Ten Lessons We Must Learn from Charles Keating

By William K. Black

I knew Charles Keating, the head of Lincoln Savings, in my capacity as a financial regulator and as the subject of his wrath.  His fraud schemes and the manner in which they targeted our system’s vulnerabilities in an era before Citizens United made the corruption of politicians by fraudulent CEOs child’s play remain the play book for the world’s most destructive financial frauds.  Our failure to learn the ten lessons has caused immense suffering.  Keating’s life, and the great harm he caused, will not have been in vain if we step back and use the occasion of his death to reflect on the changes we need to make.

I want to make clear up front that I have personal reasons to feel upset about Keating.  He sued me in my individual capacity for $400 million, he hired private investigators to investigate me on at least two occasions that became public, he tried very hard, in league with Speaker of the House James Wright, Jr. to get me fired, he successfully extorted the pusillanimous heads of our regulatory agency to take the unprecedented, and disastrous step of removing the Federal Home Loan Bank of San Francisco’s (FHLBSF) jurisdiction over Lincoln Savings, and he secretly issued this infamous written command to his chief political fixer.



Yes, that is how the original reads – Keating was an “all caps” plus “underlining” kind of guy.

Keating was also a lawyer, so one of the typical, hilarious minor steps he took was withholding the memorandum that I just quoted from production in response to discovery commands on the grounds that it was an “attorney-client” communication.  (His chief political fixer/leg breaker was a lawyer.)

Keating always claimed we (the FHLBSF) had a “vendetta” against him and that I was a leader of this vendetta.  He thought our lives were focused on destroying him.  The reality is that we were overwhelmed countering the epidemic of accounting control fraud that was driving the second, far more destructive, phase of the S&L debacle.  Keating was one of roughly 300 fraudulent S&L heads from our perspective.  Collectively, this very non-Spartan “300” and their political allies were vastly more powerful than we were.  We also never dwelt on the personalities and did not classify fraudulent CEOs as “evil.”  Keating was obsessed with us in ways we were never obsessed with him.  So, let me begin by offering my condolences to his family and friends.


The Savings and Loan debacle was the test bed for the epidemics of accounting control fraud that drove our subsequent financial crises.  The debacle was the only one that was “successfully” contained before it could cause a financial crisis.  The debacle was widely described at the time as the “worst financial scandal is U.S. history,” so the phrase “successfully contained” is obviously one that could spark disbelief.  The critical modifier is “before it could cause a financial crisis.”  The S&L debacle did not lead to even a mild national recession.  It did hyper-inflate regional real estate bubbles that pushed parts of the Southwest region into a serious economic decline.  The Enron-era frauds substantially contributed (in conjunction with the related collapse of the dot com bubble) to a $7 trillion fall in market capitalization and the fraud epidemics hyper-inflated the largest bubble in history and drove a Great Recession that is projected to cost over $20 trillion in lost production.  The S&L debacle, therefore, allows us to understand not only went wrong, but also how to prevent things from going wrong.

Keating was the poster child of the S&L debacle.  One of the telling aspects of the current crisis is that it has no poster child.  The elite CEOs that led the frauds that drove the crisis became wealthy through frauds that they led with total impunity because we forgot the lessons we learned at such a high price during the debacle.

The 10 Lessons

1. We know what makes the criminogenic environments that produce the epidemics of accounting control fraud that drive our financial crises.  The three most important characteristics are the three “de’s,” modern executive compensation, and modern professional compensation and structures.  The three “de’s” are deregulation, desupervision, and de facto decriminalization.

“Neither the public nor economists foresaw that [financial 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” (Akerlof & Romer.1993: 60).

The key to modern executive compensation is that it allows immense wealth transfers from the firm to the CEO in a manner that makes prosecution far more difficult because it employs a seemingly normal corporate mechanism for looting.  A fraudulent CEO doesn’t have to send an email directing a subordinate or “independent professional” to commit or aid and abet accounting fraud – he simply uses compensation and the power to hire and fire to create the perverse financial incentives to commit and aid and abet such frauds.

“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.” (Franklin Raines: CEO, Fannie Mae)

Modern professional compensation and structure (limited liability partnerships and corporations) makes it child’s play to for the CEOs that lead the frauds to generate a powerful “Gresham’s” dynamic that suborns elite professionals that will aid and abet the frauds.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”  George Akerlof (1970).

2. We have failed to learn that the bank’s CEO is the greatest threat to the bank and to the global economy because what criminologists term “accounting control fraud” makes fraud – not high-risk gambles – a “sure thing” for the CEO.

Akerlof and Romer make the key point in their famous 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”).

“Nevertheless, many economists still seem not to under-stand that a combination of circumstances in the 1980s made it very easy to loot a financial institution 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).

3. We have failed to learn that the principal function of financial regulators must be to serve as the regulatory “cops on the beat” dedicated to preventing and halting control fraud.  Effective regulation blocks the Gresham’s dynamic and allows honest CEOs and professionals to prevail in the markets.  Effective regulation is essential to effective financial (and many other) markets.

4. “Capital” requirements can never substitute for effective financial regulation.  “Capital” is simply an accounting residual (Assets – Liabilities).  As Keating showed, it is simple to use accounting fraud to inflate reported assets – massively and create enormous amounts of “fictional” capital.

5. “Private market discipline” is an oxymoron.  Creditors rush to fund accounting control frauds such as Lincoln Savings that report record (albeit fictional) profits.  Creditors fund the massive growth of accounting control frauds rather than “disciplining” such frauds.  (This also means that markets are often massively “inefficient.”)

6. The “recipe” for accounting control fraud is also a superb device for hyper-inflating bubbles.  Keating hyper-inflated a bubble in Arizona.

7. Keating suborned the aid of an incredible group of elite politicians even before the Citizens United decision.  Keating is infamous for using Alan Greenspan as his lobbyist to recruit the five U.S. Senators who became known as the “Keating Five.”  They met with us (the FHLBSF) on April 9, 1987 (and today is the 27th anniversary of four of those Senators meeting with Bank Board Chairman Edwin Gray).  Keating’s goal in both meeting was for the Senators to intimidate us not to take enforcement action against the largest and most destructive violation of agency rules in history.

But Keating also was a close ally of Speaker Wright.  Keating got a majority of the House of Representatives to co-sponsor a resolution calling on us not to go forward with the reregulation of the industry.  Had we given in to that coercion the cost of the debacle would have increased to trillions of dollars.  Keating got the Reagan administration to seek to appoint two “members” of his choosing to the three-member Bank Board.  That would have given Keating, the most notorious S&L fraud, majority control over the regulatory agency.  Consider how many trillions of dollars in losses that would have caused.

Our saying during the debacle was the highest (reported) rate of returns for S&Ls was always achieved through political contributions.  Today, the Supreme Court provided a fit memorial for Keating’s career as a political fixer by making it even easier for plutocrats to use dark money to secretly suborn politicians.

8. Keating was only stopped by regulators who were willing to risk their careers by stopping him.  There are few lies as foul as Reagan’s joke about government workers.  Every day, it is government workers (soldiers, sailors, airmen, police officers, and fire fighters) who risk their lives for all of us.  As financial regulators we risked only our careers, so we never compared ourselves to the sacrifices these other fields, but we did risk our careers.  There is a reason Clinton, Bush, and Obama never even thought of appointing any of us who had been so successful as financial regulators to a position in which we could prevent future crises.  Keating was happy to suborn Democrats and Republicans – and we were happy to imprison and expose the crimes of the most prominent Democrats and Republicans.

Consider just one passage from my extensive notes of the April 9, 1987 meeting with the Keating Five.  Michael Patriarca was the FHLBSF’s top professional supervisor.  He was personally selected and recruited from the Office of Comptroller of the Currency (OCC) because of his stellar reputation and placed in California because, after Texas, it was our biggest problem.  His work as an S&L regulator burnished that reputation.  As you read, consider how much better the world would be now if Mike had been made a top regulator by the second President Bush or President Obama.  Notice that DeConcini phrases his ultimate question in a manner designed to force anyone to respond “no.”

McCAIN: Why would Arthur Young say these things about the exam – that it was inordinately long and bordered on harassment?

GLENN: And Arthur Anderson said they withdrew as Lincoln’s prior auditor because of your harassment.

RIEGLE: Have you seen the Arthur Young letter?


RIEGLE: I d like you to see the letter. It’s been sent all over the Senate. [Hands Cirona the letter.]

PATRIARCA: I’m relatively new to the savings and loan industry but I’ve never seen any bank or S&L that’s anything like this. This isn’t even close. You can ask any banker and you know about these practices. They violate the law and regulations and common sense.

GLENN: What violates the law?

PATRIARCA: Their direct investments violate the regulation. Then there’s the file stuffing. They took undated documents purporting to show under writing efforts and put them into the files sometimes more than a year after they made the investment.

GLENN: Have you done anything about these violations of law?

PATRIARCA: We’re sending a criminal referral to the Department of Justice. Not maybe; we’re sending one. This is an extraordinarily serious matter. It involves a whole range of imprudent actions. I can’t tell you strongly enough how serious this is. This is not a profitable institution. Prior year adjustments will reduce that reported $49 million profit. They didn’t earn $49 million. Let me give you one example. Lincoln sold a loan with recourse and booked a $12 million profit. The purchaser rescinded the sale, but Lincoln left the $12 million profit on its books. Now, I don’t care how many accountants they get to say that’s right. It’s wrong. The only thing we have as regulators is our credibility. We have to preserve it.

DECONCINI: Why would Arthur Young say these things? They have to guard their credibility too. They put the firm’s neck out with this letter.

PATRIARCA: They have a client. The $12 million in earnings was not unwound.

DECONCINI: You believe they’d prostitute themselves for a client?

PATRIARCA: Absolutely. It happens all the time.

I treasure to this day the stunned look on DeConcini’s face when Mike responded that the AY audit partner (who Keating soon made wealthy by hiring, and quadrupling his compensation) was willing to “prostitute” himself for Keating.  “Absolutely.  It happens all the time.”  It did, and it does and until we realize that fact and bring back regulatory leaders with the courage and honesty of Michael Patriarca to enforce our vital rules we will continue to suffer from recurrent, intensifying financial crises.  It is also important to understand that to this day I have no idea what political affiliation, if any, my three FHLBSF colleagues had/have – and I worked with them closely for years.  Politics never mattered to us.

9. The key to the most damaging control frauds is not the CEO’s intelligence.  It takes no great brains to run an accounting fraud scheme that is a “sure thing.”  The factor that sets the worst CEO frauds apart is their audacity.  Keating provides the perfect example.  Consider first the audacity of seeking the unprecedented removal of the FHLBSF’s jurisdiction over Lincoln Savings.  But there are five defining examples of audacity that remain fresh with me.  In each case, Keating converted a true weakness into a fake asset.

i. After the removal of our jurisdiction Keating discovered that his head of regulatory compliance was embezzling from Lincoln Savings.  That was deeply embarrassing, but when Keating was dealt lemons he made Dom Perignon.  Keating couldn’t fire the guy for obvious reasons, and he couldn’t leave in a position to steal from Lincoln Savings.  Keating’s elegant solution was to tell him he had to go but to give him great references so he could get a new job.  But Keating’s true stroke of genius was to create a fake reason why the embezzler was leaving – that he could no longer stand to deal with the fascists at the FHLBSF!

ii. Michael Milken, who led the control fraud at Drexel Burnham Lambert (remember “junk bonds?”), funded Keating’s entire acquisition of Lincoln Savings by having the holding company he controlled (ACC) issue a raft of junk bonds.  The deal was that Lincoln Savings would serve as Milken’s “captive” and would buy a billion dollars in junk bonds.  (Akerlof and Romer 1993 explain the perverse financial implications of these “off the books” deals.)  Lincoln Savings had zero input on its junk bond portfolio – it learned at the end of the day in a telex from Milken what it now owned.  The problem is that buying a junk bond constitutes making a loan to a troubled debtor and our rules required a written record of Lincoln Savings’ underwriting process.  There was, of course, zero underwriting process by Lincoln Savings, which would have led our examiners to shut down the junk bond portfolio.  Keating’s solution was to hire ACC’s outside auditor – Arthur Andersen (AA) – as a consultant to create fictional underwriting documents to stuff into the loan files to deceive our examiners.  AA proceeded to create thousands of pages of faux underwriting documents.  A FHLBSF reviewer, Bart Dzivi, eventually discovered this scam.  (Explaining how important and brilliant Dzivi’s work was is beyond the scope of this paper, but I remain amazed 28 years later.)  Had the Department of Justice prosecuted AA in response to our criminal referral much of the Enron-era accounting control fraud epidemic might have been avoided.

iii. When AA decided it was facing excessive liability for aiding Keating, it decided to resign as the outside auditor.  Such a resignation can be a very bad signal to investors, so Keating adopted an audacious response.  Keating threatened to sue AA – unless it rewrote its draft disclosure of the basis for its resignation.  AA’s draft explained that Lincoln Savings was engaged in too many high risk accounting decisions.  Keating’s threats of suits eventually produced a resignation disclosure that said that AA was resigning because the FHlBSF was a group of raging fascists.  Keating and Greenspan then used the AA resignation letter as part of their effort to successfully recruit the Keating Five.

iv. When the Bank Board adopted the rule restricting “direct investments” it had a “grandfathered” clause for investments that were already in the pipeline.  Lincoln Savings in-house lawyers, being cowards, forced the paralegals and secretaries to forge hundreds of documents and thousands of signatures to make it appear that the scores of projects were grandfathered.

v. Keating’s claim that the FHLBSF had a “vendetta” against him had an obvious fatal flaw.  Why would we have a vendetta against him?  Through one of his lieutenants, Keating supplied the “answer” to that question.  Here was the “logic” chain.  (1) We knew that he was homophobic and a fierce opponent of pornography and (2) there was a secret gay conspiracy among FHLBSF staff to destroy Keating because he hated gays and porn.  (We never could figure out why they kept emphasizing the porn.  The “logic” appears to be that regulators are so addicted to porn that we seek to destroy anyone opposed to porn.)  The “secret gay conspiracy” was a major threat to regulators’ careers because the same pusillanimous head of our agency (Danny Wall) who removed our jurisdiction over Lincoln Savings had publicly taken “credit” for forcing out our agency’s most distinguished supervisor in our most troubled region (Texas) on the “grounds” that Speaker Wright wanted him forced out.  (The Speaker’s stated “grounds” for removing Joe Selby were that he was a homosexual.)  The FHLBSF did not discriminate against gays, so we obviously had a material number of gay employees.  The lawyer for Keating’s lieutenant made a “good faith” representation to the court that there was such a secret gay conspiracy against Keating.  The court (which heard the discovery dispute remotely by telephone) permitted the discovery to proceed on the basis of this representation.  The lawyer’s next question in the deposition of one of our officials was:  “have you heard any rumors about whether anyone who works at the FHLBSF might be gay?”  We went back to the judge with this fact and he ripped the lawyer to pieces for his false representations and ordered an end to Keating’s great gay fishing expedition.  It takes exceptional audacity to argue that “people are out to get me because I’m a bigot.”

10. The key to success against an epidemic of accounting control fraud is to rely on the examiners and put zero reliance on the econometricians.  Econometric studies during an epidemic of accounting control fraud will always praise whatever practices best aid accounting fraud.  Neoclassical economists are not simply incorrect about financial regulation; they give the worst conceivable policy advice.  Keating’s economists exemplify these points.  Alan Greenspan claimed that Lincoln Savings posed no foreseeable risk of loss – it was the most expensive failure ($3.4 billion – which is hard to do when your S&L only has $6 billion it total (reported) assets).  Greenspan and George Benston lauded 33 S&Ls that made large amounts of direct investments as the model for the industry and ridiculed the rule we adopted restricting direct investments (the rule that Keating tried to evade through massive forgeries).  Within two years, all 33 S&L had failed.  Most of them were accounting control frauds.  It is impossible to do worse than zero for 33.  Daniel Fischel claimed that his study showed that Lincoln Savings was the best S&L in the Nation – it was the worst.  Economics cannot be done worse than Fischel did.  When he and his co-author Judge Easterbrook wrote their famous book that claimed that financial fraud was impossible they carefully neglected to inform their readers that they had tried their dogmas in the real world and caused grave harm.