Bill Black: What if the SEC investigated Banks the way it is investigating Mutual Funds?

Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Cross posted from New Economic Perspectives.

The Wall Street Journal ran a story yesterday (12/27/11) entitled “SEC Ups Its Game to Identify Rogue Firms.” “Rogue” is an interesting word with a range of definitions. When it is used as an adjective its meaning is: “a playfully mischievous person; scamp.” The trivialization of the most destructive elite frauds is one of the most common forms of what criminologists call “neutralization” of the moral content of wrong doing. Neutralization increases crime.The actual story makes it clear that the criminals that the SEC was identifying were not “rogues.” They were the CEOs of seemingly legitimate firms. The SEC is identifying “accounting control frauds” – the frauds that cause greater financial losses than all other forms of property crime combined. The SEC is not identifying a few rotten apples, but roughly 100 hedge funds likely to have engaged in accounting fraud. The WSJ describes the SEC’s identification system:

“The list is the low-tech product of a high-tech effort by the SEC to crack down on fraud at hedge funds and other investment firms. After the agency failed to detect the $17.3 billion Ponzi scheme by Bernard L. Madoff, who wowed investors with steady returns over several decades, SEC officials decided they needed a way to trawl through performance data and look for red flags that might signal a possible fraud.

In 2009, the SEC began developing a computer-powered system that now analyzes monthly returns from thousands of hedge funds. Officials won’t say exactly how it works or how much it cost to build, but the agency has announced four civil-fraud lawsuits filed as a result of what it calls the “aberrational performance initiative.”” The SEC should be applauded for finally understanding that “if it’s too good to be true; it probably isn’t true.” Our agency put a similar system in place in 1984 to identify the S&L accounting control frauds that were driving that crisis. A quarter-century later, the SEC began to follow our well-trodden trail – but only with regard to felons inhabiting the middle of the fraud food chain (hedge funds).

The SEC has, inevitably, discovered that accounting fraud is common among hedge funds. It is unlikely that the SEC system is really “high-tech” in information science terms. Low-tech information systems have been capable of identifying “aberrational performance” for at least thirty years. We did not have to create any pioneering software in 1984 in order to identify aberrational performance. The cost and time to create our “red flags” was trivial (a few hours of programming time by an agency staffer). (We were collecting the data and computing the necessary ratios anyway. One simply decides the level of a few key variables worthy of being flagged. There’s nothing magic about a “flag.” All it means is that suspicious levels are highlighted on the computer screen and on physical copies of the periodic reports so that they capture the reader’s attention.)

The SEC took two years to create its “aberrational performance” system and is embarrassed enough about the cost that it wants to keep it secret. The two year development process allowed the SEC to make a major advance relative to our system – they invented a title consisting of two words and eight syllables. Devising a title that recondite doubtless accounts for six months of the time it took the SEC to develop its flags.

The most interesting aspects of the WSJ story, however, are two unexamined topics that should have been central to the story. First, there is not a word in the article about criminal prosecutions for the frauds the SEC has identified. The frauds, as described in the article, are so blatant that they would make relatively simple to prosecute. There is no indication that the SEC wanted the WSJ to know that they had made well over a hundred criminal referrals against hedge fund CEOs and senior officers. There is no indication that the WSJ reporters were interested in whether the SEC had made criminal referrals against these moderately elite felons. As a result, we have no information on whether the SEC has in fact made hundreds of criminal referrals against the senior officers at the hedge funds that they have identified as having engaged in likely fraud. Indeed, we have no evidence that they have made any criminal referrals. Neither the SEC nor the WSJ reporters indicated that any prosecutions, or even Department of Justice investigations, resulted from the SEC hedge fund investigations.

Second, why isn’t the SEC’s top priority the systemically dangerous institutions (SDIs)? The SDIs are the financial institutions that are so large that the administration fears that their failure will cause a new global crisis. The SDIs pose by far the greatest risk to the economy and investors of any entity. Their frauds reached “epidemic” proportions and drove our ongoing crisis and the Great Recession. The SEC, however, applied its “aberrational performance” system to its smallest entities and is now expanding it to mutual funds. There is no indication that the SEC intends to use the system to spot fraudulent SDIs. There is no indication that the SEC has even contemplated using the system to spot fraudulent SDIs. There is no indication that the WSJreporters asked why the SEC was failing to use its system where it was most needed.

Applying the SEC system to the SDIs would have led the SEC to develop a more sophisticated analytical approach to identifying fraud. There is no indication that the SEC has any familiarity with the criminology, economics, and regulatory literature about how to identify accounting fraud. Admittedly, the SEC (finally) has taken seriously the warning that generations of parents have impressed upon their children – “if it’s too good to be true; it probably isn’t true.” The Achilles’ heel of the SEC analytics is that it assumes fraud must be aberrational and its flags are (at least as described in the story) all tied to identifying aberrations premised on the implicitassumption that fraud cannot be endemic. The SEC official told the WSJ reporter that they looked for “outliers.” Accounting control fraud, however, can become endemic, particularly in a product line, because it produces a “Gresham’s dynamic” in which bad ethics drives good ethics out of the market. Accounting control frauds report results that are too good to be true, but they all report extraordinary results because accounting fraud is a “sure thing” (George Akerlof and Paul Romer, “Looting: the Economic Underworld of Bankruptcy for Profit, 1993). Accounting control fraud was far more common among the SDIs than the SEC system has identified among hedge funds.

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About Matt Stoller

From 2011-2012, Matt was a fellow at the Roosevelt Institute. He contributed to Politico, Alternet, Salon, The Nation and Reuters, focusing on the intersection of foreclosures, the financial system, and political corruption. In 2012, he starred in “Brand X with Russell Brand” on the FX network, and was a writer and consultant for the show. He has also produced for MSNBC’s The Dylan Ratigan Show. From 2009-2010, he worked as Senior Policy Advisor for Congressman Alan Grayson. You can follow him on Twitter at @matthewstoller.


  1. Cathryn Mataga

    Yeah, no kidding. Look no further than the MF Global implosion — not only bad gambling, but, even worse, confused accounting. Where is customer money? Who knows, it could be anywhere? Everyone’s playing dumb. Corzine doesn’t know. Lah dee dah! Honestly, I don’t think these wheeler-dealer type guys have the discipline to keep a tight set of books. The big money is in the gambling.

    I think this is a huge hidden risk in the system right now. The MF global failure is proof that there are no checks in place.

    1. Damian

      they are not confused! the state of the books is always due to obstruction for those unraveling the fraud – the bigger the crime the more disaray of the records – if they know how much their bonus should be to the penny – they know where the clients money is

      1. Cathryn Mataga

        There was a time when those committing fraud kept two sets of books, one for the public, and one secret set that let on where all the money is leaking off to. It could be, since no one is checking anymore, that all this is unnecessary. You just have a giant server filled with confused data that you steel from now and then — no one ever checks that.

        That’s some kind of progress, I suppose.

  2. patrick

    They are afraid that if they start pulling on any loose threads the whole edifice will unravel. Also enquiries may result in cover-ups which would then lead to “Martha Stewart” type criminal prosecutions.

    Plus they have to divine who has insufficient political clout to make a prosecution palatable to the powers that be. They have a problem of selection as well as detection.

    1. Cathryn Mataga

      Probably nothing happens unless a Bradley Manning shows up. And, if he did, Obama, would probably put him in solitary for threatening strategic financial infrastructure. Wikileaks was starting to get stuff from Financial companies about the time they went after Assange for ‘Sex by Surprise.’

      1. Jim Clausen

        Speaking of topics related to Wikileaks,

        just what happened to the proposed document dump regarding BOA that was to be dumped in early ’11?

    2. jsn

      Now that the SEC is paying attention to the real core of Obama funders, rest assured DOJ will not respond.

      If Obama is re-elected he will continue his efforts as the “statute of limitations” president and help the clock run out before FOA requests can force the magnitude of corruption into the light of day: expect Holder to insist that investigations are “ongoing” until sometime in 2016 and then drop everything.

      That will leave things to our next Corrupter in Chief to decide if he still needs these felons to fund him. I’ve got my pitchfork, just looking for a plan.

      1. Jimbo

        >Now that the SEC is paying attention to the real core of Obama funders, rest assured DOJ will not respond.

        Because DOJ is under orders from the boss.
        Since “no laws were broken.”

  3. Hugh

    Elite criminals are never criminally prosecuted for preying upon the innocent, that is non-rich. That’s what fines are for and it’s really only a pantomime for the rubes anyway. Madoff’s crime, on the other hand, was that he preyed on the wrong group of other criminals/rich people.

  4. Conscience of a Conservative

    On a 60 minutes segment not too long ago, Bernanke said a big bank will not fail under his watch. As far as the SEC using computer algorithms to help detect fraud, I applaud this move, but agree the key is execution..They could start with coding a Benford’s law algorithm.

    1. mully

      a big bank wont fail because the big banks own the fed. The fed exists to defend the big banks. Its kinda simple really. Why does the fed do everything to extend the status quo? Because its owned by the status quo.

      1. Conscience of a Conservative

        The Fed along with many mainstream economists believe for the system to work, confidence must be restored and maintained. To them, a big bank failing would not generate confidence. Perhaps in their eyes, this confidence is like Keynse’s “animal spirits” and not not based on rational things like solid bank balance sheets, conservative leverage ratios and asset prices that reflect reality.

  5. MyLessThanPrimeBeef

    ‘Neutrailize’ (or ‘neutralization’) seems itself to be a word used often to trivialize.

    Neutralize or terminate with extreme prejudice – what do criminologists say about them?

    When you use ‘neutralization’ to trivialize, would that be ‘neutralization squared?’

  6. GSTrader

    The SEC needs a computer program to find aberrational performance? Here’s a hint (courtesy zerohedge):

    “In the quarter ended March 31, Goldman made money on every single trading day. The firm did not record a loss of even $0.01 on even one day in the last quarter. That’s 63 days profitable out of 63 trading days.”

  7. Kevin Smith

    At the Art Gallery of Ontario today I saw some paintings depicting the reaction against selling indulgences [rich people could pay money to The Church and in effect buy a license to commit a wide range of offences, including murder. It was cheaper if you paid in advance.]

    I immediately thought of the current situation, where rich people and companies are often able to use their money to avoid or defeat prosecution for a wide variety of offenses.

    Might be an interesting parallel for some writer to explore. If nothing else, there is quite a lot of art depicting the gruesome fate of some of those who bought [and sold] indulgences. This art might be used to illustrate an article, blog or paper.

  8. Damian

    If the S&L fraud debacle in 1990 was actually the NY banks committing the fraud at that time – would Mr. Black have been as effective in gaining criminal prosecutions against the banks?


    did the politics evolve for more effective regulatory capture in 20 years?

  9. orionATL


    this is one way for the chicago demo mob, aka, the uber-bama machine, to raise money.

    sic the sec on hedge-fund richies some months before an election,

    collect lots of money from them,

    then null process the sec legal claims after inauguration.



  10. Rex

    OK, let’s talk.

    When I read about this true stuff, it makes me feel the righteous indignation we should all feel. But all the big banks are now apparently run by deliberate scumbags. If we take them to task properly, won’t we crash the bank-driven facade that is running our current puppet show?

    That is, if we call out the scum leaders, won’t we upset the apple cart while we are trying to put it right?

    Those of us with any awareness about CO2 in the atmosphere know that we are dancing a lie every time we move ourselves more than a block or keep the room close to 70 degrees or have children.

    Is there a way to pull the big lies out of our tower of self deceit slowly enough that the whole thing doesn’t crash down around us, yet fast enough that we don’t all eventually burn in the sea of our own negligence?

    So many problems, so little time. Major crashes seem inevitable. Which one first.

    1. Susan the other

      Really good point. It is sooo hard to fight See No Evil. That must be why war happens – the last stage of denial.

  11. LucyLulu

    The story that it took two years to develop the software may well be just that, a story. Cover for why its taken the SEC so long to take action. And why bother make referrals for prosecution to the DOJ? They’d have a better chance referring to the DC cops.

    The quality of reporting has gotten abysmal, which is why I won’t pay for subscriptions to newspapers anymore. Investigative journalism seems to be a lost art at the mainstream newspapers (as well as proofreading). Thank goodness for work from people such as Matt Taibbi and Jane Mayer and by internet bloggers.

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