John Kay - Banks got burned by their own ‘innocent fraud’

Banks got burned by their own ‘innocent fraud’

There are only a few basic kinds of deception and self-deception in finance. John illustrates some of the key mechanisms.

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.

 

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