7

Bernie Madoff: Frauds, Swindles, and the Credit Cycle

Charlie Ponzi is the most famous banker in American history, immortalized in the term ‘Ponzi scheme’. Ponzi owned a small firm that sold deposits in one of the Boston suburbs in the early 1920s; he promised to pay the buyers of these IOUs 45 percent interest a year at a time when the traditional banks were paying two or three percent. Ponzi’s operation was straightforward – he used the money that he received from the sale of deposits on Wednesday to pay the interest to those who had bought the deposits on Monday. The interest rate that he was paying was so high that most of those who bought the deposits on Monday were happy to keep their money with Ponzi, so they could earn ‘interest on the interest’. But eventually some of the newly rich depositors decided to withdraw some of their money, and unfortunately, the money wasn’t there. Ponzi went to jail. His scheme flourished for eighteen months.

Bernie Madoff managed the largest Ponzi scheme in American history; at the time of the collapse in December 2008 the liabilities were reported to be $50 billion or $64 billion – although the most recent estimates suggest that the losses will probably be in the range of $20 billion to $25 billion. (One measurement problem is deciding whether the losses should include only the amounts of the initial deposits that individuals made with Madoff, or whether these losses should also include the ‘investment income’ that they had earned over the years. Another involves whether the cash withdrawn from the accounts should be included.) Madoff had run the scheme for twenty years, so he may hold the world’s record for both the largest and the most long-lived Ponzi scheme.

Every Ponzi scheme has a ‘story’ – an explanation for why the firm earns such high returns. Ponzi himself said he was arbitraging international postal reply coupons. (You don’t really need to know the details.) Madoff said he had a ‘split strike option strategy’.

Madoff’s scheme differed from Ponzi’s in one other important dimension – the rate of return on the funds entrusted to Madoff were in the range of 10 to 12 percent a year – a bit higher than stocks, and much higher than on bonds. Madoff’s returns were steady but not spectacular.

Ponzi was flamboyant. Madoff in contrast was understated, and he created the impression that he accepted money to invest only from a few close friends and their close friends. Subsequent investigation showed that he had more than 4500 close friends, and that he relied on at least four or five ‘feeder firms’ to bring him the money. The payment arrangements to these feeders varied, they appeared to get one percent of the money up front and then another one percent each year the money stayed with Madoff. Subsequently the attorneys responsible for cleaning up the mess indicated that some of these feeder firms received rates of return of 40 or 50 percent a year on their own money that they invested with Madoff.

Investigation by the court-appointed attorney to seek funds for Madoff’s clients showed that Madoff rarely traded any securities. In 2008 clients withdrew $11 billion from their accounts. Madoff went out of business when there was no more money to withdraw. Most of the clients probably withdrew the money because they were losing money on most of their other investments.

Ponzi was in jail for about two years and then he moved to Florida to sell real estate during the mid-1920s bubble around Miami. Madoff will be in jail until the end of his time on earth.

Ponzi and Madoff shared one attribute – they both traded in mis-information. Both lied about the rates of return that their clients would be earning. Much of the corruption in financial markets involves mis-representation about the values of inventories, the values of investments, and profit rates. But some corruption involves the theft of information and the efforts of outsiders to obtain information from insiders before that information is publicly available.

The implosion of a bubble always leads to the discovery of fraud and swindles. As long as asset prices are rising, investors are content and often are happy to borrow against the increase in their wealth if they need the money for their living expenses. When asset prices decline, some of them sell securities to get the cash for living expenses. And they generally sell their most liquid securities because they can’t bear to take the large losses associated with selling illiquid assets.

Ponzi schemes tend to be personal, and the basic crime is that the promoters – Madoff excepted – almost always make promises about exceptionally high rates of returns from day one. Corporate chicanery involves false statements about the value of inventories and of other assets, and the profit rate with the difference that the fraud begins long after the firm has been established. Information is withheld or dissembled. Enron was the poster-child of corporate fraud in the 1990s dot.com boom. Enron had been in business for many years – the fraud appears to have begun in the mid-1990s, when the firm had a massive need of money to finance its expansion. It then began its tumble into bankruptcy within a few months of the peak in US stock prices in 2000.

Measuring the supply of corruption is not rocket science. What is ‘measured’ is the corruption that rises to the surface; the corruption that remains undiscovered obviously cannot be measured. Corruption is discovered when money becomes tight and credit is less readily available, and when asset prices decline. Corruption increases in a pro-cyclical way, much like the supply of credit. Soon after a recession begins the loans to firms that were fueling their growth with cheap credit decline as the lenders became more cautious. In the absence of more credit, the fraud sprouts from the corporate edifice like mushrooms in a soggy forest.

Most fraudulent behavior is illegal, but some hovers on a fuzzy legal borderline. Should the award of options to senior management and employees be considered a cost, like wages, or should the award be buried in a footnote so that costs and profits are not affected? The answer affects how rapidly profits increase and presumably how rapidly the stock prices will increase. Should Henry Blodgett and Mary Meeker and Jack Grubman, the gurus of the telecom firms and dot.coms in the 1990s, have been obliged to inform the investing public of the rationale for their forecasts for the increases in the prices of individual stocks, or was it sufficient for them to announce the price targets for each firm at the end of the next six and twelve months – more or less like touts at the racetrack? (See ‘Shills, touts and thieves’, below, p. 137) Should the governmental authorities establish ‘truth police’ to prevent the investing public from being misled, or should this public be on its own in determining which statements made by the stock sales personnel are not strictly true? Certain business practices are legal, yet those engaged in such activities would be reluctant or embarrassed to have their transactions reported on the front pages of the New York Times or the Wall Street Journal or the Chicago Tribune or the London Daily Telegraph because the sunshine would awaken the victims to the con. Consider Enron, MCIWorldCom, Adelphia, Tyco, HealthSouth, Global Crossing – the stars of some of the financial excesses of the 1990s stock price bubble. Much of the fraudulent behavior initially had occurred in the mania phase as stock prices were increasing but was obscured in the froth of the bubble; the high-risk borrowers were able to refinance their maturing loans because the lenders were eager to increase their total loans. The investment banks believed in caveat emptor; in their view, customers old enough to vote should be capable of looking out for their own financial interests.

Corruption is multi-faceted. One form involves breaking laws, perhaps with the connivance of government officials. A great deal of corruption involves the misuse of information; someone may provide misleading information about profits, dividends, and possible mergers. Information may be stolen, and there are laws against insider trading, where well-connected individuals may seek to obtain information before it is generally available.

In this context, should Goldman Sachs have told some of the buyers of mortgage-related securities in 2006 and 2007 that the suggestions for the design of these securities had come from the firm that wanted to short them, or were the buyers regarded as sufficiently knowledgeable to conclude that someone believed that the prices of these bonds would decline? (Goldman agreed to pay more than $500 million to the Securities and Exchange Commission to keep its name out of the papers – about $250 million will go to the German bank that bought these bonds.)

Large CPA (certified public accounting) firms had been established to protect investors from miscounts of the numbers of beans and widgets that corporate firms report; the CPAs are there to verify the bean count. Arthur Andersen, at one time one of the ‘Big Five’ global accounting firms and the one with a reputation for paying exceptional attention to ethical issues, was ‘captured’ by several of the firms that it was auditing – firms that were paying its bills – and colluded in misleading investors. Did the law firms that provided legal advice to Enron and MCIWorldCom and their ilk discharge their obligations to investors as well as to their clients – or were the lawyers, who may have had billing rates of $800 an hour, also seduced by their clients?

The banks and the investment banks were on the front pages of the newspapers when property prices declined in 2007 and 2008. The Royal Bank of Scotland together with Santander Bank of Spain and Fortis of the Netherlands and Belgium bought ABN-AMRO for $100 billion in what has proved to be one of the most costly business decisions of the decade. (The smartest business decision of the decade was to sell ABN-AMRO to these eager buyers.) While there was no obvious fraud, there was a lot of delusional grandiosity on the part of the buyers.

AIG (the acronym for the American International Group), then the world’s largest insurance company, is the ‘poster child’ of the 2008 collapse because of the massive amount of financial assistance that it received from the US government to avoid bankruptcy. Most of its problems stemmed from the sale of credit default swaps (CDSs), which are a form of insurance purchased by the owners of bonds to protect themselves against loss if the firms that have issued the bonds go bankrupt. (These swaps are similar in concept to private mortgage insurance; the mortgage lenders require that the borrowers with less than 20 percent of the cash needed for the traditional down-payment buy insurance to protect themselves from loss if the borrowers default.) The buyers of the CDSs want the higher interest rates attached to the riskier securities but want to avoid the default risk attached to these securities.

A lot of the fraud in the mortgage market in the housing boom between 2003 and 2007 occurred at the ‘retail level’ – borrowers lied about their incomes and their credit histories, and the mortgage brokers knew that the borrowers were lying, but hey, ‘It’s business’. Several senior managers of Bear Stearns were indicted for misleading investors about the quality of the assets in the hedge funds that they managed – but the jury voted ‘Not Guilty’.

The classes of swindles and corruption

Swindles, fraudulent behavior, defalcations, and elaborate hustles are part of life in market economies, more so in some countries than in others. Many of the swindles involve supplying misleading information about inventories and profits. Occasionally the swindle involves the theft of information or news – when the presumption is that in a market economy each investor should have the same information at the same time, when some individuals jump the queue it is a form of fraud.

Transparency International publishes an annual index of corruption; Finland has a lock on the number one position in terms of virtue and Iceland was close behind until the implosion of its massive stock price bubble in 2008. (A subsequent investigation revealed that the banks had been looted by their owners.) For many years Bangladesh, the Democratic Republic of the Congo, and Nigeria were considered the most corrupt. The United States is much nearer the top of this hit parade although it may have slipped several places in the rankings because of the extensive fraud and deception that occurred in corporate America during the stock price bubble of the 1990s and the real estate bubble ten years later.

A traditional form of swindling involves overstating the value of inventories. The McKesson Robbins scandal of the late 1930s involved the use of forged warehouse receipts as collateral for loans. Billie Sol Estes, the Texas plunger of the 1960s, falsified the number of fertilizer tanks he had under lease and borrowed against the much larger fictitious number. Tino De Angelis stung American Express and other large lenders by using tanks of ‘salad oil’ in the 1960s as collateral for loans; Tino knew that that oil was less dense than water and he floated a six-inch layer of salad oil on top of twenty feet of water.¹

Swindles that involve falsified statements about the value of inventories can be tested when the promises are made. Eventually the lenders wised up to Billie Sol Estes; someone went out and counted the fertilizer tanks. The lenders can be taken in by the falsified values of the collateral offered by the borrowers, and initially the lender’s accountants don’t catch the deception. Swindles in financial markets may involve statements about the growth of corporate earnings or about the ‘warranted’ prices of shares of individual firms. Corporations ‘manage’ their earnings so they appear less variable from one quarter to the next, because investors will pay higher prices for the stocks of firms with stable earnings. A typical statement is that the ‘price of Amazon stock’ will climb to $400 a share by 4 July; or the wording might be ‘Our price target is $400 a share’. Another statement might be ‘Corporate profits will increase at the rate of 15 percent a year for the next five years’. Some of the swindles in the financial markets involve ‘excessive optimism’ about the earnings of firms or future stock prices that those making the statements know are not likely to be true.

Wall Street makes a lot of its money selling stocks, and it prospers by having ‘stars’ who are paid – very well paid – to make statements that the prices of the shares of individual firms will increase; they’re like the shills in front of the side-shows at carnivals who persuade the public to buy tickets to see the sword swallowers and the hermaphrodites. Stocks increase in price twice as often as they fall, so that the odds are that the ‘market strategists’ will be right twice as often as they are wrong – although being right on the direction is different from making the right calls on stock prices. The market strategists typically are reluctant to indicate that stock prices as a group will decline and very rarely suggest that the price of the stock of individual firms will decline (because the top executives of those firms would become furious and threaten never to bring any underwriting business to the investment bank ever again). If share prices decline when the pitch has been that they will increase and the touts become an embarrassment to their employers, well they’ve been well paid and they’re expendable and, hey, it’s business. It’s not hard to find replacements.

Corruption can’t be measured unless an economy or a society has laws or norms or rules that distinguish permissible from illegal or immoral behavior. Anything would be permissible and acceptable in a society without rules or norms, corruption would not occur because there would be no perceptible boundary between acceptable and non-acceptable behavior. Virtually every society has rules or norms – these codes about what is and what isn’t acceptable behavior were adopted to reduce the costs of doing business.

Laws differ among countries, practices that are legal in some countries may be illegal in others. Moreover the laws and the norms about non-acceptable behavior within a country change over time; some financial practices that were legal in the United States in the 1870s were illegal a hundred years later. Despite these differences across countries and over the years, there is a broader, more universal sense of acceptable financial behavior that is based on the Eighth Commandment: ‘Thou shalt not steal’.

Corrupt behavior is part of virtually every economy. The number of transactions that appear to overstep both moral and legal norms increases in euphoric periods like the 1990s. Paradoxically, increases in personal wealth as the prices of stocks and real estate and commodities increase at 30 or 40 percent a year for several years seem to trigger an increase in fraudulent behavior by those who want even more rapid increases in their wealth. Some individuals wish to keep up with the Joneses, and they may blur the truth and cut a few corners. Some entrepreneurs and managers may skate close to the edge of fraudulent behavior because of an apparent increase in the reward-risk ratio; the potential increase in their wealth from bending the rules and deceiving the public may seem extremely large relative to the risk of being caught and fined and exposed to public embarrassment. Some may have calculated that they can make a big fortune because the likelihood that they will be detected is low; they may still get to keep half if they’re caught. The odds on going to jail are low, and the prisons for white-collar crime are like modest country clubs with drab clothing and hard-surface tennis courts.

Crash and panic, with their motto of sauve qui peut, induce many to cheat in the effort to forestall bankruptcy or some other financial disaster. A little cheating today may avert a catastrophe tomorrow. When the boom ends and the losses become apparent, some individuals will make a big bet in the hope that a successful outcome will provide an escape from what otherwise would be a disaster.

Nick Leeson was a modest functionary – one of five or six employees – in the Singapore office of Baring Brothers, the venerable London merchant bank. Leeson traded options on stocks and especially options on the Nikkei, the primary stock price index in Tokyo. The London office of Barings had set a limit on Leeson’s position, the maximum amount of the firm’s capital that he could risk. Leeson bought and sold call and put options on the Nikkei; the purchase of a call option was a bet that Japanese stocks would increase in price, and the purchase of a put option was a bet that Japanese stocks would decline in price. The sale of a call option was a bet that the Nikkei would not increase significantly in price, and the sale of a put option was a bet that the Nikkei would not decrease significantly. When Leeson bought either call options or put options, he had to pay a premium to the sellers of the options who were acquiring the price risk; when he sold options, he earned the premium because he was acquiring the price risk.

Someone in Leeson’s office apparently made an error in a transaction which led to a loss in his trading account. Rather than acknowledge the error to the head office of Barings, Leeson sold some put options on the Nikkei; his plan was to use the premium income to offset the trading error loss. However, the Kobe earthquake led to a sharp decline in the price of Tokyo stocks, which meant that he incurred a loss on the options contract that was much larger than the premium income. Leeson then ‘doubled his bet’ in the hope that a profit on the new contract would offset the previous losses, the position would be closed and no one in the head office would be wiser. Unfortunately for Leeson he lost on the second bet. Each time that his position incurred a loss, he made another ‘double up’ bet in the hope that it was his turn to win. So it went, until the cumulative losses in his trading account were more or less equal to all of Baring’s capital. Leeson probably made four or five losing bets in a row. Consider the probability that he could have made five successive losing calls on the traditional coin-flip – a run of five heads in a row is a 1 in 32 chance. If he had won just one of the bets, his misadventure would not have made the front pages of the newspapers and he would not have spent two years in a Singapore jail.

The gallery of rogue traders includes John Rusnak of the Baltimore office of the Allied Irish Bank who lost $750 million trading currencies before the head office in Dublin realized how large the losses were. Yasuo Hamanaka of the New York office of Sumitomo Bank lost several billion dollars trading in the copper market. Five traders for the National Australia Bank in Sydney lost several hundred million dollars trading currencies.

Leeson and Rusnak and the Aussies made an extended series of losing bets before being discovered. Their problems made the headlines because they ran out of cash to pay off on the losing bets before they had one winning bet.

The likelihood is high – very high – that there have been other rogue traders who started like Leeson and Rusnak and incurred losses on two or three or four of their ‘double or nothing’ bets before winning again. The bank’s capital was not affected and their illegal and fraudulent behavior went undetected.

The approach toward financial fraud in this chapter is descriptive and anecdotal. Guinness World Records does not yet have a chapter on the magnitude of financial swindles and fraud. Financial chicanery occurred in the US economic expansion following the Civil War, and fraud was widespread in the Gilded Age of the 1880s. In the late 1920s a few bankers continued to sell the bonds of several Latin American countries after they had been told that the countries had stopped paying interest.

BCCI – the Bank of Credit and Commerce International – was a major financial beneficiary of the oil price shocks of the 1970s. BCCI had been chartered in Pakistan; the firm then established a network of branches and subsidiaries throughout the Middle East and in London and subsequently in some of the major cities in Europe and Africa. BCCI prospered following the surges in the oil prices in the 1970s; the Middle East was awash with money and some of its early depositors were wealthy sheikhs from the Persian Gulf. BCCI’s subtle appeal was to Muslim depositors. BCCI made large loans to rulers for political reasons, which eased its regulatory problems and helped it expand.

BCCI may have been one of the largest-ever Ponzi schemes in the pre-Madoff days. Non-performing loans were refinanced, in effect delaying the recognition of losses. Some of BCCI’s loans to a shipping magnate went sour, and the bank used fraudulent accounting to hide the losses; the auditors were bribed. BCCI dealt extensively in options to make good the loan losses, and the firm recognized ‘in the money’ options at their market value and valued ‘out of the money’ options, on which it had losses, at zero. BCCI continued to expand as long as it could sell its deposits to its ‘captive clientele’.

When the bubble imploded in Japan at the beginning of the 1990s, the large banks headquartered in Tokyo and Osaka incurred massive losses on their loans that had been made to finance the purchases of real estate and stocks. Some of the regional banks in Japan had incurred even larger loan losses. Many of their loans for golf courses, hotels, and amusement parks were undertaken to promote local economies. The tradition that loans would be repaid was not well established in Japan; instead the practice was that the borrowers would use the cash from new loans to pay the interest on the outstanding loans so that their indebtedness would increase at the rate of interest. This practice of ‘evergreen finance’ was safe as long as the rate of increase in property values was higher than the interest rate.

Once real estate prices began to decline some of the hanky-panky in the loan approval process became known. A woman who owned a small restaurant in Osaka had borrowed the yen equivalent of several billion dollars from the local branch of Sumitomo Bank; she had a ‘friendly relationship’ with the local banker. Some of the real estate appraisers for the banks had been bribed – or perhaps frightened – by the yakuza, who had concluded that the low-risk way to rob banks was to secure loans based on highly inflated appraisal values of the real estate that was pledged as collateral. The senior officers of several of the large regional banks made loans to real estate developers so that they could buy land that was owned by the bank officials. Several senior officials of the august Ministry of Finance were entertained at a ‘pantyless shabu-shabu restaurant’ that had a mirrored floor; the suspicion was that these officials provided advance information to their hosts about impending changes in financial regulations.

When the real estate bubbles in Thailand and Malaysia and the other nearby Asian countries imploded and the banks incurred large losses, ‘crony capitalism’ suddenly appeared – favored treatment for certain borrowers that somehow had not been evident in the earlier years of exuberant economic growth. Indonesia had been a ‘Suharto family business’ for more than thirty years – and remarkably successful measured by the increase in its GDP. When Indonesia was doing well, the banks were happy to make loans to the business enterprises headed by President Suharto’s children – indeed some of the banks were headed by his children. The banks were not especially concerned with whether the projects that would be financed with these loans would be profitable.

One of the persistent US financial headlines in the early 1980s was the impending financial disaster of the US savings and loan associations and the US mutual savings banks – thrift institutions that had been established to help Americans of limited means finance the purchase of their first home. The thrifts used the funds obtained from the sale of deposits with short-term maturities to buy fixed interest rate mortgages with long-term maturities. Because the maturities were not matched, the thrifts acquired a ‘transformation risk’ (sometimes called ‘duration risk’) that short-term interest rates could increase relative to long-term interest rates and the excess of the interest rates they earned on their loans over the interest they paid on their deposits would decline, and perhaps even become negative. The thrifts had lived with this risk for fifty years because the interest rates on short-term deposits had been regulated by US government agencies to limit ‘excessive’ price competition among the banks and thrifts for deposits. In the second half of the 1970s, however, interest rates on US-dollar securities surged, and many individuals withdrew their money from the thrifts so they could buy US Treasury bills and money market funds that offered higher interest rates than the thrifts were allowed to pay.

The conundrum for the thrifts was that if they raised interest rates on their deposits to levels that were competitive with interest rates on US Treasury bills (assuming that they could get the regulators to raise the interest rate ceilings) then their interest payments would be higher than the interest rates they were earning on their mortgages and their capital would erode and eventually disappear. If instead they sold mortgages to reduce the excess of their interest payments over their interest income, they would incur large and immediate losses because the sale prices of the mortgages would be below – probably far below – the prices they had paid for them.

Most thrifts decided to pay the higher interest rates on deposits; slow death was preferable. Each thrift could estimate the monthly rate of depletion of its capital and project the date when its capital would be fully exhausted.

Hundreds, then thousands of these thrift institutions failed. Initially a failed thrift was taken over by the Federal Savings and Loan Insurance Corporation or the Federal Deposit Insurance Corporation, the US government’s deposit insurance guarantee agencies. These government agencies would sell the good loans of the failed thrifts and use the cash from these loan sales and their accumulated reserves to pay the depositors 100 cents for each dollar of deposits.

The accumulated reserves and the capital of both the FSLIC and the FDIC, which had been built up over nearly fifty years, soon were exhausted. Then the deposit insurance agencies could no longer afford to close those thrifts with negative net worth since they didn’t have enough money to honor their deposit insurance guarantee; they needed a subterfuge to enable the failed thrifts to remain open. They discovered the policy of ‘forbearance’, which allowed these bankrupt thrifts to continue in business.

Inevitably the losses of the FSLIC and the FDIC would have to be made good, either by a transfer of taxpayer money from the US Treasury or by increases in the deposit insurance premiums charged to the surviving banks and thrifts. These banks and thrifts were vehemently opposed to paying higher premiums to cover the losses of their failed competitors.

Several members of the US Congress stalled the efforts to obtain funds from the US Treasury so the FSLIC and the FDIC could pay off the depositors and close the failed institutions; these elected officials wanted to use this financial disaster to force a deregulation of the financial services industry. Some of the failed thrifts were ‘re-capitalized’ as ‘phoenix institutions’; one failed thrift would acquire another and the asset side of the balance sheet of the acquiring institution would be credited with a large entry for ‘good will’ and there would be a corresponding increase in its capital. The idea – more precisely the hope – was that over the next twenty or thirty years the profits of the acquiring institutions would be sufficient so they could amortize the good will and their negative net worth.

Some entrepreneurs had the bright idea that the way to save the failed thrifts was to help them rapidly increase their deposits and loans so that their profits on new mortgages and loans would be larger than their losses on the older, low interest rate mortgages. In 1982 the US Congress reduced the regulations applied to the thrifts, which meant they would be allowed to buy almost any type of security. At the same time the ceiling on the maximum insured deposit that any individual might have in a single thrift was increased from $40,000 to $100,000. (However, individuals could easily circumvent this ceiling by acquiring deposits under slightly different versions of the same name; Mr Jones might have an insured deposit of $100,000, Mrs Jones might have an insured deposit of $100,000, and Mr and Mrs Jones together might have a third insured account of $100,000. And the Jones family could buy separate deposit accounts for each child as well as a series of deposits in joint child accounts.)

These failed thrifts were eager to buy any loan or security that offered relatively high interest rates – and so they became one of the ‘natural markets’ for junk bonds. Initially the supply of junk bonds had been limited to those of the ‘fallen angels’; bonds that had lost their investment grade rating because the firms that had issued them had fallen on tough times. The loss of the investment grade rating meant that some financial institutions could no longer hold these bonds, so the interest rates increased sharply.

Michael Milken of Drexel Burnham Lambert developed some market innovations that greatly increased both the demand for and the supply of junk bonds. The decline in interest rates and the increase in the rate of economic growth of the 1980s created an encouraging environment for the growth of the junk bond market. The sales pitch was that the excess of the interest rates on the junk bonds over the interest rates on investment grade bonds was much larger than the losses the owners of its bonds would incur when one of these borrowers failed.

Milken provided the financing for some of his friends and associates to gain control of thrift institutions and insurance companies and other firms that would be ‘natural’ buyers of the junk bonds. Milken provided ‘comfort letters’ to entrepreneurs contemplating a takeover of an established firm, assuring them that Drexel could raise the money they would need. Once his friends had ownership of these industrial companies, the firms would issue junk bonds that would be underwritten by Drexel, and Milken would place these bonds with the thrifts and the insurance companies that were controlled by his friends. Drexel established its own mutual funds that would buy the junk bonds that it had underwritten.

Milken had a money machine. Drexel earned underwriting fees when its client firms issued new junk bonds, fees for selling the bonds to the mutual funds, sales fees for selling the shares in the mutual funds to the American public, and management fees for operating the mutual funds.

Merrill Lynch – ubiquitous Merrill – began to broker deposits for thrifts; the thrifts in California and the Southwest began to offer much higher interest rates and Merrill’s army of thousands of brokers became the channel for moving money from around the country to the thrifts controlled by Milken’s friends. The deposits that the thrifts were selling were guaranteed by the US Treasury – which was all that the buyers of these deposits wanted to know.

Few of the corporate raiders financed by Milken had much industrial experience. They used Uncle Sam’s money – money obtained from the sale of deposits guaranteed by the US government – to acquire more than fifty firms. They often ‘overpaid’ for these firms, but then they were paying with Sam’s money.

Many of the firms were unable to earn enough to pay the interest on the outstanding junk bonds. Not to worry, these firms issued some new securities that relieved them of the obligation to pay the interest on their outstanding bonds and the Milken-friendly thrifts bought these securities too. The money machine continued to work as long as the junk bond market remained vibrant. (Is this reminiscent of Ponzi finance?) However, the junk bond market collapsed at the end of the 1980s, after Federal regulators changed the rules so that the thrifts could no longer buy these bonds. The liquidity disappeared from the junk bond market; the prices of these bonds declined sharply, and the bondholders incurred large losses. Most of the junk bonds that came to the market in the 1980s had been underwritten by Drexel, and about half of these junk bond issues went into default. Drexel incurred large losses on its inventories of these bonds and went bankrupt in 1992.

In the end the debacle of the thrifts cost the Federal government more than $100 billion. If the US Congress had supplied the deposit insurance agencies with the money to close the failed thrifts in the early 1980s when their capital was depleted, the cost to the American taxpayers would have been in the range of $20–$30 billion. A large part of the excess of the actual costs over the costs that would have been incurred if the failed thrifts had been closed in a timely manner resulted from the costs of closing down failed thrifts that had become major buyers of junk bonds.

Milken and his family became billionaires and he probably remained one even after paying a fine or penalty of $550 million and spending thirty months in a federal ‘country club’ (minimum-security prison).

Swindles and theft in the 1990s

There was a bumper crop of scams, swindles, and frauds in the United States in the second half of the 1990s. As outlined earlier, Enron was at the top of the hit parade of firms involved in the fraud and chicanery associated with the stock market boom; the firm was born from the merger of two regulated natural gas pipelines. Enron had two ‘arms’; ‘Enron Heavy’ made massive investments in an electrical generating plant in India and in water systems in Britain and in Mexico. ‘Enron Light’ began to expand rapidly in the production and trading of electricity and natural gas and broadband and anything else that could be traded in a wholesale market; the press hyped Enron as the single most important firm in the move to deregulate the market for electricity. The rapid expansion of both arms of Enron required large amounts of money for investment in plant and equipment, trading facilities, and software. Enron sold a lot of bonds and provided substantial revenues for its primary investment bankers, Merrill Lynch and Salomon Smith Barney. At its peak, the market capitalization of the firm was $250 billion, the market value of its stock at $100 a share was over $200 billion and the market value of its publicly owned bonds was $40 billion.

Soon after US stock prices began to fall sharply in 2000, Enron – at one time touted (by its own public relations flacks) as the seventh largest firm in the United States and described by Fortune magazine as one of the most innovative firms in the country – filed for bankruptcy. The market value of the stock was zero, and the market value of the bonds declined sharply.

One intriguing issue is when the top managers at Enron came to the proverbial ‘fork in the road’ and started on their elaborate path of financial chicanery. A large part of the total compensation of the senior managers of Enron would come from selling the stock options they had received from the company as incentives. The more rapid the rate of growth of Enron’s profits, the higher the price of Enron stock; the more valuable the options, the wealthier the owners of the options. Enron’s senior officers had a powerful reason to keep profits growing, since their individual wealth was geared to the stock price.

Enron was responding to the challenges presented by the stock market analysts on Wall Street. Quarter by quarter, the analysts predicted the earnings per share to the penny. There were plenty of examples of firms that failed to make their earnings estimates; their stock prices declined by 10 or 20 percent. The chief financial officers of Enron, as well as of other companies, had a strong incentive to ‘smooth’ earnings so they met the estimates of the Wall Street analysts.

Enron had entered into sale-and-leaseback arrangements with Merrill Lynch and JP Morgan for some electrical generating barges in Nigeria. Merrill and Morgan paid above-market prices for the barges so that Enron could realize a profit from their sale, which would contribute to Enron’s reported profits for the year. Merrill and Morgan are not charities; because they paid above market prices for barges, the annual lease payments that they were charging were correspondingly higher. From Enron’s point of view, the increase in profits in year one would be at the expense of profits in the next few years.

Enron was scrambling to increase this year’s profits regardless of the negative impact on next year’s profits. Next year’s problem in growing earnings could be solved next year.

Enron had placed very high values on some esoteric futures contracts that were due to mature in five and ten years and which had no ready-reference market prices. Enron increased the value placed on these contracts from one year to the next and the increase in these values contributed to Enron’s reported profits; a 1990s counterpart to Billie Sol Estes exaggeration of the number of fertilizer tanks that he had leased.

Enron’s financial finagling led to increases in its reported profits of more than $1 billion at a time when the firm was concealing substantial debt, which had been buried in off-balance sheet financing partnerships, so-called special financing facilities or vehicles (SFVs). Many banks and industrial firms used these SFVs to remove debt from their balance sheets so they would be better positioned to increase the amounts they could borrow. The accounting rules provided that these SFVs could be considered independent entities as long as 3 percent of the equity in the SFV was owned by ‘unrelated individuals’. Enron owned 97 percent of the partnerships and some of the individuals who owned the remaining 3 percent were senior employees and some were the firm’s bankers. These bankers were eager to lend to and invest in these partnerships because Enron was a source of large underwriting income. These partnerships had names taken from Star Wars – JEDI, Chewco, and so on. The partnerships would borrow from the banks and other lenders as if they were independent from Enron and then invest the funds with Enron.

Enron used some of the cash obtained from the SFV’s borrowings to support the price of its own stock. That is more or less a Nick Leeson go-for-broke strategy; if the stock price should fall, then the value of the partnerships would decline and they would be ‘under water’. But that is the traditional practice and it had been used by American railroads in the nineteenth century.

The collapse of Enron led to the demise of Arthur Andersen, formerly the most respected of the large US accounting firms – although in the previous few years Andersen had been sued by the creditors of the Baptist Hospital of Arizona, Waste Management and several other audit clients that had gone belly-up. Andersen was accused of shredding documents after the Securities and Exchange Commission had started its investigation into Enron’s finances.

Andersen had been selling $2 million a year of auditing services to Enron and $25 million of consulting services. The implication was that Andersen’s desire to retain the consulting income clouded its judgment about the appropriateness of how Enron should measure its profits – and that’s a charitable statement. Andersen was convicted of obstruction of justice in June 2002; hundreds of its clients did not want to be associated with a firm with a tarnished reputation, and the firm folded. Andersen was only one of the outside groups that had been co-opted by Enron; its board of directors had multiple conflicts of interest since some members received consulting income from the firm. Enron had established several groups of advisers, usually from the media, on a $25,000 a year retainer for one meeting a year. Enron’s chair, Kenneth Lay (‘Kenny boy’ in some political circles in Washington) was also a major contributor to politicians.

Criminal charges were filed against more than thirty Enron officials. There were three principal types of financial chicanery; the general thrust was to overstate income and understate the growth of indebtedness. Some of the top officials also under-reported their incomes to the Internal Revenue Service. Ken Lay and others were charged with providing misleading information about the financial well-being of the firm. Five were found guilty after trials and one was acquitted; fifteen pleaded guilty.

Jeffrey Skilling, the number two at Enron, was charged with thirty-five violations of the law, including conspiracy, securities fraud, wire fraud and insider trading and received a long prison sentence (24 years 4 months) in 2006. Andrew Fastow, the chief financial officer, pleaded guilty to the conspiracy to commit securities fraud and was imprisoned for a minimum of ten years without the possibility of parole; Leah Fastow, his wife, pleaded guilty to tax fraud and was jailed for six months. Ben Glisan, the corporate treasurer, pleaded guilty to wire and securities fraud and received a five-year sentence. Michael Kopper, a finance executive, pleaded guilty to fraud and money-laundering. The former directors of Enron agreed to a $168 million settlement of a lawsuit brought by the shareholders; $13 million of this amount came from their own pockets and the rest from the proceeds of an insurance policy. Lehman Brothers paid $222 million as part of this settlement and Bank of America paid $69 million.

WorldCom had been one of the most rapidly growing telecommunications firms in the 1990s, with more than sixty acquisitions. Bernie Ebbers, a Canadian-born former high school gym teacher and basketball coach in Jackson, Mississippi, was the maestro of its rapid expansion. WorldCom’s earnings per share increased at a rapid rate which meant that the ratio of its stock price to its earnings was higher than the stock prices of the firms that were being acquired. WorldCom paid for its acquisitions by exchanging newly issued shares in WorldCom for the shares in the firms being acquired.

WorldCom’s earnings per share were increasing at a rapid rate because it was ‘buying’ the earnings of firms that had lower stock prices. (WorldCom could not afford to buy a firm with a stock price higher than its own because that would lead to decline in the rate of growth of its earnings.) Ebbers was riding the proverbial tiger: to keep WorldCom’s stock price high, the firm had to continue to acquire other firms that had lower stock prices. As these acquisitions led to an increase in the WorldCom’s size, the only way it could maintain the rapid growth of earnings was to acquire larger and larger firms. The problem – the generic problem for firms that grow their earnings per share by acquisition – is that the number of firms that remained attractive takeover targets was declining as WorldCom became larger.

WorldCom’s last acquisition was MCI, one of the most innovative firms in the US telecommunications industry; through the use of microwave towers it had broken AT&T’s monopoly on long-distance phone services. MCI was so large that the merged firm was re-named MCIWorldCom. In the effort to maintain the growth of its earnings, MCIWorldCom then attempted a merger with US Sprint, but the proposal was blocked by the US regulatory authorities.

Soon thereafter MCIWorldCom filed for bankruptcy – at the time the largest bankruptcy in US history. Subsequent investigation revealed that the chief financial officers in the firm had overstated earnings by claiming that $4.8 billion of everyday expenses were ‘investments’ – eventually the fudged numbers amounted to $10 billion. The major reason for this accounting fraud was to maintain the growth of earnings to support the stock price. Two of WorldCom’s senior officials were arrested and charged, pleaded guilty and went to prison.

Later it became known that MCI had lent Bernie Ebbers more than $400 million in off-the-books loans. Ebbers had used his WorldCom stock as collateral for the loan – and he used some of the cash obtained from the loan to buy more WorldCom stock. Ebbers flunked the first lesson in investing – diversification of assets.

Enron and WorldCom had become victims of their own success. The stock market analysts on Wall Street had developed the practice of forecasting each firm’s quarterly earnings. If the firm failed to meet the earnings targets, the stock price would decline by 15 or 20 percent. A big hit. So the senior financial officials began to play the game, in two ways. If the prospective earnings were likely to be much higher than anticipated, they had an incentive to prepay expenses or delay receipts, in effect postponing the recognition of earnings. The rationale was that the Wall Street analysts would raise the bar, and what might have been a one-time surge in earnings could become the new and higher benchmark. Conversely if earnings reported by the firm came in below estimates, they had a strong incentive to ‘borrow’ earnings from the future by delaying payments or advancing receipts. The problem would become more intense the next quarter.

Bernie Ebbers’ trial on the charge of misleading the public about the financial condition of the firm began in January 2005. His lawyers claimed he was misinformed by Scott Sullivan, WorldCom’s chief financial officer, and that Sullivan claimed that Ebbers directed the fraud to obtain a reduction in his own prison time. Ten of the former directors of WorldCom agreed to pay $18 million from their own funds as part of a $54 million settlement with the shareholders. Ebbers received a 25-year prison sentence.

Dennis Kozlowski, head of Tyco, a $200 billion dollar conglomerate, and Mark Swartz, its chief financial officer, were accused by the Federal government of looting Tyco of hundreds of millions of dollars in two ways: they awarded themselves options to buy Tyco stock without the approval of Tyco’s directors, and they tapped into Tyco’s treasury to pay their personal living expenses. The Feds made a big deal of the $6000 shower curtain and the $2 million birthday party for the second Mrs Kozlowski in Sardinia; Tyco picked up 50 percent of the costs of the party. The press reported that one of the highlights of the party was an ice sculpture reproduction of Michelangelo’s David that dispensed vodka from a vital lower body part.

Tyco had acquired several hundred firms in a wide variety of industries, mostly paid for with its stock but occasionally with the cash obtained by selling bonds and by borrowing from banks. Tyco massaged the earnings of the firms that it was about to acquire. After these firms had agreed to the acquisition, their earnings would be squeezed or otherwise temporarily depressed; then earnings would surge when they were integrated into the Tyco family, which contributed to the rapid growth in Tyco’s earnings.

Tyco was also sensitive about its costs and especially its taxes; the firm’s operating headquarters were in New Hampshire (a state with neither an income tax nor a sales tax) and its legal headquarters was in Bermuda, which enabled the firm to avoid paying US corporate income taxes. The State of New York alleged that Kozlowski had failed to pay the appropriate sales tax of $1 million on paintings that he purchased in New York City by asserting that the paintings would be shipped to New Hampshire; the empty crates that had contained the paintings were shipped there after the paintings had been removed to Kozlowski’s New York apartment.

Kozlowski was found guilty at a second trial, the first trial ending with a hung jury. Tyco, unlike Enron and MCIWorldCom, did not go bankrupt; the fraud was personal not corporate.

The Rigas family was charged by the Federal government with looting Adelphia Communications, the sixth largest cable system in the United States, of $2.3 billion; the family’s transgressions combined elements of the misbehavior of both Enron and WorldCom. The family collected more than $3 billion in off-balance sheet loans; the company inflated capital expenses and hid debt. Adelphia had started as a small family-owned firm; and the boundary between personal accounts and business accounts is often blurred in such situations. Many of the borrowings by the firm were guaranteed by the family, and many of the Rigas family borrowings were guaranteed by the firm. The family borrowed in large part to use the cash to support the firm’s stock. The former director of finance and the former vice president pleaded guilty. Two of the Rigas family members were convicted.

The founder and chair of HealthSouth, Richard Scrushy, was charged with an accounting fraud of nearly $3 billion; a trial began in January 2005, in which he was acquitted, although there was agreement that fraud was committed. Scrushy claimed that the fraud was committed by his subordinates and that they suggested that he managed the fraud so their own prison time would be reduced. At a second trial he was found guilty on a range of charges and jailed; later, in a civil trial, he was ordered to pay a $2.86 billion penalty, perhaps the largest in US history, according to the Wall Street Journal’s report.

Sam Waksal, the founder and promoter of ImClone, was committed to a federal prison after pleading guilty to six federal charges. Waksal had told his father and his daughter to sell their shares in the firm because an adverse statement from the Food and Drug Administration would be released the next day and lead to a decline in the stock price.

Martha Stewart’s five-month stay in a federal prison may have been related to Sam Waksal’s decision to sell shares in ImClone. Stewart sold her shares but denied that she had received any information from Waksal. An interesting coincidence. The Federal government indicted Stewart on an ‘obstruction of justice’ charge. She was found guilty and went to jail.

Richard Grasso, the chairman and chief executive officer of the New York Stock Exchange, made it to the nation’s front pages with the news that his retirement benefit package would be $150 million. The NYSE is owned by its members and both provides them with a trading floor and regulates their trading practices, as well as being, formally, a not-for profit institution. The Exchange is the arbiter of permissible trading practices. Most of the directors of the exchange are senior officers of the firms that are regulated by the exchange – or perhaps more precisely, are supposed to be regulated by the exchange. Grasso’s retirement compensation package seemed high – very high – relative to the revenues of the Exchange (a $28m surplus the previous year) and to the retirement benefits packages of other leaders on Wall Street. The suspicion was that Grasso was soft on the regulatory front because he did not want to offend the directors who determined his salary and bonuses. After an uproar and pressure from pension fund investors Grasso resigned. Subsequently Grasso was sued by the New York Attorney-General over his compensation package.

Global Crossing swapped network capacity with other carriers to inflate its revenues. The company shredded documents and went bankrupt, but before it did, its founder and Chairman Gary Winnick received $800 million from the sales of his shares. He later paid substantial compensation in a class-action lawsuit by former shareholders, without, however, admitting wrongdoing.

Shell Oil agreed to pay a fine of $150 million to the US and the British regulatory authorities for overstating the volume of oil in its reserves in the ground. It’s harder to quantify underground oil reserves than to count Billie Sol Este’s fertilizer tanks. Several Shell officials were bounced from the firm, but none went to jail.

The increase in the number of swindles and the scope of fraudulent behavior has attracted the economic theorists. Many of the swindles – often the low class ones – involve ‘Ponzi finance’, a pattern of financial transactions when a firm’s interest payments are larger than its cash flows from operations.² Another theorist noted that those borrowers who can set the interest rates on their personal debts engage in Ponzi finance and use the cash obtained from new loans to make the debt service payments on their outstanding loans.³

Most of the entrepreneurs who establish a Ponzi finance operation appear to know and understand what they are doing; they live high for a few months or years before the authorities catch up with them. Occasionally an innocent becomes involved and seems unable to understand the pattern of finance.

Shills, touts, and thieves

If you’re at the carnival or the circus or the county fair, you know that the shill for the sideshow is likely to engage in some exaggeration about the attractions of those that you might see if you pay the six bucks entry fee. If you are at the racetrack, you know that the touts that want to sell you their list of winners are not likely to pass the boy scouts’ code of honor when they describe how many winners they have picked in the last several days and the last week – somehow your intuition suggests that if they were half as successful as they claim they are, they would not be hustling their tip sheets. But what interpretation should you place on the statements of the touts for Merrill and Morgan Stanley and Credit Suisse when they indicate their price targets for the shares of individual firms?

In a good year in the late 1990s Henry Blodgett earned $10 million, Mary Meeker $15 million and Jack Grubman $20 million. Henry, Mary and Jack were the apostles of the dot.coms and the telecommunications firms in the bubble years of the 1990s. They earned these rock-star incomes because they brought a lot of underwriting and trading business to their Wall Street employers. There is no rule of thumb that relates their incomes to the profits they generated for their employers, but it’s a safe bet that their employers had calculated that the profits they produced were at least three to five times larger than their incomes.

Henry Blodgett of Merrill Lynch became famous for setting price targets for the stocks of individual dot.com firms, and some of these targets were achieved; in the heyday of the bull market these achievements could be seen as testimony to his success as a forecaster, or to a self-fulfilling prophecy. Henry got a lot of attention because in some internal e-mails within Merrill he was deriding the attractiveness of some of the same stocks that he was promoting to the American public. Henry agreed to leave the security business never to return. But he kept the money.

Jack Grubman of Salomon Smith Barney, then part of the Citigroup family, became infamous because he changed his recommendation on AT&T stock after a polite request from his boss Sandy Weill. The apparent quid pro quo was that Jack wanted Sandy’s help in getting Jack’s twin daughters admitted to the kindergarten class at the 92nd Street YMHA. About the same time Citigroup made a contribution of $1m to the ‘92Y’, Jack left Salomon Smith Barney with a $20 million golden handshake. Jack paid a penalty of $20 million and agreed not to work in the securities business again.

Parmalat (the name combines that of the city of Parma, Italy and latte or milk) the Italian dairy and food products company headquartered in Parma, used fabricated certificates of deposits to overstate its assets by $4 billion; the fraudulent CDs were prepared by superimposing one document on another in a copying machine. This fraud – the deception of the investing public and the investment banks – continued for more than ten years.

Boiler shops are another form of a swindle. Robert Brennan of First Jersey Securities operated a series of high-profile boiler shops. The sales brokers in these shops specialize in making cold calls to individuals about a stock, say Shazam Rockets. Shazam’s share price is usually low, perhaps between $2 and $5 a share, and initially many of the shares in Shazam are owned by insiders – those who own the boiler shop. The insiders trade with each other and manage increases in the price of the stock say from $2 to $3 a share, and they then begin to make their cold calls, pointing to the 50 percent increase in the price of Shazam’s stock in the last six weeks; they’ve learned that the gullible are much more willing to buy a stock whose price has increased rapidly. They also know that the unwashed investors have a preference for low-price stocks.

Swindles differ from ordinary robbery in that they abuse a trust. Daniel Defoe thought the stock-jobber cheat 10,000 times worse than the highwayman because the swindler robbed people he knew – often his friends and relatives – and ran no physical ‘risque’.⁴

Swindles should be distinguished from bribery, both of government officials and of the employees of one business by those of another. These illegal and/or immoral transactions involve both misrepresentation and the violation of an explicit or implicit trust between particular groups. Was Arthur Andersen corrupted by the $25 million a year in consulting fees from Enron? Was Bernie Ebbers bribed by Jack Grubman because Jack arranged for Bernie to be able to buy shares in twenty or thirty firms on the days when these stocks would be sold to the public for the first time? In the bubble euphoria, the odds were extremely high that the share prices would double on the first day of trading. Or did Bernie bribe Jack Grubman with the implicit threat that unless he was provided with favored treatment in buying newly issued stock he would take WorldCom’s underwriting business across the street to Merrill Lynch or Morgan Stanley? The rules of the stock exchanges and the rules of the futures exchanges are like a ‘code of purity’ designed to instill confidence in the public that everyone will be treated fairly – but the rules are really designed to protect some of the members of the exchanges from the adverse consequences for the industry of recognition of cheating by others.

The National Association of Security Dealers (NASD) pursues disciplinary actions against those of its members who have violated the rules. In recent years, hundreds of its members have been at the receiving end of disciplinary actions.

Corruption has been discussed historically by Jacob van Klavaren, who was especially interested in corruption as a form of market transaction that facilitated getting things done that were profitable but forbidden, as in black markets, or simply dishonest, such as the looting of India by Clive or Hastings.⁵ Van Klavaren also discussed the systematic embezzlement from the Royal African Company and the East India Company by insiders who skimmed the profits due to stockholders through contracts with companies that they controlled. In a similar manner, the Credit Mobilier in the United States in 1873 diverted profits from Union Pacific stockholders to the inside group run by Oakes Ames, a congressman from Massachusetts, and his congressional and business cronies. Drew, Fisk, and Gould milked the Erie Railroad in similar fashion.⁶

Swindling in financial markets is many-faceted – the directors swindle the stockholders, the senior managers swindle the directors, the security underwriters swindle both the owners of the firms that they are bringing to the public and the stockholders, borrowers swindle their bank lenders, and one group of employees may swindle another. Some swindlers issue fraudulent bills of exchange to the cost of those who own these bills when the fraud is discovered and who only then discover that they are holding counterfeit securities.

The line separating moral from immoral acts is now less fuzzy than it once was. One way that modernity is distinguished from backwardness is morality. In early stages of economic development, codes provided for honor and trust only within the family. Nepotism was efficient in these circumstances since strangers virtually had a license to steal. In 1720 a firm could buy a man’s services but not his loyalty; to be a clerk was an invitation to start a new and competitive business at a time when embezzlement and fraudulent conversion were not regarded as crimes.⁷ Lines between business and theft, commerce and piracy were not precise.⁸ Hammond noted that it was not until 1799 that the borrowing of bank funds by bank officials was definitively ruled illegal,⁹ although the 1720 House of Commons investigation of the South Sea Bubble ruled that the directors of the South Sea Company, having been guilty of a breach of trust in lending money of the company on its own stock, should use their own wealth to make good investor losses.¹⁰

A financial journalist writing a preface to a fictionalized biography of Ponzi drew a parallel between the 1920s and the 1970s and suggested that swindles were a product of inflation; his view was that when increases in the cost of living pinched family budgets, the heads of some households took additional risks to increase their incomes.¹¹ A somewhat different view held that destabilizing speculation in the absence of ‘avoidable ignorance’ is gambling, which provides utility to the participants even when they know they are likely to lose, in much the same way as participating in a lottery.¹²

Whether swindles should be included in the category of ‘avoidable ignorance’ is debatable. Cynics may share the belief of W.C. Fields that ‘You can’t cheat an honest man’ and conclude that victims of swindles mainly have themselves to blame. Mundus vult decipi – ergo decipitatur: ‘the world wants to be deceived, let it therefore be deceived’.¹³ Some psychiatrists believe that the swindler and his victims are bound together in a symbiotic, love-hate relationship that provides satisfaction to both.

The theft of information

In 2009, Raj Rajaratnam, founder of the Galleon Fund group, was arrested by the FBI and indicted by the Securities and Exchange Commission for the use of ‘inside information’ – before the information was available to the public. His fund traded on that information and realized exceptional profits. Rajaratnam was charged with fourteen counts of securities fraud and pleaded not guilty; he asserted that the profits reflected his research. The government charged 26 people with illegal behavior; 21, including several who were traders for Galleon, have pleaded guilty. Some of the inside information involved corporate acquisitions, some involved large changes in corporate earnings. The jury was still deliberating when this edition went to press.

Fraud and euphoria

Fraudulent behavior increases in economic booms. Fortunes are made in a boom, individuals become greedy for a share of the increase in wealth and swindlers come forward to exploit that greed. The number of sheep waiting to be shorn increases in booms and an increasing number offer themselves as sacrifices to the swindlers. ‘There’s a sucker born every minute.’ In Little Dorrit, Ferdinand Barnacle of the Circumlocution Office tells Arthur Clennam, who had hoped that the exposure of Mr Merdle’s swindles would serve as a warning to dupes that ‘the next man who has as large a capacity and as genuine a taste for swindling will succeed as well’.

Greed also induces some amateurs to commit fraud, embezzlement, defalcation, and similar misfeasance. The demise of Overend, Gurney and Company, the well-established ‘Corner House’, in 1866, after the original partners had retired and the firm had gone public, was brought about by a pleasure-loving gallant inside the firm who had appointed an outsider as adviser for £5000 a year, paid in advance and returned to the insider. D.W. Chapman, the insider, kept ten horses and entertained lavishly at Prince’s Gate, Hyde Park. His outside adviser, Edward Watkins Edwards, a former accountant, recommended that many new activities be added to the bread-and-butter discount business: speculation in grain, production of iron, shipbuilding, shipping, railroad finance. The firm became ‘partners in every sort of lock-up and speculative business’ and Edwards drew commissions on each. By the end of 1860 the firm was losing £500,000 a year net even though it was earning £200,000 a year on its discount business. The bubble was pricked by the failure of an unrelated firm of railway contractors, Watson, Overend and Company.¹⁴

From the world of fiction – in this case, Melmoth réconcilié, by Honoré de Balzac – the comparable figure to Chapman is Castanier, a bank cashier, whose mistress, Mme Aquilinia de la Garde, has expensive tastes in silver, linen, crystal, and rugs, passions that prove his undoing. For a time he survives by issuing promissory notes. At the point of no return, when he finally calculates his debts, he might have been saved by leaving Mme de la Garde, but he cannot give her up. Finally, because of the impossibility of continuing his financial maneuvers, given the growth of his debts and the very large interest payments it is clear that he is bankrupt. But he prefers fraud to honest bankruptcy and dips into the bank’s till.¹⁵

Swindling increases in economic booms because greed appears to grow more rapidly than wealth; it’s as if the increase in wealth triggers an increase in greed. Dennis Kozlowski was one of the richest people in America; yet the money to pay for the $6000 shower curtain and the other furnishings in his apartment were taken from Tyco. Swindling also increases in times of financial distress as a result of a taut credit system which induces declines in asset prices; at that stage the fraudulent behavior is undertaken to avoid a financial disaster. Ponzi resisted the suggestions of his associates that he should take the money and run and they in their turn swindled him.¹⁶ The London banker Henry Fauntleroy forged conveyances of estates to use as collateral for loans. These men served as models for Augustus Melmotte, the swindler of Trollope’s The Way We Live Now, who forged both a conveyance and a deed when the price of his Mexican railroad stock declined and he could no longer sell stock to raise cash.¹⁷ John Blunt of the South Sea Company, Eugène Bontoux of the Union Générale, Jacob Wasserman of the Darmstäderund Nationalbank (Danatbank), and the directors of the Credit Anstalt all bought the shares of their firms in the open market to support their prices in the hope that they might sell more shares at a later date. A bank that buys its own stock to keep the price high reduces its own liquidity since the ratio of its cash holdings to its deposits declines as it pays out cash to obtain the stock. In 1720 the Bank of England borrowed using its own stock as collateral. Clapham noted that the Bank of England did not penetrate into the far wilder and ‘absolutely dishonest’ finance of the South Sea Company.¹⁸

The revelation of a swindle or embezzlement increases distress which in turn often precipitates a crash and panic. In 1772 Alexander Fordyce absconded from London to the Continent, leaving his associates to meet obligations of £550,000, largely in dubious acceptances of the Ayr Bank, if they could – but they could not. Fordyce had personally been short of East India stock, whose price had risen enough to wipe him out.¹⁹ On 24 August 1857, it became known that a cashier in the New York office of the Ohio Life Insurance and Trust Company had embezzled almost all the assets of that highly reputed enterprise to sustain his stock market transactions; the news triggered a series of failures that reverberated in Liverpool, London, Paris, Hamburg, and Stockholm.²⁰ A kind of mid-nineteenth-century version of Nick Leeson.

In September 1929 the Hatry empire in London, a set of investment trusts and operating companies in photographic supplies, cameras, slot machines, and small loans, collapsed. Clarence Hatry wanted to expand into the steel business, but was caught using fraudulent collateral in an attempt to borrow £8 million to buy United Steel; his failure led to tightening of the British money market, withdrawal of call loans from the New York market, and a topping out of the stock market.

Bubbles and swindles

Some bubbles are swindles, some are not. The Mississippi Bubble was not a swindle; the South Sea Bubble was. A bubble generally starts with an apparently legitimate or at least legal purpose. What became the Mississippi Bubble initially started as the Compagnie d’Occident, to which the Law system added the farming-out of national tax collections. John Law owned about one-third of the Place Vendôme and other valuable real estate in Paris and at least a dozen magnificent rural estates. His activities were not a swindle, but his financial demise reflected a mistake that was based on two fallacies: (1) that stocks and bonds were money and (2) that issuing more money as demand increased was not inflationary.²¹

In the South Sea Bubble, the monopoly of trade in the South Atlantic was purely incidental.²² Very quickly, the consolidation of British government debt overwhelmed the South Atlantic trade aspects of the enterprise, and stock-jobbing overwhelmed government debt shortly thereafter. John Blunt and his insiders sought to profit on stock issued to themselves against loans secured by the stock as collateral. As they realized the capital gains from the increases in the price of the stock, they used the cash to buy estates; Blunt had six contracts to buy estates at the time of the collapse and a man named Surman had four contracts to buy real estate on which he owed £100,000. To get the cash to pay profits, the South Sea Company both needed to increase its capital and to have the price of its stock increase continuously. And it needed both increases at an accelerating rate as in a chain letter or in a Ponzi scheme.²³

History has given less immortality to certain of Ponzi’s forerunners. The former Munich actress Spitzeder paid 20 percent a year interest on the funds received from Bavarian farmers. She received 3 million gulden from these farmers. She and her helpers drew long jail sentences at the end of 1872. Placht, a dismissed officer, promised to pay 40 percent a year and borrowed the pennies of 1600 widows and orphans to get the money to play the stock market. His stock purchases were not profitable and he spent six years in jail.²⁴

As economic booms progress, greed mounts and the excuses become thinner, more nearly gossamer bubbles. In 1720 and again in 1847 (two occasions when lists were compiled), such swindles were numerous, although they have been embroidered with hoaxes perpetrated by and on later historians.²⁵ In 1720, for example, there was one proposal for carrying on an undertaking of great advantage that would be revealed only in due time. The perpetrator charged two guineas a share and made off with £2000, keeping his secret intact by failing to attend a meeting with the investors.²⁶ Another scheme was for the ‘nitvender’, or selling of nothing.²⁷ In the late 1990s stock market boom, some firms were able to raise money from the public before they had any business plans.

A project of modest current interest offers a premature example of women’s liberation:

A proposal by several ladies and others to make, print and stain calicos in England and also fine linen as fine as any Holland to be made of British flax ... They were resolved as one man [sic] to admit no man but will themselves subscribe to a joint-stock to carry on said trade.²⁸

In later periods, both historians and novelists noted that stock promotions had little connection with reality. ‘Many companies were founded without undertaking operations, railroads with any right-of-way or traffic.’²⁹ ‘Construction companies grew like mushrooms. Many of these companies speculated in building sites rather than in construction.’³⁰ ‘Limehouse and Rotherhithe bridge ... It was not at all necessary for them that the bridge should ever be built; that, probably, was out of the question ... But if a committee of the House of Commons could be got to say that it ought to be built, they might safely calculate on selling out at a large profit.’³¹

Financial distress leads to fraud in the effort to dump the losses on others before they cascade into ever larger losses. If the market goes decisively the wrong way, for example, bucket-shop operators abscond. When new cash subscriptions failed to meet profits paid out to greedy insiders, Blunt borrowed the cash of the South Sea Company for his own use;³² a preview of the story of the Rigas family and Adelphia. In 1861 Bleichröder characterized Bethel Henry Strousberg as ‘clever but his manner of undertaking new ventures in order to mend old holes is dangerous, and if he should encounter a [sudden] obstacle his whole structure may collapse and under its ruins bury millions of gullible shareholders’.³³ Bleichröder was right. Another German financier, the Hamburg banker Gustav Goddefroy, lost heavily in railroad and mining shares in 1873 and then bled his overseas trading company to support his position in the stock market.³⁴

These incurable optimists, who know they are going to win the first time, but lose, frequently try again, often doubling their bets and increasing their risks by transactions that either are of dubious morality or clearly illegal. In the late 1920s, when US banks were still allowed to underwrite securities (before the Glass-Steagall Act of 1932), Albert Wiggins of the Chase Bank and Charles Mitchell of National City continued to sell Chilean and Peruvian bonds at the old prices even after they had learned by cable from those governments that they had stopped paying interest.³⁵ Horace understood the position, if Sprague quotes and translates him accurately: ‘Make money; make it honestly if you can; at all events, make money.’³⁶ Equally cynical is Jonathan Swift over the South Sea Bubble:

Get money, money still

And then let virtu follow, if she will.³⁷

On this topic, Balzac has the last word: ‘The most virtuous merchants tell you with the most candid air this word of the most unrestrained immorality: “One gets out of a bad affair as one can”.’³⁸

Noble gamblers

The literature abounds in condemnation of noble gamblers and insiders, who might have been thought to regard financial obligations as debts of honor but are better at promising than at paying their subscriptions.³⁹ The Austrian nobility was worse than the Junkers, who at least ostensibly disdained money. Eduard Lasker maintained that ‘when the dilettantes enter, they make it even worse than the professional swindlers’.⁴⁰ Daigremont in Zola’s L’Argent sends Saccard to the Marquis de Bohain to help launch his Banque Universelle: ‘If he wins, he pockets it; if he loses, he does not pay. That is known, people are resigned to it.’⁴¹ Again in novels and in real life, nobles seek seats on boards of directors. Wirth enumerates Austrian princes, Landgrafs, counts, barons, Freiherren, and other nobles on the boards of railroads, banks, and other industrial firms ‘for which they have no capacity’.⁴² To control the accounts of the Banque Universelle, Saccard appoints a sieur Rousseau and a sieur Lavignière, the first completely subservient to the second, who is tall, blond, very polite, approving always, devoured by ambition to come on the board.⁴³ L’Argent is a roman à clef based on Eugène Bontoux and the Union Générale, whose subscribers included the Pretender, royalists, notables, and country squires.⁴⁴ In Britain The Economist in October 1848 included the nobility and aristocracy at the head of a list of dishonor:

Present prostration and dejection is [sic] but a necessary retribution for the folly, the avarice, the insufferable arrogance, the headlong, desperate and unprincipled gambling and jobbing which disgraced nobility and aristocracy, polluted senators and senate houses, and traders of all kinds.⁴⁵

Rosenberg claims that while the Austrian and French aristocracy led the other estates in pursuit of the golden calf, Berlin bureaucrats successfully opposed a similar movement in Prussia, noting an abortive attempt by Mevissen to get some counts on the board of a 50 million thaler bank. Junkers speculated in spirits and land products, he admits, but shied away from urban developments.⁴⁶ Perhaps this was so in 1857. In the following decade, the perception of money as evil had weakened. Railroad finance, both inside Germany and in Strousberg’s maneuvers in Romania, was tinged with scandal, reaching up to the peaks of the aristocracy and virtually into the Prussian court itself.⁴⁷

Venal journalism

Speculation generally was helped by the press. Some members of the press were for sale, some were critical, and some were both. Daniel Defoe excoriated stockbrokers in November 1719 when the South Sea stock sold at 120 yet turned around to defend them at the peak of 1000 in August 1720.⁴⁸ He expressed his ‘just contempt’ for people who claimed he wrote for the Royal African Company, stating he had sold his stock; but a modern critic concluded that he either continued to hold the stock or was hired by the company to attack individual traders who competed with the monopoly.⁴⁹ The press was still in an underdeveloped stage in France in the early nineteenth century; in 1837 a journalist wrote: ‘Give me 30,000 francs of advertising and I will take responsibility for placing all the shares of the worst possible company that it is possible to imagine.’⁵⁰ Laffitte financed newspapers.⁵¹ Charles Savary of the Banque de Lyon et de la Loire had 500 journalists singing the praises of his operations, using releases, largely paid for, as if they were stories created by the journal’s staff.⁵² Journals often sought favor with banks, the stock exchange, and the public by whipping up the speculative fever.⁵³ Bleichröder was cautious in avoiding speculation and outright misrepresentation, but he owned general and financial newspapers and used journalists to hype his financial interests. In 1890–91 he financed a trip to Mexico for one Paul Lindau, who wrote thirty-four articles and a book on the country without mentioning his connection with Bleichröder who then was selling Mexican bonds on the Berlin market.⁵⁴ A critical press developed slowly during the nineteenth century on the Continent.

In the 1890s in the United States, on the other hand, a financier closer to the line was pursued by the press and lived in fear of it; at least this is the inference from Theodore Dreiser’s fictionalized biography of Charles Tyson Yerkes, the Chicago streetcar tycoon who operated along, and sometimes over, the knife-edge that separates legitimate from illegitimate transactions. Yerkes needed favorable publicity to sell securities, which he sought and won through his gift of an observatory to the newly formed University of Chicago. The well-publicized gift helped restore his reputation and enabled him to sell his streetcar bonds in Europe.⁵⁵ But later the press drove him from Chicago.⁵⁶

Tipping off friends before hawking a stock to the world in an investor column may be an old trick, but it is more readily detected today, along with all buying and selling of shares based on insider information. Suspicious trades in a stock and in options to buy and sell the stock before the news that affects its price is made public are now analyzed by computer programs. The technique led to the arrests of investment columnist R. Foster Winans of the Wall Street Journal, who fed his tips in advance to a friend, and of former Undersecretary of Defense Thayer, who told a friend of forthcoming events in a company of which he was a director. (Thayer’s friend speculated on the basis of the information; Winans capitalized on his experience by writing Trading Secrets: Seduction and Scandal at the Wall Street Journal, St Martin’s Press, 1986.) Similarly, a young Merrill Lynch broker in New London, Connecticut bought information from the local printers of Business Week before the magazine appeared on the newsstands. Once the ease of tracing trading on insider information became known, some miscreants with advance information would call a broker in, say, Zurich, instead of their local broker. The Zurich bank would place a massive order in London or New York before brokerage houses there became wary and would delay execution for a couple of days to see if a large order was based on breaking news.

Most recently the internet has become the vehicle for manipulating stock prices. Jonathan Lebeck, aged seventeen, posted ‘news’ about particular thinly traded stocks (which he owned) on internet chat rooms. The stock prices would increase and Jonathan would sell his shares. The Securities and Exchange Commission made Jonathan pay a penalty of $500,000.

MSNBC is a business news TV channel. Many of the commentators on the programs promote the stocks that they own.

Dubious practices

There are many forms of financial felony. In addition to stealing, misrepresentation, and lying, other dubious practices include diversion of funds from the stated use to another, paying dividends out of capital or with borrowed funds, dealing in company stock on inside knowledge, selling securities without full disclosure of new knowledge, using company funds for non-competitive purchases from or loans to insider interests, taking orders but not executing them, and altering the company’s books.

George Hudson, who may have been the greatest figure in British railroad history, practiced nearly all of these at the same time in the 1846 railway mania. At one time he was chairman of four railways, and he mistakenly believed he was above the law that applied to his less powerful competitors. His accounts were muddled, and he may not have understood that he had appropriated shares or funds belonging to the York and North Midland railway. As a private individual he made contracts with various companies of which he was an officer, in direct violation of the Companies Clauses Consolidation Act. He raised the dividend of the Eastern Counties railway from 2 to 6 percent just before preparing the financial statements and then altered the accounts to justify the payments. Dividends of the York and North Midland were paid out of capital. He defended his actions against similar accusations in the case of the Yorkshire, Newcastle and Berwick by noting that he had personally advanced funds to the railway to extend its network. The risk was his, and he was entitled to the advantages that ultimately accrued from the expansion of the rail system. He embarked, on his own authority, on transactions that he deemed advantageous to the company, but that were nevertheless of doubtful legality. Still, he had a career of great brilliance that greatly benefited the British railway network.⁵⁷

A less interesting and imposing character in the United States in the 1850s was Robert Schuyler, who was president of the New York and New Haven, the New York and Harlem, and for a time the Illinois Central railroads. Called the ‘genteel swindler’ by one author, he absconded to Europe in 1854 with almost $2 million obtained from fraudulently selling New York and New Haven stock and keeping the proceeds. Van Vleck suggests that the crisis of 1857 in the United States was precipitated by British withdrawals of funds following the publication of the news of Schuyler’s defalcation. Schuyler had resigned from the presidency of the Illinois Central in 1853, but his fraud perpetrated on the New York and New Haven led to a massive sale of Illinois Central stock and bonds. The stock fell drastically, and the bonds declined to 62 from 100 by August 1855. British investors had been looking for this opportunity and they bought large amounts of these bonds; by February 1856 the bonds were back to 90. European investors owned more than 40,000 shares of the stock and 85 percent of the $12 million in bonds.⁵⁸ Schuyler was connected with a panic in September 1854 but not with the one in 1857.⁵⁹

The 1920s in the United States has been called ‘the greatest era of crooked high finance the world has ever known’ – but that was before the 1990s.⁶⁰ Notorious swindlers of the period include Harold Russell Snyder, who stole to extricate himself from losses incurred from the stock market crash (a precursor of the Rigas family, but on a smaller scale, even after adjusting for inflation). Arthur H. Montgomery paid the sincerest form of flattery to Ponzi by organizing a foreign-exchange investment scheme that promised a 400 percent return in sixty days. Charles V. Bob sought and obtained favorable publicity through a $100,000 gift to the Byrd Antarctic Polar Expedition and won the right to call the admiral ‘Dick’, which presumably helped promote his aviation stocks, which enjoyed a boomlet after Lindbergh’s 1927 flight to Paris.⁶¹

The 1930s produced many memorable examples of fraud and alleged fraud, led by the bankruptcies of the Bank of the United States, of Ivar Kreuger, and of Samuel Insull’s Middle West Utilities holding company. In his riveting account of the New York stock market from 1929 to 1933, Barrie Wigmore observed that Insull’s reputation was irreparably damaged when he fled the United States to escape trial before what he considered would be inflamed juries for crimes of which he was later acquitted. Wigmore asserted that Insull was a brilliant manager of operating utilities who went on a buying binge, acquiring badly run companies for multiples of their net worth. Insull’s purchases burdened his holding company with a mountain of debt, and the interest payments on the debt wiped out the equity of those who owned the common stock when the utilities got into trouble in the 1930s depression.⁶² Wigmore treads warily in assessing the marketing practices of New York banks and their security affiliates. Albert Wiggins of the Chase Bank had a reputation as ‘the most popular man on Wall Street’ but his reputation was shattered when a Senate investigation exposed a picture of self-dealing at the expense of his bank, its subsidiaries, and its clients. Charles E. Mitchell of the National City Bank and its security affiliate, the National City Company, also marketed securities intensely, even though he had the inside information that the profits of the companies concerned were declining rapidly.⁶³

Corruption in the 1990s and 2000s

The amount of corruption seems greater in the 1980s and the 1990s than in the 1920s. One explanation is that there has been a decline in adherence to moral norms. A second is that the risk-reward trade-off has been skewed; stock options have provided a much greater pay-off from financial success. Finance has been democratized. A third is the rise of certified public accountants, which can be traced to the legislation that led to the Securities and Exchange Commission of the 1930s. The initial role of the accounting firms was to protect the public from the financial chicanery of corporate managers who might have had a tendency to overstate the value of inventories and of accounts receivable. The accounting firms were paid to verify or certify the data on financial performance presented by the firms’ financial managers. The accountants may have been the guardians of the public interest but the fees for their services were paid by the financial managers. Some of the firms being audited leaned on their accountants; the accounting firms were then forced to choose between agreeing to the firm’s demands or walking away from the account.

Securitization was a central feature of the bubble in US real estate between 2002 and 2007; the investment banks issued new bonds, which were claims on the interest income and principal of mortgages, credit card debt, and student loans that they had placed in a trust. The new bonds were much more liquid than the individual securities that were placed in the trust. The investment banks earned fees from securitization; their fee income soared. They then issued asset backed securities (ABSs), which were claims to the interest income and principal of the segments of the ABSs that had been deposited in the trust. The investment banks earned a second round of fees from creating these new instruments, which had been based on ‘slicing and dicing’ the MBSs into three, four, or five different tranches, which differed in terms of their risk characteristics – one set of trusts contained the tranches that had the first claim on the interest income of the MBSs and hence they were the least risky, while another set of trusts constrained the tranches that had the last claim on the interest income of the MBSs, and they were the most risky.

The investment banks relied on the credit rating agencies – Moody’s, Standard and Poor’s – to rank the securities that the investment banks were producing. (The credit rating agencies are like the CPA firms, established to provide ‘objective’ information. The CPA firms were paid by the firms that they were auditing and the credit rating agencies were paid by the investment banks that issued bonds.) But these agencies were relying on the ‘models’ that the investment banks had provided for them. The investment banks had indicated to the credit rating agencies that if they could not get rankings that would help them sell these securities, they would take their business to one of the other firms that provided ratings.

Was this illegal? Who knows? Was it corrupt? You bet. Is anyone from a credit rating agency likely to go to jail? Are you kidding?

In the end there was some crude justice, since the investment banks were done in by the declines in the market value of their holdings of asset-backed securities that they could not sell.

The temptation of banks

There are no firm data that permit comparisons of financial chicanery and fraudulent behavior across several centuries. The development of journalism as a profession may mean that any untoward activities are much more likely to be exposed today (although the activities themselves may not have changed). Exposure is the risk side of the equation; the reward is that the gains in wealth can be much greater. Martin Mayer’s The Bankers does not dwell on safeguards against defalcation in the same way that James S. Gibbons did in 1859: ‘There is perhaps no record of a bank fraud extant of which the perpetrator was not honest yesterday.’⁶⁴ Gibbons added, with emphasis, ‘It will occur to the reader that there is one peculiar feature running through the whole system; and that is the apprehension of fraud.’⁶⁵

What Gibbons said in 1859 is still true. The tendency is to believe that the banks and the bankers are ‘paragons of integrity’ and perhaps some of them are. A large number of banks lent extensively to Long-Term Capital Management in the 1990s, at the time believed to be one of the most innovative of the ‘hedge funds’. (The term ‘hedge funds’ is a Madison Avenue home run, since the impression conveyed is that the firm has arranged its portfolio to reduce risk while in fact these firms rely extensively on borrowed funds to increase the return to their shareholders and investors.) LTCM had been remarkably profitable – at least until its collapse. The banks were eager to lend to LTCM because they hoped to mimic its trades and profit accordingly. In the spring and summer of 1998, LTCM encountered financial difficulties.

The awkward handling of derivatives and unclaimed deposits by Bankers Trust and the money laundering for Russia by the Bank of New York suggest that standards are not much higher today than they were, say, in the 1920s.

In the boom years of the second half of the 1990s, everyone – well, nearly everyone – was getting rich. The major investment banks had very high incomes from the fees associated with underwriting new issues of stocks and bonds, especially those of firms associated with information technologies and bio-genetics. The traditional ‘Chinese wall’ between the investment banking activities of these firms and their asset management activities was supposed to be retained after the repeal of the Glass-Steagall Act, which had become law in the early 1930s to force the separation of the traditional commercial banking activities of firms from their investment banking activities. The law had been adopted in response to the abuses of the 1920s. The firms ‘promised’ that they would maintain a Chinese wall and that the statements made by their security analysts would not be influenced by the desire of their investment bankers to sell more securities.

But consider the scorecard of Merrill Lynch. The firm was extensively involved in brokering deposits to the rogue thrift institutions in the 1980s. Henry Blodgett hustled information that he knew was misleading. Blodgett’s superiors almost certainly knew that Blodgett was involved in a con. Merrill helped Enron falsify its income by paying an above-market price for the Enron barges in Nigeria.

Consider the scorecard of Citibank/Citigroup. The tale of Jack Grubman’s hustles for the telecom firms has been noted; Citibank/Citigroup paid a settlement of $150 million. Citibank was obliged to close its private banking activities in Tokyo because of the failure of bank officials to deal fairly with customers by repeatedly buying inappropriate securities for them after ignoring the warning from the Japanese authorities to stop the practice. Several of the top managers of Citibank ‘resigned’ – a Park Avenue euphemism for being fired. Citibank’s traders in London dumped a lot of German government bonds on the market and caused the prices to dive; they then repurchased these bonds at much lower prices. Several of the managers of Citibank’s mutual funds took rebates based on the revenues of the bank rather than of the funds.

What happens when a swindler is found out? Charles Blunt, the brother of John Blunt and himself an insider in the South Sea Company, in early September 1720 cut his throat ‘upon some discontent’, as contemporary newspapers put it; Charles Bouchard, the retired manager of LeClerc, a small Geneva bank that lost money in unauthorized real estate investments, was found dead in Lac Léman, an apparent suicide, in May 1977. Psychiatry holds that suicide in these circumstances comes from an intolerable loss of self-esteem, stemming from the realization of the irrationality of past behavior. The picture of stockbrokers jumping from Wall Street windows in October 1929 as they faced bankruptcy is now believed to be a myth.⁶⁶ An upswing in suicides is also part of the legend of the Austrian krach of 1873.⁶⁷ Nonetheless, the response does occur: ‘Thus died by his own hand [having taken poison on Hampton Heath], at the early age of forty-two, John Sadleir, one of the greatest, if not the greatest, and at the same time the most successful swindler that this [Britain] or any other country has produced.’⁶⁸ (Greatness and success seem curious as characterizations in the circumstances.) Denfert-Rocherau of 1888, and Ivar Kreuger, the ‘match-king’ of the 1920s, both committed suicide;⁶⁹ Clifford Baxter, one of the senior officials of Enron, took his own life. But suicide may be more usual in fiction. Mr Merdle cut his throat in a public bath with a tortoiseshell penknife in Dickens’s Little Dorrit, and Augustus Melmotte in Trollope’s The Way We Live Now took prussic acid at his club.

Flight is a less final form of exit than suicide. The prize case is Robert Knight, who doctored the books of the South Sea Company and then escaped to the Continent, there to make another fortune in Paris after breaking out of an Antwerp jail.⁷⁰ Robert Vesco fled to Costa Rica and then Cuba with an embezzled fortune. Charles Savary, who swindled the Banque de Lyon et de la Loire, died in Canada. Eugène Bontoux returned to France after five years of self-imposed exile to take advantage of a loophole in French law that held that prison terms not begun within five years of sentencing had to be dropped.⁷¹ The analogous case roughly a century earlier was that of Arend Joseph, whose failure in January 1763 initiated the financial distress that culminated in the bankruptcy of the brothers DeNeufville on 25 July, touching off the panic of the same year. Arend Joseph left Amsterdam with 600,000 guilders, in a coach-and-six, for the free city of Kruilenburg in Holland, where he was immune from further process. He left a debt of one million guilders in Amsterdam.⁷²

Comparisons can be made across the cycles in terms of the number of individuals who were indicted and the number who did jail time. Consider several episodes, from the 1920s, the 1980s, and the 1990s. In the 1920s two individuals went to jail for hustling the purchases of securities in a market that already had turned bearish. Eight or ten of the participants in the junk bond transactions of the 1980s, including Michael Milken, Ivan Boesky, Dennis Levine, and Charles Keating, were jailed for crimes that included insider trading, ‘parking’ of securities, and collusion to defraud; among those who served the longest sentences were heads of the thrifts that had been large buyers of junk bonds. The number of those who will have served jail sentences for their transgressions in the 1990s is still expanding and includes five individuals who had received pay-checks from Enron and two who had been involved with MCIWorldCom. Most of the Enron officers who have been indicted have gone to jail. Several of the individuals involved with HealthSouth have gone to jail. Two executives associated with Rite-Aid went to jail. Several members of the Rigas family went to jail. Sam Waksal and his good friend Martha Stewart have gone to jail. Very few Wall Street bankers have been jailed. Frank Quattrone, one of the star investment bankers for Credit Suisse First Boston, was found guilty in a second trial of obstruction of justice by destroying e-mails but his appeal succeeded. One Arthur Andersen partner involved with the Enron account did jail time.

Hundreds of Andersen partners and former partners implicitly paid large fines when the firm was forced to close and the value of partnerships and former partnerships collapsed. (Thousands of Enron employees lost their pensions and much of their financial wealth as well as their jobs when the firm went bankrupt.)

The Milken family probably had $2 billion in the bank when Michael Milken was released from prison. It would be impossible to figure out how much of the fortune was earned legally from innovation and how much was earned from illegal behavior. But assume that half of the family fortune could be tracked to transactions that were illegal. Consider how Milken might answer the charge, ‘You were in the jail for 1000 days, you graduated with $1 billion so you were paid $100,000 for each day in the jail.’

Economists are not qualified to discuss the appropriate punishment for the white-collar crime of swindling. At the time of the South Sea Bubble, Molesworth, then a member of the House of Commons, suggested that parliament should declare the directors of the South Sea Company guilty of parricide and subject them to the ancient Roman punishment for that transgression – to be sewn into sacks, each with a monkey and a snake, and drowned.⁷³ The suggestion is echoed in Dreiser’s novel The Titan. ‘Here the punishment consists of strangling first, then being sewn into a sack, without company, and thrown into the Bosphorus, a punishment reserved for cheating girl friends.’⁷⁴ In Christina Stead’s House of All Nations, written a quarter of a century later, a character suggests that old sultans used to punish a faithless wife by tying her into a sack with two wildcats and sinking the sack in the Bosphorus.⁷⁵ These suggested punishments seem excessively harsh. Still, those who commit white-collar crimes seem to get off lightly, and many keep most of their ill-earned fortunes. The fines paid by the Wall Street firms are a tax on the wealth of their shareholders and not a real burden on the malfeasants except in as much as they are also shareholders.

Whether swindlers are punished or live out their days in indulgent luxury is a more appropriate topic for corporate governance and business ethics than financial history. The revelation of swindles, frauds, and defalcation, and the arrests and punishment of those who violate trust are important signals that economic euphoria has reached too high a pitch and that there will be significant social consequences.