A recent study confirmed that control fraud was endemic among our most elite financial institutions
The key conclusion of the study is that control fraud was “pervasive” (PSW 2013: 31).
“[A]lthough there is substantial heterogeneity across underwriters, a significant degree of misrepresentation exists across all underwriters, which includes the most reputable financial institutions” (PSW 2013: 29).
Finance scholars are not known for their sense of humor, but the irony of calling the world’s largest and most harmful financial control frauds our “most reputable” banks is quite wondrous. The point the financial scholars make is one Edwin Sutherland emphasized from the beginning when he announced the concept of “white-collar” crime. It is the officers who control seemingly legitimate, elite business organizations that pose unique fraud risks because we are so loath to see them as frauds.
The PSW 2013 study confirmed one form of control fraud and provided suggestive evidence of two other forms that I will discuss in a future column. The definitive evidence of control fraud that PSW2013 identifies is by mortgage lenders who made, or purchased, mortgages and then resold them to “private label” (non-Fannie and Freddie) financial firms who were creating mortgage backed securities (MBS). The deceit they documented by the firms selling the mortgage loans consisted of claiming that the loans did not have second liens. The lenders knowingly sold mortgages they knew had second liens under the false representations (reps) and warranties that they did not have second liens. (The authors confirm the point many of us have been making for years – the banks that fraudulently sold fraudulent mortgages did have “skin in the game” because of their reps and warranties. The key is that the officers who control the banks do not have skin in the game – they can loot the banks they can control and walk away wealthy.) The PSW 2013 study documents that the officers controlling the home lenders knew the representations they made to the purchasers as to the lack of a second lien were often false (pp. 2, 5 n. 6), that such deceit was common (p. 3), that the deceit harmed the purchasers by causing them to suffer much higher default rates on loans with undisclosed second liens (pp. 20-21), and that each of the financial institutions they studied – the Nation’s “most reputable” – committed substantial amounts of this form of fraud (Figure 4, p. 59).
The most interesting reaction to the PSW 2013 study is that of a fraud denier, The Economist’s “M.C.K.” In his January 25, 2013 column, (“Just who should we be blaming anyway?”)
M.C.K. argued that we should blame the victims of the fraud (“the real wrongdoers were not those who sold risky products at inflated prices but the dupes who bought them….”).
Only three weeks later, in his February 19, 2013 column discussing the PSW 2013 study, M.C.K. admitted that fraud by banks had played a prominent role in the crisis.
“BUBBLES are conducive to fraud. Buyers become less careful about doing their due diligence when asset prices are soaring and financing for speculation is plentiful. Unscrupulous sellers exploit this incaution. The victims are none the wiser as long as the bubble continues to inflate.”
I will explain in a later column why I believe this passage is badly flawed, but my point here is that the fraud denier and “blame the victim” columnist has recanted.
“During America’s housing bubble, mortgage originators were told to do whatever it took to get loans approved, even if that meant deliberately altering data about borrower income and net worth. Many argue that the banks that bundled those loans into securities deliberately and systematically misled investors and private insurers about the risks involved. It is easy to be unsympathetic in the absence of hard evidence. As I argued in a previous post , ‘investors were not forced to take the losing side of so many trades.’
While I stand by that view, a new paper by Tomasz Piskorski, Amit Seru, and James Witkin convincingly argues that banks deliberately misrepresented the characteristics of mortgages in securities they pitched to investors and bond insurers. The misrepresented loans defaulted at much higher rates than ones that were not—a result that would not be produced by random errors. Moreover, the share of loans that were misrepresented increased as the bubble inflated. The authors estimate that underwriters may be liable for about $60 billion in representation and warranty damages (emphasis in original).”
These two paragraphs are worth savoring in some detail. The central point we have been arguing for years is now admitted – and treated as a universally known fact: “mortgage originators were told to do whatever it took to get loans approved, even if that meant deliberately altering data about borrower income and net worth.” The crisis was driven by liar’s loans. By 2006, half of all the loans called “subprime” were also liar’s loans – the categories are not mutually exclusive (Credit Suisse 2007). As I have explained on many occasions, we know that it was overwhelmingly lenders and their agents (the loan brokers) who put the lies in liar’s loans.
The incidence of fraud in liar’s loans was 90% (MARI 2006). Liar’s loans are a superb “natural experiment” because no entity (and that includes Fannie and Freddie) was ever required to make or purchase liar’s loans. Indeed, the government discouraged liar’s loans (MARI 2006). By 2006, roughly 40% of all U.S. mortgages originated that year were liar’s loans (45% in the U.K.). Liar’s loans produce extreme “adverse selection” in home lending, which produces a “negative expected value” (in plain English – making liar’s home loans will produce severe losses). Only a firm engaged in control fraud would make liar’s loans. The officers who control such a firm will walk away wealthy even as the lender fails. This dynamic was what led George Akerlof and Paul Romer to entitle their famous 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” Akerlof and Romer emphasized that accounting control fraud is a “sure thing” guaranteed to transfer wealth from the firm to the controlling officers.
M.C.K. now admits that liar’s loans were endemically fraudulent and that it was lenders and their agents who “deliberately” put the lies in liar’s loans. Given the massive number of liar’s loans and the extraordinary growth of liar’s loans (roughly 500% from 200-2006) it is clear that that they were the “marginal loans” that caused the housing markets to hyper-inflate and created the catastrophic losses (in the form of loans, MBS, and CDOs) that drove the financial crisis. The key fact that must be kept in mind is that once a fraudulent liar’s loan begins with the loan officer or broker inflating the borrower’s income and suborning the appraiser into inflating the home appraisal the subsequent sales of that mortgage (or derivatives “backed” by the mortgage) by private parties will be fraudulent.
The authors of the PSW 2013 study expressly cautioned that their data allowed them to examine only two of the varieties of fraud. Lenders’ frauds in originating and selling liar’s loans were far more common, and far more harmful, than the two forms of fraud the PSW study was able to study. The many forms of mortgage frauds by lenders and their agents, of course, were cumulative and the frauds interact to produce greatly increased defaults.
The greatest importance of the PSW 2013 study is that even the fraud deniers have to admit that our most prestigious banks were the world’s largest and most destructive financial control frauds. Given this confirmation that the banks engaged in one form of control fraud in the sale of fraudulent mortgages (false representations about second liens), there is no reason to believe that their senior officers had moral qualms that prevented them from becoming even wealthier through the endemic frauds of liar’s loans and inflated appraisals. Appraisal fraud is almost invariably induced by lenders and their agents. Given the “pervasive” willingness of the officers controlling our most prestigious banks to enrich themselves personally by lying about the presence of second liens, they certainly cannot have any moral restraints that would have prevented them from creating the perverse incentives that caused loan officers and brokers to put the lies in liar’s loans and to induce appraisers to inflate appraisals – two other control fraud schemes that were far more “pervasive” (and even likelier to produce severe losses) than the two forms of fraud studied by the PSW 2013 authors.
Once the fraud deniers have to admit that one form of control fraud involving mortgages was “pervasive” among our most prestigious banks, it becomes untenable to ignore the already compelling evidence that other forms of control fraud involved in the fraudulent origination and sale of mortgages and mortgage derivatives were even more pervasive at hundreds of financial institutions. The PSW 2013 study destroyed the myth of the Virgin Crisis. It also exposes the falsity of the ridiculous “definition” of mortgage fraud that the Mortgage Bankers Association (MBA) foisted on the FBI and the Department of Justice that implicitly defines control fraud out of existence for mortgage lenders. Attorney General Holder and President Obama have no excuse for their faith in the Virgin Crisis, conceived without fraud and should repudiate the MBA definition immediately and train the regulators and agents to spot and prosecute the epidemic of control frauds that drove this crisis (and the S&L debacle and Enron-era frauds).
We know that leading up to the Great Financial Crisis Goldman Sachs used Accounting Control Fraud to make big profits for itself and its executives. Unfortunately, the fraud has been overlooked by both the White House and the Department of Justice in the interests of the banks’ not failing. It does not seem to matter that millions of ordinary people have lost their pensions and savings because of this banks’ actions.
Here’s another reminder of what accounting control fraud looks like:
Goldman Sachs: Doing “God’s Work” by inflicting the Wages of Sin Globally
The central point that I want to stress as a white-collar criminologist and effective financial regulator is that Goldman Sachs is not a singular “rotten apple” in a healthy bushel of banks. Goldman Sachs is the norm for systemically dangerous institutions (SDIs) (the so-called “too big to fail” banks). Impunity from the laws, crony capitalism that degrades democracy, and massive national subsidies produce exceptionally criminogenic environments. Those environments are so perverse that they produce epidemics of “control fraud.” Control fraud occurs when the persons who control a seemingly legitimate entity use it as a “weapon” to defraud. In finance, accounting is the “weapon of choice.” It is important to remember, however, that other forms of control fraud maim and kill thousands.
Large, individual accounting control frauds cause greater financial losses than all other forms of property crime – combined. Accounting control frauds are weapons of mass financial destruction. One of the crippling flaws of the World Economic Forum (WEF) is ignoring private sector control frauds. Control fraud makes a mockery of “stakeholder” theory. Accounting control fraud, for example, aims its stake at the heart of its stakeholders. The principal intended victims are the shareholders and the creditors (which includes the workers). Other forms of control fraud primarily target the customers. If the WEF wishes to effectively protect stakeholders it is imperative that they undertake a sea change and make the detection, prevention, and sanctioning of control fraud one of their central priorities. WEF does the opposite, it wishes away fraud with propaganda because the alternative is to admit that many of its dominant participants are the central problem – they are degrading the state of the world. In 2012, in response to endemic, elite financial frauds, the WEF declared the following without citation or reasoning in its 2012 report on “Rethinking Financial Innovation.”
6.1.1 Consumer Disservice
Malfeasance and outright fraud [in finance] are extraordinarily damaging but also, fortunately, extremely rare.
This passage Report demonstrates that WEF was unable to escape its dogmas and conduct a fundamental rethinking of what caused the crisis. In a criminogenic environment fraud is common, not “rare.” That is an empirical fact if one has competent investigators. The national commission to investigate the savings and loan debacle found that control fraud was “invariably” present “at the typical large failure.” We obtained over 1000 felony convictions in cases designated as “major” by the Justice Department. The (2001) Nobel Laureate in Economics, George Akerlof and Paul Romer published their classic article in 1993 entitled “Looting: the Economic Underworld of Bankruptcy for Profit” explaining accounting control fraud. Akerlof and Romer emphasized five points:
They had supplied the missing economic theory of control fraud, so economists no longer had an excuse for ignoring such frauds
The regulators in the field recognized that deregulation was “bound” to create widespread fraud because it created a criminogenic environment in which fraud paid
Accounting control fraud was a “sure thing” – if lenders followed the fraud “recipe” three results were certain: (a) the bank would promptly report record (albeit fictional) profits, (b) the controlling officers would promptly be made wealthy by modern executive compensation, and (c) the bank would suffer catastrophic losses
If many banks in the same area followed the same strategy the result would hyper-inflate a bubble and delay loss recognition because bad loans could be refinanced, and
Now that we had an economic theory confirming that the field regulators had gotten it right from the beginning the economists could prevent future fraud epidemics if they supported the regulators rather than pushing deregulation
The accounting control fraud recipe for a lender has four “ingredients”:
Grow like crazy by
Making really crappy loans at a premium yield, while
Employing extreme leverage, and
Providing only trivial reserves for the inevitable, massive loan losses
Akerlof had identified another control fraud variant – anti-purchaser fraud – in his seminal article on markets for “lemons.” He identified a critical principle in that article – the “Gresham’s” dynamic. Akerlof explained that if a seller gained a competitive advantage over his honest competitors through fraud market forces would become perverse and “bad ethics would drive good ethics from the marketplace.”
WEF has been acting for decades to make banking criminogenic. They have pushed the three “de’s” – deregulation, desupervision, and de facto decriminalization. They have favored executive compensation systems. They have pushed for ease of entry. And they have spread the myth that fraud by corporate elites is “rare.” WEF has optimized the intensely criminogenic environments that produce recurrent, intensifying fraud epidemics, bubbles, and financial crises.
WEF’s complacency about accounting control fraud has led to its embarrassing failures in finance. It’s “competitiveness” scales and “financial market development” scales have praised the most criminogenic financial systems – Iceland, Ireland, the UK, the U.S., and Spain – even as the largest banks in those Nations were (in reality) destroyed along with the much of the national economy. Similarly, the WEF’s “global risks” series has proven unable to identify the major financial risks until the hurricane has roared through the system. The central problems are the same – the WEF “stakeholder” premise and the WEF’s domination by powerful corporations is an elaborate propaganda apparatus that assumes away the reality of how CEOs running control frauds use compensation (and the power to hire, promote, and fire) and political power to deliberately create the perverse incentives that produce widespread fraud. The irony is that the WEF’s dogmas have encouraged elite frauds to drive stakes through the stakeholders.