Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.
Reading the FHFA complaints against many of the world’s largest banks is a fascinating and troubling process for anyone that understands “accounting control fraud.” The FHFA, a federal regulatory agency, sued in its capacity as conservator for Fannie and Freddie. Its complaints are primarily based on fraud. The FHFA alleges that the fraud came from the top, i.e., it alleges that many of the world’s largest banks were control frauds and that they committed hundreds of thousands of fraudulent acts. The FHFA complaints emphasize that other governmental investigations have repeatedly confirmed that the defendant banks were engaged in endemic fraud. The failure of the Department of Justice to convict any senior official of a major bank, and the almost total failure to indict any senior official of a major bank has moved from scandal to farce.
The FHFA complaints are distressing, however, in their failure to explain why the frauds occurred and how an accounting control fraud works. The FHFA complaint against Countrywide is particularly disappointing because it accepts hook line and sinker Countrywide’s internal claim that it acted improperly for the purpose of attaining a larger market share. Executive compensation drops entirely out of the story even though it is the reason the frauds occur and the means by which controlling officers loot “their” banks. The FHFA complaint against Countrywide ignores executive compensation. The FHFA complaint against J.P. Morgan (purchaser of WaMu) mentions only that loan officers’ compensation was based on loan volume rather than loan quality.
The complaints fail to explain the extraordinary significance of widespread appraisal fraud – something that only the lender and its agents can produce and a “marker” of accounting control fraud. No honest lender would inflate, or permit to be inflated, appraisals.
The complaints also fail to explain why no honest mortgage lender would make “liar’s” loans. The FHFA complaint against Countrywide notes that Countrywide loan officers would use undocumented loans to aid their creation of fraudulent loan applications.
Even neoclassical economists – the weakest of all fields in understanding fraud – understand that this crisis was driven by executive compensation. Consider the admirably short piece entitled
“Fake alpha or Heads I win, Tails you lose” by Raghuram Rajan. Rajan’s piece is badly flawed, but it at least understands the importance of compensation, accounting, and risk.
“What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risk. Hence pay for alpha.”
Rajan is correct that the neoclassical theory of CEO compensation is that the CEO should only be compensated for high (“excess”) returns if they were not generated by “taking more risks.” Modern bonus plans often purport to provide exceptional compensation to CEOs who achieve extreme short-term “excess” returns that are not generated by “taking more risks.” Rajan gets the next point analytical point correct as well: “In reality, there are only a few sources of alpha for investment managers. [S]pecial ability is by definition rare.” It is the “rare” CEO who can achieve massive bonuses through exceptional performance, but all CEOs desire massive bonuses.
Rajan gets the next step in the analytics correct – the answer to the CEO’s dilemma is to create “fake alpha,” but he falls off the rails in the last clause.
“Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities – to pick stock, identify weaknesses in management and remedy them, or undertake financial innovation. Unique ability is rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but actually taking on hidden tail risk.”
In his recent book, Rajan explains that by “hidden tail risk” he means taking risks that will only cause losses in highly unusual circumstances. I will return to why this aspect of Rajan’s reasoning is false.
Rajan gets the next part correct – generating fake alpha will cause the bank to fail when the risks blow up. Rajan’s “tail risk” theory, however, predicts that these risks will only blow up rarely.
Rajan then stresses, correctly, that executive compensation based largely on short-term reported income will create perverse incentives to generate fake alpha. He also
“True alpha can only be measured in the long run …. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialize, encourage the creation of fake alpha.”
Rajan, being a good neo-classical economist, recognizes the vital need to change compensation, but has no urgency about doing so.
“[U]nless we fix incentives in the financial system, we will get more risk than we bargain for. And the enormous pay of financial sector managers, which has hitherto been thought of as just reward for performance, will deservedly come under scrutiny.”
Corporations have changed executive compensation in response to the crisis – by making it even more dependent on short-term reported income. Rajan does not ask why corporations base executive compensation on short-term reported income without clawbacks. Rajan is correct that such compensation systems create intensely perverse incentives that cause managers to loot the shareholders and creditors and cause the bank to fail.
Rajan’s extreme tail risk theory describes an accounting control fraud. Rajan does not understand that he is describing conduct that would constitute accounting fraud. Rajan also does not understand that his hypothetical has nothing to do with what actually happened in the crisis. The extreme tail risk scheme he hypothesizes would be a terrible fraud scheme. He does not understand accounting control fraud.
The real investments that drove the financial crisis were not assets that would suffer losses only in rare circumstances. They were nonprime loans. Roughly 30% of total loans originated by 2006 were “liar’s” loans – with a 90% fraud incidence. Liar’s loans and subprime are not mutually exclusive categories. By 2006, half of all loans called subprime were also liar’s loans. Appraisal fraud was also epidemic. The probability of endemically fraudulent loans causing losses (instead of fictional “excess return”) was certainty. The loss recognition could only be delayed through a combination of accounting fraud (failing to provide remotely adequate allowances for loan and lease losses (ALLL)) and hyper-inflating the bubble. Hyper-inflating the bubble increases the ultimate losses.
Making extreme tail risk investments is a deeply inferior fraud scheme. Rare risks produce tiny risk premiums and the entire game is to create substantial risk premiums. Making liar’s loans allows exceptional growth (part one of the fraud “recipe” for a lender) and booking a premium yield (if one engages in accounting fraud on the ALLL). The key is found in George Akerlof and Paul Romer’s article title – “Looting: the Economic Underworld of Bankruptcy for Profit” (1993). As they correctly observed, the fraud recipe is a “sure thing” – it maximizes (fictional) short-term reported income, executive bonuses, and real losses.
Rajan got many things correct and many things wrong about generating fake alpha, but at least he sought to explain the perverse dynamic. The FHFA complaints lose explanatory power and persuasiveness because they ignore compensation and accounting. It pays to understand accounting control fraud.
New Economic Perspectives