Black: Understanding Financial “Risk” in Legal Contexts

The Criminology of the “Sure Thing” Portrayed as “Risk”

John Coates, a former derivatives trader at Goldman Sachs is now a researcher. He wrote a column in the New York Times entitled “The Biology of Risk” that I hope will be widely read.

In this column I explain why his most important conclusions cannot follow logically from his own description of his research finding. While he relies on blood tests, his account of trading when it goes horribly wrong is curiously bloodless and disingenuous. As a Goldman and Deutsche Bank refugee he knows better, but he presents a sanitized version of the crisis portraying the controlling officers and traders at the largest banks as helpless victims of raging hormones rather than fraud perpetrators and facilitators.

Coates’ description of the crisis as triggered by a biologically-induced excessive risk-aversion on the part of traders rests on a failure to understand why varieties of financial risk are vastly different. More fundamentally, he fails to even consider the facts (and relevant literature) demonstrating that the key financial participants were engaged in a series of “sure things” accomplished through accounting control fraud and cartels.

“Risk,” particularly Coates’ false implicit assumption that “risk” is a single concept in the financial sphere, has almost nothing to do with the current crisis, any more than it had to do with the Enron-era crisis or the second (and vastly more destructive) phase of the savings and loan debacle. Further, but for the recognition of S&L regulators that we were dealing with an epidemic of accounting control fraud and the resultant “sure things” the S&L debacle would have grown to resemble closely our most recent crisis in terms of its magnitude and damage.

Coates work is not flattering to finance in the conventional form of flattery. He essentially says Michael Lewis’ description of the “culture” in Liar’s Poker is correct – traders are males who act crazy because they are selected by crazy male bosses. Coates reports that traders have raging hormones and that these hormones vary and tend to be convergent. It is a measure of finance’s desperate search for praise that Coates’ work is warmly received by big finance. The attraction is that it serves as an apologia for their culpability. We’re not crooks – we’re perpetually pubescent prisoners of our pituitaries. White-collar defense attorneys are already seeking to present behavioral finance and neuroscience defenses to prosecution.

Coates Relies on Implicit (False) Assumptions

Coates was subjected to the disastrous training about finance provided by failed finance theory, Goldman Sachs, and Deutsche Bank, and has gone on to specialize in studying biology, so it is not surprising that his key errors are in finance, criminology, and logic. He was taught, for years, to think about finance in a manner that was not simply incorrect, but dangerously false. Because so much of his work relies on implicit assumptions he is blind to when those assumptions are false. When we make implicit assumptions we cannot test those assumptions and challenge ourselves to support them with facts and logic. Reliance on (false) implicit assumptions is the hallmark of why theoclassical economics fails to learn from its catastrophic errors that shape the criminogenic environments that drive our recurrent, intensifying financial crises.

Financial Risks Vary Widely in Ways that are Critical to Crises

Throughout his article, Coates implicitly conflates “risk” with “volatility” and treats “risk” as a single, uniform concept. Financial risks, however, vary enormously in ways that are critical to understanding crises. They can all produce volatility, but that is an effect of a complex interaction of a vast number of factors. A measure such as purchasing credit default swaps (CDS) that might protect an investor against some types of risks will fail entirely against other types of risks even if they produce the same (initial) volatility. When the protective measures fail, that failure will produce much greater volatility.

Risks with Negative Expected Values: Gambling against the House

There are many risks that have a negative expected value. Gambling against the House is a common example. Gambling against the State (lotteries) has an enormously negative expected value. Most forms of control fraud produce an extremely positive expected value from the perspective of the firm or NGO. From the perspective of society, of course, such frauds produce a negative expected value. Accounting control fraud produces an exceptionally negative expected value for the firm or NGO as George Akerlof and Paul Romer explained in their 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”) and as I have explained many times. The accounting control fraud “recipe” for a lender, or purchaser of loans, explains why this is true and why it produces the three “sure things.” The fraud recipe guarantees (1) record (albeit fictional) reported profits in the near term, (2) the controlling officers will promptly be made wealthy by modern executive compensation, and (3) and the lender (purchaser) will suffer severe losses, though it will only recognize those losses years later.

The fraud recipe produces severe “adverse selection” because its second “ingredient,” grow like crazy by making (purchasing) really crappy loans with a premium yield, requires the lender (purchaser) to gut its underwriting system and controls. When one guts underwriting and controls one makes adverse selection severe. (This is most true in long-term real estate lending.) We have known for centuries that adverse selection in lending produces a negative expected value.

Conflicts of interest also produce loans and investments that have a negative expected value.

Risks that Have a Zero Expected Value

Some financial risks have a zero expected value. Taking interest rate risk is a good example of this kind of risk. There are, and will be, many claims that there is a sure thing strategy that investors can follow to make money by taking interest rate risks, but these are scams. If there were really a “sure thing” strategy for making money by taking interest rate risk the creator of the strategy would have most of the world’s wealth within a year.

Risks with Positive Expected Value

Some financial risks have a positive expected value. Credit risk is an example of this kind of risk. A lender with expertise in evaluating credit risk and sound underwriting and controls will not only minimize loan fraud, but also bad loans from all causes. Its expertise should generate a profitable operation.

Policy Responses Should Vary by the Nature of the Risk

Fraud, Cartels, and Conflicts of Interest

Fraud is a crime as well as a civil wrong because it causes such large harm to society. As I have often noted, many forms of control fraud maim and kill. Accounting control fraud is particularly pernicious among financial crimes. First, such frauds cause greater financial losses than all other forms of property crime – combined.

Second, such frauds have no redeeming elements. They harm the firm as well as society. They often target the most vulnerable to make even wealthier the most powerful, substantially increasing income inequality.

Third, they tend to cause severe negative externalities. A) They misallocate capital and assets in wasteful investments. B) They are ideal for producing a series of Gresham’s dynamics in which “bad ethics drives good ethics” from the markets and professions. This corrupts the key “controls” on which our financial and commercial systems must rely. C) By gutting underwriting and controls they expose the firm to unintended fraud by outsiders and more junior insiders.

Fourth, it produces crony capitalism. Fraudulent CEOs use the seeming legitimacy and resources of the firm to make the environment more criminogenic. They create, for example, regulatory “black holes” and they buy, bully, and bamboozle regulators and prosecutors.

Fifth, it produces financial crises. I explained immediately above one of the major contributors – crony capitalism and its ability to maximize the three “de’s” that contribute to creating a criminogenic environment – deregulation, desupervision, and de facto decriminalization. But accounting control fraud epidemics drive crises through four additional means. A) Epidemics of accounting control fraud are themselves criminogenic. Given modern executive compensation, they inherently generate a Gresham’s dynamic in which the CFO and CFO of non-fraud firms fear losing their bonuses and jobs if they do not mimic the record earners of those who engage in fraud. B) The fraud recipe is a superb device for hyper-inflating a financial bubble – and the collapse of massive bubbles can drive a massive financial crisis. C) The continued existence of systemically dangerous institutions (SDIs) means that a single large financial failure can trigger a global crisis. D) Accounting control fraud poses a grave risk of causing a break down in trust. Trust is an essential component of modern financial markets. Accounting control fraud causes a massive inflation of the value of assets. Once market participants begin to believe that the inevitable collapse of the bubble is beginning they begin to fear that their counterparts are engaged in fraudulently inflating the value of their assets (and capital, which is simply a residual: A-L = K). When trust fails markets fail. When markets fail prices and liquidity go bonkers. This can cause cascade failures.

Firms cannot make money by engaging in accounting control fraud but the controlling officers are guaranteed to be made wealthy. Officers are real – firms are legal fictions. Officers make decisions for firms. Officers running an accounting control fraud have powerful incentives to act in manners that seem like they are caught up in a frenzy of wild risk-taking but are actually fraud-optimizing behaviors (FOBs) if one understands the fraud recipe.

Our policy responses to the risk of these forms of elite fraud should be severe. Avoiding a criminogenic environment should be the key going forward. That requires fundamentally changing executive and professional compensation, the three “de’s,” and ending the SDIs. All three areas of change are unambiguously desirable from a societal and a firm perspective – and horrific from the perspective of CEOs.

The second policy response would be to adopt an effective means of holding accountable the senior bankers that led the control frauds that caused the current crisis.

Cartels should be eliminated and conflicts of interest minimized. Both have a negative expected value from a societal perspective. Both of them misallocate assets and capital.

Interest rate risk

Lenders should not be taking substantial amounts of interest rate risk. It is a gratuitous risk that can be avoided and it has a zero expected value for the firm and for society. At high (relative to real capital and liquidity) levels of interest rate risk, however, it can easily have a negative expected value because it can morph into fraud, credit, and liquidity risk. Taking severe interest rate risk can be a variant on accounting control fraud. I have explained these points in my works on Orange County’s bankruptcy, Fannie’s accounting control fraud in the early to mid-2000s, the negative amortization loans, and the operations of the investment bankers’ Special Investment Vehicles (SIVs).

Credit risk

Prudent credit risk is a sensible function for banks. Sound underwriting is the core of making prudent loans.

Investment risk

Investment risk – buying an ownership interest – is equivalent to evaluating credit risk in lending. There is very little evidence that banks can make superior equity investments through some process truly analogous to loan underwriting. At any given time, of course, some banks will have a run of great investment success, but the banks or hedge funds that have demonstrated the ability to make consistent superior returns on equity investments for many years are likely to have succeeded through insider information. We do know that senior insiders, as a group, do obtain positive returns when they are able to trade on the basis of insider information. This is one of the reasons why Glass-Steagall was such a successful law in reducing financial crises. As I have explained in prior works, one of the primary contributors to the S&L debacle was the ability of S&Ls to engage in commerce as well as banking. S&L losses on investments (which include acquisition, development, and construction (ADC) loans that were in economic substance investments rather than loans) were exceptionally high and accounted for roughly half of total S&L losses even though they were a far smaller percentage of total S&L assets.

The Ambiguity of our Hormones

Neurological and behavioral research is vital and often helpful. The brain, and the body, and our activities all interact in complex feedback patterns. One of the reasons that a polygraph works (and works pretty well with a skilled operator not dealing with someone trained to defeat the test) is that when we lie we tend to release hormones that produce physiological effects that we can measure. People engaged in fraud, therefore, could be interpreted as engage in deceit if they were studied with the aid of a polygraph or as carried away by risk if studied on the basis of serum hormone levels. Moreover, even frauds that are “sure things” in the financial sense are risky in the sense that they are criminal and we could return to the rule of law against such elite frauds. Interpreting what is causing the hormone levels Coates’ studies’ measure would be monstrously difficult if one were consciously studying the role of accounting control fraud. If, instead, one has implicitly assumed the paramount cause of our modern financial crises out of existence the methodology and the results of the tests have to fail to answer accurately the question of what is driving our recurrent, intensifying crises. Are traders’ hormone levels vastly different today than 35 years ago?

Coates unintentionally makes my point when he criticizes risk managers who are unaware of an entire concept that is critical to understanding reality, and therefore implicitly assume it out of existence.

“I consult regularly with risk managers who must grapple with unstable risk taking throughout their organizations. Most of them are not aware that the source of the problem lurks deep in our bodies. Their attempts to manage risk are therefore comparable to firefighters’ spraying water at the tips of flames.”

I do not consult regularly with risk managers. My research demonstrates why so many societies have a saying that “fish rot from the head.” No risk manager is going to hire someone who tells him or her that the CEO poses the greatest risk to Lehman, Bear Stearns, Lincoln Savings, Enron, our the hundreds of other accounting control frauds that drove our three most recent financial crises. The CEO would have the head of any chief risk officer who invited a top white-collar criminologist to explain the reality that everyone in such a corporation must assume out of existence.

Corporations controlled by CEOs who use them as control frauds do not “manage risk.” They follow some variant of the fraud recipe that makes sense in their industry. These CEOs are quite aware that the “source of the problem” “lurks deep in our bodies.” More precisely they know that the source lurks in one part of our body – our minds – the site of greed. (Coates takes the position that our minds are far less important than our bodies in this context, but he bases that position on yet another implicit assumption – that greed does not drive fraud.) Coates is correct that people generally dislike most forms of severe financial risk and that this dislike can be visceral – it can deeply upset our bodies. What he misses entirely is that this is a powerful source of the attraction that accounting fraud has for fraudulent CEOs. They love substituting the “sure thing” of wealth and fame for the hard, painful alternative of taking an honest large credit risk that is particularly likely to fail.

CEOs do not “spray[] water at the tips of flames” when they lead a control fraud. They pour gasoline on the fire by sculpting perverse compensation systems for their officers and employees that encourage the creation of the “sure thing” of fraudulent loans. Simultaneously, they disconnect the fire alarms – they gut the underwriting and internal controls that would have sounded the alarm. Then the CEO’s suborned or turned off the automatic fire suppression devices (the office building sprinklers) – the risk officers. Next, the bank CEOs created overwhelming (perverse) incentives for outsiders (loan brokers) to stoke the fires of fraud. The CEOs then lied to the regulators (the firefighters), saying that everything was great and that the raging fire that was consuming the bank was really a pyrotechnic show demonstrating the bank’s strength.

But we do have the evaluation of Enron’s top risk officer of how valuable it would be if risk officers did listen to white-collar criminologists about white-collar crime. The most sincere compliment my book ever received was from Enron’s (honest) top quant – Vincent Kaminski. He wrote these words in a professional site for senior corporate risk managers.

“There is one particular book I wish I had read in the early days of my business career, which would have saved me and the firms I worked for a lot of money.

Many companies that have eventually gone bankrupt have been very successful at projecting the image of unstoppable success for a long time

The book, entitled The best way to rob a bank is to own one: how corporate executives and politicians looted the S&L industry, was written by William Black, associate professor of economics and law at the University of Missouri-Kansas City. It is based on his experience as a regulator of savings and loans (S&L) institutions during the S&L crisis of the 1980s and early 1990s. Within its pages, Black introduces the concept of ‘control fraud’ – effectively, a very simple recipe for great riches and limited civil and criminal liability.”

Kaminski then reports on the fraud “recipe.”

Accounting control fraud strategies often appear to be “unstable risk taking” – particularly if the same practice is found “throughout their organization.” It is far more likely that there is a single cause – the perverse incentives crafted by the CEO through the executive compensation system – for a problem found in many units (think of the recent exposures of GM’s problems in multiple shops).

Because Coates has no clue – despite being at ground zero during the three most destructive U.S. epidemics of accounting control fraud in history and the world’s largest cartel, and a raft of other control frauds in which Goldman and Deutsche Bank played lead roles – that accounting control fraud exists he ignores the differences in types of risk and the existence of the three “sure things” that arise from accounting control fraud. Again, because he has implicitly assumed the actual causes of the crisis out of existence he feels no need to explain why he thinks this is the first “Virgin” crisis. Today, no one seriously denies the role of accounting control fraud epidemics in causing the Enron-era crisis or the second phase of the S&L debacle. Why would one create a study design that purports to study “risk” and the recent financial crisis in which one assumes out of existence what he knows was the paramount cause of the other modern crises? (In both crises, the first response of economists and financial professionals was to blame “risk” rather than fraud, but those knee-jerk apologies proved to be embarrassing failures as investigators documented the thousands of insider frauds.)

You know you don’t understand risk, fraud, or crises when you write….

Coates’ metaphors demonstrate his lack of understanding of risk, fraud, and crises.

“Risk by its very nature threatens to hurt you, so when confronted by it your body and brain, under the influence of the stress response, unite as a single functioning unit. This occurs in athletes and soldiers, and it occurs as well in traders and people investing from home. The state of your body predicts your appetite for financial risk just as it predicts an athlete’s performance.”

No, it doesn’t. A trader who can rig the trade, by gaming Libor after the trade to ensure success succeeds because the game is rigged. The CEO running a control fraud or engaged in insider trading seeks a “sure thing” and he creates perverse incentives for his employees, officers, and outside professionals to ensure that they too can secure wealth through “sure things” that will aid and abet his frauds. Merrill Lynch officers, for example, “ate their own cooking” – purchased huge amounts of the super senior CDO tranches because the combination of a AAA rating and the premium yield – because doing so guaranteed that they would receive large bonuses. The massive losses, of course, would fall on the shareholders. The Merrill traders’ hormone levels would have been interesting to study. Did it trouble their “bodies” (Coate’s focus) to destroy the firm to make them rich through a “sure thing?”

The fraudulent CEO’s power and lack of ethics “predicts [his] performance.” Athletic performance is often “predict[ed]” by cheating. That is true of a very substantial number of the world’s top athletes – and that portion would be far larger but for enormous efforts to detect and sanction such frauds because athletic cheating creates a Gresham’s dynamic. Only vigorous regulators, enforcers, and prosecutors can break the Gresham’s dynamic and allow the honest to prevail. Coates knows that we have not had effective financial regulators, enforcers, and prosecutors for two decades and that the result will be a powerful Gresham’s dynamic and endemic fraud.

Again, Coates and everyone reading Coates knows these facts – but chooses to exclude them from reality. Behavioral finance and the mind (which Coates sees as overemphasized relative to the body) are the keys to understanding why we lie to ourselves about lying to ourselves.

Once more, Coates’ argument actually explains why control fraud would be common. If you risk losing your bonus and your job as CEO or CFO if you cannot match the record earnings reported by rival banks engaged in accounting control fraud then Coates’ findings suggest your body and mind will unite to drive you to mimic their “sure thing” fraud strategy.

“Risk by its very nature threatens to hurt you, so when confronted by it your body and brain, under the influence of the stress response, unite as a single functioning unit.”

Another example of Coates’ failure to understand risk, fraud, trust, and crises is found in this paragraph.

“Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite.”

No, not even close. Markets froze up because market participants realized the end of the financial version of “don’t ask; don’t tell” had arrived and they could no longer continue to massively overvalue toxic waste assets. Those assets lost value because they lacked value – not because of a change in “risk” preferences. The “sure thing” does eventually come to an end when the bubble collapses and asset values fall as new fraudulent loan originations largely cease. What would happen to a trader who followed Coates’ advice and assumed there was no change in the recognition of fundamental values and instead merely an increase in risk aversion? It would buy up the toxic waste near its peak values. The economy does not “need people to take risks” that have a negative expected value due to fraud. By assuming that all “risk” is the same and implicitly assuming the frauds that drove the crisis out of existence Coates produces a policy prescription for disaster.

They weren’t so helpless to their hormones that they failed to optimize their frauds

Again, I want to emphasize the strong desirability of behavioral and neurological research. I also want to emphasize that whatever their (interacting) behavioral and hormonal states the CEOs that ran the accounting control frauds that drove the crisis were able to consistently take actions that optimized those frauds. They were able to create the biggest bubble in history in the U.S. (and even larger bubbles relative to GDP in Ireland and Spain), the most destructive financial fraud epidemics in history, the largest cartel by three or four orders of magnitude, to get fabulously wealthy through the frauds, and to keep their reputations and wealth without being prosecuted. They expertly added each of the four ingredients of the fraud recipe. They took great advantage of the infamous industry saying: “a rolling loan gathers no loss.” They adjusted as the bubble came closer to ending, bringing every more hopeless home borrowers to purchase homes at massively inflated prices with the critical aid of fraudulent appraisals which they induced by creating a Gresham’s dynamic. They increasingly adopted “neg am” loans that would delay the defaults to get past EPD buy-back provisions. They suborned auditors and credit rating agencies (again, by creating Gresham’s dynamics) so successfully that they were consistently able to get AAA ratings for toxic waste – backed by clean audit opinions for massively fraudulent operations that had often rendered the lender deeply insolvent.

The CEOs of the most fraudulent SDIs then managed to get the largest bailouts in history and to grow far larger. They caused an estimated loss of U.S. GDP of $21 trillion (measured from the onset of the crisis to the projected full recovery) and ten million jobs (those figures will be far larger for the EU). Despite all of this, their political power has grown and scholars now commonly describe the result as crony capitalism. Some of the largest banks openly cheer the creation of a “plutonomy.” No one should believe in the theoclassical myths of rationality, but it is a mistake to believe that elite frauds aren’t able to channel their hormonal rage into a means for aiding their frauds. I want to emphasize again that Coates’ statements about the impact of risk on our bodies offer powerful support for what I have just described about highly competent fraud mechanisms. If he is correct that avoiding risk leads to hormone releases that cause our bodies and minds to work together intensively to seek a “sure thing” then the folks who rise to the top will be those who understand how to run a control fraud and lack sufficient ethical barriers to resist that urge to avoid any risk of failure.

Coates’ Claims about the Fed

I have not responded to Coates’ claims about Fed policy because his attempt to suggest causality to trader behavior is so weak as to not require refutation. I do think Coates is correct, however, about the dangers of complacency. Hyman Minsky made this point famous. Alan Greenspan and Ben Bernanke’s belief that the markets automatically excluded accounting control fraud is the central example of disastrous complacency. Unfortunately, Coates exemplifies the same complacency, though he is blind to it. Consider this unintentionally hilarious claim the former trader makes about trading and traders.

“Traders are immersed in novelty and uncertainty the moment they step onto a trading floor. Here they encounter an information-rich environment like none other. Every event in the world, every piece of news, flows nonstop onto the floor, showing up on news feeds and market prices, blinking and disappearing. News by its very nature is novel, adds volatility to the market and puts us into a state of vigilance and arousal.”

Coates either doesn’t believe a word of his third sentence or he does. In either case he stands condemned by his own words. Let’s assume for purposes of analysis that he actually believes what he says in that sentence.

  • In 2000, this news spread across trading desks:

“From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets” (FCIC 2011:18).

A survey of appraiser in 2003 found that 55% reported personally experiencing coercion to inflate an appraisal in the last year. The updated survey in 2006 found the percentage had risen to 90 percent.

  • In 2004, the FBI warned publicly that there was a growing “epidemic” of mortgage fraud and predicted that it would cause a financial “crisis” if it were not stopped
  • In early 2006, the mortgage industry’s own anti-fraud experts (MARI) sent these five warnings in writing to every member of the Mortgage Bankers Association (MBA):

“Stated income and reduced documentation loans … are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.

One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.”

Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans.”

  • These are the twin epidemics of accounting control fraud by lenders and their agents (principally the loan brokers) in the loan origination process.
  • By 2006, at least half of all the loans called “subprime” were also “liar’s” loans.
  • By 2006, 40% of home loans originated that year in the U.S. were liar’s loans (in the UK, the figure was 45%).
  • At the 90% fraud incidence for liar’s loans, this meant that over two million fraudulent liar’s loans were originated in 2006 alone.
  • In response to these warnings the industry massively increased its liar’s loans (a 500% increase from 2003-2006)
  • Simultaneously, loss reserves fell to the lowest level since the S&L debacle.
  • Massive loan origination fraud must lead, if sold to the secondary market, to massive fraud in the “reps and warranties” used to sell loans to the secondary market.
  • Clayton, the largest underwriter of loan purchases for the secondary market found that 46% of the “reps and warranties” for such loans were false.
  • Hilariously, Clayton purported to use one fraud to purportedly “compensate” for another fraud. If they discovered that the borrower’s income was inflated they would claim that the low loan-to-value ratio (often arising from inflated appraisals) “compensated” for the lender’s fraud in inflating the borrower’s income (and vice versa).

Coates assures us that:

“Every event in the world, every piece of news, flows nonstop onto the floor, showing up on news feeds and market prices, blinking and disappearing. News by its very nature is novel, adds volatility to the market and puts us into a state of vigilance and arousal.”

So traders were in a “state of vigilance and arousal” about each of these facts documenting the three most destructive epidemics of accounting control fraud in history. What is Coates’ story about what they did in response to these facts that they were primed by self-interest and biology to view hyper-vigilantly? In Coates’ tale these normally hyper-vigilant traders turned off their vigilance and arousal because the economic news was too good. Except that I’ve just shown that the economic news was terrible and demonstrated that the Fed’s story was a fantasy creation of ideologues. So why didn’t the traders – any of the traders – react to the fraud epidemics? Indeed, even years after the fact (putting the lie to the absurd claim that “hindsight is always 20:20”) Coates can’t bring himself to use the “f” word about his former firms or anyone else in finance. Self-interest is the best explanation. There was enormous income to be made for everyone involved as long as the financial version of “don’t ask; don’t tell” remained.

(Will journalists please ask Coates when he first became aware that Libor wasn’t kosher?)

But Coates’ claim in the quoted sentence is also silly. Only a tiny percentage of the events of the world are reported in the media. Traders listen and read a tiny percentage of the media content. Traders are multi-tasking when they do read or watch and everything we have learned shows that this is a terrible way to learn. Traders do not understand more than a tiny percentage of what they fitfully read and watch. Traders do not know what they do not know. They are wilfully blind to entire fields such as white-collar criminology. Traders’ analysis of what they think they know is commonly wrong. Traders have perverse incentives. The saying in the trade is that “every trader’s first option is on the firm.” The claim that, but for stable interest rates, traders would have seen the fraud epidemics that drove the crisis is ludicrous. Coates cannot even see the fraud epidemics 14 years after the appraisers’ warnings. Coates even thinks that the crisis was driven by excessively risk averse traders. Coates’ bottom line is the one we always hear from Wall Street – it’s not our fault, it’s always the government’s fault – they messed up our hormone levels.


Coates’ book about the crisis uses the word “fraud” only once – and it is the context of explaining how a particular “short” can be structured without causing fraud. Remember, he worked at Goldman and Deutsche bank and regularly consults with the biggest, most fraudulent banks in the world. He, of course, would like to continue this lucrative consulting relationship. There is one sure way to kill such a relationship – writing and speaking candidly about control fraud. Because of his background, a candid, confessional Coates could be a major asset to repairing the harm the rampant, elite frauds are creating. There is vital neurological work to be done on understanding what makes the fraudulent controlling officers tick on the biological level. I hope that Coates will join us in helping to stop the people he knows full well are growing ever wealthier by causing ever greater misery.

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