Why do Conservatives Oppose Prosecuting Elite Corporate Frauds?

By William K. Black
(Cross posted at Benzinga.com)

There are at least four principles that virtually all conservatives purport to support – except when the potential defendant is socially elite.  I have written previously about two of these principles on several occasions – the need for accountability and “broken windows” theory that calls for the prosecutors to make the prosecution of even minor street crimes a high priority if they have, even indirectly, a material effect on the community.

The third principle is that it is vital to punish in order to deter crime.  Gary Becker, the very conservative Nobel laureate in economics, emphasized this point (again, in the context of street crime).  Under Becker’s theory of crime our current practices of allowing elite banksters to become wealthy through leading the “sure thing” of accounting control fraud with immunity from the criminal laws will predictably lead to new, larger epidemics of fraud that will continue to cause our recurrent, intensifying financial crises.  It is rare, however, to find a prominent conservative who is demanding a priority effort to prosecute the elite bank officers who ran those frauds.  I know of no conservative member of Congress publicly making that demand today.  Senator Chuck Grassley has previously criticized the Obama administration’s failure to prosecute elite bankers.

The fourth principle, the one this column addresses, is the conservative love of “creative destruction” – a concept made famous by the economist Joseph Schumpeter.  I have a simple proposition – there is no more creative destruction than putting a control fraud out of business through a prosecution, receivership, or enforcement action.  I have never met personally a conservative, however, who agrees with that proposition in the context of a large, elite corporation.  When blue collar workers complain that their clothing manufacturing firm was put out of business by a rival firm that locates its plants in Bangladesh and is able to charge less for their goods because they pay their workers a pittance and “save” money by building factories that are death traps the conservative answer is to tell the U.S. workers to stop whining and light a candle on the altar devoted to the worship of capitalism celebrating the “creative destruction” of their jobs.

Conservatives should view control frauds as the supreme evil that they will devote their lives to eradicating.  Control frauds are the ultimate betrayal of capitalism.  First, they are the elite face of capitalism that gives capitalism a terrible name.  They become wealthy not because they are skilled, innovative, or willing to take risk but because they cheat – and George Akerlof and Paul Romer aptly characterized cheating as a “sure thing” in their famous 1993 article – “Looting: The Economic Underworld of Bankruptcy for Profit.”

“[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).

Worse, the way they cheat causes terrible harm to the public and, in the case of accounting control fraud (looting), the firm.  Control frauds cause immense “destruction” of wealth, but they are the opposite of “creative.”

Second, control fraud harms not only the primary intended victim, e.g., the bank’s creditors and shareholders, but also honest firms by creating a “Gresham’s” dynamic in which bad ethics can drive good ethics out of the markets.  George Akerlof was the first modern economist to explain this point in his famous 1970 article on anti-purchaser control frauds (“lemons”) that led to him becoming a Nobel laureate.

“[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”  Akerlof (1970).

A perceptive observer drew the same conclusion as Akerlof – in 1726.

“The Lilliputians look upon fraud as a greater crime than theft.  For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage” (Swift, J., Gulliver’s Travels).

We saw how the controlling officers of the fraudulent lenders who drove the financial crisis deliberately generated a Gresham’s dynamic in order to create an “echo” epidemic of control fraud among appraisers to support their origination of millions of fraudulent “liar’s” loans.

“From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011: 18).

No honest home lender, of course, would inflate an appraisal.  Appraisal fraud, like fraudulent liar’s loans, became epidemic.  A national survey of appraisers conducted in early 2004 found that 75% had been the targets of coercion during the last 12 months.  In 2005, Demos released a report that described appraisal fraud as “epidemic.”  Then N.Y. Attorney General Cuomo’s 2007 investigation confirmed that Washington Mutual (WaMu) had blacklisted honest appraisers and stated that WaMu’s conduct was the norm among nonprime lenders.  A follow-up survey of appraisers in 2007 demonstrated the response of the fraudulent lenders to these warnings.  The percentage of appraisers who had been coerced in the last 12 months rose to 90 percent.  Sixty-eight percent of appraisers reported losing at least one client when they refused to inflate the appraisal and 45% reported that they were not paid for at least one appraisal because they refused to inflate the appraisal.

Consider how perverse both the mortgage origination industry and the appraisal profession became due to the operation of a Gresham’s dynamic in each sphere.  The worst, most incompetent and unethical bank officers and appraisers grew wealthy from frauds while the most honest were driven from the industry and the profession.  Accounting control fraud is so devastating because accounting control frauds maximize their (fictional) income by making epic numbers of crappy loans at premium yields.  The consequences for our Nation and the global economy were catastrophic.  It was the epidemic of fraudulent liar’s loans that hyper-inflated the bubble and drove the losses.  No government entity forced or urged lenders to make liar’s loans (or inflate appraisals) or secondary market purchasers to buy liar’s loans (and that includes Fannie and Freddie).

Third, control frauds are the agents of crony capitalism.  Their CEOs may spout Randian sayings, but they are ultimate moochers who delight in translating their immense economic power into dominant political power that they use to defraud with impunity.  Control frauds betray and destroy capitalism.  If they are not stopped by the regulators and prosecutors (the “cops on the beat”) they destroy capitalism and democracy.

The best possible action would have been to put the accounting control frauds out of business.  It would have prevented the crisis, but it would have also been the possible protection of honest business people and professionals.  The honest appraisers did everything possible to warn us to the developing epidemic of accounting control fraud by home lenders.  I invite every lender, organization, and elected official to make public the specific steps they took in response to the appraisers’ petition to urge the mortgage industry, the regulators, and the prosecutors to put the fraudulent lenders out of business.  I am not aware of any conservative who urged the “creative destruction” of the fraudulent lenders.  The Obama administration is a fierce opponent of the creative destruction of the fraudulent lenders.  It has taken the opposite position – the elite frauds are too big to prosecute or jail precisely because they are large economic entities.  When the industry, regulators, or prosecutors destroy a control fraud the world improves.

Conservative scholars love (purported) “private market discipline.”  This is the theory that creditors will promptly destroy any control fraud.  The problem is that creditors actually fund the massive growth of control frauds rather than “disciplining” them.  Control frauds report extreme profits.  In the case of accounting control frauds these reported profits are fictional, but the creditors love to fund their growth.  In the case of other forms of control fraud the supra-normal profits produced by the fraud are real, so private market “discipline” is a complete oxymoron.  The creditors eagerly fund these other forms of control fraud because of their highly profitable frauds.

The honest accountants at Arthur Andersen (AA) were not “destroyed” by the prosecution of AA.  They went to work for other firms.  AA was a serial aider of the worst accounting control frauds, and had been since at least 1986 when they helped the worst savings and loan control fraud (Charles Keating’s Lincoln Savings) try to deceive the S&L regulators about Lincoln Saving’s huge purchases of junk bonds from Michael Milken’s Drexel Burnham Lambert (another control fraud) that was creatively destroyed by prosecution.  Had the Department of Justice acted on our criminal referral against AA in 1987 many future accounting control frauds that AA assisted in the Enron-era could have been prevented.

I urge conservatives to lead the charge for the creative destruction of the elite control frauds.  This is one of the many critical areas in which people of different political views should be able to find common cause.

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