Bill Black: Our System is So Flawed That Fraud is Mathematically Guaranteed
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?
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:
- Grow like crazy...
- ...by making really, really crappy loans but at a premium yield (yield just means 'interest rate')...
- ...while employing extreme leverage, and...
- ...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):
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:
- Harvey Organ
- Paul Tustain
- Khosla Ventures
- Charles Biderman
- Gretchen Morgenson
- Chris Martenson (answers your questions - part 2)
- Marc Faber
- Robert Mish
- Erik Townsend
- Ben Davies
- Jim Rickards
- Chris Martenson (answers your questions)
- Charles Eisenstein
- James Dines
- John Mauldin
- Jack Keller
- Rick Rule
- Robert Rapier
- Gordon Chang
- Turd Ferguson
- Eric Janszen
- Paul Brodsky
- Carolyn Baker
- David Stockman
- Rob Hopkins
- Joel Salatin
- Charles Hugh Smith
- Frank Barbera
- Nate Hagens
- David Morgan
- James Turk
- Eric Sprott
- John Rubino
- Addison Wiggin
- Simon Black
- Axel Merk
- Paul Tustain
- Francis Koster
- Bud Conrad
- John Williams
- Robert McFarlane
- David Collum
- Joe Saluzzi
- Jim Rogers
- Bill Fleckenstein
- Marc Faber
- Willet Kempton
- Dan Ariely
- Ted Butler