The Best Way to Rob a Bank Is to Own One:
How Corporate Executives and Politicians Looted the S&L Industry
“Control frauds” cause greater financial losses than all other property crimes combined. “Control fraud” is my term for when the person controlling a firm (or nation) uses it as a fraud vehicle. Yet our nation does not fund any research efforts against control fraud, train anyone to fight it, or even keep track of it. If you don’t count it, it doesn’t exist. We did not even identify it as a category until a few years ago. Sticking our heads in the sand has failed.
In other nations, control fraud is so devastating that it causes both greater financial losses and greater losses of life and health than all other forms of crime combined. Widespread fraud devastates entire economies.
The Best Way to Rob a Bank Is to Own One was written to explain the risks posed by control fraud and how to counter them. Our failure to learn the right lessons from the S&L debacle led to policies that optimized the environment for control fraud. The conventional economic wisdom held that deposit insurance was the central cause of the debacle and concluded, therefore, that the debacle had no relevant lessons for the general economy. It also held that fraud was trivial during the debacle.
The S&L industry became the best environment for control fraud in the early 1980s. Opportunistic criminals move to superior venues for their illegal acts. Deregulation, desupervision, mass insolvency, the Administration’s paramount priority of covering up the debacle’s cost, deposit insurance and the regulatory “race to the bottom” optimized the S&L industry for a wave of control fraud.
But the S&L debacle proved that deposit insurance is not essential to “control fraud.” S&L control frauds routinely defrauded uninsured creditors and shareholders. Accounting fraud is the control fraud’s “weapon of choice.” It makes control frauds that are actually insolvent and unprofitable appear to be ultra profitable and safe. This is why a top tier audit firm is the control fraud’s most valuable ally. Firms that can get GAAP (Generally Accepted Accounting Principles) financial statements that purport to show ultra profitable operations do not need to deposit insurance to borrow funds and grow rapidly.
In 1993, I served as deputy staff director for the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE). Commissioner Elliot Levitas and I tried to convince NCFIRRE’s executive director that deposit insurance was not the key. Both of us had real-world experience fighting fraud, which the executive director lacked. We pointed out that Carlo Ponzi made Ponzi schemes famous without the benefit of deposit insurance. But the executive director was an economist and economic standard models stated that the markets effectively constrained fraud, absent government guarantees. This director was best known for his arguments that deposit insurance made banks act dangerously. Adopting our arguments would have required him to reject his discipline’s core beliefs and his own theories.
As a result, the NCFIRRE report (1993) never warned about the risks of control fraud and recommended no reforms outside the deposit insurance context. Worse, other “law and economics” theorists relied on the same standard economic models to predict that the markets effectively prevented even abusive behavior. They called for reductions in fiduciary duties and argued that the SEC (Securities and Exchange Commission) was unnecessary—even harmful. They assumed that stock options aligned the CEO’s interests with the shareholders and that top tier audit firms would cherish their reputations and refuse to give clean opinions to control frauds. This missed warning from a prestigious group (one of NCFIRRE’s co-chairs, John W. Snow, is now the Secretary of the Treasury) and the misguided advice of the law and economics scholars helped create an environment in which the SEC became a regulatory paper tiger and fraudulent CEOs became our heroes. This climate produced the current wave of control fraud.
Looking back on the events that led to the debacle, I felt it was essential that a book show how control frauds operate, how successful they are at fooling (and suborning) the most sophisticated market participants, why even a single control fraud can cause greater monetary losses than all other property crimes combined, and how waves of control fraud begin. The debacle is a great case study of each of these points, and I have the unique ability to explain it from my perspectives as an academic, professional and participant.
But the debacle can also teach us critical lessons about other topics, and I included those elements as well. Ethical leadership is often discussed, but the debacle presents the paradox that the individuals who most prided themselves on their morality—Charles Keating, James Wright, Danny Wall and Rosemary Stewart—often performed poorly. Others whose ethics were heavily criticized, Ed Gray and traditional S&L CEOs, played vital roles in preventing the debacle from becoming a catastrophe. The economic theory of “public choice” assumes that public officials maximize their self-interest (typically at the expense of the public). Gray acted contrary to his interests and his actions saved the nation over a trillion dollars.
I’ll end by expanding on that hopeful note. In 1984, Gray, the top S&L regulator simultaneously took on the Administration, the industry, most of Congress and much of his own agency to reregulate and resupervise the industry and close the control frauds. Within a year he dealt a deathblow to every S&L control fraud by restricting growth—Ponzi schemes must grow or die. He did it even though he knew it would end his career.
Related Links
Cracking down on corporate fraud
Last modified May 2, 2005
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