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Bubble Psychology and Complicity in Financial Fraud

Matt Yglesias does write about things other than monetary policy and zoning regulation. Today, he’s got a post [1] up about the relationship of fraud to credit bubbles:

Federal Reserve governor Jeremy Stein has a learned talk out today [2] about the need to take an “institutional view” of credit market dynamics. There are a lot of stylized models out there in which credit intermediation institutions basically don’t exist, and the volume of credit is simply determined by fluctuations in household and firm preferences. He argues that you have to think about the way the institutions actually function and the incentives facing actors within them.

Specifically, he notes “three factors that can contribute to overheating” in credit markets.

One is “financial innovation.” The second is “changes in regulation … new loopholes … exploited by variants on already existing instruments.” The third is “a change in the economic environment that alters the risk-taking incentives … a prolonged period of low interest rates … ‘reach for yield.'”

And fair enough. But here’s some evidence that’s emerged [3] from litigation between Dexia, a large Belgian bank that lost a ton of money buying mortgage-backed securities from JPMorgan and also from two banks that JPMorgan has since acquired:

According to the court documents, an analysis for JPMorgan in September 2006 found that “nearly half of the sample pool” — or 214 loans — were “defective,” meaning they did not meet the underwriting standards. The borrowers’ incomes, the firms found, were dangerously low relative to the size of their mortgages. Another troubling report in 2006 discovered that thousands of borrowers had already fallen behind on their payments.

But JPMorgan at times dismissed the critical assessments or altered them, the documents show. Certain JPMorgan employees, including the bankers who assembled the mortgages and the due diligence managers, had the power to ignore or veto bad reviews. […]

In other words: JPMorgan – and other banks in the mortgage derivatives business – had powerful incentives to commit what looks like fraud (though Yglesias is careful to note that he isn’t equipped to speak to the question of legal liability).


The thing to remember, though, is that the incentives for doing this sort of thing exist on both sides of the desk in any transaction. You would think that a buyer of a security would want full disclosure of all the risks, and the seller would want to hide potentially damaging information. And relative to some market benchmark, that’s generally true – a less-scrupulous seller will try to get away with disclosing less than his competitors, a more conservative buyer to get more information than her competitors. But the benchmark itself moves, and both sides are complicit in moving it during bubbles – because in bubbles, market participants are more worried about missing out on profit opportunities than with incurring losses.

At the height of the bubble, if you brought a piece of paper to market with a high percentage of no-doc “liar” loans in the portfolio, the market would demand a higher interest rate because of the higher risk that these loans would go bad. But eventually the rate would be high enough that investors convinced themselves they were being compensated for that risk – and they wanted to convince themselves, because they needed the yield.

(Actually, that’s not strictly true – at the very height of the bubble, perversely some of these deals would have been priced tighter than some other deals, because certain issues that were included on common “short” lists or that were included in indices had a more liquid credit-swap market associated with the paper, and that greater perceived liquidity – which appeared to reduce market risk – drove yields down to levels that did not reflect the underlying credit risk. But that’s a wrinkle that cuts against a story that in general is correct.)

Ratings agencies benchmarked the quality of their work against each other. In a raging bull market, a single agency could grab market share by lowering standards, and the others would have to follow suit. The effect was observable within institutions as well, as the risk management departments of institutions couldn’t get away with demanding tougher risk assessments than competitors, and legal departments couldn’t get away with taking a more conservative view of proper disclosure. And everyone in the market, buyers and sellers, is subject to the same pressures.

There were, of course, plenty of instances of out and out fraud. But “consensual” fraud, where all parties know that there’s more being left out than said, was vastly more common – indeed, was almost ubiquitous.

Yglesias concludes:

[I]t’s clear that in economic terms we were dealing with a marketplace in which major vendors were concealing materially relevant information. The ability to get away with that kind of thing is a factor that can easily lead to overheating. After all, the actual creditworthiness of potential borrowers is a major constraint on the expansion of credit. If intermediaries believe they can get away with misstating the creditworthiness of borrowers (either through direct fraud or by covering up fraud on the part of the borrowers) then there’s going to be a lending boom.

None of this is to undermine the stuff Stein does say, but there continues to be a big blind spot in the economics world to this stuff, even though there’s more and more lawyering around it every day.

The lawyering is actually pretty important to restraining this kind of behavior. The prospect of a prison term concentrates the mind wonderfully – at least for a while. People will still commit out-and-out fraud, but the prevalence may go down, and, to the extent that a new bubble still emerges eventually, it might take just a little bit longer to get going. But, as I say, “consensual” fraud is a much bigger phenomenon than clear-cut lawbreaking. To the extent that buyers succeed in suing sellers over this kind of thing, that’ll make sellers more cautious next time – but it’ll make buyers more complacent, and more willing to encourage sellers to tell them what they want to hear. So I’m not sure, in the end, lawsuits will do much to restrain the biggest driver of misinformation.

Similarly, an agency [4] designed to protect the consumer in these transactions could do real good (if properly staffed) inasmuch as it might compensate for the massive information asymmetry between consumers and financial professionals. But the kinds of transactions Yglesias is talking about take place between “big boys,” where even if there are information asymmetries (and there always are), there’s no suggestion that they should be regulated away (nor is it obvious how they could be). And anyway, inasmuch as much of the fraud that takes place at that level is “consensual,” regulation would have the same effect as a legal regime tilted more towards buyers: it would encourage greater vigilance by sellers, but laxer vigilance by buyers, and it’s hard to know what the net effect would be.

So the key word is “ability.” In any bull market, the willingness of intermediaries to “conceal materially relevant information” goes up, and so does the willingness of risk-takers to let that information be concealed. It’s very hard to regulate away that behavior – doing so would be tantamount to regulating away bubble psychology. But how possible it is to conceal this kind of information is a function not only of the regulatory environment (which also gets laxer during bubbles – bubble psychology works on regulators, too) but of the nature of the products themselves. Credit securitization provided multiple opportunities to inaccurately represent risk, each of which was seized by somebody, and which collectively resulted in a much more substantial mis-representation than would have been the case with simpler products.

I’d be interested to know whether there’s any academic literature addressing this question of opacity/complexity and its relationship to bubbles.

8 Comments (Open | Close)

8 Comments To "Bubble Psychology and Complicity in Financial Fraud"

#1 Comment By Geoff Guth On February 7, 2013 @ 7:09 pm

“But the kinds of transactions Yglesias is talking about take place between “big boys,” where even if there are information asymmetries (and there always are), there’s no suggestion that they should be regulated away (nor is it obvious how they could be).”

This is probably the key to the problem and perhaps a solution as well.

Basically, we either need to regulate and/or tax the “big boys” in order to cut them down to size, or we need to find a way to wall them off from the rest of the economy so that they can play in their own sandbox without having the same effect on the rest of us.

I’ll note that most Depression era regulation of the financial system was more or less explicitly directed towards one or both of these goals. As had been pointed out ad infinitum, a very great deal of the blame for the bubble and ensuing crisis can be ascribed to the repeal of many of those controls in the ’80s and ’90s.

I’d add that the shift in the structure of retirement funding from defined benefit to defined contribution (an unmitigated disaster in and of itself) resulted in tons of money flooding into the financial system with little in the way of oversight and with truly massive information asymmetry. That almost certainly fed this “soft fraud” perpetrated by vendors of securities.

#2 Comment By Fran Macadam On February 8, 2013 @ 4:09 am

Yes, defined-contribution pension money is a massive legalized scheme to benefit those financial “big boys” who get to speculate with it on their own account. This windfall could be aptly described by fraudster capitalist Conrad Black as “a splendid conveyance of wealth” from those who worked for it to his untaxed speculator class.

The mandate to purchase unaffordable health insurance from wholly owned subsidiaries of the same Wall Street banksters follows just the same pattern of abuse.

#3 Comment By Steve Sailer On February 8, 2013 @ 11:39 pm

A real life example would help make this less abstract.

The CEO who has the best (or worst) claim to be at the center of the mortgage mess was Angelo Mozilo of Countrywide. About a decade ago, Mozilo did a whole bunch of speeches and interviews explaining how Countrywide could be growing so fast. Where were they finding all these creditworthy new borrowers? Well, Countrywide, Mozilo explained over and over, was just not being racist. Countrywide had figured out that minorities, especially immigrants, were worthy of sharing in the American Dream.

Note the special genius of his tactic: Are YOU going to say that minority immigrants aren’t worthy of sharing in the American Dream? On the one hand: vast sums and social respectability and one the other hand: missing out on short term profits and social pariahhood and discrimination lawsuits. Which would you have chosen?

Indeed, here we are about decade out from Mozilo’s Diversity Offensive, and almost nobody dares criticize it _today_.

#4 Comment By Daniel G.Jennings On February 10, 2013 @ 11:13 am

Take a look at Nicholas Nassim Taleb’s works. Especially “The Black Swan” and “Antifragile: Things that gain from Disorder.” He’s already addressed a lot of these problems.

#5 Comment By EliteCommInc. On February 10, 2013 @ 12:20 pm

I was surprised to find that there is no legal definition for due diligence.

I think despite the psychological aspects involved in investing in any market, the consistent behavior of:

-hiding debt
-hiding the actual value stock
-selling stock product(s) known by the seller to have $0.00 value
-the creation of dummy corporations to hold debt as profit
-the manipulation of actual mortgage via the manipulation of amortization payments
-the failure of credit agencies to accurately assess mortgage products as per home as opposed to packages
– leveraging multiple values over available reserves

There are so many practices beyond those listed above that comprise failures of due diligence and as such I think managing/regulating finacial investment institutions is possible.

I have only heard an interview with the author of Bail Out, but the excuse that human psychology explains behavior, does not lay a sufficient defense of what went on from 1978 (or just prior) — and is still practice today. Most of the decisions people make are interelated with their psychology. I am not sure that is a defense. Nor does it justify the subsequent bail outs, they went to the those who crashed the system via pasing billions (trillions?) of worthless product hidden in packages with product of value.

“Patrick M. Parkinson, Deputy Director, Division of Research and Statistics The Role of Hedge Funds in the Capital Market Before the Subcommittee on Securities and Investment, Committee on Banking, Housing, and Urban Affairs, U.S. Senate May 16, 2006” uses trems that are rife with problems: appropriate market dicsipline, appropriate diligence, excessively leveraged, privately created databases (in which available funds requiring no substantive dollars in support), etc. [5]

Below is a fraud case in which similar or exact behaviors could found in past financial institutional practice (in my view): [6]

#6 Comment By Clare Krishan On February 12, 2013 @ 1:44 pm

I agree re: Nicholas Nassim Taleb and Antifragile (but he will tell you its a not about an academic proof but a change in philosophy, a worldview grounded in humility on man’s inherent limits, and the persistent flaws of human nature. Price discovery on risk needs to be the mantra, not insuring against risks we don’t even have (everyone is now mandated to purchase insurance for the risk of… not being able to access the currently cheap and plentiful supply of a plethora of birth control and abortion products and services, even those of who are sterile because of age or past medical history, are not fearful of the risk of not being able to access said supplies because they don’t have a need (men), won’t have a need (use natural alternative means to regulate their reproductive acts) or can’t form the intent to desire to need to purchase them (religious objections to forming an intent to interrupt natural reproductive acts).

Proportionality is key to pricing anything – subsidiarity the social justice philosophy that governs who’s at the table when the risks are being weighed in the balance. Stakeholders and stewards sabotage subsidiarity every time they diminish the value of assets under management that they do not own. This is criminal behavior under any fiduciary statute you care to apply in most all the municipal code in US jurisdictions. The problem is that the assumptions we make on the static nature of the units of measurement of value/purchasing power in the marketplace (and the revenue raised to pay for public services) aren’t that static. They are warped over time by the processes of money creation by FIAT. And the unit’s depreciation in over time benefits one agent on one side of the fractional reserve currency transaction disproportionately compared to the other (scholastic history here
The one doing the reserving gains (at no risk, any firm too big to jail) while the one doing the depositing loses (any and all holders of the greenback — foreign or domestic– carry all the risks until they resolve not to, whereupon war ensues when the debtor wields the force majeure he’s accumulated on easy credit).

This is abjectly unjust, but its the monetary system we have in our centrally-planned economy, overseen by the quant-monetarists on the Mall. It needs to be abolished forthwith, but who ya’ goin’ t’ call? Absent a fresh vocabulary to engage discussion, we’re terribly exposed to our own systemic fragility (see Taleb, above)

Assymetry per se is not the problem. Asynchronicity per se need not be the problem. Magical thinking that denies the reality of man’s power to corrupt power itself is and can only be overcome by questioning the assumptions of the master magicians…

#7 Comment By Clare Krishan On February 12, 2013 @ 2:17 pm

Megan McCardle makes the same rhetorical error:

Most of nature’s majesty is not ‘snap-the-whip’ simple but opaque, complex leveraged fractals – with anti-fragility built in. That’s the clue to where the discussion needs to begin – what’s built-in to the solidarity of human nature that helps sustain stable subsidiarity? Our moral sense is where the dialog may play out cognitively, but success or failure rests in our religious sense, our desire for the good that is willing to form the intent to resist evil and act for objective goods at risk of whatever subjective means are at stake.

We have to reform not the distorted goods but the distorted acts. Without the will to hold all agents to account from bottom to top, we are lost…

#8 Comment By cdugga On February 13, 2013 @ 9:59 am

My understanding of the financial debacle was simply that the fraud between the buyer and seller of mortgage securities was gamed by many buyers who did their due diligence but could make even more money by buying enough securities to make other investors buy even more. They could then hedge those securities with the new credit default options, and that by many times the amt they would lose in the securities. In other words, they created the bubble on purpose with the plan to clean up with their options. For the most part they overplayed their hand and the companies like AIG who did not have the assets to pay out on the options left them high and dry until they just had to yell uncle.
The most disgusting thing about the multi-trillion dollar worldwide financial meltdown was that republicans rushed in, and still do, to blame the initial poor borrowers or the government for trying to get more citizens into homes. And who is going to jail? Nobody who really gamed the system since they are all part of a shadow market of credit default options, and investors and the SEC are unable to see who the gamers are. My guess is that the gamers are the same people who co-opted the original tea party in order to dismantle the parts of government regulating their enterprise and dissuade legislation aimed at shining a light on their shadow market manipulations. That’s right, yuze guys are being punked.