John Kay, in “Banks got burned by their own ‘innocent fraud’,” argues that banks got themselves and the world at large in a heap of trouble via self delusion. Had the bets embodied in their products been presented in simpler terms, they would have recognized that they were bogus and bound to lose money. But the complicated structures blinded them to the fact that they were bound to end in tears.
Kay draws the term “innocent fraud” from John Kenneth Galbraith and describes it as:
the process that systematically benefits one group at the expense of another but generally falls short of outright criminality.
I have trouble with the construct, and am always amazed how activities, if perpetrated by someone outside by the banking classes, are seen in a different light. The damage wrought by the credit crisis is truly colossal, but the fact that the perps (for the most part) thought the products worked and the benefits were shared makes them “innocent?” I don’t buy that. Criminality is too low a standard for deeming behavior innocent of not.
Consider the sad fate of Eben Byers, an athlete, industrialist, and man about town of the 1920s. After sustaining an arm injury that refused to heal, his doctor prescribed (and received a 17% patent rebate on) a patent medicine. Eben thought it did him a great deal of good and began taking the potion two to three times a day.
The drink, Radithor, was radium dissolved in water. Byers lost his teeth and most of the bone mass in his jaw, and before his death, developed abcesses on his brain and holes in his skull. But the maker of the toxic potion was never prosecuted, since selling radium drinks was not against the law.
By the time Byers had the vast misfortune to happen upon Radithor, the risks of radium were coming to light, as factory workers who painted radium onto clocks and would use their lips to establish a point on their brushes were developing lip and mouth cancers. But the potion-makers nevertheless continued to sell their tonics until the Byers death killed the industry. Yet by falling short of Galbraith’s low bar of “outright criminality”, the makers of radium drinks would be deemed “innocent fraudsters” even as evidence that their products were dangerous mounted.
Similarly, there were early signs that the sourcing of mortgage product was turning toxic. Warnings started surfacing in 2005. The reason that Merrill was stuck with such a large book of “super senior” CDOs was that US buyers had started to cool on the product in 2006, and salesmen were increasingly looking to overseas buyers.
Now there were no doubt many technicians, focused on their little part of the production process, who were indeed insulated from knowledge of how dubious these instruments were becoming. But using the phase “innocent fraud” lets too many people, most importantly those at the top, who should have a broader perspective, off the hook.
Moreover, innocence hasn’t worked terribly well as a defense in the securities industry. Consider the case of Joseph Jett. Jett was a government bond trader at Kidder Peabody in the early 1990s. who had seemingly found a way to exploit anomalies and was coining money, In fact, what he had found was an anomaly in Kidder’s accounting system.
Unlike other demonized rogue trades, everything Jett did was in the open. His bosses, delighted to reap large bonuses based on his outside productions, never questioned the obvious: it ought to be impossible to earn that much money in a highly efficient market. And unlike other rogue traders, Jett did not lose money, although he did cause Kidder to produce overstated profits that later had to be reversed, a huge embarrassment for parent GE.
By all accounts, Jett was convinced that his strategy really did produce real profits, He believed what the systems told him. The strongest proof that he was not knowingly perpetrating a fraud was that he kept his accounts at Kidder, where they were seized. A crook would have moved a significant portion of his gains elsewhere.
The higher-ups were never investigated; all enforcement efforts focused on Jett, who initially won a victory with the NASD but the SEC later forced him to disgorge his bonuses, imposed a fine, and barred him from any involvement with financial trading.
I much prefer the terminology and analysis of George Akelof and Paul Romer. From the abstract of their paper, “Looting: The Economic Underworld of Bankruptcy for Profit“:
During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent – and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and the suffered a dramatic collapse. Also in the United States, the junk bond market, which fueled the takeover wave, had a similar boom and bust.In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds.
Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.
Had anyone taken this line of thinking seriously, we might not be where we are today.
From the Financial Times:
How could banks have persuaded themselves, their shareholders and the public that they were making so much money when in reality they were losing it? The history of financial deception and self-deception is as old as humanity, but a few themes recur. A Ponzi scheme offers a high return using the funds of newcomers to make payments to earlier subscribers, and collapses when the supply of suckers runs out. The New Economy was the greatest of Ponzi schemes. It has been different this time. But not so different.I have several times in this column described the Taleb distribution of regular small profits interspersed by large losses. Taleb distributions are the basis of the carry trade – which exploits interest rate differentials – and many types of statistical arbitrage. Taleb distributions are exploited by traders in hedge funds and at proprietary trading desks.
The martingale is not an exotic bird but a gambling strategy. Imagine a coin-tossing game in which you win on heads. Every time you lose with a tail, you double your bet. Simple arithmetic shows that when you eventually throw a head, you will recoup all your earlier losses and make a small profit. Ultimate success seems guaranteed.
Little worldly wisdom is required to realise that the more usual outcome is bankruptcy. But when the concept is dressed up as a collateralised debt obligation, the problem seems less obvious. If the credit initially provided is inadequate, the issuer will top it up. Moreover, such instruments fitted with the models of rating agencies. Simulations of performance, run with the benefit of powerful computers but without the benefit of common sense, show how martingales may deliver small, predictable returns.
Their once attractive valuations depend on the ability to anticipate future returns. The adage that a bird in the hand is worth two in the bush is now old hat. A conservative accountant counts the bag at the end of the shoot and a less conservative one registers the numbers as the birds fall from the sky. But the modern accountant not only eats what he kills but also takes credit for the expected cull as soon as the hunters’ guns are primed.
Mark-to-market accounting is criticised today for forcing banks to recognise that unsalable assets have little value. Companies resent the obligation to use mark-to-market accounting when the market is down. But the public should be more concerned for the implications of mark-to-market accounting when the market is up. The authors Bethany McLean and Peter Elkind describe how Enron’s Jeff Skilling, in a fit of uncharacteristic generosity, once ordered champagne for all his colleagues. The toast was in appreciation of a letter from the Securities and Exchange Commission agreeing that Enron could make wide use of mark-to-market accounting.
Mr Skilling believed, as do many traders and financiers, that people should receive credit for the full discounted expected present value of their ideas at the moment of inspiration. Newton, thou shouldst be living at this hour! But it is easier to reward people on the basis of what they believe they are worth than to recover bonuses from people whose ideas turn out not to have been as good as they thought. Even Newton’s heirs might have struggled to repay when Einstein demonstrated flaws in Newtonian mechanics.
Ponzi schemes, Taleb distributions and martingales, revenue recognition and mark-to-market accounting: these are the means by which successive generations of financial hotshots perpetrate what John Kenneth Galbraith described as innocent fraud. This is the process that systematically benefits one group at the expense of another but generally falls short of outright criminality.
But to benefit from the innocent fraud, you must be organiser rather than participant. In the New Economy, banks collected commissions on transactions but limited their own direct involvement. The participation of banks in the recent round of follies brought humiliation. Is the deception of others more or less venal when one has also deceived oneself? That question must be left for moral philosophers – and historians of our era – to answer.
dearieme 
Posts
Am i confused, or shouldn’t the FT article about martingales and Taleb be referring to mark-to-model accounting, not mark-to-market when talking about Enron’s Schilling (or should I say Shill’ing)?