On Financial Frauds and Their Causes Investor Overconfidence

American Journal of Economics and Sociology, Inc.
On Financial Frauds and Their Causes: Investor Overconfidence Author(s): Steven Pressman Reviewed work(s): Source: American Journal of Economics and Sociology, Vol. 57, No. 4 (Oct., 1998), pp. 405-421 Published by: American Journal of Economics and Sociology, Inc. Stable URL: http://www.jstor.org/stable/3487115 . Accessed: 09/03/2013 11:48
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Frauds and TheirCauses: On Financial

Investor Overconfidence
PRESSMAN* By STEVEN ABSTRACT. This paper examines two possible explanations for why inves-
tors are so often and so easily taken by the likes of RobertBennett and his New Erafraud or Nick Leeson's sinking of the esteemed BaringsBank. I rule out the traditionalexplanations offered by neoclassical economics such as asymmetricinformationin a world of calculable risk. I argue that the literatureon empirical psychology, which emphasizes how people make choices in a world characterizedby uncertaintyprovides a more plausible explanation for why financial fraud is so prevelant.The paper aspects of financialfraudsand concludes emphasizes the interdisciplinary with some policy prescriptionsfor preventingfinancialfraud.
Introduction EVERY FEW MONTHS another case of financial fraud seems to make it to the front pages of the daily newspapers. On a somewhat small scale, company heads such as Barry Minkow (Akst, 1990; Domanick, 1989) and "Crazy Eddie" Antar, the New York electronics king who ran commercials that concluded with the memorable line "Our prices are insaaaaaaaaaaaane" (Queenan, 1988), receive jail sentences after embezzling large sums of money from the firms they started. In search of much larger sums of money, Michael Milken deceived investors about the risks involved when investing in junk bonds (Stewart, 1991; Sobel, 1993), while Bankers Trust deceives its clients about the dangers of financial derivatives (Holland, Himmelstein, and Schiller, 1995; Loomis 1995). And in one of the greatest frauds of this *[StevenPressman, of Economicsand Finance,Monmouth University, Department Professor West Long Branch,NJ 07764. E-mail(pressman@mondec.monmouth.edu).] andincomedistribution, and includemacroeconomic Pressman's interests policy,poverty and ItsDiscontents includeEconomics of economicthought.Hispublications the history A Critique (editedwith Richard Holt,Elgar,1998)and Quesnay'sTableau Economique: and Reconstruction (Kelley,1994)
American Journal of Economics and Sociology, Vol. 57, No. 4 (October, 1998). ? 1998 American Journal of Economics and Sociology, Inc.
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AmericanJournal of Economics and Sociology
centuryor any other century,Nick Leeson (Leeson, 1996;Pressman,1997) brings down BaringsBank, one of the oldest and most conservativefinancial institutionsin the world, throughhis illicitand riskytradingin foreign exchange options. Baringshad financedthe Americanpurchaseof the LouisianaTerritories from Francein 1803, and by the early nineteenth century had become bankerto the Britishroyal family. Instances of financialfraudhave not been limited to the privatesector. FrancesCox, the Treasurer of FairfaxCounty,Virginiaused her position to embezzle more than half a million dollars duringthe 1960s and the 1970s Lynch,went (Coughlan,1983). And OrangeCounty,encouragedby Merrill in financial derivatives after (Jorion,1995). wildly speculating bankrupt What are the causes of Why do such financialfrauds continuallyrecur? these fiascos?Whatcan traditional economic theorytell us aboutthe causes of financialfrauds and their possible cures?These are the questions that will be addressed in the remainderof this paper. The next section looks at one particularcase of financial fraud-New Era Philanthropy.This case of study is useful for two reasons. First,it contains many characteristics other financial frauds. Thus, it is a good case to use if we want to draw some lessons or morals. Second, because many colleges and universities were duped by New Era,New Erais likely to be of greaterinterestto the academic readersof this journalthan the collapse of a large financialinstitution or some egregious case of embezzlement.
II New Era Philanthropy-A Case Study
IT IS HARDTO BELIEVE THATA CHARITY WOULDRUN A PONZI SCHEME; but this
is exactly what the Foundationfor New Era Philanthropydid, making it part of the biggest financialscandal in the historyof philanthropy. John G. Bennett,Jr., was the founder and drivingforce of New EraPhilanthropy.He was born in 1938 and grew up in a working-classPhiladelphia neighborhood. In 1963, Bennett graduatedfrom Temple University and began work as an administrator for a drug and alcohol abuse program. Then in 1982 he began a company called the "Centerfor New EraPhilanthropy."This firm advised corporationsabout which nonprofit organizations should receive their money (Stecklow, 1995). In 1989, Bennett began the Foundation for New Era Philanthropy.At
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first,New Eraprovided free investmentadvice and assistanceto nonprofit organizations.Nonprofits were instructedwhere and how to best invest theirendowments. These services earnedBennettconsiderablerecognition and respect in the nonprofit community.They also earned Bennett a position on the Boards of Directorsof numerous Philadelphianonprofitorganizations,includingthe PhiladelphiaOrchestra. New EraPhilanthropy then went into the business of helping nonprofits raise money. But it attemptedto do so in a manner that was unique and unorthodox. Bennett promised that in six months time he would double the investment of any nonprofit organizationthat gave him money. Such returns,Bennett claimed, were made possible by wealthy philanthropists who wanted to make anonymous donations to charitythrough New Era. to have to turnover money Whileit is unusualfor charitable organizations New Erahad a readyanswerfor anyone to receive additionalcontributions, who questionedthis practice.Bennettclaimedthat New Eraneeded the intereston this money to cover theiroperatingcosts (Knecht& Taylor,1995). turnmoney organizations requestthatnonprofit Despitetheirunconventional over to them, New Erathrivedand prosperedin the early 1990s. Numerous factors contributedto the success of New EraPhilanthropy. First,Bennett had close ties to established and well-known Christian philof him and Era an aura and This New respectability gave anthropicgroups. trustworthiness.Second, Bennett had an infectious optimism that made fees" to any inpeople trusthim. Third,Bennett paid substantial"finder's termediariesdirecting charitabledonations to New Era. Fourth,over the course of several years, New Eradid pay enormous returnson the money that philanthropistsand charitiesdeposited into special accounts. For the many nonprofitorganizationsthat were hard hit by cuts in Federalspending during the 1980s and early 1990s, the lure of an annual rate of return of 300 percent was just too hard to pass up. Finally, and perhaps most important,charitableorganizationsfelt that the money they gave to New Erawas secure. Bennetttold donors thattheir money would be put into escrow or custodial accounts at PrudentialSecurities.These accounts would make it easier for each donor to keep track of its money and the returnsit was making.The accounts also reduced the risk that something might go wrong and the charityor philanthropicorganizationwould lose the money it gave to New Era. In the early 1990s, hundreds of nonprofitsgave large sums of money to
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Bennett. Some were prominentnonprofitorganizationssuch as the American Red Cross,the SalvationArmy,and elite academic institutionssuch as Harvard,Princeton,and Brown Universities.When New Erafolded, these institutionsall lost the money they had on deposit. John Brown University in Siloan Springs,AK,lost $2 million, close to 4 percent of its endowment. The big loser, however, appearsto be Lancaster Bible College in Lancaster, PA, which had $16.9 million deposited with New Era. Even cautious charities that carefully checked out New Erafell victim to John Bennett's philanthropyscam. Nature Conservancyis a nonprofit organizationthat works to preserve threatenedwildlife habitats.It is one of the most respected and most conservativecharitiesin the United States. Afterone of its majordonors made a $15,000 gift through New Era,New Eraapproached NatureConservancyand discussed their programof doubling deposits in six months. Being skeptical by nature, Nature Conservancy called other nonprofit organizations that had relationships with New Eraand asked for references. They also called PrudentialSecurities, which held New Era's funds, the IRS, and the Pennsylvania Bureau of CharitableOrganizations. Then they performed an extensive search of newspaper articles looking for any negative informationabout New Era. In all cases New Erachecked out as legitimate and problem-free(Knecht & Taylor, 1995). However, New Erawas not what it seemed, and Bennett defraudedall of these organizations.In fact, there were few wealthy philanthropists conto New Era. Bennett took a substantial fraction of the Rather, tributing he received for his own and he used the money personal benefit, deposits he made with Prudentialas collateralon a personal loan. When it came time to pay off early investors, Bennett used the funds he obtained from later investors. In essence, he was running a huge pyramid or Ponzi scheme. It took nearlysix years for all the facts to be discovered and for New Era to collapse. Two separateincidentsin 1995 led to the downfall of New Era. Albert Meyer, an accounting professor at Spring Arbor College in rural Michigan,became concerned about the endowment money his school was giving to New Era.He contactedthe Securitiesand ExchangeCommission (SEC)and the WallStreet Journal, and he wrote to the IRSfor information about New Era'stax returns.This information was all very slow in coming. Finally,at the end of March1995, Meyerreceived a copy of New Era's1993
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tax return.The key number, the proverbialsmoking gun for Meyer, was the $34,000 in interestthat New Eraclaimed it had earned duringthe year. If New Erahad invested millions of dollars,as it claimed, New Erashould have received close to $1 million in interest.The $34,000 in reported interest was clear evidence that something was wrong at New Era(Demery, 1995;Michelmore,1996). At about the same time, New Era failed to repay a loan to Prudential Securities.As a result, Prudentialtook control of New Era'sfunds and demanded to see its financial records. These records showed that New Era had virtuallyno assets and virtuallyno income, yet at the same time they the deposits had more than $135 million in liabilities,which were primarily that nonprofitorganizationsmade to New Era. On May 15, 1995, New Erafiled for protection under Chapter11 bankan articleaboutthe New ruptcylaws afterthe WallStreetJournalpublished Era fraud (Knecht & Taylor, 1995). When lawyers for New Era admitted that there was no chance the organizationcould be saved througha reorganization,the case was moved into Chapter7 liquidation. Soon the indictmentsand lawsuits began. Bennett was charged with 82 the SEC counts of fraud,money laundering,and tax evasion. Furthermore, with U.S. securities sued Bennett and New Era, charging them violating laws. They claimed that the matchingfund programof New Erawas really an unregisteredpublic offering of securities. The SECalso charged that Bennett moved $4.2 million from New Erainto several companies that he personallyowned and then used the money for the benefit of himself and his family. In January 1996, Bennett agreed to turn over $1.2 million in personal judge. This included property,cash, and securitiesto a Federalbankruptcy his his $620,000 home in suburbanPennsylvania, Lexus automobile, and the $249,000 home he bought for his daughter (Stecklow, 1996). These to the charitable funds were added to the assets of New Erafor distribution which New Era owed to money. organizations A 1996 bankruptcycourt settlement returned nearly two-thirds of the money that nonprofit organizationshad on deposit with New Era. In an attempt to recoup the remaining money, 30 nonprofits sued Prudential Securities for $90 million, charging that the brokerage firm was a coconspiratorin the New Erafraud.Specifically,they chargedthatPrudential assured them that their funds were being held in escrow accounts, when
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in fact Prudential knew thatall New Erafundswere held in a single, general account and were being used to repayloans to Prudential (Bulkeley, 1996). This lawsuit was settled out of court in November of 1996. On March 26, 1997, Bennett pleaded no contest to charges of fraud and money laundering. He was sentenced in late 1997 to 12 years in prison. III
The Causes of Financial Frauds-The Neoclassical Story
THE NEW A CLEAR ERA CASE PROVIDES of how easily investorscan be EXAMPLE defraudedby a simple Ponzi scheme. In most instances,the investors John Bennettduped were sophisticated with extensiveexnonprofitorganizations perience investinglarge sums of their money. Most of these organizations checked out New Era (although not thoroughly),and they believed their was a legitimate endeavor. money was safe and thatNew EraPhilanthropy The case of New Eraraises two questions. First,how can something like this happen to sophisticatedinvestors?Second, what can be done to keep less knowledgeable and experienced investorsfromfallingprey to financial frauds on a regular basis? Neoclassical economic analysis provides one possible explanationfor the recurrenceof financialfrauds;but, as this section argues, the neoclassical explanation is ratherlimited and unconvincing. The next section relies on the findings of empirical psychology to present a more convincing explanationfor why financialfraudslike New Eraoccur with great regularity. The main reason standardeconomic theory provides little help in understandingthe prevalence of financialfraudsis that neoclassicaleconomics prettymuch rules financialfraudsout of existence by assumption.The key assumptionsleading to this result are that people are knowledgeable and thatthey are rational.Rationality impliesthatpeople want to maximize their returnson investment (given a known degree of risk). This means thatwhen a greatdeal of money is at stake, investorswill seek a greatdeal of informationabout where they invest their money. There is no denying that individualinvestorsknow that cases of fraudexist (sufficientevidence of this appears in magazines and newspapers). Individualinvestors also know thatthere is a nonzero probabilitythatthey will be defrauded.When large sums of money are at stake, neoclassical theory holds that rational
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investors should weigh their potential gains against their potential losses and that they should seek out large amounts of informationabout who they are giving their money to. But once it is assumedthatpeople are rationalin the sense justdescribed, and that they know what they are doing before they invest, it is hard to explain why people should frequentlybe duped or why financialfrauds exist. such as New EraPhilanthropy It is at this point that neoclassical theory brings in the notion of asymmetricinformation.In cases of investment,the investormust always know less than the person or institutionthatreceives theirmoney. The individual who gives his or her money to someone to invest does not know that the money will really be used as part of some Ponzi scheme, or to establish the facade of a legitimatebusiness whose proceeds then get used for personal consumption. Investors are thus at a disadvantage,and this disadvantage leads to Ponzi schemes, embezzlements, and so on. But fallingback to the notion of asymmetricinformation reallydoes little to explain financialfrauds.First,there are internalproblems with this approach-even within the neoclassicalparadigmit does not provide a good explanation for the existence of financial frauds. Despite asymmetricinformation,any rationalindividualgiving up money has great incentivesto make sure that the monies are actually being employed as promised. In many cases, potential losses can run into the millions of dollars. So why don't individualstake better care and try to obtain the additionalinformaNeoclassicaltheory and the tion thatwould reveal the existence of a fraud? notion of asymmetricinformationprovide no answer to this question. In addition,why don't individualsstop investing or not invest until they have Rasufficientinformationto make sure that they are not being defrauded? tional and knowledgeable investors (in the neoclassical sense) should realize that extremely high gains are unlikely, and promises or payments of large returns should be a red flag indicating the possibility of a Ponzi scheme. It should signal to investorsthat "moreinformationis necessary" ratherthan "thisis a good place to invest money." Moreover,the basic factsin the New Eracase do not supportneoclassical theory. Manyinvestorsdid not check New Era'sfinancialrecordscarefully before they gave New Eramillions of dollars. In addition, everyone took at face value assurances from PrudentialSecuritiesthat the money they gave to New Erawas being held in individualescrow accounts. Not one
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nonprofit organizationdemanded to see an account statementfrom Prudentialbearingsolely its name and containingexactlythe amountof money it deposited with New Era.AlbertMeyer, the mild-manneredaccounting professorwho pressed SpringArborCollege to get this informationand to have other questions answered, was met with indifferenceand hostilityby at his school. He even felt that he was puttinghis the senior administrators as an untenured professor at risk by merely asking such questions job (Michelmore,1996). check Investors do not thoroughly Mostfinancial fraudsfollow this pattern. out who they are giving theirmoney to, and even if they do this, swindlers DrakeEstateswindle provides are able to cover theirtracks.OscarHartzell's information and neoanothergood exampleof how and why the asymmetric classicaltheorydo not get to the root causes of financialfrauds.In this case, withsubstantial investors were not largenonprofit the defrauded organizations in Iowa,that investment experience;they were midwestemfamilies,primarily knew littleaboutinvestingtheirhard-earned money. The Drake swindle involved the supposed estate of the Britishadmiral and explorer SirFrancisDrake. Hartzellconvinced hundreds of families that they were descendants of the great explorer, and that Drake had left an estate valued in the hundreds of millions of dollars or even more. Hartzell also convinced them that he was trying to get the Drake Estate distributed to its rightful heirs and that all he needed was "expense money." Those who contributed to this enterprise, he claimed, would receive a portion of the Drake Estate. Using this sales pitch, Hartzell conned 70,000 American families out of more than $2 million (in 1920s and 1930s money). Many farmers in Iowa and other midwestern states went into debt and heavily mortgaged their farms to meet Hartzell's continual requests for expense money. Eventually, many of these farms went into foreclosure. Yet, no one asked the simple questions that would have revealed Hartzell to be a con artist.Forexample, Drake died childless, so his heirs could not inherithis fortune,no matterhow massiveit was. In addition,the statute of limitationson wills in Englandis thirtyyears. So even if Drake did hide away billions worth of gold, and even if he did have an heir, that heir would not be legally entitled to any of the Drake Estatein the twentieth century(Brannon,1995;Nash, 1976, pp. 77-93). Again,the problemis not asymmetricinformationin the neoclassical sense of investors tryingtheir
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best to get informationand being thwarted by scam artists. Rather,the problem is that investorsthemselves do not ask the appropriatequestions and naively believe what they are told and apparentlywhat they want to believe. They are not rationalin the neoclassical sense of the term,nor for that matter,in any other sense of the term. A final problem with the traditionaleconomic view of financial frauds is that in cases of financial investment, individualsare not facing risk,but uncertainty. Traditionaltheory attempts to convert situations of uncertainty into cases of risk by assuming that people form subjective probability assessments for the situation based on the laws of probability.But it is unlikely that any investor can come up with probabilities for the likelihood that they are being defrauded. One reason for this is the lack of informationabout the number of fraudulentinvestments. Manyfraudulent investments never become known to the public because the great risks undertaken by some individuals eventually get paid off. Others remain unknown because the victims are too embarrassedto come forward. So it becomes a matterof faith ratherthan a matterof probabilitythat an investment is legitimate. In the next section we will see that having a particularpsychological makeup increases the likelihood that an individual will take this leap of faith.
IV Causes of Financial Frauds-The Other Story
THE NEOCLASSICAL EXPLANATION OF FINANCIAL FRAUDS viewed
investmentdecisions as primarilymattersof risk. They are cases in which people make probabilityassessments of futureevents and then make rationaldecisions that maximize the expected utilitythey will receive from their investment
opportunities. However, it is not clear that investment decisions involve choices in which people know the risks of different possible investments. Nor is it clear that investmentdecisions involve formingprobabilityassessmentsof possible future outcomes. Rather,most investment decisions are choices made when facing some degree of uncertainty.In cases of uncertainty, people typicallyresortto some kind of focal point for makingtheirdecision or coordinatingtheir actions (see Schelling, 1960, chap. 3). If uncertain about whether to refinanceone's mortgage,one looks at what one's neigh-
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bors and acquaintances are doing.Whena largenumber that refinance, a for others to refinance. when uncertain whether Likewise, provides signal to investmoneyin a certain mutual fundor business,one looks at what one'sfriends and acquaintances aredoing.If they aregivingtheirmoney to firmX or individual then one does not look like a lonerif he or she Y, a personmaylookfoolishif he or she didnot does so as well. Conversely, get in on a good thing.Thus,when manypeople investin a certain way, thereis a tendency forothersto do so as well. Butif investment decisions arebasedon focalpoints,thesituation is ripe for financial frauds. As we saw earlier, the typicalfinancial scambegins witha few investors who receiveextremely Itis these largeratesof return. returns attract more that investors and that make a certain investment great or becomea focalpoint. seem legitimate a good dealof evidencethatpeopleare Empirical psychology provides constituted to make the very sortsof errors thatlead to psychologically casesof massive financial fraud. Oneresult fromthe empirical psychology is thatjudgments literature aboutpotential riskare frequently mistaken, and humanfallibility tendsto be greatest when people hold theirfaulty withgreatconfidence & Lichtenstein, 1982). (Slovic,Fischhoff, judgments are to be whenMoreover, people psychologically predisposed optimistic ever they are individually involvedand have had no bad personal experiences from Forexample, their thisinnate a large pastto counter optimism. of people thinkthattheywill live past80 (Weinstein, 1980)and majority thatthey,personally, areunlikely to be harmed by products theybuyand use (Rethans, 1979).Psychologically, people tend to live in the worldof LakeWobegon,where all childrenare smarter thanaverageand better behavedthanaverage. Peoplealso tendto believethatgood thingswill happento them.They overestimate theirchancesof winningthe lottery andthinkthattheywill not sufferseriousinjury if they are involvedin a caraccident but do not weartheirseatbelt(Slovic, & It then 1978). Fischhoff, Lichtenstein, appears thatpeople are psychologically to believe of predisposed perpetrators financial andto believethattheythemselves frauds will not be the victims of suchfrauds. Another relevant resultfromthe empirical literature is that psychology in are overconfident their believe that people judgments. People theyare and more to a much than are right often, larger degree, theyactually right
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in their assessments (Oskamp, 1965). Whatis true of laypeople is also true of "experts" in a particular area. It is this overconfidencethat leads to such disastersof human errorsuch as Three Mile Island and the collapse of the Teton Dam, and such ecological and biological disasterssuch as acid rain and ozone depletion (Slovic et al., 1982). Overconfidenceby investorsalso explains why investors do not raise obvious questions and why perpetrators of fraud seem to have such an easy time duping even sophisticated investors.Fromthe perspective of human psychology, it is no wonder that individualslike John Bennett and organizationslike New EraPhilanthropy are not rigorously scrutinized and pass inspection even when they are checked out carefully. Moreover,the human disposition toward overconfidencegets rewarded and reinforcedby the typical formatof a financial fraud. Normally,large gains are paid to initial investors to generate overconfidence. There is a great deal of psychological evidence thatpeople frequentlymake misjudgments when looking at events that occur purely by chance. Instead of atfor tributingthese events to chance, people develop some rationalization is a belief that they are betterthan others these events. One rationalization or luckier than others. Thus is born the belief in the "hot hand" among basketball players, even though good statisticalanalysis and arguments point to the conclusion that the hot hand is not a real phenomenon and that the chance of a basketball player's making a given shot is the same whether he or she made or missed the last few shots (Gilovich,1991, chap. 2; Gilovich,Vallone, & Tversky,1985). By paying out large returnsinitially, fraudulententrepreneurscreate overconfidence in the public and a belief that high returnswill continue into the indefinitefuturebecause they have a "hot hand."Adding furthercredence to these beliefs is the fact that most mutual funds advertise their returnsand attemptto attractnew investors with their claims of having "beatenthe market." Given theirpsychological investors stand little chance financial frauds. makeup, against Furthercompounding this problem are the phenomena of framingeffects, recency effects, and halo effects. Framingeffects, or anchoring,occurs when people make judgments based upon a given initial value or startingpoint. Tverskyand Kahneman(1974, p. 1124) note that in cases of uncertaintypeople rely on heuristicsto make decisions. For example, decisions about purchasinginsurance are known to be affected by the way the decision is presented to people. Decision choices frequently get re-
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versed when the decision is portrayedas accepting a small financialloss insteadof makinga gamble on futureevents or vice versa(Fischhoff,Slovic, & Lichtenstein,1980; Hershey & Shoemaker, 1980). In financial matters, past returnsor promisedreturns(or some combinationof the two) become anchors,and people come to expect such returnsin the future(despite the requireddisclaimersabout past returnsand futurereturns). Recency effects occur when the most recent informationwe are given greatlyinfluences our judgments.Halo effects occur when one positive trait influences our evaluations to a large degree. Entrepreneursor flimflam artistswith upbeat and outgoing personalities immediatelydevelop halo effects. We tend to like them and believe them. If these individualsare able to provide above average returnsduring any recent time period, recency effects lead others to believe that these people will always generate above average rates of returnand that these people are trustworthyindividuals to whom it is safe to give your money. with charming and Manycases of financialfraudhave involvedindividuals were Ponzi schemes of who able to sorts convincingpersonalities develop based on recency effects. Nick Leeson's(1996) superiorsdid not question Indomany of his activitiesbecause duringthe year he spent at the Jakarta, nesia, branchof BaringsBank he cleaned up an office in shamblesand collected largeamountsof money thatBaringsBankwas not even awarethatit was owed. Leesonwas rewarded with the assignment of starting up and runbut because of the halo effect and ning the Baringsoperationin Singapore; and his futureactionswere the recencyeffect,he was not monitoredcarefully at Barings Bank not questioned.Recentexperienceled the seniormanagement to assumethatLeesonwould turnthe Singapore office into a highlyprofitable endeavor. Problemsbegan when a traderbought shareswhen she should have sold them. Leeson hid this mistakein an erroraccountand sought to make up the loss by using this accountto speculatein foreigncurrency. The to London,however,showed thatallhis foreign numbersthatLeesonreported was earningBaringsBanka greatdeal of money. Leeson's exchange trading superiorswere happy to see the firmmakinglarge profitsand to cash their largebonus checks.Withno one questioninghim, and with no one checking his financialreports,Leeson was allowed to speculatein foreigncurrencies Bankdeposits.His speculations became increasingly riskyover using Barings time because winning a riskygamble was the only hope Leeson had of reversinghis losses.
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also had the upbeat and outgoing John Bennettof New EraPhilanthropy personalitythat caused people to immediatelytrusthim. His long association with Christian philanthropicgroups and his associationwith charities of through years giving them advice helped to anchor people's beliefs about Bennett. It was thus relativelyeasy for him to get money and references from those people he had dealt with for many years. Added to this anchor was the halo effect and the recency effect. When investors seek above average returnson the belief that such returnswill continue to be paid in the future, there will always be Ponzi schemes waiting to occur. As we saw, New EraPhilanthropypaid investors more than 100 percent interest during its first few years of operation. Because of these high returns,investors came to expect large returnsand became reluctantto question New Erafor fear of being asked to put their money elsewhere. Furtherreinforcinganchoring,halo effects, and recency effects, people believe that someone is monitoringthings and that fraudscannot happen. But this is not the case in the realworld. Firmsthatseek to evade regulators usually are able to do so with little difficulty.Regulatorshave too few resources and too little time relativeto the number of firmsthat need moncan also at times be bought off or stalledthroughpromitoring.Regulators ises of compliance with regulationsin the future or complaints about intrusive government interference with the free market. Even seemingly independent and objective parties might be paid "finder'sfees" as in the case of New EraPhilanthropy. This section has argued that financialfraudsarise not because of asymbut because of the psychologicaldispositionsof human metricinformation, beings and the fact that human decision makinginvolves employing some heuristicor focal point in the face of uncertaintyregardingfuture events. The next section examines the policy implicationsof this view.
V Preventing Financial Frauds
when it comes USELESS THEORY IS RELATIVELY ECONOMIC JUSTAS NEOCLASSICAL
to explaining financial frauds, so too is it relatively useless for devising solutions to this problem. As we saw earlier,neoclassical theory sees the problem in terms of asymmetricinformation.Only one solution follows
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from this-to increase the amount of informationavailable to potential investors so that they can rationallyand intelligently invest their hardearned money. But in the real world, this solution will not likely work. Again, the literature from empiricalpsychology can help us understandwhy more information is not the solution. Greaterinformationis only helpful if it is received correctly,without any biases, and interpreted and used intelligently. But many psychologicalstudies have found thatjudgmentsdo not improve with more information(see Janis & Mann, 1977, chap. 8; Rabin,1998, pp. 26-32). Just as damningof the neoclassicalperspectiveis the work of Kahneman and Tversky(1972; Tversky& Kahneman,1982), which finds that increasingthe knowledge of statisticsdoes not eliminate or reduce biases in judgment. Most financialfrauds contain warning signs that should have been obvious to those who were taken in or deceived; yet most investorsfail to be swayed by the evidence staringthem in the face. This is true of the Sir FrancisDrake Estatescam to a very large extent, but it is also true of New EraPhilanthropy. If all that neoclassicaltheory can recommendis that investorsshould be provided with more information,neoclassical theory becomes a recommendation for playing a game of financialsurvivalof the fittest, in which those who are smartenough or lucky enough to avoid fraudsthrive and the average person gets duped with some degree of regularity.But this outcome is not acceptable;in the long run it will lead to dissatisfaction with the currentsystem and, when the fraudsbecome too numerous and egregious, a reluctance to invest that will hinder the ability of the capitalist system to run well. Just because neoclassical economics is of no help in understandingand curingfinancialfraudsdoes not mean that economics cannot help. One of the most importantlessons to be learnedfromeconomics is thatincentives are important.With respect to financialfrauds,potential gains are always enormous. If I take someone's money, gamble with it, and win, I wind up makinga large sum of money and my actionswill not likely be discovered. On the other hand, if I do not succeed, I can still live extremelywell. As we saw, RobertBennett prospered for many years on the monies given to him by variousnonprofitorganizations; he was also able to use this money as collateralfor personal loans. Even when caught,the penalties for finan-
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cial fraud are generally small relativeto the potential gains. AlthoughMichael Milkenspent a few years in jail, he was still able to accumulategreat wealth. Similarly, although RobertBennett had to turnover $1.2 million to the state for distributionto charitableorganizationsowed money by New Era,if the SECestimatesare correct,Bennettshould have at least $3 million increasedrelativeto hidden somewhere. Unless penalties are substantially rewards,there will be little change on the supply side of frauds. But the demand side is even more importantthan the supply side. And action on the demand side is even more difficultbecause here we have to contend with humannatureand the tendencies to be overly optimistic,and to hope for and expect large gains. The psychological literature, however, does offer some hope. One lesson from this literatureis that informing people of the risks in concretetermsmakes people judge risksto be greater and makes them perceive risksto be much closer to the actualrisks(Slovic et al., 1982, p. 484). In many instances, concrete examples of something bad happening will cause people to overstatethe risk of something bad happening to them. This leads to the following importantconclusion. Ratherthan assuming investors are knowledgeable about investment opportunities,and rather than providing investors with more informationabout particularinvestments, providinginvestorswith more informationabout investmentsgone awry is necessary. The best solution to the problem of financialfraudis to keep remindinginvestors about the CharlesPonzis, the Nick Leesons, the CrazyEddies, and the John Bennetts.
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StevenStecklow,"HowNew Era'sBoss Led Richand Gullibleinto a Web of Deceit," WallStreetJournal (May19, 1995),pp. Al, A8. Now He's GivingBack," StevenStecklow,"NewEra'sBennettTook Others'Millions; WallStreetJournal 24, 1996),pp. Al, A6. (January Den of Thieves (New York:Simon& Schuster, 1991). JamesB. Stewart, UnderUncertainty: Heuristics and Amos Tverskyand Daniel Kahneman, "Judgement 1974),pp. 1124-31. Science,Vol 185,# 4157(September Biases," of and by Representativeness," in Amos Tverskyand Daniel Kahneman, "Judgments ed. Daniel Paul Under Heuristics and Biases, Kahneman, Uncertainty: Judgment (New York:Cambridge Press,1982),pp. 84Slovic,and AmosTversky University 98. LifeEvents," N.D.Weinstein, "Unrealistic AboutFuture Journalof Personality Optimism Vol. 39 (1980),pp. 806-20. and SocialPsychology,

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