See No Evil, Make More Money

by digby

Ezra has an interesting graph up about the Madoff scandal which illustrated this:

[T]he central feature of [Madoff’s] scheme, viewed in the clear light of its collapse, seems to have been this: “[I]n investing, trust matters as much as greed. And investors trusted Madoff. They knew him, or his family, or his friends, or they trusted the intermediaries who sent their money to him.”

That’s not only a plausible explanation of how Madoff convinced his investors that the laws of financial gravity had lifted, but how the financial industry did the same for the country, not to mention itself. Every bank felt more comfortable going into this madness because every other bank was walking in as well. And if all the banks were trading these products and trusting these trends, then what reason was there for the rest of us to worry about the fundamentals of the market?

I would suggest that there are two more aspects to this, one of which is arguably more important and was foreshadowed by the Enron scandal which should have been a warning: complexity and greed.

The first is simply the fact that many of these bankers didn’t understand what was going on any more than the layperson. Naturally, they didn’t want to admit that, so they pretended they did. Recall this prescient (and dismissed) 2001 story about Enron by Bethany McLean of Fortune magazine:

Enron now trades at roughly 55 times trailing earnings. That’s more than 2 1/2 times the multiple of a competitor like Duke Energy, more than twice that of the S&P 500, and about on a par with new-economy sex symbol Cisco Systems. Enron has an even higher opinion of itself. At a late-January meeting with analysts in Houston, the company declared that it should be valued at $126 a share, more than 50% above current levels. “Enron has no shame in telling you what it’s worth,” says one portfolio manager, who describes such gatherings as “revival meetings.” Indeed, First Call says that 13 of Enron’s 18 analysts rate the stock a buy.

But for all the attention that’s lavished on Enron, the company remains largely impenetrable to outsiders, as even some of its admirers are quick to admit. Start with a pretty straightforward question: How exactly does Enron make its money? Details are hard to come by because Enron keeps many of the specifics confidential for what it terms “competitive reasons.” And the numbers that Enron does present are often extremely complicated. Even quantitatively minded Wall Streeters who scrutinize the company for a living think so. “If you figure it out, let me know,” laughs credit analyst Todd Shipman at S&P. “Do you have a year?” asks Ralph Pellecchia, Fitch’s credit analyst, in response to the same question.

The same story unfolded with the mortgage business just a few years later. It’s a feature, not a bug. Which leads us to the other aspect of this: greed. Even if they suspected that the scheme didn’t make sense, they didn’t want to say anything because they were making so much money.They may not understand it, but they sure as hell want to ride the tiger as long as possible.

So, in one sense it was a matter of “trust,” in that they may have trusted that somebody somewhere must have known what they were doing. But one of the major lessons of the past decade of cascading financial scandals is that they happened because people didn’t understand the business but they didn’t say anything (and shut down anyone who did) because they didn’t want to spoil the party.

And it’s still happening today.

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