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William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City The Banks Association of Turkey Istanbul, Turkey June 14, 2010 How to Prevent the Recurrent, Intensifying Global Bank Crises

William K. Black Associate Professor of Economics and Law University of Missouri – Kansas City

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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. - PowerPoint PPT Presentation

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Page 1: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

William K. BlackAssociate Professor of Economics and Law

University of Missouri – Kansas City

The Banks Association of Turkey Istanbul, Turkey June 14, 2010

How to Prevent the Recurrent, Intensifying Global Bank Crises

Page 2: 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 TurkeyEmphasis is on our mistakes, in the

hopes you can avoid themWill also look briefly at some other nations

I’ve studiedYou decide, and we can discuss, whether

our errors are relevant to Turkey

Page 3: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 bubbles4. Currency speculators could target you5. “Can’t happen here”: Japan confident

Page 4: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Fraud is a “Sure Thing”“Control fraud” is a “sure thing”Finance: accounting = “weapon of choice”Fraudulent lenders’ optimization recipe: 1.Grow massively2.Make really bad loans with higher yield3.Extreme leverage4.Trivial loan loss reserves (ALLL)Direct insider looting shows no fear of law

Page 5: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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

Page 6: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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

Page 7: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Past Turkish CrisesFraud and Banking Crises: Evidencefrom Micro-level Transactions Data• H. Bartu Soral, Talan B. İşcan, and

Gregory Hebb: Dalhousie University• December 1, 2003Related lending & “back-to-back” loansEsbank: self-funded “capital”: authors find

Akerlof & Romer style “looting”

Page 8: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 crises1999-2000 one of the most severe in worldBut sees great regulatory improvement:

hopes are EU accession & Basel II

Page 9: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Such Frauds Can Maim & Kill

Chinese infant formulaNew York inspector: asbestos & leadTurkish building inspectors: seismic riskFake anti-malarial drugsUnlawful disposal of toxic wasteBlood diamondsDeforestation: fake certificates

Page 10: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

“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 perverseErosion of ethics will spreadParticularly if done by elitesMakes reputation perverse

Page 11: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Three Recent U.S. Crises

Each was the largest financial scandal in history – until it was quickly surpassed

Each driven by a control fraud epidemic1.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

Page 12: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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)

Page 13: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Finding the Facts: “Autopsies”

We reviewed every failureNTSB reviews every plane crashDidn’t rely on false accountingOptimization led to patterns: analyticsKnew econometrics were perverseUnderstanding fraud schemes essentialOur findings enraged industry, politicians

and many regulators

Page 14: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Enron era Frauds

All accounting control fraudsOver $6 trillion loss of market capitalizationLed to Sarbanes-Oxley law (no input from

criminologists, doesn’t address problem)Helped lead to Greenspan supporting

particularly expansive monetary supply

Page 15: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Current U.S. Crisis Ignores Fraud

Despite prior control fraud epidemicsAbsurd framing: “perfect storm”FBI (2004) “epidemic” of mortgage fraudPredicted a crisis if fraud increasedAnti-regulators triumphNo criminal referralsNo convictions, indictments, arrests

Page 16: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Mission Accomplished

Page 17: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 criminalsPrevented nonprime crisis: 1990-91

Page 18: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Where We Look, We Find

WaMuCiticorpLehmanGoldmanRating agenciesFannie & FreddieThe most elite institutions in the world

Page 19: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 yields3.Essentially infinite leverage4.Loss reserves were a sick jokeSure thing: record “profits” & losses

Page 20: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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.”

Page 21: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Gambling MetaphorAs 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.

Page 22: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Bad LuckMark Flannery’s “Post-Mortem” (p. 91):“Any firm’s failure reflects some

combination of bad luck and bank management.”

No: Not underwriting = adverse selectionCreates negative expected valueFake profits and real losses are certain

Page 23: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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)

Page 24: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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

Page 25: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Accounting Cover Ups

The Icelandic scams are old scams“Dirt for stock”: self-funded (fictional – not

“weak” capital)Self-funded loansRefinancing: “A rolling loan gathers no loss”Guaranteed “profit” w/o losses

Page 26: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Ireland

Anglo Irish Bank ScandalSelf-funded “capital”Loans to Insiders & CroniesRegulatory captureMassive bubbleSecret, then public, bailouts

Page 27: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Spain

Originally touted as success storyClaim based on “dynamic provisioning”But the loss reserves were perhaps one-

fifth as large as appropriateNest of insider loans, Cajas the worst?Massive property bubbleNot recognizing losses; markets frozen

Page 28: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Fraud Epidemics & Bubbles

Perverse incentives are the keyThe most criminogenic environment losesParticularly if entry is easy: regulationSome assets are superior “ammunition”

for accounting fraud: “liar’s loans”Causes frauds to cluster: industry/assetsRecipe causes bubbles to hyper-inflate

Page 29: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Echo Epidemics

Nonprime lenders: primary epidemicCreate criminogenic environmentsUpstream: buy anything; pay for yieldMust gut underwriting & suborn controlsNecessary & sufficient to cause upstreamNecessary, but not sufficient, to cause

downstream epidemic of CDOs & CDS

Page 30: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Adverse Selection

Crises began when the loans were madeNot underwriting causes adverse selectionThat causes negative expected valueIt necessitates accounting fraud: ALLLHonest accounting would show the loans

were losses when they were madeThe firm fails; the fraud scheme succeeds

Page 31: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Perfect Storms & Black Swans

Both assume risk is exogenousWe spawn the black swans & storms through our

perverse market incentivesControl 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

Page 32: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 riskRegulation = easy to prosecute cover ups

Page 33: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Lying Becomes Endemic

Upstream: appraisers, loan brokersPrimary: loan officers, auditorsDownstream: rating agencies, poolersFinancial version of “don’t ask; don’t tell”Lying about big things: farblondgetFire the honest; promote the worst Gresham’s dynamic only needs a minority

Page 34: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Markets Fail Rather than Clear

Fraud: create, then betray, trustFraud is worst “acid” for eroding trustTrust often vital, e.g., in markets Gresham’s can make fraud endemicWhat if one bottle in 100 is contaminated?Markets can fail rather than clearNonprime secondary market

Page 35: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Private Market Discipline

Control frauds falsify modern financeTherefore, 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

Page 36: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Naïve Oxymoron

Control frauds turn sources of “private market discipline” into fraud allies

They fund the frauds’ growthThey’re vectors spreading fraud epidemicsCaused downstream CDO/CDS epidemicDon’t ask; don’t tell – so you can sellSubordinated debt: failed utterly

Page 37: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

“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.]

Page 38: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Criminogenic Economists

Complacency: we know it can’t happenDeregulation, non-regulation, desupervisionModern compensation• Executive• Professional• ManagerialU.S. exports these failed economic theories

that cause recurrent, intensifying crises

Page 39: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Ideology, Methodology & Theory

Theoclassical ideology: anti-governmentalEfficient contracts/markets hypotheses

falsified by criminology 60 years agoFischel wrote after he’d worked for fraudsEmbrace of econometrics, which must

get the “sign” wrong in accounting control fraud epidemics, leading to criminogenic policies

Page 40: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

The Anti-Regulators Rise

Bush’s “Wrecking Crew” (Tom Frank)If “the government is the problem”…And private market discipline is idealThen appoint anti-regulators to leadHarvey Pitt & “Chainsaw Gilleran”The reanimation of Dochow

Page 41: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Regulatory “Black Holes”

Theoclassical economics’ bipartisan triumphRepeal of Glass-Steagall: Lehman, et aliaCommodities Futures Modernization ActEndorsing “competition in laxity”Fed refuses to use HOEPA (1994) authorityPreempt state rules v. predatory lendingCrippling the OECD initiative v. tax havens

Page 42: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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

Page 43: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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%.”

Page 44: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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.)

Page 45: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

S&Ls: Mission ImpossibleDr. Pratt: federal/state competition in laxityKey state regulators & whoresEvery economist against reregulationAdministration: Give Keating control of

agency & prosecute Chairman GrayMajority of House cosponsors & Speaker“Keating Five”: A Senator for each fingerLobbyists, media & many staff opposed

Page 46: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Halted a Raging Fraud Epidemic300 control frauds growing at 50%300 new TX & CA charters (+200 annually)Would have caused >$1T losses & crisisDone in impossible circumstances Cost several careers: I’m a miracle survivorSpeaker Wright; Keating suit for $400 MM;

hired private investigators twice; “Highest priority. Get Black … Kill Him Dead.”

Page 47: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

How Did We Succeed?Independent regulatory agency essentialLeadership the key: Gray’s hired those with track

record of success & gutsLearned via “autopsies”: patterns/markersKnew econometrics studies perversePrioritized the frauds while “successful”Growth limit targets frauds’ “Achilles’ heel”Contained nonprime w/o crisis: 1991-1992

Page 48: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 accomplicesGreatest success v. elite criminals

Page 49: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

We Need to Jail the CrooksTo deter & to stop Gresham’s dynamicInvestigations produce the facts and

change understanding of crisisTurns it from an arcane story to front pageCreates the political space for real reformDiscredits the crooks & apologistsPut a stake in theoclassical economics

Page 50: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Mortgage Fraud “Epidemic”

FBI warned of it, and coming crisis: 9.0480% of losses induced by lendersFY07; 08: >50K; >63K criminal referralsInvestment banks (03-07): 36 referralsUnregulated: 80% nonprime loansMost frauds undiscovered; referrals are

exceptionally uneven & biased

Page 51: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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)

Page 52: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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.

Page 53: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Trivial Loss ReservesReserves must track risk: GAAPBank risk was skyrocketingA.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 loansLosses on foreclosed nonprime loans

are running >50% for S&LsMortgage fraud = accounting fraud

Page 54: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Drunken Cockeyed Optimists?

Look for control fraud “markers”• Adverse selection = negative value• Appraisal fraud is a fraud & a markerBoth markers are endemicConsistent pattern of nonprime lenders

and purchasers acting in a manner that was optimal for control frauds and suicidal for an honest firm

Page 55: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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).

Page 56: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

“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).

Page 57: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Appraiser Coercion = Fraud

Deliberately created Gresham’s dynamicNational study(early 2004): 75% coercedCuomo 2007 investigation: nationwide2007 study: 90% coercedHonest 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

Page 58: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

“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]

Page 59: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 agentsVirtually no regulatory criminal referralsBush’s AG: mortgage fraud is “white-

collar street crime” – don’t investigate, don’t indict

FBI “partners” with trade ass’n of perps

Page 60: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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 tillA dozen layers of controls v. fraudPrivate market disciplineAmerican tradition of whistleblowers Civil suitsRegulators, prosecutors and the FBI

Page 61: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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]

Page 62: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Four Failed ParadigmsEfficient markets & contractsPrivate market discipline: perverseAgency cost: shareholders can’t

stop accounting control fraudCorporate governance: One can’t

“govern” control fraudsBusiness ethics: assumes the

“tone at the top” is honest

Page 63: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

Add Criminology to Economics

Incentives: the core of economics and white-collar criminology

Fraud epidemics aren’t randomThe factors that produce criminogenic

environments are clearThe incentives are perverse, but they

have predictable marginal effectsWhy don’t the SEC & FDIC have “Chief

Criminologists”?

Page 64: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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).

Page 65: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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

Page 66: William K. Black Associate Professor of Economics and Law  University of Missouri – Kansas City

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