Markets for Financial Crime
Twenty years ago I worked for a very large privately owned pension fund consultant, advising Shell, GM, IBM and other blue chip companies, as well as the Royal Family of Kuwait and a handful of other wealthy clients. In many respects, this was a great job. We were paid (and paid well) to tell the truth about investments.
In most cases, we were looking after retirement accounts of workers. Which is to say, few people cared about the investors, and many of the firms "representing" the pension funds were focused on how to generate as many fees and commissions as possible. I remember one co-worker who only half jokingly used to start the day with the remark -- "who are we going to f**** today." Some days it was not much of a joke.
Part of my job was to find the lies in an investment proposal that had been pitched to a pension fund. There was never any doubt about the fact that someone had lied about something. It was our job to find out what the lies were, and how important they were. This was one of the best parts of the job.
A typical sign that a deal was over-priced would be a complex financial structure, with all sorts of options, complicated debt instruments and profit sharing agreements that would mature years later, and whose value would depend on events and outcomes that were hard to forecast. Another was a deal that allowed the money managers to use non-transparent and not particularly independent appraisals to estimate returns and report above average earnings -- for a while, so that one putative high-performing fund could attract investments into the next fund -- on the theory that investors were only looking at the last few years of reported earnings when choosing new investment funds. These were sometimes managed as quasi Ponzi schemes.
One way that a pension fund manager could make some money on the side worked as follows: Pension fund A hired consultant B to evaluate an investment from Fund manager C. Fund manager C made sure consultant B was hired to do some high paid "independent fiduciary" work for a fund it managed. Consultant B gave a favorable report on the deal pitched by Fund manager C to Pension fund A.
A less spectacular type of lubricant for a deal might be a $2,500 lunch (real money back then) and field level box seats at a Yankee game, from a fund manager pitching a deal.
At a certain point, I was shopping around for a new job, and interviewed with the head of real estate investments TIAA-CREF, then the biggest private pension fund in the world. I didn't get a job, and the stated reason was interesting. I was told I was great at sucking the hype out of proposed real estate deals. But actually, I was too good at it. And the person managing the TIAAA-CREF real estate portfolio told me he didn't want to hire me, because he was afraid he could not buy any real estate. I made every deal look like crap. He "believed" in real estate, indeed he loved real estate, and wanted to expand the portfolio.
These are just a few examples of the larger problems in financial markets. Most investors are incredibly ignorant of the true values of the securities they buy. The notion that you can depend upon the market for efficient pricing has been challenged several times in the recent past. I know from personal experience there are negative incentives to become an internal whistle blower, and over the years, Congress has shown only occasional interest in improving the integrity of financial markets. When I was still working in the field, I personally contacted a Congressional committee about abused loopholes in certain pension fund regulations. There was no interest at all.
Why does it matter? Is this just a case of money being shifted from one stupid investor to a smarter investor? No. It is actually more than just a wealth transfer from poorly informed investors to more savvy and less honest parties. Widespread fraud and dishonest financial practices also result in real economic waste as scarce investment capital is driven into low value and sometimes worthless projects.
One of the main reasons for poverty in certain developing countries is the rampant corruption that discourages investments in legitimate businesses. I would go further and claim that a certain level of consumer protection is necessary to sustain an efficient and productive society. It is not always easy and rarely well remunerated. The lawyers and consultants that enable the fleecing of the public have vast incentives. We need to think more about the reasons why markets for honesty and consumer protection work so poorly.
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I have said the same thing so many times. Unregulated (unfettered) markets don't breed investment. They breed corruption.
The reason the "markets" for honesty and consumer protection work so poorly is that there are no "markets" for these items.
It now is apparent that a large part of the blame for the mess we are in can be attributed to our attempts to "marketize" everything.
Financial regulations? Who needs them; the financial markets would certainly take no action not in their own best interests, so let them regulate themselves.
Health care? Gosh, we wouldn't want to "keep folks away from their own doctors", so that has to be market driven, despite the fact that our resulting per capita costs are roughly twice those of other modern nation states. (Just consider the waste of screening potential insureds and advertising drugs and services.)
Student loans for college tuition? Create a program of private lending to see to this, and get the government out of it. Check on the problems at Sally Mae to see how this has been going.
The last items of relevance in a purely and truly effiecient market are honesty and consumer protection. If you believe that the invisible hand should make all decisions, then your only real rule is caveat emptor.
We need to decide to let the "market" provide the goods and services it is best at and to assign to our government those tasks it is most efficient at. I think Bernie Madoff would tell us that vigilence with regard to the regulation of financial markets falls into the latter category.
There is a study I read and recently posted here that shows you why whistleblowers don't get any attention. Our competitive, greedy culture has degenerated into one that not only sustains but actually encourages and breeds sociopaths. The study shows that the government always does better by not being ethical and we can predict the government's choice of strategy because there is a single strategy - no ethics - that is better for the government no matter what choice the public makes. This is a "strictly dominant strategy," or a strategy that is the best choice for the player no matter what choices are made by the other player.
What is even worse is the fact that the public is PENALIZED for behaving ethically. Since we know that the government, in the above regime, will never behave ethically because it is the dominant strategy, we find that ethical behavior on the part of the public actually costs MORE than unethical behavior.
In short, psychopathic behavior is actually a POSITIVE ADAPTATION in such a regime.
The public, as you see, cannot even minimize their losses by behaving ethically.
http://www
What an awesome link! Have you heard of "game theory" (I think it's in the movie "Century of the Self".)
What an awesome link! I like the way the movie, "The Century of the Self" explains game theory.
Over my period of 40 years working I watched my investments. Every time it looked like I gained
a good deal a BLACK FRIDAY came along and took most of it. And then it started all over again.
After a while I figured it out, there is no way a normal middle class person can get rich of these types
of investment. Then someone told me if you can't afford to lose one million dollars you have no
business in the stock market. I have to agree now!
Efficient market theory has been thoroughly debunked, yet here we sit, pretending that it might have some validity. "The notion that you can depend upon the market for efficient pricing has been challenged several times in the recent past. "
Despite "the Google," the availability of information resource inequality, accounting tricks, and outright lies available for sellers to use in hawking products, stocks, CDOs or whatever, overcomes all rational argument in favor of the Efficient Market theorem.
Economists who claim otherwise are either charlatans or fools.
Congratulations on getting out. Hopefully there will some people like you to help rebuild it after it collapses
"One of the main reasons for poverty in certain developing countries is the rampant corruption that discourages investments in legitimate businesses. I would go further and claim that a certain level of consumer protection is necessary to sustain an efficient and productive society. It is not always easy and rarely well remunerated. The lawyers and consultants that enable the fleecing of the public have vast incentives. We need to think more about the reasons why markets for honesty and consumer protection work so poorly."
I would add the US to that list of developing countries. Great post.
Okay James. So what are you going to do about it?
Try to demand from our reps that the government enforce the laws on the books vigorously, and plug the loopholes being exploited?
I'm in my 30s. In the year 2000, at the height of the tech boom, I had a little money kicking around I wanted to invest. I surfed all the financial websites looking at stock recommendations and charts.
I noticed right away that every single stock I looked at, including Nortel which later crashed from over $1000/share to $1/share, was rated as a Strong Buy. Now I know this is a rudimentary way to research stock buys, but I was a novice and that's what I looked at.
Smartly, I never did invest the money. It wasn't that much money but that wasn't the point. ever since then, I have watched the Enron scandal unfold, the airlines go bankrupt, WorldComm, etc etc... and now all of this. Mergers of massive companies just for the sake of merging, all cheerlead by "consultants" who make tens of millions of dollars just by being there. IPOs that aren't available to the general public until they have already soared 100-200%, at which point they are unloaded for a quick buck by the "preferred brokers" who got first crack. And the list goes on and on.
The entire US (and world, really) financial system is one big Ponzi scheme that completely falls apart if there is anything but massive growth year after year. Isn't that the definition of a Ponzi scheme? A system so crooked and fragile that one or two quarters of stale growth is considered a disaster.
Great post. I hope Obama realizes this and tries to implement some lasting fixes. You know the corporations will have all their media outlets and right wing idiots trying to stop him, saying he's un-American etc.. It ain't gonna be easy. Oh well, even if he fails it will eventually collapse and then hopefully a better system will be put in place.
"The entire US (and world, really) financial system is one big Ponzi scheme that completely falls apart if there is anything but massive growth year after year. Isn't that the definition of a Ponzi scheme? A system so crooked and fragile that one or two quarters of stale growth is considered a disaster."
Yep, pretty much.
Except when you design a worldwide Ponzi based upon the GDP, it's not just considered a disaster. It is a disaster. The bigger the Ponzi, the bigger the disaster.
Growth stops, Ponzi is over.
Yet another reason to abandon the GDP as the primary indicator of economic health. It's an indicator that, when always rising, should be seen for what it is: a bubble.
Bubbles always burst.
Interesting, your comments about the TIAA-CREF interview. I've seen much the same mindset in residential RE. Hype is almost demanded, from both sides. Telling people what they want to hear is by far more successful that telling them what they need to hear. Laying out the facts is either actively discouraged, or ignored despite the obvious benefits of full information. Illusion almost always trumps reality.
More likely a defect of human nature than any systemic flaw. Check out libraries and book stores, fiction is obviously preferable to fact. The mix of information choice only reflects what most people are inclined to invest in (fiction).
I never claimed to be a financial wizard, but when it came to investing my 401K funds, I did call my IRA broker and asked where I should invest my money (given the options offered). He told me that a "fixed asset account" would have a lower yield, but would never loose value. I took that advice and all the money that I did invest (plus interest) was never affected by market volatility. So at some point in time, people need to acknowledge that Wall Street and Investments are a "gamble"..
My husband and I did the same thing. But we were pressured and told that we would never have enough to live on in our retirement. We didnt listen. Very glad now. Often I wondered if we did the right thing.
Some people's pensions are out of their control, such as mine which is invested in for me by my former employer.
Deceit and obfuscation are hardly necessary when people will accept the patently absurd. Such as the concept of "privatization" of government services. There is obviously nothing a private concern can do that the Government couldn't. How then can ANY private concern provide a service, and take a profit, without unnecessarily wasting taxpayer money? It is simply not possible.
Or the idea of effectively eliminating cash reserves in the name of "efficiency" in response to the threat of hostile-takeovers? If businesses exist on short-term debt is the cost of all the interest paid outweighed by the "returns" from capital investments replacing of cash reserves? I'd doubt it, and that's without even considering the inherent risk in having a business wholly dependent on of good graces of outside financiers, as are currently being amply illustrated.
And isn't it interesting that the banks which profit so handsomely from all those short-term loans are the same banks forcing business to forgo cash reserves or face bank financed LBOs?
I'm not an economist or financial professional but its seemed to me for a long time that our economy is based on a thoroughly corrupt financial system. That "investors" are simply gamblers. And that "the markets" are all giant ponzi schemes.
This is far & away one of the most important articles ever written here. It goes right to the root cause of our economic collalse. People make big money manipulating paper. especially overvalued paper. And they don't for producing real goods!
I learned in the stockmarket meltdown of 2002 that the game was fixed. And most of the biggest players got away free & clear. Even at Enron, they went after the management, not the biggest investors. And especially not those who sold early at the highest prices.The
Anyone in doubt should look a little more closely at how much SoT Paulson got for seeling some of his stock at the initial sale to the public. High tech owners were bringing in hundreds of millions. Paulson certainly unloaded tens of millions.
These ae spectacular highlights, but the real crime is sending our best jobs overseas to add a few percent to the short-term bottomline. I personally watch the disk drive industry send to SE Asia, while labor was only six percent of the total cost. Of course, American workers were blamed!
Thank you.
In addition there is a language problem. The language of money is obscure to say the least. The formal language of economics does not differentiate waste from fruitful cash flow. If I wreck my car and have it fixed I have improved our GDP. Economics does not discuss the externalization of costs into the environment (fallacy of the commons). And then there is the terminology of investing.
It is hard to address a problem if the public does not have terms for it.
I heard a joke recently that shows the point. two economists are walking in the park and one takes a crap. He turns to the other and says I will pay you a million dollars to eat that. Yuck well ok and he eats it. Later the second economists takes a crap and offers the same deal to the first. So he eats it and gets his million back. the first says I think we are wasting our time, the second says absolutely not we have just increased GDP by 2 million.
Great joke
this is one of the most informative and clear-headed articles i've read lately. thank you for the information, and I hope you have some ideas about how to solve this problem - how to provide a good incentive for consumer protection and a better disincentive for the biggest lies.
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