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How to Prevent the Recurrent, Intensifying Global Bank Crises. The Banks Association of Turkey Istanbul, Turkey June 14, 2010. William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City. Discussing What We Got Wrong. Won’t try to tell you about Turkey

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william k black associate professor of economics and law university of missouri kansas city

How to Prevent the Recurrent, Intensifying Global Bank Crises

The Banks Association of Turkey Istanbul, Turkey June 14, 2010

William K. Black

Associate Professor of Economics and Law

University of Missouri – Kansas City

discussing what we got wrong
Discussing What We Got Wrong

Won’t try to tell you about Turkey

Emphasis is on our mistakes, in the hopes you can avoid them

Will also look briefly at some other nations I’ve studied

You decide, and we can discuss, whether our errors are relevant to Turkey

caution no crisis in turkey
Caution: No Crisis in Turkey?
  • Crime displacement v. reduction: other nations were more “criminogenic”
  • The global crisis is not over: The EU/ECB/Euro quagmire; “periphery”, & U.S. accounting gimmicks
  • China: the mother of all bubbles
  • Currency speculators could target you
  • “Can’t happen here”: Japan confident
fraud is a sure thing
Fraud is a “Sure Thing”

“Control fraud” is a “sure thing”

Finance: accounting = “weapon of choice”

Fraudulent lenders’ optimization recipe:

  • Grow massively
  • Make really bad loans with higher yield
  • Extreme leverage
  • Trivial loan loss reserves (ALLL)

Direct insider looting shows no fear of law

recipe for catastrophe
Recipe for Catastrophe

The same recipe maximizes (fake) record profits and (real) catastrophic loss

“Criminogenic environments” lead to fraud epidemics & hyper-inflated bubbles

“Echo” epidemics: fraud epidemics are criminogenic – cause/permit epidemics

Deceit erodes trust: markets can fail

what is control fraud
What is Control Fraud?

Criminology: The persons controlling a seemingly legitimate entity use it as a “weapon” to defraud. The Best Way to Rob a Bank is to Own One (Black 2005)

Economics (Akerlof & Romer 1993): “Looting: Bankruptcy for Profit”

Superb theoretical & empirical support by top scholars & regulators – ignored

past turkish crises
Past Turkish Crises

Fraud and Banking Crises: Evidence

from Micro-level Transactions Data

  • H. Bartu Soral, Talan B. İşcan, and Gregory Hebb: Dalhousie University
  • December 1, 2003

Related lending & “back-to-back” loans

Esbank: self-funded “capital”: authors find Akerlof & Romer style “looting”

lessons learned
Lessons Learned?

The Turkish Banking Sector: Challenges &

Outlook in Transition to EU Membership

Alfred Steinherr, Ali Tukel and Murat Ucer

BEEP briefing n°9: December 2004

Recurrent Turkish banking crises

1999-2000 one of the most severe in world

But sees great regulatory improvement: hopes are EU accession & Basel II

such frauds can maim kill
Such Frauds Can Maim & Kill

Chinese infant formula

New York inspector: asbestos & lead

Turkish building inspectors: seismic risk

Fake anti-malarial drugs

Unlawful disposal of toxic waste

Blood diamonds

Deforestation: fake certificates

gresham s dynamic
“Gresham’s Dynamic”

George Akerlof’s 1970 “lemons” article (Nobel Prize, Economics, 2001)

When cheaters gain a competitive advantage: drive honest from market

Markets become intensely perverse

Erosion of ethics will spread

Particularly if done by elites

Makes reputation perverse

three recent u s crises
Three Recent U.S. Crises

Each was the largest financial scandal in history – until it was quickly surpassed

Each driven by a control fraud epidemic

  • S&L debacle of the 1980s ($150 B)
  • Enron, WorldCom (>$1 T)
  • Nonprime (multi-trillion)

Failure to learn lessons due to “theoclassical” economic myths

fraud in the s l debacle

Fraud in the S&L Debacle

“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)

finding the facts autopsies

Finding the Facts: “Autopsies”

We reviewed every failure

NTSB reviews every plane crash

Didn’t rely on false accounting

Optimization led to patterns: analytics

Knew econometrics were perverse

Understanding fraud schemes essential

Our findings enraged industry, politicians and many regulators

enron era frauds
Enron era Frauds

All accounting control frauds

Over $6 trillion loss of market capitalization

Led to Sarbanes-Oxley law (no input from criminologists, doesn’t address problem)

Helped lead to Greenspan supporting particularly expansive monetary supply

current u s crisis ignores fraud
Current U.S. Crisis Ignores Fraud

Despite prior control fraud epidemics

Absurd framing: “perfect storm”

FBI (2004) “epidemic” of mortgage fraud

Predicted a crisis if fraud increased

Anti-regulators triumph

No criminal referrals

No convictions, indictments, arrests

real regulation can work
Real Regulation Can Work

Used “markers” to identify control frauds

Regulators recognized control frauds were the key: served as “Sherpa”

1000 FBI agents & top agency priority

>1000 priority felony convictions

Greatest success v. elite criminals

Prevented nonprime crisis: 1990-91

where we look we find
Where We Look, We Find





Rating agencies

Fannie & Freddie

The most elite institutions in the world

iceland looked found fraud
Iceland Looked, Found Fraud

SIC found the Big 3 followed the recipe for optimizing accounting fraud

  • Exceptional growth: 50%
  • Bad loans with high yields
  • Essentially infinite leverage
  • Loss reserves were a sick joke

Sure thing: record “profits” & losses

but sic calls it bad luck
But SIC Calls it Bad Luck

“The situation in the international financial markets in the autumn of 2008 has been described as the perfect storm. It was under this situation that the three Icelandic banks, Glitnir, Landsbanki and Kaupthing Bank, collapsed at the beginning of October 2008.”

gambling metaphor
Gambling Metaphor

As the winter of 2007-2008 progressed, the banks were very dependent of their share prices and largest debtors. Rather than hanging on to their liquid assets, the banks provided substantial amounts as loans for own shares and to support their principal owners. Kaupthing Bank in particular loaned large amounts for the purchase of own shares. The banks were betting everything on life.

bad luck
Bad Luck

Mark Flannery’s “Post-Mortem” (p. 91):

“Any firm’s failure reflects some combination of bad luck and bank management.”

No: Not underwriting = adverse selection

Creates negative expected value

Fake profits and real losses are certain

bad loans are best

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 1994)

gresham s the auditors

Gresham’s & the 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)

Control frauds are criminogenic; they can cause “echo” epidemics by creating these perverse incentives

accounting cover ups
Accounting Cover Ups

The Icelandic scams are old scams

“Dirt for stock”: self-funded (fictional – not “weak” capital)

Self-funded loans

Refinancing: “A rolling loan gathers no loss”

Guaranteed “profit” w/o losses


Anglo Irish Bank Scandal

Self-funded “capital”

Loans to Insiders & Cronies

Regulatory capture

Massive bubble

Secret, then public, bailouts


Originally touted as success story

Claim based on “dynamic provisioning”

But the loss reserves were perhaps one-fifth as large as appropriate

Nest of insider loans, Cajas the worst?

Massive property bubble

Not recognizing losses; markets frozen

fraud epidemics bubbles
Fraud Epidemics & Bubbles

Perverse incentives are the key

The most criminogenic environment loses

Particularly if entry is easy: regulation

Some assets are superior “ammunition” for accounting fraud: “liar’s loans”

Causes frauds to cluster: industry/assets

Recipe causes bubbles to hyper-inflate

echo epidemics
Echo Epidemics

Nonprime lenders: primary epidemic

Create criminogenic environments

Upstream: buy anything; pay for yield

Must gut underwriting & suborn controls

Necessary & sufficient to cause upstream

Necessary, but not sufficient, to cause downstream epidemic of CDOs & CDS

adverse selection
Adverse Selection

Crises began when the loans were made

Not underwriting causes adverse selection

That causes negative expected value

It necessitates accounting fraud: ALLL

Honest accounting would show the loans were losses when they were made

The firm fails; the fraud scheme succeeds

perfect storms black swans
Perfect Storms & Black Swans

Both assume risk is exogenous

We spawn the black swans & storms through our perverse market incentives

Control fraud creates risk, but “risk” is the wrong lens: record (fictional) profits and (real) catastrophic losses are certain for looting control frauds; the only issues are timing and the magnitude of the loss

provide fraud markers
Provide Fraud “Markers”

Metaphor from pathology: fraud “markers”

No honest secured lender would routinely:

  • Inflate appraisal values
  • Knowingly permit inflated appraisals
  • Create severe adverse selection
  • Create a Gresham’s dynamic
  • Reduce ALLL while increasing risk

Regulation = easy to prosecute cover ups

lying becomes endemic
Lying Becomes Endemic

Upstream: appraisers, loan brokers

Primary: loan officers, auditors

Downstream: rating agencies, poolers

Financial version of “don’t ask; don’t tell”

Lying about big things: farblondget

Fire the honest; promote the worst

Gresham’s dynamic only needs a minority

markets fail rather than clear
Markets Fail Rather than Clear

Fraud: create, then betray, trust

Fraud is worst “acid” for eroding trust

Trust often vital, e.g., in markets

Gresham’s can make fraud endemic

What if one bottle in 100 is contaminated?

Markets can fail rather than clear

Nonprime secondary market

private market discipline
Private Market Discipline

Control frauds falsify modern finance

Therefore, they must not exist

  • “a rule against fraud is not an essential or … an important ingredient of securities markets” (Easterbrook & Fischel 1991)
  • Greenspan: no need to regulate v. fraud
  • Patrick Parkinson: no derivatives fraud
na ve oxymoron
Naïve Oxymoron

Control frauds turn sources of “private market discipline” into fraud allies

They fund the frauds’ growth

They’re vectors spreading fraud epidemics

Caused downstream CDO/CDS epidemic

Don’t ask; don’t tell – so you can sell

Subordinated debt: failed utterly

don t ask don t tell

“Don’t Ask; Don’t 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 ’01, emphasis in the original.]

criminogenic economists
Criminogenic Economists

Complacency: we know it can’t happen

Deregulation, non-regulation, desupervision

Modern compensation

  • Executive
  • Professional
  • Managerial

U.S. exports these failed economic theories that cause recurrent, intensifying crises

ideology methodology theory
Ideology, Methodology & Theory

Theoclassical ideology: anti-governmental

Efficient contracts/markets hypotheses falsified by criminology 60 years ago

Fischel wrote after he’d worked for frauds

Embrace of econometrics, which must get the “sign” wrong in accounting control fraud epidemics, leading to criminogenic policies

the anti regulators rise
The Anti-Regulators Rise

Bush’s “Wrecking Crew” (Tom Frank)

If “the government is the problem”…

And private market discipline is ideal

Then appoint anti-regulators to lead

Harvey Pitt & “Chainsaw Gilleran”

The reanimation of Dochow

regulatory black holes
Regulatory “Black Holes”

Theoclassical economics’ bipartisan triumph

Repeal of Glass-Steagall: Lehman, et alia

Commodities Futures Modernization Act

Endorsing “competition in laxity”

Fed refuses to use HOEPA (1994) authority

Preempt state rules v. predatory lending

Crippling the OECD initiative v. tax havens

ask the experts how it s done

Ask the experts how it’s 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

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%.”

Do as I say, not as I do

the anti canary

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, emphasis in original.)

s ls mission impossible

S&Ls: Mission Impossible

Dr. Pratt: federal/state competition in laxity

Key state regulators & whores

Every economist against reregulation

Administration: Give Keating control of agency & prosecute Chairman Gray

Majority of House cosponsors & Speaker

“Keating Five”: A Senator for each finger

Lobbyists, media & many staff opposed

halted a raging fraud epidemic
Halted a Raging Fraud Epidemic

300 control frauds growing at 50%

300 new TX & CA charters (+200 annually)

Would have caused >$1T losses & crisis

Done in impossible circumstances

Cost several careers: I’m a miracle survivor

Speaker Wright; Keating suit for $400 MM; hired private investigators twice; “Highest priority. Get Black … Kill Him Dead.”

how did we succeed
How Did We Succeed?

Independent regulatory agency essential

Leadership the key: Gray’s hired those with track record of success & guts

Learned via “autopsies”: patterns/markers

Knew econometrics studies perverse

Prioritized the frauds while “successful”

Growth limit targets frauds’ “Achilles’ heel”

Contained nonprime w/o crisis: 1991-1992

jailed the control frauds
Jailed the Control Frauds

Regulators recognized control frauds were the key

We served as “Sherpa”

1000 FBI agents & top agency priority

>1000 priority felony convictions of senior insiders and their accomplices

Greatest success v. elite criminals

we need to jail the crooks
We Need to Jail the Crooks

To deter & to stop Gresham’s dynamic

Investigations produce the facts and change understanding of crisis

Turns it from an arcane story to front page

Creates the political space for real reform

Discredits the crooks & apologists

Put a stake in theoclassical economics

mortgage fraud epidemic

Mortgage Fraud “Epidemic”

FBI warned of it, and coming crisis: 9.04

80% of losses induced by lenders

FY07; 08: >50K; >63K criminal referrals

Investment banks (03-07): 36 referrals

Unregulated: 80% nonprime loans

Most frauds undiscovered; referrals are exceptionally uneven & biased

fbi finds control fraud

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” (FBI: Pistole 2009)

the facts it s control fraud
The Facts: It’s Control Fraud

Bo Cutter (Warburg Pincus 2009):

by 2006 and early 2007 everyone thought we were headed to a cliff….The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.

trivial loss reserves

Trivial Loss Reserves

Reserves must track risk: GAAP

Bank risk was skyrocketing

A.M.Best (2/06; 3/07): “new record lows for the last four years.” Matches low in 1985: last disaster

Reserve ratio (2005): 1.21% of loans

Losses on foreclosed nonprime loans are running >50% for S&Ls

Mortgage fraud = accounting fraud

drunken cockeyed optimists

Drunken Cockeyed Optimists?

Look for control fraud “markers”

Adverse selection = negative value

Appraisal fraud is a fraud & a marker

Both markers are endemic

Consistent pattern of nonprime lenders and purchasers acting in a manner that was optimal for control frauds and suicidal for an honest firm

conscious adverse selection
Conscious Adverse Selection

Optimizes accounting fraud & bonuses

“Stated income and reduced documentation loans speed up the approval process, but they are open invitations to fraudsters.” (MARI 2006).

liar s loan was a hint
“Liar’s loan” was a Hint

When the stated incomes were compared to the IRS figures: [90%] of the stated incomes were exaggerated by 5% or more. [A]lmost 60% were exaggerated by more than 50%. [T]he stated income loan deserves the nickname used by many in the industry, the “liar’s loan” (MARI 2006).

appraiser coercion fraud

Appraiser Coercion = Fraud

Deliberately created Gresham’s dynamic

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

Demos warned of disaster in 2005

disconcerting results

“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]

why elites loot with impunity

Why Elites Loot with Impunity

FY 1992: 2,926 positions (992 agents, 655 attorneys, and 1,279 other); 2,795 FTE; $265M

FY 2008: 160 FBI agents

Virtually no regulatory criminal referrals

Bush’s AG: mortgage fraud is “white-collar street crime” – don’t investigate, don’t indict

FBI “partners” with trade ass’n of perps

control fraud should be hard

Control Fraud Should be Hard

Can’t send a memo to 1000 employees ordering accounting frauds be done

CEO can’t stick his hand in the till

A dozen layers of controls v. fraud

Private market discipline

American tradition of whistleblowers

Civil suits

Regulators, prosecutors and the FBI

gresham s grim dynamic

Gresham’s 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]….”

[Moody’s 2007]

four failed paradigms

Four Failed Paradigms

Efficient markets & contracts

Private market discipline: perverse

Agency cost: shareholders can’t stop accounting control fraud

Corporate governance: One can’t “govern” control frauds

Business ethics: assumes the “tone at the top” is honest

add criminology to economics

Add Criminology to Economics

Incentives: the core of economics and white-collar criminology

Fraud epidemics aren’t random

The factors that produce criminogenic environments are clear

The incentives are perverse, but they have predictable marginal effects

Why don’t the SEC & FDIC have “Chief Criminologists”?

fraud experts fooled

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).

failure is an option

Failure is an Option

CEO can profit enormously despite firm’s failure

The firm’s 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

if you don t count it

If you don’t 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]


Property crime: never higher