Is mathematics a vehicle for control fraud?
Bill Black
A couple of nights I ago I attended this event at Columbia on the topic of “Rent-Seeking, Instability and Fraud: Challenges for Financial Reform”.
The event was great, albeit depressing – I particularly loved Bill Black‘s concept of control fraud, which I’ll talk more about in a moment, as well as Lynn Turner‘s polite description of the devastation caused by the financial crisis.
To be honest, our conclusion wasn’t a surprise: there is a lack of political will in Congress or elsewhere to fix the problems, even the low-hanging obvious criminal frauds. There aren’t enough actual police to take on the job of dealing with the number of criminals that currently hide in the system (I believe the statistic was that there are about 1,000,000 people in law enforcement in this country, and 2,500 are devoted to white-collar crime), and the people at the top of the regulatory agencies have been carefully chosen to not actually do anything (or let their underlings do anything).
Even so, it was interesting to hear about this stuff through the eyes of a criminologist who has been around the block (Black was the guy who put away a bunch of fraudulent bankers after the S&L crisis) and knows a thing or two about prosecuting crimes. He talked about the concept of control fraud, and how pervasive control fraud is in the current financial system.
Control Fraud
Control fraud, as I understood him to describe it, is the process by which a seemingly legitimate institution or process is corrupted by a fraudulent institution to maintain the patina of legitimacy.
Once you say it that way, you recognize it everywhere, and you realize how dirty it is, since outsiders to the system can’t tell what’s going on – hey, didn’t you have overseers? Didn’t they say everything was checking out ok? What the hell happened?
So for example, financial firms like Bank of America used control fraud in the heart of the housing bubble via their ridiculous accounting methods. As one of the speakers mentioned, the accounting firm in charge of vetting BofA’s books issued the same exact accounting description for many years in the row (literally copy and paste) even as BofA was accumulating massive quantities of risky mortgage-backed securities (update: I’ve been told it’s called an “Auditors Report” and it has required language. But surely not all the words are required? Otherwise how could it be called a report?). In other words, the accounting firm had been corrupted in order to aid and abet the fraud.
“Financial Innovation”
To get an idea of the repetitive nature and near-inevitability of control fraud, read this essay by Black, which is very much along the lines of his presentation on Tuesday. My favorite passage is this, when he addresses how our regulatory system “forgot about” control fraud during the deregulation boom of the 1990’s:
On January 17, 1996, OTS’ Notice of Proposed Rulemaking proposed to eliminate its rule requiring effective underwriting on the grounds that such rules were peripheral to bank safety.
“The OTS believes that regulations should be reserved for core safety and soundness requirements. Details on prudent operating practices should be relegated to guidance.
Otherwise, regulated entities can find themselves unable to respond to market innovations because they are trapped in a rigid regulatory framework developed in accordance with conditions prevailing at an earlier time.”
This passage is delusional. Underwriting is the core function of a mortgage lender. Not underwriting mortgage loans is not an “innovation” – it is a “marker” of accounting control fraud. The OTS press release dismissed the agency’s most important and useful rule as an archaic relic of a failed philosophy.
Here’s where I bring mathematics into the mix. My experience in finance, first as a quant at D.E. Shaw, and then as a quantitative risk modeler at Riskmetrics, convinced me that mathematics itself is a vehicle for control fraud, albeit in two totally different ways.
Complexity
In the context of hedge funds and/or hard-core trading algorithms, here’s how it works. New-fangled complex derivatives, starting with credit default swaps and moving on to CDO’s, MBS’s, and CDO+’s, got fronted as “innovation” by a bunch of economists who didn’t really know how markets work but worked at fancy places and claimed to have mathematical models which proved their point. They pushed for deregulation based on the theory that the derivatives represented “a better way to spread risk.”
Then the Ph.D.’s who were clever enough to understand how to actually price these instruments swooped in and made asstons of money. Those are the hedge funds, which I see as kind of amoral scavengers on the financial system.
At the same time, wanting a piece of the action, academics invented associated useless but impressive mathematical theories which culminated in mathematics classes throughout the country that teach “theory of finance”. These classes, which seemed scientific, and the associated economists described above, formed the “legitimacy” of this particular control fraud: it’s math, you wouldn’t understand it. But don’t you trust math? You do? Then allow us to move on with rocking our particular corner of the financial world, thanks.
Risk
I also worked in quantitative risk, which as I see it is a major conduit of mathematical control fraud.
First, we have people putting forward “risk estimates” that have larger errorbars then the underlying values. In other words, if we were honest about how much we can actually anticipate price changes in mortgage backed securities in times of panic, then we’d say something like, “search me! I got nothing.” However, as we know, it’s hard to say “I don’t know” and it’s even harder to accept that answer when there’s money on the line. And I don’t apologize for caring about “times of panic” because, after all, that’s why we care about risk in the first place. It’s easy to predict risk in quiet times, I don’t give anyone credit for that.
Never mind errorbars, though- the truth is, I saw worse than ignorance in my time in risk. What I actually saw was a rubberstamping of “third part risk assessment” reports. I saw the risk industry for what it is, namely a poor beggar at the feet of their macho big-boys-of-finance clients. It wasn’t just my firm either. I’ve recently heard of clients bullying their third party risk companies into allowing them to replace whatever their risk numbers were by their own. And that’s even assuming that they care what the risk reports say.
Conclusion
Overall, I’m thinking this time is a bit different, but only in the details, not in the process. We’ve had control fraud for a long long time, but now we have an added tool in the arsenal in the form of mathematics (and complexity). And I realize it’s not a standard example, because I’m claiming that the institution that perpetuated this particular control fraud wasn’t a specific institution like Bank of America, but rather then entire financial system. So far it’s just an idea I’m playing with, what do you think?
mathbabe 
Mathematics and statistics are the primary languages of control frauds. They are used to legitimize deceptive transactions where no “meeting of the minds” occurs. The deception occurs, sometimes inadvertently when at least one party doesn’t understand these languages. For much of the population, this problem starts with gambling, “adjustable rate” loans and anything else with more complexity. It’s not limited to financial engineering.
As long as there is significant variation in math/stat capabilities within the population opportunities for fraud abound. It’s doubtful that we’ll ever make much of a dent in this variability. That’s why we need regulatory support for “plain vanilla” financial transactions. Reducing complexity is the easiest way to reduce fraud opportunities in transactions between consumers, agents, and “professionals.”
Agents are supposed to solve this problem, but they just make it much easier to commit fraud. They have little or no skin in the game and are easy marks for intellectual capture – buying into a fraudulent system designed to skim massive profits from unwary pension beneficiaries, retirement account holders and other sources of “dumb” money.
Guess that’s why they call it “dumb money.” Folks who can’t speak the languages of math and stat. Given my level of participation and understanding of the inner workings of my retirement accounts, I’m probably one of the dummies.
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Is manipulation of risk numbers covered by fraud statutes in the same way as manipulation of accounting numbers? If not, this would be useful. Also useful would be an appetite to prosecute fraud- Black has pointed out the discrepancy between fraud prosecutions for the S&L crisis and for the current crisis.
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Modern societies appear to based more on hoodwinking than anything else, including especially love, the modern conception of which is permeated with tons of hoodwinking. Hate sounding like a crank, but to me it sure looks like a duck, sounds like a duck…I’m pretty sure it’s a duck!
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I largely agree with what you’re saying here, but there’s something wrong with this paragraph: “In the context of hedge funds and hard-core trading algorithms, here’s how it works…”. Complex derivatives like CDOs are bespoke instruments, traded over the counter. They are not algorithmically traded. No one who works with ‘hard core trading algorithms’ has anything to do with them.
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In the context of mathbabe books and blog posts, “algorithms” were mentioned in that sentence just to add some flesh. (But don’t be surprised if you see a book containing mathbabe blog posts at some future time…hint hint!)
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You’re suggesting that mathbabe mentioned algorithms just to sex up the post? I hope that’s not true.
Algorithmic trading and complex derivatives trading are very different businesses, both in terms of the players and in terms of their impact on the rest of the economy. However, they’re frequently conflated in the popular press. This is not surprising: Both disciplines are technologically sophisticated and secretive about their methods, so the public can’t be expected to distinguish easily between them. But it is problematic, because the derivatives traders are much larger in scale and have done real economic harm, whereas the algorithmic traders aren’t big enough to do much in the way of economic damage. Casually confusing the two makes it much easier for the derivatives industry to escape necessary regulation.
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Should have said “and/or”. You are right that many of the most toxic instruments were OTC.
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No Auntie. The way I read that sentence is: hedge funds and hard-core trading algorithms both occasion control fraud. That the rest of the paragraph had only to do with complex derivatives didn’t blur this.
As for whether *hard-core* trading algorithms were not just tossed in to add more flesh to the sentence, but also to “sex up” the post, well…your guess is as good as mine!
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yes yes
mix
1 math no one incl regulators managers and your own accountants understand
and produce valuations that
2 dont match your counterparty
3 have no market reference— like what they can sell for
it used to be if you took out 8 figure compensation and your company promptly blew up, you could go to jail or worse. now its how could we have known our accountants said it was ok (the airtight Sarbox defense) and they can go before the congress investivating commitee and blow smoke up everyones a..
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The mathematics purported here is invented by eliminating the plethora of variables necessary to adequately represent the situation. As such control frauds are more honest since they are more obvious frauds. The math you need won’t appear on any 2-D surface.
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You got mentioned on Ritholz’ econ blog! Go you! http://www.ritholtz.com/blog/2013/03/10-friday-am-reads-56/
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Great article/post.
I believe credit default swaps are an innovation replacing (or should) the rating agencies in assessing value to fixed income products. CDS is closer to a market reflection of value than a couple of dudes (who get paid by the issuer). How is a rating agency incentivized?
Reminds me of trying to commit fraud in a poker club. Very hard to do. Why? Because the floor man/ game supervisor is good at monitoring the action and keeping it honest? No. Its the other players defending their own interests (ensuring a competitor is not cheating) that watch for the fraud/ cheater. A well run/reputable club has good processes in place – well trained floor man, 10 video cameras on replay at every table. When a dishonest play is detected, floor man takes action. Its a win-win partnership.
The regulatory agencies should be set up like the well run/reputable club. I’m not sure what they are today. You don’t need MORE regulation just structure it to be more effective.
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“Why? Because the floor man/ game supervisor is good at monitoring the action and keeping it honest? No. Its the other players defending their own interests (ensuring a competitor is not cheating) that watch for the fraud/ cheater.”
Oh sure Debra, just like eggs identify and reject legitimate rape sperm.
Your main thesis may have merit, but your analogy to support it is very fallacious. The majority of poker players are so-called “fish” who are there just because they enjoy the game and trying to improve their skill at playing it (I happen to be rather aquatic myself; I keep constant track of my results and the data do not lie). The last thing most players are watching for at a public card room is cheating. Most have little or no ability to even catch “tells” (indicators of poker hand strength, some general, others player-specific) their opponents might be giving away.
And what about blackjack? What do you suppose happens more often, blackjack players catching the dealer cheating, or the house catching blackjack players “cheating” (in other words doing anything that breaks house rules)? Card counters, etc. need to go to great lengths to “cheat” at blackjack. In general nobody is better at defending their own interests in this or any other casino game than the house is.
Also worth noting, the house itself is subject to (obviously necessary) regulation.
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“We’ve had control fraud for a long long time, but now we have an added tool in the arsenal in the form of mathematics (and complexity).”
And also now, we have the added counter-fraud tool of Antifragility ala’ Nassim Taleb of Black Swan prescience. His new math will probably not be taken seriously until after the next bubble-blackbird of disaster dumps on the world economy (if quants and the risk industry even exist then).
As prescient as Antifragility mathematics is, I speculate that it will not be in a fully developed, practically applicable form until it is connected to the concepts of (topological) Structural Stability, which alone considers parametric variation, not just that of dependent variables in complex dynamical systems.
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