Dimon’s Dictum: “Poorly underwritten loans represent income today and losses tomorrow.”

By William K. Black

The aphorism is by Jamie Dimon. I took it from his March 30, 2012 Letter to shareholders (p. 8).  The immediately preceding sentence was: “Low-quality revenue is easy to produce, particularly in financial services.”

Aphorisms are pithy.  They capture the essence of the point without the details.  Dimon’s aphorism captures the essence of “control fraud.”  The details are important, but the insight contained in the aphorism is the key that eludes most people who find it paradoxical that making bad loans is the surest means of reporting record short-term income and making the controlling officers instantly wealthy through modern executive compensation.  It is “easy” to produce fictional near-term “income,” massive near-term executive compensation, and catastrophic losses whose recognition will be (improperly) delayed until “tomorrow.”  All the financial firm needs to do is to deliberately make “poorly underwritten loans” of abysmal quality.

The details explain how accounting control frauds optimize fraudulent income and make clear why deliberately making terrible loans is part of that optimization.  The recipe for accounting control fraud for a lender (purchaser) of financial assets has four ingredients.

  1. Grow extremely rapidly by
  2. Making (purchasing) loans of very poor quality at a premium yield while
  3. Employing high leverage and
  4. Providing only  grossly inadequate allowances for loan and lease losses (ALLL)

George Akerlof and Paul Romer aptly describe accounting control fraud as “a sure thing.”  (“Looting: the Economic Underworld of Bankruptcy for Profit” (1993).)  The formula is expressed in words, but it describes a mathematical concept.  The first two ingredients of the “recipe” are related.  Finance is generally a mature, highly-competitive industry.  A lender that attempted to grow extremely rapidly through making high quality loans would have to “buy market share” by cutting the yield it charged to make loans.  Its rivals would cut the interest rates they charged on their loans.  The result would be reduced reported profits for the entire industry.  By making extremely poor quality loans, however, the firm can grow exceptionally rapidly and lend at a premium yield.

If the firm making or purchasing the bad loans (improperly) fails to provide an ALLL appropriate to the terrible quality of those loans the result is that it must report substantial income in the near term.  That reported income is, as Dimon recognizes, fictional.  It represents accounting fraud.  The loans have a negative expected value when they are made and purchased, which would be clear if the firm complied with generally accepted accounting principles (GAAP) and provided an adequate ALLL (which would exceed any net revenue generated by the loan).  (International accounting rules are often interpreted to allow this fraud by purportedly forbidding establishing an ALLL for the future losses inherent in making bad loans.  There is a vital and urgent need to change this invitation to accounting control fraud.)

Only a fraudulent officer would make or purchase loans with a negative expected value.  Making or purchasing terrible loans requires the controlling officers making securities filings subject to U.S. GAAP to commit securities fraud because the U.S. securities laws incorporate GAAP.  The officers must fail to establish adequate ALLLs to make accounting control fraud produce large amounts of fictional income.

The fraud recipe requires the controlling officers of a firm engaged in accounting control fraud to eviscerate prudent underwriting by “their” firm.  This is an obvious fraud “marker.”  Dimon sees the essential relationship between optimizing accounting fraud through making bad loans and the need to gut underwriting to make large amounts of bad loans.  It is possible to make small loans such as credit cards with minimal underwriting.  Microcredit is typically conducted with minimal conventional underwriting.  Both of these forms of lending create a severe risk of adverse selection.  Fraud is a common problem.  Credit card and microcredit lenders tend to produce “lemons” markets characterized by high interest rates.  High credit quality borrowers cross-subsidize poor quality borrowers.  This does not work for large loans.  The losses on fraudulent residential and commercial real estate loans are so large that they can quickly cause firms making or holding large amounts of such loans (or derivatives such as CDOs “backed” by the fraudulent mortgage loans) to suffer catastrophic losses.

It is not clear whether Dimon has recognized that the fraud recipe makes accounting control fraud a superb device for hyper-inflating financial bubbles and causing “echo” fraud epidemics in other fields (e.g., mortgage brokers) and professions (e.g., appraisers).  These details, while very important, do not detract from the central truth of Dimon’s accounting control fraud aphorism.

All we have to do is get Attorney General Holder, President Obama, the banking regulators, Congress, and the media to understand accounting control fraud.  They all agree that Dimon is a genius.  Now that Dimon has figured out how accounting control fraud works and the damage it causes, he can explain it to Holder and his department.  Senior Justice Department officials have demonstrated their inability to understand accounting control fraud.

“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. ‘It doesn’t make any sense to me that they would be deliberately defrauding themselves,’ Wagner said.”


Dimon understands that that “they” (the CEO running the fraud) and “themselves” (the bank) are not the same entity.  He explains that gutting underwriting for the purpose of making or purchasing large amounts of bad loans is sure to produce record (albeit fraudulent) reported “income today” and the catastrophic recognition of real “losses tomorrow.”  The “income today” allows the fraudulent CEO to become wealthy by looting the bank through modern executive compensation – and walk away wealthy when the bank fails.

White-collar criminologists, competent financial regulators, a Nobel laureate in economics and his prestigious co-author (George Akerlof and Paul Romer), and Jamie Dimon all recognize how accounting control fraud works and why epidemics of these frauds cause our recurrent financial crises.  The excuses for refusing to prosecute the elite frauds that drove the crisis become ever more threadbare.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

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