Lying for Money

Lying for Money is a branch book that covers financial fraud.

• Division of labor for trust / checking up on things allows fraud to go further before detection. Consider the scenario in big short where the credit agencies where rating the bankers bonds as low risk because they were captured (the banks were their customers).

• White collar crime is often about creating a set of transactions that look legitimate. And more troubling, when things go wrong it becomes a question of whether they intentionally went wrong through malfesance or whether the person(s) just failed.

• Fraud is easier:

  • When dishonesty is a rare exception rather than an everyday rule
  • When trust is outsourced or where there is a “division of labor” for trust (checking up on things)

• Fraud plays on weaknesses in checks and balances. It is what is not “checked up on” where fraud permiates.

• A key feature of frauds is that they were stoppable early if someone had taken the time to confirm all the facts.

• Four levels of abstraction for financial crime:

  • Long Firm - borrowing money and not paying it back or buying goods and not paying for them
  • Counterfeiting - abusing the trust in ways ownership and value are verified by creating false documents
  • Control fraud - when operators/managers extract value on the basis of fictious profits or unreal assets. This occurs as operation is separated from providing capital
  • Market Crimes - for example cartels or insider dealing ring. The victim is the market itself rather than a given individual

• A subjunctive crime - if things turn out well for the underlying business and the wild risks that the control fraudster pay off, the victims may not know that crime ever took place.

  A long firm makes you question whether you can trust anyone. A counterfeit makes you question the evidence of your eyes. A control fraud makes you question your trust in the institutions of society, and a market crime makes you question society itself. Since it’s impossible to run a modern economy without all four levels of trust, fraud is an insidious crime.

  This is a crucial theme; a good fraudster will know what the weaknesses in a checking-up process are and attempt to steer through them. But a great fraudster will target the strengths of the system that is meant to catch him, and design his deceit around that

Fraud can be enabled by the difficulty of fraud prevention mechanisms. There may be a cost (time or money) to preventing fraud. The ease of the transaction will be dictated by the relative power of the buyers and suppliers in the market. The “implicit value” of preventing fraud rises in low trust environments and lowers in high-trust environments.

The lesson from the darknet frauds is that you can build technical controls into the system, but fraud will work around them. Precautions are expensive, or inconvenient, or both, and trust is free. This means that people will substitute trust for precautions up until the point at which the “shadow cost of trust”—the expected fraud loss—begins to exceed the direct cost of precautions.

As J. K. Galbraith noted, fraud is unusual in having this time dimension to it, and it means that there is a happy period when the nation as a whole feels richer because the fraudster knows that he has stolen the proceeds, but the victim is not yet aware that he has lost them. He coined the phrase “the bezzle” to describe the aggregate stock of undiscovered fraud in the economy and suggested that its fluctuations might explain quite a few things about the business cycle.

The Canadian paradox

With that in mind, given what we know about the following two countries, why is it that the Canadian financial sector is so fraud-ridden that Joe Queenan, writing in Forbes magazine in 1985, nicknamed Vancouver the “Scam Capital of the World,” while shipowners in Greece will regularly do multimillion-dollar deals on a handshake? We might call this the “Canadian Paradox

Technical controls to prevent fraud will be worked around when the implicit price of those controls is too high.

Chapter 02 : Chapter 2: The Basics

He coined the phrase “the bezzle” to describe the aggregate stock of undiscovered fraud in the economy and suggested that its fluctuations might explain quite a few things about the business cycle.

Patterns of payment

In the first place, it is comparatively cheap to provide. If the alternative to making a sale on credit is letting the goods hang around until the customer can raise the cash, there is a saving to be made by getting them moved out of your warehouse and into the customer’s. This is particularly the case for things like fresh bread, which has a limited shelf life. Second, and related to this, it drives sales

You can tell more about the structure of an industry by looking at patterns of payment terms than you can from any “five forces” or “SWOT” analysis.

Collateral

As the Liechtensteinian innkeepers knew, holding on to a customer’s valuables (otherwise known as “taking collateral”) makes it a lot easier to extend a loan to a business or a person. It reduces your risk in two ways. In the first place, it is usually easier to check out the quality of things than of people, so if your main risk is the collateral, this is easier to manage than if your main risk is a debtor’s ability and willingness to pay. And in the second, when your collateral is more valuable than the amount of your loan, the debtor stands to lose more by defaulting on the loan than by paying it back

The limiting case here is where you have established a legal right to repossess the house that the debtor lives in, which makes mortgage loans one of the safest forms of credit

Collateral is a substitute for trust. It relies, however, on strong legal institutions to make sure you can actually “realize” it by taking possession of it when a debtor defaults. The activity of “perfecting an interest,” “establishing security,” and similar euphemisms forms a large part of what lawyers send bills to bankers for, because the law on this is tricky at the best of times and damn near impossible when the borrower starts to play games

Wrong way risk

Check Kiting

check kiting4 is the simple practice of stealing money or valuable goods by paying for them with a check that you know (or ought to know) will be rejected because there aren’t sufficient funds in the bank account to honor it. In this form it is known to the specialists as “paper hanging,” and it’s often a crime of desperation or one carried out with stolen checkbooks rather than a calculated commercial decision

The important technical detail here is that because paper checks are particularly common in America, and because the check-clearing cycle is so long, American banks have—unusually in a global context—historically been very generous when it comes to allowing their business customers to make payments out of “uncleared funds,” that is to say checks that have been deposited into their account but that have not yet been endorsed by the bank that they are drawn on

What you do (in the simplest form) is that you open accounts in two banks. Call them Bank A (from which you get a checkbook with pictures of trees in it) and Bank B (which gives you a checkbook full of pictures of sports cars). Pretend for the time being that you put a token hundred bucks into each account. But now you write a check for $500,000 from your “trees” checkbook and deposit it in your Bank B account. That check is going to bounce, for certain. Except… it will only bounce when the check gets presented, and in the meantime, thinking that you have $500,000 in the bank, Bank B will not mind if you write a sports-car check and deposit it in Bank A. If Bank A sees the sports-car check, they will not mind honoring the trees check for the time being, while they are waiting for the sports-car check to clear. If they honor that check, then you can write another check to Bank B, and so on…

Chapter 03 : Chapter 3: The Long Firm

From the lender’s side, it was a perfect storm of the right conditions to get ripped off. Field warehousing was a new financial technology, which had not been thought through. The Amex subsidiary in charge of it had been given tough “stretch” targets and so needed to land big customers. The Bayonne facility was staffed by people who were comparatively cheap to corrupt. And oil floats on water.

• delegation of fact checking is a weak point for fraud to exploit
• Economizing on fraud controls “makes sense” because it is a tail risk. For business, since large scale frauds risk is close to zero, it is reasonable to act as though it is zero.
• lawyers and accoutants do serve as a barrier to bad actors, but it only takes one corruptable one to get past this defense and once inside, there is rarely any further checking.

The government is often a victim of this sort of tactic, because it has some unusual characteristics as a victim (it is large, and has problems turning customers away: see Chapter 11). Many defense procurement frauds work in a similar way. But large private-sector entities are also vulnerable to shotgun/rifle approaches—something like this tactic is usually at the heart of organized insurance fraud, as well as some credit-card and mortgage frauds. Usually at the heart of a shotgun/rifle disaster, you will find a system that somebody has painstakingly engineered to optimize for the average unit cost. This is of course the right thing to do for most industrial processes, but you need to be careful that the thing you’re working on is an industrial process and not a decision-making process. Optimizing for the common case is not the same thing as trying to get the right answer, and a single medium-sized fraud can blow away all the costs saved by shaving a cent off a hundred thousand “normal” transactions

• Insolvency
  • “commercially insolvent”“legally insolvent”“cash-flow insolvent” occurs when you have a payment come due and cannot pay it.
  • “technically insolvent”“factually solvent”“balance-sheet insolvent” when the liabilities are greater than total assets

• “Wrongful trading” - when you are technically insolvent, but have not reached the point of being commercially insolvent and you continue to trade.

  Doug Henwood coined a monetary policy rule that “any time Donald Trump is able to borrow money to buy or build anything, interest rates are probably too low.” This reflected the tendency of the Trump organization to load up its properties with debt, extract cash out of them in unusual ways, and then end up in situations where Mr. Trump had extracted multiples of his own initial investment from a project but the bankers and bondholders were left with defaulted debt and collateral worth considerably less than its appraisal value

  • Prosecuting commercial fraud is difficult because everything a fraudster does are similar to the kind of actions a risk taking entrepreneurs would take. The difference between the two is in intent.
  • Fraudsters can also defer blame by having a “front” (knowing participant) or “patsy” (unknowing) to take the fall

• The optimal level of fraud is not zero, optimal progress and with appropriate risk checking will dictate the level of fraud