Epidemics of 'Control Fraud' Lead to Recurrent, Intensifying Bubbles and Crises

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Control Fraud

Notes

“Control frauds” are seemingly legitimate entities controlled by persons that use them as a fraud “weapon.”

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Fraudulent CEOs that follow this strategy are guaranteed to obtain extraordinary income while minimizing the risks of detection and prosecution.

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When many firms follow the same optimization strategy in the same financial field a financial bubble will arise, extend, and hyper-inflate.

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Modern Finance Theory and Its Implications for the Developing New Criminology

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even the weakest meaningful definition requires that the markets (1) not make systematic pricing errors and (2) move consistently towards more accurate pricing

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each of the signals that economists asserted could only be sent by honest companies were routinely sent by accounting control frauds.

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Bubbles are impossible if markets are efficient because they represent systematic pricing errors

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White-collar Criminology’s Struggle to Address Elite Financial Frauds

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the embezzlers he studied are exceptionally unlike the elites that Sutherland was concerned about

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the fraud triangle’s predictive failures are at their worst when applied to accounting control fraud. Outside auditors’ central priority should be accounting control fraud – which causes greater losses than all other forms of corporate fraud combined

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The officers that lead control frauds have always thought “outside the triangle”

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Elite white- collar criminals are generally highly intelligent and older. They demonstrate higher impulse control than the general population. On many dimensions, elite white-collar criminals are the antithesis of Wilson’s & Herrnstein’s and Gottfredson’s and Hirschi’s supposed universal criminal traits.

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the ultimate triumph of elite white-collar criminals is to have the state define actions as at most unlawful – not criminal.

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Wheeler & Rothman Point the Way

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[M]ore thought should be given to alternative mechanisms of control. Is it possible, for example, to develop better warning signs that would indicate when a company is in financial trouble and, therefore, more likely to adopt illegal solutions to its problems? Given the power of the organizational form, should we create more windows into the organization so that outsiders can see more clearly what insiders are doing? Can we make better use of the accountants and lawyers whose presence lends legitimacy to organizational conduct? Maybe we can predict under what circumstances organizations will be more likely to violate the law. Perhaps more sophisticated indicators can be developed, allowing regulatory and other enforcement workers to focus all-too-limited investigative resources in areas where they will be most effective (1982: 1425- 1426).

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analogs to “ballistics laboratories” to analyze major crimes by organizations.

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The Confluence of Research Streams that Generated a New Approach to the Study of Elite White-Collar Criminology

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Adverse selection:

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Moral hazard:

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shareholders of an insolvent corporation have no downside risk and immense upside potential.

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Agency cost theory:

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shareholders will bear costs designed to increase the chance that the officers and directors will act in the shareholders’ interests, e.g., by providing bonuses based on performance.

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Criminologists, Regulators & Economists Combine to Create a New Criminology of Elite White-Collar Crime

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struggled to find regulators and prosecutors that could explain how the frauds were using the S&L as a weapon.

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led them to coin the term “collective embezzlement.”

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“profits” allow the person controlling the corporation to convert its assets to his personal benefit through seemingly normal corporate compensation mechanisms

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Embezzlement, by contrast, requires the employee to take an unlawful action

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The term “unlawful risk taking” was also misleading.

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two difficulties with the concept of unlawful risk taking. First, it wasn’t unlawful.

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Second, it didn’t describe a real strategy.

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The Conventional Economic Wisdom Did not Recognize that Criminology had Falsified the Efficient Markets Hypothesis

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Criminologists argued that control frauds did not simply evade effective private market discipline, but actually profited from it because even uninsured creditors and shareholders funded the control frauds’ growth.

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Optimizing Accounting Control Fraud

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Accounting fraud is a sure thing – not a “risk”

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deliberately making uncreditworthy loans optimizes short-term accounting profits

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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

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Optimizing the Ability to Make Bad Loans

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Creating a Corrupt “Tone at the Top” Suborns Internal Controls

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A large firm obviously cannot send a memorandum or email message to a thousand employees instructing them to commit accounting fraud. The firm can, however, send the same message without any risk of criminal prosecution through its compensation system.

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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%

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The CEO simply communicates – by paying large bonuses based on fictional profits – that he does not care how they meet the target. This can create a perfect crime for it gives the CEO ideal deniability.

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paying loan officers bonuses on the basis of loan volume irrespective of loan quality.

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can also use the power to hire, fire, reward, and discipline to break any resistance to making bad loans. The best employees will reject bad loans – and be criticized and overruled by their superiors. If they persist in rejecting bad loans they can be disciplined or fired – and their vacant cubical will serve as a warning to their peers.

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Using Compensation to Suborn External Controls

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Moody’s (2007) reports how much business it lost when it sought to give more realistic (i.e., lower) ratings to the most toxic tranches of toxic CDOs:

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our competition, Fitch and S&P, went nuts. Everything was investment grade. We lost 50% of our coverage

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90 percent of appraisers reported that mortgage brokers, real estate agents, lenders and even consumers have put pressure on them to raise property valuations

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75 percent of appraisers reported "negative ramifications" if they refused to cooperate

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"You show me an honest appraiser and I'll show you a [financially] poor one"

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Why did so many lenders directly, or indirectly through their agents, push for inflated appraisals when inflated appraisals are disastrous for the lender?

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Accounting control frauds do not act to further the best interests of the lender. They maximize the CEO’s interests at the expense of the lender.

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Accounting control frauds normally control their boards of directors and cause their compensation to be based largely on short-term accounting gains and to be exceptionally large if the firm is highly “profitable.”

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They can get rich enough through a year or two of accounting fraud to retire wealthy. The firm’s failure does not mean that the fraud mechanism has failed.

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Why Individual Control Fraud Failures Can be Massive

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Why Epidemics of Control Fraud Occur and Cause Recurrent, Intensifying Crises

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The initial clustering produces “learning effects.” Other CEOs observe that the initial frauds’ business practices produce guaranteed, record profits and minimal reported delinquencies and losses – followed by exceptional bonus payments to the officers.

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cheaters are guaranteed to prosper while honest CFOs will tend to be driven out of the marketplace.

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The Epidemic of Nonprime Mortgage Fraud that Drove the Crisis

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"Any request for loan level tapes is TOTALLY UNREASONABLE!!!. … Most investors don't have it and can't provide it. … we MUST produce a credit estimate. … It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so."

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The fact that Fitch could identify the frauds simply through a file review without any investigation tells us something else about the accounting control frauds. They, correctly, determined that the risk of detection of their frauds was so minimal that it was not even worth the minimal cost of creating fictional, but credible, financial statements.

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The FBI indicates that the difficulty is not the lack of criminal culpability on the part of the nonprime lending specialists, but rather acute “systems capacity” problems.

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