By William K. Black
(Cross-posted from Benzinga.com)
Reading the FHFA complaints against many of the world’s largest banks is a fascinating and troubling process for anyone that understands “accounting control fraud.” The FHFA, a federal regulatory agency, sued in its capacity as conservator for Fannie and Freddie. Its complaints are primarily based on fraud. The FHFA alleges that the fraud came from the top, i.e., it alleges that many of the world’s largest banks were control frauds and that they committed hundreds of thousands of fraudulent acts. The FHFA complaints emphasize that other governmental investigations have repeatedly confirmed that the defendant banks were engaged in endemic fraud. The failure of the Department of Justice to convict any senior official of a major bank, and the almost total failure to indict any senior official of a major bank has moved from scandal to farce.
The FHFA complaints are distressing, however, intheir failure to explain why the frauds occurred and how an accounting controlfraud works. The FHFA complaint againstCountrywide is particularly disappointing because it accepts hook line andsinker Countrywide’s internal claim that it acted improperly for the purpose ofattaining a larger market share. Executive compensation drops entirely out of the story even though it isthe reason the frauds occur and the means by which controlling officers loot“their” banks. The FHFA complaintagainst Countrywide ignores executive compensation. The FHFA complaint against J.P. Morgan(purchaser of WaMu) mentions only that loan officers’ compensation was based onloan volume rather than loan quality.
The complaints fail to explain the extraordinarysignificance of widespread appraisal fraud – something that only the lender andits agents can produce and a “marker” of accounting control fraud. No honest lender would inflate, or permit tobe inflated, appraisals.
The complaints also fail to explain why no honestmortgage lender would make “liar’s” loans. The FHFA complaint against Countrywide notes that Countrywide loanofficers would use undocumented loans to aid their creation of fraudulent loanapplications.
Even neoclassical economists – the weakest of allfields in understanding fraud – understand that this crisis was driven byexecutive compensation. Consider theadmirably short piece entitled
“Fake alpha or Heads I win, Tails you lose” by Raghuram Rajan. Rajan’spiece is badly flawed, but it at least understands the importance ofcompensation, accounting, and risk.
“Whatthe shareholder will really pay for is if the manager beats the S&P 500index regularly, that is, generates excess returns while not taking more risk.Hence pay for alpha.”
Rajan is correct that the neoclassicaltheory of CEO compensation is that the CEO should only be compensated for high (“excess”)returns if they were not generated by“taking more risks.” Modern bonus plans oftenpurport to provide exceptional compensation to CEOs who achieve extreme short-term“excess” returns that are not generated by “taking more risks.” Rajan gets the next point analytical pointcorrect as well: “In reality, there areonly a few sources of alpha for investment managers. [S]pecial ability is by definition rare.” It is the “rare” CEO who can achieve massivebonuses through exceptional performance, but all CEOs desire massive bonuses.
Rajan gets the next step in theanalytics correct – the answer to the CEO’s dilemma is to create “fake alpha,”but he falls off the rails in the last clause.
“Alphais quite hard to generate since most ways of doing so depend on the investment managerpossessing unique abilities – to pick stock, identify weaknesses in managementand remedy them, or undertake financial innovation. Unique ability is rare. Howthen can untalented investment managers justify their pay? Unfortunately, alltoo often it is by creating fake alpha – appearing to create excess returns butactually taking on hidden tail risk.”
In his recent book, Rajan explainsthat by “hidden tail risk” he means taking risks that will only cause losses inhighly unusual circumstances. I willreturn to why this aspect of Rajan’s reasoning is false.
Rajan gets the next part correct– generating fake alpha will cause the bank to fail when the risks blow up. Rajan’s “tail risk” theory, however, predictsthat these risks will only blow up rarely.
Rajan then stresses, correctly,that executive compensation based largely on short-term reported income willcreate perverse incentives to generate fake alpha. He also
“Truealpha can only be measured in the long run …. Compensation structures that reward managersannually for profits, but do not claw these rewards back when lossesmaterialize, encourage the creation of fake alpha.”
Rajan, being a good neo-classicaleconomist, recognizes the vital need to change compensation, but has no urgencyabout doing so.
“[U]nlesswe fix incentives in the financial system, we will get more risk than webargain for. And the enormous pay of financial sector managers, which has hithertobeen thought of as just reward for performance, will deservedly come underscrutiny.”
Corporations have changedexecutive compensation in response to the crisis – by making it even moredependent on short-term reported income. Rajan does not ask why corporations base executive compensation onshort-term reported income without clawbacks. Rajan is correct that such compensation systems create intenselyperverse incentives that cause managers to loot the shareholders and creditorsand cause the bank to fail.
Rajan’s extreme tail risk theorydescribes an accounting control fraud. Rajan does not understand that he is describing conduct that wouldconstitute accounting fraud. Rajan alsodoes not understand that his hypothetical has nothing to do with what actuallyhappened in the crisis. The extreme tailrisk scheme he hypothesizes would be a terrible fraud scheme. He does not understand accounting controlfraud.
The real investments that drovethe financial crisis were not assets that would suffer losses only in rarecircumstances. They were nonprimeloans. Roughly 30% of total loansoriginated by 2006 were “liar’s” loans – with a 90% fraud incidence. Liar’s loans and subprime are not mutuallyexclusive categories. By 2006, half ofall loans called subprime were also liar’s loans. Appraisal fraud was also epidemic. The probability of endemically fraudulentloans causing losses (instead of fictional “excess return”) was certainty. The loss recognition could only be delayedthrough a combination of accounting fraud (failing to provide remotely adequateallowances for loan and lease losses (ALLL)) and hyper-inflating thebubble. Hyper-inflating the bubbleincreases the ultimate losses.
Making extreme tail riskinvestments is a deeply inferior fraud scheme. Rare risks produce tiny risk premiums and the entire game is to createsubstantial risk premiums. Making liar’sloans allows exceptional growth (part one of the fraud “recipe” for a lender)and booking a premium yield (if one engages in accounting fraud on theALLL). The key is found in GeorgeAkerlof and Paul Romer’s article title – “Looting: the Economic Underworld ofBankruptcy for Profit” (1993). As theycorrectly observed, the fraud recipe is a “sure thing” – it maximizes(fictional) short-term reported income, executive bonuses, and real losses.
Rajan got many things correct andmany things wrong about generating fake alpha, but at least he sought toexplain the perverse dynamic. The FHFAcomplaints lose explanatory power and persuasiveness because they ignorecompensation and accounting. It pays tounderstand accounting control fraud.