01/13/2009 05:12 am ET | Updated May 25, 2011

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.