What If There's Massive Fraud?

What If Everyone Just Did Their Jobs? Would We Be Better Off?

The answer should be, “yes,” and in most cases, it is – simple as that. In financial services, unfortunately, the answer is, more often than not, “no.”

Misunderstanding that situation played a large part in precipitating the last decade’s financial crisis, and the Great Recession which followed, but more on that later.

On the most basic level, markets of all nature operate when buyers and sellers unite. The seller provides a good or a service, and the buyer desires one or both. Business occurs when money is exchanged for those goods or services (setting aside barter for simplicity). The better the job (product or service) a seller does, the greater the demand will be for their product. If all operates as it should, sellers who do the best jobs should have the greatest success selling their products, and everyone should be happy – buyers and sellers alike.

Price needn’t enter into the equation. The best inexpensive paint job for your house should be, on a relative basis, as pleasing to the buyer as the best expensive paint job is to a different buyer.

Simple, right? No so fast.

For markets to work properly, both the buyers and the sellers have a, “job” to do. The seller’s job needs to be this: to consistently sell the most product possible at the greatest possible profit; AND, the buyer’s job must be this: to educate themselves in order to purchase the best possible product, at the most reasonable cost. If both buyers and sellers do those jobs well, everything will be ok. Change any one element in the above requirements, and the result is suboptimal.

Let’s continue with the house painting example, because it conveniently includes the sale of both a good (the paint) and a service (the painting). What should the seller’s job be? If he views his job correctly, to consistently sell his product (both the paint and the painting) at the greatest profit, then we would hope he would find the best possible paint, at the cheapest cost, to use on the job. This is clearly in the best interest of the customer. Could he use a paint that offers him the opportunity to increase his profit by marking up the price, or whose manufacturer offers him a financial incentive? Of course, but that would not be in the customer’s best interest, and, over time, educated customers (buyers) would discover the price discrepancies, stop using that painter, and the seller would fail the, “consistency test.” The same thing would happen if the painter attempted to increase profits by overcharging for his labor, the painting. He could maximize his profit on a limited number of jobs, but would soon find demand for his product falling, perhaps to the point where his business fails.

We also mentioned the educated customer, or buyer, above. The customer has a job as well, and that’s mainly to make sure that the seller is doing his job. This is, perhaps surprisingly, the more difficult task, mainly because the customer needs not only to determine whether the seller is doing his job well, but also, more importantly, what the seller’s job actually is.

Continuing with house painting, if a potential customer wants her house painted, and meets with a representative of the painting company, she first needs to figure out in what capacity that painting company representative is acting in. What are his goals? How is he compensated? Is he a salesman whose job is to sign up as many customers as possible, without regard for their long term satisfaction? Does he have a financial incentive to recommend one paint over others? If either of those things are true, he might be doing a fantastic job, “at his job,” but not for the customer. In fact, if any of those things are true, it would be very difficult for a customer to determine whether it’s even possible for her to gain the benefit of an efficient market, which is the best product at the best price. Then on top of that we need to layer the question of the charge for the actual painting. Her chances of being able to make a decision that she’s fully comfortable with is quite small, if not impossible. 

House painting? Financial Crisis? Great Recession? What? – We’ll get there.

You know those people who walk around wearing rose colored glasses all the time? Glass is always half full? Trusts everyone? Well, that was me. I mean, I don’t want to make it sound like I’m Captain America or something, but (and it’s hurt me, financially, in the past) I have never been driven to act only in my best interest. I’ve always thought of the other person – the counterparty, if you will (and that was well before I’d ever heard the word, counterparty).

So, fast forward through bond trading, graduate school, consulting, investment banking, etc., and I’m managing several billion dollars of subprime mortgage backed securities for a large insurance company. Naturally, I think I’m pretty big stuff. Sometime in the early 2000’s, my partner and I want to increase our investment in a particularly risky, therefore profitable, security. We feel we have done the analysis, understand the risk, and are comfortable with it. We make a lengthy presentation to our boss to get approval for the investment. We feel we hit all the right points. We answer any number of questions about the bonds, their structure, the collateral, the companies involved, etc. We feel good. Then he says,

“What if there’s massive fraud?”

My partner and I looked at each other. I’m pretty sure we laughed. But our boss was serious. “What kind of fraud?” we asked. He really meant it, soup to nuts, fraud up and down the whole mortgage loan production line. We responded by saying we’d conducted appropriate due diligence, visiting lenders, servicers, banking units, etc., and that we’d only invest with those who were doing their job correctly.

In the end, we made the investments for a while, and our firm profited greatly, until we eventually became uncomfortable with overall mortgage related risk and stopped investing in those products. We made the right decision, but not for the right reasons. We looked at the overall economy, consumer debt, etc. – all the things you think a good investment manager should take into account - but what we didn’t consider at all was whether the people who were creating and selling the products we were investing in were doing their jobs. And if we did, we didn’t ask what their jobs really were. If we had, we might have gotten a lot more nervous, a lot sooner.

Turns out there was massive fraud. Or was there?

Webster defines, “fraud” as, “deceit, trickery, specifically : intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right.

Was there fraud in the mortgage & real estate market leading up to the crash? Of course, but not enough to crash the U.S. housing market. Was there fraud on Wall Street? Sure, but far less than people would like to believe, and certainly not enough to blow up the global economy. But there were, however, thousands and thousands of people doing jobs which didn’t require them to act in their customer’s best interest. In fact, in many cases, doing their jobs well (and getting paid well) basically required them to act against their customer’s best interest. It wasn’t illegal. It wasn’t fraudulent. But it wasn’t right either.

You may have heard the term, Collateralized Debt Obligation, or “CDO.” You may know it’s some kind of bond. You may have heard that their failures had something big to do with starting the financial crisis. You may not know any of that. You don’t need to. The question is, if everyone was doing their jobs, without, “massive fraud,” how did we end up with enough bad investments to tank the economy? To make a CDO, Wall Street bankers needed mortgage loans, and lots of them. They got packaged up and sold to investors the world over. Their structures are complex and the math requires computers, but at the heart of it, as long as home buyers make their mortgage payments, everything works. The problem turned out to be that the human chain was very long, and there were a ton of opportunities for bad outcomes to compound.

The players in this game: Home buyers and sellers, Property appraisers, Real estate agents, Mortgage lenders, Wall Street banks, Investors, Rating agency analysts, etc.

Opportunities for Trouble: Infinite

At each step, with again, hundreds or even thousands of individuals involved, each looking out for only his or her best interest, not their customers’, there was an opportunity to layer in some form of counterparty risk. By the time we got to the end, and created CDOs, which were then carbon copied & placed within the entire global banking sector in one form or another, the risk was increased exponentially, hence, the global financial crisis that was so “unexpected.”

The lesson I took away from this experience is to always ask of any counterparty: How are you paid? And then to determine on my own whether they are in it for the long haul, or just a short term reward?

Ask those questions, and you’ll be a lot better off in your own life, financial and otherwise.

Hedge Fund Manager’s Office, circa 2009

“There will be no more coal burned in this office today, is that quite clear, Mr. Cratchit?”