Accounting Control Fraud Reverses Pareto Efficiency

William K. Black

Associate Professor of Economics and Law

University of Missouri – Kansas City

Franklin & Marshall College

Economics Department: March 27, 2009

Criminologists are the Experts in Dysfunctional

MarketsFour key criminology concepts:

• Criminogenic environment

• Control fraud

• Systems capacity

• Neutralization

If it’s bad criminology, it’s bad economics. If it’s good criminology it’s good econ.

Control Frauds as Financial Super-predators

Person (typically CEO) that controls a seemingly legitimate firm/agency uses it as a “weapon” to defraud

Causes greater $ losses than all other forms of property crime combined

Some forms maim & kill (infant formula)

Produce, extend & hyperinflate bubbles

Deceit erodes trust & closes markets

Economics & Criminogenic Environments for Control

Frauds Criminogenic environments create

perverse incentive structures

Control fraud epidemics & bubbles

Not random; not “black swans”

Conventional economics praxis optimizes criminogenic environment

Result: recurrent, intensifying crises

Pareto Efficiency

Ex ante: we expect voluntary exchanges to make both parties better off

Even ex post we expect learning effects to rectify mistakes

Positive sum transactions should be the norm

Very limited role for government

Reverse Pareto Efficiency

Both parties are made worse off

Nonprime lenders & borrowers

Financial bubbles

The paradox of falling spreads

The “predatory” loan paradox

Unfaithful agents gain

Immense wealth destruction

Akerlof: Lemon’s Markets

Every example he uses is an anti-consumer control fraud

Deception: quality/quantity

Seemingly legitimate fraudsters

Gresham’s dynamic: frauds can drive honest from the market

Partially dynamic: discusses only honest counter strategies

Market Flaw Becomes Triumph

Akerlof never used “F” word

Literature triumphal – reputation trumps lemons & conflicts

Ignored endemic control fraud

 “a rule against fraud is not an essential or even necessarily an important ingredient of securities markets” (Easterbrook & Fischel 1991)

Signaling Diogenes

Three signals only honest can use

Hire top tier audit firm

Have CEO own stock in firm

Extreme leverage

Fischel wrote this after he knew it was false: Lincoln & Centrust

Each “signal” aids control fraud

Mimic. Suborn controls into allies.

Economic Praxis Criminogenic

Deregulation: good

Non-enforcement: good

Bad accounting: irrelevant

Extreme leverage: good

Extreme growth: good

Conflicts of interest: good

Reliance on auditors/rating: good

Huge performance pay: good

Optimizing accounting fraud

Invest in nominal high yields

Extreme leverage

Grow rapidly – Ponzi

Gut controls & underwriting

Suborn controls: allies

Comp. based on short-term “Y”

Hide losses; tiny loss reserves

Produces Paradoxes

Making the worst loans, in the worst manner produces record profits during expansion (“sure thing”)

Econometric studies praise the worst control frauds’ practices

Huge losses certain

Competing for growth lowers spread while credit risk skyrockets

Bubbles delay loss recognition

Gresham’s Dismal Dynamic

Control frauds that create competitive advantages: infant formula

Accounting control fraud doesn’t

Modern compensation has created a Gresham’s dynamic

Short-term tenures of CFOs

Why Lenders Lose Deliberately making bad loans

Perverse incentives to loan officers

NINJA = adverse selection = fraud

No controls/underwriting exposes lender to unintended frauds

Frauds inflate appraisals

Lending increases as bubble grows

Competing for growth lowers yields

Paying excessive compensation

Why Borrowers Lose

Buy homes near peak of bubble

Borrow at rates/amounts = default

Harm their credit ratings

Strips wealth from working class, particularly minorities

Who Wins?

Loan officers on commission

Appraisers, auditor & rating agency

Lender’s executives

Shareholders that sell for a gain

Borrowers that engage in “equity stripping” or sell for a profit

Fraud Causes Inefficiency

Mispriced asset values

Sends false price signals

Bubble expansion & collapse inefficient

Poor care of houses = lost value

Neighborhood effects of vacancies

Systemic risk: failures & deceit erodes trust – mkt. failures

Praxis: The S&L Debacle“Autopsies” v. econometrics

Recognized that “optimization” created patterns: triage

Control frauds were Ponzi scheme

Hit their Achilles’ heel: growth

Dealt with “systems incapacity”

Proving fraud neutralized neutralization

Avoid criminogenic environments