YOU CAN BET THE FARM THAT PLOWING DEEPER TURNS UP MORE WEEDS

(By Sri Ramamoorti) In two previous posts, colleague Vic Hartman addresses the $1.365 billion settlement between the federal government and Standard & Poor’s Financial Services LLC (S&P) and the miasma from which it emerged. He presents the tacit and possibly subconscious widespread collusion involved in a situation where all the players he described could dismiss individual and collective risks and focus on their incentives to incur those risks. The problems were systemic, of a scope that Vic suggests could be covered by the term, “Bad Farmer’s Market (a dimension enveloping and including Bad Apple, Bad Bushel, and Bad Crop).”

I want to expand that dimension even more. For ease of understanding the dynamics and interplay, Vic kept it simple. Here are additional complicating components that made a bad Market even worse:

· Congress-passed laws such as the Community Reinvestment Act (CRA), forcing banks to sell sub-prime mortgages to those who could ill-afford them—low income, high-default risk customers;

· Auction Rate Securities, that served to prop up the market (and their later collapse);

· Insurance companies (such as AIG), which “insured” the securities issues through Credit Default Swaps, to be on the hook for a whopping $450 billion in notional value and needing a $182 billion bailout;

· Regulators, including the SEC, that were hamstrung and discouraged by the prevailing mood of de-regulation and rolling back important Great Depression-era laws such as Glass-Steagall to create irreconcilable conflicts of interest;

· Investment banks such as Goldman, Merrill, Lehman, and Bear Stearns, all heavily invested in the subprime mortgages as a significant segment of their portfolios (other major banks were also at this trough);

· Hedge Funds, adding fuel to the fire.

This was a crazy Market indeed, and one that basked in the sunshine. Clearly, the rewards outweighed any risks in the view of these players. As Joe Koletar points out, in some cases it may be ineptitude, but more often it is unethically reward-focused. Here, it seems that the rewards dazzled the whole ecosystem into dismissing the risks as minimal. Citigroup’s Board of Directors was famously ignorant of some of their arcane financial products, such as “CDO-Squared.” CEO Charles Prince captured the moment when he said, “As long as the music is playing, you’ve got to get up and dance!” New Century, Countrywide Financial, Washington Mutual, Bank of America, JP MorganChase, Wells Fargo, they all got up and danced as the Market prospered, ignoring the reality that sometime soon, the music would end. Some may have been “too big to fail,” but that assumption too would be put to the test.

In the end, the risk was mostly unseen but systemic in scope. And it illustrates the need for someone to connect the dots between and among the actions of bad actors in the marketplace. One possibility would be the formation of a “Financial Stability Council” to connect those dots and judge the resulting image.

We do have marketplace referees, such as auditors, raters, and regulators. But how do we keep the public guardians (acting as referees) honest and effective in their role? Two Nobel laureates, George Akerlof and Robert Shiller, wrote, “The public, and the regulators who were supposed to act on their behalf…failed to understand a fact of life that is totally obvious to everyone who has played a serious team sport: There have to be rules and there has to be a referee who enforces them—and a good and conscientious (italics added) referee at that. Otherwise, there will be random cheating….and dangerous and aggressive play, so that many people will get hurt and the game will cease to reward good play.”

S&P was obviously less than “good and conscientious” in its ratings performance as it got up and danced with the other farmhands. I humbly proffer one Freudian insight, with Daven’s expert critique: “If it is those who love us who can hurt us the most, does it not follow that it is those we trust to protect us (such as auditors, raters, regulators, even the police) can hurt us the most when they violate or betray our trust?” And then, when this happens, what do we do about such malignant golden apples?

Join us for more insights into behavioral forensics (behind fraud and similar white collar crimes) from the authors of ABCs of Behavioral Forensics (Wiley, 2013): Sri Ramamoorti, Ph. D., Daven Morrison, M.D., and Joe Koletar, D.P.A., along with Vic Hartman, J.D.  These distinguished experts come from the disciplines of psychology, medicine, accounting, law, and law enforcement to explain and prevent fraud.  Because we are inspired to bring to light and address the fraud problems in today’s headlines, we encourage our readers to come back and revisit us regularly at BringingFreudtoFraud.com.

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