Epidemics of ‘Control Fraud’ Lead to Recurrent, Intensifying Bubbles and Crises
“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.