The Economics of Everyday Things - 60. Money Laundering

Episode Date: August 19, 2024

How do criminals turn their ill-gotten gains into taxable income? And how does law enforcement stop them? Zachary Crockett follows the money. SOURCES:Patrick McKenzie, fraud prevention expert and strategic advisor at Stripe.Kerry Myers, associate professor of instruction at the University of South Florida and former F.B.I. special agent. RESOURCES:"National Assessments of Money Laundering Risks: Stumbling at the Start," by Joras Ferwerda and Peter Reuter (Risk Analysis, 2024)."Hacker 'Washes' $25M in Stolen Crypto Through Magic: The Gathering Card Scheme," by Oliver Dale (Blockonomi, 2023)."Money Spending or Money Laundering: The Fine Line between Legal and Illegal Financial Transactions," by Matthew R. Auten (Pace Law Review, 2013)."HSBC to Pay $1.9bn in US Money Laundering Penalties" (BBC News, 2012)."How a Big US Bank Laundered Billions From Mexico's Murderous Drug Gangs," by Ed Vulliamy (The Guardian, 2011). EXTRAS:"Why Does One Tiny State Set the Rules for Everyone?" by Freakonomics Radio (2023)."Kafkaesque," S3.E9 of Breaking Bad (2010).

Look, hey, this is a squeaky clean, highly profitable, at least potentially local institution. This is a scene from season three of Breaking Bad. Saul Goodman, a crooked lawyer, is meeting up with his drug dealer client, Jesse Pinkman, and he's trying to explain why a criminal should own a nail salon. I take your dirty money and I slip it into the salons nice clean cash flow. The revenues from the salon go to the owner. That's you. Your filthy drug money has been transformed into nice clean taxable income brought to you by a savvy investment in a thriving business. So you want me to buy this place so I can pay taxes?

This is a classic form of money laundering. And schemes like this aren't just Hollywood fiction. The United Nations Office of Drugs and Crime estimates that laundered money makes up 2 to 5 percent of the global GDP. That's trillions of US dollars every year. But as we've moved toward a cashless economy, today's criminals are ditching the nail salons and finding new ways to hide their money. I really wish money laundering was as easy as it appears to be on Breaking Bad. It's really much more complicated than that.

For the Freakonomics Radio Network, this is the economics of everyday things. I'm Zachary Kroket. Today, money laundering. In the simplest terms, money laundering is the act of moving money to obscure the proceeds of a crime. You take the dirty money earned through criminal activity and turn it into clean money that has a seemingly legitimate origin. Like anything to do with criminal activity, it can be tough to find people who

can talk about the details. Almost all the experts in money laundering are located in one of two places. They are either currently employed by the government doing money laundering investigations, or they're in prison. That's Kerry Myers. He's an associate professor at the University of South Florida, and he's one of the few exceptions to that rule. I teach a class called Forensic Accounting for the master's students who are working on their accounting degree. And forensic accounting is just a big fancy way of saying financial investigation, white collar crime, fraud, and money laundering.

Jared Suellentrop Before he taught money laundering, Myers was fighting it. He spent 25 years as a special agent with the FBI. I worked drug cases. I worked white collar crime cases, fraud cases, domestic terrorism cases, international terrorism cases. I worked armored car robberies, bank robberies, kidnappings. In the process of all that, I worked a number of money laundering investigations. Every time a crime occurs, if that crime has produced criminal proceeds, there's a 95% chance you also have a money laundering charge on top of the underlying crime. Now, let's say you're a criminal who sells drugs for physical cash.

You've got a suitcase under your bed with $100,000 in it. You can probably go undetected when buying smaller things with it locally, like gas, groceries, or clothes. But if you want to make a large purchase, say a house or your kid's private school tuition, you generally can't hand over a suitcase full of crumpled bills. You need to get that money into a bank account that's part of the legitimate financial system. The problem is, banks are heavily regulated and have compliance departments that screen for suspicious deposits. So, you have to make your money look legit.

Almost every money laundering technique is a thing that people do in the legitimate economy for legitimate reasons. And the only thing that distinguishes money laundering from those legitimate uses is it has an ultimately illegitimate purpose in the eyes of society. That's Patrick McKenzie. He's a fraud prevention expert who has worked in the payment processing industry. He says money laundering has three basic stages, starting with placement. In placement, we start with money, typically physical cash, that is connected directly to a crime. And we need to move that into the regulated

financial industry in some fashion. Then the money has to be layered. In layering, we move the money around in fashions which are complicated and designed to make financial institutions and law enforcement ignorant as to the ultimate source of the money. And the final stage is integration. We take the money from the last place we have layered it to and use it to buy something of value in the real world such that it seems like your provenance of that thing is completely clean. This process can play out in all kinds of ways. One is to partner with a basically legitimate business with flexible morals.

A classic technique of money launderers is to approach businesses that are somewhere on that spectrum of gray and say, I have a bag of money and you will ask relatively few questions about it. Can I give you this bag of money in return for one, you saying it is your bag of money and two, me giving you some cut of it. You could also take the Breaking Bad approach and buy your own business to use as a front. Again, here's Kerry Myers. 30 years ago, if I wanted to be a money launderer, I'd buy me a bar and grill that sold beer

and hamburgers because it's basically mostly a cash business. Or I'd get me a taxi cab company or a vending machine company, which basically is dealing all in cash. If you go this route, the process is pretty straightforward. You run the bar and grill as a normal business while running your drug empire on the side. Every week, you bake some of that drug money into your books. And when you deposit your cash at the bank, you explain that it's revenue from burgers and cheap beer. But today, McKenzie says, the cash business strategy is losing steam. We're in a much less cash-based society in 2024 than we were in 2004 or 1984 or 1964. And so money launderers are less likely to start out with a bag of money that has been

exchanged piecemeal for drugs. They are more likely to start out with a bank transfer from a legitimate person that was received for fraudulent reasons. For modern-day money launderers, the art is in the layering and integration process. Some use their illicit funds to buy rental properties, which generate legitimate income. Real estate is heavily used by money launderers, not because there is something intrinsically hinky about real estate, but simply because there is a lot of money flowing around the real estate sector attached to systems which are not optimally designed to catch money laundering. And so a classic pattern is to transfer money to a lawyer who is working in a jurisdiction like London, New York, as an overseas client,

and to direct your lawyer to effect the purchase of property on your behalf. And then at the end of the day, the client ends up with an LLC that owns a building where that building has real tenants who are paying real, thoroughly clean money to their landlord for rent. Another strategy is something called trade-based money laundering. Criminals will disguise their illicit proceeds through the trade of a physical good, often across international borders. The thing that was always used in the James Bond films back in the day was like a bar of gold or diamonds.

But these are a bit difficult to transport for a variety of reasons. One is that they certainly look like you're trying to do something you saw in a James Bond film. Criminals have gotten craftier with the types of goods they use to launder money. A thing that doesn't look that hinky to customs officers is a Black Lotus from the Magic the Gathering card game. Maybe an Alpha Black Lotus, maybe a pristine Alpha Black Lotus. Maybe an Alpha Black Lotus, maybe a pristine Alpha Black Lotus. Magic the Gathering is a popular card game, and the Alpha version of the Black Lotus is the rarest and most valuable card.

A card in good condition can sell for hundreds of thousands or even millions of dollars. By weight, they are more valuable than diamonds. And so you'd buy your Alpha Black lotuses using tainted currency in China, ship them to the United States, and go to a broker in San Francisco or Seattle or any other place that rich geeks congregate and say, I collected cards when I was in middle school, and now I want to turn them into money. And they will say, absolutely.

Do you want cryptocurrency? Do you want a bank transfer? Let's go. And when your bank gets the transfer, well, that is a totally legal item and a legitimate use of the financial system. Or if I swap my magic cards for Bitcoin and then I send my Bitcoin to Coinbase and then I moved it out to another money in a shell corporation, yada, yada, yada, then the game of follow the money becomes exponentially harder for the good guys. Shell corporations are companies that exist only on paper with no active business or significant

assets. They're generally not illegal, and some have a legitimate purpose, but they're often used by money launderers to throw the authorities off their trail. Here's how Kerry Myers would do it. I would open up a Shell Corporation in Wyoming. Then I would open up a Shell Corporation in Panama. The sole asset would be 100% of the Wyoming corporation stock. I would then open up a Luxembourg corporation. and the stock would be 100% of Panama corporation. I would then open up a Cypriot corporation and 100% of the stock would be the Luxembourg corporation. And then I would have the corporation at the very end do the transaction. You with me? So along comes the investigator and I'm trying to figure out who actually did this

transaction. Well, I have to investigate in Europe and Panama trying to gather all of this information to find out who is at the end of this rainbow all around the world. So how exactly do people like Kerry Myers get to the end of that rainbow? That's coming up. The modern techniques of money laundering trace their roots to the prohibition era of the 1920s and 30s. Bootleggers were making huge sums of cash selling alcohol in the black market, and they started looking for ways to get it into the banking system.

One of the pioneers of this financial trickery was the gangster Al Capone, whose use of laundromats to wash funds might be the origin of the term money laundering. The feds didn't have enough evidence to convict Capone for the illegal sale of alcohol or the violence that he used to protect his franchise. Traditionally, some crimes, particularly white collar crimes, are just murderously difficult to prosecute. Again, that's Patrick McKenzie. The thing that we notoriously here in Chicago got Al Capone for wasn't for all the actual

crime crime, it was for the tax evasion, the paperwork crimes that were incident to the real crime. Laws aimed at money laundering weren't passed until decades later when drug crimes were becoming a serious issue. In 1970, the Bank Secrecy Act required financial institutions to file reports of large cash transactions. And in 1986, the Money Laundering Control Act officially made money laundering a federal crime. In the years since then, a number of other acts have tightened bank reporting policies and given federal and state authorities more power to take down criminal enterprises on financial grounds. Anti-money laundering regulations create a paperwork crime that's incident to the real

crime that is much easier to interdict than the real crime is. And investigators use that fact to interdict the real crime. Kerry Myers, the ex-FBI agent, says these laws allowed him and his colleagues to cut off the head of the snake. Think of a drug dealer. He buys drugs. He sells them. He takes the cash, he buys more drugs. We traditionally always criminalized the first act, the sale of the drugs. What money laundering

did is we now criminalize what you do with the proceeds from it, which is usually buy more drugs and keep the enterprise going. Not only can we put them in jail, but we can wipe out all their assets and we kill the enterprise by depriving it of its money. Now how exactly does someone like Myers catch a money launderer? Well, the initial signs often aren't hard to spot. Let's say I live in a neighborhood. I know how much money it takes for me to live in this neighborhood. What if I have a neighbor who has no job, lives in the same house I have, has the same bills I have,

they're driving a brand new car, their kids are all in the best private schools, and they're both unemployed. What does that tell me? That they are living off money that's not earned income. Now can that be legal? Yes. Maybe they hit the lottery. Maybe they had a grandmother who died and left them a million dollars. But then again, maybe they're living off the proceeds of criminal activity. Once the feds have a suspicion, they do a little digging.

And that starts with a bunch of boring paperwork filed by banks. By law, major financial institutions are required to have compliance departments that screen their customers and file reports on certain types of activity. Any transaction that involves $10,000 or more of physical cash, for instance,

automatically gets a currency transaction report, or CTR. Money launderers are now aware of this $10,000 threshold, and they often try to avoid getting CTRs filed by breaking up their deposits into smaller amounts. But that's illegal too. If you do a withdrawal for $8,000 and one for $2,000, you've just committed a crime, and that crime is called structuring. Structuring is simply any instructions that you give to a financial institution designed to evade the filing of a currency transaction report. The bank will also sometimes file a memo called a suspicious activity report or SAR.

On the left end of the spectrum, a SAR could be as useless and socially counterproductive as a man named Mohammed stepped into my bank today and tried to pay money for his cousin's tuition. On the right end of the spectrum, a SAR could be a team of experts have successfully tracked a human trafficking ring that has been operating in several European countries and we have provided enough information for various national governments to successfully interdict that. All of these reports are filed into a central database controlled by the Financial Crimes Enforcement Network or FINCEN. It's part of the U. the US Department of the Treasury. FinCEN receives millions of these reports every year, and hardly any of them are actually read. And that's kind

of the point. The reports are there to help aid authorities in building a case once they already have a suspect on their radar. Aaron Ross Powell What law enforcement will typically do is they develop a suspicion that a particular person is involved in crime in some fashion, a person, a business, an address, some identifier. And then they run a search on that identifier through the SARS database and then start to build out a network graph. And so if you have a suspicion that John Smith might be engaged in crime, it suddenly becomes very useful to you to have a paper trail that says,

well, John Smith owns Wayne Enterprises, and Wayne Enterprises banks at Citibank. And it turns out that Wayne Enterprises gets repeated wire transfers in $10 million or more from the following three accounts. And it turns out that those accounts, one of them is owned by someone who went to prison last year for drug laundering. And this investigation kind of snowballs from something that was never investigable by itself on the basis of the SARS. Here's Kerry Myers graciously using me as an example. So let's say I'm doing an investigation on Zach Crockett, and I think, hey, Zach Crockett might be involved with some suspicious transactions. I as an FBI agent can

contact FinCEN and say, FinCEN go through all your documentation and send me every currency transaction report, every suspicious activity report that any financial institution has ever filed on Zachary Crockett. Here's his name, here's his date of birth, here's his social security number. FinCEN will go in, search their database and send me all those reports. I'm just over here washing all these podcast funds. Well, let me assure your listeners that was a hypothetical. I'm sure you are doing nothing illegal at all.

Now if Myers determined that I was doing something illegal, say using Magic the Gathering cards to wash my illicit podcast proceeds, I'd be pretty screwed. In the US, a federal money laundering sentence can be up to 20 years in prison and include thousands of dollars in fines. And the bank that took me on as a customer? They could be in hot water too. In 2010, Wachovia Bank, now a part of Wells Fargo, was issued criminal charges for failing to have proper money laundering controls in place.

Its lax policies had made it a safe haven for Mexican drug cartels to la proper money laundering controls in place. Its lax policies had made it a safe haven for Mexican drug cartels to launder money. The bank had to forfeit $110 million and pay a $50 million fine to the U.S. Treasury. A few years later, HSBC, headquartered in London, ran into similar compliance issues. It was forced to pay nearly $2 billion in fines and civil penalties. There were some bank branches in Mexico where the teller window was physically enlarged so that drug smugglers could put more cash through it. In the full knowledge, that was what was happening. It's unclear whether all of these money laundering laws, procedures, and penalties have actually

led to a reduction in money laundering crimes. But McKenzie says they've opened the door for a broader debate about the role of banks. I think there is definitely a societal question as to whether financial institutions should be deputized to work as law enforcement. Our elected representatives have definitively made the choice that financial institutions should be deputized in this fashion because they have the know-how, they have the data, they have the budgets. Privacy advocates say, if it would be illegal for a policeman to look through records on

a transaction by transaction basis, why is it okay when you have the police ask the bank to do it on their behalf? Aaron Ross Powell Those on the enforcement side say that banks and their reports are a necessary investigative tool and that without their cooperation, we'd have a harder time catching drug dealers, human traffickers, and other big time bad guys. But McKenzie thinks that a little money laundering isn't the worst thing in the world. Aaron Ross The optimal amount of fraud is not zero. And that's true of most things that you can measure that are bad. Influencing a system that would drive the amount of money laundering

to zero would interdict so much legitimate commerce. It would cause so much privacy intrusion of basically innocent individuals that we as a society would not possibly countenance that. Aaron Ross Powell Carrey Myers isn't so sure. Zachary Crockett Is it perfect? No. Are we where we want to be? No. But we are moving in the right direction. For the economics of everyday things, I'm Zachary Crockett. This episode was produced by me and Sarah Lilly and mixed by Jeremy Johnston. We had help from Daniel Moritz-Rabison.

There's nothing particularly suspicious about laundromats. They're actually kind of male adapted to the kind of laundering you need to do. The Freakonomics Radio Network. The hidden side of everything.