The best way to rob a bank is to own one.
WILLIAM CRAWFORD, COMMISSIONER OF THE CALIFORNIA DEPARTMENT OF SAVINGS AND LOANS, INTRODUCING HIS CONGRESSIONAL TESTIMONY BEFORE THE U.S. HOUSE COMMITTEE ON GOVERNMENT OPERATIONS IN 1988
A control fraud is a company run by a criminal who uses it as a weapon and shield to defraud others and makes it difficult to detect and punish the fraud (Wheeler and Rothman 1982). (I also use the phrase in some places to refer to the person who directs the fraud.) Fraud is theft by deception: one creates and exploits trust to cheat others. That is one of the reasons the ongoing wave of corporate fraud is so devastating: fraud erodes trust. Trust is vital to making markets, societies, polities, and relationships work, so fraud is particularly pernicious. In a financial context, less trust means more risk, and more risk causes lower asset values. As I write, stocks have lost trillions of dollars in market capitalization. To use a term from economics, fraud causes terrible “negative externalities” because it inflicts injury on those who were not parties to the fraudulent transaction.
Control frauds are financial superpredators that cause vastly larger losses than blue-collar thieves. They cause catastrophic business failures. Control frauds can occur in waves that imperil the general economy. The savings and loan (S&L) debacle was one such wave.
Successful control frauds have one primary skill: identifying and exploiting human weakness. Audacity is the trait that sets control frauds apart. Charles Keating was the most notorious control fraud. His ability to manipulate politicians became legendary. Any control fraud could have done what Keating did in the political sphere, but only a few tried.
Well-run companies have substantial internal and external controls designed to stop thieves. The chief executive officer (CEO), however, can defeat all of those controls because he is in charge of them.1 Every S&L control fraud succeeded in getting at least one clean opinion from a top-tier audit firm (then called the “Big 8”). They generally were able to get them for years. The ongoing wave of control frauds shows that they are still routinely able to defeat external audit controls. The outside auditor is a control fraud’s most valuable ally. Keating called his accountants a profit center. Control frauds shop for accommodating accountants, appraisers, and attorneys.
Control frauds create a “fraud friendly” corporate culture by hiring yes-men. They combine excessive pay, ego strokes (e.g., calling the employees “geniuses”), and terror to get employees who will not cross the CEO. Control frauds are control freaks (Black 2000).
The second reason control frauds are so destructive is that the CEO optimizes the firm as a fraud vehicle and can optimize the regulatory environment. The CEO causes the firm to engage in transactions that are ideal for fraud. Control frauds are accounting frauds. Investments that have no readily ascertainable market value are superior vehicles for accounting fraud because professionals, e.g., appraisers, value them. S&Ls shopped for outside professionals who would support fraudulent accounting and appraisals. Control frauds use an elegant fraud mechanism, the seemingly arm’s-length (independent) transaction that accountants consider the best evidence of value. They transact with each other or with “straws” on what appears to be an arm’s-length basis, but is really a fraud that massively overvalues assets in order to create fictitious income and hide real losses.
Control frauds grow rapidly (Black 1993d). The worst control frauds are Ponzi schemes, named after Carlo Ponzi, an early American fraud. A Ponzi must bring in new money continuously to pay off old investors, and the fraudster pockets a percentage of the take. The record “income” that the accounting fraud produces makes it possible for the Ponzi scheme to grow. S&Ls made superb control frauds because deposit insurance permitted even insolvent S&Ls to grow. The high-tech bubble of the 1990s allowed similarly massive growth.
Control frauds are predators. They spot and attack human and regulatory weaknesses. The CEO moves the company to the best spot for accounting fraud and weak regulation.
Audacious control frauds transform the environment to aid their frauds. The keys are to protect and even expand the range of accounting abuses and to weaken regulation. Only a control fraud can use the full resources of the company to change the environment. Political contributions and supportive economic studies secure deregulation. Control frauds use the company’s resources to buy, bully, bamboozle, or bury the regulators. In my case, Keating used the S&L’s resources to sue me for $400 million and to hire private detectives to investigate me (Tuohey 1987).
The third reason control frauds are so destructive is that they provide a “legitimate” way for the CEO to convert company assets to personal assets. All fraudsters have to balance the potential gains from fraud with the risks.2 The most efficient fraud mechanism for the CEO is to steal cash from the company, e.g., by wiring it to his account at an offshore bank. No S&L control fraud, and none of the ongoing huge frauds, did so. Stealing from the till in large amounts from a large company guarantees detection and makes the prosecutor’s task simple. The strategy could appeal only to those willing to live in hiding or in exile in a country without an extradition treaty. Marc Rich (pardoned by President Clinton) notwithstanding, few fraudulent CEOs follow this strategy.
Accounting frauds are ideal for control fraud. They inflate income and hide losses of even deeply insolvent companies. This allows the control fraud to convert company funds to his personal use through seemingly normal, legitimate means. American CEOs, especially those who run highly profitable companies, make staggering amounts of money. They receive top salaries, bonuses, stock options, and luxurious perks. Control frauds almost always report fabulous profits, and top-tier audit firms bless those financial statements. The S&L control frauds used a fraud mechanism that produced record profits and virtually no loan defaults, and had the ability to quickly transform any (real) loss found by an examiner into a (fictitious) gain that would be blessed by a Big 8 audit firm. It doesn’t get any better than this in the world of fraud! Chapter 3 discusses this fraud mechanism.
Almost no one gives highly profitable firms a hard time: not (normal) regulators, not creditors or investors, and certainly not stock analysts. This is why our war on the control frauds was so audacious: at a time when hundreds of S&Ls were reporting that they were insolvent, we sought to close the S&Ls reporting that they were the most profitable and generally left the known insolvents open. Our political opponents thought us insane. There was only one way our war could be rational: there would have to be hundreds of control frauds; they would have to be massively overstating income and understating losses; and this had to be happening because the most prestigious accounting firms were giving clean opinions to fraudulent financials.
Control frauds are human; they enjoy the psychological rewards of running one of the most “profitable” firms. The press, local business elites, politicians, employees, and the charities that receive (typically large) contributions from the company invariably label the CEO a genius. In fact, they are pathetic businessmen. If they had been able to run a profitable, honest company in a tough business climate, they would have done so.
Control frauds who take money from the company through normal mechanisms (with the blessing of auditors) and receive the adulation of elite opinion makers are extremely difficult to prosecute. The control frauds we convicted became too greedy and began to take funds through “straw” borrowers.3 A prosecutor who detects the straw can win a conviction.
The CEO who owns a controlling interest in the company maximizes the seeming legitimacy of his actions. Ordinary individuals, academic economists, even otherwise suspicious reporters simply cannot conceive of a CEO ever finding it rational to defraud “his” own company. Similarly, law-and-economics scholars argue that it would be irrational for any top-tier audit firm to put its reputation on the line by blessing a control fraud’s financial statements (Prentice 2000, 136–137). It is easy to see why they reject control fraud theory: they think it requires them to believe that the CEO and auditor are acting irrationally. Rationality is the bedrock assumption of neoclassical economics, so these scholars must reject that paradigm in order to see control fraud as real. Control fraud theory does not require irrationality.
Individual control frauds should be a central regulatory concern because they cause massive losses. The worst aspect of control frauds is that they can cluster. The two variants of corporate control fraud, “opportunistic” and “reactive,” can occur in conjunction. Opportunists are looking for an opportunity to commit fraud. Reactive control frauds occur when a business is failing. A CEO who has been honest for decades may react to the fear of failure by engaging in fraud.
Economists distinguish between systemic risk that applies generally to an industry and risks that are unique to a particular company. Systemic risks can endanger a regional or even a national economy. Systemic risks pose a danger of creating many control frauds. In the S&L case, the systemic risk in 1979 was to interest rates. S&L assets were long-term (thirty-year), fixed-rate mortgages, but depositors could withdraw their money from the S&L at any time. If interest rates rose sharply, every S&L would be insolvent.
In 1979, the Federal Reserve became convinced that only it had the will to stop inflation. Chairman Paul Volcker doubled interest rates. By mid-1982, on a market-value basis, the S&L industry was insolvent by $150 billion. This maximized the incentive to engage in reactive control fraud and made it far cheaper for opportunists to purchase an S&L. These factors ensured that there would be an upsurge in control fraud, but the cover-up of the industry’s mass insolvency (and with it, that of the federal insurance fund), deregulation, and desupervision combined to create the perfect environment for a wave of control frauds. Criminologists call an environment that produces crime “criminogenic.”
Control frauds’ investments are concentrated and driven by fraud, not markets. This causes systemic regional, or even national, economic problems. One of the remarkable things about the S&L debacle is how alike the control frauds were. Almost all of them concentrated in large, speculative real estate investments, typically the construction of commercial office buildings. (In this context, “speculative” means that there are no tenant commitments to rent the space.) Because the control frauds grew at astonishing rates, this quickly produced a glut of commercial real estate in markets where the control frauds were dominant (Texas and Arizona were the leading examples). Moreover, being Ponzi schemes, they increased their speculative real estate loans even as vacancy rates reached record levels and real estate values collapsed. Waves of control frauds produce bubbles that must collapse. They delay the collapse by continuing to lend, thus hyperinflating the bubble. The bigger the bubble and the longer it continues, the worse the problems it causes. The control frauds were major contributors to, not victims of, the real estate recessions in Texas and Arizona in the 1980s.4
What we have, then, is a triple concentration. Systemic risk causes control frauds to occur at the same time. They concentrate in the particular industries that foster the best criminogenic environments. They also concentrate in investments best suited for accounting fraud. That triple concentration means that waves of control fraud will create, inflate, and extend bubbles.
Moral hazard is the temptation to seek gain by engaging in abusive, destructive behavior, either fraud or excessive risk taking. Failing firms expose their owners to moral hazard. This is not unique to S&Ls; it is in the nature of corporations. Moral hazard arises when gains and losses are asymmetrical. A company with $100 million in assets and $101 million in liabilities is insolvent. If it is liquidated (sells its assets), the stockholders will get nothing because they are paid only after all the creditors are paid in full. In my example, the assets are not sufficient to repay the creditors’ claims (liabilities), so liquidation would wipe out the shareholders’ interest in the company. The CEO runs the company until it is forced into liquidation. There are two other keys. Limited liability limits a shareholder’s loss to the value of his stock. He is not liable for the company’s debts, no matter how insolvent it becomes. The creditors lose if the insolvency deepens.
The “upside” potential of a failing company is enjoyed by the shareholders. They win big if investments succeed. Assume that my hypothetical insolvent company makes a movie that produces a $70 million profit. That gain will go almost entirely to the shareholders.
Risk and reward are asymmetric when a corporation is insolvent but left under the control of the shareholders. If the corporation makes an extremely risky investment and it fails, the loss is borne entirely by the creditors. If the investment is a spectacular success, the gain goes overwhelmingly to the shareholders. The shareholders have a perverse incentive to take unduly large risks rather than to make the most productive investments.
The examples of moral hazard I have used involve unduly risky behavior. The theory, however, is not limited to honest risk taking. Moral hazard theory also explains why failing firms have an incentive to engage in reactive control fraud (White 1991, 41). Indeed, since S&L control fraud was a sure thing (it was certain to produce, for a time, record profits), reactive control fraud was a better option than an ultra-high-risk gamble.
Bad regulation exposed the S&L industry to systemic interest-rate risk and caused the first phase of the debacle. Bank Board rules prohibited adjustable-rate mortgages (ARMs). ARMs would have reduced interest-rate risk.5 This prohibition caused a wave of reactive control fraud, though it is remarkable how small that wave was.
Opportunistic control fraud can also occur in waves. Opportunists seek out the best field for fraud. Four factors are critical: ease of obtaining control, weak regulation, ample accounting abuses, and the ability to grow rapidly.
These characteristics are often interrelated. An industry with weak rules against fraud is likely to invite abusive accounting. Industries with abusive accounting have superior opportunities for growth because they produce the kinds of (fictitious) profits and net worth that cause investors and creditors to provide ever-greater funds to the control fraud.
The interrelationship between the opportunities for reactive and opportunistic control fraud made the regulatory and business environments ideal for control fraud. Interest rate risk rendered every S&L insolvent (in market value) in 1979–1982, making it far cheaper and easier for opportunists to get control. Owners and regulators were desperate to sell S&Ls; opportunists were eager to buy. The Bank Board and accountants used absurd “goodwill” accounting to spur sales.
In another common dynamic, a financially troubled industry, particularly one with an implicit or explicit governmental guarantee (e.g., deposit insurance), is one most likely to abuse accounting practices and to restrain vigorous regulation. (Appendix B is a copy of a candid letter from Norman Strunk, the former head of the S&L trade association, to his successor, Bill O’Connell. It explains how the industry used its power over the administration and Congress to limit the Bank Board’s supervisory powers.) Regulators, fearful of being blamed for the industry failing on their watch, experience their own version of moral hazard. The temptation (shared with the industry) is to engage in a cover-up. The industry will lobby regulators, the administration, and Congress to aid the cover-up by endorsing accounting abuses and minimizing takeovers of insolvents.
Taken together, these factors mean that the incentives to engage in opportunistic and reactive control fraud will vary over time and by industry and that they can both peak at the same time and place (Tillman and Pontell 1995). This is not a random event, and it is not dependent on an industry having a heavy initial endowment of evil CEOs. Control fraud was a major contributor to the S&L debacle because the industry environment was the best in the country for both reactive and opportunistic fraud. The wonder is not that the control frauds caused so much damage, but that we stopped them before they hurt the overall economy. This is not a regulatory success story. The control frauds caused scores of billions of dollars of losses. However, a betting person in the mid-1980s would have judged the agency’s chances of removing every control fraud from power within five years as none, not slim. The Bank Board did put the control frauds out of business and, remarkably, did so despite Danny Wall—a serial appeaser of control frauds—becoming chairman in mid-1987.
The fact that characteristic business and regulatory environments cause waves of control fraud is critical for public policy. It means that we can predict the fields that are most at risk and choose policies that will reduce, instead of encourage, waves of control fraud. Similarly, we can identify likely control frauds by knowing their characteristic practices. We can attack them because we can aim at growth, their Achilles’ heel.
The reason the S&L control frauds died even when Bank Board chairman Wall reached a separate peace with them is that they were Ponzis. Former chairman Gray’s restrictions on growth were fatal to them. The irony is that although Wall desperately wished to avoid closing S&Ls like Lincoln Savings, he never understood that he was dealing with Ponzi schemes. As a result, he never understood the need to change the rule limiting growth. The control frauds that Gray lacked the funds to close collapsed during Wall’s term, to his horror and bafflement.
The cover-up of the S&L debacle was the dominant dynamic during the Reagan administration. If the industry was insolvent by $150 billion, then the Federal Savings and Loan Insurance Corporation (FSLIC) fund (with $6 billion in the till) was insolvent by nearly $150 billion. The U.S. Treasury stands behind the federal insurance funds, so the FSLIC fund’s insolvency meant that the U.S. Treasury should show a contingent liability of $150 billion. That translates as follows: the federal budget deficit was $150 billion worse than reported because the S&L industry’s insolvency was not on the books.
No one wanted to recognize that contingent liability. The Reagan administration didn’t want to because it was trying to get the 1981 tax cuts passed and was already facing criticism that it would not meet its campaign promise to balance the budget. The industry didn’t want to admit that it was insolvent. The agency’s nightmare, which I shared once I joined it on April 2, 1984, was a nationwide run sparked by depositors who might “do the math” and realize that $150 billion was considerably greater than the $6 billion in FSLIC.
Congress wanted a cover-up. Americans loved the S&L industry because S&Ls made loans to people, not corporations, and made possible the American dream (owning a home). The industry was superb at burnishing its reputation. (It also helped that the public thought of Jimmy Stewart and It’s a Wonderful Life when they thought of S&Ls.) Politicians loved S&Ls because Americans did, because S&Ls were large contributors, and because they had the best grassroots lobbyists. Their trade association, the United States League of Savings Institutions (the League), was a force of nature, as were its allies the National Association of Homebuilders (NAHB) and the National Association of Realtors (NAR). (Their PACs traveled in packs.)
Moreover, cuts in government programs would deepen if the budget deficit were $150 billion worse. Members of Congress did not want to cut popular programs.
One testament to the times is that the Federal Deposit Insurance Corporation (FDIC) also engaged in a cover-up of the savings banks it regulated. The FDIC, which was much more staid than the Bank Board, used phony accounting to hide the insolvency of savings banks. Their industry was much smaller than the S&L industry, and the FDIC considered regulating savings banks a distraction from its “real” job of regulating commercial banks, so savings banks had little influence with the FDIC. The FDIC fund was far larger than the FSLIC fund, and the FDIC had no fear of a systemic run on savings banks even should the public learn of their insolvency. Despite all these differences, the FDIC adopted phony accounting for savings banks to hide their insolvency and stopped closing them, showing how strong the pressures were for cover-ups in the 1980s.
No one intentionally designed the cover-up to optimize the industry for control fraud. Indeed, if someone had set out to optimize the problem, I am sure he would have failed. The interaction of a series of steps made the industry ideal for control fraud.
There are five central facts that explain why the Bank Board’s implementation of the cover-up proved so harmful. First, it came from the top, and it came via consensus. Chairman Pratt endorsed and designed the cover-up. He did so with the aid of other leaders. The infamous Joint Task Force on Profitability combined the talents of senior Bank Board economists and regulators and the most prominent outside accountant specializing in the S&L industry. The task force endorsed accounting abuses, but it was the manner in which it did so that makes such depressing reading. It didn’t hold its nose and say we need to do this as an unpleasant emergency measure. Instead, it endorsed absurd accounting abuses like “loan loss deferral” (which meant not recognizing losses currently) as purportedly superior accounting treatments under economic and accounting theory.6 The task force also encouraged fast growth and interest-rate risk in a get-rich-quick scheme called “risk-controlled arbitrage” (RCA).7
Second, the design and implementation of the cover-up guaranteed a disaster. Moral hazard theory unambiguously predicts that if you greatly weaken restraints on abuse at a time of mass, intense moral hazard, you will suffer severe abuses. Had you asked Richard Pratt, when he was still a graduate student, to write a paper on the effect of removing restraints at a time of mass insolvency, I am confident that you would have received a sound analysis predicting disaster. Moreover, you didn’t need a PhD in economics to figure any of this out. Common sense would have worked just fine. Daniel Fischel (1995, 211) says that the second stage of the debacle was “completely predictable.” A cover-up works by grossly inflating net worth and net income, but to close an S&L the regulator often needs to show insolvency. This can make it very hard to close control frauds prior to their failing catastrophically (e.g., losses exceeding 30 percent of liabilities).
Third, no economist contemporaneously predicted that the administration’s policies would produce a disaster.8 Worse, they predicted the opposite, that Pratt’s policies were the industry’s best hope. As future Bank Board member and financial economist Larry White would famously write (1991, 90), there were “no Cassandras” among economists.
Fourth, although no economist spotted the problems, roughly two hundred opportunistic control frauds promptly spotted the opportunities and rushed to enter the industry. Larry White (1991, 92) makes this point at the close of his discussion of the lack of Cassandras:
The enhanced opportunities-capabilities-incentives nexus was simply not seen—except by entrepreneurs who would take advantage of it. (emphasis in original)
Fifth, the Bank Board lost vital moral capital when it abused accounting practices to cover up the industry’s and the FSLIC’s insolvency. A regulator succeeds largely on the basis of moral suasion. When a regulator embraces fraudulent accounting, it loses legitimacy and will have great difficulty convincing, for example, courts that an S&L CEO should go to jail for using (different) fraudulent accounting methods to inflate net worth and income.
No prior book has noted the centrality of the cover-up to the debacle, the control frauds, and the administration’s war on Gray. Gray’s war on the control frauds threatened the administration. First, closure of the frauds would reveal the industry’s insolvency just when the Administration was pronouncing it cured. Reregulation was the second threat. Regulation was vital for defeating the frauds, but it was ideologically anathema and considered political suicide. The administration designed, implemented, and praised the deregulation that attracted the control frauds and made them superpredators. Reregulation would have been an admission of guilt.9
White does not discuss why only the entrepreneurs saw this nexus and responded immediately by entering the S&L industry. (As will become clear, I disagree with White’s view that the entrants were primarily honest entrepreneurs.) Surely this is an important question. One group, with extensive professional training, the aid of a theory that unambiguously predicts that the policy they designed will be disastrous, and a disciplinary emphasis on how individuals respond to incentives, got it entirely wrong. They designed the blunder, they opined that it was the solution, and they did not even warn of the inevitable problems it would produce. Fischel (1995) is right that the second stage of the debacle was “completely predictable” under standard economic theory, but like every other economist he failed to predict it, and does not discuss why he failed. Indeed, Fischel’s villain is Gray, the “press flack” who did predict it (ibid.).
Economists refused to admit that the administration had created a disaster, and they stalled our efforts to end both individual control frauds and the wave of fraud. They are still in denial about the role of deregulation and fraud in the debacle.
Why is it that economists performed so badly and became, with the accountants and lawyers, leading allies of the control frauds? Why did the Reagan administration listen only to their perspective? I believe that the answer has four parts. Economists know almost nothing about fraud. The dominant law-and-economics theory is that there is no serious control fraud, so it is not worth studying. There is no coherent theory of fraud, though there is finally some interest in developing one.
Second, prominent U.S. economists generally believe that regulation is the problem and deregulation is the solution. The deregulators’ ideology was the initial problem, but the fact that their policies led to disaster also brought on acute embarrassment. They had the normal human wish to avoid taking responsibility for their mistakes. Their embarrassment was particularly acute because they consider themselves the only true social scientists and believe that theory and facts, not ideology, drive their views. As I explained, their theory did not fail them. It predicted that the policies they recommended would cause a disaster. All of this strengthens the desire to avoid admitting error.
Third, economists (and the administration) were like generals preparing to fight the last war. In the S&L context, this meant concentrating on interest-rate risk. Thus, traditional S&Ls were the problem and high fliers the solution. The high fliers, unfortunately, were frauds.
Fourth, economists missed the problem because of social class and self-interest. Few economists are prepared to see business people, particularly patrons, as criminals. Many of the top financial economists worked for the control frauds, and the collapse created such embarrassment that they felt compelled to deny that their employers were frauds. (The most famous economic study of fraud was conducted by Bert Ely, a financial consultant who, as an expert witness, assisted in the defense of S&L managers and outside auditors. In fact, the study did not cover fraud [Black, Calavita, and Pontell 1995].) This self-interest was not unique to economists; it applied fully to accountants and lawyers. Economists are particularly vulnerable to this fault, however, when the CEO is the dominant shareholder. The leading law-and-economics text asserts that this is the ideal structure because it ensures managers’ fidelity to shareholders’ interests (Easterbrook and Fischel 1991, 106, 120). This is one of the areas where the field’s lack of knowledge of fraud has embarrassed it, for William Crawford had it exactly right: the best way to rob a bank is to own it. The person with the greatest incentives to engage in fraud is the CEO owner of a failing firm.
Fifth, economists developed a conventional wisdom about the debacle and have not reexamined it. The conventional wisdom is that moral hazard explains the debacle, that control fraud was trivial, and that insolvent S&Ls honestly made ultrarisky investments (and became high fliers) that often failed. All aspects of the conventional wisdom proved false upon examination. Traditional S&Ls gambled for resurrection by continuing to expose themselves to interest-rate risk in 1982–1984. They won these gambles and greatly reduced the cost of the debacle (NCFIRRE 1993a, 1–2). Next, the high fliers were not honest gamblers, but control frauds. Studies of failed high fliers invariably found control frauds (ibid., 3–4). There were over 1,000 felony convictions of S&L insiders. The pattern of failures shows that the high fliers were control frauds. They invariably reported high initial profits, and they all failed. Honest gambling cannot explain any aspect of the pattern (Black, Calavita, and Pontell 1995). Finally, the high fliers invested in a manner (particularly by embracing adverse selection and consistently underwriting incompetently) that would have been irrational for honest gamblers (ibid.).
The great controversies during the S&L debacle almost universally involved control frauds. There was no real controversy about how to deal with the 1979–1982 crisis in interest-rate risk. There was uniform belief that the twin answers were a cover-up and deregulation. It did not occur to anyone involved in making policy that combining the mass insolvency of an industry, deposit insurance, extraordinarily inadequate examination and supervision, a cover-up based on accounting abuses, and deregulation would create an ideal environment for control fraud. The idea of asking a white-collar criminologist whether the policy could spur crime never arose. We consider it normal that nearly every federal agency (and many of their subunits) has a chief economist and that no agency has a chief criminologist; indeed, the federal government has no job category for criminologist. As a result, we never ask vital regulatory questions.
The control frauds did not create this optimal environment for fraud. They exploited the criminogenic environment and led the campaign to maintain and even improve it.
The control frauds, of course, did not announce that they were entering the industry to loot it, and since the essence of control fraud is the vast inflating of income, they appeared to be the most profitable S&Ls in America. As a result, Pratt never identified and put out of business a control fraud and never identified the wave of control frauds entering the industry. He praised them as entrepreneurs. Pratt disdained traditional S&L CEOs and considered them the problem. The control frauds had dug in for two years before Gray began to fight back.
Gray had a huge problem that no book about the debacle has noted. The Bank Board staff often worked sixty-hour weeks with no overtime and at low rates of pay. In particular, the FSLIC staff did this for Pratt, a charismatic leader. They approved 500 goodwill mergers in two years. Pratt praised them for their efforts, which he said had saved the FSLIC fund from disaster. Senior supervisors praised the CEOs who bought failed S&Ls in the mergers, and lauded the high profits the entrepreneurs reported. No matter how we sugarcoated the message, the FSLIC staff knew what Gray’s war meant. The incredible hours they had worked for years were worse than useless: they had made things worse. The goodwill mergers did not resolve failed S&Ls; they created fictitious income and hid real losses. The accounting was fraudulent, the goodwill was worthless, and the new managers weren’t geniuses. Indeed, they were often criminals.
This was an inherently unattractive message for the staff to receive. But the comparison between Pratt and Gray was worse. Pratt was dynamic, quick, funny (he is brilliant at self-deprecation), ultracompetent, organized, efficient, and self-assured, and he looks like the former football player he is. Gray was not quick and not funny. He was disorganized and unfocused, and he radiated nervousness and indecision. Instead of self-deprecating humor, he compared himself to Winston Churchill. Pratt was an expert in the field, and Gray was a press flack who had worked for an S&L.
You can see why the Bank Board staff often did not adopt Gray’s view that their labors had been harmful, particularly since he was contradicting everything Pratt had told them; in addition, the administration and the industry were shouting that Gray was wrong and Pratt was right. The staff knew that Pratt had tried to keep the administration from making Gray his successor. This could explain why Gray was trashing Pratt’s policies. This dynamic got worse as Gray promoted those who shared his views about the control frauds. Each promotion can upset a dozen other staff members. The Bank Board leaked, and the leaks were aimed at Gray.
Gray had poor relationships with Don Hovde and Mary Grigsby, his colleagues on the Bank Board. Neither of them really supported reregulation. They felt oppressed by Gray’s constant pressure to intensify the war against the control frauds. Hovde wanted to succeed Gray as chairman, and he became a source for Keating and reporters. He later tried to help Keating’s “straw” make a phony purchase of Lincoln Savings.
Whereas the control frauds knew our strategy, we knew little about theirs. We could learn about them through whistle-blowers or effective examination. There were virtually no whistle-blowers at the control frauds. I cannot remember any. Control frauds are control freaks: they hire yes-men and yes-women and get rid of people who ask tough questions. Bank examiners are valuable as investigators, but even their bosses usually miss their other critical role as scouts. An effective force making frequent exams gives its leaders not only the facts about a particular field of battle, but information on overall intentions and common tactics that is critical to intelligence analysts.10 When you don’t have effective scouts, you walk into ambushes—and that produces massacres. The Bank Board did not have remotely enough scouts.11 One of the reasons Gray was invaluable was that he spotted the control fraud pattern on the basis of skimpy initial information.
Hindsight is not always 20:20. If it were, we would always learn the lessons of the past and not be condemned to repeat them. The ongoing financial crisis shows how poorly we learned the lessons that the S&L debacle should have taught. First, control frauds will cause the worst losses. The markets will not detect them timely. Outside professionals will aid, not restrain, control frauds. Directors provide camouflage for frauds. Stock options further misalign the interests of shareholders and control frauds because CEOs structure them to maximize their self-interest and use them as a means of converting firm assets to personal use.
Ed Kane developed a famous analogy to sum up his view of the S&L debacle. He said that the Bank Board’s distorted accounting left the agency like the driver of a car with a muddy windshield (Kane 1989, 167–169). Control frauds, however, create something far worse than a muddy windshield. Mud is noticeable, an irritant. The driver knows the view is obstructed and has a strong incentive to get out and clean the windshield.
Control frauds use accounting fraud to deliberately make everything appear brilliantly transparent. They are like the side mirrors that seem to reflect so normally that the government requires a permanent warning to be affixed to them: “Objects in this mirror are closer than they appear.”12 Massive insolvency is far closer than it appears for control frauds.
I will examine how the control frauds were able to manipulate politicians and regulators and even to spark a civil war among the regulators. Key administration officials, senior staff members, and presidential appointees at the Bank Board aided the control frauds. Only one of these individuals was corrupt, but Humbert Wolfe’s poem captures the ambiguous import of this fact:
You cannot hope
to bribe or twist,
thank God! the
British journalist.
But, seeing what
the man will do
unbribed, there’s
no occasion to.13