(By Joe Koletar and Jack Bigelow) (See previous two postings for additional information) Thus far in exploring the factors we believe to be behind the FBI’s downgrading of its mortgage fraud investigations, we’ve considered two factors:

• Concurrence with the priority-lowering decision by other affected government agencies;
• The dramatic emergence of counterterrorism as a top priority in the wake of 9/11.

The third factor is the fact that our Federal criminal justice structure for white collar crime is largely based on laws passed 80 years or so ago. Today’s reality is very different from the environment of the 1930s. New laws have certainly been added and better reflect the realities of the times, but the old laws are still on the books. They can still be quite effective, but their language is dated. Therein lies a problem.

When the old laws were written, five thousand dollars was a lot of money. For Federal involvement to occur, the loss had to meet or exceed five thousand dollars as a threshold for Federal action. Five thousand dollars doesn’t mean much these days.

At the same time, the structure for enforcing the laws has remained stable. There are 94 Federal Judicial Districts in the United States, each with its own Chief Judge, lesser judges, and a United States Attorney (USA). The USA is the lead prosecutor for Federal crimes committed in that district (including mortgage fraud). The USA is assisted by the Assistant United States Attorneys (AUSAs). These are civil servants employed by the Department of Justice (DOJ). Many don’t serve full careers, but are permanent employees as long as they hold their positions. The USAs are not elected: they are highly competent attorneys appointed by the President, normally based on party affiliation. They serve at the pleasure of the President and can be removed at any time. Most are not removed, but many leave with a change in administration. This leads to at least a moderate level of turnover among the Federal prosecuting community. This is the structure for prosecuting all Federal crimes, including terrorism cases, cyber-crime, public corruption, counterintelligence cases, civil rights cases, organized crime, violent crimes, and, by the way, white collar crimes such as mortgage fraud. It is a structure without an infinite capacity to handle, say, every case of mortgage fraud involving five thousand dollars or more.

Which brings us to a fourth possible cause of the FBI’s reduction:

The five thousand dollar floor can generate a lot of potential cases. So many potential Federal crime cases come up that a USA’s office functions much like a hospital emergency room. Both can have more than they can handle at the moment, so they must set priorities (a kind of triage). In a USA’s office, this is called an “in-take” function. As with the emergency room, there’s a need to decide what is most important. This doesn’t mean any given issue is unimportant. It’s just the required resource allocation decision: With limited resources, where do we start?

Here’s how the USAs make that choice, given the 5G threshold from many of the old laws. USAs routinely establish or revise Prosecutive Guidelines (PGs). These are policy statements of priorities for a USA’s office at a given time for allocating the office’s resources (people and budget). With 94 Judicial Districts doing this, the PGs can vary widely, often based on population density of the area. The PGs for the Southern District of New York (Manhattan) may set a threshold limit of five million dollars when a USA in a less-populated region may set a threshold of 500 thousand dollars. This spectrum of varied Prosecutive Guidelines provides for equitability in the allocation of resources per capita, but it certainly makes the even application of justice across the country problematic. Or to put it more bluntly in the context of this post: Why should the FBI investigate large numbers of cases that are not likely to be prosecuted? Equally problematic is the fact that many of the cases of mortgage fraud are decentralized, scattered, and therefore difficult to target under the PGs required by resource limitations.

(By Joe Koletar and Jack Bigelow) (See previous posting for background information) In Post 1 of this series, we noted that one factor involved in the FBI’s decision to reduce its investigative activity into mortgage fraud is that “The FBI does not act on its own….Other entities and institutions [must concur in its priorities]”. The purpose of this post is to explore the reasons for why this reality plays a role in the downgrading of mortgage fraud investigations.

We get the first hint at why the FBI has downgraded its attention to mortgage fraud by viewing its web site’s mission statement:

The mission of the FBI is to protect and defend the United States against terrorist and foreign intelligence threats, to uphold and enforce the criminal laws of the United States, and to provide leadership and criminal justice services to federal, state, municipal, and international agencies and partners.

Mortgage fraud appears to come across as a minor irritant when it is competing against “terrorist and foreign intelligence threats.”

The web site goes on to describe the various areas of FBI investigations (listed in this order):

• Terrorism
• Counterintelligence
• Cybercrime
• Public Corruption
• Civil Rights
• Organized Crime
• White Collar Crime (note that this is second from the bottom of the list)
• Violent Crimes and Major Thefts

Now, imagine that you are the FBI leadership and you are directly accountable to the citizens of the United States, represented by Members of Congress and, in the Executive Branch, the President of the United States and the reporting lines below that office. Every choice you make concerning what to investigate and what not to investigate is subject to questioning by those to whom you are accountable. You can be summoned before Congressional Hearings, you can either visibly support the administration in your decisions or you can bring shame to it. Your job, your career and your reputation are at stake. And beyond that—-The Bureau’s image and ability to secure funding for its operations are at risk also.

Given the stakes and given a very finite operating budget ($8.3 Billion), would you make the priority-setting in a vacuum of input, agreement, and consensus from the different areas of government affected by that priority-setting?

Our point is that the FBI’s action to reduce its focus on mortgage fraud is supported by other departments and agencies in the Federal Government—agencies with priorities that could conflict with the mortgage fraud issues.

A lot of those priorities changed on September 11, 2001.

The impact of 9/11 on the Federal Government’s priorities was immense. Clearly a terrorist attack, the impact was felt most profoundly among the nation’s law enforcement and counterterrorism structures. Americans were dramatically awakened from a somewhat smug sense of security by the signal that there are actually brilliant people out there who would kill themselves to kill us! A new and scary clarity emerged. Not only had our national security been compromised, it had been violated in a tragic and public action fraught with outrageous dismissal of the values of what we believed to be civil existence in the international arena.

From the wreckages of The Pentagon, the World Trade Center, and the downed airliner in Pennsylvania arose a new determination and a redoubling of effort to investigate, prosecute, and prevent further acts of terrorism in the United States and in other nations too. The Federal Government, on behalf of its citizenry constituency, jumped into action.

Thus the second reason for relegating mortgage fraud to a lower priority:

The events of 9/11 changed everything. Not only our personal lives, but the priorities of the military and any number of law enforcement, intelligence, and other national securities agencies. Congress provided some budget assistance in reaction to this attack, but other programs were, of necessity, reevaluated and adjusted in the scale of post-attack priorities.

Guess what one of the “other programs” was: FBI investigations of reported incidences of mortgage fraud.

In this posting, we are not questioning the reevaluations and adjustments. We are duly noting that they occurred and are suggesting that this is likely to be a second factor in the reduction of investigatory focus on mortgage fraud. This is a case study in the political “ripple effect” of how a searing national event can have a substantial effect far and wide on government operations of all kinds. Including the investigation of mortgage frauds.

I

(By Joe Koletar and Jack Bigelow) The Federal Bureau of Investigation is easing its investigation of mortgage fraud. This is a topic receiving national attention after the recent release of a report by the Justice Department’s Inspector General. The Report covers the period of 2009-2011 and indicates the FBI has downgraded mortgage fraud as an investigative priority.
Mortgage fraud is a very serious problem, easily totaling billions of dollars a year. And it wasn’t all that long ago that it was seen as one upstream factor contributing to the financial crisis that brought the United States to near financial collapse. (Bad mortgages were bundled into what turned out to be bad securities that were “insured” but not underwritten.) So the obvious question is, “Why would the FBI do such a thing in light of the seriousness of the problem?”
“Mortgage fraud” describes a bad brew of fraudulent activities associated with mortgage sales, processing, and closings. Typical examples:
• The deliberate over-valuation of the properties in appraisals;
• Attorneys winking at unfair, unethical, and even unlawful transaction provisions;
• Misrepresentation of applicant information regarding loan servicing capabilities;
• Brokers’ fee-fishing by submitting applications from financially unfit buyers;
• Kickbacks to lawyers who proceed with deals appearing to be bogus from the outset.

The impact of these activities is not just financial. They are crimes violating state and federal laws enacted to protect an unsuspecting public—a public that was clearly unprotected. Who knows what the ultimate cost to that public, our economy, and our financial structures was, is, and will be? Those costs, as we mention above, run into the billions.

The FBI’s decision is therefore puzzling and requires analysis. We’ve identified at least five factors that we believe came into play in the choice to turn down the heat.

1. The FBI does not act on its own. No Federal agency does. Other governmental entities and institutions are entwined in the FBI’s decisions, recommendations, and policies. After all, it is a federal investigating agency and so its scope is broad. Most FBI priority decisions—to be effective—require concurrence by other agencies affected by those priorities.

2. The events of 9/11 changed everything. Not only our personal lives, but the priorities of the military and any number of law enforcement, intelligence, and other national securities agencies. Congress provided some budget assistance in reaction to this attack, but other programs were, of necessity, reevaluated and adjusted in the scale of post-attack priorities.

3. The language and structure of our criminal justice system at the Federal level is based on laws passed in the 1930s, and the FBI is dealing with a very different reality today.
4. The volume of mortgage fraud cases that meet the legal dollar threshold justifying investigation (based on the 1930’s laws) could overwhelm the resources of the FBI, a fact that demands some degree of priority-setting.
5. Mortgage fraud is a diffused problem. This diffusion complicates the priority setting because it consists of many, many, instances of fraud committed in many, many, different transactions. Were the perpetrators united in easily-targetable organizations, the investigations would be more easily assigned, conducted, and prosecuted with resources justifiably budgeted for greater impact. And yet the aggregate impact of all these diffuse fraudulent activities is immense.

Mortgage fraud is a wide-spread problem of significant financial impact and the FBI is apparently saying, “We have bigger fish to fry.” (Implied here is that “the bigger fish are easier to catch with the size of netting we are budgeted to use”.) But it is a type of white-collar crime. Our book, written with Sridhar Ramamoorti, A.B.C.’s of Behavioral Forensics (Wiley, 2013) focuses on corporate fraud, but we see mortgage fraud as driven by some of the same psychological factors described in A.B.C.s of Behavioral Forensics, and for that reason, in following posts, we will consider the FBI’s decision-making factors listed above in light of the realities of mortgage fraud.

(wIth Daven Morrison, Joe Koletar, and Jack Bigelow) So wrote the finance chief at Dewey & LeBoeuf LLP to the Chief Operating Officer at the prestigious law firm in New York in 2008, according to an SEC complaint and 106-count indictment mentioned in the Wall Street Journal account of the indictment of the fallen firm’s leaders. It’s what fraud investigators often call the “smoking email.” And it points to a scandal now rocking the legal profession—a scandal amplified by the pristine reputation of a law practice going back to a New York governor, two-time presidential candidate, and more than a century of practicing law.
The article traces the impetus for fraudulent accounting when the firm’s leaders discovered they were about to violate the terms of a bank loan requiring certain cash flow levels. The indictment states that in 2008, the firm was $50 million short of the required cash level. From then on, the firm “lived at the edge of disaster for years, resorting to increasingly desperate measures to keep existing creditors happy and entice others to give fresh injections of capital.” One cited instance describes how the firm classified as a client payment what was really a partner’s $1,080,000 check to cover his equity stake, to inflate the firm’s reported income. Alleged tactics include:
• Inflating 2008 profits by $36 million with this and other improper accounting entries;
• Recording simple reimbursements from clients as income;
• Understating expenses;
• Asking clients to backdate checks in payment;
• Characterizing millions of dollars in credit card debt as disbursements owed by clients.
SEC Enforcement Director Andrew Ceresney described these moves as “pulling dollars out of thin air” to keep from violating the loan agreement with a consortium of banks.
Our book, A.B.C.’s of Behavioral Forensics (Wiley, 2013) examines the psychological drivers of behavior at the C-Level suite that encourage highly-positioned executives such as those just indicted to put their firms in such extreme jeopardy. These drivers are both motivational for planning and implementing such accounting shenanigans and rationalizing to allow themselves to keep doing it, with the consequent, inevitable erosion of moral beliefs and values. The Wall Street Journal article dismisses “greed” as a driver: “The fraud didn’t appear to have grown out of individual greed, but was perpetrated by people ‘who succumbed to the pressure of running a large law firm,’ according to a person briefed on the probe.” This assessment is not inconsistent with the major theme in A.B.C.’s of Behavioral Forensics that very often greed is not the key motivator, and provides precious little in terms of insight into the fraud perpetrators’ underlying motivation. Instead, other factors are at play.
The fraud-initiating and sustaining factors discussed in our book may be related to what happened at Dewey & LeBoeuf. The many examples of fraud listed underscore a group dynamic consistent with the irreversibly shifted moral compass of a street gang: all options are open to keep threats to the organization at bay (“whatever it takes,” or, “the end justifies the means”). This is just one of several motivations highlighted in our book as we explore causes of fraud beyond greed. In this case, when the Dewey & LeBoeuf partners apparently decided to circumvent the accounting rules, they must have also resorted to rationalizations around several other thoughts, such as:
• The Short-term Fix: “Is this a game we can use for escape, short-term, and then back out of it?”
• Continuity and Survival: “Is doing this a service to our clients, allowing us to continue serving them?”
• The Noble Cause Argument: “Might this be a noble cause to preserve our organization?”
“Noble cause” is a rationalization based on the belief that because one’s goal is a very worthy one, some cheating is justified because of that larger agenda. The Dirty Harry movies portray noble cause thinking. In the academic world, teachers might self-justify cheating on standardized tests so that “the kids will have a chance for a better life.” But in the business world, “noble cause” quickly degenerates into ignoble cause—plain old corruption. The top brass may have thought they were fudging just a bit to save the firm to protect the livelihoods of employees and to protect the services valued by their clients. As time went on, more and more fudging was required until they crossed the point of no return and it all collapsed under its own weight. This scenario parallels the anecdote recounting that a frog placed in boiling water will immediately jump out, but if it’s placed in cold water that is slowly heated, it won’t perceive the danger and will be “cooked to death.” Prosecutors will most likely focus on the noble cause reasoning from the viewpoint that the book-cooking allowed them to keep their own jobs, salaries, and bonuses. And it did. Psychologically, noble cause is seductive in convincing fraudsters that their illegal actions are really acts of heroism. It’s a mental trick that translates these actions into something akin to being a modern day Robin Hood, stealing from the rich to give to the poor or the moral ambivalence of robbing Peter to pay Paul. Or considering their actions to be heroic vengeance against large, faceless organizations that they believe are harming people (a conveniently twisted David vs. Goliath interpretation).
But organizations can feel under assault as well, and law firms have definitely been under fire. They are under extreme financial pressure as internet resources become more available to clients, freeing them from seeing the need for expensive attorney consultations. The web also communicates more options from competing firms and suggestions for strategies to reduce legal fees. Established partners who “grew up” with one business model (investing selves in its values and standards) become entangled with newer partners sensitive to the new reality of shrinking revenues (offering conflicting values and standards). In this new reality, what we observe is a game of chicken and the leaders are left waiting to see who will blink first. In some ways, this mirrors the factor outlined in A.B.C.’s of Behavioral Forensics that’s related to the challenge of late adulthood: “I’ve come too far not to get mine.”
Finally, there’s the challenge of the organization’s leadership being competent with emotions and the guidance that this competence provides for navigating the inevitable ethical questions. Organizations find themselves in significant and potentially self-destructive binds when they cannot openly admit to themselves and others the setbacks that always occur. They work harder to save face when they are incapable of experiencing the embarrassment of reality, convincing themselves that no morals and values have been sacrificed. In their closed-system logic, the temptation to commit fraud becomes self-reinforcing and inexorable. And consider the ultimate cost—financial and otherwise—to this once-storied law firm: a cost far greater than the short-term impact of some minor public embarrassment. Incompetence in managing shame can thus lead to fraud perpetration. The case of Dewey & LeBoeuf illustrates this cause-effect link powerfully.

Fish Always Rots from the Head Down (With Daven Morrison and Jack Bigelow) In recent months, the U.S. military has been beset by a proliferation of fraud scandals. At first glance, some of the offenses may not seem like “fraud”.

• In the past seven years, the Navy uncovered at least five cases of cheating on exams and tests qualifying members for new or additional responsibilities (leading to more privileges and greater pay).
• In January, 92 Air Force Nuclear Missile officers were implicated in alleged cheating in a key proficiency exam.

Other cases are more obviously fraudulent:

• In the Army, a recruiting program for the National Guard involving bonuses for soldiers influencing friends to join up was found to have been rife with fraudulent, phony recruitments. An Army audit found that 1,200 recruiters received payments potentially fraudulent, according to USA Today. Another 2,000 recruiting assistants received “questionable” payments and more than 200 officers are still under investigation.

Many of these cases remain under investigation and hence, few details have been published. So all we can do at this point is to offer educated opinions as to what seems to be in play in these cases. We do so looking through the lens proposed in our book, The A.B.C.’s of Behavioral Forensics (Wiley, 2013). In the book, we point out that every incident of fraud results from the well-known fraud triangle—a time-tested explanatory model that posits, a la the fire triangle (oxygen, heat and fuel), that for a fraud to occur three elements must be present – means (access to funds,) perceived need (I need or deserve the money,”) and rationalization (It’s OK, because….)”

Here, the factor of Opportunity is quite obvious. Where there’s smoke there’s fire, and where egregious scandals pointing to a cheating culture have emerged, there must have been ample opportunity. We can be sure that investigators are attempting to determine why the controls over these opportunities were either absent or ineffective. As Senator Claire McCaskill (D-MO) said in scheduling hearings on the National Guard incident, “Frankly, a halfway sophisticated high school student could have seen the ability to commit fraud here.” Then why was the program so poorly designed and structured without adequate controls? The Incentive existed to commit fraud in these cases. Clearly, the factors at play here must go far beyond the standard explanation of “greed,”—but what were they? Absent the opportunity to interview the accused, all we can do is opine. Some thoughts:

Our military services are large groups with distinct cultures—collections of people with shared values, shared beliefs and understandings, and shared group identities.

Many service members find that when they join these “groups,” they must decide whether to go along with group behaviors with which they may potentially be in conflict. You conform to group-sanctioned behaviors or you quit. If you choose to resist, you may have to suffer the consequences of censure (a shame-inducing outcome) or worse, exclusion and ostracism. Leaving can be a challenge under a typical military service contract that requires dedication and commitment for a number of years. And then would come the need to find a job in the civilian world.

The temptation (the “pressure” in the fraud triangle) then is to participate in the behavior minimally until departure is more of an option. It is the “path of least resistance” and shows how “the road to hell is paved with good intentions.” Over time, the participation becomes easier (see rationalization comments below) and more rewarding. Now, the individual is “addicted,” having reached the point where there is no desire to leave. Law enforcement professionals refer to the process of adopting the path of least resistance as the “slippery slope.”

Implied in the slippery slope is the very human coping mechanism of Rationalization, the psychological mechanisms that grease the slope of egregious human behaviors. A “psychological” autopsy of the fraud including targeted interviewing of those who participated would be helpful in identifying the forces of rationalization in these cases, but here are some additional rationalizations based on psychologist Michael J. Apter’s new model of motivation “Reversal Theory” from our text:

• “Everybody gets ahead here by getting a little ‘help’ with their exams; I wanna be part of the gang (benefit others and belong).”
• “I am in service to my country and so I can take all the breaks I can get (serving others).”
• “Our pay is too damn low; our command officers expect us to scratch in any way possible to improve it (mastery of a challenge).”
• “Once I get qualified (or requalified), I am able to prove my ability. This is just a little roadblock that I need to get over (rebel against rules).”
• “People around here are too damn uptight about the rules and restrictions; the real way to get ahead is to find ways around them and it’s a fun game (play).”

At this point, the question arises as to how the “Tone from the Top” plays into this behavioral pathology. Especially top-down communications regarding expectations (Incentive) and permissiveness (Rationalization). We can see where an “up or out” career path in the military provides vibrant incentive to cheat, enabling the “up” and avoiding the “out.” Countering this pressure is the military’s emphasis on conducting oneself with honor. The result? Value conflict for the service member, a conflict that is somewhat eased when highly esteemed leaders stray from model behaviors and allow the promotion of less meritorious officers (commissioned and noncommissioned), or wink at less-than-honorable behaviors—in effect condoning them. Perhaps they have become enamored of their power and the attention – like Petraus and his biography writing mistress, or they have created a dynamic of a charismatic leader and unquestioning followers.

What are the risks associated with these scandals? In the context of the military, there is a very real possibility that the proficiency exam cheating could put the public at risk (and at the very least, colleague service members too). The Navy scandals came out of the Navy’s Nuclear Propulsion Program; and the Air Force incidents involved nuclear missile officers! That is what we would call world class risk! The risks involved in the National Guard recruiting case are more heavily weighted to the financial: In all the National Guard paid more than $300 million for more than 130,000 enlistments. Over 100,000 people received bonuses. And according to the USA Today report, those being investigated range from enlisted soldiers to two general officers, including a major general. A less obvious but more damaging risk is the assumption now reinforced in the broader culture among those in the ranks that cheating and “beating the system” is “the way things get done.” We have come full circle in our speculations about the origins and evolution of a “cheating culture” in the U.S. armed forces. What do you think?

(With Daven Morrison and Jack Bigelow)

Mathew Martoma (nee Ajay Mathew Thomas) has been convicted by a federal jury of insider trading and as of this writing awaits sentencing. Mr. Martoma was found guilty of recommending that SAC Capital Advisors, his employer, sell its shares in two companies after receiving a confidential report discussing problems with the clinical trial of an experimental Alzheimer’s drug. According to a New York Times article, the report came from a key cooperating witness in the case, Dr. Sidney Gilman, an 81-year old researcher affiliated with the University of Michigan. A separate report indicates that the year of these SAC trades, Mr. Martoma received a bonus of $9.3 million.

The Times article reported that Mr. Martoma had cheated 15 years earlier by falsifying his grades at Harvard Law School, using a computer program to change several grades from B’s to A’s. This forged transcript went to 23 judges as part of the application process for a summer job.

The report adds that during a Harvard disciplinary hearing, Mr. Martoma tried to cover his tracks with a fake paper trail of fabricated emails and a counterfeit report from a bogus computer forensics firm he created. He was expelled from Harvard and then changed his name.

A separate article quotes the Harvard administrative report at the time as including this comment: “The Board notes that Mr. Thomas was apparently under extreme parental pressure to excel academically.” According to the Times article, seven additional SAC employees were also criminally charged with insider trading.

Our book, The A.B.C.’s of Behavioral Forensics (Wiley, 2013) examines the behavioral pathology and indicators of cases such as Martoma’s. Specifically, Forbes.com blogger, Walt Pavlo’s blogpost on Mr. Martoma’s emotional state when he was first arrested appears on pp. 239-241. (1) This is an egregious case illustrating disregard for the law to the detriment of others. It oversimplifies to blame his behavior on greed: our book suggests that fraudulent actions are driven by a far more complex set of factors. Incidents of fraud result from at least three factors—opportunity (Martoma received the confidential information and could do something with it), pressure or incentive (it seems that at least a part of his incentive is to be successful in his parents’ eyes; another part may well be the highly affluent and permissive culture in which he worked), and rationalization (justifying his actions to fit his values—we don’t know what the rationalization was, but we can be certain that it was there). In addition to these fraud triangle factors, the element of “capability” that is postulated in the fraud diamond characterization of the antecedents of fraud is clearly demonstrated here. Martoma, by wilfully engaging in such illegal behaviors, provides further evidence for “crime-as-choice” theory.

Martoma’s behavior is consistent with what is known about other bad actors such as the convicted Raj Rajratnam of Galleon Funds, and many others engaging in insider trading. It conforms to the psychopathic continuum (2),  a concept highlighted in The A.B.C.’s of Behavioral Forensics. It also displays, in a long view of his biography tracing back to Harvard, a painful story of a young man trying to be the ideal child his parents wanted him to be: from poignancy, to tragedy, to conviction. This is the steep price paid by an individual committing fraud. At a community level, the price of fraud to our society is immense: among other things, it further erodes trust and integrity in the capital markets. If our equity market place were not an arena requiring trust, then it would not matter. But it does, and the consequences are both tragic and devastating.

1. See Appendix B, “Supplement to Chapter 8: On the Psychology of an Unindicted Co‐conspirator Sought by Government as a Cooperating Witness.” (pp. 239-41). Ramamoorti, S., Morrison, D.E., Koletar, J.W. & Pope, K.R. ,A.B.C.’s of Behavioral Forensics: Applying Psychology to Financial Fraud Prevention and Detection. Hoboken, NJ; John Wiley & Sons, 2013.
2. See A.B.C.’s of Behavioral Forensics (Wiley) pp. 114-116