BUSINESS
06/21/2010 05:12 am ET | Updated May 25, 2011

William Black Warns That Financial Reform Bill Won't Stop The Wall Street Crime Wave

The securities fraud case against Goldman Sachs is a powerful reminder that the financial crisis responsible for millions of lost jobs and lost homes wasn't just the result of market vagaries and regulatory failure -- it was also the result of massive fraud at all levels of the financial system.

This epidemic of fraud has gone largely uninvestigated and almost entirely unprosecuted.

And the incentive structures that led so many people to intentionally take advantage of so many others for personal gain remains largely unaddressed by the legislation being considered in Congress.

Indeed, while there's plenty of talk of unwinding big banks, there's been little discussion of undoing the system that rewarded mortgage brokers for getting people to lie on their applications, sent more business to credit raters the fewer questions they asked, and encouraged massive investment banks to hide their losses and pitch investment vehicles designed to crash.

When you start to see fraud at the heart of the financial crisis, you turn to different people to explain what happened -- and to propose solutions. "Once you understand the implications of massively fraudulent practices," said James Galbraith, a progressive economist at the University of Texas, "it changes the professional community that has the principal say about interpreting the crisis."

Economists, he said, should move into the background -- and "criminologists to the forefront."

One such criminologist -- with a personal track record of two-fisted regulatory effectiveness during the savings and loan crisis of the late 1980s -- is William F. Black, now a professor at the University of Missouri and author of the book, "The Best Way to Rob a Bank Is to Own One".

Black sees what he calls "control fraud" at the heart of the financial crisis. "Control fraud," he explained, "is when the people controlling a seemingly legitimate entity use the entity as a weapon to defraud." It's fraud committed by design, by the people at the top.

"WaMu is a control fraud," he said, referring to the case of Washington Mutual Bank, the largest bank failure in history, where evidence suggests that executives knew about rampant fraud in their mortgage loans and didn't stop it, allowing them to report higher profits and get bigger bonuses.

"Lehman is a control fraud," he said, referring to the massive investment bank that went bankrupt after making a record numbers of mortgage loans based on little or no documentation (known as "liar's loans") and using accounting tricks to make the company look healthier than it was.

Criminologists, Black said, are trained to identify the environments that produce epidemics of fraud -- and in the case of the financial crisis, the culprit is obvious.

"We're looking at incentive structures," he told HuffPost. "Not people suddenly becoming evil. Not people suddenly becoming crazy. But people reacting to perverse incentive structures."

CEOs can't send out a memo telling their front-line professionals to commit fraud, "but you can send the same message with your compensations system, and you can do it without going to jail," Black said.

Criminologists ask "fundamentally different types of question" than the ones being asked.

"First we ask: Does this business activity, the way they're conducting it, make any sense for an honest firm? And we see many activities that make no sense for an honest firm."

One example is the "liar's loans." With something like 90 percent of them turning out to be fraudulent, they are not profitable loans to make -- unless you're getting paid based on volume, and unless the idea is to sell them off to someone else.

"We also ask: How it is possible that they were able to sell this stuff?" When it comes to toxic assets -- or securities built on top of them -- "all standard economic explanations say it should have been impossible to sell them."

The answer, in this crisis, is "the financial version of Don't Ask Don't Tell," Black said. Incentives for short-term profits and the resulting bonuses were so great that buyers preferred booking the revenue than looking too closely at what they were buying.

Black is concerned that the financial legislation currently being debated on Capitol Hill doesn't change the rules enough. He's concerned about loopholes in derivative regulation and thinks that demanding "skin in the game" won't actually help curb fraud.

Yes, "skin in the game" means that companies could go bankrupt if they place bad bets. But, he said. "if the corporation gets destroyed, that's not a failure of the fraud scheme." Former Lehman Brother CEO Richard Fuld, for instance, "walked away with hundreds of millions of net worth that would never have been created but for the fraud."

Black would like to see reform that ends regulatory black holes and that "requires not just rules" but approving regulators with teeth, to enforce them. Regulators should not be cozy with the entities they regulate; they should be skeptical. "Some of us have to stay skeptical, so that everyone else can trust," he said.

He also thinks it's important to address compensation -- both for executives and professionals. Black isn't calling for limits on executive pay, just for executives to keep their own promises to make bonuses based on long-term success, rather than short term. And he means really long-term. "The big bonuses, they come after 10 years, when they show it's real," Black said.

"Professional compensation has to be changed to prevent conflicts of interest," he said. Appraisers, accountants, ratings agencies and the like need to be rewarded for accuracy rather than amenability. Right now, Black said, "cheaters prosper."

Black was testifying on Capitol Hill on Tuesday, ironically enough sitting alongside Fuld, the former Lehman Brother CEO, who Inartfully dodged questions about what actually caused his bank's spectacular failure. Black didn't hold back.

WATCH Black's Testimony:

From the transcript (courtesy of Firedoglake's Jane Hamsher):

Lehman's failure is a story in large part of fraud. And it is fraud that begins at the absolute latest in 2001, and that is with their subprime and their liar's loan operations.

Lehman was the leading purveyor of liar's loans in the world. For most of this decade, studies of liar's loans show incidence of fraud of 90%. Lehman sold this to the world, with reps and warranties that there were no such frauds. If you want to know why we have a global crisis, in large part it is before you. But it hasn't been discussed today, amazingly.

Financial institution leaders are not engaged in risk when they engage in liar's loans -- liar's loans will cause a failure. They lose money. The only way to make money is to deceive others by selling bad paper, and that will eventually lead to liability and failure as well.

When people cheat you cannot as a regulator continue business as usual. They go into a different category and you must act completely differently as a regulator. What we've gotten instead are sad excuses.

Not all experts on fraud are as pessimistic about the current legislation as Black. Michael Greenberger, a University of Maryland law professor who worked for the Commodity Futures Trading Commission in the Clinton administration, said he shares Black's view on the significance of fraud.

"I think it played a very big role in the crisis, and I think that the Goldman suit is only the beginning of what will be a full range of suits, not only by the SEC," Greenberger told HuffPost.

But, he said, "I think the legislation is getting at this from a different angle." The extreme bonuses that created such perverse incentives for executives were fueled mostly by the huge profits from the unregulated derivatives markets, he said.

Regulations that enforce transparency, ban certain kinds of derivatives, reduce transaction costs and narrow spreads will inevitably "shrink this market down... making it an honest market," he said. "The odds will be clear to everyone. And it is essentially going to force banks back into the business of making loans, which is what they should be doing."

Black also described control fraud in an interview with David Heath of the Huffington Post Investigative Fund in December:

So the person at the top sets a tone that is corrupt. Then he creates a financial incentive structure where you cheat, you make a lot of money. And when you don't cheat, not only do you not make a lot of money, you get in trouble. You get in trouble in the sense that you don't get your bonus, since you're not producing income, But worse, far more powerful, you keep your peers, your friends in the organization, from getting their bonuses.

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Dan Froomkin is senior Washington correspondent for the Huffington Post. You can send him an e-mail, bookmark his page; subscribe to RSS feed, follow him on Twitter, friend him on Facebook, and/or become a fan and get e-mail alerts when he writes.