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OpEdNews Op Eds    H2'ed 6/10/14

The Criminology of the "Sure Thing" Portrayed as "Risk"

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Because Coates has no clue -- despite being at ground zero during the three most destructive U.S. epidemics of accounting control fraud in history and the world's largest cartel, and a raft of other control frauds in which Goldman and Deutsche Bank played lead roles -- that accounting control fraud exists he ignores the differences in types of risk and the existence of the three "sure things" that arise from accounting control fraud. Again, because he has implicitly assumed the actual causes of the crisis out of existence he feels no need to explain why he thinks this is the first "Virgin" crisis. Today, no one seriously denies the role of accounting control fraud epidemics in causing the Enron-era crisis or the second phase of the S&L debacle. Why would one create a study design that purports to study "risk" and the recent financial crisis in which one assumes out of existence what he knows was the paramount cause of the other modern crises? (In both crises, the first response of economists and financial professionals was to blame "risk" rather than fraud, but those knee-jerk apologies proved to be embarrassing failures as investigators documented the thousands of insider frauds.)

You know you don't understand risk, fraud, or crises when you write".

Coates' metaphors demonstrate his lack of understanding of risk, fraud, and crises.

"Risk by its very nature threatens to hurt you, so when confronted by it your body and brain, under the influence of the stress response, unite as a single functioning unit. This occurs in athletes and soldiers, and it occurs as well in traders and people investing from home. The state of your body predicts your appetite for financial risk just as it predicts an athlete's performance."

No, it doesn't. A trader who can rig the trade, by gaming Libor after the trade to ensure success succeeds because the game is rigged. The CEO running a control fraud or engaged in insider trading seeks a "sure thing" and he creates perverse incentives for his employees, officers, and outside professionals to ensure that they too can secure wealth through "sure things" that will aid and abet his frauds. Merrill Lynch officers, for example, "ate their own cooking" -- purchased huge amounts of the super senior CDO tranches because the combination of a AAA rating and the premium yield -- because doing so guaranteed that they would receive large bonuses. The massive losses, of course, would fall on the shareholders. The Merrill traders' hormone levels would have been interesting to study. Did it trouble their "bodies" (Coate's focus) to destroy the firm to make them rich through a "sure thing?"

The fraudulent CEO's power and lack of ethics "predicts [his] performance." Athletic performance is often "predict[ed]" by cheating. That is true of a very substantial number of the world's top athletes -- and that portion would be far larger but for enormous efforts to detect and sanction such frauds because athletic cheating creates a Gresham's dynamic. Only vigorous regulators, enforcers, and prosecutors can break the Gresham's dynamic and allow the honest to prevail. Coates knows that we have not had effective financial regulators, enforcers, and prosecutors for two decades and that the result will be a powerful Gresham's dynamic and endemic fraud.

Again, Coates and everyone reading Coates knows these facts -- but chooses to exclude them from reality. Behavioral finance and the mind (which Coates sees as overemphasized relative to the body) are the keys to understanding why we lie to ourselves about lying to ourselves.

Once more, Coates' argument actually explains why control fraud would be common. If you risk losing your bonus and your job as CEO or CFO if you cannot match the record earnings reported by rival banks engaged in accounting control fraud then Coates' findings suggest your body and mind will unite to drive you to mimic their "sure thing" fraud strategy.

"Risk by its very nature threatens to hurt you, so when confronted by it your body and brain, under the influence of the stress response, unite as a single functioning unit."

Another example of Coates' failure to understand risk, fraud, trust, and crises is found in this paragraph.

"Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite."

No, not even close. Markets froze up because market participants realized the end of the financial version of "don't ask; don't tell" had arrived and they could no longer continue to massively overvalue toxic waste assets. Those assets lost value because they lacked value -- not because of a change in "risk" preferences. The "sure thing" does eventually come to an end when the bubble collapses and asset values fall as new fraudulent loan originations largely cease. What would happen to a trader who followed Coates' advice and assumed there was no change in the recognition of fundamental values and instead merely an increase in risk aversion? It would buy up the toxic waste near its peak values. The economy does not "need people to take risks" that have a negative expected value due to fraud. By assuming that all "risk" is the same and implicitly assuming the frauds that drove the crisis out of existence Coates produces a policy prescription for disaster.

They weren't so helpless to their hormones that they failed to optimize their frauds

Again, I want to emphasize the strong desirability of behavioral and neurological research. I also want to emphasize that whatever their (interacting) behavioral and hormonal states the CEOs that ran the accounting control frauds that drove the crisis were able to consistently take actions that optimized those frauds. They were able to create the biggest bubble in history in the U.S. (and even larger bubbles relative to GDP in Ireland and Spain), the most destructive financial fraud epidemics in history, the largest cartel by three or four orders of magnitude, to get fabulously wealthy through the frauds, and to keep their reputations and wealth without being prosecuted. They expertly added each of the four ingredients of the fraud recipe. They took great advantage of the infamous industry saying: "a rolling loan gathers no loss." They adjusted as the bubble came closer to ending, bringing every more hopeless home borrowers to purchase homes at massively inflated prices with the critical aid of fraudulent appraisals which they induced by creating a Gresham's dynamic. They increasingly adopted "neg am" loans that would delay the defaults to get past EPD buy-back provisions. They suborned auditors and credit rating agencies (again, by creating Gresham's dynamics) so successfully that they were consistently able to get AAA ratings for toxic waste -- backed by clean audit opinions for massively fraudulent operations that had often rendered the lender deeply insolvent.

The CEOs of the most fraudulent SDIs then managed to get the largest bailouts in history and to grow far larger. They caused an estimated loss of U.S. GDP of $21 trillion (measured from the onset of the crisis to the projected full recovery) and ten million jobs (those figures will be far larger for the EU). Despite all of this, their political power has grown and scholars now commonly describe the result as crony capitalism. Some of the largest banks openly cheer the creation of a "plutonomy." No one should believe in the theoclassical myths of rationality, but it is a mistake to believe that elite frauds aren't able to channel their hormonal rage into a means for aiding their frauds. I want to emphasize again that Coates' statements about the impact of risk on our bodies offer powerful support for what I have just described about highly competent fraud mechanisms. If he is correct that avoiding risk leads to hormone releases that cause our bodies and minds to work together intensively to seek a "sure thing" then the folks who rise to the top will be those who understand how to run a control fraud and lack sufficient ethical barriers to resist that urge to avoid any risk of failure.

Coates' Claims about the Fed

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)
 
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