The Amazing Vanishing Act

Accounting Control Fraud Disappears from the Regulatory Lexicon

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Criminologists know that accounting control fraud causes greater financial losses than all other forms of property crime – combined.  Some of the world’s best economists, George Akerlof and Paul Romer, praised the S&L regulators’ early recognition of these frauds and set out a formal economic theory of accounting control fraud (“Looting: the Economic Underworld of Bankruptcy for Profit”).  They ended their 1993 article with this paragraph, in order to emphasize its importance.

“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself.”

The primary reasons that accounting control fraud can produce catastrophic losses are the seeming legitimacy of the firm, the supreme status and respectability of the CEO leading the fraud, the fact that accounting control fraud is a “sure thing” (Akerlof & Romer 1993), the ability of control fraud to hyper-inflate bubbles, allowing the fraud to persist for years and magnify losses, and the paradox that the optimal means for a fraudulent CEO to loot “his” bank is to cause the bank to make exceptionally bad loans. 
The last element is so counter-intuitive that despite the accounting control frauds’ dominant role in driving the S&L debacle and the Enron-era accounting control frauds many people cannot really believe that elite CEOs would loot “their” banks despite the many felony convictions of the elite CEOs that drove the two predecessor crises.

“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. “It doesn’t make any sense to me that they would be deliberately defrauding themselves,” Wagner said.”

Wagner is so befuddled that he thinks that he cannot keep his pronouns straight in the same sentence.  “They” is the fraudulent CEO.  The fraudulent CEO loots “his” bank.  The bank is “themselves” in Wagner’s bewildered sentence.  The CEO is not looting himself when he loots the bank.  Wagner is so confused that he assumes away the existence of insider fraud.  Sacramento is one of the epicenters of mortgage fraud by some of the largest accounting control frauds, and it is no surprise that they have been able to commit their frauds with impunity.

The national commission that investigated the causes of the S&L debacle found:

“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).
The fraud “recipe” for a lender engaged in accounting control fraud has four ingredients:

  1. Grow like crazy by
  2. Making bad loans at a premium yield while
  3. Employing extreme leverage, and
  4. Providing grossly inadequate allowances for loan and lease losses (ALLL)

Understanding the second element is essential to effective financial regulation and prosecution.  Requiring sound underwriting is the best, no cost means of preventing the worst bank frauds.   Making enormous numbers of bad loans requires fraudulent banks to suborn internal controls and underwriting.  The bank operates in a manner that makes no sense for an honest lender.  (See my earlier writings on “adverse selection” and the resultant “negative expected value.”)  Understanding why the recipe is a “sure thing” (the bank will report superb, albeit fictional, income and the controlling officers will, promptly, be made wealthy) is essential to effective regulation because the regulator must treat the fiction as real.

If there was one agency that should have understood the fraud recipe, it was the Office of Thrift Supervision (OTS).  The Federal Home Loan Bank Board (OTS’ predecessor) first identified it, wrote about it, trained its staff, trained the FBI and the Justice Department, and used our understanding of the recipe to identify, close, sue, sanction, and convict the frauds.  By August 1983, the Bank Board had detailed written examination manuals that explained much of the accounting control fraud dynamic.

Regulatory Concerns In summary, incentives to report higher earnings, the nature of assumptions used in certain transactions, like securitizations, and improper reporting in general may affect reported earnings.  Examiners should be alert to the regulatory concerns cited throughout this section, and to the following additional regulatory concerns as well:

  • Management may use gains to further leverage the balance sheet. You should consider the quality of capital supporting asset growth to the extent that management based gains on optimistic assumptions or that the value of the retained interest is highly sensitive to accelerating prepayments or declining asset quality. 
  • Management compensation or dividend payouts may be excessive, and dependent on earnings.  Associations often tie compensation and dividends to reported profits. To the extent that reported profits are overstated, these payouts can dissipate assets and capital. 
  • Management may ignore credit quality. The incentive for profits can override attention to quality of earnings. The potentially significant profit that management can generate by gain-on sale accounting creates a strong incentive to produce originations, often with little attention to credit quality. 
    http://www.ots.treas.gov/_files/422322.pdf

Remember, this was written nearly 30 years ago.  We have known for a very long time that modern executive compensation plus deregulation created an intensely criminogenic environment that could lead bank CEOs leading accounting control frauds to make epic amounts of bad loans in order to optimize fictional reported income and the CEO’s compensation.

Unfortunately, OTS retreated to the dark ages as it came under the sway of anti-regulators influenced by theoclassical economists who were ignorant of the criminology, regulatory, and economics literature about control fraud.  These economists were unaware of how central underwriting is to lenders’ success.
Clinton administration economists “knew” that a lender would never deliberately make a bad loan.  They knew that accounting control fraud did not exist – even though it had so recently devastated the S&L industry.  The June 20, 2000 HUD/Treasury report on lending abuses made explicit this claim, which ignored Akerlof & Romer, criminologists, and OTS’s (a bureau of Treasury) contrary findings,.

“In most respects, lending in the subprime mortgage market follows the same principles as lending in other markets.  Basic economic theory, not to mention common sense, tells us that a lender will only lend money to a borrower if the lender expects to be repaid. That repayment has two components: the return of the original amount lent (the principal), and compensation for the opportunity cost of lending the money and for taking the risk that the loan is not repaid as promised (the interest rate charged).  While a lender will not make a loan unless he or she expects to be repaid, clearly not all borrowers present a lender with the same risk of default.”

On January 17, 1996, OTS’ Notice of Proposed Rulemaking proposed to eliminate its rule requiring effective underwriting on the grounds that such rules were peripheral to bank safety.

“The OTS believes that regulations should be reserved for core safety and soundness requirements.  Details on prudent operating practices should be relegated to guidance. Otherwise, regulated entities can find themselves unable to respond to market innovations because they are trapped in a rigid regulatory framework developed in accordance with conditions prevailing at an earlier time.”

This passage is delusional.  Underwriting is the core function of a mortgage lender.  Not underwriting mortgage loans is not an “innovation” – it is a “marker” of accounting control fraud.  The OTS press release dismissed the agency’s most important and useful rule as an archaic relic of a failed philosophy.

"By getting away from 'cookie cutter' and 'one size fits all' regulations, we're giving thrifts more flexibility to tailor their operations to better meet the needs of their customers," said John Downey, executive director, Supervision. "Enhancing flexibility and reducing paperwork will hopefully make the lending process easier for both savings institutions and their customers," he noted.

"We believe we can simplify our rules and give thrift management more flexibility without jeopardizing the safety and soundness of thrifts' lending and investing operations," said Carolyn Buck, OTS chief counsel. "We are eliminating numerous picky details from the regulations, while leaving fundamental safety and soundness constraints in place," she said.

The OTS underwriting rules imposed the minimum, not the optimal, underwriting processes that a prudent lender would follow.  It imposed no costs on honest lenders.  Any prudent lender should have done considerably more than was required under the rules.  

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About William K Black PhD

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