Posts filed under “Bailout Nation”
The Finance sector is back to record revenue, and of course, record bonuses and pay. I was surprised to see how much greater the Commercial Bank revenue and comp was versus Wall Street totals. When you think about it, they have many more assets, transactions and commercial activity than Wall Street does, so it makes…Read More
“The F.C.I.C. is the first to take a close look at the missteps at Citigroup, which virtually every book about the financial crisis has overlooked. It is a devastating portrait of negligence at the top — including the once sainted Robert Rubin.” -Joe Nocera, NYT, Inquiry Is Missing Bottom Line > Say it ain’t so,…Read More
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He is a white-collar criminologist who has spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
By William K. Black
When Reputation becomes Ineffective or even Perverse
Control fraud also makes reputation perverse. Theoclassical economists predict that reputation trumps everything, even auditors’ conflicts of interest. This prediction has repeatedly been falsified by reality. The asserted reputational trump ignores crippling errors. Several theoclassical assumptions about reputation and fraud are implicit and interrelated. Implicit assumptions pose the greatest risk of error because the people making the assumption never had to defend the unstated assumptions. Reputation and fraud turn out to have an important, and complex, relationship. One cannot understand reputation without understanding fraud techniques. Common theoclassical assumptions, most of them implicit, about fraud and reputation include:
- An individual has a consistent set of behaviors that drive his reputation
- The public’s perception of an individual’s reputation is accurate
- Members of the public have a consistent perception of an individual’s reputation at any given time
- A good reputation can only be achieved through consistent good deeds
- Fraud is discovered because of its very nature
- Fraud is discovered because of “private market discipline”
- The people who lead frauds are discovered
- The people who lead frauds are sanctioned so that fraud does not “pay”
- All other market participants that might deal with the entity will learn promptly that it has engaged in fraud
- Other market participants will not aid or permit fraud by another party
- Other market participants will not deal with an entity with a reputation for acting fraudulently even if the entity has not (yet) defrauded those market participants
- The people who lead frauds suffer disabling damage to their reputation that makes it impossible for them to commit future frauds even if they are not sanctioned
- Elite financial firms and independent experts will not commit, aid, or permit frauds because of their interest in their reputations
- Elite financial firms and independent experts would lose their valuable reputations if they committed, aided, or permitted frauds
- The least likely persons to commit frauds in elite institutions are their senior leaders
- When CEOs set a “tone at the top” that tone emphasizes integrity and reputation
White-collar criminologists have found that each of these assumptions is unreliable. Economists rarely study fraud or read the criminology literature, yet they often have powerful ideological “priors” about fraud. Easterbrook & Fischel (1991), the deans of applying law and economics to the study of corporate law, exemplify each of these characteristics. They assert that “a rule against fraud is not an essential or … an important ingredient of securities markets.” That assertion is remarkable for its certainty, lack of exceptions, and certitude. It would be wonderful if the assertion were true. Fraud, one of history’s great scourges, would (like polio) be eradicated. Financial markets would be efficient. Bubbles would be much rarer and far less severe. Unfortunately, the assertion is also unsupported and unsupportable. Fischel was an expert for three notorious control frauds during the S&L debacle, where he employed the theories he and Easterbrook would soon write about in their 1991 treatise containing their remarkable assertion.
Individuals, entities, society, and market participants are all far more complex than theoclassical economists assume. It is normal that the same person is perceived differently by every person with a perception, and those differences can be polar. “Fraud” is one of the most variegated of activities. One common characteristic, however, is that fraudsters do not rely on fooling everyone. Many successful frauds, such as the Nigerian “419 frauds”, are obvious to nearly everyone, but “nearly” universal detection of the 419 frauds is not sufficient to prevent them from being profitable. Fraud detection is rarely universal because people vary in their susceptibility and because detection by one person typically fails to spread to most people.
When most people, including economists, think of “fraud” they generalize from what they know from personal life. Nigerian 419 scams, most things advertised on cable television after 10:00 p.m., and con jobs shown on television dramas are what the general public thinks of when they consider “fraud.” The nature of these frauds typically leads the victim to discover (albeit too late) that he has been defrauded. Victims of 419 frauds send “fees” or make “deposits” and do not get the $40 million in funds that the late oil minister allegedly stole from the Nigerian government. The “debt counseling” service charges its victims fees, falsely claims that one need no longer pay one’s creditors and leaves its victims even more insolvent.
These frauds, if they succeed, almost certainly will be discovered by the victim. (There are important exceptions – many fraudsters prey on victims suffering from the earlier stages of Alzheimer’s, those who are functionally illiterate in English, or are incapable of understanding financial matters. Fraudsters profit from their selective reputation with their peers as criminals by selling their mailing lists of vulnerable victims to other fraudsters.) The fraudsters who run the 419 and debt counseling scams know that most of their victims will become aware that they were defrauded. The fraudsters also know that they can continue to defraud others even though the victims learn that they were defrauded and even if the government closes their business. Entry is exceptionally easy for each of these common frauds. If the government shuts down a debt counseling scam it can create a new name and be in operation again within a week. If the fraudulent CEO were banned from the industry he would recruit someone to serve as his “straw” and be back in operation within a week.
Victims of some common, unsophisticated frauds typically do not discover that they have been defrauded. The classic example is the scam drug that promises to enlarge the penis. The victim buys the drug. He is desperate for the drug to work. It is easy for the victim to believe that the drug is working. The alternative is to feel inadequate, hopeless, and made a fool of by a con. This fraud illustrates a key point; an “unsophisticated” fraud can be highly successful because it rests on an insightful understanding of human nature and vulnerabilities.
Accounting control frauds closely approximate the perfect crime. To be a nearly perfect crime a control fraud must reduce the risks of regulatory and prosecutorial sanctions. They are normally not identified as frauds. Even when they are identified as frauds they are normally not sanctioned. Instead of destroying the CEO’s reputation, accounting control fraud normally creates the CEO’s undeserved reputation as a “genius.” This is a subject deserving of extended treatment in future columns, so I will only summarize the key points here in the context of mortgage lending.
- Everyone is reluctant to view a seemingly legitimate lender as a criminal enterprise
- The fraudulent CEO increases this reluctance by mimicking many corporate mechanisms
- No overt conspiracy is required – the CEO creates the perverse incentives and uses his ability to hire, promote, compensate, discipline, and fire to ensure that the recipe will be implemented at the firm and by its loan brokers and that the independent experts will bless the fraudulent valuations and loss reserves
- The CEO can quickly convert large amounts of firm assets to his personal benefit –sufficient to make him wealthy – through seemingly normal corporate compensation mechanisms driven by the record (fictional) income generated in the short-term by employing the recipe
- If there is a bubble, particularly one hyper-inflated by an epidemic of accounting control fraud, then the lender’s bad loans can be refinanced and the record income created by the recipe can be continued beyond the short-term
- The firm fails eventually, but a CEO can always offer a non-fraudulent explanation for a bank failure. This is particularly true when an epidemic of accounting control fraud hyper-inflates a bubble and triggers a severe recession.
Control frauds exploit “agency” problems in order to turn reputation perverse. The Big Four audit firms do have a substantial financial interest in their reputations. The Big Four audit firms are able to charge far more for their audits than can second tier firms. Unfortunately, the more valuable the audit firm’s reputation the more value the audit partner can extract by “selling” that reputation by blessing an accounting control fraud’s financial statements. White-collar criminologists have found that the theoclassical assumptions about top tier audit firms are false.
Back in 2009, I published a list of causal factors of the financial crisis: Who is to Blame, 1-25. It was culled from Chapter 19 of Bailout Nation. For this morning’s exercise lets see where the FCIC and BN differ in emphasis and causal factor. 1. Federal Reserve Chairman Alan Greenspan: We each agree that…Read More
So far, only the New York Times has the story — nothing from the WSJ or Bloomberg yet: The FCIC found that the crisis was caused by “widespread failures in government regulation, corporate mismanagement and heedless risk-taking by Wall Street” — but I expect this to be explosive in advance of the actual FCIC release…Read More
More to come after I digest this, but so far it looks spectacular . . . Highlights from the NYT: “The 2008 financial crisis was an “avoidable” disaster caused by widespread failures in government regulation, corporate mismanagement and heedless risk-taking by Wall Street, according to the conclusions of a Congressional inquiry.” The government commission that…Read More
I never want to make excuses for the excesses of Wall Street or the horrific judgment exercised by iBank management — you cannot, its inexcusable — but it long past time we begin holding the Street’s grand enabler’s responsible for their actions. Which brings me to the accountants. The New York attorney general may be…Read More