Trash for Cash

Bill Black is well positioned to appreciate the criminality of Enron and the wave of financial fraud now soaking American business. As litigation director for the Federal Home Loan Bank Board, Black took the lead in flushing out the crooks who commandeered the Savings & Loan industry in the early 1980s. All told, taxpayers paid about $150 billion to clean up the S&L scandal. Black blames $125 billion of the total on massive fraud, mostly perpetrated by real estate developers who used S&Ls as personal piggy banks, and then manipulated accounting to hide their losses.

Black not only exposed corrupt S&Ls, but helped push through legislation to prevent future fraud. In doing so, he personally tangled with some of the most powerful men in America. His pursuit of Texas high flyers like Don Dixon, who ran Vernon Savings & Loan, pitted him against then-U.S. House Speaker Jim Wright. Vernon, which regulators nicknamed “Vermin,” had a 96 percent default rate. Despite Wright’s forceful resistance, Black and the Bank Board filed a civil racketeering suit against Dixon in April 1987 for looting $540 million from Vernon. A federal court in Dallas convicted Dixon on 23 counts of bank fraud, sentenced him to five years in prison and ordered him to repay $600,000.

In Texas between 1982 and 1986 paper assets for S&Ls grew by 299 percent, as compared to 55 percent nationwide. Black repeatedly went to the media to publicly call attention both to the fraud and the political machinations protecting it. A special counsel to the House Ethics Committee investigated and found that Wright had violated House rules four times in relation to the S&Ls, including efforts to fire Bill Black. In the end, the House Ethics Committee sanctioned Wright for other minor matters and he resigned from Congress on May 31, 1989.

S&L kingpin Charles Keating proved Black’s strongest foe. Keating controlled Lincoln Savings & Loan through his company, the American Continental Corporation. His political patronage bought him an appointee, Lee Henkle, to the three-person Bank Board, and almost paid for another pick. Black exposed Henkle’s machinations on behalf of Keating, and forced his resignation. In an effort to stop Black, Keating sued the regulator for $400 million. He also mustered five U.S. senators to meet with Black and his boss to pressure the Bank Board. Black took impeccable notes at the fateful meeting that forever branded the senators as “the Keating Five,” and earned them a slap on the wrist from their Senate colleagues. By then the collapse of Lincoln had cost taxpayers over $2.5 billion and Keating was on his way to jail.

The Texas corporate marauders Black pursued created deals like “trash for cash,” in which an S&L overlends, and in exchange for the extra money, the borrower buys an inflated property carried by the S&L. That way, the S&L posts a gain and cleans the books. Another variant on this theme, Black explains, was called “you trade me your dead horse for my dead cow,” in which two S&Ls swap overpriced bad loans and then both register “new” profits.

After leaving the government in 1994, Black added a Ph.D in criminology to a resume that already featured a stint as a corporate lawyer and training in economics. The still-idealistic Black has developed a theory he calls “control fraud,” to explain how a CEO bent on fraud, in the right conditions, can do massive damage. Like a pyramid scheme, these accounting scams and others worked as long as the S&L traded in assets that had an uncertain market value, in this case, future construction projects. It also needed to show constant growth to hide the vanishing money. As Black relates, all of the S&Ls that purported to be the most profitable proved to be catastrophic failures in the end.

He sees multiple parallels between the S&L debacle and Enron, which according to recent reports seems to have overstated its assets by $24 billion. The Houston-based energy trader was not the only major fraudster operating in the American economy. As K-Mart struggles to survive exposure of its accounting trickery and major institutions like JPMorgan Chase teeter under the weight of dubious lending and derivative profits, Black’s critique grows ever more illuminating. The Observer recently caught up with Black at the LBJ School of Public Affairs at The University of Texas where he is a professor.

Texas Observer: What are the ideal conditions for control fraud?

Bill Black: You want to look for situations where one individual has total control over a weak firm. You want to look for any industry with mass insolvency–that’s an environment where control frauds are likely to move. Next look at whether [the business] can be acquired cheaply. Then, is there a way to grow rapidly? So what you are going to look for are areas that create phony accounting. And that is where this would really come into Enron.

What Enron and the various high-tech folks have done is they have found things that have no clear market value, but that can create phony accounting income and hide real losses. So this is all those high-tech swaps that you have been reading about–not just in Enron–where people do stuff like exchange bandwidths and then they book gains. That’s completely phony income. And it is very difficult to know when the market becomes dominated by this phoniness, what the real market value of that bandwidth is. In fact it is presumably a tiny portion of what they are declaring.

TO: What are some of the parallels with Enron and the S&Ls?

BB: One of the things that [Kenneth] Lay did was go to his chief regulator, the chairman of the Federal Energy Regulatory Commission (FERC) that regulates pipe lines, and said, “if you want to be reappointed, I could be helpful to you. If you modify your position.” The second thing that Lay did was give a list of proposed regulators to Bush. The people currently serving are from that list.

Arthur Andersen is a direct parallel. In fact Arthur Andersen, in the case of Lincoln [Savings and Loan] did worse things than it did in Enron. What AA is getting in tremendous trouble for [now] is a cover-up after the fact, not from shareholders, but from trying to escape liability itself.

In the Lincoln case, Keating’s entire purchase of the S&L was funded by Michael Milken of Drexel Burnham. And Michael did what he commonly did, which was to overfund dramatically. Keating needed $51 million to buy Lincoln Savings. Instead Milken issued well over $100 million in Keating’s parent company bonds. Now this is a really, really heavily leveraged company. Which is to say that Milken had Keating by the short hairs.

So Lincoln is soon buying more than a billion dollars in junk bonds, overwhelmingly from Milken. But now they have a problem, because a junk bond, as Milken used to be fond of emphasizing, is really a corporate loan. So we have these little things called rules which say that if you are going to make a loan to somebody, you have to underwrite it first. You have to make sure you are going to get paid back. But Keating has zero control or input on this billion-dollar junk bond portfolio. He finds out at the end of the day in a telex what he now owns. Milken just does all the trades. You can see how useful this is to Milken in manipulating junk bond prices, creating his record low default rates that he always bragged about. So they have done no underwriting, and they know that our examiners, the first thing we look at is underwriting. So they go, “oh shit, we have a problem.”

Again like Enron, they hire Arthur Andersen in their consulting role, then simultaneously as their auditor. They have a team of folks in a big conference room who spend weeks creating phony documents. It’s more clever than backdating. Undated. This is in some cases two years after they bought the junk bonds. When they do the undated stuff, they make sure that they only have information in there up to the date the investment was actually made. So the intent is obviously to make it look like they were contemporaneous underwriting documents, but without ever dating them, and creating an express falsehood. They did that to at least hundreds of files.

Then you have the special partnerships. Keating used the special partnerships as a way to get money to his family from the S&L. Keating even had an [Andrew] Fastow like character.

TO: How hard is it to ferret out these frauds?

BB: One of the things that you have to remember is that there are not that many people looking for these things. We were in a regulatory agency that was actually supposed to look at an industry. And eventually we discovered many of these things, albeit far too late. But FERC doesn’t see it as its mission to be going around looking for these kinds of frauds in the energy industry. It doesn’t have much jurisdiction. So you are really talking about the SEC, which is completely overwhelmed.

The amount of resources you need to take on a sophisticated fraud is much bigger than most believe. You are talking about hundreds of FBI agents to even begin to look at a place with two to three thousand partnerships. And most FBI agents can’t do financial cases. It goes back to control fraud. You control the structure. So you make the structure whatever optimizes for control fraud. And one of the things that does it best is complexity.

TO: Why else is it so important to be in control?

BB: The difference in being at the top of the food chain as opposed to the bottom is enormous. Part of it is how much damage they do. Keating caused three billion dollars in losses. You can take all the burglars, probably in America, and not come up to three billion dollars in losses.

Part of it is how they do it. If I am the CEO, all the internal controls are designed by me. All of them report to me. I choose the external controls such as the auditor. I can fire the outside auditor. People are not willing to look at me as a thief.

These frauds create record profit and an enormous turnaround. What are the normal things you do for a CEO at that point? You give them a raise. You give them a bonus. You give them stock dividends, and the stock appreciates like all crazy because of what’s happening to the income statement and the balance sheet. These guys get private air forces. The perks can run into the tens of millions.

TO: The bonuses and stock performance allow for a certain deniability?

BB: It’s perfect, if you are able to have the discipline to just take your money in those mechanisms. Those are all normal corporate systems. None of them are suspicious. And you can now use the professional in another way. You can say, “I am not the expert in the value of real estate. That is why we have appraisers. Here is the wonderfully talented person who said it was worth this. Here are the loan officers who looked at the appraisal. They have X years of experience, they said it was okay. Here is God’s Auditing Representative on Earth, he said it was kosher. Here are sixteen law firms that signed off on my financials after discussions with these folks. They all said it was good.” There is no way to prosecute somebody if they limit it to that. The only way we could get them was if they got too greedy.

TO: How do you get the “professionals”–accountants, appraisers, lawyers–to play along?

BB: The outside professional vouches for the value. Do you pick a crummy accountant or a really good accountant if you are engaged in control fraud? No.You pick the best firm in the world. That is why they always had a big eight [now five] accounting firm, because it is far more prestigious.

I never tell the accountant to inflate the value. I don’t go and hire an accountant by saying, “Hello, I want to commit a control fraud.” What you do is say, “Hello, I want someone that is really, really smart. I want your smartest guy. I want someone who is innovative, someone who hustles for my business.” We call it accountant shopping. You exploit market pressures. That’s how you make it in a big firm. Can you pull in the big clients? These S&Ls were willing to be very good clients and pay you a lot of money.

The way you get an appraisal is you don’t tell him or her how big the appraisal has to come in. If it is a new appraiser, you say, “give me a preliminary appraisal orally.” And if it comes in at the right number, you say, “great, go do the final.” Remember: You get more for a commercial appraisal. The percentage is bigger on bigger projects. Obviously, if they give you the wrong answer you say, “Thanks, don’t bother to write it up. We will probably not go ahead with it.” And then of course, you go to another appraiser. Pretty soon, as you’ve probably figured out, you get to the right appraiser.

Whoever was willing to be sleazy, you could send your business to them. You didn’t need to suborn a whole industry. You just needed a few, and that proved never to be terribly difficult.

TO: These guys are not necessarily dumb. Don’t they know what is going on?

BB: Do they know what is going on? Some part of them knows. People are very good at denial. In the criminal business, our jargon is “neutralization techniques.” Rationalization is just one of those examples. For example, the Keatings of the world don’t simply do the, “Well it’s okay, everybody does it,” type rationalization. They have a much better variant. It’s “We are geniuses. We are transcendent individuals and we are dealing with stupid bureaucrats.”

Then you tell each of your people–and you’ve hired very callow folks with very little experience–they are geniuses. You fire anybody who asks questions. That was the central rule. Pretty soon you have a group of yes-men who think they are really bright. And the next step is to say, “Not only are the government regulators stupid, but they are out to get us.” It’s Us against Them.

TO: Was there more willingness on the part of the government to go after the S&Ls than to prosecute today’s fraudsters?

BB: We ended up getting a thousand convictions, arguably one of the most successful white collar crime efforts in history. But then priorities shifted, and it was very hard to get support to do anything more in that area. Now you have an SEC commissioner who is being dragged kicking and screaming into a more assertive enforcement mode, but who still has no meaningful resources to do it, even if he really believed in it, which it is not clear he does. You don’t see much on the investigative as opposed to the enforcement side being done to try to find how many other Enrons are there. We started looking very intensively at how many other Vermin Savings and Loans there were. I don’t think that’s happening now.

TO: Where is the line between creative accounting and fraud?

BB: What we seem unwilling in our business culture to admit is that it became fraud a long time ago in a broad range of businesses. Let me give you an example. I live near Silicon valley. It is very common in the high-tech companies to sell merchandise on December 31 and have it returned two days later. Typically it’s software. You sell it to someone who understands the game, and they have a complete right to return it. You book the gain in the current fiscal year, do your financial reports with that gain, and it makes your statement look really good. And that is known as “window dressing.” Window dressing is fairly pervasive. Managing earnings is incredibly pervasive. They teach it in business school. You want to smooth e
rnings, so you man
ge them. Let’s book this gain, but not book that gain until the next month. Then it will be more steady and investors will like that and such. All of those things are actually fraudulent practices. You are not following appropriate rules. You are doing so to mislead the investor. But we don’t treat it as if it is illegal.

The rules actually say it is securities fraud to deliberately not follow generally accepted accounting principles (GAAP). If they deliberately don’t follow GAAP, under SEC rules, that’s fraud. But nobody believes the SEC is going to bring that action unless you have also done other bad things, in which case they may add in a charge. And so those practices become not universal, but pervasive. And in my criminology ethics hat, that is a very bad thing, because that’s an erosion. And if we can justify that, then it’s not that much greater a step to lay on this phony partnership and this phony deal because we really think there is value down the line in the investment. You can see this whole rationalization practice. People do that, and it gets easier, I think, because the SEC allows it.

I don’t know if you ever heard of Stanley Sporkin. Sporkin was the SEC enforcement head back maybe 30 years ago. He was the guy who was just hell on wheels about evil conduct. When I was a lawyer at my big law firm, Sporkin was really useful with clients because you could say, “It’s wrong to do it. If you do it, you know what Stanley Sporkin is like. You may end up on the front page of the Washington Post.” We haven’t had a Stanley Sporkin for a long time.

TO: Then how prevalent do you think fraud truly is in American business?

BB: I don’t think control fraud is frequent in the Fortune 500. But I think we now know that it was not remotely an unheard of thing. Some of the biggest companies in America were at root financial frauds. Enron’s strategic plan was to engage in fraud, which is basically what the Powers’ report shows. As soon as you make it clear that it is fine to scam the numbers–not only fine, but the central business strategy–what kind of message are you sending? We now have several other major firms and charities where that has also proven true. And we have seen all of those folks get clean opinions from big five audit firms, which is really scary.

More generally, people are starting to figure out that having something like the high-tech bubble is really bad for the American economy. When you allow values to get way out of whack with the fundamentals, it’s not just money moving around, you can screw up your economy big time. I have some hope that the collapse of our tech bubble, which was one of the largest bubbles in the history of the world, has also scared some folks into thinking that maybe this isn’t such a clever way of doing it. Unfortunately, the attitude was “The rules are silly” and “Aren’t we so clever.” And that combination produces a lot of the worst disasters.

TO: Do you think the SEC Chairman Harvey Pitt and the major accounting firms have a real commitment to reform?

BB: No. And that’s kind of appalling. They think of these things as hostile, but AA and the others have lost so much more money than they gained. If they simply ran a good business and said, “It would be cheaper to do this right, and to make sure that our audit partners out in the field do it right,” they’d make money, and they would have a vastly better reputation.

I have somewhat more hope that there may actually be restrictions put in place, for example, that auditing firms not be allowed to be both the outside auditor and the consultant for the same company. That would be helpful, but I don’t think it will produce much. Then it becomes even more intense: You absolutely have to get the client. So yes, it will reduce one sort of conflict of interest and that’s good, but it may have a negative effect that comes close to counter-balancing it.

TO: How do the scandals of today measure up to the S&L scandal?

BB: You want my pessimistic way of approaching it? If Keating and Milken didn’t have the small problem of both having confessed to felonies, they would have made Enron look trivial. The key problem that Keating and Milken had was that they found it very difficult to raise equity. Think of what Keating could have done during the greatest stock boom in the history of the world, where you could have no product at all, and it could be worth billions the next day in an IPO. If Milken had still been at the helm during this incredible boom, think what he would have done in leveraged buyouts. It’s staggering. Lay actually got started in part through Milken back in the old days. If the master had been available during this time period, we might be in recession now.

TO: Will Lay take the brunt of the blame for Enron?

BB: [Jeffrey] Skilling is in deep trouble because he has witnesses who are clearly aiming at him. And you have this bizarre non-whistle-blower whistle-blower [Sherron Watkins]. The whistle blowing is when you tell the public, not your boss, and then act like he doesn’t know anything about it. That’s Godsend testimony from Lay’s standpoint. But Skilling also has the wrong persona: unrepentant, and very nasty. The kind that folks love to hate. If you are Bush, and want to show you are doing something, who better than Skilling as a target?

TO: Is there a possibility that fraudulent accounting practices could catch up with more companies?

BB: Oh yeah. The recession and the collapse of the high-tech bubble act like a stress test. There is no doubt that there are pretty broad-scale games in accounting, and there are a lot of products that didn’t make a whole lot of sense or never came through. The only way typically to hide it is to grow a whole lot more–and with the current economy, the money isn’t even remotely coming in the same way. It will catch up to them because when you lie, you eventually do end up getting caught once it collapses.