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Financial Fraud: It Takes Two

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stockmasterflash   Saturday, 08/12/17 01:58:21 PM
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Financial Fraud: It Takes Two

Schemes need more than just a schemer. They depend on willing customers as well.
Ralph Orlowski / Reuters

Mihir A. Desai Aug 9, 2017 Business

https://www.theatlantic.com/business/archive/2017/08/investor-role-fraud/536226/

At a time when Americans are divided on matters of criminal justice, the conviction last week of Martin Shkreli for securities fraud seemed a momentary unifying force. Many were overjoyed to see the widely disliked former hedge-fund manager found guilty, and there was perhaps an additional layer of public satisfaction given how many bankers escaped punishment in the aftermath of the financial crisis. Finally, a verdict everyone seemed pleased with.

But the glee surrounding Shkreli’s conviction points to a naive conception of financial scams. The Justice Department’s indictment of Shkreli and the view that prevailed in court represent the typical view of financial frauds: an act perpetrated by an evildoer on ignorant investors. When hucksters get most of the attention, financial frauds come to be seen only as a problem of supply; the usual narrative is that eliminating fraud simply requires banishing the Shkrelis and the Bernie Madoffs of the world, for they are the unique source of the problem, tricking unwitting and innocent investors.

That logic doesn’t hold up, much like any argument that puts all of the blame for drug trafficking or illegal immigration on Mexico; the market for financial frauds, like those for labor and drugs, depends on demand as well as supply. Modern financial schemes involve fraudsters as well as investors who choose to believe in unbelievable returns.

Plenty of inexperienced traders lose their money to fraud schemes, but typically, in cases like Shkreli’s, the victims are investors who are “sophisticated”—meaning, in the words of the Securities and Exchange Commission (SEC), they “have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.” In other words, many of those who give their money to fraudsters are experienced enough that they should know the advertised promises can’t be true.

Take some of the so-called victims in the Shkreli securities fraud conviction. Many of them were not just experienced investors, but had an expertise in biotechnology, the field Shkreli was dealing in. Others were fund managers themselves. Moreover, most of these victims not only got their money back from Shkreli, but ended up multiplying their investment several times over (albeit thanks to profits earned from a separate endeavor of Shkreli’s).

Of course, these investors have every right to chase outsize risks as they please, and indeed some might argue that it’s human nature to seek out and believe in the possibility of enormous returns. But because of how markets work, overestimating what kinds of returns are feasible in markets that are roughly efficient can stoke demand for financial fraud.

Even better examples of implausible victims are those enveloped by Bernie Madoff's schemes. Most of them were part of highly sophisticated financial institutions and pools of funds tasked with choosing money managers on behalf of their clients. It is hard to believe these institutions fully trusted that a strategy that only invested in 30 to 40 of the largest companies in the S&P 100 would routinely provide monthly returns in excess of 15 percent.

The most powerful force on the demand side of the market for financial frauds is not individual investors but the professional managers who they appoint to manage their wealth; it is these investors who should know better.

As the 10th anniversary of the financial crisis approaches, it’s even more important that the narrative of financial fraud moves away from exclusively supply-side explanations. Take the much-demonized Collateralized Debt Obligations (CDOs), the structured financings that repackaged the risky mortgages at the heart of the financial crisis into highly-rated securities. Most narratives of the role of CDOs in the financial crisis emphasize the poor behavior of the homeowners who took on too much debt, or the banks that didn't exercise enough discretion in issuing home loans, or the investment banks that packaged up those transactions and sold them without enough disclosure, or the ratings agencies that ignored the risks inherent in those structured securities.

But CDOs wouldn't have thrived if there weren't buyers for them. Ultimately, it was insurance companies and other investors that demanded these highly rated notes with their enticing yields. And they were willing to suspend their disbelief about where that yield originated from as long as they could point to a high AAA rating when the investments went sour.

So, a more trustworthy narrative of the financial crisis is one that accounts for the demand side. Before the crash, investors aggressively sought higher returns on their portfolios as inflation-adjusted interest rates declined in a historically rapid manner. Investment banks created (and rating agencies approved) securities via CDOs that would satisfy these yield-hungry investors. And banks, seeing that they could make new loans and resell them into CDOs, started making even more loans. Homeowners, in turn, happily took out more debt as banks loosened lending standards.

Of course, focusing exclusively on supply and demand overlooks the critical role that regulations could play in halting these processes. But given the imperfections in regulatory approaches, narratives about evil hucksters preying on naive investors should give way to a more subtle picture that sees investors and buyers as playing a role too.

If that picture takes hold, expectations could be raised for the professional investors who represent pensioners and households. Stricter requirements for financial advisors and professional investors would make them less willing to overlook obviously problematic behavior and could lead to a much more responsible financial marketplace. Getting to that point would also mean deflating the myth that the financial markets are full of arbitrage opportunities. Until then, there will be more Shkrelis, more Madoffs, and more financial crises.


#1). You have money. Other people want it. All of it!
#2). You want easy money. So does everybody else. They'll get it, too....yours! (and all of it!)
#3). You tell yourself you're smart. You won't lose your money. Fact: Other people are smarter,
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