By William K. Black

Roger Lowenstein has just taken the brave step of praising the failure to prosecute elite financial managers for fraud as a demonstration of the greatness of America. Lowenstein declares (1) that Blankfein was right- Goldman really was doing “God’s work,” (2) virtually no financial elites committed crimes, (3) any crimes they may have committed were trivial and played no material role in causing the crisis, (4) those that wish to hold fraudulent elites accountable for their crimes are (a) financially illiterate, (b) paranoid conspiracy theorists equivalent to those claiming the U.S. attacked the twin towers on 9/11, (c) a threat to our democracy and constitutional rights, and (d) engaged in”punishing profit,” (5) the prosecutors who refuse to bring criminal charges where they find elite frauds are the heroes safeguarding our democracy and constitutional rights, (6) the FBI is conducting a”serious” investigation of the elite financial frauds (despite points one through four above), and (7) the crisis was caused by “society” – because we’re all guilty no one should be held accountable – except those paranoids who want to destroy America’s greatness by prosecuting financial CEOs on fraud charges.

Wall Street: Not Guilty (May 12, 2011)

Lowenstein’s former colleague at the New York Times, Andrew Ross Sorkin, twittered that Lowenstein was “courageous” and “probably right.”

I join Lowenstein and Sorkin in denouncing the demagogues that denounce America’s financial CEOs for fraud and corruption and those that denounce our economic system for cronyism. My research has detected the ravings of two of the worst examples of this form of parasite. Two of the nation’s leading financial commentators have filled their books and columns with demagogic attacks on the productive class. Here are some of one’s vicious assaults on America’s CEOs and capitalist system.
“[Vast] pay-offs for failed executives exposed [American capitalism] as a fraud at its uppermost reaches.”
The author goes on to describe how senior corporate officials routinely engage in accounting fraud to make “the number” and maximize their bonuses. He stresses the complicity of the outside auditors and banks in aiding accounting control fraud. He claims that at investment banks:”the system was designed for cronyism” (emphasis in original). Indeed, he offers a comprehensive account of the criminogenic environment that creates the incentive and ability to engage in fraud with impunity. The author claims that the officers that control accounting frauds like Adelphia successfully manipulate banks by creating conflicts of interest because they believe that doing so will make it more likely that banks will fund their frauds- and he charges that our most elite banks are eager to be suborned and to turn a blind eye to the underlying fraud.
“The repeal of the Glass-Steagall Act, a Depression-era banking law, had paved the way for commercial banks like Citibank and Bank of America to get into the more lucrative business of underwriting. Adelphia’s Brown shrewdly exploited the banks’ greed. In a memo to bankers early in 2000, which cordially began, ”I hope your New Year is off to a great start,” Brown pitched the co-borrowing idea and pointedly observed, ”All of the lead managers and co-managers of each of these credit facilities are expected to have an opportunity to play a meaningful role in . . . public security offerings.”

In others words, if the banks lent the Rigases/Adelphia money, then Adelphia would spill some gravy onto their investment-banking divisions. When the bankers saw that, their mouths watered. This was exactly the sort of conflict that Glass-Steagall had been intended to prevent. The banks went for it. From 1999 to 2001, three banking syndicates, led by Bank of America, Bank of Montreal and Wachovia Bank, allowed the Rigases/Adelphia to borrow a total of $5.6 billion, a staggering sum. Citigroup, J.P. Morgan, Deutsche Bank and scores of other banks participated.
Anyone looking for mere gaps in the Chinese wall is missing the larger point: banks weren’t trying to separate departments but to integrate them. That was the whole reason they had lobbied for Glass-Steagall’s repeal. Thus, the banks would send teams of 8 or 10 investment bankers and commercial bankers — no distinction was evident, according to Tim Rigas — to Adelphia pitching every financial service under the sun.

Bank of America’s securities unit was so proud of the way it combined its services, which it referred to as ”delivering the one-stop shop,” that it produced a case study for interns in 2001 on how the technique had worked with a particular client. The client was Adelphia. Page after page describes how Bank of America had devised ”an integrated financing solution” for Adelphia, including underwritings, strategic advice, supportive (i.e., positive) research from its analyst and co-borrowing debt. Apparently, the only time Bank of America did not have an integrated approach to Adelphia was when it added up the debt that was disclosed in Adelphia prospectuses.”
The author stresses the negative effects of changes in the law that made it harder to bring civil suits against accounting fraud and the anti-regulatory agenda of industry. In the 1990s:
“Fueling the permissive climate, the Justice Department showed little interest in prosecuting cases of accounting fraud, which was not considered a major problem. These developments gave executives, accountants, and corporate lawyers a general sense that the risk to themselves had diminished. Veteran investors detected a new swagger in the executive suite.”
This is precisely the kind of attack on the Justice Department that Lowenstein decries. It is, of course, inconceivable that the Bush administration would have proven even more opposed to regulating and prosecuting elite white-collar criminals than the Clinton administration.

The author also attacks the private sector. Neoclassical economists have long assured us that fraud is impossible in the securities markets because creditors and investors exercise effective”private market discipline.” Private market discipline is the core function essential to efficient markets and capitalism, but the author claims that private market discipline has become so perverse that the supposed sources of discipline actually aid what criminologists call”accounting control frauds.”
“However badly the Rigases behaved, they were helped along the way by lenders and investment bankers, auditors, lawyers, analysts — just about anyone whose job it should have been to protect the public. And this is what truly distinguishes the latter stages of the last bull market: not that a handful of executives got greedy but that the safeguards supposedly built into our financial culture stopped functioning.”
The author writes that the Rigases involved facts so egregious that any honest lender should have refused to lend to them.
“Even to people familiar with Wall Street scandal, the central detail of this one remains astonishing. Somehow, the Rigases persuaded a network of commercial banks to lend to them more than $3 billion that not only the family, but also Adelphia, a public company with public shareholders, would be liable for repaying. The money was used, in large part, to buy Adelphia securities, which subsequently lost most of their value, as well as to make payments on stock the family had bought on margin. It was also used as a sort of A.T.M. to finance extravagances of the Rigases both small and not so small.”

“[I]nvestment banks floated billions of dollars of securities to the public with detailed descriptions of Adelphia’s finances that somehow neglected to mention the extra $3 billion of indebtedness. Even the S.E.C. was aware that Adelphia and the Rigas family each let the other borrow on its own credit, an unusual arrangement that, by its very nature, was vulnerable to abuse. But the S.E.C. apparently never investigated it.”

“And now that the stock market is back in the pink, a collective amnesia has settled over Wall Street, which takes comfort from the notion that the system essentially worked. The only problem is, it didn’t.”
The author claims that capitalism has become corrupt because of our elites’ power and class advantages.
[“T]he larger truth is that plenty of people were in a position to have blown a whistle and didn’t, for the simple reason that Wall Street during the 90’s operated like a grander version of Coudersport, a place where big fish had license to do as they pleased. ”The failed gatekeeper is a lesson you take away from all of these cases,” says Steve Thel, a Fordham University law professor who specializes in security fraud. ”Auditors who didn’t want to lose a client, bankers who were doing a ton of deals — there was a sense in our society that people who have a lot of money are supposed to have it.””
The same author has written about the major role that fraud played in the current crisis.
[World Savings’] “loan applications [were] so rife with fraud, that the quality of their book was as suspect as WaMu’s.
The author went on to complain about lenders
“Peddl[ing] these mortgages with a willful disregard, bordering on fraud, for whether their customers could repay them.”
Indeed, the author’s logic compels the view that the loans were on the wrong side of the fraud “border.” As the author describes the lenders, loans, and rating agencies that drove the crisis, the lenders knew that the borrowers could not repay the loans and the credit rating agencies willfully failed to determine whether the loans could be repaid because they would not have liked the answer had they inquired. The author doesn’t conclude that the loans are fraudulent because his analytics are so weak, but the facts he provides are damning. The context is that a rating agency, Moody’s, permitted him to examine an exemplar of a mortgage-backed security (MBS) (whose identity was disguised from the author and referred to as”XYZ”) collateralized by nonprime loans that it rated in 2006. The author notes that all of the loans backing the MBS were subprime – the lenders knew they were loaning money to borrowers with serious credit deficiencies. The author reports that this was only one aspect of why the loans’ were exceptionally likely to default.
Moody’s learned that almost half of these borrowers – 43 percent – did not provide written verification of their incomes.
By 2006, Credit Suisse estimated that half of all loans called “subprime” were also “liar’s loans.” The author does not note that the mortgage banking industry’s own anti-fraud experts reported that the incidence of fraud in liar’s loans is roughly 90 percent. The author also fails to note that investigators found that it was overwhelmingly the lenders and their agents, i.e., the loan brokers, who put the lies in liar’s loans. Instead, he reported that Moody’s: “reject[ed] the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.” The author is also naive in accepting Moody’s explanation that:
“Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property’s presumed resale value, which meant the borrowers had not a cent of equity.”
This is naive because the author has, elsewhere, noted that Washington Mutual’s loans were “rife with fraud.” Andre Cuomo, when he was New York’s Attorney General, found that WaMu kept a blacklist of appraisers – and that one got on the list by refusing to inflate appraisals. No honest lender would ever inflate appraisals, but doing so optimizes accounting control fraud. Only the lenders and their agents, not the borrowers, can cause widespread inflation of appraisals. This means that the borrowers on liar’s loans commonly had negative equity in their homes from the day they purchased the house – they overpaid for the homes. The lenders and their agents, by inflating the appraisals, deceived less sophisticated borrowers about the value of their homes and placed them in a position where they were highly likely to lose the home and their very limited savings. The lenders and their agents’ primary reason for inflating the appraisal was to lower the reported loan-to-value (LTV) ratio. By falsely reporting a lower LTV ratio the lenders increased the ease of securing”AAA” ratings from a rating agency and the premium they could receive by selling the loan.

The author’s naive acceptance of Moody’s claims continues in his explanation of why the rating agencies gave ludicrously inflated ratings to MBS “backed” largely by fraudulent loans structured to have exceptionally high default rates.
“Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications.”We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me.”

In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them.
The first clause is absurd. Moody’s did have “access to the individual loan files.” The claim that Moody’s was rating the bonds, not the underlying assets, is absurd. The bond derives its value (and risks) from the underlying mortgages. The only way to reliably evaluate the credit risk of a nonprime MBS was to review a sample of the loans. The author concedes that all Moody’s had to do to get access to the underlying mortgages was to say it would not rate securities unless it could sample loan quality.
“The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody’s, S.&P. and Fitch say that they are tightening procedures – they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model.”
The only reliable way to determine the credit risk of mortgage loans is to review a sample of the loans. Fitch finally did so, in November 2007 (a non-random date- the secondary market in nonprime loans had collapsed and there were no more fees to be received by inflating credit ratings). Fitch reported:
“Fitch’s analysts conducted an independent analysis of these files with the benefit of the full origination and servicing files. The result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.

[F]raud was not only present, but, in most cases, could have been identified with adequate underwriting, quality control and fraud prevention tools prior to the loan funding. Fitch believes that this targeted sampling of files was sufficient to determine that inadequate underwriting controls and, therefore, fraud is a factor in the defaults and losses on recent vintage pools.”
Fitch also explained why these forms of mortgage fraud combine with “layered risk” to cause severe losses.
“For example, for an origination program that relies on owner occupancy to offset other risk factors, a borrower fraudulently stating its intent to occupy will dramatically alter the probability of the loan defaulting. When this scenario happens with a borrower who purchased the property as a short-term investment, based on the anticipation that the value would increase, the layering of risk is greatly multiplied. If the same borrower also misrepresented his income, and cannot afford to pay the loan unless he successfully sells the property, the loan will almost certainly default and result in a loss, as there is no type of loss mitigation, including modification, which can rectify these issues.”
Note that Fitch, like Moody’s, places the onus for fraud solely on the borrowers rather than the rating agencies’ customers. This is understandable, but false. Because the author naively assumes that Moody’s could not review a sample of loans so that they could determine their credit risk the author does not ask the central analytical question- why did the rating agencies consistently refuse to sample the asset quality of nonprime loans that were known to be pervasively fraudulent. If the rating agencies had reviewed a sample of the loans we know what they would have found- exactly what Fitch found. That would have made it impossible to rate the securities above a “C” rating – virtually certain to default. The author explains the rating agencies’ perverse incentives to give the desired “AAA” rating.
“A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating.”
The author does not understand the logic of facts he reports, but those facts explain why the rating agencies adopted the financial version of”don’t ask; don’t tell.” The one thing they could never do was actually review the credit risk of the securities they were rating. If they looked, they would document the endemic fraud and never get paid. If even a few rating agencies reported that fraud was endemic among liar’s loans the entire secondary market in nonprime loans would have collapsed and the rating agencies’ most lucrative source of fees would have disappeared.
Their profits surged, Moody’s in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent.
The author disagrees sharply with Lowenstein. He believes that the lenders and rating agencies saw the “classic signs” of a bubble before the bubble collapsed. The author, however, again displays naivete about ARMs.
“Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs – “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble – lending on the belief, or the hope, that new money will bail out the old.”
The author neglects two critical aspects of “teaser” ARMs. First, the lenders “qualified” borrowers on the basis of their purported ability to repay the initial – far lower – “teaser” interest rate. An honest lender would not do so because it would ensure extreme default rates. Second, the very low rates delayed the defaults, optimizing and extending accounting fraud. The facts that the author report are not”classic signs of a bubble” but rather classic signs of accounting control fraud.

While the author does not use the phrase, the facts he report demonstrate that the investment and commercial banks that created the nonprime securities deliberately and successfully generated a Gresham’s dynamic (bad ethics drives good ethics out of the marketplace) among the rating agencies by “shopping” their business to the least ethical rating agency.
“But in structured finance, a handful of banks return again and again, paying much bigger fees. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”

And it seems to have helped the banks get better ratings. Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.’s defaulted eight times as often. One interpretation of the data is that Moody’s was far less discerning when the client was a Wall Street securitizer.”
The author reports that Moody’s created an absurd empirical methodology to justify claiming that pervasively fraudulent loans would have only minimal defaults.”Nonetheless, its credit-rating model continued to envision rising home values.” As long as home loans increased forever the borrowers could simply refinance their loans. The industry saying is: “a rolling loan gathers no loss.”

Sorkin, who so courageously championed Lowenstein’s column denying the existence of fraudulent lending and sales on nonprime securities and praising the “serious” prosecutions of fraudulent lenders, should turn his wrath to another author who has taken the opposite position. This author has been very harsh in his critique of the Department of Justice, complaining:
“If the government spent half the time trying to ferret out fraud at major companies that it does tracking pump-and-dump schemes, we might have been able to stop the financial crisis, or at least we’d have a fighting chance at stopping the next one.”
The same author has disparaged Attorney General Holder’s announcement that the Department of Justice has made such investigations a top priority, as evidenced by “Operation Broken Trust.”
[A]fter you get past the pandering sound bites, a question comes to mind: is anyone in the corner offices of Wall Street’s biggest firms or corporate America’s biggest companies paying any attention to Mr. Holder’s “strong message”?

Of course not. (I actually called some chief executives after Mr. Holder’s news conference, and not one had heard of Operation Broken Trust.)

That’s because in the two years since the peak of the financial crisis, the government has not brought one criminal case against a big-time corporate official of any sort.

Instead, inexplicably, prosecutors are busy chasing small-timers: penny-stock frauds, a husband-and-wife team charged in an insider trading case and mini-Ponzi schemes.
This is the first of a multi-part response to Lowenstein’s column. The remaining columns will address why control fraud drove the current crisis and respond to Lowenstein’s strawman arguments. The sources of the quotations used in this column, from Messrs. Lowenstein and Sorkin, are provided below.


Roger Lowenstein, The End of Wall Street (2010); Origins of the Crash: the Great Bubble and its Undoing (2004); Origins of the Crash: the Great Bubble and its Undoing (2004).

The Company They Kept
By Roger Lowenstein
Published: February 01, 2004
April 27, 2008

Triple-A Failure
The Ratings Game
DECEMBER 6, 2010, 8:59 PM
Pulling Back the Curtain on Fraud Inquiries

Bill Black is an associate professor of economics and law at the University of Missouri-Kansas City. He is a white-collar criminologist, a former senior financial regulator, a serial whistle blower, and the author of The Best Way to Rob a Bank is to Own One. He blogs primarily on the UMKC’s economics department’s blog: NewEconomicPerspectives. Bloomberg recently solicited a column from him on the role of fraud in the crisis.

He also discussed the role of fraud in the crisis extensively with Harry Shearer on Le Show.

Bill Black is an associate professor of economics and law at the University of Missouri-Kansas City, a white-collar criminologist, and a former senior financial regulator. He was an expert witness for OFHEO in its enforcement action against the former senior leaders at Fannie Mae. Bill Black is the author of The Best Way to Rob a Bank is to Own One.

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