

William K. Black

April 11, 2011 6:05 AM Why aren’t the honest bankers demanding prosecutions of their dishonest rivals?April 11, 2011 6:05 AM

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This is the second column in a series responding to Stephen Moore’s central assaults on regulation and the prosecution of the elite white-collar criminals who cause our recurrent, intensifying financial crises. Last week’s column addressed his claim in a recent Wall Street Journal column that all government employees, including the regulatory cops on the beat, are “takers” destroying America.

This column addresses Moore’s even more vehement criticism of efforts to prosecute elite white-collar criminals in an earlier column decrying the Sarbanes-Oxley Act’s criminal provisions: “White-Collar Witch Hunt: Why do Republicans so easily accept Neobolshevism as a cost of doing business?” [American Spectator September 2005] This column illustrates one of the reasons why elite criminals are able to loot “their” banks with impunity – they have a lobby of exceptionally influential shills. Moore, for example, is the Wall Street Journal’s senior economics writer. Somehow, prominent conservatives have become “bleeding hearts” for the most wealthy, powerful, arrogant, and destructive white-collar criminals in the world. Criminology research has demonstrated the importance of “neutralization.” Criminals don’t like to think of themselves as criminals and their actions as criminal. They have to override their societal inhibitions on criminality to commit their crimes. When prominent individuals like Moore call their actions lawful and demonize the regulatory cops on the beat and the prosecutors it becomes more likely that CEOs will successfully neutralize their inhibitions and commit fraud. People like Moore have never studied white-collar crime, have no knowledge of white-collar criminology, do not understand control fraud, and do not understand sophisticated financial fraud mechanisms. They show no awareness of the economics literature on accounting control fraud, particularly George Akerlof & Paul Romer’s famous 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” People like Moore not only spur neutralization, they actively campaign to minimize the destructiveness of elite white-collar crime and to deny the regulators and the prosecutors the resources to prosecute the criminals.

My favorite in this genre was authored by Professor John S. Baker, Jr. and published by Heritage on October 4, 2004.

http://www.heritage.org/Research/Reports/2004/10/The-Sociological-Origins-of-White-Collar-Crime

Baker concludes his article with this passage:

“The origin of the “white-collar crime” concept derives from a socialist, anti-business viewpoint that defines the term by the class of those it stigmatizes. In coining the phrase, Sutherland initiated a political movement within the legal system. This meddling in the law perverts the justice system into a mere tool for achieving narrow political ends. As the movement expands today, those who champion it would be wise to recall its origins. For those origins reflect contemporary misuses made of criminal law–the criminalization of productive social and economic conduct, not because of its wrongful nature but, ultimately, because of fidelity to a long-discredited class-based view of society.”

We “stigmatize” criminals precisely to increase the difficulty potential criminals face in neutralizing restraints against engaging in crime. Stigmatization is an important restraint reducing crime. Indeed, it is likely that stigmatization can be most effective in reducing crime in the context of elite white-collar criminals because such individuals have more valuable reputations that can be harmed by stigma. A violent street criminal may find a reputation for violence useful. Sutherland’s research demonstrated that elite white-collar criminals were often able to violate the law with impunity. The corporation they controlled might pay a fine, but the CEO was typically not sanctioned when the corporation violated the law – even when the violations were repeated and egregious. Class proved, empirically, to be a powerful predictor of criminal prosecutions, convictions, and sentencing. Sutherland correctly sought to stigmatize elite white-collar criminals and to get policy-makers, academics, and the criminal justice system to view their crimes as important. Sutherland’s partial success in doing so is what enrages people like Moore and Baker. By the way, in order to publish his famous book on white-collar crime, Professor Sutherland was forced to delete his tables setting forth the violations of law by many of America’s top corporations – even though it was all public record information. The censorship had the ironic effect of demonstrating the accuracy of Sutherland’s observation that class mattered when it came to how we framed and responded to fraud by elite criminals. What aspect of holding fraudulent CEOs criminally responsible for their crimes is “socialist”, “anti-business”, or “neo-Bolshevism”? Baker claims that “class” has long been discredited as an important variable. Baker is not a social scientist and he is flat out wrong about class. There are literally thousands of empirical studies demonstrating the explanatory power of class in a host of settings. Baker is also flat out wrong empirically in claiming that white-collar prosecutions target “productive social and economic conduct.” White-collar prosecutions of elites are overwhelmingly based on fraud. Fraud is one of the most destructive of all social and economic conduct. Consider six forms of economic injury caused by accounting control fraud.

Eroding Trust

The essence of fraud is convincing the victim to trust the perpetrator – and then betraying that trust. The result is that fraud, particularly by elites, is the most destructive acid for eroding trust. Research in economics, political science, psychology, and sociology concurs on the enormous value that trust provides in each of these settings. We have all attended conferences that provided the participants with bottled water. If we knew that one bottle in a hundred were contaminated how many of us would drink our bottle? This dynamic explains why hundreds of markets collapsed during the events leading to the Great Recession – bankers no longer trusted other bankers’ representations as to asset quality. Accounting control fraud can cause systemic risk by eroding trust. Bubbles

When bubbles hyper-inflate they can cause catastrophic economic damage and systemic risk. Accounting control fraud can hyper-inflate bubbles. The first two ingredients in the recipe for lenders engaged in accounting control fraud (extreme growth though lending to uncreditworthy borrowers) have the effect of right-shifting the demand curve. Because particular assets are superior devices for accounting fraud and because accounting frauds will tend to cluster in industries in which entry is easier and regulation and supervision are weak, accounting frauds tend to cluster in particular industries and regions. Accounting control frauds drove the Southwest bubble in commercial real estate during the S&L debacle and the U.S. residential real estate bubble in the current crisis. Hyper-inflated bubbles cause catastrophic losses to lenders and (late) owners, trigger severe recessions, and misallocate credit and assets (causing real economic losses).

Misallocation of credit and human talent

Even when accounting control fraud does not lead to a hyper-inflated bubble, it misallocates credit and human and non-human capital. Accounting control fraud substantially inflates individual asset values. Individuals with strong science and mathematics skills – critical shortages in our real economy – are wasted in making models designed to inflate asset values by fraudulently ignoring or minimizing risk. Accounting control fraud commonly produces reverse Pareto optimality – the borrower and the lender on a liar’s loan made in 2006 and 2007 typically suffered losses while the unfaithful agents become wealthy by betraying their principals and customers. (It is important to recall that it was the lenders and their agents who normally prompted by false statements in liar’s loans.) Fraud makes markets profoundly inefficient.

Gresham’s dynamics

“Private market discipline” becomes perverse under accounting control fraud. Capital is allocated in abundance, at progressively lower spreads (despite massively increased risk), to fraudulent firms and professionals. In this form of Gresham’s dynamic, bad ethics drives good ethics out of the marketplace. Note that once, for example, a significant number of appraisers are suborned by the fraudulent lenders to inflate appraised value it is more likely that such appraisers will go on to commit other frauds during their career. If cheaters prosper, then honest businesses are placed at a crippling competitive disadvantage. Effective regulation and prosecution is essential to make it possible for honest firms to compete.

“Echo” fraud epidemics

Fraud begets fraud. Or to put it in criminology terminology – accounting control fraud is criminogenic. Fraudulent lenders created perverse incentives that produced endemic fraud (often by generating Gresham’s dynamics) in other fields. Fraudulent lenders making liar’s loans, for example, created overwhelming financial incentives they knew would lead their loan officers and loan brokers to engage in pervasive fraud. Indeed, fraudulent lenders embraced liar’s loans because they facilitated endemic fraud by eviscerating underwriting. Accounting control fraud also leads to the spontaneous generation of criminal profit opportunities, causing opportunistic fraud. Liar’s loans, for example, generated a host of fraudulent entrepreneurs offering illicit opportunities to use someone else’s credit score to secure a loan. (Austrian school economists should recognize this dynamic.) Undesired frauds arising from control fraud

Lenders engaged in accounting control fraud must suborn or render ineffective their underwriting and internal and external controls. They also select, praise, enrich, and promote the most unethical officers. The real “tone at the top” of a control fraud is pro-fraud – often overlaid with a cynical propaganda campaign extolling the Dear Leader’ astonishing virtues. The result is that the firm environment is criminogenic. Some officers may loot the firm through private schemes, e.g., embezzlement at Charles Keating’s Lincoln Savings and self-dealing at Enron. White-collar crime prosecutions are overwhelmingly taken against frauds. There is nothing economically productive about fraud. When Heritage and the Wall Street Journal feature odes to elite frauds they are fertilizing the seeds of the destruction of capitalism and its replacement by crony capitalism.

Moore’s article has the same tone and themes as Baker’s complaints against prosecuting elite white-collar criminals. “[T]he anti-capitalist left … [is] using the criminal law for the endgame purpose of striking down the productive class in American that they so envy and despise….”

Moore decries the passage of “Sarbanes-Oxley and other such laws criminalizing economic behavior….” He claims that prosecuting CEOs leading control frauds will harm shareholders – which he plainly sees as prohibiting criminal liability for corporate officers. Moore’s complaints about SOX are confusing because Sarbanes-Oxley does not criminalize honest “economic behavior.” “Economic behavior” is not privileged. It can be honest or dishonest. Only honest economic behavior is potentially productive. Even honest economic behavior may prove unproductive or cause severe negative externalities. Dishonest economic behavior can benefit shareholders. A firm that gains a competitive advantage over its market rivals through fraud will be more profitable and should have a higher share price. That increased profit and share price is bad for the world. It creates a Gresham’s dynamic and misallocates capital. It may also maim and kill if the competitive advantage arises from selling harmful products to consumers or firms.

Moore eventually explains that what disturbs him most about white-collar prosecutions is that the CEO of a publicly traded company can be prosecuted for accounting fraud. SEC rules require that registrants comply with GAAP, so material accounting fraud constitutes securities fraud (a felony). Criminologists have long pointed out that accounting is the “weapon of choice” for financial firms. Moore objects to prosecuting the most destructive property crimes committed by elite white-collar criminals. Accounting control fraud drove the second phase of the S&L debacle. The first phase was interest rate risk and ultimately led to roughly $25 billion in losses. The Enron-era frauds prosecuted by the federal government were accounting control frauds. The current crisis was driven by the accounting control frauds – the largest nonprime lenders, Fannie, and Freddie. The officers that were prosecuted during the S&L debacle and the Enron-era frauds were not members of the “productive class.” No one destroyed more wealth, for purposes of personal greed, than these fraudulent elites. Their crimes and the harm they caused, however, pale in comparison to the accounting control frauds that drove the current crisis. That makes it all the more astonishing that not a single fraudulent senior officer at the major nonprime lenders, Fannie, or Freddie has been convicted. The shills for elite white-collar criminals have swept the field. The administration they constantly deride as socialist has continued the Bush administration’s policy of de facto decriminalization of accounting control fraud. Moore and Baker have, once more, proven Sutherland correct – we treat elite white-collar criminals in a way that bears no relationship to street criminals. We now bail them out after they loot and cause “their” banks to fail and change the accounting rules at their demand to hide their losses. We even invite them repeatedly to the White House to advise us on what policies we should follow. The anti-regulators got their wish – they took the regulatory cops off the beat. The banking regulatory agencies ceased making criminal referrals, the SEC ceased bringing even their wimpy consent actions against the massive accounting control frauds, and the Justice Department ceased prosecuting the accounting control frauds during the run up to the crisis. The results were multiple echo epidemics of fraud, a hyper-inflated bubble, and the Great Recession. If Baker and Moore think these fraudulent CEOs constitute the “productive class” – then capitalism was killed by the producers. The financial frauds, however, were not productive. They were weapons of mass financial destruction. Their fraudulent CEOs were motivated by the most banal of motivations that every major religion warns against – unlimited greed, ego, and a radical lack of empathy for their victims. The most pathetic figures in the crisis, however, are not the CEOs but their shills. Why aren’t the honest bankers leading the charge to prosecute their fraudulent rivals?

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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.