This is crossposted from mathbabe.org. The opinions expressed are those of Cathy O’Neil.

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 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?