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Key House Republicans Almost Get Accounting Control Fraud

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Message William K. Black, J.D., Ph.D.
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"[M]any economists still [do] not understand that a combination of circumstances in the 1980s made it very easy to loot a [bank] with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?" (Akerlof & Romer 1993: 4-5)

Accounting control fraud produces three "sure things" -- the lender (loan buyer) is sure to report record (albeit fictional) profits in the near term, the officers controlling the lender (loan buyer) will promptly be made wealthy, and the firm will actually suffer severe losses.  Akerlof and Romer's point was that it would be the rare executive who would optimize the perverse incentives created through moral hazard by taking an honest but ultra-high risk investment gamble that would be extremely likely to fail rather than engaging in the "sure thing" of accounting control fraud.  It takes aggressive and effective regulation and prosecutions to make the CEO's optimal strategy honest gambling rather than control fraud.

Fraudulent CEOs can easily use modern executive and professional compensation not only to enrich themselves but also to suborn more junior officers and employees and "independent" professionals.  By suborning the people who are supposed to function as controls the CEO is able to turn them into his most valuable fraud allies.  Fannie provides superb examples of the CEO's ability to produce this perverse dynamic.

In one of those splendiferous acts of unintentional self-parody, America's most elite business organization made Frank Raines, Fannie Mae's CEO, its spokesperson to explain to the public what went wrong in the Enron-era scandals.  Businessweek asked Raines what caused the recurrent scandals.  Raines reply was accurate.

"Don't just say: "If you hit this revenue number, your bonus is going to be this.' It sets up an incentive that's overwhelming. You wave enough money in front of people, and good people will do bad things."

Raines was an expert on this subject.  The SEC would soon charge that he led an accounting control fraud to hide large losses his business strategy caused so that Fannie Mae could, (fraudulently) report that it hit earning targets that would maximize the controlling officers' bonuses.  The SEC also nailed Freddie Mac for accounting fraud.  Fannie and Freddie reprised their accounting control frauds during the recent financial crisis.

The single most revealing document that came out in the investigations was a speech by a Fannie Mae executive to his troops.  We know that Raines read the speech because he sent (positive) written comments on his copy of it to the speaker.  The speech was about why helping Fannie report that it had hit the earning per share (EPS) target that maximized everyone's bonus must be the unit's overriding goal.

"By now every one of you must have 6.46 [EPS] branded in your brains.  You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46".  After all, thanks to Frank, we all have a lot of money riding on it".  We must do this with a fiery determination, not on some days, not on most days but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%.

Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46.  So it is our moral obligation to give well above our 100% and if we do this, we would have made tangible contributions to Frank's goals."  (Mr. Rajappa, head of Fannie's internal audit, emphasis in original.)

Internal audit, of course, is a discipline with the mantra of "independence" as its defining characteristic.  I refer to Fannie's internal audit unit as the "anti-canary."  The "canary in the mine," of course, is chosen because it is more susceptible than humans to carbon monoxide.  When the canary becomes unconscious the miners still have just enough time to escape the mine.  Internal audit should be the least susceptible unit in a corporation to being suborned.  Given how effectively Fannie Mae's internal auditors were suborned by its controlling officers every other unit at Fannie is likely to have been rotten due to the perverse incentives of modern executive compensation.

Hensarling lacks the courage to follow the logic acknowledging accounting control fraud

To review the bidding to this juncture, Hensarling is correct that Fannie and Freddie were control frauds run by fraudulent CEOs eager to grow wealthy at Fannie and Freddie's expense.  The CEOs' choice to run a fraud was, according to two of the world's best economists, criminal and immoral, but rational.   White-collar criminologists and effective financial regulators agreed with Akerlof and Romer.  Indeed, Akerlof and Romer credited the regulators with the discovery.

"Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself" (George Akerlof & Paul Romer.1993: 60).

Economists, criminologists, and effective financial regulators agree on the circumstances that are "bound to produce looting."  Criminologists have a term for it: the creation of a "criminogenic environment."  We would all expect control fraud to be most likely to become epidemic where the "three de's" (deregulation, desupervision, and de facto decriminalization) combine with modern executive and professional compensation.    Akerlof and Romer erred only in believing that economists and anti-regulatory politicians "learn from experience" and are willing to set aside their dogmas and "know better."  The result was that they intensified the three "de's" and executive and professional compensation while weakening civil accountability.  The combined effect made the environment so much more criminogenic that "history" did "not repeat itself" -- we vastly exceeded the S&L debacle.

Hensarling, of course, was one of the leading proponents of expanding the three "de's" and one of the most ideological of the apologists for modern executive and professional compensation while weakening their civil accountability.  His hate for Fannie and Freddie and their controlling officers is so overwhelming that it leads him to emphasize that they were control frauds.  He also explains how the perverse incentives created by the intersection of modern executive compensation and weak regulation and supervision combined to spur Fannie and Freddie's managers to lead the control frauds.

What is intellectually bizarre, but perfectly human, is that Hensarling implicitly assumes that Fannie and Freddie ceased to be accounting control frauds later in the crisis -- and that other mortgage lenders and purchasers were never accounting control frauds.  Hensarling's ideology requires him to blame the government for the crisis -- not private CEOs.  Hensarling cannot blame the private managers' who led the control frauds at Fannie and Freddie that caused massive losses.  He certainly can't blame their actions on perverse compensation and the three "de's."  That would require him to become a progressive!

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)
 
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