If my dear departed aunt heard about myriad cases of fraud, she probably would say ‘Well, it is going around.’
She did not limit her customary response to news of sickness or infectious diseases like measles or chicken pox. It could be invoked for hernias, hemorrhoids, slipped discs and other maladies not generally regarded among medical scientists as communicable.
But she would not be entirely wrong in implying some link between the actions of just-sentenced Tom Petters, pending-sentencing mortgage scammer Michael Prieskorn and just-confessed foreign-currency trader Trevor Cook.
One also could mention the alleged fraudulent mortgage closer in Forest Lake who is said to have pocketed money from new mortgages meant to pay off old ones, the prominent lawyer just canned for taking more than $1 million from clients or the former bank officials being pursued by the FDIC to pay back millions to cover losses from bad loans that broke their bank.
That is just in Minnesota. Nationally, federal regulators on Friday charged Goldman Sachs defrauded investors by not telling them that one of its subprime mortgage financial products was shaped by hedge fund manager John Paulson, who was betting the housing market would fail and take the securities down with it. Paulson, not named in the suit, reaped big gains while investors lost billions. Goldman calls the charges “unfounded” and vows to fight.
Meanwhile, Lehman Brothers CEO Richard Fuld is under scrutiny for any role he may have played in overseeing a set of accounting dodges that critics say constituted a multi-billion dollar swindle of the firm’s own shareholders and eventually of taxpayers.
And of course, there is Bernie Madoff.
So yes, something really does seem to be going around. Fraud is not a transmissible disease per se. It is, however, a human behavior in which many different people respond to the same motivating circumstances in similar ways.
The explanation comes more from criminology than economics, or at least than from the humans-are-rational-decision-makers theory that dominated the past two centuries.
Motive and opportunity help determine why people commit crimes. Opportunities to commit fraud and motivations to do it both are more common in a boom-bust cycle than in a more stable economy.
Opportunities to defraud become easier when the population as a whole gets swept away in irrational exuberance. If there are news reports of all sorts of investments that yield double-digit returns, it is easier to get people to put their money into a sham one.
As Petters demonstrated, if you show the ability to profit repeatedly in apparently legitimate business deals, even sophisticated investors will lend you money without doing much due diligence.
If there is a pervasive atmosphere of housing prices going up without end and popular lore about fortunes made in real estate deals, it is easier to line up people willing to put their name on some sham mortgage for a price.
The more hoopla about globalization and currency trading and accounts of speculators making billions betting against the British pound, the easier it is to get naïve but greedy people to write big checks to your “risk-free” foreign exchange trading system.
If millions of homeowners are refinancing and the system is overloaded, the easier it may be for a dishonest closer to divert some of the proceeds of a new mortgage.
If your own bank and your competitors are profitable making legitimate mortgages, why not stretch the rules a bit to increase business even more? After all, continuously rising real estate prices will make all deals turn out well.
All of these circumstances provide opportunities for fraud when a bubble is expanding. Many of the resulting frauds are large indeed.
Motive is the more important factor on the downside. Many more people succumb to temptation but the sums are often smaller.
People get into debt over their heads during the boom and then cannot pay their bills during the bust. People who ordinarily would not steal to improve their lifestyle may do so to keep their level of living from sliding backwards. This is a flip-side variation of the old “revolution of rising expectations” theory in political science. This argued that people are more likely to revolt when things are getting better and then stop than when things are bad and get worse.
Tom Petters and perhaps even Trevor Cook probably did not set out to defraud people. Competently or incompetently, they started legitimate business deals that went increasingly bad. Rather than admit their mistakes and losses, they doubled down, initiating fraudulent deals that they hoped would restore them to solvency so their mistakes would never be revealed.
These examples are mega-frauds. Micro ones are more common. The clerk skims the till to pay threatening creditors. The bookkeeper generates sham purchase orders to nonexistent vendors and deposits the checks in her own account. The attorney writes checks on clients’ escrow accounts. Many think it only temporary, imagining that circumstances will change and they will be able to replace the money and cover their tracks. But the webs of deceit get ever more tangled.
Unfortunately, the old observation that the petty thief who steals a goose from the village common is more harshly punished than the rich man who steals the commons out from under the goose often is proved true. Lehman Brothers’ use of a fraudulent swap transaction to hide a big chunk of its true liabilities at the close of each accounting period defrauded its own shareholders, including many of its own unsuspecting employees. This also defrauded other investment firms that lent it money, not to mention the federal government that eventually cleaned up the mess.
But don’t expect any Lehman execs to spend much time behind bars.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.