United States, that there was no housing bubble in Ireland, that there was no housing bubble in Japan, that there was no housing bubble in Spain.
us that if we paid CEOs massive amounts of money based on
short-term performance that was fictional, it would align the
interests of the CEO with the shareholders and the public and be
the best possible thing.
they do back in the day? They looked at Europe. This is
named, of course, after a famous Roman—a very conservative
anti-think tank in the United States. Cato, in 2007, as
Iceland was collapsing in massive fraud, said these words:
"‘Incomes are rising, unemployment is almost non-existent, and the government is collecting more revenue from a larger tax base.’
"So, they cut taxes, but overall tax revenue grows because the country is growing at a massive rate. Why? Because the big three banks in Iceland are all accounting control frauds. They are growing at an average rate of 50% every year. And by the time they collapse in 2008, they are ten times the GDP of Iceland. And they suffer 60% losses on their assets. That was their prediction of proof-positive that deregulation, low taxes, privatisation produce economic booms.
(c. 41:36) “They said something very similar about Ireland in an article entitled 'It’s Not Luck':
"Ireland [...] boasts the fourth highest gross domestic product per capita in the world. In the mid-1980s, Ireland was a backwater with an average income level 30% below that of the European Union. Today, Irish incomes are 40% above the EU average.
"'Was this dramatic change the luck of the Irish? Not at all. It resulted from a series of hard-headed decisions that shifted Ireland from big government stagnation to free market growth.'
they wrote this in 2007, a year after the Irish bubble had
popped and Ireland was going into freefall. And what
are we being told now is the answer? Hard-headed decisions that
shift the governments from big government stagnation to free
market growth. They have learned absolutely nothing from their
past failed ‘predictions.’ In fact,
Trichet came to Ireland in 2004 and said Ireland should be
the model for nations joining the European Union.”
William K. Black: “But we have seen this movie many times before in many countries. We had seen it in the savings and loan crisis. But then came the Enron-era crisis and WorldCom. And I’ll focus on just one aspect. Again, we had accounting control fraud that drove an immense crisis. But what people forget is that most of the world’s largest banks eagerly aided and abetted Enron’s frauds. They knew Enron was engaged in fraud; and they thought that was a good thing because they would get more deal flow, as we say, more volume. These frauds were documented extensively by investigations, hundreds of pages about it. Not a single one of the large conventional bankers were prosecuted. There was a prosecution about Merrill Lynch, which the courts obstructed. Indeed, the U.S. Supreme Court ruled that only the government could bring civil suits—against an enforcement action, of course—against banks that aided and abetted fraud. Think of that! You could have indisputable proof that the bank had aided Enron, knowingly done so, caused you billions in losses, and you could not sue the bank. That’s how bad the law has become in the United States.
(c. 45:26) "So, that left us with could the government sue? Well, the Federal Reserve, we now know from recent testimony in front of the national commission that investigated this current crisis, the leadership actively resisted bringing any action against the banks, even what we call a slap on the wrist. And it was only when the Securities and Exchange Commission took a slap on the wrist that the Federal Reserve was embarrassed into taking any action. We also know, from this extraordinary testimony by the long-time head of supervision at the Federal Reserve that he was deeply disturbed by the fact that most of the largest banks in the world had aided Enron’s fraud. So, he put together a comprehensive briefing for the leadership of the Federal Reserve. At that meeting, the senior officials of the Federal Reserve and the senior Economists of the Federal Reserve did not criticise Enron and they did not criticise the banks that aided Enron’s frauds. They were enraged at the Supervisor. How dare he criticise banks? And this was the era—and continues—in the United States to be the era of reinventing government, which is a neoclassical, neoliberal, be soft on bankers. And I witnessed, personally, when our Washington staff came at a training conference and instructed us that we were to refer to banks as our clients. We were the regulators. And we were, not only, supposed to refer to them as clients, we were supposed to treat them as clients. Being a quiet type, I stood up and began protesting; and they simply shouted us down. [Applause]”
(c. 47:59) “So, this was occurring in 2001, 2002, 2003, 2004. At that point, Italy enters the picture. And Italy enters the picture because of Parmalat. And it enters the picture because, again, you have a massive accounting control fraud where the CEO is looting Parmalat and taking the money out of Italy to tax havens where he can hide it in a wave of special complex corporate forms designed to hide the fraud. And what does the Federal Reserve say about all of this? Well, first they brag about their ‘enforcement’ action. Note that they won’t name the large institutions:
"'In these enforcement actions, certain large institutions were required to revise their risk management practices where examiners found failures by these institutions to identify those transactions that presented heightened legal and reputational risk, particularly, in cases where transactions were used to facilitate a customer’s accounting or tax objective that resulted in misrepresenting the company’s true financial condition to the public and regulators.'
“So, this is another passage that requires translation, not
because it’s in English, but because it’s in gobbledygook.
So, what are they really saying? First,
they are bragging about an enforcement action that they tried
very hard not to bring and which was utterly useless.
Second, note what their concern is. Their concern is
heightened legal and reputational risk. They’re worried that
when the bank aids Enron or Parmalat’s frauds they’ll get caught
and then their reputations will suffer. They’re not worried
about Enron’s shareholders. They’re not worried about the
12,000 Enron employees who lose their jobs. They’re not worried
about Parma’s economy. None of that matters. They
don’t even discuss it. And they’re not worried about morality.
Call me old school, but I thought, when I was a regulator, if
the banks I was regulating were engaged in fraud, first, my job
was to stop it. Second, my job was to remove the CEO from
office. Third, my job was to help prosecute him and put him in
prison. And, fourth, my job was to sue him, so that he walked
away with not a lira or a euro or a dollar. But all of that is
"'We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts [...] due to the widely-accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves.'
specifically blames Greenspan and his deregulatory ideology.
That could have helped to avoid a catastrophe.
"Well, what about Europe? There was a conservative dissent to
the conclusions I’ve just read. They claimed that deregulation
could not have been a major cause of the crisis in [the U.S.A.]
because the crisis also occurred in Europe. That’s all they
said. They implicitly assumed that Europe must have been tough
on bank regulation.
(c. 55:30): “You’ve been listening to
William K. Black. Today’s show has been ‘Formula
for Fraud.’ William Black is Associate Professor of
Law and Economics at the University of Missouri, Kansas City.
He is a lawyer, academic, and former bank regulator and the
author of The Best Way to Rob a Bank is to Own One:
How Corporate Executives and Politicians Looted the S&L Industry.