How Fraud Explains the Economy

[MUSIC PLAYING] MARK BLYTH: Hello, my name's Mark Blyth. I'm the Director of the Rhodes Center for International Economics and Finance at the Watson Institute at Brown University. As part of our programming, we run a podcast series, which we've been doing for a few years now, where we try and bring you some of the most interesting, innovative, and interdisciplinary insights in the worlds of finance and economics.

In that capacity, I'm delighted to be talking to Dan Davies today about his forthcoming book, Lying for Money, How Legendary Frauds Reveal the Workings of Our World. Welcome, Dan.

DAN DAVIES: Hi, thanks very much for inviting me.

MARK BLYTH: A little bit of background on Dan before we dive into the topics. Dan Davies is head of research at Frontline Analysts, the Bangalore based global credit and risk management firm. He's a former bank regulator and investment banker, who investigates global economics and finance for consultancy clients and writes books and articles for the general public.

And he writes about fraud. Now, fraud is something we all think we know. And I encourage you to go get this book, because it will tell you, you really don't know fraud at all. There's a tendency for us to think of fraud as individual malfeasance, a few bad apples. And that's the way it often seems to be portrayed in the media, even when hundreds of millions of dollars are involved. I'm thinking about an example of the LIBOR scandal of late.

But what Dan suggests in his book is that there's a much more systematic dimension to this. That it isn't just about bad apples. In fact, that's probably the wrong way to look at it. Dan, would it be fair to see that fraud is endemic to finance? You can't have basically a functioning financial system without some degree of fraud?

DAN DAVIES: Yeah, absolutely. You can't check up on everything. I once, when I was a banker, for a bet with a client, I did one of those management consultancy envelope calculation exercises just to work out what kind of manpower it would take for every single transaction in a medium-sized financial market to be fully investigated.

And we ended up concluding that pretty much every chartered financial analyst who has ever got the qualification, plus every chartered accountant to have qualified in England, Wales, and Scotland would have been needed to work full time doing nothing but credit checks on interbank transactions for the market in London. If you wanted to add New York to that, then you're basically looking at every accountant that has ever qualified anywhere in the world since the beginning of accountancy.

And, of course, most of that time would be completely wasted. These guys would be working eight-hour days, and they might find two or three crooked transactions in a year. And because that's an absolutely absurd ratio of input to output, no one does that. So, the one thing I think that people misunderstand about finance from the outside is how much we all trust each other.

Once you're in the circle of trust, no one checks up on you at all anymore. But that means that once you're in the circle of trust, you can do what you like. So, it's not realistic to assume that every now and then someone's not going to take advantage of the fact that every single day they are put down effectively in a room full of sacks of dollar bills on the assumption that they won't try to put some of them in their own pockets.

MARK BLYTH: So, if I'm choosing to commit a fraud somewhere in the world, in the world of finance, you would suggest that I go to Canada rather than Greece. Most people would not actually think that would be the case. Why would that be the case?

DAN DAVIES: Well, listen to yourself, Mark, you don't sound very Greek. Not only that, but you're not Greek. And even if you were to become naturalized Greek or marry into a Greek family, you wouldn't have been there since well before the Second World War, or ideally before the birth of Christ. And so, you would find it very difficult to get anyone to do business with you.

You could buy a ship, but you wouldn't get into the Ship Owner's Corp in Paris, or if you did, it would be only because you had married into a family of existing members. In Greece, you will find people who will do deals on a handshake, but they will do them with people that they know.

On the other hand, in Canada, show up, kind of trustworthy Scottish accent, nice suit, talk a good line, it would not take you very long at all in Toronto to find someone who would advance you $10 million Canadian worth of interbank lending versus a portfolio of securities that you had only reasonable proof of their ever existing. And people do do that.

If you wanted to float a podcast series with a completely made up set of accounts on the Toronto Stock Exchange, you could get a broker to do that for you. They might-- they'd do some degree of due diligence on that, so you would need a crooked accountant. But if you've got an accountant who is prepared to keep their mouth shut, then I would say if you're not making millions out of that, you're not trying.

MARK BLYTH: So, we live in a world in which trust is both the thing that makes everything work, but is also the weakest point in the armor. That's where fraudsters go for. The fact that everything can't be checked, the system runs on trust. You also describe it as an equilibrium phenomenon. What do you mean by that?

DAN DAVIES: The first thing I mean by that is that the optimum level of fraud is not zero. It is not worth trying to get fraud completely out of the system, because even very prosperous places do. The second thing I would say is that I think of it as an equilibrium in an economic sense because similar fact patterns keep on repeating themselves across time and space. The same kinds of frauds keep on showing up. To me, that suggests that something like a commodities finance fraud is an equilibrium solution to a set of underlying economic incentives.

And then, I would think probably that I would regard the level of trust in society and the level of fraud in a society as being in some way jointly determined. But unfortunately, not in a straightforward way, or certainly not in a way that I could describe by a simple linear or even U-shaped curve.

You can have high trust, high fraud, low trust, high fraud. You can have all four kind of courses, the box filled in. But once you get one, they tend to be quite stable. You don't get many cases of places migrating from having low trust and low amounts of fraud to a different kind of quadrants of the box.

MARK BLYTH: So, in the book, one of the great things about the book is it's got 20 or 30 anecdotes, anec-data, all the classic frauds. He's not your favorite-- Charles Ponzi is the one that everyone's probably heard of, but then there's also Charles Keating. There's a whole bunch of different frauds and fraudsters.

But what you do is you basically create a typology of different frauds. So, you talk about long and short firms, counterfeit as a form of fraud, control fraud, and then market crimes. And each one basically becomes more complex as you go up. Could you walk us through that? Basically, what's a long firm? What's the scam? How do you pull it?

DAN DAVIES: Yeah, well, a long firm is where you get a load of goods on credit, fridge-freezers was the classic one. You put them in a shop. You sell them at prices well below the going rate to everyone in the neighborhood. Once you've got all your cash takings in there, you just disappear, set fire to the premises if you feel like it.

But in any case, you basically take advantage of the fact that when people sell you goods, in real business world, but not necessarily in economic textbooks, they don't do it for cash on the nail. They will give you 30 or even 60-day terms. And 60 days is plenty of time to turn an inventory into cash.

And the great thing about this, of course, is that if you steal a car, then immediately the owner is looking for it, and you have to go to a lot of trouble to sell the damn thing. If you take delivery of a car to your fraudulent auto dealership, then the guy that you've stolen it from is going to expect to see it there on the forecart with a price sticker on it. And because you don't look like a fraud, because you aren't until you've committed the crime. It's that kind of time dimension. So, that's the long firm.

Counterfeit is what it appears. I regard it is economically a bit more sophisticated because you're not exploiting peoples' trust in you. You're exploiting their trust in a particular system, usually paper money. But you're just either creating something which creates the appearance of being of value itself, or creates the appearance of certifying the value of something else. And you're exploiting that kind of system.

And those are-- those are the kind of individual things. Then you get to the real kind of levels of obstruction. A control fraud is a term that's only really been around since the nineteen-eighties. It was invented by a guy called Bill Black, who was the hero of bank regulators, basically. He busted S&L frauds.

And what he pointed out was that the interesting thing about an S&L fraud, and you can generalize this, is that the individual actions by which the owners of corrupt savings and loan banks stole money were not illegal. They bought real estate developments. They paid salaries. They paid dividends.

The crime was in the scheme of the thing, which was based around inflating balance sheets with bad loans, and then walking away, leaving the US taxpayer with the bill. So, that control fraud is interesting, because you're exploiting your control of an economic entity that's larger than yourself.

And then the fourth type that I deal with in the book is something I call a market crime. We've got a lovely example of that in the last couple of weeks, where JP Morgan settled an ungodly amounts of regulatory fine for spoofing orders in the commodity futures market. And where's the commandment for that one?

A long firm is thou shalt not steal. A counterfeit is thou shalt not bear false witness. But thou shalt not place orders into an electronic trading system designed to effect other market participants' algorithmic perception of the underlying balance of supply and demand. There's lots of people who would not see that as a crime.

I'm not necessarily sure I see it as a crime myself. What it is is a recognition of the fact that the commodity futures market is big enough and important enough to society as a whole that it's market conventions have the status of crimes. And I think of it as a rising ladder of abstraction.

You've got trust in other people. You've got trust in the certification system. You've got trust in the capitalist economy. And then you've got trust in the organization of society itself. And it's the level of trust that the fraudsters' exploited that interests me in that context.

MARK BLYTH: So, let's give some examples from each. I don't want to talk about Ponzi, because you don't like Ponzi, and I don't like him either. But one of the interesting things you see about the Ponzi scheme model, the pyramid model, is it's actually very hard sometimes to figure out that this is actually a fraud.

DAN DAVIES: Yeah.

MARK BLYTH: So, why is-- why is it sometimes-- this is obviously a fraud. Actually, it's really hard to see that as a fraud.

DAN DAVIES: Well, yeah, it's the scheme. And it's in many ways the intention that makes the fraud. And you can have absolute massive debates about this. One of my buddies is a guy called John Hampton in Australia, who's a fund manager, who makes a specialty out of busting frauds.

And he has a very strong interest in a company called Herbalife. And Herbalife is a multi-level marketing scheme. And it's a scheme in which you have the classic property that people make money, not so much by selling the product as by recruiting more people into the scheme, and so on, and so on.

And as I say, John is a former Australian Treasury economist. He's a sharp guy. He doesn't think it's a pyramid scheme at all. He thinks it's a legitimate nutritional marketing scheme, which probably sells generic protein powders for more than they cost, but which, on the other hand, organizes a whole load of working class people who really need to lose weight into social situations where they can lose weight.

And, yeah, if you go around calling Herbalife a Ponzi scheme in his presence, you will get a mouthful of choice Australian invective. And that's an interesting one to me. You can have a genuine uncertainty in your mind about whether something is a pyramid scheme or a Ponzi scheme, broadly defined or not, because it's the intention that makes the crime.

It's the same thing as a long firm. I talk about a long firm as you buy a whole load of stuff on credit, sell it for cash, and then disappear. That looks like an honest business which just went bust. And that's one of the reasons why the criminologists who write about these things say everyone gets one free go at the long firm.

The first time out, if you have had the sense to get rid of the money from your own bank account, if you've got no previous convictions, and you just sit around saying, I'm really sorry, this was my attempt to go into business and it just didn't work out, the chances of you getting even put on trial, let alone convicted, are apparently absolutely minimal. I'm not I'm do that, but it is a fact that you wouldn't get caught.

MARK BLYTH: It's not a recommendation, but nonetheless.

DAN DAVIES: Yeah, just an interesting fact about the world.

MARK BLYTH: Just an interesting fact about fraud. In our earlier conversation, you did mention, though, there's a kind of like holy troika to do with fraud, which is different from the one which we normally associate with crime. So, any detective show you've watched is means, method, opportunity, right? What's the one for fraud? It's subtly different, isn't it?

DAN DAVIES: Well, yeah, it's kind of-- motive is very similar. Because the motive for fraud is just basically you want the money, either pure greed, or your company is going bust, and you need to do something to change that or whatever. The opportunities are also pretty similar, because an opportunity to commit fraud is just a weakness in a crime.

But it's not so much the means that you're interested in fraud, because the means is just one of the ways that I've said, to counterfeit something, or run a long firm, or whatever. The third component of the fraud triangle-- a guy called Donald Cressey, who was a sociologist who first noticed this in a book, which is called Other People's Money.

And it's interesting because, every single academic library I've been in, that copy, that book has been stolen from it or mis-laid. The British Library records their copy has mis-laid, but I'm telling you, I do not believe it was mis-laid.

But he says that the third component in the fraud triangle is rationalization. Because from a sociological point of view, the interesting thing about this as a crime is that it is literally white collar crime. It's committed by people who are not-- lovely sociological speak-- deviant members of society.

They're not of the underclass. It's intrinsic to the crime that the fraudster has to keep on presenting themselves as a member of the legitimate business community. And they have to keep presenting themselves to their self as a legitimate business.

So, if you go through this, and this is actually one of the things that makes the autobiographies of fraudsters, of which I have read more than the normal person, so nauseating to read, they've always got an explanation about how it wasn't really their fault.

They've always got an explanation about how they weren't really a dishonest person, and they didn't do anything quite so simple as stealing the money because they wanted it. And that's the crucial component, according to the people who study these individuals.

MARK BLYTH: But there's also something else that you point out, which is very arresting. And we all think about it, but it's also kind of obvious, but it makes it different. And it's the following. As you put it, a drug dealer can just stop selling drugs. A shoplifter can stop nicking stuff out of shops. A bank robber can just stop robbing banks. But once you start at a fraud, you have to keep going. Why do you have to keep going?

DAN DAVIES: It's because you have to conceal the existence of the crime itself. There's no really good television series about the fraud squad because it just doesn't fit a dramatic structure. If someone's been murdered or a house has been robbed, it's pretty obvious what's happened. And then you have to find out who did it,

When Enron went bankrupt, it was pretty obvious whose fault it was. When Barings Futures Singapore, the very first fraud I was ever involved with on the regulatory side, showed up with $1 billion Sterling of losses, it was absolutely obvious there was only one person could have been responsible.

So, what the fraudster has to do is to conceal the existence of the crime itself. And the trouble is, like anything in business and economics, it involves that dimension of time. And the other trouble is that over dimension of time, things grow.

And so, if you are trying to be the new Bernard Madoff, if you want to keep the fraud going for three or four years, you end up having to steal $2 or $3 million US worth of new investors money in order to cover up your original theft of the million.

Madoff himself, when he went to prison, had probably stolen roughly $40 billion US of investors' money for an original fraud that could not have netted him more than three figures of millions. Now, the ratio of error and bullshit, and basically compound interest on the original stolen money, was extraordinary.

MARK BLYTH: One of the most interesting parts of the book for me is how fraudsters are themselves victims of fraudsters. So, you talk about two things. The first one is the Silk Road. And the second one is this incredible thing I'd never heard of before, prime bank securities.

DAN DAVIES: Oh, God, I will feel terribly guilty if you develop an interest in prime bank securities.

MARK BLYTH: It stops you today, I promise, I promise. But it's just absolutely fascinating. Because it's the con for the con.

DAN DAVIES: Yeah.

MARK BLYTH: Right, that's what's amazing about it.

DAN DAVIES: Yeah, for the podcast listeners, prime bank securities is-- it's an ongoing species of fraud, but it's weird, because it's a culture of fraudsters. It's a-- the nature of the fraud is just simply counterfeit securities. They are worthless securities. And they are sometimes people charging advance fees for the service of dealing in, again, counterfeit worthless securities.

It's all based up with a completely false theory about how the Federal Reserve works. But there's a large and self-sustaining community of people who really believe in them. And these people have convinced themselves that the market really exists, and they just need to raise enough money in order to trade on it themselves. And then they will make enough money to pay back all their victims. That's their rationalization.

But, yeah, you regularly get in the prime bank guarantee market someone who has defrauded-- most recently a guy called Paul Heerema, who is a shipping magnate, who wanted to build basically the world's biggest ship. And some fraudsters told him that by investing his seed capital in the prime bank guarantee market he would make returns big enough to finance the whole building of his ship.

He handed it over to them. They stole it. And he ended up, because he's Dutch, and in general, if you're building the world's biggest ship, you're quite a determined guy, so when the Feds decided they were dropping the prosecution for lack of evidence, he took it on and ran it as a private prosecution, ran it through to the fraudsters going to prison.

But couldn't get his money back, because they had already spent it. And what did they spend it on? They spent it on an exactly similar fraud to their own being run by a different guy, who had told them that if they invested in the prime bank guarantee market with him, then they would make enough money to get themselves out of trouble with Paul Heerema.

There's no guarantee that this other person hasn't also been conned by someone. It's a very, very strange subculture. It is also the subject of my initial warning, a massive Internet rabbit hole, which I genuinely guarantee-- recommend that people don't care into.

MARK BLYTH: I will not be going down it. What about Silk Road? Because that's meant to be the classic honor amongst thieves story, but it turns out that they just got defrauded as well.

DAN DAVIES: Yeah, well, the thing about the Silk Road frauds, they were exit frauds. An exit fraud is a particular kind of long firm. So, if you're on the good old Silk Road illegal drugs marketplace, there was a lot of professionalism on that marketplace. And you could operate through the escrow system that they used.

It turned out that that was a bad idea, because in the end that was run by thieves as well, and they just stole the money. Most people didn't run through the escrow system. They just literally sent off Bitcoin, which was value bearing magic numbers by email into the void. And they got drugs back. And it worked nearly all the time.

But you tend to get this problem in online drug markets, that people grow up. People leave college. People might get busted for some of their other crimes. And at the end of the day, no one really goes into the online drug dealing business thinking that they're going to build up a fantastic name, retire, and hand it onto their kids. So, people stop.

And when you stop dealing drugs, you think, well, I could just stop, but people are emailing me money for free at the moment. So, I could take a load of orders for drugs and then disappear. And because the thing about the Silk Road market was the disappearing bit was made very easy. And that happened all the time.

But the interesting thing was that although people who traded on that market regularly desperately wanted the exit frauds to stop and kept on warning buyers, exit frauds happen all the time, use the escrow system, don't send money just by emailing people bitcoins, no one did it, because it was a pain in the neck. And so, that was, I suppose, an example of what we're talking about in terms of fraud being an equilibrium quantity.

There was a certain amount of hassle in being involved in the escrow system. There was a certain level of sending the money and not getting your drugs that was endemic to the market. And there seemed to be nothing that anyone could do to affect the tradeoff that the buyers used to use.

Of course, if Silk Road had had a government, they could have passed a law saying, you will use the escrow service and there would have been no fraud problem. But they didn't have anyone to enforce that, because anyone enforcing that might have enforced the don't sell drugs law. And so, as a result, they had to deal with the market finding its own conventions. And those conventions tended to involve people making themselves very vulnerable to exit scams.

MARK BLYTH: So fraud, upon fraud, upon fraud.

DAN DAVIES: Yeah, and also a lot of the time the drugs they were buying were counterfeit as well.

MARK BLYTH: You can't win. So I want to turn to one topic in closing, and two examples, which I think is the most fascinating part of the book, which is the notion you can have fraud without fraudsters. So this is control fraud, but what you call a distributed control fraud.

You've got two examples. One is British, and one is American. Could you walk through both of them, and tell us what they are? And basically, why this is so bonkers? Because you can have lots and lots of people committing fraud, but nobody knows they're committing fraud. And there's no actual fraudster controlling the gig.

DAN DAVIES: Yeah, well, the distributed control fraud is an extension of Bill Black's original concept. And another word that he coined was the criminogenic organization. And a criminogenic organization is one where a control fraudster has subverted all of the practices and incentives of the company to his criminal act. And you have a system where people are paid a bonus for getting high evaluations on real estate assets, you will get fraudulent real estate loans.

And the interesting thing to me was that if you looked at a lot of the worst things that happened in the run up to the global financial crisis, Royal Bank of Scotland in the UK was clearly a criminogenic organization. And it was an organization in which-- I'm picking on them because I happen to dislike the chief executive. All the other UK banks were just as bad.

They had branch staff who were given very aggressive sales targets for a badly overpriced insurance product, which had been drafted with extremely consumer unfriendly terms, which were easy to misrepresent. And in that situation, you've created that set of incentives.

What's going to happen? Well, what's going to happen is what actually did happen, which was the product, which is called Payment Protection Insurance, it was a kind of private unemployment insurance that was extremely difficult to claim on, got sold to huge, like macro economically significant numbers of consumers for whom it was completely inappropriate.

And it ended up-- over $50 billion US ended up having to be repaid to these customers. But then in the inevitable inquiry into this in the UK, it turned out that the chief executives were as horrified as anyone else to find out that this had happened. There was no single meeting at which anyone said, here's a product that's absolutely brilliant for ripping off British consumers.

There was just a series of meetings at which the sales targets were set. There was a series of meetings at which the product was designed. People wrote sales material. The whole kind of raft of normal business things came together to create a criminogenic environment.

Similarly, in the USA, you have there a system called MERS. And MERS is the Mortgage Electronic Record System. And it exists because US land title is really, really ridiculous. There's no central land registry in the USA. All the records are in local courthouses, which is a problem. Because obviously, the land registry also has to be a record of mortgages. Because the whole point of a land registry is that you can't sell the land if there's a mortgage on it.

If you want to create a mortgage bond securities market, and then you can't be going around to every courthouse in Rhode Island every time someone trades a bond or every time someone creates a security. So, they have to do it electronically. They cut corners in doing this.

What the banks ended up doing was what they called robo signing. So you had literally 1,000 mortgage notes with exactly the same signature on them of a bank employee who often hadn't even been employed at the time when the mortgage was taken out. And so, you had literally industrial production of forged documents.

In most cases these were forged records of a real transaction. So, they weren't forging fictitious mortgages. But, of course, the fact, they had been forged concealed many things about the original lending decision, which might have caused a court to look more favorably on the borrower, and to give them more generous treatment in agreeing a restructuring plan.

So, what you had here was, probably in terms of the amount of documents counterfeited, the biggest counterfeiting fraud that there is ever being by several orders of magnitude. And if you were to multiply that by the amount of fraudulent mortgages that were created, it's just an absolutely head-spinning number.

No one went to prison for it, because if you want to send someone to prison they have to meet you halfway by committing a crime. The only people committing a crime were the poor, lowly clerks, who were at a table with 100 mortgage notes on it to sign. And prosecuting them and throwing them in jail just feels pointless and unedifying.

The guys at the top of the business claimed not to know it was going on, and probably did not know what was going on. All they'd created was a situation in which people lower down the organization had no alternative except to commit fraud.

Obviously, they didn't hand back the bonuses that they had as a result of these things. That would have been too much. What I end up thinking is, can you think of anything that is more calculated to destroy confidence in the system as a whole than a situation in which it's possible to create, or for almost for an organization to spontaneously create, a massive crime that can't be pinned on any specific individual?

MARK BLYTH: Essentially, what you're saying is fraud is endemic and unavoidable. It's just going to happen. It's the nature of the system. Should we try and eliminate it? Or is that actually a fool's errand?

DAN DAVIES: Well, the trouble is that you can't eliminate it without spending absolutely ridiculous amounts of time and effort on doing so. You can reorganize the incentives. You don't get, for example, much bank fraud in Sweden because the chief executives of banks aren't paid as highly in Sweden as they are in the USA.

They've got-- the joke I always make is that bankers steal money for the same reason that heroin addicts do. They've been put in a position where they can't get the money they need by honest means. And in an egalitarian society, that happens a lot less.

But as well as saying that you can't eliminate fraud, you also can't tolerate it. Because once you start tolerating it, if you tolerate it at the high level, then you make it much easier to rationalize it at the low level. So, again, in the Netherlands, or Sweden, or even Canada, anyone who's caught carrying out a fraud has to think of themselves as being a bad guy. Because the people at the top of the tree don't act like that.

In a place like stereotypical Nigeria, or stereotypical Greece, or Lebanon, anyone caught carrying out a fraud shrugs their shoulders, and says, it's the way of the world, what are you going to do? Because the people at the top of society act like that.

It's one of the cases where the case for putting someone in actual prison as a deterrent to other potential criminals is far easier to make even than crimes of violence. It surprises me that that doesn't happen a lot more. Because certainly, in my experience of talking to people who used to go close to the line in terms of insider dealing, the fear of actual prison is absolutely disproportionate to the fear of financial penalties.

MARK BLYTH: Dan Davies, thanks very much for this wonderful conversation. Just a reminder to everybody, the book's coming out in March. It's coming out with a Simon and Schuster imprint called Schreibner. And the title of the book is Lying for Money, How Legendary Frauds Reveal the Workings of Our World. Thanks very much, Dan.

DAN DAVIES: Thanks very much.

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MARK BLYTH: This episode of the Rhodes Center Podcast was produced by Dan Richards. For more information, go to watson.brown.edu/rhodes. Thanks for listening.

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