Podcast

Bill Black: Our System is So Flawed That Fraud is Mathematically Guaranteed

How did we allow things to get this bad?
Friday, April 27, 2012, 3:09 PM

When plunder becomes a way of life for a group of men in a society, over the course of time they create for themselves a legal system that authorizes it and a moral code that glorifies it. ~ Frederic Bastiat

Bill Black is a former bank regulator who played a central role in prosecuting the corruption responsible for the S&L crisis of the late 1980s. He is one of America's top experts on financial fraud. And he laments that the U.S. has descended into a type of crony capitalism that makes continued fraud a virtual certainty while increasingly neutering the safeguards intended to prevent and punish such abuse.

In this extensive interview, Bill explains why financial fraud is the most damaging type of fraud and also the hardest to prosecute. He also details how, through crony capitalism, it has become much more prevalent in our markets and political system. 

A warning: There's much revealed in this interview to make your blood boil. For example: the Office of Thrift Supervision. In the aftermath of the S&L crisis, this office brought 3,000 administration enforcements actions (a.k.a. lawsuits) against identified perpetrators. In a number of cases, they clawed back the funds and profits that the convicted parties had fraudulently obtained.

Flash forward to the 2008 credit crisis, in which just the related household sector losses alone were over 70x greater than those seen during the entire S&L debacle. So how many criminal referrals did the same agency, the Office of Thrift Supervision, make?

Zero.

Similar dismal action was taken by such other financial regulators as the Office of the Comptroller of the Currency, the Federal Reserve and the FDIC. 

Where is the accountability? you may be asking. Or perhaps, How did we allow things to get this bad?

To find out, click the play button below to listen to Part I of Chris' interview with Bill Black.

Fraud is both a civil wrong and a crime, and it's when I get you to trust me and then I betray your trust in order to steal from you. As a result, there’s no more effective acid against trust than fraud, and, in particular, elite fraud, which causes people to no longer trust folks. Economies break down, families break down, political systems break down and such, if you don’t have that kind of trust. So that’s what fraud is.

But what my work focuses on is: What kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, systemic problems and such, arise when we have, what we call in criminology, control fraud. And control fraud simply means when you have a seemingly legitimate entity and the person who controls it uses it as a weapon to defraud others. And so in the financial sphere, the weapon of choice is accounting, and the losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.

So for example, in the current crisis, as with the prior ones, if you’re a lender, there’s an easy recipe for maximizing fake accounting income. And it goes like this. You need four ingredients:

  1. Grow like crazy...
  2. ...by making really, really crappy loans but at a premium yield (yield just means 'interest rate')...
  3. ...while employing extreme leverage, and...
  4. ...while setting aside only the most trivial reserves or allowances for the inevitable losses this kind of behavior produces.

George Akerlof and Paul Romer wrote the classic article in economics about this in 1993. And their title really says it all in terms of the dynamic: Looting the Economic Underworld of Bankruptcy for Profit. The idea is, you have a seemingly legitimate entity, the person at the top is looting it. They loot it by destroying it, but they walk away wealthy. Of course, in the modern era, we don’t necessarily, we may bail out the entity. So it may not even fail in that sense.

But here’s what Akerlof and Romer also said that was so critical as an understanding. They said these four steps, these four ingredients, it's just math. It is – and I’m quoting them now “a sure thing.” So you’re mathematically guaranteed, if you do these four things, to report, not just substantial income, but record levels of income. 

The big thing about the seemingly legitimate entity when the CEO is the crook is, first, everybody reports to the CEO ultimately, right? So the CEO is the point failure mechanism where if he or she goes bad, almost everything may go bad as well. So all those things that we call internal and external controls, all report to the CEO. And the CEO therefore can, as I’ll describe, use compensation, hiring, firing, praise, and such, to produce the environment that will create allies for his fraud.

Now, note that what I’m saying. The CEO, the art of this is not to defeat your controls. The elegant solution as in mathematics is to suborn the controls and turn them into your most valuable allies. And therefore, for example, when you’re running accounting control fraud where your weapon of fraud is accounting and that weapon of choice in finance is accounting, you’re going to want to hire the most prestigious accountants as your outside auditors because it is precisely their reputation that is most valuable when you can suborn them. And, they give you that clean opinion that you just described that will help you deceive other shareholders. So one enormous advantage is internal and external controls come to the CEO level.

A second incredible advantage is the CEO can optimize the firm as a weapon of fraud. And the CEO can do that. Basically, this falls into two big categories. One, you can put it in assets that have no readily verifiable market value, because then it's a lot easier to inflate asset valuations and to hide real losses. And the second thing you do is grow like crazy. And, of course, that is the essence of something your listeners have all heard about, and that is a Ponzi scheme. And so these accounting control frauds have strong Ponzi-scheme like elements, which is why they tend to cause such catastrophic losses.

Click the play button below to listen to Part I of Chris' interview with Bill Black (58m:28s):

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Or click here to read the full transcript

To listen to Part II, click here.


Bill Black is an associate professor of economics and law. He was the executive director of the Institute for Fraud Prevention from 2005-2007. He previously taught at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.

Professor Black was litigation director of the Federal Home Loan Bank Board, deputy director of the FSLIC, SVP and general counsel of the Federal Home Loan Bank of San Francisco, and senior deputy chief counsel, Office of Thrift Supervision. He was deputy director of the National Commission on Financial Institution Reform, Recovery, and Enforcement.

His book, The Best Way to Rob a Bank Is to Own One (University of Texas Press 2005), has been called “a classic.” Professor Black recently helped the World Bank develop anti-corruption initiatives and served as an expert for OFHEO in its enforcement action against Fannie Mae’s former senior management.

He teaches white-collar crime, public finance, antitrust law and economics, and Latin American development.


Our series of podcast interviews with notable minds includes:

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12 Comments

emaij's picture
emaij
Status: Member (Offline)
Joined: Jul 12 2010
Posts: 2
Excellent Interview

One of your best.

Jaime

KugsCheese's picture
KugsCheese
Status: Platinum Member (Offline)
Joined: Jan 2 2010
Posts: 677
Fundamental

The irony is (if we need simple regulations that are well-enforced) that the regulators (increased by GWB on count of the myriad regulatory sub-bodies) were captured as well and consequently aided and abetted the crime!   So the fundamental is fraud must be punished harshly: 1) no bailout;  2) prosecuted prison time.  In fact, large regulator bodies tend towards corruption.  KISS.

But we also have to accept that fraud can never be prevented.  Therefore punishment must be true.

Ergo, America is DONE!

KugsCheese's picture
KugsCheese
Status: Platinum Member (Offline)
Joined: Jan 2 2010
Posts: 677
Medicare

@34 minutes Bill Black describes why Medicare failed and Obamacare will fail.

KugsCheese's picture
KugsCheese
Status: Platinum Member (Offline)
Joined: Jan 2 2010
Posts: 677
Wild Stuff

@40 minutes.  Wild Stuff!

jberall's picture
jberall
Status: Member (Offline)
Joined: Apr 28 2012
Posts: 1
Oversight with regulation

I greatly enjoyed the interview but I can't help but wonder the economist was correct.  The free market would possibly overcome fraud.

HOWEVER, A true gold standard or commodity currency, with no central banks, andno  fractional reserve wh!ich are currently legal would not exist.  Thus so much of the fraud could never have happened to the extent in the first place.

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Online)
Joined: Feb 4 2010
Posts: 2438
Viking Law

The Vikings had much better laws.

In front of witnesses the agrieved draws a circle in the dirt. (Called "The Island") He then calls his opponent onto the island. Refusal to play brands one a coward and an outlaw. Only one man walks off the Island. We have allowed the criminal class to confuse us by conflating squeemishness with morality

. In Greece recently a man shot himself. What a waste. He could have done some good on his Island.

No laws are required, the market is self regulating. Re Orlov''s "Invisable hand attached to the invisable idiot."

This fog of deception can be cleared very quickly. As a bonus only the fit get to breed. With 9 billion the law of supply and demand kicks in. Humans loose their value. Economics 101.

wroth5's picture
wroth5
Status: Member (Offline)
Joined: Apr 16 2008
Posts: 21
Must read

This is a must read as are most of Doug Noland's weekly posts at Prudent Bear. Either you or Chris should interview him sometime.
http://www.safehaven.com/article/25236/the-many-facets-of-roro
 

Arthur Robey's picture
Arthur Robey
Status: Diamond Member (Online)
Joined: Feb 4 2010
Posts: 2438
Your Mental Claws.

It is only by comprehending our past that we can apprehend our present situation.

Once you have inwardly digested the mindset of the power that be by listening to Professor Michael Perlman then I suggest that you listen to the roll of debt in society by listening to Max Keiser talking to David Graeber the author of "Debt. The First 5 Thousand years."

You will understand that we are not in this situation by accident, but by design.

Any thought of "Fairness" is but the mewling of an infantile mind.

Friends, I cannot over-emphathise the importance of sharpening your mental claws.

Emmett's picture
Emmett
Status: Member (Offline)
Joined: Apr 30 2012
Posts: 2
Short-selling

If you truly want to stop financial fraud then the place to begin is to halt and make illegal the insane practice of short-selling. A three-year old knows if you "borrow" his or her ice-cream cone, take a big bite out of it and give it back to him or her that the remaining cone-if any-has been severely reduced in size and he or she has just been screwed. Stocks, commodities and currencies are no different because the principle is the same-borrow, deplete and return. An even more insidious perversion of this theft is naked short-selling where imaginary shares or commodities are borrowed (OTC stocks or the Crimex e.g.) depleted and most often never returned.

Simply set a date when all shorted items must be returned preceded by a halt of all shorting activity and watch the markets take off.  For those who claim that short-selling provides unreasonable valuations and bubbles from occuring I say that is under the purview of the normal supply and demand forces in a healthy, functioning economy.

Emmett's picture
Emmett
Status: Member (Offline)
Joined: Apr 30 2012
Posts: 2
100-day rule

After short-selling, day-trading is the second-worst scourge in the marketplace.  Some have made an art-form out of this practice by employing multiple trades in a single day using algorithms. As long as these people get their percentages they care not about the gyrations in prices caused by their practices. We call this the VIX or volitility index.

This practice can be stopped with the imposition of a 100-day rule which would require any investor to hold a stock, commodity or currency a minimum of 100 days and at least the passage of a single fiscal quarter. This eliminates the casino-investors and replaces them with market investors with a time horizon beyond a nano-second. Markets would "exhale" as the gamblers leave their favorite casino while true investors and the corresponding valuations once again take hold and the VIX flat-lines. Prices would be made by the normal supply and demand features in a healthy functioning economy which got perverted by short-selling and day-trading.

While the gamblers might initially leave the markets where are they going to go "invest" their money? Las Vegas, money markets, overseas...I think not. Some may gamble but few will accept low returns and physical separation from their assets. Eventually most will return to markets as investors on a level playing field.

calmcalm's picture
calmcalm
Status: Member (Offline)
Joined: May 1 2012
Posts: 2
Can't Find Part II

I click to listen to part 2 and it does not work.

Calm

calmcalm's picture
calmcalm
Status: Member (Offline)
Joined: May 1 2012
Posts: 2
Economic Crisis Began With Free Trade

I think you need to research as far back as 1980 (Free Trade) and when the U.S. Capitalists deliberately set out to abandon the North American Continent and walk away from every promise made to the working class since the end of World War II.

Free Trade was all about giving the rich folks an unfettered opportunity to move their wealth and assets offshore because the rich folks decided in 1980 to abandon the North American Continent, and to walk away from every promise made to the working class since the end of World War II.

The Rich Folks had no intention of sticking around while 15 thousand people lined up each day to collect on the retirement benefits which were promised to the working class.

The Rich Folks moved their accumulation of wealth offshore and out of reach to any worker who might want to sue and seize assets in lieu of broken promises.

This is exactly what the Capitalists did in 1870 as the British economy bankrupted itself and the Rich Folks in Britian moved their wealth into North America.

We did not see it happening because the U.S. Capitalists created an illusion of success with 15 trillion worth of Federal debt since 1980. (Not including 600 Trillion in Toxic Assets.) Prior to NAFTA being implemented, there was no U.S. Federal debt.

The largest U.S. export to China is scrap metal and scrap paper.
http://www.dotandcalm.com/calm-archive/EconomicNotes.html

Calm

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