RegulationAug 1 2014

Control fraud: the white-collar crime

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‘Control fraud’ is a white-collar criminology term describing schemes in which the person who controls a seemingly legitimate firm uses it as a ‘weapon’ to defraud. The CEO is usually the controlling person so I will use that term for brevity. Accounting is the ‘weapon of choice’ of financial frauds. The primary intended victims are the shareholders and creditors. Control frauds cause greater financial losses than all other forms of property crime – combined.

Epidemics of accounting control fraud drove the three modern US financial crises (the second, far more damaging phase of the savings and loan debacle, the Enron-era scandals, and the current crisis).

A fourth, incipient epidemic, was halted by regulators in 1991 before it could cause a crisis. That incipient crisis, and its successful prevention by the regulators, should have made the current crisis easy to avoid because the primary ‘ammunition’ of accounting fraud was the same in both crises – ‘liar’s’ loans.

According to the fraud ‘recipe’ exemplified by some unscrupulous lenders – it is better to exaggerate than invent.

The fraud ‘recipe’ for a lender (or loan purchaser) optimises (fake) income by overstating asset values: (1) Growing extremely rapidly by (2) making or buying bad loans at premium yield (3) while employing extreme leverage, and providing (4) grossly inadequate allowances for loan and lease losses.

The four optimisation conditions of the fraud recipe are linked, but each contributes a key element to the equation.

The high growth rate is essential to bring in the cash (as in any Ponzi-type) scheme, but it also is essential to report the record (albeit fictional income) which allows the rapid growth because a firm reporting record profits finds it easy to borrow (which allows it to attain extreme leverage).

Extreme leverage plus record levels of reported income combine to produce a superb (albeit fictional) return on earnings, which causes stock appreciation which directly or indirectly boosts bonuses to the senior officers, puts their stock options “in the money,” and makes the CEO (fraudsters care about status as well as money).

Following the fraud recipe, however, allows firms to grow extremely rapidly because there are scores of millions of people who could not clearly afford to buy a home because their ability to repay the home loan was dubious. The lender can charge them premium yields.

The recipe produces three ‘sure things’. The firm will report record earnings, the senior managers will promptly be made wealthy by modern executive compensation, and the firm will eventually suffer crushing losses.

Sales to the secondary market can only be made through ‘reps and warranties’ that promise that the loans are of high quality and not fraudulently originated. Providing false reps and warranties exposes the firm and the officers to prosecution and civil suit and the requirement to repurchase the loans – at the worst possible time.

An honestly managed bank exercises great care in making these reps and warranties by engaging in superb ‘underwriting’ of the quality of the loans it is selling to the secondary market and the loans it is packaging as mortgage-backed securities and collateralised debt obligations.

Underwriting is supposed to be the process by which a lender evaluates (and prices) credit risk. Lending without effective underwriting produces ‘adverse selection’, which produces a ‘negative expected value’ for the lender.

In plainer English: the bank will lose money from such loans. But the bank, if it follows the fraud ‘recipe’, will report large, albeit fictional, profits for years before the losses become so large that they cannot be hidden by further accounting fraud, allowing the CEO to loot the bank and walk away wealthy even if the bank is not bailed out.

These facts allow competent regulators who understand accounting control fraud to identify lenders (and loan purchasers) engaged in accounting control fraud while they are still reporting record profits.

The combination of terrible underwriting, suborned ‘controls’, premium yield, record reported profits, and trivial reported losses despite making (or purchasing) exceptional numbers of terrible quality loans is a sure indicator of accounting control fraud.

Consider the following key facts about accounting control fraud that one could not learn from US Attorney General Eric Holder:

* There were twin epidemics of loan origination fraud in which the CEOs of the lenders and their agents extorted appraisers to inflate their valuations and inflated the borrower’s income through ‘liar’s’ loans.

* The third epidemic was the fraudulent sale of the fraudulently originated loans through false ‘reps and warranties’.

* No senior Wall Street officer has been prosecuted for leading the fraud epidemics.

* Only one senior bank officer was sued civilly by US Department for Justice for her role in making and selling bad loans after the crisis. DoJ ignored the whistleblower that brought that case.

* The officers leading the accounting control fraud schemes typically looted ‘their’ banks, so DoJ’s claim that fining the shareholders, while leaving the officers with that loot, constitutes holding the perpetrators ‘accountable’ is a sick joke.

Accounting control fraud by the officers controlling our largest financial institutions became the norm. It has become a perfect crime in which the CEO has de facto immunity from prosecution and gets to keep his job and his fraud proceeds. He is welcome at his clubs.

Nothing has been done to end or even seriously limit the ability of bank CEOs to achieve the ‘sure thing’ of wealth through leading an accounting control fraud. Indeed, current regulators and (non) prosecutors do not even admit that accounting control fraud exists.

Instead, they operate under a faux ‘definition’ of ‘mortgage fraud’ created by the Mortgage Bankers’ Association. DOJ “partnered’ with the MBA (the trade association) in 2007. Under the MBA’s fraud ‘definition’ control fraud cannot exist in the lending industry.

Wi-Fi provider Gowex

Gowex collapsed in Spain among admissions by its CEO that the wi-fi firm’s accounting records had been fictional for at least four years.

The crude accounting fraud created fake contracts that were reported as Gowex’s principal assets and revenues.

Gowex and its CEO were the toast of Spain, receiving the nation’s top entrepreneurial awards.

Gowex’s crude frauds schemes show why accounting control fraud is so dangerous even when it is performed poorly:

* Accounting fraud is a ‘sure thing’ that produces record (albeit fictional) profits and capital.

* The CEO leading the fraud scheme abhors risk – he is the anti-entrepreneur.

* Accounting numbers are seductive, particularly in finance – our first instinct is to trust.

* While we claim to be sceptical of reported returns, our ‘revealed preferences’ demonstrate that we rarely follow our own warnings about ‘too good to be true’.

* The CEOs can easily suborn or fool auditors into ‘blessing’ fraudulent accounting statements.

* ‘Private market discipline’ is frequently an oxymoron – banks fund the rapid growth of frauds.

* Rapid growth is a typical strategy because it brings in cash.

* Audacity, not ‘genius’ is the key characteristic of the fraudulent CEO.

* Once fictional assets are discovered the fraud is indefensible and the CEO is likely to be removed and prosecuted.

William K Black is associate professor of Economics and Law at the University of Missouri-Kansas City