Are We Going to Let the Biggest Financial Fraudsters Keep Their Money and Avoid Jail Time?

The role of the criminal justice system with regard to financial fraud by elite bankers in 2011 is likely to reprise its role last decade — de facto decriminalization. The Galleon investigation of insider trading at hedge funds will take much of the FBI’s and the Department of Justice’s (DOJ) focus.

The state attorneys general investigations of foreclosure fraud do focus on the major players such as the Bank of America (BoA), but they are unlikely to lead to criminal liability for any senior bank officials. It is most likely that they will lead to financial settlements that include new funding for loan modifications.

The FBI and the DOJ remain unlikely to prosecute the elite bank officers that ran the enormous “accounting control frauds” that drove the financial crisis. While over 1000 elites were convicted of felonies arising from the savings and loan (S&L) debacle, there are no convictions of controlling officers of the large nonprime lenders. The only indictment of controlling officers of a far smaller nonprime lender arose not from an investigation of the nonprime loans but rather from the lender’s alleged efforts to defraud the federal government’s TARP bailout program.

What has gone so catastrophically wrong with DOJ, and why has it continued so long? The fundamental flaw is that DOJ’s senior leadership cannot conceive of elite bankers as criminals. On Huffington Post, David Heath writes:

Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. An investor in loans who documents fraud can force a bank to buy the loan back. But convincing a jury that executives intended to make fraudulent loans, and thus should be held criminally responsible, may be too difficult of a hurdle for prosecutors. ‘It doesn’t make any sense to me that they would be deliberately defrauding themselves,’ Wagner said.”

Mr. Wagner is confused by his own pronouns: “It doesn’t make any sense to me that they would be deliberately defrauding themselves.” This direct quotation needs to be read in conjunction with the author’s description of his position: “banks lose money” when loans “turn out to be fraudulent.” Wagner was responding to a question about control fraud — frauds led by the person controlling the seemingly legitimate entity who uses it as a “weapon.” The relevant “they” is the person looting the bank — the CEO. The word “themselves” refers not to the CEO, but rather to the bank. The CEO is not looting the CEO; he is looting the bank’s creditors and shareholders. Two titles capture this well known fraud dynamic. The Nobel laureate in economics, George Akerlof, and Paul Romer co-authored Looting: the Economic Underworld of Bankruptcy for Profit in 1993 and I wrote The Best Way to Rob a Bank is to Own One (2005). The CEO becomes wealthy by looting the bank. He uses accounting as his ammunition because, to quote Akerlof & Romer, it is “a sure thing.” The firm fails (or in the modern era, is bailed out), but the CEO walks away wealthy.

Here is the four-part recipe for maximizing fraudulent accounting income in the short-term:

1. Grow extremely rapidly

2. By making bad loans at high yields

3. While employing extreme leverage, and

4. Providing only minimal loss reserves

A bank that follows this recipe is mathematically guaranteed to report record income in the near term. The first two ingredients in the recipe are linked. A bank in a reasonably competitive, mature market such as home mortgage lending cannot decide to grow extremely rapidly by making good loans. A bank can, however, guarantee its ability to grow rapidly — and charge a premium yield — if it lends to the tens of millions of people who cannot afford to own a home. Equally importantly, if many lenders follow the same recipe they will cause a financial bubble to hyper-inflate. Financial bubbles extend the lives of accounting control frauds by making it simple to refinance loans to those who cannot afford to purchase the asset. The longer that delinquencies and defaults can be delayed the more the CEO can loot the bank.