Why Has This Epidemic of Accounting “Control Fraud”

Caused Catastrophic Losses?

William K. Black

Associate Professor of Economics and Law

University of Missouri – Kansas City

AALS “Hot Topics” Panel on the Financial Crises

January 9, 2009

Criminogenic Environment:

Accounting Fraud Epidemic

Non-regulation & desupervision

Plus three critical “vectors”

• Securitizing & rating agencies

• Credit default swaps

• Perverse compensation incentives: Gresham’s dynamic

BackgroundStaff leader of the successful

reregulation of S&L industry

Defeats “control fraud” epidemic

“Coroner” – autopsied failures

Designed the economic studies

Fraud: “invariably present”

Recognized pattern: triage

Achilles’ heel: limited growth

Burst SW real estate bubble

“Control Fraud”1. CEO uses firm as a “weapon”

2. Apparent legitimacy & power

3. Accounting: “weapon of choice”

4. Causes more losses than all other property crimes combined

5. Control frauds can kill & maim

Synthesis of criminology, finance, law, economics & accounting with implications for each field.

Optimizing Accounting Fraud

1. Assets w/o clear mkt. values

2. Yield, not risk, is the key

3. Loan to the worst borrowers

4. Bad underwriting is good

5. Cover up defaults & book new income by refinancing

6. Grow rapidly – Ponzi

7. Make your “controls” allies

Focus on Rating Agencies

Mortgage bankers were always the mortgage cowboys

Constrained by inability to grow

Freed by nonprime securitization

Which was freed by AAA ratings for “toxic waste”: SIVs & CDOs

Created “originate to sell” model

Mortgage Fraud “Epidemic”

FBI warned of it in 9.04

80% of it induced by lenders

Fitch: nonprime incidence >40%

FY07: >50,000 criminal referrals

Investment bankers (03-07): made 34 referrals

Unregulated: 80% nonprime loans

50K is a massive underestimate

Epidemic, What Epidemic?

“Sophisticated models, combined with strong risk management, allow lenders to better quantify the credit risk associated with scaling back the verification of a borrower's income and assets.” [Moody’s 11.24.04]

Moody’s explanation for weakening its standards on “low doc” loans.

Economic Implications

Massive direct losses fatal to any lender/buyer – hidden

Perverse econometric models

Hyper inflate & extend bubble

Maximize “adverse selection” and info. asymmetry – Lemon’s

Deceit: create & betray trust – cause markets to shut down

Securitization Implications

Unsafe at any price

Why only 34 referrals?

No one did any due diligence

Don’t ask; don’t tell

“Most sophisticated” risk raters ignored the worst credit risk

Potemkin models of mendacity

Paradox of “predatory lending”

Rating Implications

Ignored worst underlying risk

Ignored fraud epidemic warnings

Ignored housing bubble

Pineapple v. grenade comparison

Ratings were farblondget

Toxic waste transformed into AAA

Dishonest: CDO credit v mkt. risk

Made rating business “lucrative”

It’s Not Insane; It’s Fraud

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]

See no evil….

“There's a lot of fraud that's involved there, things that we didn't see.

We're on notice that a lot of things that we relied on before just weren't true. [W]e relied on reps and warrantees that no loans were originated in violation of any … law. We know that's a lie.” Moody’s ’07

Gresham’s 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]

“Most Investors Don’t Have It”

Purchased >$1T nonprime loans

During a fraud epidemic

Buy liar’s loans w/o fraud checks

CDO & CDS: can’t know risks

Spreads narrowed – increasingly inefficient, inflated markets

Can’t know values, can’t trade

Vectors for Fraud Epidemics

Didn’t shift risk to best able to bear

Concentrated, spread & increased losses

Made markets far less “efficient”, the spread narrowed as losses grew

Killed our most elite banks: no relevant expertise or data

Spread the crisis globally & shut down many markets

Unintended Consequences

1. Non-regulation, deregulation & desupervision = no cops on the beat. Decriminalizes, de facto, control fraud.

2. Opaque markets; lack of independent verification of asset values: markets fail.

3. Optimal criminogenic environments – securitization