Market Overview

Attorney General Holder: The Most Valuable Friend of Angelo

The Federal Government's latest demonstration of prosecutorial futility was captured in Friday's LA Times:

http://www.latimes.com/business/la-fi-mozilo-20110219,0,3665171.story

U.S. drops criminal probe of former Countrywide chief Angelo Mozilo
Mozilo's actions in the mortgage meltdown — which led to $67.5-million settlement against him — did not amount to criminal wrongdoing, federal prosecutors have determined.

By E. Scott Reckard, Los Angeles Times
4:11 PM PST, February 18, 2011

How is it possible that a crisis driven by fraudulent nonprime lenders, securitizers, and purchasers of nonprime paper has managed to lead to the conviction of not a single elite leader of a nonprime lender? A lender making liar's loans must lie – pervasively. How is it that other state and federal investigations and investigations by private parties have consistently found endemic fraud by Countrywide, something that is impossible without C-suite support? When we responded to the savings and loan debacle we prioritized the “Top 100” institutions (producing over 600 felony convictions of the elites that drove that crisis) plus roughly 400 convictions of the roughly 200 additional “control frauds” that did not make the Top 100 list.

What has gone so devastatingly wrong with the Bush and Obama Justice Departments that we have fallen from over 1000 elite convictions to zero elite convictions of the failures that drove this crisis? There were three contemporaneous disasters. First, the regulators must serve as the “Sherpas” – we have to do the heavy lifting in the investigations and we have to serve the guide function because only we have the essential industry expertise and expertise with fraud mechanisms. Our most valuable function is to explain why an honest lender would never engage in particular activity, e.g., making liar's loans or inflating appraisals. In the S&L debacle, the agency made its top priority putting the control frauds into receivership and made their prosecution its second highest priority. The agency made well over 10,000 criminal referrals about S&L frauds. In the current crisis, the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (the two agencies that regulated Countrywide depending on the time period being examined) made zero criminal referrals. Over ten thousand criminal referrals fell to zero.

In the absence of its regulatory Sherpa, the FBI formed a “partnership” with the Mortgage Bankers Association (MBA) – the trade association of the “perps.” The MBA created a definition of mortgage fraud in which the CEO running the lender was always honest. Sadly, this worked brilliantly with the Department of Justice (DOJ). Here is the full text of a letter I sent to a U.S. Attorney in California who fell for the MBA's self-serving lure hook, line, and sinker.

The Honorable Benjamin Wagner
United States Attorney
Eastern District of California,

Dear Mr. Wagner,

My name is William K. Black. I am a white-collar criminologist. My primary appointment is in economics, I have a joint appointment in law at the University of Missouri – Kansas City. I filed testimony on May 4 before the (U.S.) Senate Subcommittee on Crime at their invitation. (I am writing from Iceland, where I have been meeting with their prosecutors, regulators, and academics concerning the release of the special investigative commission documenting endemic fraud at the Big 3 banks that destroyed Iceland's economy. I testified on April 20 before House Financial Services on Lehman's failure. I also testified recently before the Senate (on the role of financial derivatives in the crisis) and the House (on executive and professional compensation).

I served as the Litigation Director of the Federal Home Loan Bank Board, Deputy Director of the FSLIC, SVP and General Counsel of the Federal Home Loan Bank of San Francisco, Deputy Chief Counsel for Enforcement and Litigation (OTS), and (on detail) and Deputy Chief of Staff for the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE – the inevitable national commission to report on the causes of the S&L debacle.).

EOUSA used me repeatedly to train AUSAs, FBI, Secret Service and IRS agents about how to investigate and prosecute frauds by financial institutions (particularly what are known in criminology as “control frauds” – where the individuals that control a seemingly legitimate entity use it as a “weapon” to defraud.) Financial frauds' “weapon of choice” is accounting. I served as an expert witness for DOJ in three successful prosecutions of senior insiders (including CEOs). One of the cases was a “Top 100” case, which led to a top departmental award for the AUSA.

My doctorate in criminology is from U.C. Irvine. (The “cc” is to Henry Pontell, one of the top white-collar criminologists in the world.) I have law and economics degrees from the University of Michigan.

I am writing you because we were both quoted in a recent article about the death of criminal referrals by key banking regulatory agencies. In particular, this excerpt in which you are quoted prompted me to write you:

http://huffpostfund.org/stories/2010/05/too-big-jail

Too Big to Jail?
"Not everyone agrees that such a case can be successful. Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. An investor in loans who documents fraud can force a bank to buy the loan back. But convincing a jury that executives intended to make fraudulent loans, and thus should be held criminally responsible, may be too difficult of a hurdle for prosecutors."

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

I assume for purposes of this communication that the reporter has quoted you accurately. I request an opportunity to convince you that your position is inaccurate and that it can prove exceptionally harmful to efforts to efforts at prosecuting the control frauds. Indeed, if I were a defense counsel for a control fraud I would be quoting you.

Consider the terms “they” and “themselves”: “banks”, of course, are not animate. Officers and employees are the relevant actors. When a senior officer deliberately causes bad loans to be made he does not defraud himself. He defrauds the bank's creditors and shareholders, as a means of optimizing fictional accounting income. Pointing this straightforward fact out was the key to our success in prosecuting the S&L control frauds. The standard defense was a statement by counsel identical to the statement you are quoted as making. We were nearly always successful in explaining why making bad loans optimized fictional accounting income -– but would be wholly irrational for an honest firm. Jurors “got it.”

I will explain the logic momentarily, but I will quote other authorities here first lest you be tempted to stop reading. James Pierce was NCFIRRE's executive director. He led the research into the causes of the debacle. Here are two quotations from Pierce (1994) and NCFIRRE (1993). James Pierce, NCFIRRE's Executive Director, explained:

"Accounting abuses also provided the ultimate perverse incentive: it paid to seek out bad loans because only those who had no intention of repaying would be willing to offer the high loan fees and interest required for the best looting. It was rational for operators to drive their institutions ever deeper into insolvency as they looted them (1994: 10-11)."

"The typical large failure was a stockholder-owned, state-chartered institution in Texas or California where regulation and supervision were most lax…. [It] had grown at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used to make the institution look profitable, safe, and solvent. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization through high dividends and salaries, bonuses, perks and other means (NCFIRRE 1993: 3-4)."

Two economists have found this same perverse dynamic. Akerlof & Romer's (1993) title says it all: Looting: Bankruptcy for Profit. (Akerlof was awarded the Nobel Prize in 2001.) Their article cites, favorably, my work. Indeed, Akerlof has stated that my book on control fraud (The Best Way to Rob a Bank is to Own One (2005)) will be “a classic.” Paul Volcker also provided a “blurb” praising the book. http://www.utexas.edu/utpress/books/blabes.html

The point is that the failure of the firm does not represent the failure of the fraud scheme. The senior insiders walk away rich.

Here is the “recipe” for optimizing accounting control fraud:
1. Grow really fast
2. Make really bad loans at higher yields
3. Extreme leverage
4. Pitiful loss reserves

Note that the first two points are related. Here's the thought exercise. Assume that a firm attempted to grow at extreme rates by making high quality loans in a mature, reasonably competitive market. It could not do so. It would have to “buy market share” by reducing its interest rates – which its competitors would quickly match. Even if it was the “first mover” (note that the hundreds of fraudulent lenders cannot all have been first movers) it will obtain only a small increase in market share and it will do so through a material reduction in yield. This minimizes accounting income. It would an irrational fraud strategy.

Consider the realistic alternative (which comports with the facts). Nonprime lenders grew extremely rapidly by ceasing effective underwriting. Growth is simple because the lender taps a vast new market – people that cannot afford to repay their mortgage loans. Better, the lender can charge such borrowers a premium interest rate (yield). This maximizes (fictional) accounting income.

The reality, of course, is that lending without underwriting creates intense “adverse selection” (the worst folks apply for loans). This is compounded (again, this comports with reality) by placing loan officers on commissions paid on the basis of loan volume – not quality and by pressuring appraisers to inflate appraisals. (Step back and ask yourself why an honest lender would ever inflate, or permit endemic inflation of, appraisals. There is no honest reason. Yet the data show that nonprime lenders and their agents commonly inflated appraisals.) (My congressional testimony and academic articles have the supporting data in detail.)

Adverse selection inherently produces a “negative expected value” for a lender. (Betting against the house also creates a negative expected value – but it does not produce the upfront fictional income that making loans does.)

Akerlof & Romer concluded (as did the S&L regulators and criminologists) that following the four-part recipe that optimized fictional accounting income was a “sure thing” in both respects. It was mathematically certain to produce record (albeit fictional) income in the short-term and catastrophic losses in the longer run. The CEO walks away rich because the fictional profits lead to enormous compensation and the run up of the stock price. If a material number of lenders follow the same strategy they will hyper-inflate financial bubbles. This eventually causes systemic collapses, but what it does in the short and intermediate term is to mask losses through refinancing. The industry joke is: “a rolling loan gathers no loss.”

I am reasonably certain that you know that nonprime lenders characteristically did make deliberately bad loans because you know that they made massive amounts of what the trade called “liar's loans.” Liar's loans produce adverse selection and a negative expected value – failure is a “sure thing.” Studies of liar's loans show endemic fraud (primarily led by loan brokers).

I would be happy to provide you, or an assistant, with my testimony and articles supporting these propositions. I would also be happy to speak with you or an assistant if you wish. My cell is [deleted]. My email address is: blackw@umkc.edu.

Volcanic plumes willing, I will return from Iceland to Kansas City late Friday night. My primitive cell phone does not work in Europe. FYI: Iceland's Big 3 banks deliberately made, and refinanced, bad loans. They too were accounting control frauds.

Best,
Bill Black

The response to my letter illustrates the third contemporaneous problem that has crippled the prosecutorial response to this crisis. I, of course, received no response. This is characteristic of the Bush and Obama Justice Departments. To my knowledge, they have not spoken at length to any of us who created the most successful criminal justice response to elite white-collar criminals that drove a financial crisis. Mr. Wagner's comments, and remember that he heads one of the offices taking the lead in the Department's response to the crisis, show that he has no awareness of the useful white-collar criminology and economics literature and has never examined how the Department succeeded so brilliantly against the S&L control frauds. He has such a poor understanding of the dominant accounting fraud mechanism that he finds deliberate indifference to loan quality (yield uber alles) by a lender to be inconceivable, even though it was ubiquitous among nonprime specialty lenders. It appears from the decision about Mr. Mozilo that Mr. Wagner's counterpart in Los Angeles shares these same crippling blinders.

It was bad enough that the Bush Justice Department allowed a Gresham's dynamic to develop in which cheaters prospered and drove honest business people out of the industry. That is the single greatest factor that drove the current crisis. It is unconscionable that the Obama Justice Department allows those who became wealthy through fraud to do so with impunity. That dynamic will make the next crisis come sooner and far more destructively. Attorney General Holder should resign and he should be replaced by someone with the backbone, integrity, and brains to take on the most elite frauds regardless of their political power.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

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Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He is a white-collar criminologist. He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He taught previous

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