This is the transcript for Bill Black: Our System is So Flawed That Fraud is Mathematically Guaranteed
Chris Martenson: Hello and welcome to another www.PeakProsperity.com podcast. I am your host, of course, Chris Martenson. And today, we have the pleasure of speaking with Bill Black, associate professor of economics and law at the University of Missouri, Kansas City, and a former bank regulator and a central figure in prosecuting – there’s a strange work – the corruption associated with the savings and loan crisis of the late 80s. He’s been since a prominent voice against financial and political fraud. And in 2005, authored the excellent book, The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. So I’m sure he has a lot to say about our current situation. I’m really looking forward to Bill helping us understand why there were nearly two thousand convictions resulting from the S&L crisis but hardly any so far from the mortgage fraud and other criminal activity that caused the 2008 near system collapse, the one that made the scope of the S&L losses look positively quaint in comparison. Bill, I’m so glad you could join us today.
Bill Black: Thank you.
Chris Martenson: Well, let’s jump right in. For many today, what they’re experiencing is a crisis in confidence, confidence in our entire system, that it’s fair and fairly regulated and adjudicated. Perhaps even that if you make both your financial crime wither large enough or complex enough or both, that you can get away with it. Perhaps maybe paying a fine that’s a fraction of your illicit gain but never facing criminal charges, at least that’s the common experience today. So let’s begin here. What is the basic definition of fraud, and more specifically, what is the form of fraud that we seem to be enmeshed in today?
Bill Black: Well, fraud is both a civil wrong and a crime and what it is is when I get you to trust me and then I betray your trust in order to steal from you. And 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, well, what kind of frauds are the most devastating? And it turns out that the most kind of problems that we’re seeing, as you said, 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 these losses from these kinds of control frauds exceed the financial losses from all other forms of property crime combined.
Chris Martenson: All other forms combined – well, I can believe that. I mean I saw what happened with Worldcom, with Enron, it took down Arthur Anderson, I guess, but most of the people that worked there ended up going to work other places. All of the – there seems to be – it’s not just the person at the top, the CEO, saying I’m going to really shuffle some deck chairs here and hide what the true state of my operation here is, what my risks are, what my liabilities are, whether I have the assets I claim I have. That requires a willing partner on some level, does it not?
Bill Black: Well, that’s the thing. I mean if you have this person at the top being a crook they get to choose their partners. And they get to incentivize their partners and, as a result, you’re quite right. They’re very good at spreading frauds. And we call those echo epidemics. So for example, in the current crisis, as with the prior ones, if you’re a lender there’s an easy recipe for maximizing your accounting, fake accounting income, if you’re a lender. And it goes like this, four ingredients. One, grow like crazy. Two, by making really, really crappy loans but at a premium yield. Yield just means interest rate. Three, while employing extreme leverage, and four, while setting aside only the most trivial reserves, allowances for the inevitable losses this kind of behavior produces. So 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. It’s, Looting: The Economic Underworld of Bankruptcy for Profit. So again, 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 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 is 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. And that’s when Akerlof and Romer said, now that’s the next thing that comes in that’s really important and that is modern executive and modern professional compensation. Because with modern compensation, first at the executive level, the CEO level, I can guarantee with modern executive compensation that if I follow this recipe I will personally be wealthy almost immediately as the CEO. Because I’ll base my compensation as CEO, and that’s the nice thing about being CEO, you get to make the rules for yourself. You’ll base it on short-term reported income and you’ll make that compensation extremely large for supposed superlative results in jargon in the industry, stretch goals. So you’re going to say, hey, if I double my income in just a few years, which is what the Fannie Mae goal was, then I get an off the charts bonus, huge compensation except, of course, that goal is easy to meet. You just have to cheat. It is a sure thing.
Chris Martenson: Now Bill, is it possible to follow this four-step prescription and remain within the letter of the law?
Bill Black: No, not within the letter of the law although it is in places that – it may be – this is the question right now that’s up for grabs – in places where international accounting rules apply. Because under international accounting rules they’re being interpreted by many folks as saying you are not permitted as a lending institution to establish any meaningful allowances for losses, loan losses now, even though it is absolutely certain that making – you don’t remember what the ingredient is, the first to grow extremely rapidly by making really, really awful loans at a premium yield. Well, that’s guaranteed to produce massive losses down the road. The international accounting rules – some people are, actually many people are interpreting as you are not permitted to establish any reserves. So that could create the perfect crime in Europe in particular.
Chris Martenson: The perfect crime – now, so even if you stay within these four though, the parts that get me confused are what happens when say your supposed third part auditing company comes in and performs their yearly due diligence audit and then signs off on the financial statement. So this company then says these have all been fairly represented and the risks have all been adequately explained and we think this company is fairly representing itself. And then surprise, surprise, like Lucy pulling a football away. I mean we always seem to be surprised when it turns out that there are glaring, overt gross material misrepresentations of risk, of assets, of liabilities, of all kinds of things. And somehow that happens again, and again, and again. Where – I’m really interested where the letter of the law is on this. Is there no responsibility here?
Bill Black: Well, the letter of the law in the United States under general accepted accounting principles is that you have to establish the loss reserves now if you make large losses inevitable in the future. So in that if you actually establish the appropriate loss reserves, of course, you would show under this recipe that you are losing money, not making money, and you wouldn’t get any bonus. So under the letter of the law there’s a fraud in the United States. It turns out there are many frauds in Europe as well because people get greedier. Now, let me approach your more basic question. And your more basic question really has two areas, and that is, so again why are these control frauds unique. Why are they much more dangerous than regular frauds? And what is this thing that I alluded to and that is professional compensations. So that’ll bring in your question about the auditor. So if we back up, what’s special when you have a seemingly legitimate entity and the person at the top of the food chain is the crook the joke that actually many cultures have like China is, of course, the fish rot from the head. And that’s designed to capture precisely this point.
Well, so the big thing is about the seemingly legitimate entity when the CEO is the crook, 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 in controls, 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 commit, 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 could 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 – give strong Ponzi scheme like elements, which is why they tend to cause such catastrophic losses.
Chris Martenson: Well, if the fish rots from the head then you’re talking about a culture issue. and I’m wondering if the head of the largest fish that we could talk about here is what is substantially different about the type of control fraud you’re talking about that’s happening at the corporate level versus, say, oh I don’t know. What happens when I examine the federal government’s balance sheet and look at its accrual liabilities expanding by four to five trillion dollars per year once you factor in the actual entitlements and the government’s reporting. It’s cash balance deficits, which are shocking enough, but on an accrual basis there’s absolutely no possible chance that we can square this circle. Are companies following sort of a – is this – are we talking about American culture now? Is this something that extends really broadly? I’m really confused…
Bill Black: You know this is human culture.
Chris Martenson: Human culture – oh okay.
Bill Black: And it is not limited to corporations. We’ve been focusing on corporations but these frauds occur in the governmental sector, they occur in the non-profit sector, and of course, they occur in combined, in combination. And so crony capitalism is all about the combination of public sector and private sector control frauds working together as cronies.
Chris Martenson: So this is interesting because what you’re saying is something I believe, which is that human nature does not change and it’s always human nature to try and game the system, get an advantage, have a free lunch, however we want to put that. And so we’ve known – we’re sophisticated enough that we’ve seen these happen often enough that we know what the dynamic is, you’ve just mentioned this paper, these two gentlemen where there’s four steps. We know what these all are. It is my view that we had tighter regulatory structures that were around the concept of saying listen. These things are going to happen. We’re going to put a basket around this as best we can, and then do what we need to do in order to assure that these things do not flourish. Maybe we’ll have prosecutions. So fast forward, I’m looking at a chart here that shows federal prosecutions for financial fraud are at an all-time low. And my personal perception is that the amount of fraud is probably at an all-time high. They seem potentially correlated, those two pieces of data. Is that true and how did we get here?
Bill Black: Well, you have really interesting phraseology. You said, you talked about we know and you talked about we’re more sophisticated. So this was part of, an important part of, what Akerlof and Romer were talking about in that paper. They chose to include the following paragraph, which I’ll get approximately right from memory. And to make it their last paragraph for emphasis. They said, look, in the savings and loan crisis economists and the public had no theory of this kind of fraud, control fraud. And, as a result they were not in a position to give strong support to the examiners in the field, the regulators, banking regulators, actually savings and loan regulators in the field who recognize from the beginning that this kind of deregulation was bound to create widespread fraud. Now we know better. If we take advantage of this knowledge we need not repeat this kind of crisis. That was written in 1993.
Chris Martenson: Right
Bill Black: And what happened, of course, is right around the same time we did get allegedly more sophisticated in a small part of we. And that small part of we dominated and continues to largely dominate policy. And that small portion of we had exactly the opposite conclusion on the basis of this alleged sophistication. And they said, and this Easterbrook and Fischel. So your listeners need to know that George Akerlof goes on to win the Noble Prize in economics in 2001. So we’ve been talking about one of the most prominent economists in the world. But in the law of economics world a generation of American lawyers has been taught when they study the economics of corporations by a treatise writ in 1991by Judge Easterbrook of the seventh circuit, and Fischel, who was then professor at the University of Chicago Law School, eventually the dean of the University of Chicago Law School. And Easterbrook and Fischel, and again, I’ll get this virtually word for word, say famously, “a rule against fraud is not essential or even particularly important in the securities context.” Now notice how radical a statement that is. It isn’t that we don’t need laws, that we don’t need prosecutors, that we don’t need FBI agents. U.S. attorneys, those kind of folks, we don’t even need a rule against fraud. We don’t need the ability to bring civil suits. We don’t need the securities and exchange commission. Markets, securities markets, are so efficient that they automatically exclude any meaningful accounting control fraud. And we know that they’re efficient because we’ve hypothesized they’re efficient in a wonderful circularity. This was, of course, the efficient market hypothesis that was the centerpiece of all of modern finance theory. And even the weakest version of efficient market hypothesis requires that there be no systematic errors in pricing because if there’s any systematic error in pricing, well, then somebody would correct it. They would make money by correcting it. Therefore, financial bubbles are impossible as well. Fraud is impossible.
Now all of this is insane. And indeed, Fischel was the outside expert for three of the most notorious accounting control frauds of the savings and loan debacle era. Lincoln savings, Michael Milkon at Drexel Burnham Lambert And this incredibly sleazy Florida one as well where the headquarters building was shown in Miami Vice for people who are old enough to know that. And then after he tried his theories in the real world and ended up praising the worst fraud in America, Charles Keating’s Lincoln Savings, as the best saving and loan in America. He wrote those words that I’ve just quoted without ever telling the reader, hey, by the way I tried this in the real world and it was the most embarrassing disaster conceivable. So there’s a strong element of intellectual dishonesty as well that went along with all of this. But anyway, if you believe that fraud’s impossible in the financial sphere, if you believe that markets are inherently efficient and self-correcting, then there’s a clear answer about what you should do about regulation, financial regulation. Financial regulation, A, is unnecessary, and, B, is potentially very harmful because it will potentially stop or interfere, at least, with the self-correcting efficient nature of the marketplace. And therefore, you must be a lead jihad against regulation if you want the country to prosper. and that’s precisely what these folks did.
Well, okay, now that’s academics and, yeah, they’ve trained a generation of lawyers who are now out there in key positions in business and regulation. But surely no one, the adults, right, can’t believe this. But, in fact, they did and, in particular, Alan Greenspan had this view. So he famously, in his first meeting, first person-to-person meeting with Brooksley Born, then the new chair of the commodities future trading commission, invites her over to meet her and says, in the course of the lunch, but of course we’re going to disagree about things. Now, you know, they’ve never had a substantive discussion like this and Brooksley’s wondering what. And he follows up and says because you, for example, believe that fraud provides a basis for regulation, preventing fraud.
Now that’s how extreme and that was, unfortunately of course, the most powerful financial regulatory position in the world was held by someone who believed in this insanity. But it gets worse because Greenspan was also involved, hired by Charles Keating. In fact, Charles Keating hired Greenspan in multiple capacities and one of those capacities was to, as lobbyist, to walk the floors of the senate to recruit the five senators who would become known as the Keating Five. When thirty – I’m sorry, twenty-five years ago on April 9th, 1987, they intervene on Keating’s behalf, those five senators, secretly to try to get us not to take enforcement action against Lincoln savings. Keating also famously put in writing to our agency that Lincoln Savings should be allowed to do hundreds of millions of dollars of these direct investments, which is what we provide the information to do, and they did anyway. That was the violation of rules that the senators were trying immunize by their political pressure. Well, Greenspan opined in writing that we should allow it because, and I’m quoting again, “Lincoln Savings poses no foreseeable risk of loss.” Gosh, he almost got that exactly right except for the fact that it was the most expensive failure of the entire debacle at 3.4 billion dollars, which as you say now, sounds quaint. But back in the day used to be considered a substantial amount of money.
Chris Martenson: Well, if I can turn the phrase around, it looks no bad deed goes unrewarded in this story. And Greenspan is somebody that I’ve been – I wrote about him extensively going, stretching way back because I really, really disagreed with his understanding of risk. He thought the derivatives markets made risk go away. So since you didn’t have risk anymore you could just let people expand their balance sheets and just go hog wild and use that, his view of risk, for as the justification for allowing the sweeps program, which allows banks to effectively hold zero reserve requirements against demand deposits, which I thought was a bad idea at the time. At any rate, so he had some failings, this guy.
Bill Black: But see this is related.
Chris Martenson: Okay, tie it in.
Bill Black: Right, if you believe that fraud is possible then derivatives are a possible problem. If you believe that fraud is impossible and that these people are sophisticated – remember your sophistication illusion again?
Chris Martenson: Yep.
Bill Black: Then it is unambiguous with neoclassical economic theory that the greater the choices the better the results because people will only make good choices for themselves. And as a result, by definition, the purchaser of the derivative will be the one who finds it most valuable and since asset valuation and risk are inversely related it will be the entity that perceived holding that derivative as least risky. In other words, you will get derivatives held by the ideal people for whom they’re in idiosyncratic conditions that reduce the holding, the risk of holding, that derivative for them. And so you will optimize throughout the entire financial symptom the placement of risk in the ideal fashion where the people best situated to have that risk. And not only do you have that advantage, but on top of that it means you will broadly diversify the risk such that there is very little concentration of risk. And therefore, your entire financial system will systemically be far less risky. So they knew all of those things as soon as they started with the assumption that there couldn’t be any frauds.
Chris Martenson: Well, if you’re going to risk that on the efficient market hypothesis there is one other little assumption baked into that, which is that we have even flows of information. There are no information asymmetries. And the very definition of fraud is that it has an asymmetry of information. I can’t square that circle either. There’s an intellectual hole in what you’re describing that’s just gigantic.
Bill Black: Well, enough to drive the world’s largest financial bubble through and the greatest epidemic of the elite fraud in the history of the world, yeah. This is what we call – you know, America is just gone through this recognition that it was being scammed by merchants who were secretly adulterating our hamburgers by adding pink slime, right. And pink slime turned out to be added to a level that maxed out at about fifteen percent. And the reason that it was maxed at about fifteen percent is that it tended to smell and taste bad.
Chris Martenson: Uh-huh
Bill Black: But in the financial end, by the way, pink slime starts out with these ultra-fatty tissues, which are much more susceptible inherently to being, to having strong contamination by e coli, I mean in particular in sense of other things. So they give it an ammonia bath, right, they put Mr. Clean in in gaseous form to try to reduce how infectious pink slime. And it turns out there’s a tradeoff. That’s why it stinks. If you put enough ammonia to really make it close to safe them it really smells and tastes bad. So they don’t put enough ammonia in to really keep it safe. So it’s also an unsafe, but it’s – I’m not – if you eat a burger you’re not typically going to get sick. In fact, it’s quite unusual if you order it at least medium. But that’s not true in finance. In finance it wasn’t a maximum of fifteen percent of some areas were fraudulent. We had whole areas, liars loans, where the fraud incidence, when the people measured it, was ninety percent, nine zero. And we had whole areas like collateralized debt obligations in which the most typical CDO, collateralized debt obligation, was backed overwhelmingly by fraudulent liar’s loads.
Chris Martenson: And we knew about this at the time. There were open articles about ninja loans and this was a very open secret, at least it was to me. I was shorting them of this matter of public record. I was shorting a bunch of mortgage insurers, and homebuilders, and what not, all the way down through this piece because it was so obvious to me that this was a problem. And I’m just an outsider, right. I’m just some guy. I read stuff and I understand a few things. But it was so painfully obvious to me that we had this huge, gigantic issue going on, and it was to insiders too. Michael Lewis and the Big Short details very carefully about how Goldman Sachs with John Paulson went out and handpicked the worst things that were designed to blow up. And, then Goldman Sachs went out and got a so-called independent thirty party’s position saying, hey, this portfolio is randomly selected to succeed when it was actually, I believe, selected to fail. And, then misrepresented that to clients and sold these toxic bundles off because needed somebody on the other side of that trade, often maybe a German bank or somebody like that. So when I look at that, to me that, I can’t find a more clear-cut definition of fraud than that. And yet, I’m not aware of any prosecutions or criminal activity that resulted from that. I believe there might have been a fine but that’s all I can recall at this point. How does that skate through? Did I have the essence of that story right?
Bill Black: Yes, but it goes farther back, so, and there’s a more basic economic problem as well. The definition after all, the defining element about what makes something a liars loan is that you don’t do adequate underwriting, underwriting as a process of evaluating whether you’re going to get repaid when you make a loan. And what are the risks of is so that you can price, decide whether you should make the loan and what conditions and at what price you should do that? And because when you don’t do underwriting on this kind of loan, a mortgage loan, you inherently create something that we call adverse selection. So if you thought of running a health insurance company or life insurance company, and you weren’t going to do any evaluation of your customer’s health or their parents, genetic relatives’ health, you were just going to charge a high price for your insurance to compensate for the risk. Which customers would come to you? Well, obviously, only the sickest. It’s the same thing if you couldn’t determine loan quality and you said just charge everybody a high rate of interest as a result, which customers would come to you? Only the worst. And so in this kind of loans, if you create adverse selection you create from the lender’s perspective a negative expected value of making a loan. In plain English that means you will lose money. It’s equivalent of betting against the house. And therefore, honest lenders don’t engage in adverse selection. So it’s a wonderful natural experiment as to which entities were clearly engaged in fraud, entities making liars loans were clearly engaged in fraud, mortgage lenders doing that.
Okay, so we realized this as regulators in 1990 and 1991. Now let me emphasize those dates again, 1990 and 1991. And America being America, liars loads being the fraud, began most heavily where all financial frauds tended to develop in America and that would be Orange County, California, right. And we were the regional regulators for California, Arizona, and Nevada. And eventually a broader who one-third of the west, one-third of the United States that’s the west. So we looked at these and we said this is insane. These liars’ loans are becoming common. They must lead to fraud. In fact, they only make sense from a lender’s perspective if the lender is engaged in accounting control fraud. And so we use normal supervisory means to drive them out of the savings and loan industry. The leading entity making these liars loans also targeted minorities particularly blacks and Latinos families who couldn’t speak English as well – blacks because they have fewer connections and few choices in the financial industry. So this is a real pernicious place. It was called Long Beach Savings. And we – they were one of the entities we cracked down on. So Long Beach Savings had voluntarily gave up federal deposit insurance, voluntarily gave up his charter to run a savings and loan, and became a mortgage bank for the sole purpose of escaping our regulatory jurisdiction. And as a mortgage bank he was subject to no federal regulation in that era other than active discrimination against minorities, right, this is not community reinvestment act. This is active, I’m out discriminating against minorities, the truth, the fear of lending laws.
Now, his leading competitor is another entity run by a husband/wife team that we removed and prohibited from the savings and loan industry, the gen X. To ease this fraud the head of Long Beach Savings also changes the name of the organization to now mortgage bank and names it Ameriquest. So for people who know this industry they will now be nodding. So Ameriquest becomes the biggest and the baddest, and as it’s going out the door we make this referral for discrimination. And the justice department follows up and finds active discrimination. So that’s their second strike, right. The first strike that we went after them for the liars loans, the second strike is the justice department goes after them, and, of course, they make nice, nice, and they promised that they will – they approve things and, of course, the justice department doesn’t bring a criminal action, just a civil action and gets a settlement. Then, of course, Ameriquest does absolutely the same thing targeting blacks, targeting Latinos, outride fraudulent loans, forges people’s signatures, the whole nine yards just completely out of control accounting control fraud, following the recipe that I talked about. And at that juncture, forty-nine state HEs, plus the attorney general of the District of Columbia sued them. Why not the fiftieth? Well, because there was Virginia and at that time Virginia actually had some rules. And so they avoided making mortgages in Virginia. But everybody else sues them, they settle for hundreds of millions of dollars, the biggest settlement of such a kind. Again, no criminal action where upon we make the head of Ameriquest our ambassador to the Netherlands.
Why? Well, because, of course, he was the leading campaign contributor to George Bush. Now that’s politics as usual, the same as I know. But if you want, again, the antecedent of this crisis, two entities rush to acquire Ameriquest from our, now, ambassador or now, about to be, ambassador. Now, again, this place is absolutely notorious. It has a thousand employees, there about, who everyday go in and, if they’re doing substance, what they do is engage in fraud. And, a particularly pernicious fraud where they look for the most vulnerable people in society to defraud. And Citi Corp and Washington Mutual rushed to acquire its operations. And therefore, we are shocked, shocked, that Citi Corp and Washington Mutual made tens of billions in the case of Washington Mutual, hundreds of billions – actually in the case of both of them, hundreds of billions of dollars of fraudulent loans and loan sales. So yes, that just brought us up into the 90s and the early 2000s. So again, we knew in spades, and we not only didn’t bring criminal action we rewarded the frauds, we left them wealthy, we allowed them to sell. They were treated as respectable by the most elite financial institutions in the world, Citi Corp a