The Bust-Out

At least two key differences with the current outlook emerge when you look at fraud in this way. The first is that while legitimate companies try to grow for as long as they can, frauds are not structured with the long-term in mind. They are built to fail—they tend to happen, as Black explains, at companies where the “wealth optimizing strategy” for those at the top is to loot the firm.

The people who run such companies know that they will eventually blow up. Their object is to get out with what they can before that happens. Decisions—like those of subprime lenders who handed out hundreds of billions in bad loans—that to neoclassical economists look merely misguided may actually be evidence that the folks who run it are getting ready to burn down the store.

The second difference that emerges in this view of fraud is that you just can't look at frauds in isolation. An economist looking at a bust-out scratches his head wondering why a loan shark would cut off his own best source of revenue or a bar owner would burn down his own business. But in real life there are lots of others involved—from liquor distributors to mob bosses to crooked insurance investigators—and lots of ways of hiding the profits.

If you need to see this to get how the bust-out works, it goes double for complicated financial frauds. You have to pay attention to who is really calling the shots and where the money lies. You can't look at the profits (or losses) of a subprime lender without also looking at the fees taken in by the investment banks that packaged the loans into bonds. You can't look at what happened. You can't look at a lender without also looking at the incentives paid to brokers to peddle junk mortgages.

Legitimate companies make profits and pay them out to shareholders or plow them back into the business. Frauds create huge losses for the public and hidden profits that are hard to find. And some of the biggest are designed for the chief executives to loot the company while being able to claim that he didn't know what was going on and take shelter under the claim that he just couldn't predict where the market would go. “You don't need to send out a memo telling your employees to make fraudulent deals,” says Black, who wrote a book called The Best Way To Rob a Bank Is To Own One. “You can send the same message through your compensation system.”

None of this means that the entire financial crisis can be chalked down to fraud—though Black believes that much of it can. I've written before about how what happened on and off Wall Street with the mortgage crisis was linked to a national delusion in which both ordinary people and those who should have known a lot better imagined that real-estate prices could keep going up forever. Yet as charitable as one might want to be, there is still the issue of that extraordinary statistic about the number of successful prosecutions in this crisis, that big fat zero.

To believe that none of the mortgage crisis was the result of fraud is just as mistaken as to believe that all of it was. And maybe more pernicious, because the lesson is that if a fraud is big enough, it will be ignored. The outlook for that changing soon is not promising. In the case, for instance, of Angelo Mozilo, the chief executive of Countrywide, once the country's biggest mortgage lender, and arguably the man who most defined the mortgage meltdown, the government is pursuing civil, not criminal, penalties. The rest of the world has figured out that the markets are not very good at self-policing.

The economists haven't caught up yet. Nor have the regulators and enforcement agencies. As Black pointed out to me, recently the FBI announced a new and unlikely partner in its efforts to fight mortgage fraud. It is the Mortgage Banker's Association, the trade group for the very industry that set the financial crisis in motion.

Mark Gimein is a columnist for The Big Money. E-mail him here, read his blog and  click here to follow him on Twitter.