Expect More De Facto Decriminalization of Elite Financial Fraud in 2011

By William Black On Dec 28, 2010

What’s coming in 2011? New Deal 2.0 asked Bill Black this question. He takes a hard look at the criminal justice system — and how financial fraudsters are beating it.

The role of the criminal justice system with regard to financial fraud by elite bankers in 2011 is likely to reprise its role last decade — de facto decriminalization. The Galleon investigation of insider trading at hedge funds will take much of the FBI’s and the Department of Justice’s (DOJ) focus.

The state attorneys general investigations of foreclosure fraud do focus on the major players such as the Bank of America (BoA), but they are unlikely to lead to criminal liability for any senior bank officials. It is most likely that they will lead to financial settlements that include new funding for loan modifications.

The FBI and the DOJ remain unlikely to prosecute the elite bank officers that ran the enormous “accounting control frauds” that drove the financial crisis. While over 1000 elites were convicted of felonies arising from the savings and loan (S&L) debacle,there are no convictions of controlling officers of the large nonprime lenders. The only indictment of controlling officers of a far smaller nonprime lender arose not from an investigation of the nonprime loans but rather from the lender’s alleged efforts to defraud the federal government’s TARP bailout program.

What has gone so catastrophically wrong with DOJ, and why has it continued so long? The fundamental flaw is that DOJ’s senior leadership cannot conceive of elite bankers as criminals. On Huffington Post, David Heath writes:

Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. An investor in loans who documents fraud can force a bank to buy the loan back. But convincing a jury that executives intended to make fraudulent loans, and thus should be held criminally responsible, may be too difficult of a hurdle for prosecutors. ‘It doesn’t make any sense to me that they would be deliberately defrauding themselves,’ Wagner said.”

Mr. Wagner is confused by his own pronouns: “It doesn’t make any sense to me that they would be deliberately defrauding themselves.” This direct quotation needs to be read in conjunction with the author’s description of his position: “banks lose money” when loans “turn out to be fraudulent.” Wagner was responding to a question about control fraud — frauds led by the person controlling the seemingly legitimate entity who uses it as a “weapon.” The relevant “they” is the person looting the bank — the CEO. The word “themselves” refers not to the CEO, but rather to the bank. The CEO is not looting the CEO; he is looting the bank’s creditors and shareholders. Two titles capture this well known fraud dynamic. The Nobel laureate in economics, George Akerlof, and Paul Romer co-authored Looting: the Economic Underworld of Bankruptcy for Profit in 1993 and I wrote The Best Way to Rob a Bank is to Own One (2005). The CEO becomes wealthy by looting the bank. He uses accounting as his ammunition because, to quote Akerlof & Romer, it is “a sure thing.” The firm fails (or in the modern era, is bailed out), but the CEO walks away wealthy.

Here is the four-part recipe for maximizing fraudulent accounting income in the short-term:

Grow extremely rapidly
By making bad loans at high yields
While employing extreme leverage, and
Providing only minimal loss reserves

A bank that follows this recipe is mathematically guaranteed to report record income in the near term. The first two ingredients in the recipe are linked. A bank in a reasonably competitive, mature market such as home mortgage lending cannot decide to grow extremely rapidly by making good loans. A bank can, however, guarantee its ability to grow rapidly — and charge a premium yield — if it lends to the tens of millions of people who cannot afford to own a home. Equally importantly, if many lenders follow the same recipe they will cause a financial bubble to hyper-inflate. Financial bubbles extend the lives of accounting control frauds by making it simple to refinance loans to those who cannot afford to purchase the asset. The longer that delinquencies and defaults can be delayed the more the CEO can loot the bank.

Note that the same recipe that maximizes short-term fictional income in the near term maximizes real losses in the longer term. Mr. Wagner is unable to understand that accounting control fraud represents the ultimate “agency” problem — the unfaithful agent (the CEO) enriches himself at the expense of the principals he is supposed to serve and the firm’s creditors. Agency problems are well known to white-collar criminologists, economists, lawyers that practice corporate, securities, or criminal law, and financial regulators. Yes, accounting control fraud causes the bank to suffer huge losses. The loans don’t “turn out to be fraudulent” — they are fraudulent when made. The recognition of the losses is delayed when an epidemic of accounting control fraud hyper-inflates a bubble, but the bubble will increase the ultimate losses. Sacramento, California is one of the epicenters of the mortgage fraud that drove the financial crisis, so Mr. Wagner’s lack of understanding of fraud mechanisms is particularly harmful.

Financial regulators are essential to prevent this kind of error by senior prosecutors. The regulators have to serve as the Sherpas for the criminal justice system to succeed against epidemics of control fraud. The FBI cannot have hundreds of agents expert in many hundreds of industries. The regulators have to do the heavy investigative lifting. They have the expertise and greater staff resources. The regulators also have to serve as the guides. Their criminal referrals have to provide the roadmaps that allow the FBI to conduct successful investigations. The regulators played this role successfully at key times during the S&L debacle, filing thousands of criminal referrals that led to over 1000 priority felony convictions. During the current crisis the OCC and the OTS – combined – made zero criminal referrals. None of the federal regulatory agencies appear to have enforced the regulatory mandate that federally insured depositories file criminal referrals – and noncompliance with that requirement was and is the norm. There is no indication that the FBI has demanded that the regulators enforce their rules.

Absent guidance and support from the regulators, the FBI turned to the worst conceivable source of guidance and support – the trade association of the “perps” — the Mortgage Bankers Association (MBA). The MBA, predictably, defined its members as the victims of mortgage fraud. The MBA invented a nonsensical definition of mortgage fraud which made accounting control fraud impossible. All fraud supposedly fell into one of two categories: “fraud for housing” or “fraud for profit.” The MBA members are, in fact, victims of accounting control fraud. The mortgage banks, however, do not set MBA policy. The CEOs of the mortgage banks determine MBA policy and they are not about to tell the FBI that they are the primary source of the epidemic of mortgage fraud. Similarly, they are not about to make criminal referrals, which might cause the FBI to investigate why some lenders made loans that were overwhelmingly fraudulent. MBA members virtually never made criminal referrals even though they made millions of fraudulent loans. Why don’t the victims make criminal referrals and help the FBI protect them from the frauds?

Why did an industry, home mortgage lending, which had traditionally been able to keep losses from all sources to roughly one percent suddenly begin to suffer 80-100 percent fraud incidence on “liar’s” loans? Why would an honest mortgage lender make “liar’s” loans knowing that doing so would produce intense “adverse selection” and a “negative expected value”? They would not do so. They were not mandated to do so by federal regulation or law. They were not encouraged to do so by federal regulation or law. They did so because their CEOs decided they would do so in order to maximize fictional income and real bonuses. The CEOs increased the number of liar’s loans they made after they were warned by the FBI that there was an “epidemic” of mortgage fraud and the FBI predicted it would cause an “economic crisis” were it not contained. The CEOs increased their liar’s loans after the MBA’s own anti-fraud experts stated that they deserved the name “liar’s” loans because they were pervasively fraudulent and after those experts said that “liar’s” loans were “an open invitation to fraudsters.” The industry’s formal euphemisms for liar’s loans were “alt-a” and “stated income” loans. None of this makes sense for honest CEOs.

The federal regulators have not made any public study of liar’s loans. The FDIC and OTS’ joint data system on mortgages is an anti-study — it uses a categorization system that ignores whether the loans were underwritten. This makes the data base useless for studying loans made without full underwriting — the loans that were overwhelmingly fraudulent and drove the crisis. Credit Suisse reported that mortgage loans without full underwriting constituted 49% of all new originations in 2006. If that percentage is even in the ballpark it indicates that that there were millions of fraudulent loans originated in 2005-2007. It is appalling that the regulators are not studying the facts necessary to understand the crisis and hold the perpetrator accountable.

Fortunately, the state attorneys general have studied these mechanisms and they have found that it was the lenders and their agents that overwhelmingly (1) prompted the false loan application data and (2) coerced appraisers to inflate market values. An honest lender would never engage in either practice or permit its agents to do so. The federal regulators, however, have spent their passion trying to preempt state efforts to protect borrowers. The federal regulators took no effective action in response to the State AGs’ findings.

The combined effect of these private sector, regulatory, and criminal justice failures has created a set of intellectual blinders that have caused DOJ to mischaracterize the nature of mortgage fraud. Attorney General Mukasey famously dismissed the epidemic of mortgage fraud as “white-collar street crime.” He did so in the context of refusing to establish a national task force against mortgage fraud. A national task force is essential in this crisis because of the national lending scope of many of the worst accounting control frauds. Attorney General Holder has maintained Mukasey’s passive approach to the elite frauds that drove the crisis.

The U.S. needs to take three major steps to be effective against the epidemic of accounting control fraud. First, DOJ needs to realize that it is dealing with accounting control fraud. That task is not terribly difficult. The criminology, economics, and regulatory literature — as well as the data on fraud and analytics are all readily available. The FBI must end its “partnership” with the MBA.

Second, the regulators need new leadership picked for a track record of success as vigorous regulators and a willingness to hold elites accountable regardless of their political allies. The regulators need to make assisting prosecutions, and bringing civil and enforcement actions, against the senior officers that led the control frauds their top priority. The regulators need to make detailed criminal referrals, enforce vigorously the regulatory mandate that insured depositories file criminal referrals, and prioritize banks that made large numbers of nonprime loans but few criminal referrals. The regulators need to work with DOJ to prioritize the cases. In the S&L debacle we used a formal process to create our “Top 100″ priority cases. The regulators need to investigate rigorously every large nonprime lending specialist by creating a comprehensive national data base. We have unique opportunities given the massive holding of nonprime paper by the Fed and Fannie and Freddie to create a reliable data base and use it to conduct reliable studies and investigations.

Third, the regulators and the DOJ need to partner with the SEC and the state AGs to share data (where appropriate under Grand Jury rule 6e). The federal regulators need to end their unholy war against state regulatory efforts and the SEC needs to end its disdain for the state AGs. The SEC needs to clean up accounting and the Big Four audit firms. The bank control frauds’ “weapon of choice” is accounting. The Big Four audit firms consistently gave clean opinions to even the most egregious frauds. Provisions for losses (ALLL) fell to farcical levels. Losses were not recognized. Clear evidence of endemic fraud was ignored.

What are the prospects for these three vital changes occurring in 2011? They are poor. There is no evidence that any of the three changes is in process. The new House committee chairs have championed even weaker regulation and have not championed the prosecution of Wall Street elites.

The media, however, has begun to pick up our warnings about the failure of the criminal justice response to the epidemic of fraud. Prominent economists, particularly Joseph Stiglitz and Alan Greenspan, have joined Akerlof, Romer, Galbraith,Wray, and Prasch in emphasizing the key role that elite fraud played in driving this crisis. Even Andrew Ross Sorkin, generally seen as an apologist for the Street’s elites, has decried the lack of prosecutions.

Our best bet is to continue to win the scholarly disputes and to continue to push media representatives to take fraud seriously. If the media demands for prosecution of the elite banking frauds expand there is a chance to create a bipartisan coalition in Congress and the administration supporting prosecutions. In the S&L debacle, Representative Annunzio was one of the leading opponents of reregulation and leading supporters of Charles Keating. After we brought several hundred successful prosecutions he began wearing a huge button: “Jail the S&L Crooks!” Bringing many hundreds of enforcement actions, civil suits, and prosecutions causes huge changes in the way a crisis is perceived. It makes tens of thousands of documents detailing the frauds public. It generates thousands of national and local news stories discussing the nature of the frauds and how wealthy the senior officers became through the frauds. All of this increases the saliency of fraud and increases demands for serious reforms, adequate resources for the regulators and criminal justice bodies, and makes clear that elite fraud poses a severe danger. Collectively, this creates the political space for real reform, vigorous regulators, and real prosecutors.

Cross-posted from New Deal 2.0

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.