Ghost of Scandals Past: A Short History of Financial Scandals
- Extra Reading
The litany of great financial scandals is long, and sadly unending. Dickens himself covers scandals we would recognise today in Little Dorrit and Nicholas Nickleby. Beyond Dickens, the South Sea Bubble (of course), railway shares, bonds in newly independent countries (Kingdom of Poyais), never again... IOS, Saavundra, Rolls Razor, Bank of Gibraltar, BCCI, never again... endowment mortgages, Barlow Clowes, Equitable Life, Maxwell, Lloyd's names, Lehman Brothers, payment protection insurance, never again... This symposium seeks, through the ghosts of scandals past, present and future, to see what lessons we can learn and to assess which is rosier, the future of finance or of financial scandals.
10 January 2013 Ghosts of Scandals Past: A Short History of Financial Scandals Edward Chancellor I want to follow on from what Michael was saying and give you a rough outline of the history of financial scandals, and start with trying to explain to you the cycle of scandal that appears to take place, then some of the practices as they have appeared over the ages, very unchanged, and to conclude, going slightly beyond my remit, to say how one might be able to identify some future scandals from the study of past scandals. Now, Michael was talking to you about bubbles, and the relationship between bubbles and financial scandals. I would argue that the two are intricately linked. In fact, they are etymologically linked because the original meaning of the term “bubble” is actually a fraud or, as the OED’s definition is, the bubble is “anything fragile, unsubstantial, empty or worthless, a deceptive show”. But if you go back to the early eighteenth century definitions of bubbles, you can see here a reference by Defoe: “In the good old days of trade, there were no bubbles and no stock shopping.” The very term “the South Sea Bubble” is actually a reference not to the inflation of the South Sea stock from a hundred to a thousand, but it is to the South Sea fraud. So, a bubble itself is actually a fraud, and in fact the cycles of speculation, or speculative bubbles, and the cycles of fraud and scandal are one and the same, and that has always been the case in the past and always will be the case in the future. The verb “bubbling”, in fact, in the early eighteenth century was, as the OED says, a bubbler is “one who gets up bubble companies, a swindler, a cheat”, and the bubbled is someone who is “befooled, cheated and deceived”. If you go to the 1690s, which was the first bubble in Britain, as far as I can understand, the first thing one notes about both the speculative bubble and the bubble of corruption and scandal is they invariably appear in ages of what you might call a zeitgeist of greed or an eagerness to get rich quick, so that in the 1690s, which was an era of the so-called “moneyed men”, it was said of the period that “it rained gold and silver”, and the historian Macaulay later described it as “an age that showed an impatience to be rich and a contempt for those slow but sure gains which are the proper reward of industry, patience, thrift, had spread through society”. In fact, this holds true if you go to the mid-nineteenth century, there was a financial journalist called David Morier Evans, who wrote a book called “Facts, Failures and Frauds”, which covered the scandals of the railway mania of the 1840s and 1850s, in the Dickensian periods. Evans writes in this book that: “All incentives to commercial crime may be brought under one common rubric, the desire to make money easily and in a hurry. The speculator may be a perfectly honourable man, but if fortune is averse and he is on the high road to wrongdoing and, moreover, there are many crimes not enumerated in the Statute Book that are still heavy sins against the dictates of morality.” So there is this notion, and I think you see it time and again, in the Gilded Age in the US that Mark Twain satirised, in the 1920s, and obviously in our own era, in the sort of post-Thatcherite/Reaganite era, the era where greed is good. These are eras which are conducive to financial scandal and conducive to speculative bubbles. However it is not merely that you should have people willing to cut corners; you should also have a certain amount of credulity – you need the bubbles, or, as Defoe also called them, “cullies”. Defoe himself was constantly falling for one scandal after another. During the South Sea Bubble, Jonathan Swift wrote a poem called “The Directors”, referring to companies being built as castles in the air. Swift wrote: “For fools will see as wise men please”. In the 1820s, perhaps the most famous scandal in the City of London occurred when the Kingdom of Poyais, in South America, launched a loan for £600,000, and the Kingdom of Poyais, run by the so-called Cazique of Poyais, was a sort of fictional entity, and the Cazique a Scottish adventurer by the name of Gregor MacGregor, and the wretched people who fell for it went out to the mosquito-infested swamp in South America and died or committed suicide or sloped off home. The new Times, at the time, carried a notice that said: “If the very respectable Mr Lemuel Gulliver were to appear on the stage again to issue proposals for a loan to the Republic of Laputa, he would run the hazard of being suffocated by the pressure of subscribers to set down their names.” Now, referring back to Dickens, and Dickens is, again, writing in the period of the financial scandals of the 1840s and ‘50s, his comments on the banker, the corrupt banker, Merdle, who appears in “Little Dorrit” resonate through the times. Dickens writes, after Merdle’s death: “The next man who has as large a capacity for swindling will succeed as well. Pardon me, but I think you really have no idea how the human bees will swarm to the beating of any old tin kettle. In that fact lies the whole manual of governing them. When they can be got to believe that the kettle is made of precious metals, in that power lies the whole power of men like our late lamented.” Dickens’ contemporary, Walter Bagehot, in Lombard Street, wrote another seminal comment on the credulity of investors, where he writes here: “The good times too of high price almost always engender much fraud. All people are most credulous when they are most happy, and when money has been made, when some people are really making it, and when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost anything will be believed for a while, and long before discovery, the worst and most adroit deceivers are geographically or legally beyond the reach of punishment, but the harm they have done diffuses harm for it weakens credit still further.” Galbraith, who Michael mentioned wrote a very good short history of the 1920s boom and crash, in which he takes and plays with Bagehot’s thought, introducing a concept of what he calls “the bezzle”. Here, the bezzle is the illusionary increase of wealth that occurs during booms and, here, Galbraith writes: “In good times, people are relaxed, trusting, and money is plentiful. Under these circumstances, the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression, all this is reversed: money is watched with a narrow, suspicious eye; the man who handles it is assumed to be dishonest, until he proves himself otherwise; audits are penetrating and meticulous; commercial morality is enormously improved – the bezzle shrinks. So, there, you get a picture, I hope, of both the greed and the credulity that characterised both the speculative boom and the fraudulent cycle. Now, what forms do the frauds take? Here, I will just give you a few pointers… First, of course, are the promotions, the stock market promotions, and again, you can find this back to the 1690s, where the promotions including diving engines to pick up treasure from the bottom of the sea, fire engines, burglar alarms, and there were a whole category of what were called patent-mongers, who collected sham patents and launched companies on the backs of these patents. Thomas Shadwell, the playwright, satirised them in his play, “The Volunteers”, these patent companies, where a stock jobber tells of a new company to manufacture “a mousetrap that will invite all mice in, any rats too, whether they will or not – the whole share before is £15, but after the patent, they will not take £60.” The promoters of the 1690s were the great scammers of that period. Another writer, Thomas Baston, in about 1705, writes how: “The projectors would alight upon some fair project, such as getting silver out of the mountain of Wales. Afterwards, he procures a patent, opens books for subscriptions, promising prodigious and incredible advantages to all that will venture their money on this project.” Then the real mischief starts: the projector engages what Baston calls “…topping dons to subscribe to the issue, at heavily discounted prices. These conspirators then employ brokers to cry out the reputation of the project.” In order to support the stock price, they employ “many other tricks and rogueries as publishing books and advertisements which are stuffed with monstrous absurdities and lies”. Many of you who have the misfortune to read contemporary brokerage reports will recognise that not much has changed in the meantime. I think that Baston is referring in fact to a fraudulent project of an MP and Welsh landowner called Sir Humphrey Mackworth, who, in the 1690s, launched the Company of Mine Adventurers, which was engaged in mining for silver in Wales, and financed actually with lottery bonds, a project which the historian W.R. Scott described as “honeycombed with fraud”. Actually, the practices of Mackworth were quite similar. First of all, he put a Lord on the board, in the form of the Duke of Leeds, to give it respectability. Donations were given to charity, pamphlets were commissioned to hype prospects, there were false reports of silver production, interests were paid on bonds with borrowed money, out of capital, shares were sold without authorisation, and money was diverted for Mackworth’s own use. In 1710, he was found guilty of notorious and many scandalous frauds by the House of Commons, but somehow or other managed to get off scot-free. The 1720s of course, coinciding with the South Sea Company, the whole number of bubble companies, most of which were fraudulent, which were lampooned in part, and I suppose the most famous lampoon was a company for carrying on an undertaking of great advantage but no one to know what it is. So, this practice of fraudulent, or semi-fraudulent, promotions has continued through to our own day, and obviously the dot-com era was an era in which many companies came to the market that were really not fit to come to market. I remember one of my colleagues said there was one company which changed its name to [NetJ.com], that had in its prospectus “the company has no business plans, no business, and no plans for one”! I was told once of a company listed on the stock market in Germany that purported to give traffic information, but they did not have anything so they just took a cardboard box and cut a hole out of the cardboard box and stuck a map in it to show what the business might be doing at one stage. Now, remember, one of the scandals that came out of that was the brokers engaged in distributing shares to their friends, so called spinning the shares, at favourable prices, and then subsequently those friends coming back into the market to support the shares, a practice that was known as laddering. Again, not so dissimilar, this practice, to ones you found in the 1690s. Another feature of these, and related to it, is the notion that the brokers are engaged in stock manipulation. In fact, the first official investigation into the stock market accused the brokers of confederating themselves together to raise or lower prices to their own profit and to the injury of their clients. Options dealings were abused and become a means of fraud – in other words, the first reference to derivatives being, as Buffett would refer, “a weapon of mass destruction”. The other side of it are the corporate scandals. I think the first thing to note about the corporate scandals is that they are often led by messianic figures. The first notable sort of corporate messianic figure, to my mind, is Sir John Blunt, the leader of the South Sea Company in 1720, a man described at the time as “driven away from his anchor”. It is the sense that the corporate leader gets so overblown by his projects and their success in the initial stages that he loses control. This is, in fact, as Trollope described the figure Melmotte in “The Way We Live Now”, as a figure whose insane ambition had driven him away from his anchorage. The figure of Melmotte and the figure of Sir John Blunt is one familiar to us and familiar throughout the ages. George Hudson, the so-called railway king of the 1840s, is another type of sort of messianic, much-lauded business figure. You might say that Robert Maxwell belonged to the same ilk, the figures at Enron, Jeff Skilling and Ken Lay, much-lauded, much given to preaching to the world how they had come across a new way of doing business that was better than anyone had engaged in before. Another thing linked to the corporate messianic figure is they are often rather acquisitive and they need to inflate their share prices in order to use the share prices, as the brokers say, as currency to take over other companies, and again, I think the first emblematic example of that is George Hudson, the railway king, who paid dividends out of capital and then, inflating his share prices, was able to amalgamate a large number of companies, eventually accused of paying, in the end, £800,000 of dividends on the York and North Midland Railway. I suppose a common feature of corporate corruption is the corruption of incentives. Again, you see this in the South Sea Bubble, where the South Sea directors gave themselves shares in the company, or issued themselves shares at favourable prices, and then you have an incentive to pump up the share price. In fact, that would be the common theme of many of the corporate frauds we have seen in the era of so-called shareholder value – Tyco and Sunbeam, which were mentioned, Worldcom, Enron, and even companies which never quite made it to court, like Coca-Cola and General Electric, were engaged in manipulation of earnings in order to boost the stock options value of their managers. One of the features of these corporate frauds is that they tend to foster complexity, so they hide behind this incredible complexity. As Sir John Blunt said in the South Sea Bubble, “The more confusion, the better – people must not know what they do.” And Hudson himself castigated red tape, saying “I will have no statistics on my railway,” and even “We do not mind principle in matters of business.” In the 1920s, Ivar Kreuger, the Match King, created a corporate structure of Enron-esque complexity, with a holding company listed in Lichtenstein that did not have to report its accounts. Perhaps the most complex story is that of what I call Tanzi finance, at Parmalat, where the complicated arrangements included special purpose vehicles with concealed liabilities, asset-based securities collateralised with fake invoices, credit-linked notes which allowed the issuer to bet on its own creditworthiness, bonds with secret covenants that varied the coupons payable according to the company’s interest cover, liabilities sliced up and distributed as Collateralised Debt Obligations, and bank loans rendered safe with Credit Default Swaps. Linked to the complexity that characterises frauds is actually a shift to what the American economist Hyman Minsky called Ponzi finance, or Ponzi finance structures, where companies are dependent for their solvency on rising asset prices, and when that situation arises, and really, Enron was a case where, once the share price started to fall, this crystallised liabilities in off-balance sheet entities that came, eventually, back onto the balance sheet of the company. Once you are in a Ponzi finance structure, where, in order to validate your debts, you need rising asset prices, when the bubble bursts, then there is a great inducement to fraud. As a commentator or writer of the recent biography of Ivar Kreuger wrote, that Kreuger believed – and Kreuger went bust in 1932 – Kreuger believed that, if he kept raising cash to pay earlier debts, his businesses would grow fast enough to survive. Even if they continued to pay high dividends, this belief was not unreasonable. So, as long as the boom continues, you can get away with a type of Ponzi finance structure or financing, but then it collapses in the end. One feature of speculative scandals, at least in the early days, is that the politicians had their hands in the lucre too. In the 1690s, the East India Company had a secret stash, known as the Secret Service Fund, to bribe politicians. The South Sea Bubble was characterised by the enormous corruption of Parliament – the King, the Prince of Wales, members of the Government, the Chancellor of the Exchequer, 100 peers, 300 MPs, were all granted shares in the South Sea Company so the South Sea Company could have its sway. The role of the government in the bubble and in the fraud, actually encourages the fraud. Afterwards, there is a backlash, when the bubble bursts, and it is only, by and large, when the bubble has burst that the actual frauds are revealed. So, in 1697, you had the act to refrain the number and ill-practices of brokers and stock jobbers, and in 1733, after the South Sea Bubble, you had the Sir John Barnard Act to prevent the infamous practice of stock-jobbing. Now, I want to give you a few conclusions. First of all, I would say that scandals are inevitable, that history, as Mark Twain says, does not repeat itself but it rhymes, that Galbraith’s bezzle is a constant, and that this shift from safe financial structures to fragile Ponzi financial structures is a feature of capitalism, as Hyman Minsky observed. Secondly, that these scandals thrive on complexity, opacity and, in particular, leverage; thirdly, that they are fairly generic, that the scandals tend to include the abuse of conflicts of interest by brokers, bankers, corporate managers, the promotion of worthless entities to capture the speculative fancy, insider trading, the inflating of shares by acquisitive companies, paying dividends out of capital, excesses in concealment of leverage, forging of collateral, market manipulation, political corruption, and rogue trading, that the messianic figure, from Sir John Blunt to Robert Maxwell, does not change much over the time. More contentious, I would say that scandals can be broadly anticipated, and that it was clear in the late-1990s that earnings were being manipulated in the US. In fact, Business Week had a cover story in ’97 about the decline in the quality of corporate earnings. We all knew that managers were trying to deliver their earnings numbers in order to boost the share prices in order to cash-out their stock options. In the 2000s, I did a report on the credit bubble in 2005, and it was quite clear then that the subprime nonsense was going on. If you had your eyes out for it, you could see it. How do you keep your eyes alert to where the bubble is? You follow the money. Wherever the bubble is, is the source of the next financial scandal, period – it is as easy as that. So where are the scandals going to come now? Well, I think my first choice is China. China is the source of a great boom today, the source of global credit growth, the source of global GDP growth, a country which has what looks like an epochal housing bubble going on, and a country which is “honeycombed with fraud”. We have already seen scandals relating to foreign listings in the US, Chinese foreign listings – Longtop Financial and Sino-Forest. We have had accusations of false accounting at Zoomlion, a construction equipment manufacturer. We have tales of defaulting loan sharks and fleeing developers in Wenzhou, when a housing and credit bubble burst there in September last year. We have fake collateral on local government funding vehicles, fraud at credit guarantee companies, fraud at the Rail Ministry which saw the departure of the head of the railway company last year, political corruption of an extreme, deep level, on par with the South Sea Company, revealed by the Bo Xilai affair, and now, more recently, the mis-selling of wealth management products revealed at a couple of banks in December 2002. But I think we can go further than that. We have had a commodity boom linked to the huge demand for raw materials from China. Remember that Mark Twain said that a mine was “a hole in the ground with a liar standing next to it”, and that has been the case, from Sir Humphrey Mackworth’s Company of Mine Adventurers through to the current day. Here we have a number of dodgy mining companies that have been floated on the London Stock Exchange in recent years. The Indonesian coal-miner, Bhumi, sponsored by Nat Rothschild, a figure who perhaps has tarnished the family name in recent years, is quite interesting. Apparently, it had Yemeni subsidiaries, for an Indonesian coal company, where money was being sucked into the Yemeni subsidiaries and being used to fund a political party in Indonesia. So, again, very similar to the type of activities that you saw in the 1690s. I would suspect, when China goes, that the mining companies will reveal a number of frauds, and in particular, you know, head East if you want to find some big ones. Where else you might find them is leveraged players in fixed income. As we all know, bond yields have been suppressed, and you will hear more about that recently. When interest rates were raised in ’94, a number of mortgage hedge funds blew up. I suspect that the current sort of favoured practice today is something called risk parity, which is basically leveraging government bonds, so, if there was a dislocation in the government bond markets as interest rates rise, I think you would find scandals appearing there. And then, last, but not least, I think you will find the investment banks will continue to provide us with a staple diet of frauds, corruptions and scandals, as the brokers have done from the 1690s. So, I do not know where exactly they will come from – as ever, the abuse of conflicts of interests, the manipulation of earnings, the bonuses, derivatives, excessive derivatives exposure, and so forth. My last comment would be this: is that every boom is followed by an attempt at financial regulation, but this inevitably fails, because, as Minsky, who I cited to you earlier, says, financial markets are very competitive and the course of each boom is an attempt to avoid the regulations that have been put in place after the previous crisis. That is what happens: the boom…the regulation is an attempt to stop the water flowing downhill, and what the water will do is follow the path of least resistance to find a way round it, and regulators are, frankly, not smart enough or intuitive enough to know where those frauds are occurring. So, while the regulation may hinder or prevent the last type of fraud from occurring, it may actually shape the course of future frauds. It is a rather depressing note to end on, but there you are. © Edward Chancellor 2013
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