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Monday, August 25, 2008

The Best Way to Rob a Bank Is to Own One

How Corporate Executives and Politicians Looted the S&L Industry

by William K Black

University of Texas Press (2005)


In 2003, the United States Department of Justice reported that property crimes had continued their trend and fallen to an all time low. In fact, property crimes have surged to an all-time high since Enron collapsed in late 2001. The reason for the contradiction is that the Justice Department does not count serious property crimes because it excludes white-collar crimes from its data keeping. A wave of frauds led by the men who control large corporations, what I term "control fraud", caused the massive losses from property crimes.

In the 1980s, a wave of control frauds ravaged the savings and loan (S&L) industry. I was a regulator during the heart of that crisis. As the book shows, I had an uncanny ability to end up in the wrong place at the wrong time and a talent for getting powerful politicians furious at me. After the crisis, I went back to school at the University of California at Irvine to learn to be a criminologist. I knew that the S&L crisis had grown out of systemic fraud. My dissertation studied California S&L control frauds.

This book arose from my concerns that we had failed to learn the lessons of the S&L debacle and that the failure meant that we walked blind into the ongoing wave of control frauds. The defrauders use companies as both sword and shield. They have shown themselves capable of fooling the most sophisticated market participants and academic experts. They are financial superpredators who use accounting fraud as a weapon and a shield against prosecution.

Several factors make control frauds uniquely dangerous. The person who controls a company (or country) can defeat all internal and external controls because he is ultimately in charge of those controls. Fraudulent CEOs do not simply defeat controls; they suborn them and turn them into allies. Top law firms, under the pretense of rendering zealous advocacy to the client, have helped fraudulent CEOs loot and destroy the client.

Top-tier audit firms are even more valuable allies (Black 1993e). Every S&L control fraud, and all of the major control frauds that have surfaced recently, were able to get clean opinions from them. Control frauds, using accounting fraud as their primary weapon and shield, typically report sensational profits, followed by catastrophic failure. These fictitious profits provide the means for sophisticated, fraudulent CEOs to use common corporate mechanisms such as stock bonuses to convert firm assets to their personal benefit. In short, they camouflage themselves as legitimate leaders and take advantage of the presumption of regularity (and psychic rewards) that CEOs receive.

Fraudulent CEOs can transform the firm and the regulatory environment to aid control fraud. They can use the full resources of the firm to bring about these changes. Control frauds frequently make (directly and indirectly) large political contributions. They may lobby in favor of deregulation or tort reform, or seek to remove the chief regulator. They can place the firm in the lines of businesses that offer the best opportunities for accounting fraud. This generally means investing in assets that have no readily ascertainable market value and arranging reciprocal "sales" of goods, which can transform real losses into fictional profits (Black 1993b). It can also mean, however, targeting poorly regulated industries. They can make the firm grow rapidly and become a Ponzi scheme.

The result is a dangerous package that appears healthy and legitimate but is not and that has extraordinary resources available for use by a fraudulent CEO. Control frauds have shown the ability to fool the most sophisticated market participants. They can be massively insolvent and still be touted by experts as among the very best firms in the world. The conventional economic wisdom about the S&L debacle assumed that "high flier" S&Ls existed solely because of deposit insurance. Scholars asserted that private market discipline would prevent any excessive risk taking in industries that had no government guarantee. This view was incorrect: S&L control frauds consistently showed the ability to deceive uninsured private creditors and shareholders. Elliot Levitas, one of the commissioners appointed to investigate the causes of the debacle as part of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE), emphasized this point in 1993, but no economist took him seriously. The current wave of control frauds has proved his point conclusively.

The scariest aspect of control frauds, however, is that they can occur in waves, causing systemic damage. The S&L debacle was contained before it damaged our overall economy, but this book explains how near a thing that was. Waves of control fraud have occurred in many nations, often with devastating consequences. Russia's privatization campaign was ruined by such a wave.

The current wave of control fraud has done great systemic damage. It need not have happened, had we learned the appropriate lessons from the S&L debacle. Unfortunately, the lessons we learned made us more vulnerable to control fraud, not less. This occurred because the conventional economic wisdom about the S&L debacle is fallacious.

According to the conventional wisdom:

1. The high fliers could not have occurred absent deposit insurance.
2. Fraud was trivial, and studying fraud distracts from proper public policy.
3. The high fliers were honest gamblers for resurrection.
4. Unfortunately, many gambles failed, which caused the debacle.
5. The industry "captured" the Federal Home Loan Bank Board (Bank Board).
6. Deregulation did not cause greater losses.
7. The 1986 tax act exacerbated total losses.
8. The 1989 reregulatory legislation caused the junk bond market to collapse.
9. The 1982 deregulation act was flawed because economists were excluded.

In fact, all of these statements are false, for the following reasons:

* I explained above that both waves of control fraud disproved the first claim.

* As to points 2 and 3, control frauds were leading contributors to the debacle. Over 1,000 S&L insiders were convicted of felonies. Studies of the worst failures almost invariably find control fraud. The pattern of failures is logically consistent with a wave of control fraud and inconsistent with honest gambling. Far from being a distraction, studying S&L control frauds more closely would have allowed us to avoid the present wave of control fraud.

* Every S&L high flier failed. They were all control frauds. Traditional S&Ls did "gamble for resurrection" by continuing to take material interest-rate risk in 1982-1985. These gambles were highly successful because interest rates fell sharply. The gambles greatly reduced the cost of bailing out the Federal Savings and Loan Insurance Corporation (FSLIC). Traditional S&Ls did not gamble in the way predicted by "moral hazard" theory, which predicted that they would maximize their exposure to risk.

* The S&L industry did not capture the Bank Board during the debacle. Indeed, each Bank Board chairman during the debacle was hostile to the trade group.

* Deregulation and "desupervision" added greatly to the debacle because they permitted S&Ls to invest in assets that were superb vehicles for control fraud.

* The 1986 tax act greatly reduced the cost of the debacle by bursting regional real estate bubbles. The 1981 tax act and the S&L control frauds in the Southwest contributed to the debacle by causing and inflating the bubble. Bubbles pop. Without the 1986 tax act, the Arizona, Texas, and Louisiana real estate bubbles would have continued to inflate. The resultant real estate crash would have been far worse.

* S&Ls were a small (overall) player the junk bond markets. They were important because several of them, including Lincoln Savings, were "captives" of Michael Milken and Drexel Burnham Lambert (Black 1993c).

* Economists controlled the drafting of the 1982 St Germain act.

The key lessons that proponents of the conventional wisdom drew were that "a rule against fraud is not an essential or even necessarily an important ingredient of securities markets" (Easterbrook and Fischel 1991, 285), that private market discipline turned presumed conflicts of interest into positive synergies, and that regulators like the Securities and Exchange Commission (SEC) were more harmful than helpful.

In sum, the lessons we learned from the debacle were false. The guidance that law and economics professors provided left us more susceptible to control fraud. This book is often critical of particular economists, but I am not dismissive of economics. Indeed, I write in large part to help build a new economic theory of fraud arising from George Akerlof's classic theory of lemons markets (1970) and Henry Pontell's work on "systems capacity" limitations in regulation that may increase the risk of waves of control fraud (Calavita, Pontell, and Tillman 1997, 136).

This book explains why private market discipline fails to prevent waves of control frauds. It also studies how S&L control frauds sought to manipulate public sector actors. Charles Keating and his Texas counterparts achieved staggering successes. Keating, perpetrator of the worst control fraud in the nation, caused the Reagan administration to attempt to give him majority control of the Bank Board. He enlisted Speaker Wright and the five US senators who became known as the "Keating Five" as his allies. He was able to get a majority of the House of Representatives to cosponsor a resolution designed to block the reregulation proposed by Ed Gray, the Bank Board chairman.

Keating used this immense political power and the threat of lawsuits to intimidate the Bank Board under Danny Wall. The board issued the equivalent of a cease-and-desist order against itself.

Control frauds' key skill is manipulation. Fraudulent CEOs' ability to manipulate was limited primarily by their audacity and the leadership and moral strength of their opponents.

Ed Gray emerged as the most unlikely of heroes. President Reagan made him Bank Board chairman because he supported greater deregulation. Within four months, however, Gray began his transformation into the great reregulator and became the bane of the S&L control frauds and their allies. He immediately developed an impressive list of enemies. Joseph Stiglitz wrote in The Roaring Nineties (2003, 272) that he believes in underlying forces, not heroes. I believe in both, and this book discusses both.

People matter in part because they vary in their concepts of duty, integrity, and courage. This book presents morally complex individuals, not stick figures. One aspect of that complexity is that individuals who were strongly criticized for moral lapses proved vital to preventing an S&L catastrophe. The other side of the coin is that officials who believed that they had superior morals allied themselves with the worst control frauds.

Morals matter, but people are capable of doing immoral acts while believing they are morally superior. I believe that part of the answer is that it is so hard to accept that a CEO can be a crook and that, because he owns substantial stock in the company, the risk increases that he will engage in control fraud if the firm is failing. This seems counterintuitive to most people. If officials understood control frauds, they would be more willing to see CEOs as potential criminals and to maintain the kind of healthy skepticism that could reduce future scandals.

Gray's reregulation set off two wars involving the S&L control frauds. The Bank Board rules limiting growth struck at the most vulnerable chink in control frauds' shields. Every control fraud collapsed within four years.

The control frauds, however, counterattacked using their political power, and blocked any chance that the president would renominate Gray for a second term. Gray's successor, Danny Wall, and his key lieutenants tried to appease Keating. This set off a civil war within the Bank Board. The appeasement produced the most expensive failure (over $3 billion) of a financial institution in US history and ultimately forced Wall's resignation.

Unfortunately, neither regulators nor politicians have learned enough from the S&L debacle. They are repeating the many mistakes we made in fighting the S&L control frauds, but few of our successes. To date, the effort to "reinvent" government has failed to show any utility against waves of fraud. The Government Performance and Results Act (GPRA) was the central reinvention plank. It led to two practices that could have prevented a new wave of control fraud. GPRA required agencies to formally define their mission and to develop strategic plans to achieve those missions. The General Accounting Office (GAO) was assigned the task of identifying high-risk government activities.

The SEC, for example, properly defines itself in its recent strategic plans as "a civil law enforcement agency" (SEC Annual Report for 2002, 1). The SEC's annual reports during the 1990s, however, despite the record-setting, inflating stock market bubble, never defined a wave of control fraud as a central risk to the accomplishment of its mission. The SEC had grossly inadequate resources, did not see the wave of control frauds coming, and was overwhelmed. The GAO's definition of high-risk functions includes fraud risk as a key factor. The GAO, however, limited its concept of fraud risk to situations in which someone was stealing from a public agency. It did not consider a fraud risk that would impair the SEC's ability to meet its mission as a law enforcement agency and protect the pubic from trillions of dollars of losses. Indeed, the GAO still has not classified the SEC's antifraud function as high risk.

This book is the first true insider account of the S&L debacle from a regulator's perspective. (Three Bank Board economists have written books about the debacle, but each of them avoided that perspective.)

I bring many different "hats" to the task. My education and work experience include the following: economics major, lawyer, former regulator, and white-collar criminologist. I teach intermediate microeconomics, management, public financial management and regulation, and white-collar crime at the LBJ School of Public Affairs at the University of Texas at Austin. I also dabble in ethics.

My central message is that we can do things to detect and terminate individual control frauds and to prevent, or at least reduce substantially, future waves of control fraud. To do so, however, we have to take it seriously. One step is no longer to ignore serious frauds in our data collection. A second step is to realize that we need to train people to understand fraud mechanisms and how to spot and end fraud. The SEC's professional staff, for example, consists overwhelmingly of lawyers, accountants, and economists. Historically, none of these three disciplines taught their students anything about fraud. Even today, when securities-fraud scandals are legion and when Joe Well's Association of Certified Fraud Examiners (ACFE) has offered to provide free materials to schools that teach fraud examination, only a small percentage of new business school graduates are trained to fight fraud. The University of Texas has launched a new Institute for Fraud Studies to help bring about these reforms.

Table of Contents

* Abbreviations
* Preface
* Acknowledgments
* Chapter 1: Theft by Deception: Control Fraud in the S&L Industry
* Chapter 2: "Competition in Laxity"
* Chapter 3: The Most Unlikely of Heroes
* Chapter 4: Keating's Unholy War against the Bank Board
* Chapter 5: The Texas Control Frauds Enlist Jim Wright
* Chapter 6: "The Faustian Bargain"
* Chapter 7: The Miracles, the Massacre, and the Speaker's Fall
* Chapter 8: M Danny Wall: "Child of the Senate"
* Chapter 9: Final Surrender: Wall Takes Up Neville Chamberlain's Umbrella
* Chapter 10: It's the Things You Do Know, But Aren't So, That Cause Disasters
* Appendix A: Keating's Plan of Attack on Gray and Reregulation
* Appendix B: Hamstringing the Regulator
* Appendix C: Get Black ... Kill Him Dead
* Notes
* Names and Terms
* References
* Index


William K Black is the Executive Director of the University of Texas at Austin Institute of Fraud Prevention and Assistant Professor of Public Affairs at the LBJ School of Public Affairs.

Copyright (c) 2003-8 University of Texas Press. All rights reserved.

Bill Totten


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