Deserted by Regulators

The FBI -- deserted by the banking regulators and undercut by the Justice Department -- was so desperate that it formed a partnership with the Mortgage Bankers Association in 2007. The trade association had created an absurd definition of mortgage fraud under which accounting frauds by a lender were impossible and bankers were the victims. By 2009 the financial crisis had become so acute that Treasury Secretary Timothy Geithner discouraged criminal investigations of the large nonprime lenders.

Nobel laureate George Akerlof and Paul Romer wrote a classic article in 1993. The title captured their findings: "Looting: the Economic Underworld of Bankruptcy for Profit." Akerlof and Romer explained how bank CEOs can use accounting fraud to create a "sure thing" in the form of record short- term income, generated by making low-quality loans at a premium yield while making only minimal reserve allowances for losses. While it lasts, this fictional income allows the chief executive officer to loot the bank, which then fails, and walk away wealthy.

Wealth Destruction

In criminology, we call these accounting-control frauds and we know that they destroy wealth at a prodigious rate. There's no "if" about the losses -- the only questions are when they will hit, how big they will be, and who will bear them. The record income produced explains why those involved get away with it for years. Private markets don't discipline firms reporting record profits. They compete to fund them. Fraudulent CEOs can control the hiring and firing and can create the perverse incentives that produce a dynamic in which bad ethics drive good ethics out of the marketplace.

Sophisticated accounting-control frauds not only sucked in employees who should have known better, but also loan brokers. The result is that the large fraudulent lenders -- those making a lot from liar's loans -- produced an echo epidemic of deception.
Fraud, it turns out, begets fraud.

(William K. Black is an associate professor of economics and law at the University of Missouri-Kansas City and the author of "The Best Way to Rob a Bank Is to Own One." The opinions expressed are his own.)

David Fuller's view Nothing undermines ethical standards and an economy more quickly than when people at the top are allowed to game the system, and get away with it.