27 April 2010

Control Frauds HyperInflate and Extend Bubbles Maximizing Damage - A Control Fraud at Work in the Silver Market Short Positions?

Here is a working paper by William K. Black about 'control frauds' and how they relate to the most recent credit crisis in the United States, a breakdown of stewardship that has placed the rest of the world's financial sector at risk as well.

Control frauds are by their very nature conspiratorial in that they involve the suborning of regulators, ratings agencies, exchanges, the media, and legislators to ignore and facilitate misrepresentation that enable white collar crime. They are difficult to prosecute because by their nature they involve twisting the legal into the extra-legal on a broad basis to achieve a particular financial effect, while limiting many specific aspects to the letter of the law, or at least the gray areas.

By and large they operate in the shadows, hiding behind secrecy and a general mindset towards short term greed and lapses in ethics. Investigations following the Crash of 1929 and the S&L crisis demonstrated that the existence of such pervasive lapses in stewardship do exist.

Personally I think the significant short positions in the silver market may be a form of control fraud. This is why so much effort and care is being taken by some individuals and groups to discover the extent and nature and holders of the short positions that are dominant. And this is why the participants are so vociferous and secretive regarding their activities.

To those who say that the commodity markets are too large, and too well regulated for this sort of thing to occur, this is the sort of fraud that Enron used to manipulate the energy markets, to the extent that they were able to cause significant social and commercial disruption to the state of California.

More on this another time. For now understanding how these frauds work is enough to study in instruments such as home mortgages. And most people do not need to understand this. But here is a good point for the average person to keep in mind.

Light is a good disinfectant. Fraud cannot bear exposure. While some confidentiality must be maintained in trading, obsessive secrecy regarding significantly large positions and collateral matters is often an indication that something is not right, that it is hidden from the market participants view for a particular reason that is deleterious to market pricing and efficiency.

The only way to settle this is by more transparency and disclosure. Rhetoric and supposition is often mere noise meant to distract from and promote the fraud if in fact it does exists. And if it does not, disclosure will reveal this as well.

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


“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.

Download the complete working paper here.