Video Transcript: How to Rob a Bank from the Inside

So today's top chef class is in how to rob a bank, and it's clear that the general  public needs guidance, because the average bank robbery nets only $7,500.  Rank amateurs who know nothing about how to cook the books. The folks who  know, of course, run our largest banks, and in the last go-around,  they cost us over 11 trillion dollars. That's what 11 trillion looks like. That's how  many zeros? And cost us over 10 million jobs as well. So our task is to educate  ourselves so that we can understand why we have these recurrent, intensifying  financial crises, and how we can prevent them in the future. And the answer to  that is that we have to stop epidemics of control fraud. Control fraud is what  happens when the people who control, typically a CEO, a seemingly legitimate  entity, use it as a weapon to defraud. And these are the weapons of mass  destruction in the financial world. They also follow in finance a particular  strategy, because the weapon of choice in finance is accounting, and there is a  recipe for accounting control fraud, and how it occurs. And we discovered this  recipe in quite an odd way that I'll come back to in a moment. First ingredient in  the recipe: grow like crazy; second, by making or buying really crappy loans,  but loans that are made at a very high interest rate or yield; three, while  employing extreme leverage -- that just means a lot of debt -- compared to your  equity; and four, while providing only trivial loss reserves against the inevitable  losses. If you follow those four simple steps, and any bank can follow them, then you are mathematically guaranteed to have three things occur. The first thing is  you will report record bank profits -- not just high, record. Two, the CEO will  immediately be made incredibly wealthy by modern executive compensation.  And three, farther down the road, the bank will suffer catastrophic losses and will fail unless it is bailed out. And that's a hint as to how we discovered this recipe,  because we discovered it through an autopsy process. During the savings and  loan debacle in 1984, we looked at every single failure, and we looked for  common characteristics, and we discovered this recipe was common to each of  these frauds. In other words, a coroner could find these things because this is a  fatal recipe that will destroy the banks as well as the economy. And it also turns  out to be precisely what could have stopped this crisis, the one that cost us $11  trillion just in the household sector, that cost us 10 million jobs, was the easiest  financial crisis by far to have avoided completely if we had simply learned the  lessons of epidemics of control fraud, particularly using this recipe. So let's go to this crisis, and the two huge epidemics of loan origination fraud that drove the  crisis -- appraisal fraud and liar's loans -- and what we're going to see in looking  at both of these is we got warnings that were incredibly early about these frauds. We got warnings that we could have taken advantage of easily, because back in the savings and loan debacle, we had figured out how to respond and prevent  these crises. And three, the warnings were unambiguous. They were obvious  that what was going on was an epidemic of accounting control fraud building up. Let's take appraisal fraud first. This is simply where you inflate the value of the 

home that is being pledged as security for the loan. In 2000, the year 2000, that  is over a year before Enron fails, by the way, the honest appraisers got together  a formal petition begging the federal government to act, and the industry to act,  to stop this epidemic of appraisal fraud. And the appraisers explained how it was occurring, that banks were demanding that appraisers inflate the appraisal, and  

that if the appraisers refused to do so, they, the banks, would blacklist honest  appraisers and refuse to use them. Now, we've seen this before in the savings  and loan debacle, and we know that this kind of fraud can only originate from  the lenders, and that no honest lender would ever inflate the appraisal, because  it's the great protection against loss. So this was an incredibly early warning,  2000. It was something we'd seen before, and it was completely unambiguous.  This was an epidemic of accounting control fraud led by the banks. What about  liar's loans? Well, that warning actually comes earlier. The savings and loan  debacle is basically the early 1980s through 1993, and in the midst of fighting  that wave of accounting control fraud, in 1990, we found that a second front of  fraud was being started. And like all good financial frauds in America, it began in Orange County, California. And we happened to be the regional regulators for it.  And our examiners said, they are making loans without even checking what the  borrower's income is. This is insane, it has to lead to massive losses, and it only  makes sense for entities engaged in these accounting control frauds. And we  said, yeah, you're absolutely right, and we drove those liar's loans out of the  industry in 1990 and 1991, but we could only deal with the industry we had  jurisdiction over, which was savings and loans, and so the biggest and the  baddest of the frauds, Long Beach Savings, voluntarily gave up its federal  savings and loan charter, gave up federal deposit insurance, converted to  become a mortgage bank for the sole purpose of escaping our jurisdiction, and  changed its name to Ameriquest, and became the most notorious of the liar's  loans frauds early on, and to add to that, they deliberately predated upon  minorities. So we knew again about this crisis. We'd seen it before. We'd  stopped it before. We had incredibly early warnings of it, and it was absolutely  unambiguous that no honest lender would make loans in this fashion. So let's  take a look at the reaction of the industry and the regulators and the prosecutors to these clear early warnings that could have prevented the crisis. Start with the  industry. The industry responded between 2003 and 2006 by increasing liar's  loans by over 500%. These were the loans that hyperinflated the bubble  and produced the economic crisis. By 2006, half of all the loans called subprime  were also liar's loans. They're not mutually exclusive, it's just that together,  they're the most toxic combination you can possibly imagine. By 2006, 40% of  all the loans made that year, all the home loans made that year, were liar's  loans, 40%. And this is despite a warning from the industry's own antifraud  experts that said that these loans were an open invitation to fraudsters, and that  they had a fraud incidence of 90%, nine zero. In response to that, the industry 

first started calling these loans liar's loans, which lacks a certain subtlety, and  second, massively increased them, and no government regulator ever required  or encouraged any lender to make a liar's loan or anyone to purchase a liar's  loan, and that explicitly includes Fannie and Freddie. This came from the  lenders because of the fraud recipe. What happened to appraisal fraud? It  expanded remarkably as well. By 2007, when a survey of appraisers was done,  90% of appraisers reported that they had been subject to coercion  from the lenders trying to get them to inflate an appraisal. In other words, both  forms of fraud became absolutely endemic and normal, and this is what drove  the bubble. What happened in the governmental sector? Well, the government,  as I told you, when we were the savings and loan regulators, we could only deal  with our industry, and if people gave up their federal deposit insurance, we  couldn't do anything to them. Congress, it may strike you as impossible, but  actually did something intelligent in 1994, and passed the Home Ownership and  Equity Protection Act that gave the Fed, and only the Federal Reserve, the  explicit, statutory authority to ban liar's loans by every lender, whether or not  they had federal deposit insurance. So what did Ben Bernanke and Alan  Greenspan, as chairs of the Fed, do when they got these warnings that these  were massively fraudulent loans and that they were being sold to the secondary  market? Remember, there's no fraud exorcist. Once it starts out a fraudulent  loan, it can only be sold to the secondary market through more frauds, lying  about the reps and warrantees, and then those people are going to produce  mortgage-backed securities and exotic derivatives which are also going to be  supposedly backed by those fraudulent loans. So the fraud is going to progress  through the entire system, hyperinflate the bubble, produce a disaster. And  remember, we had experience with this. We had seen significant losses, and we had experience of competent regulators in stopping it. Greenspan and Bernanke refused to use the authority under the statute to stop liar's loans. And this was a  matter first of dogma. They're just horrifically opposed to anything regulatory.  But it is also the international competition in laxity, the race to the bottom  between the United States and the United Kingdom, the city of London, in  particular, and the city of London won that race to the bottom, but it meant that  all regulation in the West was completely degraded in this stupid competition to  be who could have the weakest regulation. So that was the regulatory response. What about the response of the prosecutors after the crisis, after $11 trillion in  losses, after 10 million jobs lost, a crisis in which the losses and the frauds were  more than 70 times larger than the savings and loan debacle? Well, in the  savings and loan debacle, our agency that regulated savings and loans, OTS,  made over 30,000 criminal referrals, produced over 1,000 felony convictions  just in cases designated as major, and that understates the degree of  prioritization, because we worked with the FBI to create the list of the top 100  fraud schemes, the absolute worst of the worst, nationwide. Roughly 300 

savings and loans involved, roughly 600 senior officials. Virtually all of them  were prosecuted. We had a 90% conviction rate. It's the greatest success  against elite white collar criminals ever, and it was because of this  understanding of control fraud and the accounting control fraud mechanism.  Flash forward to the current crisis. The same agency, Office of Thrift  Supervision, which was supposed to regulate many of the largest makers of  liar's loans in the country, has made, even today -- it no longer exists, but as of a year ago, it had made zero criminal referrals. The Office of the Comptroller of  the Currency, which is supposed to regulate the largest national banks, has  made zero criminal referrals. The Fed appears to have made zero criminal  referrals. The Federal Deposit Insurance Corporation is smart enough to refuse  to answer the question. Without any guidance from the regulators, there's no  expertise in the FBI to investigate complex frauds. It isn't simply that they've had to reinvent the wheel of how to do these prosecutions; they've forgotten that the  wheel exists, and therefore, we have zero prosecutions, and of course, zero  convictions, of any of the elite bank frauds, the Wall Street types, that drove this  crisis. With no expertise coming from the regulators, the FBI formed what it calls a partnership with the Mortgage Bankers Association in 2007. The Mortgage  Bankers Association is the trade association of the perps. And the Mortgage  Bankers Association set out, it had the audacity and the success to con the FBI.  It had created a supposed definition of mortgage fraud, in which, guess what, its members are always the victim and never the perpetrators. And the FBI has  bought this hook, line, sinker, rod, reel and the boat they rode out in. And so the  FBI, under the leadership of an attorney general who is African-American and a  president of the United States who is African-American, have adopted the Tea  Party definition of the crisis, in which it is the first virgin crisis in history,  conceived without sin in the executive ranks. And it's those oh-so-clever  hairdressers who were able to defraud the poor, pitiful banks, who lack any  financial sophistication. It is the silliest story you can conceive of, and so they go and they prosecute the hairdressers, and they leave the banksters alone  entirely. And so, while lions are roaming the campsite, the FBI is chasing mice.  What do we need to do? What can we do in all of this? We need to change the  perverse incentive structures that produce these recurrent epidemics of  accounting control fraud that are driving our crises. So we have to first get rid  of the systemically dangerous institutions. These are the so-called too-big-to-fail  institutions. We need to shrink them to the point, within the next five years, that  they no longer pose a systemic risk. Right now, they are ticking time bombs  that will cause a global crisis as soon as the next one fails -- not if, when.  Second thing we need to do is completely reform modern executive and  professional compensation, which is what they use to suborn the appraisers.  Remember, they were pressuring the appraisers through the compensation  system, trying to produce what we call a Gresham's dynamic, in which bad 

ethics drives good ethics out of the marketplace. And they largely succeeded,  which is how the fraud became endemic. And the third thing that we need to do  is deal with what we call the three D's: deregulation, desupervision, and the de  facto decriminalization. Because we can make all three of these changes, and if  we do so, we can dramatically reduce how often we have a crisis and how  severe those crises are. That is not simply critical to our economy. You can see  what these crises do to inequality and what they do to our democracy. They  have produced crony capitalism, American-style, in which the largest financial  institutions are the leading financial donors of both parties, and that's the reason why even after this crisis, 70 times larger than the savings and loan crisis, we  have no meaningful reforms in any of the three areas that I've talked about,  other than banning liar's loans, which is good, but that's just one form of  ammunition for this fraud weapon. There are many forms of ammunition they  can use. That's why we need to learn what the bankers have learned: the recipe for the best way to rob a bank, so that we can stop that recipe, because our  legislators, who are dependent on political contributions, will not do it on their  own. Thank you very much.