Introducing Bank Fraud 101

Charles J. Antonucci Sr., the former president and chief executive of the Park Avenue Bank of New York, made a desperate move to try to save his bank with the infusion of TARP funds. TARP refers to the government program to provide up to $780 billion in loans and capital purchases to shore up failing banks. Antonucci's only problem: He committed fraud in the attempt.

The fraud was committed to mislead regulators into supplying $11 million from TARP. There are also a number of other charges.

What happened is described in a Wall Street Journal article by Lingling Wei and Chad Bray. Here is an excerpt:

"The bank was broken, so, in October and November 2008, [Mr.] Antonucci methodically went about pretending to fix it," said Preet Bharara, the U.S. attorney in Manhattan, at a press conference.

Prosecutors charged Mr. Antonucci with 10 counts of fraud, bribery and other crimes, including accepting free plane rides from a bank customer and stealing $103,000 from pastors of a church in Coral Springs, Fla. He could face up to 30 years in prison for each fraud and embezzlement charge.

Park Avenue Bank was recently taken over by the FDIC (Federal Deposit Insurance Corporation).

The Major Part of the Fraud

According to the WSJ article, the major dollar amount involved was a result of the following sequence of transactions:

Antonucci arranged for loans to be made by the bank to entities he controlled. The amounts of these loans have not been made public, but presumably were in excess of $6.5 million.

Antonucci then provided $6.5 million "of his own money" to shore up the capital deposited at the bank. The money was in the form of a deposit in his own name.

How this can be used to fraudulently inflate bank assets can be seen in the following simplified hypothetical example.

Simplified Hypothetical Case Study

Bank X has $1 million in deposits. From these it loans $9 million, keeping the required 1/9 reserve. If $500,000 of the loans default, the loan assets and net deposit assets are both reduced by that amount.

The bank's books now show $0.5 million in net deposits ($1 million gross deposits less $0.5 million default impairment) and $8.5 million in working assets. The reserve is now 1/19 and capital must be added to get back to 1/9.

One way this can be done is to sell enough performing assets to get back to the required reserve ratio. If $400,000 in loans can be sold at par, then loan assets will be reduced to $8.1 million ($9 million - $0.5 million default - $0.4 million increase in deposits from the asset sale). The net deposits are increased by the sale proceeds to $900,000. The 1/9 capital reserve ratio is reestablished.

However, if the remaining assets of the bank are considered to be impaired by the market, it may not be possible to ever sell enough assets to recover the required reserve and cover the $1 million in deposit liabilities.

Here is one example: If the remaining loan portfolio can be sold at $0.50 on the dollar, the 1/9 ratio is recovered by selling $4.5 million (par value) for $2.25 million. This produces a $2.25 million write-off and $2.25 million in new deposits, which exactly cancel yielding an end position of $4.5 million in assets and $0.5 million in net deposits. Bank X must still raise $0.5 million to cover deposit liabilities.

If any of the remaining $4.5 million in loan assets can not be valued at par, that creates another debit to net deposits which must be offset with more sales. This is a death spiral because the bank can not remain viable if the end position can end up with the $1 million in original deposits not being covered.

Introducing Bank Fraud 101

So how can Bank X use Bank Fraud 101 to resolve the problem with regulatory requirements? Very simple. The CEO arranges for a loan for $1 million loan to a shell company he sets up and owns. The shell company then loans the money to the an international (preferably third world) intermediary (blindly controlled by the bank CEO) which then makes a personal loan back to the CEO. The CEO now makes a personal deposit of $560,000 in an account at Bank X.

The bank now has $1,060,000 in net deposits with a loan portfolio of $9.5 million, exactly a 1/9 reserve ratio. And the CEO still has $440,000 of the bank's money for use elsewhere. What in fact has happened is that the bank's own credit, leveraged at 9/1, has been converted to a deposit asset.

The entire masquerade can be unwound in the future when the bank has restored its books and can withstand a default on $1 million, which would be triggered by a default by the third world entity producing a default by the shell company.

Or the masquerade can be ended when Bank X still goes belly up and regulators start following the money trail.

For Further Study

Another section of Bank Fraud 101 could use as text an article by Karl Denninger at The Market Ticker that discusses the bank fraud at Lehman Brothers.

Prof. William K. Black (University of Missouri - Kansas City), who was a senior regulator in the RTC (Resolution Trust Corporation) that conducted the work-out of the Savings and Loan Crisis, 1989-1996, wrote a book entitled "The Best Way to Rob a Bank is to Own One". That is the book for the more of Fraud 101, as well as 102 and upper class courses.

Note 1: The hypothetical case study here is much oversimplified. It is intended as a tutorial aid and not as a technically correct description in all details. It is a rough sketch and not a fine oil painting.

Note 2: Be careful if you want to be a whistle blower on fraud. Another Wall Street Journal article describes how a Lehman employee who raised questions about the fraud was fired.

Note 3: According to an article in the New York Times by Andrew Ross Sorkin:

"I’m concerned that the revelations about Lehman Brothers are just the tip of the iceberg,” Senator Ted Kaufman wrote in a speech he was preparing to give Tuesday on the Senate floor. “We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel.”

Note 4: According to the Sorkin article in note 3, the Lehman fraud was conducted with full knowledge and disclosure to regulators, who did not recognize that it was improper.

Note 5: All indications are that Bank Fraud 101 is merely a prerequisite to the more substantial courses coming, and will soon lead to graduate level study.

Disclosure: No stocks mentioned.