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
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?
1. Crime displacement v. reduction: other
nations were more “criminogenic”
2. The global crisis is not over: The
EU/ECB/Euro quagmire; “periphery”, &
U.S. accounting gimmicks
3. China: the mother of all bubbles
4. Currency speculators could target you
5. “Can’t happen here”: Japan confident
Fraud is a “Sure Thing”
“Control fraud” is a “sure thing”
Finance: accounting = “weapon of choice”
Fraudulent lenders’ optimization recipe:
1. Grow massively
2. Make really bad loans with higher yield
3. Extreme leverage
4. Trivial loan loss reserves (ALLL)
Direct insider looting shows no fear of law
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?
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
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?
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
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”
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
Each was the largest financial scandal in
history – until it was quickly surpassed
Each driven by a control fraud epidemic
1. S&L debacle of the 1980s ($150 B)
2. Enron, WorldCom (>$1 T)
3. Nonprime (multi-trillion)
Failure to learn lessons due to
“theoclassical” economic myths
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”
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
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
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
Mission Accomplished
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
WaMu
Citicorp
Lehman
Goldman
Rating agencies
Fannie & Freddie
The most elite institutions in the world
Iceland Looked, Found Fraud
SIC found the Big 3 followed the recipe
for optimizing accounting fraud
1. Exceptional growth: 50%
2. Bad loans with high yields
3. Essentially infinite leverage
4. Loss reserves were a sick joke
Sure thing: record “profits” & losses
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
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
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
“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
“[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
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
Ireland
Anglo Irish Bank Scandal
Self-funded “capital”
Loans to Insiders & Cronies
Regulatory capture
Massive bubble
Secret, then public, bailouts
Spain
Originally touted as success story
Claim based on “dynamic provisioning”
But the loss reserves were perhaps onefifth as large as appropriate
Nest of insider loans, Cajas the worst?
Massive property bubble
Not recognizing losses; markets frozen
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
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
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
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”
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
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
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
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
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”
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
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
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
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”
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
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%.”
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
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
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?
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
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
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”
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
“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
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
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?
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
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
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
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”
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
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 “whitecollar street crime” – don’t
investigate, don’t indict
FBI “partners” with trade ass’n of perps
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
“[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
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
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
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
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….
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]
http://www.ojp.usdoj.gov/bjs/pub/press/cv07pr.htm
Property crime: never higher