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Epidemics of 'Control Fraud' Lead to Recurrent, Intensifying Bubbles and Crises

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April 28, 2010 – Comments (1)

I am a big fan of William Black. I have written many posts linking to his interviews. I think both he and Elizabeth Warren have a similar message: "regulation of financials can and should be done far more effectively with the resources we already have".

This is a very important part of the equation, but it is not the only one. It isn't even the biggest one.

The biggest reason why we have intensifying bubbles and crises is that US monetary and economic policy over the last several decades has allowed financials to become far too big and powerful. The shadow banking system is a huge drain on the real economy and produces no benefit. Financials are not, at their core, bad businesses (at least financials of 30-40 years ago). They do perform a very vital role of facilitating the dispersion of resources. But it not productive, so there is a loss of efficiency, but there is an overall economic good that comes out of it.

But today, financials (investement / shadow banks in particular) comprise a disproportionate size of the economy to the amount of economic usefulness they perform. This non-productive garbage has to be cleaned out, just like cancer. This is precisely why I call financials the cancer of the economy. They are a huge drain that transfers the economy's money (the wealth of the productive part of society), largely between each other, collecting fees for their "work".

This is the real reason why "too big to fail" is fallacious. It is absolutely critical to allow failing firms to fail, so that real and sustainable economic growth can begin.

Effective regulation is only part of the problem, and will not in and of itself provide a solution.

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Epidemics of 'Control Fraud' Lead to Recurrent, Intensifying Bubbles and Crises
William K. Black
University of Missouri at Kansas City - School of Law
April 15, 2010

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1590447

Abstract:

“Control frauds” are seemingly legitimate entities controlled by persons that use them as a fraud “weapon.” A single control fraud can cause greater losses than all other forms of property crime combined.

This article addresses the role of control fraud in financial crises. Financial control frauds’ primary weapon is accounting. Fraudulent lenders produce exceptional short-term “profits” through a four-part strategy: extreme growth (Ponzi), lending to uncreditworthy borrowers, extreme leverage, and minimal loss reserves.

These exceptional “profits” defeat regulatory restrictions and turn private market discipline perverse. The profits also allow the CEO to convert firm assets for personal benefit through seemingly normal compensation mechanisms. The short-term profits cause stock options to appreciate. Fraudulent CEOs following this strategy are guaranteed extraordinary income while minimizing risks of detection and prosecution.

The optimization strategy causes catastrophic losses. The “profits” allow the fraud to grow rapidly by making bad loans for years. The “profits” allow the managers to loot the firm through exceptional compensation, which increases losses.

The accounting control fraud optimization strategy hyper-inflates and extends the life of financial bubbles. The finance sector is most criminogenic because of the absence of effective regulation and the ability to invest in assets that lack readily verifiable values. Unless regulators deal effectively with the initial frauds their record profits will produce imitators. Control frauds can be a combination of “opportunistic” and “reactive”. If entry is easy, opportunistic control fraud is optimized. If the finance sector is suffering from distress, reactive control fraud is optimized. Both conditions can exist at the same time, as in the savings and loan (S&L) debacle.

When many firms follow the same optimization strategy a financial bubble hyper-inflates. This further optimizes accounting control fraud because the frauds can hide losses by refinancing. Mega bubbles produce financial crises.


The paper can be found at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1590447

1 Comments – Post Your Own

#1) On April 28, 2010 at 11:27 AM, leohaas (31.52) wrote:

Fraud? I thought it was nothing else than hedging!

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