The Best Way to Rob a Bank is to Own One

How Corporate Executives and Politicians Looted the S&L Industry

William K. Black

• Publisher: University of Texas Press
• Year: 2013
• ISBN:
  9780292754201
• Topic: Business
• Subtopic: Government & Business
• Index: Business

An investigator tells the inside story of the 1980s savings-and-loan scandal and what we can do today to prevent future frauds: "Merits a wide readership." — Journal of Economic Issues In this expert insider's account of the savings and loan debacle of the 1980s, William Black lays bare the strategies that corrupt CEOs and CFOs—in collusion with those who have regulatory oversight of their industries—use to defraud companies for their personal gain. Recounting the investigations he conducted as Director of Litigation for the Federal Home Loan Bank Board, Black fully reveals how Charles Keating and hundreds of other S&L owners took advantage of a weak regulatory environment to perpetrate accounting fraud on a massive scale. In the new afterword, he also authoritatively links the S&L crash to the business failures of 2008 and beyond, showing how CEOs then and now are using the same tactics to defeat regulatory restraints and commit the same types of destructive fraud. Black uses the latest advances in criminology and economics to develop a theory of why "control fraud"—looting a company for personal profit—tends to occur in waves that make financial markets deeply inefficient. He also explains how to prevent such waves. Throughout the book, Black drives home the larger point that control fraud is a major, ongoing threat in business that requires active, independent regulators to contain it. His book is a wake-up call for everyone who believes that market forces alone will keep companies and their owners honest. "Bill Black has detailed an alarming story about financial and political corruption." —Paul Volcker "Persons interested in the economics of fraud, the S&L debacle, the problems of financial regulation, and microeconomics more broadly will find this book to be very important."? Journal of Economic Issues

1.

THEFT BY DECEPTION: CONTROL FRAUD IN THE S&L INDUSTRY

The best way to rob a bank is to own one.

WILLIAM CRAWFORD, COMMISSIONER OF THE CALIFORNIA DEPARTMENT OF SAVINGS AND LOANS, INTRODUCING HIS CONGRESSIONAL TESTIMONY BEFORE THE U.S. HOUSE COMMITTEE ON GOVERNMENT OPERATIONS IN 1988

WHAT IS A CONTROL FRAUD?

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 (Wheeler and Rothman 1982). (I also use the phrase in some places to refer to the person who directs 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. To use a term from economics, fraud causes terrible “negative externalities” because it inflicts injury on those who were not parties to the fraudulent transaction.

Control frauds are financial superpredators that cause vastly larger losses than blue-collar thieves. They cause catastrophic business failures. Control frauds can occur in waves that imperil the general economy. The savings and loan (S&L) debacle was one such wave.

WHAT PERSONAL QUALITIES MAKE A CONTROL FRAUD A SUCCESS?

Successful control frauds have one primary skill: identifying and exploiting human weakness. Audacity is the trait that sets control frauds apart. Charles Keating was the most notorious control fraud. His ability to manipulate politicians became legendary. Any control fraud could have done what Keating did in the political sphere, but only a few tried.

WHY DO CONTROL FRAUDS END IN CATASTROPHIC FAILURE?

Well-run companies have substantial internal and external controls designed to stop thieves. The chief executive officer (CEO), however, can defeat all of those controls because he is in charge of them.¹ Every S&L control fraud succeeded in getting at least one clean opinion from a top-tier audit firm (then called the “Big 8”). They generally were able to get them for years. The ongoing wave of control frauds shows that they are still routinely able to defeat external audit controls. 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.

Control frauds create a “fraud friendly” corporate culture by hiring yes-men. They combine excessive pay, ego strokes (e.g., calling the employees “geniuses”), and terror to get employees who will not cross the CEO. Control frauds are control freaks (Black 2000).

The second reason control frauds are so destructive is that the CEO optimizes the firm as a fraud vehicle and can optimize the regulatory environment. The CEO causes the firm to engage in transactions that are ideal for fraud. Control frauds are accounting frauds. Investments that have no readily ascertainable market value are superior vehicles for accounting fraud because professionals, e.g., appraisers, value them. S&Ls shopped for outside professionals who would support fraudulent accounting and appraisals. Control frauds use an elegant fraud mechanism, the seemingly arm’s-length (independent) transaction that accountants consider the best evidence of value. They transact with each other or with “straws” on what appears to be an arm’s-length basis, but is really a fraud that massively overvalues assets in order to create fictitious income and hide real losses.

Control frauds grow rapidly (Black 1993d). The worst control frauds are Ponzi schemes, named after Carlo Ponzi, an early American fraud. A Ponzi must bring in new money continuously to pay off old investors, and the fraudster pockets a percentage of the take. The record “income” that the accounting fraud produces makes it possible for the Ponzi scheme to grow. S&Ls made superb control frauds because deposit insurance permitted even insolvent S&Ls to grow. The high-tech bubble of the 1990s allowed similarly massive growth.

Control frauds are predators. They spot and attack human and regulatory weaknesses. The CEO moves the company to the best spot for accounting fraud and weak regulation.

Audacious control frauds transform the environment to aid their frauds. The keys are to protect and even expand the range of accounting abuses and to weaken regulation. Only a control fraud can use the full resources of the company to change the environment. Political contributions and supportive economic studies secure deregulation. Control frauds use the company’s resources to buy, bully, bamboozle, or bury the regulators. In my case, Keating used the S&L’s resources to sue me for $400 million and to hire private detectives to investigate me (Tuohey 1987).

The third reason control frauds are so destructive is that they provide a “legitimate” way for the CEO to convert company assets to personal assets. All fraudsters have to balance the potential gains from fraud with the risks.² The most efficient fraud mechanism for the CEO is to steal cash from the company, e.g., by wiring it to his account at an offshore bank. No S&L control fraud, and none of the ongoing huge frauds, did so. Stealing from the till in large amounts from a large company guarantees detection and makes the prosecutor’s task simple. The strategy could appeal only to those willing to live in hiding or in exile in a country without an extradition treaty. Marc Rich (pardoned by President Clinton) notwithstanding, few fraudulent CEOs follow this strategy.

Accounting frauds are ideal for control fraud. They inflate income and hide losses of even deeply insolvent companies. This allows the control fraud to convert company funds to his personal use through seemingly normal, legitimate means. American CEOs, especially those who run highly profitable companies, make staggering amounts of money. They receive top salaries, bonuses, stock options, and luxurious perks. 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. It doesn’t get any better than this in the world of fraud! Chapter 3 discusses this fraud mechanism.

Almost no one gives highly profitable firms a hard time: not (normal) regulators, not creditors or investors, and certainly not stock analysts. This is why our war on the control frauds was so audacious: at a time when hundreds of S&Ls were reporting that they were insolvent, we sought to close the S&Ls reporting that they were the most profitable and generally left the known insolvents open. Our political opponents thought us insane. There was only one way our war could be rational: there would have to be hundreds of control frauds; they would have to be massively overstating income and understating losses; and this had to be happening because the most prestigious accounting firms were giving clean opinions to fraudulent financials.

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. If they had been able to run a profitable, honest company in a tough business climate, they would have done so.

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. The control frauds we convicted became too greedy and began to take funds through “straw” borrowers.³ A prosecutor who detects the straw can win a conviction.

The CEO who owns a controlling interest in the company maximizes the seeming legitimacy of his actions. Ordinary individuals, academic economists, even otherwise suspicious reporters simply cannot conceive of a CEO ever finding it rational to defraud “his” own company. Similarly, law-and-economics scholars argue that it would be irrational for any top-tier audit firm to put its reputation on the line by blessing a control fraud’s financial statements (Prentice 2000, 136–137). It is easy to see why they reject control fraud theory: they think it requires them to believe that the CEO and auditor are acting irrationally. Rationality is the bedrock assumption of neoclassical economics, so these scholars must reject that paradigm in order to see control fraud as real. Control fraud theory does not require irrationality.

HOW DO WAVES OF CONTROL FRAUD ENDANGER THE GENERAL OR REGIONAL ECONOMY?

Individual control frauds should be a central regulatory concern because they cause massive losses. The worst aspect of control frauds is that they can cluster. The two variants of corporate control fraud, “opportunistic” and “reactive,” can occur in conjunction. Opportunists are looking for an opportunity to commit fraud. Reactive control frauds occur when a business is failing. A CEO who has been honest for decades may react to the fear of failure by engaging in fraud.

Economists distinguish between systemic risk that applies generally to an industry and risks that are unique to a particular company. Systemic risks can endanger a regional or even a national economy. Systemic risks pose a danger of creating many control frauds. In the S&L case, the systemic risk in 1979 was to interest rates. S&L assets were long-term (thirty-year), fixed-rate mortgages, but depositors could withdraw their money from the S&L at any time. If interest rates rose sharply, every S&L would be insolvent.

In 1979, the Federal Reserve became convinced that only it had the will to stop inflation. Chairman Paul Volcker doubled interest rates. By mid-1982, on a market-value basis, the S&L industry was insolvent by $150 billion. This maximized the incentive to engage in reactive control fraud and made it far cheaper for opportunists to purchase an S&L. These factors ensured that there would be an upsurge in control fraud, but the cover-up of the industry’s mass insolvency (and with it, that of the federal insurance fund), deregulation, and desupervision combined to create the perfect environment for a wave of control frauds. Criminologists call an environment that produces crime “criminogenic.”

Control frauds’ investments are concentrated and driven by fraud, not markets. This causes systemic regional, or even national, economic problems. One of the remarkable things about the S&L debacle is how alike the control frauds were. Almost all of them concentrated in large, speculative real estate investments, typically the construction of commercial office buildings. (In this context, “speculative” means that there are no tenant commitments to rent the space.) Because the control frauds grew at astonishing rates, this quickly produced a glut of commercial real estate in markets where the control frauds were dominant (Texas and Arizona were the leading examples). Moreover, being Ponzi schemes, they increased their speculative real estate loans even as vacancy rates reached record levels and real estate values collapsed. Waves of control frauds produce bubbles that must collapse. They delay the collapse by continuing to lend, thus hyperinflating the bubble. The bigger the bubble and the longer it continues, the worse the problems it causes. The control frauds were major contributors to, not victims of, the real estate recessions in Texas and Arizona in the 1980s.⁴

What we have, then, is a triple concentration. 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.

MORAL HAZARD

Moral hazard is the temptation to seek gain by engaging in abusive, destructive behavior, either fraud or excessive risk taking. Failing firms expose their owners to moral hazard. This is not unique to S&Ls; it is in the nature of corporations. Moral hazard arises when gains and losses are asymmetrical. A company with $100 million in assets and $101 million in liabilities is insolvent. If it is liquidated (sells its assets), the stockholders will get nothing because they are paid only after all the creditors are paid in full. In my example, the assets are not sufficient to repay the creditors’ claims (liabilities), so liquidation would wipe out the shareholders’ interest in the company. The CEO runs the company until it is forced into liquidation. There are two other keys. Limited liability limits a shareholder’s loss to the value of his stock. He is not liable for the company’s debts, no matter how insolvent it becomes. The creditors lose if the insolvency deepens.

The “upside” potential of a failing company is enjoyed by the shareholders. They win big if investments succeed. Assume that my hypothetical insolvent company makes a movie that produces a $70 million profit. That gain will go almost entirely to the shareholders.

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.

The examples of moral hazard I have used involve unduly risky behavior. The theory, however, is not limited to honest risk taking. Moral hazard theory also explains why failing firms have an incentive to engage in reactive control fraud (White 1991, 41). Indeed, since S&L control fraud was a sure thing (it was certain to produce, for a time, record profits), reactive control fraud was a better option than an ultra-high-risk gamble.

WHY THE S&L INDUSTRY SUFFERED A WAVE OF CONTROL FRAUD

Bad regulation exposed the S&L industry to systemic interest-rate risk and caused the first phase of the debacle. Bank Board rules prohibited adjustable-rate mortgages (ARMs). ARMs would have reduced interest-rate risk.⁵ This prohibition caused a wave of reactive control fraud, though it is remarkable how small that wave was.

Opportunistic control fraud can also occur in waves. Opportunists seek out the best field for fraud. Four factors are critical: ease of obtaining control, weak regulation, ample accounting abuses, and the ability to grow rapidly.

These characteristics are often interrelated. An industry with weak rules against fraud is likely to invite abusive accounting. Industries with abusive accounting have superior opportunities for growth because they produce the kinds of (fictitious) profits and net worth that cause investors and creditors to provide ever-greater funds to the control fraud.

The interrelationship between the opportunities for reactive and opportunistic control fraud made the regulatory and business environments ideal for control fraud. Interest rate risk rendered every S&L insolvent (in market value) in 1979–1982, making it far cheaper and easier for opportunists to get control. Owners and regulators were desperate to sell S&Ls; opportunists were eager to buy. The Bank Board and accountants used absurd “goodwill” accounting to spur sales.

In another common dynamic, 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. (Appendix B is a copy of a candid letter from Norman Strunk, the former head of the S&L trade association, to his successor, Bill O’Connell. It explains how the industry used its power over the administration and Congress to limit the Bank Board’s supervisory powers.) Regulators, fearful of being blamed for the industry failing on their watch, experience their own version of moral hazard. The temptation (shared with the industry) is to engage in a cover-up. The industry will lobby regulators,...