THE BIZOP NEWS

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These days a very popular thread about fraud and the economic crisis is William K. Black's interview by Bill Moyers.

"BILL MOYERS: I was taken with your candor at the conference here in New York to hear you say that this crisis we're going through, this economic and financial meltdown is driven by fraud. What's your definition of fraud?

WILLIAM K. BLACK: Fraud is deceit. And the essence of fraud is, "I create trust in you, and then I betray that trust, and get you to give me something of value." And as a result, there's no more effective acid against trust than fraud, especially fraud by top elites, and that's what we have.

BILL MOYERS: In your book, you make it clear that calculated dishonesty by people in charge is at the heart of most large corporate failures and scandals, including, of course, the S&L, but is that true? Is that what you're saying here, that it was in the boardrooms and the CEO offices where this fraud began?

WILLIAM K. BLACK: Absolutely.

BILL MOYERS: How did they do it? What do you mean?

WILLIAM K. BLACK: Well, the way that you do it is to make really bad loans, because they pay better. Then you grow extremely rapidly, in other words, you're a Ponzi-like scheme. And the third thing you do is we call it leverage. That just means borrowing a lot of money, and the combination creates a situation where you have guaranteed record profits in the early years. That makes you rich, through the bonuses that modern executive compensation has produced. It also makes it inevitable that there's going to be a disaster down the road.

BILL MOYERS: So you're suggesting, saying that CEOs of some of these banks and mortgage firms in order to increase their own personal income, deliberately set out to make bad loans?

WILLIAM K. BLACK: Yes.

BILL MOYERS: How do they get away with it? I mean, what about their own checks and balances in the company? What about their accounting divisions?

WILLIAM K. BLACK: All of those checks and balances report to the CEO, so if the CEO goes bad, all of the checks and balances are easily overcome. And the art form is not simply to defeat those internal controls, but to suborn them, to turn them into your greatest allies. And the bonus programs are exactly how you do that.

...

BILL MOYERS: You're describing what Bernie Madoff did to a limited number of people. But you're saying it's systemic, a systemic Ponzi scheme.

WILLIAM K. BLACK: Oh, Bernie was a piker. He doesn't even get into the front ranks of a Ponzi scheme...

BILL MOYERS: But you're saying our system became a Ponzi scheme.

WILLIAM K. BLACK: Our system...

BILL MOYERS: Our financial system...

WILLIAM K. BLACK: Became a Ponzi scheme. Everybody was buying a pig in the poke. But they were buying a pig in the poke with a pretty pink ribbon, and the pink ribbon said, "Triple-A."

This hard line on the linkage between fraud and the economic crisis is not something most economists explore.

The economists,  Steven Gjerstad and Verson Smith, who have studied the growth of bubbles in economic laboratories, state in the WSJ that

"The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge."

A leading figure in the Chicago School of Economics, Justice Posner, claims that fraud did not cause the economic crisis

"There was more than the usual amount of mortgage fraud during the housing bubble, but it was not the cause of many millions of people overpaying for houses, as we know with the benefit of hindsight that they did.

Cheap credit and soaring house values were the immediate causes of the bubble and of all that followed when it burst.

The underlying causes were the deregulation of financial services; lax enforcement of the remaining regulations; unsound decisions on interest rates by the Federal Reserve; huge budget deficits; the globalization of the finance industry; the financial rewards of risky lending, and competitive pressures to engage in it, in the absence of effective regulation; the overconfidence of economists inside and outside government; and the government's erratic, confidence-destroying improvisational responses to the banking collapse."

So who is right here?  My sense is that economists misjudge how relatively simple it is for the CEO of a high profile company to suborn and subvert the accounting controls, the board of directors, and legal counsel - precisely for the same reasons highly intelligent people get suckered into a Ponzi scheme.

Every Ponzi scheme after the fact, looks for all the world like an impossible kludge of improbable facts strung together by the greediness of the participants.  There is something to this view: but, why is it that after the fact information which seems unremarkable wasn't available to our motivating reason at least as a conjecture prior to the fraud being discovered?  This is probably the most interesting fact about fraud: after discovery, many people correctly reason how they would have detected the fraud in the first place.  One explanation is that hindsight is 20/20, but I think this is not completely adequate.  It fails to explain the cyclical nature of fraud, why last year's 20/20 hindsight seems to have no effect on this year's thinking.

Gerry Spence should have the last word here, writing about deceit and executive compensation:

"If a corporate executive will steal from the corporation it runs will it not also steal from the American public that constitutes its customers and clients? And can we really trust its products or services?"