Fraud in the Markets Fraud in the Markets Why It Happens and How to Fight It PETER GOLDMANN John Wiley & Sons, Inc Copyright © 2010 by Peter Goldmann All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data: Goldmann, Peter, 1953– Fraud in the markets: why it happens and how to fight it/Peter Goldmann p cm Includes index ISBN 978-0-470-50789-6 (cloth) Capital market Corporations—Corrupt practices I Title HG4523.G65 2010 2009046298 364.16 3—dc22 Printed in the United States of America 10 To Barbara and Leah Contents Preface xi Acknowledgments xv INTRODUCTION A Brief History of Fraud in Financial Markets Banking Fraud in the Early Days Market-Building by Morgan Flim Flam Finance Savings and Loan Fraud Follies Beginning of the End Off to the Races CHAPTER xvii xvii xxi xxii xxvi xxvii xxx The Fraud Culture I Wanna Be Rich The Spread of Ethical Erosion What It All Means How We Got Here The Evolving Shapes of Fraud Pressure, Opportunity, and Rationalization on Wall Street A Triangle or a Diamond? A Fraud Pentagon? 10 16 23 24 vii Contents CHAPTER CHAPTER The Politics of Banking Fraud 27 Politics and Regulation Antebellum Banking Early Due Diligence Central Banking: The Drive Is Revived Enter the ABA The Warburg Factor Financial Regulation Today What If? Is Regulation Here to Stay? 27 28 31 34 35 36 39 41 46 Modern Day Financial Services Fraud (1980–2010) 51 The Fraud Culture and Today’s Frauds The “Milken/Boesky” Era Fancy Financing Foments More Fraud The Ignominious Birth of “Pay for Performance” Risky .Riskier A Deluge of Derivatives The Good Side of CDSs Shortening Memories Enron et al CHAPTER CHAPTER viii Reform, Re-Regulation, and the Persistence of Fraud 52 53 56 62 65 76 77 80 84 91 Better Antifraud Controls Beyond Financial Reporting Fraud Regulation and Legislation More Aggressive Action Needed 92 95 110 111 The Real Estate Bubble and Bust: The Fraud Factor 115 Can the Circle Be Broken? America has long been a cultural paradox encompassing good, bad, and in between, with good for the most part dictating the important choices made by its citizenry, its political leadership, and its cultural leaders But the paradox has shifted The bad and the in-between have gained ground in recent years and that is why the statistics show dramatic increases in fraud of all kinds Against that backdrop, it becomes clear that the remedy for America’s ethical malady must be one of multiple approaches on multiple levels Notes Testimony of Alice M Rivlin, “Establishing a Framework for Systemic Risk Regulation,” U.S Senate Committee on Banking, Housing and Urban Affairs, July 23, 2009 Ibid Testimony of Edward L Yingling on behalf of the American Bankers Association before the Committee on Financial Services, United States House of Representatives, June 24, 2009 Ibid Richard Bitner, Confessions of a Subprime Mortgage Lender: An Insider’s Tale of Greed, Fraud, and Ignorance (Hoboken, NJ: John Wiley & Sons, 2008), 162 Nomi Prins, It Takes a Pillage (Hoboken, NJ: John Wiley & Sons, 2009), 191 Adam B Ashcraft and Til Schuermann, “Understanding the Securitization of Subprime Mortgage Credit,” Federal Reserve Bank of New York (Staff Report no.318 March, 2008), ii, www.newyorkfed org/research/staff reports/sr318.pdf Ibid, p 66 Department of the Treasury, “Financial Regulatory Reform, a New Foundation Rebuilding Financial Supervision and Regulation,” June 17, 2009, 221 Fraud in the Markets 10 John C Coffee, Jr., Adolf A Berle, and Hillary A Sale, “Redesigning the SEC: Does the Treasury Have a Better Idea?” Virginia Law Review 95 (June 2009): 734 11 Ibid 12 Ibid., 778 13 Richard E Mendales, J.D., “Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown, and How to Fix It,” Research Paper No 09-2009, 71–72 14 Ibid 15 Ibid., 75 16 Patricia Harned, “Financial Crisis: Living With the Legacy,” September 2, 2009, www.ethics.org/ethics-today/0909/pat-column.html 222 About the Author eter Goldmann is the president of White-Collar Crime 101 LLC, the publisher of White-Collar Crime Fighter, a monthly newsletter for internal auditors, controllers, corporate counsel, financial operations managers, and fraud investigators Peter has published White-Collar Crime Fighter since 1998 and has interviewed hundreds of fraud investigators, forensic accountants, white-collar crime attorneys, ex-convicts, and auditors In addition, White-Collar Crime 101 has developed the leading employee fraud awareness training program, FraudAware This is a user-friendly workshop, Webinar, and E-learning training tool designed to educate employees at all levels in how to detect, prevent, and report incidents of fraud or suspicious conduct The course, which is customized for individual corporate, non-profit, and government agency clients, reinforces companies’ whistleblowing programs, by enabling employees to detect fraudulent activity that can then be reported to supervisors or managers or by using the organization’s confidential hotline Peter has 25 years of experience as a business journalist and trainer, having launched, edited, and published numerous business trade periodicals covering small business, international trade, management strategy, banking, and personal finance He is a member of the Editorial Advisory Committee of the P 223 About the Author Association of Certified Fraud Examiners (ACFE) as well as an active member of the Institute of Internal Auditors, the HighTech Crime Investigation Association, and InfraGard He is a regular columnist for the ACFE’s newsletter, The Fraud Examiner, and is a frequent contributor to other leading industry publications on anti-fraud topics He has appeared on The Wall Street Journal This Morning, Fox Business News, The New York Times, and Internal Auditor magazine He can be reached at pgoldmann@wccfighter.com 224 Index A Adelphia, 19, 68, 85–86 AIG Financial Products (AIG-FP), 191, 192, 193 investigation of, 191 Alexander, Kobi, 64 Allion Healthcare Inc, 94 American Bankers Association (ABA), 35, 210 American Exchange National Bank, 34 Ameriquest, 118, 152–158, 184 American International Group (AIG), 16, 46, 47, 61, 77, 166, 190–194, 201, 212 and General Re fraud, 18 and Eliot Spitzer, 190, 193, 194 Apergis, Elias, 138–139 Arnall, Roland, 152–153 Arthur Andersen, 86 Asset-backed securities (ABS), xii, 163, 208 origins of, xix Association of Certified Fraud Examiners (ACFE), 1, 6, 81, 95, 101, 106 2008 Report to the Nation on Occupational Fraud and Abuse, 81 Association of Financial Professionals, 97 B BNC Mortgage LLC, 174 Bank of America, 47, 166, 172, 179, 186, 212 Bankers Trust (BT), 58–60, 61, 195 225 Index Bavarian Motor Works (BMW), 55 Bear Stearns, 6, 7, 52, 175–180 Beazer Homes USA, 92, 143–144 Billing schemes, 101 Bitner, Richard, 123–125, 126, 128, 130–131, 211 Black, William, 42, 115, 126–227 Blagojevich, Rod 104–105 Bair, Sheila, 61 Bliley, Thomas, 65 Bogel, John, Boxer, Sen Barbara, 167 Boesky, Ivan, 53–56, 189 Brightpoint Inc., 190 Bucket shops, 75 Builder Bailout Schemes, 143–144 Butler, Eric, 196–197 Buffet, Warren Bush Administration, 47 C Cassano, Joseph 191–194 CBS News, 75 CBO, 72 CMB Investments, 132 C.V Starr, 191 Cal Fed, 22 Callahan, David, 9–10, 11, 24, 96, 205 226 Carnegie, Andrew, 38 Carr, Fred, 57 Cavanagh, Ward, 60 Cendant, 69–70, 72, 81 Check fraud, 11–12, 98–100 Chunking, 144–145s Chrysler, 84 Cioffi, Ralph, 175–180 Citicorp, 21–22, 61 Citigroup, 16, 47, 77–78, 85, 166, 172, 183, 212 Citron, Robert, 73, 80, 171, 195–196 Clarke, Dumont, 34 Clinton, Bill, 8, 41, 65, 74, 76, 89, 117, 164, 167 Credit card fraud, 11–12 Cohan, William, 177–180 Collateralized debt obligations – CDOs, xxvii, 56, 79, 161–163, 167, 170, 199, 207, 214 Collateralized mortgage obligations (CMOs), 56, 73, 120–121, 162–164, 167, 207 definition of, xxvii-xxix Commodity Futures Modernization Act (CFMA), 75 Commodity, Futures Trading Commission (CFTC), 60 Index Comverse Technology, Inc., 64 Consumer Financial Products Agency (CFPA), 210 Cooke, Henry, 33 Cooke, Jay, 33 Cooper, Cynthia, 86 Corigliano, Cosmo, 70 Cox, Chris, 65 Countrywide, 19, 22, 117, 118, 172, 180, 182–187 Crash of 1929, 38 Crash of 2008, 39 Credit default swaps (CDSs), 56, 75, 76, 77–79, 88, 162–163 Credit Mobilier, xx, xxi, Credit rating agencies, 42–44, 84, 86, 87, 112, 168, 170, 172 and conflict of interest, 72–74, 163, 171, 198–200 reform of, 213–214 Credit Suisse 138–139, 196 Credit Suisse First Boston, 56 Credit Suisse Financial Products (CSFP), 56 Cressey, Donald, 14–16 Cruz, Alejandro, 102–103 Cuban Missile Crisis, Cummings, Elijah, 199 CUC, 67–72 Cyber-fraud, 109–110 D DLJ Mortgage Capital Inc (DLJ), 138–139s Daniel, Raymond, 199 Deligiannis, Stefan, 138–139 Deloitte LLP, 94 Depression of 1873, 33 Derivatives, xxix, 5, 9, 41, 45, 57, 58, 59, 60, 61, 62, 73, 74, 75, 76–79, 80, 84, 85, 88, 96, 121 definition of, 56 market reform of, 208–217 role in cause of financial crisis, 42–43, 55, 161–204 Deutsche Bank, 189 Dinallo, Eric, 75 Doumazios, Ted, 138–139 Drexel Burnham Lambert, 53 Duke University, 55 Dumas, Rodney, 131–132 DuPont, 57 E Ebbers, Bernard, 9, 18–19, 86 Edgewater Development, 139 E.F Hutton & Co., 21 Enron, 6, 7, 68, 72, 77–78, 81, 84–85, 86, 161, 171, 189 Employee-level fraud, 12–13, 97 Ethics Resource Center, 219 227 Index Equity Skimming, 145–146 European-American Bank, 21 European Bank for Reconstruction and Development (EBRD), 77 Expanded Examination Guidance for Subprime Lending Programs, 148–149 External fraud, 11–12, 108–110 Exxon, 76–77 Exxon Valdez, 76 F Fair and Accurate Credit Transactions Act (FACTA), 110 Fannie Mae, xxvii, xix, 92, 120, 184 FastQual, 168 Fastow, Andrew, 84–85 Federal Deposit Insurance Corporation (FDIC), 29, 51, 149, 151, 182, 210 Federal Home Loan Bank of San Francisco, 42 Federal Reserve (Fed), 58, 121, 213 Feingold, Sen Russ, 167 Financial Crimes Enforcement Network (FinCEN) Federal Financial Institutions Examination Council (FFIEC), 141 228 Fitch, 72, 213 Federal Reserve Banks, 37 Federal Reserve Board, 37, 44 Federal Reserve System, 33, 179 Federal Trade Commission (FTC) Feingold, Russell, 39 Financial Economists Roundtable (FER), 43 Fields, Jack, 65 Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), 51 First Boston, 121 First Canadian American Holding Corporation, 94 First Executive Corp., 57 First Nationwide Mortgage, 22 Fool’s Gold, 176–177 Forbes, Walter, 68–70 Frank, Barney, 207 Fraud by insiders/employees, 12–25, 97–108 role in early banking, xii-xxi role in subprime mortgage lending, xxx, xxxi, 80, 123–133, 137–157, 165, 186 securities, xxiii, xxix-xxx, 6, 18, 38, 53, 54, 58–60, 63, 64, 65, 66, 174, 175, 180, 190, 197 Index Fraud culture, 1–25, 52, 96, 220 Fraud Diamond, 23–24, 96, 106, 165 Fraud Enforcement and Recovery Act (FERA), 87, 111 Fraud Triangle, 14–15, 23–24, 165 Fraud Pentagon, 23–24 Freddie Mac, xxvii, xix, 120, 184 Free banking, xix, xx, 28 Fuld, Richard, 17–19, 22, 173–175, 182, 205 G GSAMP TRUST 2006-NC2, 168–169 Galleon Management, 189 Garza, Susanna, 101–104 Gates, Bill, General Accounting Office (GAO), 41 General Electric, 57 General Motors, 84 General Re, 18–19 Gibson Greetings, 58–60, 73, 195 Ginnie Mae, 216 Girgenti Richard, 20–21 Glacier Funding CDO I Ltd, 196 Glacier Student Loan Authority, 196 Glass-Steagall Act, 39–40, 41–42, 45, 74, 89, 117, 142, 164, 167, 206–207, 212 Global Crossing, 85–86 Golden State Bancorp, 22 Goldman Sachs, 8, 168, 191, 212 Golub, Harvey, 21 Gonzalez, Albert, 109–110 Gould, Jay, 38 Gramm-Leach-Bliley Act (“Banking Act of 1933”), 39, 45 Greenberg, Maurice (“Hank”), 18, 19 and risk management, 61 resignation from AIG, 190 Greenspan, Alan, 74, 121 Grundfest, Joseph, 66 Great Depression, 39 Greenberg, Maurice (Hank), 18–19, 61, 190– “Ghost” employees, 100–101 H HFC Corp., 69 HFS Incorporated, 69 Harned, Patricia, 219–220 Harriman, W Averill, 37 Harvey, Campbell, R., 55 229 Index HealthSouth, HOEPA (Home Ownership and Equity Protection Act of 1994), 150 Hogan, Edward, 138–139 House Committee on Oversight and Government Reform, 198 Household Finance, 184 Hovanian, 122 Hill, James, 38 I IBM, 57 Individual Retirement Account (IRA), 166 Inside Mortgage Finance, 168 Insider trading, xxviii, 7, 54, 175 and Securities Fraud Act of 1988, 188–189 Insider Trading Sanctions Act (ITSA) of 1984, 188 International Swaps and Derivatives Association, 88 Inventory theft, 105 Irrational Exuberance, 119 J Johnsen, James, 59, 73 Jobs, Steve, 230 JP Morgan Chase, 16, 76–77, 85, 153, 166, 174, 176, 179, 201, 212 K KB Homes, 122 KPMG, 20–21 Keating, Charles, 183 Kerviel, Jerome, 20 Kickbacks, 104 Killinger, Kerry, 22, 180–182 Koslowski, Dennis, 19 Krispy Kreme Doughnuts, 94 Kreuger, Ivar, xxiii compared to Bernard Madoff, xiv, xv Kuhn Loeb and Company, 34, 36, 37–38 L Lay, Kenneth, 84 LaLiberte, James, 22 Lehman Brothers, 45, 52, 173–175, 179, 182, 201 forces behind collapse of, 17–18 Lehman Brothers Holdings, Inc., 21 Lehman Brothers Kuhn Loeb, 21 Levitt, Arthur, 61–62 Loeb, Solomon, 36 Index Long Beach Mortgage (LBM), 153 London Interbank Overnight Rate (LIBOR), 59 Lopez, Jesse, 101–104 Loring Estates, 139 M M.M Warburg and Company, 36–37 McCain, John, 39 Madoff, Bernard, 207 Macro System Stabilizer, 209 Management-level fraud, 14–16 Martini, Steven, 138–139 Marquez Brothers International Inc., 102–104 Mendales, Richard, 216–217 Merrill Lynch, 16, 22, 74, 80, 86, 172, 183, 201 Michael, John, 138–139 Milberg Weiss Bershad Hynes & Lerach, 66–67 Milgram, Anne, 174 Milken, Michael, 7, 53–56, 81, 189 Miller, Tom, 158 Moody’s, 72, 168, 199, 213 Money laundering, 11–12 Morgan, J.P., xxii, xxv, 2, 30–31, 34, 37–38 and “Money Trust, xxi Morris, Charles, 30, 120, 122, 128, 163–164 Mortgage-backed securities (MBSs), 56, 131, 163, 207 definition of xxviii-xix rating agencies and, 198, 213 Mortgage fraud, xviii, 41, 43, 95, 96, 115, 116, 117, 127, 186, 206, 218 by borrowers, 217–218 definition of, 131 for-profit scams, 137–146 for-property scams, 146–147 predatory lending, and, 147–158 subprime, xxx, 126, 154–158 Mozilo, Anthony, 22, 182–187, 205 Muolo, Paul, 151, 152–155, 158, 184–186 N NBC News, 22–23 National Bank Act of 1863, 29 National City Bank of New York, 34 New Century Financial Corp., 117, 118, 168, 184 New York Chamber of Commerce, 34 New York Times, 178, 196 231 Index Nor-Cal Processing, 103 Northern Pacific Railroad, 33 O Obama Administration, 44, 47, 87, 88, 209–211 O’Connor, Kevin, 210 Ocwen Loan Servicing, LLC, 169 Office of Thrift Supervision (OTS), 151 O’Neal, Stan, 22, 183 Option One, 184 Orange Country, CA, 80, 195–196 P Padilla, Mathew, 151, 152–155, 184–186 Partnoy, Frank, 56–59, 62–63, 65, 74 Peabody, George, 30 Pecora, Ferdinand, xxv Pecora Commission, xxv, xxvi, 38, 87 People’s Choice Bank, 22–23 Pember, Anne, 70 Penn State University School of Law, 214 Prince, Charles (“Chuck”), 172, 183 Prins, Nomi, 212 Procter & Gamble (P&G), 60 232 ProQuest, 93 Pontell, Henry, 54–55 Ponzi schemes, Predatory lending, 147–157 Primerica, 21 Private Securities Litigation Reform Act of 1995 (PSLRA), 65–66, 207 Public Company Accounting Oversight Board (PCAOB), 93 R Real Estate Mortgage Investment Conduit (REMIC), xxviii, xxix Reagan Ronald, 40 Receivables, Theft of, 101 “Red Flags Rule Compliance Program,” 110 Reed, John, 22 Resolution Trust Corporation (RTC), 52 Ridgely, William, 36 Richardson, Michael, S., 41 Rivlin, Alice, 209 R.H Macy, 34 “Robber Barons,” 38 Roberts, Paul Craig, 40 Rockefeller, 30, 37–38 Rosoff, Stephen, 54–55 Rothbart, Murray, 30–31, 36 Rubin, Jonathan, 139 Index S S&P, 72, 213 Sabatino, Casper, 70 Safety Fund Act of 1829, 27 St Denis, Joseph, 192–194 Salomon Brothers, 58 Salomon Smith Barney, 21 Sambol, David, 186 Sarbanes-Oxley Act (SOX), 19, 64, 71, 82, 87, 91–95, 111, 171 Savings and Loan (S&L) crisis, xxvi, xxvii, 6, 7, 21, 51, 52, 115, 142 and regulatory reform, 38, 39 Schiff, Jacob, 33, 36 Scrushy, Richard, 91–92 Second Bank of the United States xviii, xix, 27 Securities and Exchange Commission (SEC), 38, 44, 60–61, 64–65, 93–94, 168, 172, 179, 186, 207, 216 Securities Exchange Act of 1934, 188 Securities fraud (see Fraud) Shaw, Leslie, 34 Shelby, Sen Richard, 167 Shiller, Robert, 119 Short Schemes, 146 Straus, Isadore, 34 Shearson, 21 Shearson Lehman/American Express, 21 Shearson Lehman Hutton Inc, 21 Shepard, Bill, 197 Shepherd, Smith, Edwards and Kantas, 197 Siegel, Martin, 53 Sieracki, Eric, 186 60 Minutes, 75–76 Skilling, Jeff, 84 Societe Generale, 20 Special Purpose Entities (SPEs), 84 Spitzer, Eliot, 190, 193–194 “Straw vendor” schemes, 104, 137–139 Stiglitz, Joseph, 167 Stock options backdating, 62–64 Structured finance, 56, 57, 217 Sub-prime mortgage crisis, 79–80, 123–125 Sullivan, Scott, 9, 85–86 Swecker, Chris, 127 T Talbott, John, 8, 200 Tannin, Matthew, 175–180 Texaco, 84 Tett, Gillian, 176–177 The Best Way to Rob a Bank is to Own One, 42 233 Index The Cheating Culture, 9, 205 The Teachers’ Retirement System of Louisiana, 190 Tillman, Robert, 53–54 Toll Brothers, 122 Travel and entertainment fraud, 106 Troubled Asset Relief Program (TARP), 47 Truth in Lending Act (TILA), 150 Turner, Lynn, 45–46 Tzolov, Julian, 196–197 Travelers Insurance, 21–22 2008 Mortgage Fraud Report “The Year in Review,” 142–143 Tyco, 6, 19, 68, 86, 171 U UK Serious Fraud Office (SFO), 191 U.S Department of Education, 196 U.S Department of Justice, 191 Utah Jazz, 57 234 V Valle, Richard, 155–158 Vanderlip, Frank, 34 Vanguard Group of Mutual Funds, W Wachovia Bank, xii Walker, Derek, 132–133 Walker, Richard H., 71 Warburg, Paul, 36–37 Washington Mutual, 22, 45, 52, 119, 138–139, 153, 180–182 Weil, Sanford, 22 Wells Fargo, 169, 212 Wellstone, Sen Paul, 167 Weiss, Melvin, 67 Wheat, Allen, 55 Wheelock, Thomas, 36 Wickes, 54 Wildcat banking, xix, xx, 27, 28, Woodstock, WorldCom, 6, 9, 68, 72, 77, 85–86, 161, 171, 189 Y Yingling, Edward, 210 Praise for IN THE FRAUD MARKETS “Peter Goldmann has written a fascinating book on the financial markets and the devastating impact of fraud and ethical erosion His historical commentary is reason enough to read this book But Goldmann really shines when he puts his unique perspective on the causative factors of the worst financial crisis since the Great Depression.” —Martin T Biegelman, Director of Financial Integrity, Microsoft Corporation “The financial crises that began in 2007 had a devastating impact on the U.S economy that was felt around the world Peter Goldmann leads us through this crisis and explains the role that financial fraud played in the tragedy Goldmann’s book is instrumental in helping us understand the devastation fraud can cause when it goes unchecked We can only hope that by examining the mistakes we made, we will not be doomed to repeat them This book provides a strong starting point for that introspection.” —John D Gill, JD, CFE, Vice President of Education, Association of Certified Fraud Examiners ... banking gave rise to what was aptly called wildcat banking It took hold in numerous states, initially in Michigan and then in New York and several other states According to one top economic historian,... book cooking, and other serious financial felonies Beginning of the End As the S&L crisis was winding down, the subprime mortgage industry was just shedding its training wheels In 1990, there was... given in late 2003 to the House Subcommittee on Housing and Community Opportunity and the House Subcommittee on Financial Institutions and Consumer Credit: CMOs redirect the cash flows of trusts to