Financial Fraud and incentives

I highly recommend this EconTalk podcast on financial fraud with William Black.  It gives a great summary of how financial fraud is perpetrated.  It also clearly highlights the difference in opinions on the cause of the recent financial crisis.    What most people seem to agree on is that the financial crisis was caused by a system wide Ponzi scheme.  Lots of mortgages were issued (some were liar loans where the recipients clearly were not qualified, while some were just risky); these loans were then packaged into mortgage-backed securities (e.g. CDOs) by investment banks who them sold them to other banks and institutional investors like hedge funds and pension funds.  As long as housing prices increased, everyone made money.  Homeowners didn’t care if they couldn’t pay back the loan because they could always sell the house.  The mortgage lenders didn’t care if the loans go bad because they didn’t hold the loans and made money off of the fees. Like a classic Ponzi scheme, when the bubble burst everyone lost money, except for those who got out early.

The motivation for the mortgage lenders seem quite straightforward.  They were making money on fees and the more mortgages the more fees.  When they ran out of legitimate people to lend to, they just lent to riskier and riskier people.  The homeowners were simply caught in the bubble mania at the time.  I remember people telling me I was an idiot for not buying and that house prices never go down. The question at dispute is what were the incentives for the investment banks and institutional investors to go along with this scheme. Why were they fueling the bubble? Libertarians like Russ Roberts, the host of EconTalk, believes that they didn’t care if the bubble burst because they knew they would be bailed out by the government.  To him, the moral hazard due to government intervention was the culprit.   The pro-regulators, like Black, believe that this was a regulatory failure in that the incentives were to commit and reward fraud.  The institutional investors simply didn’t do the due diligence that they should have because the money was rolling in.  He cites the example of Enron, where incredible profits were booked through accounting fraud, which not only didn’t raise alarm to investors, but only attracted more money leading to  more incentives to perpetuate the fraud.  He also says that thousands of people were prosecuted for fraud in the eighties after the Savings and Loans crisis but no one has been prosecuted this time around. He believes that unless we criminalize financial fraud, this will only continue.  The third view, shared by people like Steve Hsu and Felix Salmon, was that the crisis was mostly due to incompetence (Steve calls this bounded cognition).  The investment banks had too much confidence or didn’t fully understand the risks in their financial instruments. They thought they could beat the system. The fourth possibility is that people knew it was a Ponzi scheme but either felt trapped and couldn’t act or thought they could get out in time. It was a pure market failure in that the rational course of action led to a less efficient outcome for everyone.



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