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

I have not responded to Coates' claims about Fed policy because his attempt to suggest causality to trader behavior is so weak as to not require refutation. I do think Coates is correct, however, about the dangers of complacency. Hyman Minsky made this point famous. Alan Greenspan and Ben Bernanke's belief that the markets automatically excluded accounting control fraud is the central example of disastrous complacency. Unfortunately, Coates exemplifies the same complacency, though he is blind to it. Consider this unintentionally hilarious claim the former trader makes about trading and traders.

"Traders are immersed in novelty and uncertainty the moment they step onto a trading floor. Here they encounter an information-rich environment like none other. Every event in the world, every piece of news, flows nonstop onto the floor, showing up on news feeds and market prices, blinking and disappearing. News by its very nature is novel, adds volatility to the market and puts us into a state of vigilance and arousal."

Coates either doesn't believe a word of his third sentence or he does. In either case he stands condemned by his own words. Let's assume for purposes of analysis that he actually believes what he says in that sentence.

• In 2000, this news spread across trading desks:

"From 2000 to 2007, a coalition of appraisal organizations " delivered to Washington officials a public petition; signed by 11,000 appraisers". [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] "blacklisting honest appraisers" and instead assigning business only to appraisers who would hit the desired price targets" (FCIC 2011:18).

A survey of appraiser in 2003 found that 55% reported personally experiencing coercion to inflate an appraisal in the last year. The updated survey in 2006 found the percentage had risen to 90 percent.

• In 2004, the FBI warned publicly that there was a growing "epidemic" of mortgage fraud and predicted that it would cause a financial "crisis" if it were not stopped
• In early 2006, the mortgage industry's own anti-fraud experts (MARI) sent these five warnings in writing to every member of the Mortgage Bankers Association (MBA):

"Stated income and reduced documentation loans " are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.

One of MARI's customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the "liar's loan."

Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans."

• These are the twin epidemics of accounting control fraud by lenders and their agents (principally the loan brokers) in the loan origination process.
• By 2006, at least half of all the loans called "subprime" were also "liar's" loans.
• By 2006, 40% of home loans originated that year in the U.S. were liar's loans (in the UK, the figure was 45%).
• At the 90% fraud incidence for liar's loans, this meant that over two million fraudulent liar's loans were originated in 2006 alone.
• In response to these warnings the industry massively increased its liar's loans (a 500% increase from 2003-2006)
• Simultaneously, loss reserves fell to the lowest level since the S&L debacle.
• Massive loan origination fraud must lead, if sold to the secondary market, to massive fraud in the "reps and warranties" used to sell loans to the secondary market.
• Clayton, the largest underwriter of loan purchases for the secondary market found that 46% of the "reps and warranties" for such loans were false.
• Hilariously, Clayton purported to use one fraud to purportedly "compensate" for another fraud. If they discovered that the borrower's income was inflated they would claim that the low loan-to-value ratio (often arising from inflated appraisals) "compensated" for the lender's fraud in inflating the borrower's income (and vice versa).

Coates assures us that:

"Every event in the world, every piece of news, flows nonstop onto the floor, showing up on news feeds and market prices, blinking and disappearing. News by its very nature is novel, adds volatility to the market and puts us into a state of vigilance and arousal."

So traders were in a "state of vigilance and arousal" about each of these facts documenting the three most destructive epidemics of accounting control fraud in history. What is Coates' story about what they did in response to these facts that they were primed by self-interest and biology to view hyper-vigilantly? In Coates' tale these normally hyper-vigilant traders turned off their vigilance and arousal because the economic news was too good. Except that I've just shown that the economic news was terrible and demonstrated that the Fed's story was a fantasy creation of ideologues. So why didn't the traders -- any of the traders -- react to the fraud epidemics? Indeed, even years after the fact (putting the lie to the absurd claim that "hindsight is always 20:20") Coates can't bring himself to use the "f" word about his former firms or anyone else in finance. Self-interest is the best explanation. There was enormous income to be made for everyone involved as long as the financial version of "don't ask; don't tell" remained.

(Will journalists please ask Coates when he first became aware that Libor wasn't kosher?)

But Coates' claim in the quoted sentence is also silly. Only a tiny percentage of the events of the world are reported in the media. Traders listen and read a tiny percentage of the media content. Traders are multi-tasking when they do read or watch and everything we have learned shows that this is a terrible way to learn. Traders do not understand more than a tiny percentage of what they fitfully read and watch. Traders do not know what they do not know. They are wilfully blind to entire fields such as white-collar criminology. Traders' analysis of what they think they know is commonly wrong. Traders have perverse incentives. The saying in the trade is that "every trader's first option is on the firm." The claim that, but for stable interest rates, traders would have seen the fraud epidemics that drove the crisis is ludicrous. Coates cannot even see the fraud epidemics 14 years after the appraisers' warnings. Coates even thinks that the crisis was driven by excessively risk averse traders. Coates' bottom line is the one we always hear from Wall Street -- it's not our fault, it's always the government's fault -- they messed up our hormone levels.

Conclusion

Coates' book about the crisis uses the word "fraud" only once -- and it is the context of explaining how a particular "short" can be structured without causing fraud. Remember, he worked at Goldman and Deutsche bank and regularly consults with the biggest, most fraudulent banks in the world. He, of course, would like to continue this lucrative consulting relationship. There is one sure way to kill such a relationship -- writing and speaking candidly about control fraud. Because of his background, a candid, confessional Coates could be a major asset to repairing the harm the rampant, elite frauds are creating. There is vital neurological work to be done on understanding what makes the fraudulent controlling officers tick on the biological level. I hope that Coates will join us in helping to stop the people he knows full well are growing ever wealthier by causing ever greater misery.