This book will help you avoid financial fraud
This book will help you avoid financial fraud
A DIY investor's review of "Lying For Money", by Dan Davis (also a podcast guest)
Hi! It’s George from Investorama, your guide to the future of investing - without the hype.
In this newsletter, I share notes from Lying for Money: How Legendary Frauds Reveal the Workings of the World, a book that has become my guiding light to understanding how frauds happen. Highly recommend reading it.
Frauds are very much the present of investing ( FTX, crypto scams, JPMorgan and Frank, Adani), and they will be there in the future.
Thinking about fraud is a bit like doing a fire drill. The goal is to know what to do to escape quickly. You see smoke, or you hear the alarm. You get out. You’re safe. It was probably a prank or a malfunctioning kettle, anyway. Hopefully, you will never experience real danger or fraud, but being prepared can be life-saving. When it comes to fraud, it’s the same story. It’s safer to walk out quickly if you have the slightest doubt. The problem is that we don’t think about it. We don’t have drills. Having encountered a few frauds recently (something I will talk about in a future post), I’ve decided to do some research and came across Davies’s book, which is both engaging and practical. I think I am now better armed to spot the signals and run away from potential frauds.
Below are 11 big ideas from the book, with a commentary about how it applies to DIY investors and recent events (NB: the book was published in 2018)
Fraud is only apparent in hindsight and from outside
The nature of fraud is that it works outside your field of vision, subverting the normal checks and balances so that the world changes while the picture stays the same. People in financial markets have been missing the wood for the trees for as long as there have been markets.
From my days on the trading floor, I remember conversations between traders that in hindsight, could be connected to the Libor of FX fixing scandal. But they were not secret. It was the usual way to operate. (NB: I was not involved in the conversations - just overhearing!)
Large-scale fraud only happens in high-trust societies
It is much easier to carry out a securities fraud in a market where dishonesty is the rare exception rather than the everyday rule.[…].
With that in mind, given what we know about the following two countries, why is it that the Canadian financial sector is so fraud-ridden that Joe Queenan, writing in Forbes magazine in 1985, nicknamed Vancouver the ‘Scam Capital of the World’, while ship owners in Greece will regularly do multimillion-dollar deals on a handshake?
This is called the Canadian Paradox. It applies to crypto, although it is an unregulated market. FTX, Celsius and others benefited from targeting users who grew used to a highly regulated banking system.
Fraudsters always play on the weaknesses in the system
One point which will come up again and again as we look at famous and large-scale frauds is that in many cases, everything could have been brought to a halt at a very early stage if anyone had taken care to confirm all the facts.
Madoff is a case study for that. The firm was investigated early but not thoroughly by the SEC. Madoff got away by providing false documents. The fact that the investigations were not conclusive provided legitimacy to the Ponzi scheme.
There will always be fraud
Precautions are expensive, or inconvenient, or both, and trust is free. This means that people will substitute trust for precautions up until the point at which the ‘shadow cost of trust’ – the expected fraud loss – begins to exceed the direct cost of precautions.
Checking costs money. Trust is frictionless. The level of fraud in a system is never going to be zero.
It’s much easier to prove mis-selling than fraud
In unregulated markets […] there is less constraint on one’s marketing material, so one’s sales patter can be utterly shameless. And second, one is not exposed to the quite draconian and arbitrary powers usually exercised by securities regulators to shut down investment schemes for any one of dozens of technical breaches or audit failures.
Financial regulation imposes constraints on the marketing material. Fraud is hard to prove if it doesn’t break any regulatory rule. As a result, many white-collar criminals stay unpunished.
Fraud can affect whole industries
This was the pattern followed by all of the group of ‘superstar’ S&Ls who dominated the scene in the early 1980s and were held up as examples to the rest of the sleepy, half-bankrupt industry. Every one of them turned out to be frauds.
This could be happening in Cefi lenders, an area we discussed before. Very few players are still standing (Nexo?), but they’re more likely to follow the rule than be an exception.
Fraud is usually not isolated
Big frauds tend to come in waves, as a particular set of weaknesses in the control system are found and exploited.
See crypto industry
Think about the moral characteristics of our age
Hypocrisy and turning a blind eye to squalor in the name of progress were, after all, the defining moral characteristic of the age.
This quote is about Victorian England. Could it be applied to our SPAC-loving contemporaries?
Fraud must precede regulation
This is a pattern that we can recognise in the modern era too; the controls and technologies of fraud prevention tend to move forward one disaster at a time. The normal state of the political economy of fraud is one of constant pressure toward laxity and deregulation, and this tends only to be reversed when things have got so bad that the whole system is under imminent threat of losing its legitimacy.
There are a lot of wishes about crypto-regulation coming from the crypto industry, hoping it will bring legitimacy to the industry. However, Charlie Munger called from a different approach: an outright ban.
Need - Opportunity - Rationalization
A fraud happens when the following conditions are simultaneously met: Need Opportunity Rationalization
Rationalization is the reason why so many white-collar fraudsters appear so delusional, even when they are caught. They have convinced themselves that it’s ok. Think SBF planning to raise funds after FTX’s collapse.
Growing too fast = red flag
[…] the basis of my proposal for a Golden Rule: Anything which is growing unusually quickly needs to be checked out, and it needs to be checked out in a way that it hasn’t been checked before.
After reading the book, I learn to trust Dan Davies and follow his wisdom, so I’m just leaving this one here, but I’m not sure how applicable this is in the startup world. And what does “unusually” mean? ChatGPT is growing unusually quickly; should we be worried?
These are just a few highlights. Read the book to find out more.
The “democratization of alts” is a high-trust environment, lightly regulated, with few marketing constraints and many new players. This doesn’t mean frauds are being committed or will ever be, but it sure looks like fertile ground for fraud. To go back to our fire metaphor, it’s like a “high fire severity” area where it’s good to know the escape drill.