On Financial Frauds and Their Causes Investor Overconfidence

American Journal of Economics and Sociology, Inc.

On Financial Frauds and Their Causes: Investor OverconfidenceAuthor(s): Steven PressmanReviewed work(s):Source: American Journal of Economics and Sociology, Vol. 57, No. 4 (Oct., 1998), pp. 405-421Published by: American Journal of Economics and Sociology, Inc.Stable URL: http://www.jstor.org/stable/3487115 .

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On Financial Frauds and Their Causes: Investor Overconfidence

By STEVEN PRESSMAN*

ABSTRACT. This paper examines two possible explanations for why inves-

tors are so often and so easily taken by the likes of Robert Bennett and his New Era fraud or Nick Leeson's sinking of the esteemed Barings Bank. I rule out the traditional explanations offered by neoclassical economics such as asymmetric information in a world of calculable risk. I argue that the literature on empirical psychology, which emphasizes how people make choices in a world characterized by uncertainty provides a more

plausible explanation for why financial fraud is so prevelant. The paper emphasizes the interdisciplinary aspects of financial frauds and concludes with some policy prescriptions for preventing financial fraud.

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

* [Steven Pressman, Department of Economics and Finance, Monmouth University, West Long Branch, NJ 07764. E-mail ([email protected]).] Professor Pressman's interests include macroeconomic policy, poverty and income distribution, and the history of economic thought. His publications include Economics and Its Discontents (edited with Richard Holt, Elgar, 1998) and Quesnay's Tableau Economique: A Critique and Reconstruction (Kelley, 1994) American Journal of Economics and Sociology, Vol. 57, No. 4 (October, 1998). ? 1998 American Journal of Economics and Sociology, Inc.



406 American Journal of Economics and Sociology

century or any other century, Nick Leeson (Leeson, 1996; Pressman, 1997)

brings down Barings Bank, one of the oldest and most conservative financial institutions in the world, through his illicit and risky trading in foreign exchange options. Barings had financed the American purchase of the Lou- isiana Territories from France in 1803, and by the early nineteenth century had become banker to the British royal family.

Instances of financial fraud have not been limited to the private sector. Frances Cox, the Treasurer of Fairfax County, Virginia used her position to embezzle more than half a million dollars during the 1960s and the 1970s (Coughlan, 1983). And Orange County, encouraged by Merrill Lynch, went

bankrupt after wildly speculating in financial derivatives (Jorion, 1995).

Why do such financial frauds continually recur? What are the causes of these fiascos? What can traditional economic theory tell us about the causes of financial frauds and their possible cures? These are the questions that will be addressed in the remainder of this paper. The next section looks at one particular case of financial fraud-New Era Philanthropy. This case

study is useful for two reasons. First, it contains many characteristics of 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 Era is likely to be of greater interest to the academic readers of this journal than the collapse of a large financial institution or some egregious case of embezzlement.

II

New Era Philanthropy-A Case Study

IT IS HARD TO BELIEVE THAT A CHARITY WOULD RUN A PONZI SCHEME; but this is exactly what the Foundation for New Era Philanthropy did, making it

part of the biggest financial scandal in the history of philanthropy. John G. Bennett, Jr., was the founder and driving force of New Era Phi-

lanthropy. He was born in 1938 and grew up in a working-class Philadel-

phia neighborhood. In 1963, Bennett graduated from Temple University and began work as an administrator for a drug and alcohol abuse program. Then in 1982 he began a company called the "Center for New Era Philan-

thropy." This firm advised corporations about which nonprofit organizations should receive their money (Stecklow, 1995).

In 1989, Bennett began the Foundation for New Era Philanthropy. At



On Financial Frauds 407

first, New Era provided free investment advice and assistance to nonprofit organizations. Nonprofits were instructed where and how to best invest their endowments. These services earned Bennett considerable recognition and respect in the nonprofit community. They also earned Bennett a position on the Boards of Directors of numerous Philadelphia nonprofit or-

ganizations, including the Philadelphia Orchestra. New Era Philanthropy then went into the business of helping nonprofits

raise money. But it attempted to 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 organization that gave him money. Such

returns, Bennett claimed, were made possible by wealthy philanthropists who wanted to make anonymous donations to charity through New Era.

While it is unusual for charitable organizations to have to turn over money to receive additional contributions, New Era had a ready answer for anyone who questioned this practice. Bennett claimed that New Era needed the interest on this money to cover their operating costs (Knecht & Taylor, 1995).

Despite their unconventional request that nonprofit organizations turn money over to them, New Era thrived and prospered in the early 1990s.

Numerous factors contributed to the success of New Era Philanthropy. First, Bennett had close ties to established and well-known Christian philanthropic groups. This gave him and New Era an aura of respectability and trustworthiness. Second, Bennett had an infectious optimism that made

people trust him. Third, Bennett paid substantial "finder's fees" to any in- termediaries directing charitable donations to New Era. Fourth, over the course of several years, New Era did pay enormous returns on the money that philanthropists and charities deposited into special accounts. For the

many nonprofit organizations that were hard hit by cuts in Federal spend- ing 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, charitable organizations felt that the money they gave to New Era was secure. Bennett told donors that their

money would be put into escrow or custodial accounts at Prudential Se- curities. These accounts would make it easier for each donor to keep track of its money and the returns it was making. The accounts also reduced the risk that something might go wrong and the charity or philanthropic or-

ganization would lose the money it gave to New Era. In the early 1990s, hundreds of nonprofits gave large sums of money to




Bennett. Some were prominent nonprofit organizations such as the Amer- ican Red Cross, the Salvation Army, and elite academic institutions such as Harvard, Princeton, and Brown Universities. When New Era folded, these institutions all 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, appears to be Lancaster Bible College in Lancaster, PA, which had $16.9 million deposited with New Era.

Even cautious charities that carefully checked out New Era fell victim to John Bennett's philanthropy scam. Nature Conservancy is a nonprofit organization that works to preserve threatened wildlife habitats. It is one of the most respected and most conservative charities in the United States. After one of its major donors made a $15,000 gift through New Era, New Era approached Nature Conservancy and discussed their program of dou-

bling deposits in six months. Being skeptical by nature, Nature Conser-

vancy called other nonprofit organizations that had relationships with New Era and asked for references. They also called Prudential Securities, which held New Era's funds, the IRS, and the Pennsylvania Bureau of Charitable Organizations. Then they performed an extensive search of

newspaper articles looking for any negative information about New Era. In all cases New Era checked out as legitimate and problem-free (Knecht & Taylor, 1995).

However, New Era was not what it seemed, and Bennett defrauded all of these organizations. In fact, there were few wealthy philanthropists con-

tributing to New Era. Rather, Bennett took a substantial fraction of the

money he received for his own personal benefit, and he used the deposits he made with Prudential as collateral on 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 nearly six years for all the facts to be discovered and for New Era to collapse. Two separate incidents in 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 contacted the Securities and Exchange Commission (SEC) and the Wall Street Journal, and he wrote to the IRS for information about New Era's tax returns. This information was all very slow in coming. Finally, at the end of March 1995, Meyer received a copy of New Era's 1993




tax return. The key number, the proverbial smoking gun for Meyer, was the $34,000 in interest that New Era claimed it had earned during the year. If New Era had invested millions of dollars, as it claimed, New Era should 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, Prudential took control of New Era's funds and demanded to see its financial records. These records showed that New Era had virtually no assets and virtually no income, yet at the same time they had more than $135 million in liabilities, which were primarily the deposits that nonprofit organizations made to New Era.

On May 15, 1995, New Era filed for protection under Chapter 11 bank-

ruptcy laws after the Wall StreetJournalpublished an article about the New Era fraud (Knecht & Taylor, 1995). When lawyers for New Era admitted that there was no chance the organization could be saved through a reor-

ganization, the case was moved into Chapter 7 liquidation. Soon the indictments and lawsuits began. Bennett was charged with 82

counts of fraud, money laundering, and tax evasion. Furthermore, the SEC sued Bennett and New Era, charging them with violating U.S. securities laws. They claimed that the matching fund program of New Era was really an unregistered public offering of securities. The SEC also charged that Bennett moved $4.2 million from New Era into several companies that he

personally owned 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 property, cash, and securities to a Federal bankruptcy judge. This included his $620,000 home in suburban Pennsylvania, his Lexus automobile, and the $249,000 home he bought for his daughter (Stecklow, 1996). These funds were added to the assets of New Era for distribution to the charitable

organizations to which New Era owed money. A 1996 bankruptcy court settlement returned nearly two-thirds of the

money that nonprofit organizations had 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 co-

conspirator in the New Era fraud. Specifically, they charged that Prudential assured them that their funds were being held in escrow accounts, when




in fact Prudential knew that all New Era funds were held in a single, general account and were being used to repay loans 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 ERA CASE PROVIDES A CLEAR EXAMPLE of how easily investors can be defrauded by a simple Ponzi scheme. In most instances, the investors John Bennett duped were sophisticated nonprofit organizations with extensive ex-

perience investing large sums of their money. Most of these organizations checked out New Era (although not thoroughly), and they believed their

money was safe and that New Era Philanthropy was a legitimate endeavor. The case of New Era raises two questions. First, how can something like

this happen to sophisticated investors? Second, what can be done to keep less knowledgeable and experienced investors from falling prey to financial frauds on a regular basis? Neoclassical economic analysis provides one

possible explanation for the recurrence of financial frauds; but, as this section argues, the neoclassical explanation is rather limited and unconvinc-

ing. The next section relies on the findings of empirical psychology to

present a more convincing explanation for why financial frauds like New Era occur with great regularity.

The main reason standard economic theory provides little help in un-

derstanding the prevalence of financial frauds is that neoclassical economics pretty much rules financial frauds out of existence by assumption. The

key assumptions leading to this result are that people are knowledgeable and that they are rational. Rationality implies that people want to maximize their returns on investment (given a known degree of risk). This means that when a great deal of money is at stake, investors will seek a great deal of information about where they invest their money. There is no denying that individual investors know that cases of fraud exist (sufficient evidence of this appears in magazines and newspapers). Individual investors also know that there is a nonzero probability that they will be defrauded. When

large sums of money are at stake, neoclassical theory holds that rational




investors should weigh their potential gains against their potential losses and that they should seek out large amounts of information about who

they are giving their money to. But once it is assumed that people are rational in the sense just described,

and that they know what they are doing before they invest, it is hard to

explain why people should frequently be duped or why financial frauds such as New Era Philanthropy exist.

It is at this point that neoclassical theory brings in the notion of asymmetric information. In cases of investment, the investor must always know less than the person or institution that receives their money. 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 legitimate business whose proceeds then get used for personal consumption. Investors are thus at a disadvantage, and this disad-

vantage leads to Ponzi schemes, embezzlements, and so on. But falling back to the notion of asymmetric information really does little

to explain financial frauds. First, there are internal problems with this ap- proach-even within the neoclassical paradigm it does not provide a good explanation for the existence of financial frauds. Despite asymmetric in-

formation, any rational individual giving up money has great incentives to 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 individuals take better care and try to obtain the additional information that would reveal the existence of a fraud? Neoclassical theory and the notion of asymmetric information provide no answer to this question. In

addition, why don't individuals stop investing or not invest until they have sufficient information to make sure that they are not being defrauded? Ra- tional and knowledgeable investors (in the neoclassical sense) should re- alize 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 investors that "more information is necessary" rather than "this is a good place to invest money."

Moreover, the basic facts in the New Era case do not support neoclassical

theory. Many investors did not check New Era's financial records carefully before they gave New Era millions of dollars. In addition, everyone took at face value assurances from Prudential Securities that the money they gave to New Era was being held in individual escrow accounts. Not one




nonprofit organization demanded to see an account statement from Pru- dential bearing solely its name and containing exactly the amount of money it deposited with New Era. Albert Meyer, the mild-mannered accounting professor who pressed Spring Arbor College to get this information and to have other questions answered, was met with indifference and hostility by the senior administrators at his school. He even felt that he was putting his

job as an untenured professor at risk by merely asking such questions (Michelmore, 1996).

Most financial frauds follow this pattern. Investors do not thoroughly check out who they are giving their money to, and even if they do this, swindlers are able to cover their tracks. Oscar Hartzell's Drake Estate swindle provides another good example of how and why the asymmetric information and neoclassical theory do not get to the root causes of financial frauds. In this case, the defrauded investors were not large nonprofit organizations with substantial investment experience; they were midwestem families, primarily in Iowa, that knew little about investing their hard-earned money.

The Drake swindle involved the supposed estate of the British admiral and explorer Sir Francis Drake. Hartzell convinced 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 Hart- zell to be a con artist. For example, Drake died childless, so his heirs could not inherit his fortune, no matter how massive it was. In addition, the statute of limitations on wills in England is thirty years. 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 Estate in the twentieth

century (Brannon, 1995; Nash, 1976, pp. 77-93). Again, the problem is not

asymmetric information in the neoclassical sense of investors trying their




best to get information and being thwarted by scam artists. Rather, the

problem is that investors themselves do not ask the appropriate questions and naively believe what they are told and apparently what they want to believe. They are not rational in the neoclassical sense of the term, nor for that matter, in any other sense of the term.

A final problem with the traditional economic view of financial frauds is that in cases of financial investment, individuals are not facing risk, but

uncertainty. Traditional theory attempts to convert situations of uncer-

tainty 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 information about the number of fraudulent investments. Many fraudulent investments never become known to the public because the great risks undertaken by some individuals eventually get paid off. Others re- main unknown because the victims are too embarrassed to come forward. So it becomes a matter of faith rather than a matter of probability that an investment is legitimate. In the next section we will see that having a

particular psychological 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 investment decisions as primarily matters of risk. They are cases in which people make

probability assessments of future events and then make rational decisions that maximize the expected utility they 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 investment decisions involve forming probability assessments of

possible future outcomes. Rather, most investment decisions are choices made when facing some degree of uncertainty. In cases of uncertainty, people typically resort to some kind of focal point for making their decision or coordinating their actions (see Schelling, 1960, chap. 3). If uncertain about whether to refinance one's mortgage, one looks at what one's neigh-




bors and acquaintances are doing. When a large number refinance, that provides a signal for others to refinance. Likewise, when uncertain whether to invest money in a certain mutual fund or business, one looks at what one's friends and acquaintances are doing. If they are giving their money to firm X or individual Y, then one does not look like a loner if he or she does so as well. Conversely, a person may look foolish if he or she did not get in on a good thing. Thus, when many people invest in a certain way, there is a tendency for others to do so as well.

But if investment decisions are based on focal points, the situation is ripe for financial frauds. As we saw earlier, the typical financial scam begins with a few investors who receive extremely large rates of return. It is these great returns that attract more investors and that make a certain investment seem legitimate or become a focal point.

Empirical psychology provides a good deal of evidence that people are psychologically constituted to make the very sorts of errors that lead to cases of massive financial fraud. One result from the empirical psychology literature is that judgments about potential risk are frequently mistaken, and human fallibility tends to be greatest when people hold their faulty judgments with great confidence (Slovic, Fischhoff, & Lichtenstein, 1982). Moreover, people are psychologically predisposed to be optimistic when- ever they are individually involved and have had no bad personal expe- riences from their past to counter this innate optimism. For example, a large majority of people think that they will live past 80 (Weinstein, 1980) and that they, personally, are unlikely to be harmed by products they buy and use (Rethans, 1979). Psychologically, people tend to live in the world of Lake Wobegon, where all children are smarter than average and better behaved than average.

People also tend to believe that good things will happen to them. They overestimate their chances of winning the lottery and think that they will not suffer serious injury if they are involved in a car accident but do not wear their seat belt (Slovic, Fischhoff, & Lichtenstein, 1978). It appears then that people are psychologically predisposed to believe perpetrators of financial frauds and to believe that they themselves will not be the victims of such frauds.

Another relevant result from the empirical psychology literature is that people are overconfident in their judgments. People believe that they are right more often, and to a much larger degree, than they actually are right




in their assessments (Oskamp, 1965). What is true of laypeople is also true of "experts" in a particular area. It is this overconfidence that leads to such disasters of human error such as Three Mile Island and the collapse of the Teton Dam, and such ecological and biological disasters such as acid rain and ozone depletion (Slovic et al., 1982). Overconfidence by investors also

explains why investors do not raise obvious questions and why perpetrators of fraud seem to have such an easy time duping even sophisticated investors. From the perspective of human psychology, it is no wonder that individuals like John Bennett and organizations like New Era Philanthropy are not rigorously scrutinized and pass inspection even when they are checked out carefully.

Moreover, the human disposition toward overconfidence gets rewarded and reinforced by the typical format of a financial fraud. Normally, large gains are paid to initial investors to generate overconfidence. There is a

great deal of psychological evidence that people frequently make misjudg- ments when looking at events that occur purely by chance. Instead of at-

tributing these events to chance, people develop some rationalization for these events. One rationalization is a belief that they are better than others or luckier than others. Thus is born the belief in the "hot hand" among basketball players, even though good statistical analysis 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 returns initially, fraudulent entrepreneurs create overconfidence in the public and a belief that high returns will continue into the indefinite future because they have a "hot hand." Adding further credence to these beliefs is the fact that most mutual funds advertise their returns and attempt to attract new investors with their claims of having "beaten the market." Given their psychological makeup, investors stand little chance against financial frauds.

Further compounding this problem are the phenomena of framing ef-

fects, recency effects, and halo effects. Framing effects, or anchoring, oc- curs when people make judgments based upon a given initial value or

starting point. Tversky and Kahneman (1974, p. 1124) note that in cases of

uncertainty people rely on heuristics to make decisions. For example, decisions about purchasing insurance are known to be affected by the way the decision is presented to people. Decision choices frequently get re-




versed when the decision is portrayed as accepting a small financial loss instead of making a gamble on future events or vice versa (Fischhoff, Slovic, & Lichtenstein, 1980; Hershey & Shoemaker, 1980). In financial matters, past returns or promised returns (or some combination of the two) become

anchors, and people come to expect such returns in the future (despite the

required disclaimers about past returns and future returns). Recency effects occur when the most recent information we are given

greatly influences our judgments. Halo effects occur when one positive trait influences our evaluations to a large degree. Entrepreneurs or flimflam artists with upbeat and outgoing personalities immediately develop halo effects. We tend to like them and believe them. If these individuals are able to provide above average returns during any recent time period, recency effects lead others to believe that these people will always generate above

average rates of return and that these people are trustworthy individuals to whom it is safe to give your money.

Many cases of financial fraud have involved individuals with charming and

convincing personalities who were able to develop Ponzi schemes of sorts based on recency effects. Nick Leeson's (1996) superiors did not question many of his activities because during the year he spent at the Jakarta, Indo-

nesia, branch of Barings Bank he cleaned up an office in shambles and col- lected large amounts of money that Barings Bank was not even aware that it was owed. Leeson was rewarded with the assignment of starting up and run-

ning the Barings operation in Singapore; but because of the halo effect and the recency effect, he was not monitored carefully and his future actions were not questioned. Recent experience led the senior management at Barings Bank to assume that Leeson would turn the Singapore office into a highly profitable endeavor. Problems began when a trader bought shares when she should have sold them. Leeson hid this mistake in an error account and sought to make up the loss by using this account to speculate in foreign currency. The numbers that Leeson reported to London, however, showed that all his foreign exchange trading was earning Barings Bank a great deal of money. Leeson's

superiors were happy to see the firm making large profits and to cash their

large bonus checks. With no one questioning him, and with no one checking his financial reports, Leeson was allowed to speculate in foreign currencies

using Barings Bank deposits. His speculations became increasingly risky over time because winning a risky gamble was the only hope Leeson had of re-

versing his losses.




John Bennett of New Era Philanthropy also had the upbeat and outgoing personality that caused people to immediately trust him. His long association with Christian philanthropic groups and his association with charities

through years of giving them advice helped to anchor people's beliefs about Bennett. It was thus relatively easy 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 returns on the belief that such returns will continue to be paid in the future, there will always be Ponzi schemes

waiting to occur. As we saw, New Era Philanthropy paid investors more than 100 percent interest during its first few years of operation. Because of these high returns, investors came to expect large returns and became reluctant to question New Era for fear of being asked to put their money elsewhere.

Further reinforcing anchoring, halo effects, and recency effects, people believe that someone is monitoring things and that frauds cannot happen. But this is not the case in the real world. Firms that seek to evade regulators usually are able to do so with little difficulty. Regulators have too few re- sources and too little time relative to the number of firms that need mon-

itoring. Regulators can also at times be bought off or stalled through promises of compliance with regulations in the future or complaints about in- trusive government interference with the free market. Even seemingly independent and objective parties might be paid "finder's fees" as in the case of New Era Philanthropy.

This section has argued that financial frauds arise not because of asymmetric information, but because of the psychological dispositions of human

beings and the fact that human decision making involves employing some heuristic or focal point in the face of uncertainty regarding future events. The next section examines the policy implications of this view.

V

Preventing Financial Frauds

JUST AS NEOCLASSICAL ECONOMIC THEORY IS RELATIVELY USELESS when it comes

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 asymmetric information. Only one solution follows




from this-to increase the amount of information available to potential investors so that they can rationally and intelligently invest their hard- earned money.

But in the real world, this solution will not likely work. Again, the literature from empirical psychology can help us understand why more information is not the solution. Greater information is only helpful if it is received correctly, without any biases, and interpreted and used intelligently. But many psychological studies have found that judgments do not improve with more information (see Janis & Mann, 1977, chap. 8; Rabin, 1998, pp. 26-32). Just as damning of the neoclassical perspective is the work of Kah- neman and Tversky (1972; Tversky & Kahneman, 1982), which finds that

increasing the knowledge of statistics does not eliminate or reduce biases in judgment.

Most financial frauds contain warning signs that should have been obvious to those who were taken in or deceived; yet most investors fail to be

swayed by the evidence staring them in the face. This is true of the Sir Francis Drake Estate scam to a very large extent, but it is also true of New Era Philanthropy.

If all that neoclassical theory can recommend is that investors should be

provided with more information, neoclassical theory becomes a recom- mendation for playing a game of financial survival of the fittest, in which those who are smart enough or lucky enough to avoid frauds thrive 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 current system and, when the frauds become 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 understanding and

curing financial frauds does not mean that economics cannot help. One of the most important lessons to be learned from economics is that incentives are important. With respect to financial frauds, potential gains are always enormous. If I take someone's money, gamble with it, and win, I wind up making a large sum of money and my actions will not likely be discovered. On the other hand, if I do not succeed, I can still live extremely well. As we saw, Robert Bennett prospered for many years on the monies given to him by various nonprofit organizations; he was also able to use this money as collateral for personal loans. Even when caught, the penalties for finan-




cial fraud are generally small relative to the potential gains. Although Mi- chael Milken spent a few years in jail, he was still able to accumulate great wealth. Similarly, although Robert Bennett had to turn over $1.2 million to the state for distribution to charitable organizations owed money by New

Era, if the SEC estimates are correct, Bennett should have at least $3 million hidden somewhere. Unless penalties are substantially increased relative to

rewards, there will be little change on the supply side of frauds. But the demand side is even more important than the supply side. And

action on the demand side is even more difficult because here we have to contend with human nature and 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 literature is that informing people of the risks in concrete terms makes people judge risks to be greater and makes them perceive risks to be much closer to the actual risks (Slovic et al., 1982, p. 484). In many instances, concrete examples of something bad happening will cause people to overstate the risk of something bad

happening to them. This leads to the following important conclusion. Rather than assuming

investors are knowledgeable about investment opportunities, and rather than providing investors with more information about particular invest-

ments, providing investors with more information about investments gone awry is necessary. The best solution to the problem of financial fraud is to

keep reminding investors about the Charles Ponzis, the Nick Leesons, the

Crazy Eddies, and the John Bennetts.

References

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On Financial Frauds and Their Causes Investor Overconfidence