Preface, p xiii “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.”
Preface, p xiv “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.”
Preface, p xvii “Morals matter, but people are capable of doing immoral acts while believing they are morally superior. […] 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 a 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.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, p 1 WILLIAM CRAWFORD, INTRODUCING HIS CONGRESSIONAL TESTIMONY BEFORE THE U.S. HOUSE COMMITTEE ON GOVERNMENT OPERATIONS IN 1988 “The best way to rob a bank is to own one.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, What is a Control Fraud?, p 1 “A control fraud is a company run by a criminal who uses it as a weapon and shield to defraud others and makes it difficult to detect and punish the fraud. […] Fraud is theft by deception: one creates and exploits trust to cheat others. That is one of the reasons the ongoing wave of corporate fraud is so devastating: fraud erodes trust. Trust is vital to making markets, societies, polities, and relationships work, so fraud is particularly pernicious. In a financial context, less trust means more risk, and more risk causes lower asset values. As I write, stocks have lost trillions of dollars in market capitalization. […] fraud causes terrible “negative externalities” because it inflicts injury on those who were not parties to the fraudulent transaction.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, Why do Control Frauds End in Catastrophic Failure?, p 2 “The outside auditor is a control fraud’s most valuable ally. Keating called his accountants a profit center. Control frauds shop for accommodating accountants, appraisers, and attorneys.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, Why do Control Frauds End in Catastrophic Failure?, p 3 – 4 “Control frauds almost always report fabulous profits, and top-tier audit firms bless those financial statements. The S&L control frauds used a fraud mechanism that produced record profits and virtually no loan defaults, and had the ability to quickly transform any (real) loss found by an examiner into a (fictitious) gain that would be blessed by a Big 8 audit firm. […] Almost no one gives highly profitable firms a hard time: not (normal) regulators, not creditors or investors, and certainly not stock analysts. […] Control frauds are human; they enjoy the psychological rewards of running one of the most “profitable” firms. The press, local business elites, politicians, employees, and the charities that receive (typically large) contributions from the company invariably label the CEO a genius. In fact, they are pathetic businessmen. […] Control frauds who take money from the company through normal mechanisms (with the blessing of auditors) and receive the adulation of elite opinion makers are extremely difficult to prosecute.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, How do Waves of Control Fraud Endanger the General or Regional Economy?, p 6 “Systemic risk causes control frauds to occur at the same time. They concentrate in the particular industries that foster the best criminogenic environments. They also concentrate in investments best suited for accounting fraud. That triple concentration means that waves of control fraud will create, inflate, and extend bubbles.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, Moral Hazard, p 6 “Risk and reward are asymmetric when a corporation is insolvent but left under the control of the shareholders. If the corporation makes an extremely risky investment and it fails, the loss is borne entirely by the creditors. If the investment is a spectacular success, the gain goes overwhelmingly to the shareholders. The shareholders have a perverse incentive to take unduly large risks rather than to make the most productive investments.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, Why the S&L Industry Suffered a Wave of Control Fraud, p 7 “a financially troubled industry, particularly one with an implicit or explicit governmental guarantee (e.g., deposit insurance), is one most likely to abuse accounting practices and to restrain vigorous regulation.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, The Cover-up of the Insolvency of the Industry and the FSLIC, p 9 -10 “the FDIC adopted phony accounting for savings banks to hide their insolvency and stopped closing them, showing how strong the pressures were for cover-ups in the 1980s.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, Why did Economists and the Administration get the Debacle so Wrong?, p 12 – 13 “Many of the top financial economists worked for the control frauds, and the collapse created such embarrassment that they felt compelled to deny that their employers were frauds. […] This self-interest was not unique to economists; it applied fully to accountants and lawyers. Economists are particularly vulnerable to this fault, however, when the CEO is the dominant shareholder. The leading law-and-economics text asserts that this is the ideal structure because it ensures managers’ fidelity to shareholders’ interests. This is one of the areas where the field’s lack of knowledge of fraud has embarrassed it, for William Crawford had it exactly right: the best way to rob a bank is to own it. The person with the greatest incentives to engage in fraud is the CEO owner of a failing firm.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, The Many Fronts in Gray’s War Against the Control Frauds, p 13 – 14 “There was no real controversy about how to deal with the 1979-1982 crisis in interest-rate risk. There was uniform belief that the twin answers were a cover-up and deregulation.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, Economic Hindsight Proves 20:2000, p 16 “control frauds will cause the worst losses. The markets will not detect them timely. Outside professionals will aid, not restrain, control frauds. Directors provide camouflage for frauds. Stock options further misalign the interests of shareholders and control frauds because CEOs structure them to maximize their self-interest and use them as a means of converting firm assets to personal use.”
Chapter 1. Theft by Deception: Control Fraud in the S&L Industry, Economic Hindsight Proves 20:2000, p 16 HUMBERT WOLFE:
“You cannot hope
to bribe or twist,
thank God! the
British journalist.
But, seeing what
the man will do
unbribed, there’s
no occasion to.”
Chapter 2. “Competition in Laxity”, The Reagan Administration Decides to Cover Up the S&L Crisis in 1981, p 19 “Virtually every S&L was insolvent on a market-value basis in 1981. By mid-1982, the industry was insolvent by roughly $150 billion. The FSLIC fund had only $6 billion in reserves, so it was hopelessly insolvent. The Reagan administration refused to admit that the industry was insolvent, refused to give the FSLIC any additional money to close failed S&Ls, and ordered Pratt not to use the FSLIC’s statutory right to borrow even the paltry sum of $750 million from the treasury. Pratt’s orders were to cover up the S&L crisis.”
Chapter 2. “Competition in Laxity”, Goodwill: Pratt’s Patent Medicine for a Sick Industry, 20 – 29 “It all starts with a simple, logical assumption drawn from economics: the best proof of market value is what an arm’s-length buyer pays for an asset. An arm’s-length buyer is an independent buyer acting in his own interests. (When economists assume “rationality,” they err if they fail to take into account what’s rational for a fraud.) Goodwill accounting among 1980s S&Ls was overwhelmingly fraudulent. Pratt’s priorities, because the FSLIC had only trivial amounts of money relative to the scale of the industry’s insolvency, were to avoid spending FSLIC funds to resolve failed S&Ls and to cover up the insolvency of the industry and the FSLIC. That meant that the FSLIC rarely used the normal means of resolving failures, i.e., paying a healthy firm to acquire the failed S&L. Instead, Pratt induced roughly 300 buyers to acquire failed S&Ls without any FSLIC assistance. Pratt called these “resolutions” and took credit for developing innovative techniques that reduced the average cost of resolving such failures by about 75 percent.
White-collar criminologists’ mantra is “if it sounds too good to be true, it probably is.” The obvious question is why entities knowingly took on net liabilities without FSLIC assistance. (A firm whose debts exceed its assets is insolvent; it is a net liability.) Accountants’ answer was “goodwill.” A firm can have greater value than the sum of its tangible assets less its debts. McDonalds is an example. It is worth far more than what it could sell its physical assets for, less its debts. It has a reputation for safety and cleanliness and is famous worldwide. This favorable reputation has great value, and we call that value “goodwill.” Accounting literature, however, calls it a “general, unidentified intangible” […]
The concept of goodwill and the assumption of rationality are both reasonable propositions. Together, however, in the context of the mass insolvency of the S&L industry, goodwill created insane financial results. It optimized the S&L environment for control fraud. It helped cover up the mass insolvency of the industry. It allowed Pratt to claim that he had resolved failures at minimal cost and had contained the crisis, which allowed him to resign in triumph and begin a lucrative career at Merrill Lynch, trading mortgage products with the industry.
Here’s how the assumption of rationality and the concept of goodwill produced insanity. When you purchased an S&L through a merger, the assets and liabilities of the S&L you were buying were “marked-to-market.” As a practical matter, that meant that the S&L’s mortgage assets would lose roughly 20 percent of their value. […] Most S&Ls were insolvent on a market-value basis in 1981 by roughly 20 percent of their reported GAAP assets […] A typical acquired S&L might have reported under GAAP that it had $200 million in assets and $205 million in liabilities. Its GAAP insolvency was $5 million.
[…] On a market-value basis, the S&L’s assets are worth 20 percent less than on a GAAP basis: $160 million, not $200 million. The market value of the liabilities is the same as their GAAP value, $205 million. You might think that this demonstrates that the S&L being acquired was insolvent by $45 million on a market-value basis, but if you think so, you have forgotten rationality and goodwill. It would be irrational knowingly and voluntarily to buy an S&L that was insolvent by $45 million without getting at least $45 million in financial assistance from the FSLIC. But buyers got zero FSLIC assistance. The deals were done knowingly; the mark-to-market prior to completing the deal ensured that. The deals were voluntary. The FSLIC had no leverage with which to extort buyers. If the deal was done knowingly and voluntarily, then it was an arm’s-length deal, and that made it the best possible evidence of the true market value of the S&L being purchased. The logic was inescapable: the S&L being acquired must not really be insolvent. It must have enormous goodwill value that accountants could not value directly in the mark-to-market. Indeed, in this example it had to have a minimum value of $45 million because if it had any lesser value, the S&L would be a net liability and it would be irrational to purchase it. Accountants recognized this value by creating a $45 million goodwill asset on the acquirer’s books.
Note how circular and irrefutable this chain of logic is: there is no need (indeed, no way) for the auditor to check whether the S&L being acquired really has any goodwill at all, much less $45 million of it. There is no need because the arm’s-length nature of the deal makes it the best evidence of market value; the auditor has no superior process. It is also impossible for the auditor to check because “general, unidentified intangible” is a fancy way to say “ghost.” The accounting jargon means “we don’t know where to look for it, and even if we did, it wouldn’t matter because it can’t be seen or measured.”
[…] this is too good to be true. Five hundred S&Ls that are deeply insolvent on a market-value basis aren’t really insolvent on a market-value basis because they all turn out to have enormous amounts of goodwill? Then there is the odd way in which goodwill tracks insolvency. If one purchased the S&L a year later, when the mark-to-market showed it was insolvent by $60 million instead of $45 million, the accountants would put $60 million of goodwill on the books. The more insolvent the S&L being acquired, the greater the goodwill. That was, to say the least, illogical.
There was, in fact, no goodwill at the vast majority of failed S&Ls. Accountants did not consider what the source of the enormous goodwill could be. It couldn’t be deposit insurance or even the broad asset powers granted by states with the greatest degree of deregulation. Once could start a new S&L that would be solvent and would have deposit insurance and the same asset powers. Everyone doing the deals knew that the goodwill was fictitious, but it was in their interest to pretend it was real, so they did.
Why did buyers do these deals? Some of the deals were honest. For example, a large S&L would buy a much smaller S&L that was its major competitor for deposits in a metropolitan area. The large S&L would then have the market power to pay less for deposits and charge slightly more for home loans. Or, a very large S&L would buy a smaller S&L that had a good branch network in a part of a part of a state where the large S&L had no presence and wanted to expand. In both cases, there would be real intangible value, but it would be identifiable; in the second example, it was attributable to the branch network.
The bulk of the goodwill mergers, however, were accounting scams. The buyers weren’t irrational; they were taking advantage of an accounting abuse with the encouragement of the Bank Board and the blessing of a Big 8 audit firm. There are two keys to understanding why it was rational to merge despite fictitious goodwill. First the buyer was normally an insolvent S&L. Second, goodwill accounting was so perverse that the more insolvent the S&L acquired, the more “profit” reported.
The owner of an insolvent S&L and the owner of a healthy one had very different incentives when it came to making acquisitions. It was rational for an insolvent S&L to buy, without FSLIC assistance, another insolvent S&L. The insolvent buyer had no downside: limited liability meant that once the S&L was insolvent, the creditors bore any new losses. The owner of the insolvent S&L was no worse off if the merger made the S&L insolvent by an additional $45 million […]
Goodwill mergers guaranteed that fraudulent, insolvent buyers won a trifecta even when the goodwill was bogus. First, buying an insolvent S&L was an elegant way for a control fraud to optimize the S&L as a fraud vehicle. Life is full of trade-offs, even for frauds. Control frauds normally have to trade off several factors. The ideal fraud vehicle would be a large company: there is more to steal and the prestige is greater. The larger an S&L’s assets in the early 1980s, however, the greater its insolvency. Control frauds do not want to report that they are insolvent: a regulator can close them down or restrict their operations. A goodwill merger was perfect because it gave one control of a huge S&L and “eliminated” the insolvency of the purchased S&L. Under honest accounting methods, merging with a deeply insolvent S&L without FSLIC assistance should hurt profitability: the acquirer takes on more liabilities than assets, and so it should lose money.
That takes us to the second leg of the trifecta. I was serious about the claim that the more insolvent the S&L acquired, the higher the reported income. Goodwill mergers created fictitious profits in three ways. The principal means was “gains trading.” Remember that the problem in the early 1980s was that S&Ls had lent most of their mortgage money in the 1970s at much lower interest rates and that the fixed-rate mortgages had thirty-year maturities. When interest rates go up, the value of long-term fixed-rate debt instruments (mortgages, bonds, treasury bills) goes down.
The S&L industry had roughly $750 billion in assets during the worst of the interest-rate crisis. Those assets were overwhelmingly long-term (typically thirty-year) fixed-rate mortgages. Fixed-rate assets do not earn higher rates of interest when market interest rates rise. As a result, they can lose a great deal of their market value when rates rise (no one wants to buy a mortgage if it is only earning 10 percent when he can buy a recently issued mortgage and earn 20 percent interest). By mid-1982, the S&L industry had lost about $150 billion in the market value of its mortgages. That works out to a 20 percent loss of total asset values. […]
For simplicity, assume the same insolvent S&L example I have been using. We buy an S&L that has $200 million (book value) in mortgages that the S&L lent in 1977 at an 8 percent interest rate. On a market-value basis, however, they are only worth $160 million because the market interest rate for a comparable mortgage is now 16 percent. The key is that we create a new book value when we acquire these mortgages through the merger. Their book value becomes $160 million. The $205 million in liabilities at the S&L we are buying are very short-term deposits. Short-term deposits do not change materially in value when interest rates change, so their book value is unchanged by the merger accounting.
Now assume that interest rates begin to fall after we buy the S&L. One year later the market interest rate for a comparable mortgage is 12 percent. Remember: interest rates and market values of mortgages go in opposite directions. Interest rates have fallen by 25 percent since the merger, and the mortgages we acquired in the merger have increased in market value to $180 million. We sell the mortgages for $180 million and book a $20 “gain on sale.”
There were four remarkable things about this “gains trading” scam that made it one of the most perfect frauds of all time. First, one books an enormous profit through a deal that actually locks in an enormous loss. In my example, the acquirer assumes $205 million in liabilities to do this deal. The liabilities are real. The acquirer has just sold every asset acquired in the merger for $180 million. The sale locked in a $25 million loss. The merger has been disastrous, but one reports record profits! And these record profits are derived from GAAP, not creative regulatory accounting principles. Consider the policy implications of this. If one held the mortgages and if interest rates had continued to fall until the market value of the mortgages came back to $200 million, one might have survived. If one sold at $180 million, then it is irrelevant whether rates continue to fall. The other implication is that the acquirer knows that the profit is fictitious and that failure is certain, which maximizes the perverse incentives to engage in reactive control fraud.
Second, the Internal Revenue Service (IRS) treats this transaction for tax purposes as a loss. The IRS says that if one started with assets that had a book value of $200 million and sold them for $180 million, there is a $20 million loss for tax purposes that can be used to offset tax liability on GAAP profits. This is the second way in which goodwill mergers increased net income.
Third, one could maximize this fictitious income only through a merger. Here’s a simply way to understand the point. Assume the buyer was an A&L with assets and liabilities identical to those of the seller. (That is not a bizarre assumption. Most S&L acquirers were other S&Ls, and virtually every S&L was insolvent on a market-value basis during the peak merger years.) The important thing to understand is that only the seller’s mortgages are market-to-market by the merger. Again, we assume that market interest rates for comparable mortgages are 16 percent at the time of the merger and fall one year later to 12 percent. One could sell only the acquired mortgages for a gain because only they got a new (lower) book value through the mark-to-market. The buyer’s mortgages have market, but not book, values identical to those of the mortgages acquired through the merger. The book value of the buyer’s mortgages is still $200 million. If we sell them one year after the merger for their market price of $180 million, we have to book a $20 million loss under GAAP.
The S&L league seriously proposed that the entire industry mark its assets to market and create $150 billion in goodwill so that S&Ls could engage in gains trading without finding a merger partner. Even the administration thought this was beyond the pale. One can now see why S&Ls were desperate to acquire other S&Ls.
The fourth bit of elegance comes from an arcane point […] Gains trading would not have been very attractive if one had had to reduce the goodwill asset figure when selling mortgages. A reduction in goodwill would have caused a dollar-for-dollar reduction in capital, and would soon have led to recognition of the GAAP insolvency of the S&L. It seems obvious that selling the assets obtained in the merger must also reduce any goodwill. But here is where the words “general” and “unidentified” proved so useful to the scams. Because the goodwill was not associated with any tangible acquired asset, it was not written off, even if every tangible asset acquired in the merger was sold.
In addition to gains trading and the IRS treatment of the gain as a loss for tax purposes, goodwill mergers created fictitious income through a device so arcane that perhaps one accountant in a thousand knew about it. Here’s the quick and dirty version. Accountants actually created two new accounts when there was a goodwill merger. In addition to goodwill they created an account called “discount.” […] For S&Ls in the early 1980s, discount and goodwill were nearly identical in size. A percentage of goodwill had to be recognizes every year as an expense. Pratt and the buyers, of course, wanted to minimize expense recognition in order to inflate net income. They found a blunt but effective way to do so. S&Ls had to recognize only 2.5 percent of goodwill a year as expense. In my example of a $45 million goodwill figure, that would mean a bit over $1 million a year. S&Ls recognized a portion of discount as income every year. (Note that neither the expense nor the income represents cash flows.) The rate at which discount was recognized as income was significantly greater than the rate at which goodwill was recognized as expense. Given my first point, the nearly identical size of goodwill and discount, this meant that the more insolvent the S&L acquired, the more “income” it produced. The increased income from discount could be three times the increased expense from goodwill.
Years later, brilliant lawyers produced an unexpected, fourth source of income from these goodwill scams. In 1989, Congress finally began cleaning up S&L rot through the Financial Institution Reform, Recovery, and Enforcement Act (FIRREA). One of the abuses it ended was fictitious goodwill. The beneficiaries of that fictitious goodwill hired lawyers who managed to convince the Supreme Court that the Congress was taking something of value from these scam artists and that the Constitution requires the taxpayers to compensate them for the fictitious goodwill. We may have to pay $20 billion to the least deserving claimants in the history of takings litigation!
[…] Both the ability to control a large S&L without having to recognize its insolvency and the multiple sources of fictitious income are relevant to the third leg of the trifecta. The mergers protected the buyers from regulators and supercharged the S&Ls as control-fraud vehicles.
[…] The goodwill mergers gave the acquirers de facto immunity from regulatory controls for several related reasons. The most obvious stems from my discussion of the fictitious income the mergers produced. Both the buyer and the S&L it was about to acquire would, in 1979-1982, have reported losing money. The merger would occur, and, miraculously, the combined entity would almost immediately be profitable—extremely profitable. It is very difficult to take supervisory action against a firm that is profitable.
The profit turnaround was “too good to be true,” but Pratt hailed it as proof that his strategy for rescuing failed S&Ls was not only much cheaper than other solutions, but was also transforming the industry by attracting entrepreneurs whose superior management produced profits in awful economic times. Pratt knew better, as shown by his testimony before the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE).
Under GAAP, as they were applied in the early 1980s, two institutions with massive negative earnings could merge, and the combined entity could show positive income without the operations of either institution changing. (NCFIRRE: Origins and Causes of the S&L Debacle: A Blueprint for Reform, A Report to the President and Congress of the United States.)
The acquiring CEOs responded with becoming modesty or bravado, depending on their personality, and raked in the rewards (raises, bonuses, and perks) that their superior skills and the responsibility of running a much larger S&L entitled them to. The values of stock S&Ls (depositors owned many S&Ls in “mutual” form) surged after mergers in response to the “profits.”
The remarkable profits of the goodwill mergers caused nearly everyone to view the CEOs as stars. From the Bank Board perspective, the acquirer was not simply a star manager—he was someone who deserved the agency’s gratitude for resolving a failure at no cost to the FSLIC. The Bank Board wanted to believe that the profits were real. Pratt proclaimed that the profits proved his policies were correct. It would take a very brave or very stupid examiner to say that the goodwill, income, and “successes” of the mergers were equally fictitious.
The fact that senior field supervisors often recruited the acquirers in the goodwill mergers was a particular problem. The supervisor would recommend approval of the merger, vouching for the character of the principals. The merger produced the inevitable surge in “profits.” The supervisor would write a glowing letter praising the new management, and, in turn, would receive a bonus and a letter in her file praising the merger. The supervisor would then ask the CEO to come to dog and pony shows where she would try to interest other acquirers. She would introduce the CEO as her prime example of how superior management produced great profits, and she would regale the group with odes to the CEO’s brilliance. The CEO would tell his fellow real estate developers that we had met lots of jerky regulators, but his friend Mary was great.
Regulators are human. We are grateful to those who help us, particularly in times of greatest need. We are sensitive to the criticism that we are too negative; we like to say positive things. We deal constantly with the industry and make friends. We are reluctant to see our friends as crooks, and we know how embarrassing it would be if the CEO we recruited and praised turned out to be a fraud. We are subject to cognitive dissonance.
The combination of these factors meant that Bank Board supervisors were very unlikely to expose the goodwill accounting scams. Two other things compounded this problem. Very few people, even within the Bank Board, understood how the scam worked. I don’t want to overstate this point—many people were skeptical that goodwill was real—but only a handful knew how goodwill and mark-to-market virtually guaranteed substantial fictitious profits if the insolvency of the acquired S&L was large relative to the size of the acquirer. This problem became even worse once Pratt and his senior staff left the agency, for the folks who remained were even less likely to understand.
The acquirers, however, did not rely solely on these human weaknesses. They had lawyers, and they typically got forbearance provisions that said that the Bank Board could not take supervisory action against them even if they were in violation of the agency’s pathetically weak net-worth requirements if the failure was due to acquiring the failed S&L. This meant that is was difficult to crack down on S&Ls involved in goodwill mergers even if they were highly unprofitable.”
Chapter 2. “Competition in Laxity”, Desupervision, p 34 “If an S&L’s liabilities exceed its assets, the insurance fund suffers a loss; and if the liabilities of the insurance fund exceed its assets, the taxpayers bear the loss.
Mehle had an answer to that: we bear the loss only if we close the S&L, so we should not close failed S&Ls.”
Chapter 2. “Competition in Laxity”, The 1981 Tax Act: Dropping Napalm on a Forest Fire, p 37 – 38 “Many observers blamed the 1986 Tax Act for the woes that befell the S&L industry, but it was the 1981 Act that created an unsustainable boom, and encouraged “over-building.” The 1986 law hastened the collapse in the Southwest, much of whose expansion had been based on expectations of continued inflation in property values. But had the 1986 act not been passed, over-building would have been even greater, and the eventual collapse in real-estate values deeper.” (NCFIRRE: Origins and Causes of the S&L Debacle: A Blueprint for Reform, A Report to the President and Congress of the United States.)
Chapter 2. “Competition in Laxity”, The 1981 Tax Act: Dropping Napalm on a Forest Fire, p 37 “The acquirers who won gold medals for fraud used an elegant variant of this scam. They would say that they wished to contribute $5 million in capital to “their” S&L. Unfortunately, the only way they could do so was to contribute a large real estate parcel. The parcel had an appraised value of $20 million. They would contribute the parcel to their S&L, and the S&L would pay them $15 million in cash. The parcel might, in fact, be worth as little as $2 million.”
Chapter 2. “Competition in Laxity”, How Control Frauds Shop for Professionals, p 39 – 40 “Here’s how it works with appraisers. The appraisal fee is larger for commercial real estate than for residential, and it is greater in absolute size for more expensive than for less expensive properties. As a result, both appraisers and S&L control frauds gained if the S&L did more commercial real estate lending on more expensive projects. The S&L loan officer calls the appraiser and asks him for a favor. The loan officer has to make a recommendation on a proposed $60 million loan in two weeks. Could the appraiser please give him a preliminary, oral estimate of value as soon as possible, before completing the written appraisal report? (Note that the loan officer has communicated the size of the loan to the appraiser.) The S&L can’t make the loan without violating Bank Board rules if the appraiser does not come back with a value of at least $60 million. The appraiser calls with preliminary estimate of value. If it is at least $60 million, the loan officer tells him to finalize the written appraisal, pays his full fee, and uses him in the future. If he comes back under $60 million the loan officer thanks him effusively, says that there is no need to complete the written appraisal given the inadequate value of the property, pays a reduced fee, and the S&L never uses the appraiser again. Functionally paying an appraiser a fee to value property (that is, say, really worth $35 million) at over $60 million is equivalent to a bribe. But it is a “perfect crime,” impossible to prosecute. Control frauds know that they only need a tiny group of appraisers to inflate property values; there is no need to suborn the entire profession. The thing that most people don’t understand is that this whole process can (and typically was) done in a way that a transcript of the conversation could appear on the front page of the local newspaper without embarrassing the appraiser or the loan officer.” Chapter 3. The Most Unlikely of Heroes, Fallacy of Composition, p 47 “An individual S&L might be able to grow out of its problems, but an industry cannot.”
Chapter 3. The Most Unlikely of Heroes, The ADC Ponzi Scheme, p 49 “The developer would not repay the S&L unless the real estate project succeeded. Indeed, it had to succeed fully because the loan was 100 percent of the projected value; the S&L would lose money if the appraiser inflated that value even slightly. These were not close calls: the typical ADC Ponzi loan was clearly an equity investment. This makes their audit partners’ consistent treatment of them as true loans all the more disturbing.”
Chapter 3. The Most Unlikely of Heroes, p 285 NOTE 8 “the United States Court of Appeals for the Fifth Circuit ruled that Arthur Young was not liable to Western Savings’ honest shareholders because Western Savings was a control fraud! The auditors were immune from suit because they helped a control fraud cause a billion dollars in losses to the taxpayers. By protecting top-tier audit firms from liability for aiding control frauds, the courts (and later Congress) helped cause the current wave of scandals.”
Chapter 3. The Most Unlikely of Heroes, The ADC Ponzi Scheme, p 53 “A cash-for-trash deal started with an uncreditworthy borrower asking the S&L for a $3 million ADC loan. The loan officer responds that the S&L will not loan him $3 million, but it will loan him $33 million. The catch is that the borrower has to use $30 million of the loan proceeds (the “cash”) to buy a particular property (the “trash”).”
Chapter 3. The Most Unlikely of Heroes, p 286 NOTE 10 “Because a CEO did need not to expressly ask the employee or officer to engage in fraud, everyone enjoyed deniability—and almost no one wants to think of himself or herself as a criminal. People in these situations use all kinds of what criminologists call “neutralization” techniques to keep from looking at themselves as criminals. Control frauds reinforce these techniques. One of the most effective means, which Keating used to good effect, was to tell employees that they were geniuses and that the regulators were dumb, vicious perverts. He paid people well above competitive salaries. His outside professionals were generally top quality, but his in-house people overwhelmingly were graduates of second-tier schools. Telling them that they were geniuses and paying them far more than graduates of top schools at rival banks and S&Ls made for intense loyalty. The other inducement was negative. It is why I say that control frauds are control freaks. Asking questions was the one sure way to get fired by a control fraud. One could make loans with a 96 percent default rate (as happened at Vernon Savings) and get a huge bonus, but ask a question and one was gone. The control frauds hired yes-men and yes-women and got rid of inquiring minds.
Nevertheless, the officers and employees knew that they were helping a fraudulent scheme. People who were unwilling to do so left, and the ones hired to replace them were likely to be less ethical. S&L control frauds deliberately gutted internal controls designed to stop bad loans. It was easy to defraud S&L control frauds.”
Chapter 3. The Most Unlikely of Heroes, p 286 NOTE 12 “Economists are like the guy in the old joke who loses his car keys one night on the north side of the parking lot but searches for them on the south side because the light is better there—they only study where they have data.”
Chapter 3. The Most Unlikely of Heroes, The Catastrophe Gray So Narrowly Averted, p 61 “Without Gray’s late 1984 moratorium on new California, Texas, and Florida charters’ receiving FSLIC insurance, there would have been hundreds of new control frauds during his term.
The capital rule and other steps that Gray took to toughen supervision reduced growth dramatically. The industry rate of growth fell by more than half in 1985 to 9.5 percent.” Chapter 4. Keating’s Unholy War Against the Bank Board, p 63 “Within a few weeks, Keating was able to get a majority of House members to cosponsor a resolution designed to kill the rule. We had never seen such raw political power. Gray went forward with the rule even though the administration, the House, and the industry opposed it.
We discovered later that one of Keating’s effective lobbying tactics was to have the state commissioners complain to their congressional delegations about any Bank Board rule that reduced state-granted investment powers.”
Chapter 4. Keating’s Unholy War Against the Bank Board, Prepare to Repel Boarders—Keating’s Plan to Take Over the Bank Board, p 65 – 66 “One of the great advantages that white-collar criminals have over blue-collar criminals is the ability to use top lawyers, not only at trial but also before criminal investigations even begin. Control frauds maximize this advantage by paying for the lawyers who help the controlling insider loot the firm. Then, as evidence of their legitimacy, control frauds trumpet that they sought legal counsel and that the counsel advised them that their activities were lawful.”
Chapter 5. The Texas Control Frauds Enlist Jim Wright, 1986: FSLIC Recap, A Bastardized Plan Exposes the Bank Board to Extortion, p 91 “the administration placed two absolute constraints on the [FSLIC recapitalization] plan [that] were sure to cause severe problems. First, the Treasury Department would not kick in a penny to help the FSLIC. That was a bedrock administration demand—end of story. All the money had to come from the industry. Second, not a penny of the money spent could be “scored” for budgetary purposes as a federal expenditure; in other words, the whole plan had to be “off budget.””
Chapter 5. The Texas Control Frauds Enlist Jim Wright, October 21, 1986: The Ridglea Meeting and its Fallout, p 99 “The Dallas Fraud Task Force produced well over 400 criminal convictions arising from the Texas control frauds. It remains the most successful white-collar prosecution effort in world history.”
Chapter 5. The Texas Control Frauds Enlist Jim Wright, October 21, 1986: The Ridglea Meeting and its Fallout, p 101 “Pashayan was part of a group of sixteen Republican congressmen (including Dick Cheney, Newt Gingrich, and Robert Dornan) who pressured the Bank Board to give Keating privileged Bank Board information in order to help him block the direct-investment rule.”
Chapter 5. The Texas Control Frauds Enlist Jim Wright, October 21, 1986: The Ridglea Meeting and its Fallout, p 101 – 102 “real estate developers are infamous as political contributors. Many of them strike it big by getting a zoning change from the local commission or obtaining a license to develop a facility from a state agency. Real estate developers commonly donate to both parties.”
Chapter 6. “The Faustian Bargain”, The Frustrations of the League’s Professional Lobbyists, p 135 “Tom King, the Texas League’s executive director, said that Texas needed “rinky-dink” accounting. The first rule, of course, in asking for rinky-dink accounting is to never call it by its true name.”
Chapter 7. The Miracles, the Massacre, and the Speaker’s Fall, The Importance of the Bank Board’s Criticisms of the Speaker, p 166 “Gray, hated by the administration, the industry, most of Congress, and much of the media […] successfully expose[d] and [fought] the Speaker’s ability to hold the FSLIC recap bill hostage”
Chapter 8. M. Danny Wall: “Child of the Senate”, The Administration’s and Wall’s Initial Symbolic Steps, p 167 “In the absence of a serious scandal, there is a ritual when the administration appoints a chairman to succeed its prior appointee. The outgoing chairman praises his successor at the ceremony where the new chairman takes the oath of office. The successor praises his predecessor’s accomplishments and speaks of how they have made his own task much easier. The president lauds both of his appointees. But President Reagan did not invite Gray to the podium or praise him, and Wall did not mention him in the speech he made at the ceremony. The administration and Wall signaled a complete break with Gray’s policies, not continuity. They also signaled the severity of their displeasure with Gray. The process inflicted a last bit of humiliation on him.”
Chapter 8. M. Danny Wall: “Child of the Senate”, The Implications of Wall’s and Martin’s View that Gray was the Enemy, p 173 “Wall’s view of Gray as a man who had undercut the administration’s deregulatory policies, artificially created a crisis, and vindictively targeted S*Ls for closure was a common view in 1987. The control frauds and the league had spent lavishly to spread that message for years.”
Chapter 8. M. Danny Wall: “Child of the Senate”, The Implications of Wall’s and Martin’s View that Gray was the Enemy, p 174 “Consider the effect of 150 people saying the same thing—that is how many people met with Wright at Riglea to attack Gray. The Bank Board member heard the same message from the administration, the league, S&L CEOs, and real estate developers. Surely they couldn’t all by lying? […] The control frauds advanced under cover of the smoke screen they laid down.”
Chapter 8. M. Danny Wall: “Child of the Senate”, Lincoln Savings: Accepting the Werewolf’s Advice about Silver Bullets, p 185 “Keating was someone who top politicians strove to meet at parties. He had close ties to the White House, the House and the Senate, and top state officials in Arizona and California. He was a major subject of a 60 Minutes segment about the “New Southwest” that focused on his novel way of doing business and suggested that Lincoln Savings must be enormously profitable. Top-tier audit firms gave his financials “clean opinions” and decried the FHLBSF’s criticisms. Lincoln Savings reported at times that it was the most profitable S&L in the country.”
Chapter 8. M. Danny Wall: “Child of the Senate”, Lincoln Savings: Accepting the Werewolf’s Advice about Silver Bullets, p 188 “No examination had ever been halted in American financial regulatory history because of a threat of suit.”
Chapter 8. M. Danny Wall: “Child of the Senate”, Lincoln Savings: Accepting the Werewolf’s Advice about Silver Bullets, p 191 “Keating, knowing that no examiners would be permitted into the S&L, used this period of immunity to commit his most intense looting, adding massively to Lincoln Savings’ ultimate losses.”
Chapter 8. M. Danny Wall: “Child of the Senate”, False Hopes on the Road to Munich, p 196 “No S&L had ever been permitted to acquire another S&L for the purpose of escaping supervisors it found to be too vigilant.”
Chapter 8. M. Danny Wall: “Child of the Senate”, Keating: “I Didn’t Think Anyone Would Believe Me.” / Stewart: “I Believed Him.”, p 204 – 205 “Part of the problem, well known to criminologists who study fraud, is that we are not inclined to believe that respectable people will blatantly lie to us. […] Keating wore expensive clothes, and he looked like a former champion swimmer (which he was) and a highly respectable businessman (which he was not). Dochow explained to the ERC that he was comfortable with Keating because “he looked me straight in the eye”. Control frauds, of course, can lie fluently while looking one directly in the eye and swearing simultaneously on a holy text and their mother’s honor.”
Chapter 8. M. Danny Wall: “Child of the Senate”, Keating: “I Didn’t Think Anyone Would Believe Me.” / Stewart: “I Believed Him.”, p 207 – 208 + p 300 NOTE 11 “Martin’s belief in the FHLBSF’s perfidy was so complete that, like Stewart, he retained his belief that the FHLBSF was worse than Keating, even after Keating had been shown to be the worst S&L control fraud. When Patriarca left government service and joined Wells Fargo Bank, a San Francisco newspaper wrote the traditional blurb announcing the new hire and noting how he had warned the Bank Board that Lincoln Savings should be closed. Martin wrote the reporter on February 24, 1992, attacking Patriarca. The first paragraph showed that Martin’s inferential skills and standards of proof remained unchanged:
“I read with interest your flattering article of [sic] Michael Patriarca. Perhaps you wrote this because he leaked information to you.”
[… NOTE 11] The rest of the letter is equally amusing. Martin led Wall’s effort to understate greatly the cost of resolving the S&L debacle. The Bank Board mandated that the field offices use a methodology that would seriously understate losses. (Jim Barth provided them with five possible ways to estimate the losses; Wall chose the one that produced the lowest estimate.) The FHLBSF provided the number using the mandated methodology, but explained that it would seriously understate actual losses. The Bank Board criticized us heavily for that aspect of our response. Martin now cited our absurdly low estimate of losses—which he and Wall had mandated—as evidence of Patriarca’s ineptness.”
Chapter 8. M. Danny Wall: “Child of the Senate”, Keating: “I Didn’t Think Anyone Would Believe Me.” / Stewart: “I Believed Him.”, p 210 “When the FHLBSF commissioned an independent appraisal that showed a large loss on the hotel, Keating swung into high gear. Lincoln Saving paid a bank over $20 million in “fees” to arrange for the Kuwaiti Investment Office (KIO) to purchase a major interest in the hotel at a price suggesting that the hotel’s market value was well in excess of the value found by the appraiser. Simultaneously, Lincoln Savings had an outside law firm research the Foreign Corrupt Practices Act, which prohibits U.S. companies from bribing foreign officials. I joked that we now had good evidence of the market price of bribing a Kuwaiti prince (the royal family runs the KIO), not the market value of the hotel.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, p 215 “the worst S&L control frauds invariably owned substantial stock in the S&Ls they looted.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, The Instruments of Surrender, p 223 “The memorandum of understanding (MOU) was the first agreement a regulator ever made in which it effectively consented to a cease-and-desist order against its own supervisory powers.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, p 301 NOTE 4 “the Bank Board waited until after the election to close Silverado Savings, in which the vice president’s son Neil had played such a disreputable role. Bank Board economists also informed a group of us at the FHLBSF that the newest projections on the need for, and cost of, a federal bailout of the FSLIC were complete but would not be released until after the election.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, “Pull a Rabbit out of the Hat”: M. Danny Wall, p 236 – 237 “Wall’s “understanding and perspective as to this man’s success over the years” was so erroneous and so unshakeable that even when he had been shown that the “success” was really failure hiding behind a fraudulent facade, he retained his faith in Keating’s myth.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, p 302 NOTE 8 “It would require a far longer book to explain all the harm that befall the nation from September 1988 to late April 1989 when the Bank Board indisputably knew it was dealing with a massive fraud but took no effective action against it. In addition to the losses to those who bought ACC’s worthless junk bonds and the enormous new losses to the taxpayers from the new fraudulent investments, the Bank Board gave Keating’s lieutenants time to destroy documents and transfer surviving documents out of Lincoln Savings’ offices. Similarly, virtually all of Lincoln Savings’ (few) valuable assets were transferred to subsidiaries or pledged as collateral. ACC and Lincoln’s subsidiaries then filed for bankruptcy just before the California law changed and the CDSL would have taken over Lincoln Savings. The Bank Board, despite protests from Barabolak and warnings from the FHLBSF, took no action to prevent these subterfuges or to prepare to deal with the voluntary bankruptcy strategy. By filing voluntary Chapter 11 bankruptcy petitions, Keating hoped to stay in control of ACC, Lincoln’s subsidiaries, and Lincoln’s assets. (The law imposes an automatic stay that bars creditors like the FSLIC from retrieving looted assets without special permission of the bankruptcy court.) The FHLBSF, fortunately, had hired private counsel in Phoenix.
The Bank Board finally placed Lincoln Savings in conservatorship the day after the bankruptcy filings. The conservator discovered that virtually all of Lincoln’s valuable assets had been transferred to subsidiaries or sold. Lincoln Savings had no cash to stem the run. The Federal Reserve had to make unsecured loans to Lincoln Savings.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, When You Go To Kill … You Better Succeed, p 237 “[President George H W Bush] introduced legislation in early 1989 to deal with the S&L crisis. It provided that Wall be made director of OTS, without the “advice and consent” of the Senate and the normal confirmation hearings.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, When You Go To Kill … You Better Succeed, p 238 “the event that had enraged us was the Bank Board’s decision to let Keating defraud the widows in hopes that this would delay ACC’s failure and allow him “to pull a rabbit out of the hat.” Wall compounded his mistake by ordering Patriarca and me to headquarters to coordinate our testimony with his staff’s testimony. We were told that if we agreed to place the blame on our staff (for purportedly failing to document Keating’s abuses adequately), Wall’s staff would praise our efforts to bring Keating to justice.”
Chapter 9. Final Surrender: Wall Takes Up Neville Chamberlain’s Umbrella, The New Broom, p 243 “The OTS and the RTC combined to recover well over $1 billion from law and audit firms. Other than the unsuccessful White House effort to remove the OTS’s jurisdiction to bring an enforcement action against the president’s son, Neil Bush, for his contribution to the expensive failure of Silverado Savings, political intervention with the OTS halted.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, p 246 “Consider Greenspan’s, Benston’s, and Fischel’s evaluations of Lincoln Savings. Greenspan said it “posed no foreseeable risk” to the FSLIC. Benston said Lincoln Savings should serve as the model for the industry. Fischel proved it was the best S&L in the nation (perhaps the worst in the world) and pronounced it superb. That is the measure of how successful control frauds are in deceiving experts who do not understand fraud mechanisms and assume that CEOs cannot be crooks.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 2. It is Important to Understand Fraud Mechanisms, p 247 “Many of the financial experts’ most embarrassing predictive and analytical failures arose because they did not understand how control frauds operate. […] Control frauds were consistently able to fool top economists because they did not understand how CEOs turn accountants and accounting principals from a restraint into a weapon of fraud and a shield against the regulators.
Economists receive no training about fraud risk, incidence, or mechanisms (beyond the conventional wisdom that it was trivial, a distraction during the debacle). Lawyers receive no fraud training. Joe Well’s Association for Certified Fraud Examiners (ACFE) offers free materials to any business school that will teach a course in fraud examination. Only a small number of business schools took up the offer prior to the Enron scandal. The number even now remains scandalously low. The average new accountant receives no meaningful training about fraud and no training at all about control fraud.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 4. Waves of Control Fraud Cause Immense Damage, p 248 “Individual cases of control fraud cause severe losses, but waves of control fraud cause systemic injury. The direct financial damage is staggering: many tens of billions of dollars during the debacle and hundreds of billions in the ongoing scandals.
The indirect financial damage is far greater.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 4. Waves of Control Fraud Cause Immense Damage, p 248 “the indirect financial injury was primarily the inflating of regional real estate bubbles. This deepened the real estate glut and ultimately worsened the severe drop of values that harmed even honest real estate participants. Bubbles waste societal resources through misallocation both when they inflate and when they collapse. Fraud sends inaccurate price signals that move markets even farther away from efficiency. The S&L control frauds kept real estate prices artificially high by increasing the levels of ADC lending and direct real-estate investments in markets that had vacancy rates seen only in the severest recessions. The fraudulent investments contributed to regional recessions in Texas, Louisiana, and Arizona. Other indirect financial injuries were inflicted on S&L employees, who lost their jobs and pensions when control frauds destroyed the S&L; innocent stockholders; and the victims of ACC’s worthless junk bond sales. The S&L industry was not a major purchaser of junk bonds, but it provided Milken’s most important group of “captives.” They were critical to the overstating of junk bond values, which misallocates and wastes societal resources.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 4. Waves of Control Fraud Cause Immense Damage, p 248 “the ongoing scandals’ most harmful indirect economic effect has been to reduce trust. Frauds operate by creating—and abusing—trust.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, p 303 NOTE 2 “The S&L control frauds and the ongoing wave of control frauds generally targeted creditors and shareholders. However, modern control frauds often target customers, e.g., Enron and its coconspirators created and exploited the California power “crisis”; mutual funds widely abused customers; Tenet Healthcare allegedly practiced unnecessary surgery at one hospital, leading to the death of several patients, and fraudulently overbilled government health insurance programs; and, earlier, Koch Industries committed fraud against small oil producers.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 4. Waves of Control Fraud Cause Immense Damage, p 249 “Enron and its fellow conspirators (virtually every major energy trader in America and several electrical generators) caused blackouts in California, raised the price of electrical power dramatically, and bankrupted California’s electrical utilities. (These control frauds were aimed at customers, not creditors.) Similarly, corporate tax fraud surged as some of the nation’s top audit and law firms pushed fraudulent tax shelters and schemes for using tax havens to avoid taxation. Enron was so active in these frauds that it marketed its services as a consultant for eliminating corporate taxes.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 4. Waves of Control Fraud Cause Immense Damage, p 249 “Effective markets are neither natural nor inevitable. Markets are institutions shaped by law, culture, and morals.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 5. Control Frauds Convert Conventional Restraints On Abuse Into Aids To Fraud, p 250 “All the S&L control frauds were accounting frauds. All of them were able to get clean audit opinions from top-tier audit firms, typically for many years. No audit firm exposed an S&L control fraud.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 5. Control Frauds Convert Conventional Restraints On Abuse Into Aids To Fraud, p 251 “The legal profession and the accountants, in response to an embarrassing record of the top firms in their fields aiding control frauds, agreed on the primary strategic response: reduced professional liability. Leaders of the bar and the accounting industry testified before the National Commission on Financial Institution Reform, Recovery and Enforcement in 1993. They angrily denounced the OTS and RTC suits that had led, collectively, to over a billion dollars in settlements. They did not offer any apologies, accept any responsibility, or suggest any reforms of their practices.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 5. Control Frauds Convert Conventional Restraints On Abuse Into Aids To Fraud, p 252 “Everything Congress proposes is a “reform,” no matter how pernicious its effect.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 5. Control Frauds Convert Conventional Restraints On Abuse Into Aids To Fraud, p 253 CHICAGO TRIBUNE “[T]he top accounting firms successfully lobbied for a federal law that makes it more difficult for investors to sue them. The 1995 law was a major victory for the profession and was achieved only after Congress voted to override a veto by President Bill Clinton—his first ever.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, p 304 NOTE 7 “Auditors, in fact, commonly give clean opinions to control frauds that are massively insolvent. Auditors, in fact, help control frauds create fictional income and hide real losses. Auditors do this primarily for rational reasons: because control frauds pay them enormous nonaudit fees and because of agency problems (the interests of the audit partner who is under severe pressure to bring in lucrative clients or be fired frequently diverge from the interests of the firm).”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 6. Conflicts of Interest Matter, p 253 – 254 “The S&L debacle proved that human nature had not changed; conflicts of interest still cause damage. […] Unfortunately, the conventional economic wisdom taught the opposite. Conflicts became “synergies.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 7. Deposit Insurance Was Not Essential To S&L Control Frauds, p 255 “Milken sold […] $125 million in ACC sub debt at a high interest rate to the usual subjects: if Milken sold one’s junk bonds, it was understood that one bought junk bonds issued by other Milken clients. The key to Milken’s scheme was to reduce the apparent default rate, so it would not do to let ACC default on its Drexel-issued junk bonds. The situation was as elegant as it was cynical: ACC would sell junk bonds to widows (at a ludicrously low rate of interest) and use the proceeds to retire the Drexel-issued junk bonds sold (at a very high rate of interest) to Milken’s minions.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 7. Deposit Insurance Was Not Essential To S&L Control Frauds, p 256 “We should have learned from the S&L debacle that private market discipline does not stop control frauds effectively, that sub debt is not equivalent to capital for banks, and that private insurance does not effectively prevent, detect, or limit control fraud.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 9. Regulatory and Presidential Leadership Is Vitally Important, p 259 – 260 “Both Pratt and Wall demonstrated a recurrent problem with modern regulation. Placing an individual who does not believe in regulation in charge of a regulatory agency can cause great damage, especially if that agency has to deal with control frauds. Deregulatory economists argue that private market mechanisms deal adequately with control fraud. People who believe that claim (and those who have taken one course in law and economics are often its most fervent adherents) believe that financial statements are truthful and that auditors will not aid control frauds. They are taught that public-choice theory has shown that it is naive to believe that government workers act in the public interest (instead of simply maximizing their personal self-interest). Agencies are routinely captured by the regulatees, according to the economic theory of regulation. Government officials who argue that control fraud is material exemplify an agency problem: they are trying to distract attention from their own failures. Externalities such as pollution are not a valid rationale for regulation; they just represent a failure to adequately assign property rights pursuant to the Coase theorem. Antitrust laws need not, and should not, be enforced, because markets quickly sweep away the rare problems that arise, and antitrust laws are used primarily by unsuccessful competitors to bludgeon rivals they could not outcompete.
[…] Anyone who believes all (or even most) of the propositions in the above paragraph is going to be personally unprepared to identify or deal with a wave of control frauds. Indeed, such a wave is impossible under their beliefs. Further, if fraud is immaterial, then there is no reason to learn about fraud mechanisms or the means to reduce fraud. If the person who believes such theories is a senior regulatory leader, the agency will be unprepared to deal with a wave of control frauds. Indeed, such a leader would be strongly inclined to believe that any employee who vigorously argued that a corporation reporting strong profits (blessed by a top-tier audit firm) should be closed must have taken leave of his senses or be engaged in a vendetta.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 10. Ethics and Social Forces are Critical Restraints on Fraud and Abuse, p 263 “True whistle-blowers—those who inform the public or the authorities of control fraud—have been rare during the current wave of financial scandals. We cannot rely on whistle-blowers to do the work regulators and the criminal justice system should do against control fraud.”
Chapter 10. It’s The Things You Do Know, But Aren’t So, That Cause Disasters, 12. Why Doesn’t the SEC have a Chief Criminologist?, p 264 “Trust is vital for efficient commerce, social harmony, and intimacy. But some of us must remain intensely skeptical so that others can continue to trust. The regulators need to be skeptical (accountants and most lawyers also have to rediscover skepticism). That does not mean automatically assuming the worst, but it does mean that one checks hard and skillfully. It also means that if the party being examined interferes with the review, lies, or attempts to intimidate the reviewer, the reviewer’s skepticism should spike and the superiors should support the reviewer.”