When the cash value of promises goes up, when tomorrows are being sold early, swindlers are among the first to profit.

–Jonathan Kwity

If you’ve been paying attention so far, you’ll notice a lot of similarities among the hustlers, scammers, and environments in which frauds tend to occur. Every fraud is unique in its own right because the circumstances are always different, but there are themes we can point to that show the conditions that tend to be present when fraud truly flourishes.

When There’s an ‘Expert’ with a Good Story

Jerry Seinfeld once observed, “It’s amazing that the amount of news that happens in the world every day always just exactly fits the newspaper.” Author Michael Crichton once said in a speech that the media often carries a credibility it doesn’t deserve. He called this the Gell-Mann Amnesia effect, named for Nobel Prize-winning physicist Murray Gell-Mann, with whom he discussed this idea. Crichton explains this effect as follows:

Briefly stated, the Gell-Mann Amnesia effect is as follows. You open the newspaper to an article on some subject you know well. In Murray’s case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward – reversing cause and effect. I call these the “wet streets cause rain” stories. Paper’s full of them.

In any case, you read with exasperation or amusement the multiple errors in a story, and then turn the page to national or international affairs, and read as if the rest of the newspaper was somehow more accurate about Palestine than the baloney you just read. You turn the page, and forget what you know.

This line of thinking follows for financial “experts” as well. It’s easy to spot someone in our own lives who embellishes or constantly lies to us but when it comes to our finances we simply trust the first intelligent-sounding person wearing a bow tie. If someone sounds like they know what they’re talking about, makes a lot of promises, or uses jargon you don’t understand, then they must know what they’re doing, right? Au contraire.

We are storytelling creatures, and the scam artists who push people into frauds or scams are masters at spinning a yarn. One of the unfortunate realities of the investment business is that, all else equal, a talented sales staff will trump a talented investment staff when attracting capital from investors. And that’s in the legitimate money management business. When it comes to scammers and fraudsters, all bets are off. And in many cases, these people are better at sales and marketing than even the best and brightest on Wall Street.

Crichton also relayed an anecdote that explains how things typically work when so-called experts over-promise and under-deliver. There’s an old joke in which a child comes down on Christmas morning and finds the room around the tree filled with horse excrement. When the boy jumps up and down for joy, his parents ask why he’s so happy at the sight of a room filled with horse manure. The boy replies, “With this much horsesh*t, there must be a pony.”^[1]

The old there-must-be-a-pony effect is essential to the proliferation of financial fraud and malfeasance. Unfortunately, most financial promises attached to a good story don’t come with a pony either, but they are full of horsesh*t.

When Greed Is Abundant

In his classic Manias, Panics, and Crashes, Charles Kindelberger outlines the five phases of a bubble:

• Phase One: Displacement. An event or innovation occurs that sharply changes expectations. This phase is typically grounded in reality and good intentions.
• Phase Two: Expansion. This is the stage where the narrative takes hold and people begin bidding up asset prices.
• Phase Three: Euphoria. By this point, all bets are off. Everyone assumes they can get rich easily and very quickly. Risk is taken with abandon and nobody worries about the hangover in the morning. During the dot-com bubble, this is the point where people decided they could make more money day trading IPOs than going to their day job. Euphoria makes people think the good times will last forever, or at the very least, they won’t be the ones holding the bag when it turns.
• Phase Four: Crisis. The inevitable other side of any boom is a bust. This is the phase where the insiders begin selling, and panic buying quickly shifts to panic selling.
• Phase Five: Contagion. Just as prices overshoot to the upside from euphoria, they often overshoot to the downside once the contagion of bad news spreads and people think things will never get better again.^[2]

Phase three is the lynchpin in this entire cycle, because without greed, there is no fear. Without a bubble, there is no bust. And without greed and bubbles there isn’t nearly as much fraud taking place.

Gordon Gekko, as played by Michael Douglas in the classic movie Wall Street, said, “The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.”

This quote actually isn’t as far out there as some make it out to be. Gekko makes some valid points. The problem is we humans always take things too far, so once greed infects a market there’s no reining it in. The cycle goes something like this:

• After markets crash, they begin to rise when the economic or corporate landscape shifts from catastrophic to just terrible, because markets are more about relative (better or worse) than absolute (good or bad) news. These are the rallies no one trusts because people still see the carnage all around them from the market or economic downturn.
• Eventually other investors begin to take notice of rising markets that aren’t rolling over. Rising prices attract buyers just as falling prices attract sellers, so higher asset prices become something of a self-fulfilling prophecy as they continue to push higher (for a time).
• After markets have risen for long enough that people see their neighbors getting rich or read about others making money in the Wall Street Journal the herd mentality kicks in and greed takes over. Rinse and repeat.

Bull markets make us believe we’re invincible just as bear markets make us feel like idiots. The truth is usually somewhere in-between in both scenarios, but those feelings of invincibility can lead to a lax decision-making process when it comes to choosing the right people to work with.

It’s during this greed phase of the market cycle that investors become easy marks for scammers. Greed clouds your vision as it becomes harder to come by easy profits. As those easy profits dissipate, people are willing to take more risk to earn rewards they feel they’re now entitled to. So people reach for investments or strategies they shouldn’t because they begin to believe the market owes them something. This scenario is a huckster’s dream because they don’t even need to try very hard to take advantage of their unsuspecting victims.

Joseph “Yellow Kid” Weil was one of the most successful con men of the early 1900s, employing a variety of scams to bilk people out of their money: fake merchandise; a dog swindle where he pretended to have rare, expensive breed of dog for sale; staging fake prize fights; and selling land that didn’t belong to him. It’s estimated he made out with $3 to $8 million over the course of a 40-year career as a con artist. Towards the end of his life Weil admitted, “Men like myself could not have existed without the victim’s’ covetous, criminal greed.”^[3]

When Capital Becomes Blind

Walter Bagehot was an early editor at The Economist in the mid-to-late nineteenth century. In a collection of his essays, he wrote about what happens when a moment of insanity strikes and capital turns blind to risks:

At intervals, from causes which are not to the present purpose, the money of these people – the blind capital (as we call it) of the country – is particularly large and craving; it seeks for someone to devour it, and there is “plethora” – it finds someone, and there is “speculation” – it is devoured, and there is “panic.”^[4]

Charlatans and scam artists understand this dynamic better than most, and you can bet when capital becomes blind they will be there waiting to pounce. Sometimes capital turns blind because you have so much of it you simply let your guard down.

That’s exactly what happened to The King, Elvis Presley. At the tail end of his career, Elvis owned a private plane he rarely used so his father, Vernon, decided to help by putting it up for sale. An experienced con artist by the name of Fred Pro swooped in and hatched an elaborate scam to take not only the plane, but also some of Elvis’s money. To get a foot in the door, Pro concocted a detailed résumé which showed him to be a veteran of the airline industry. Once he gained their trust, the con man’s plan involved that involved buying the plane, paying off the remaining loan Elvis owed, then leasing the plane back to himself, thus netting The King a cool monthly profit of $1,000/month on the deal. Pro said he planned on making up for his losses by chartering the plane as a pilot.

Pro took the plane for a test flight all the way to New York City, using the plane itself as collateral to secure a $1 million loan. There was just one more thing he needed from Elvis to close the deal – the $340,000 check, which was how much equity Elvis has in the plane, to be used for upgrades on the aircraft. Those upgrades never took place because Pro never planned on actually leasing out the private plane. Instead, he absconded with the $340,000 and wouldn’t you know it, every single one of his checks bounced. Yet he and his other con artist friends flew all around the country in what was basically a free private jet for months, until they read in the paper Elvis had died. At that point, Pro assumed he would own it free and clear, but Vernon Presley finally went to the authorities when he figured out he’d been defrauded.

Vernon told the FBI, “You know I got to thinking. Maybe that this guy, the reason he was wanting upgrading money was to use it himself, not to – this might have been a planned deal all the way through.”^[5]

Um…ya think?

Pro’s plan all along was to blind the Presleys with a deal that was too good to pass up. They were so swayed by the idea they could earn a profit on the deal that they failed to perform any due diligence on their buyer other than what he told them.

Legendary mutual fund manager Peter Lynch once said, “Spend at least as much time researching a stock as you would choosing a refrigerator.” The idea here is that people often spend more time debating the merits of a minor money decision than they do one that will potentially impact them for years to come. There’s nothing wrong with using extra care and attention when making a big financial decision. Unfortunately, when capital becomes blind, we often throw caution to the wind, and that can lead to people getting taken advantage of.

When the Banking Industry Gets Involved

Steve Eisman is one of the most memorable characters to come out of the best book written about the Great Financial Crisis, Michael Lewis’s The Big Short (Eisman was played by Steve Carell in the movie adaptation). After learning about the cascading problems subprime loans were causing the financial system, Eisman and his team began shorting Wall Street bank stocks such as Bank of America, UBS, Citigroup, and Lehman Brothers, betting these companies would take a hit for all the subprime debt they held on their balance sheets. Eisman also shorted the now defunct firm Merrill Lynch, which was later bought by Bank of America. When asked why he shorted Merrill, Eisman replied, “We have a simple thesis. There is going to be a calamity, and whenever there is a calamity, Merrill is there.” Michael Lewis continued on this thought:

When it came time to bankrupt Orange County with bad advice, Merrill was there. When the Internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic: the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was crack the whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.^[6]

Eisman was right, of course, as all these bank stocks got destroyed in the crisis, but it’s not so much that Merrill Lynch played a role in all of these past crises as it is Wall Street circling when there’s blood in the water. Banks have a nasty habit of fanning the flames when markets take off because no one wants to be left behind on Wall Street when there’s money to be made off Main Street. And when people are making money there is sure to be fraud involved somewhere along the way. During the housing mania, the FBI reported mortgage-related fraud was up fivefold from 2000 to 2006.

Household Finance Corporation was founded in the 1870s, but during the real estate bubble of the aughts, the company was making loans at its fastest pace ever. The source of their growth was coming from second mortgages with an odd sales tactic. They were offering 15-year fixed-rate mortgage loans to people looking to pull money out of their homes in a rising housing market. But they disguised these 15-year loans as 30-year loans to prospective clients, showing them what their payment stream would look like spread out over a three-decade period. The borrower was told this made the interest rate 7% but the effective rate was actually 12.5%. This was blatant fraud and many borrowers realized what happened when a reporter began looking into the company’s sales tactics. Household was forced to pay a fine in a class action lawsuit but was sold to another bank shortly thereafter.^[7]

Wall Street firms aren’t always perpetrators of fraud, but you better believe they will be there waiting to take advantage when markets reach a fever pitch. And even if the banks keep everything completely above board, there will be other firms pushed to the brink of fraud to keep up. You can take that to the bank (pun intended).

When Individuals Begin Taking Their Cues from the Crowd

Going to the grocery store can be tricky because I have three young children. So, I buy a lot of stuff from Amazon in terms of food and household goods to save on trips to the store. Jeff Bezos has me trained well enough that Amazon is almost always the first place I look for an item we need around the house. Whenever I buy something new, I almost always choose the one marked ‘Amazon’s Choice’ if I don’t have a specific brand in mind. This may seem irrational on my part but when people don’t know exactly how to react or make certain decisions, we look to others to figure out what the correct behavior should be.

This is why so many of your favorite network sitcoms use a fake laugh track for every single joke whether it’s good, bad, or otherwise. It turns out that research shows audiences laugh longer and more often when a laugh track follows a joke, no matter how corny or overused it is. Audiences also rate the material as being funnier, which is even more effective for the worst jokes. We often look to others to decide how to react during certain situations because we are status-seeking creatures and no one wants to be left out of the joke (even when it’s not funny).

Robert Cialdini calls this weapon of influence the principle of social proof. Social proof is the idea that actions are seen as more appropriate when others are doing it. This is a double-edged sword because following the crowd can be a useful life hack under certain situations, like knowing where to pay at a store you’ve never been to by simply finding the line of other people waiting to pay. But using shortcuts when it comes to your finances can leave you vulnerable to those willing and eager to take advantage of the herd mentality. One of the reasons fraud tends to spread like a virus is because it’s difficult to witness others earn what looks like easy profits.

In the early 1900s, Oscar Hartzell conned some 70,000 people in the Midwest through promises of a 5,000% return on their money. Hartzell used a scheme similar to the Nigerian Prince scam wherein he promised access to billions of dollars from an inheritance for Sir Francis Drake, a pirate who supposedly looted a fortune from Spanish ships in the 1500s. The story was completely made up and it turns out Hartzell’s mother had fallen for the con, which gave her son the idea to try it on others. Farmers from all over the Midwest fell for Hartzell’s story. And when the authorities tried to shut it down, they received thousands of letters from angry citizens who were worried the attorney general in Iowa would derail their dreams of millions from a long-lost inheritance. So many people believed the money existed that everyone who handed money to Hartzell to help him get the inheritance from England to the US had no other choice but to believe.

John Kenneth Galbraith once wrote, “Perhaps, indeed, there is opportunity. Maybe there is that treasure on the floor of the Red Sea. A rich history provides proof, however, as often or more often, there is only delusion and self-delusion.” Even Hartzell himself fell for his own made up story, repeatedly ranting in jail that his claims were true after authorities finally put an end to his scam.

When Markets Are Rocking

When things are really good or really bad it makes for fertile breeding ground for fraud. Market booms and busts toy with our emotions but in different ways. It’s typically the booms more so than busts that suck more people into forms of financial fraud. No one wants to feel left out when everyone around them is making money. So, when things are going well, risk management goes out the window, people become more lax about their due diligence procedures, and everyone becomes more trusting in money-making ventures.

For every bust there must first be a boom, and the boom that preceded the Great Depression was the roaring 20s. The 1920s introduced innovation the likes of which the mass consumer had never experienced before. People were introduced to several luxuries we now take for granted – radios, refrigerators, washing machines, irons, full electricity in their homes, private indoor toilets, central heating, air conditioning, automobiles and much more. And the innovation that allowed so many people to make these upgrades in their lives was the explosive growth of consumer borrowing during this time. People were purchasing items on credit en masse for the first time in history.

The stock market boomed as it never had before. The ensuing market crash unwound the boom and more. Frederick Lewis Allen’s book Only Yesterday: An Informal History of the 1920s captured the sentiment of this boom, and its aftermath, beautifully:

Prosperity is more than an economic condition: it is a state of mind. The Big Bull Markets had been more than the climax of the business cycle; it had been the climax of a cycle in American mass thinking and mass emotion. There was hardly a man or woman in the country whose attitude toward life had not been affected by it in some degree and was not now affected by the sudden and brutal shattering of hope. With the Big Bull Market gone and prosperity going, Americans were soon to find themselves living in an altered world which called for new adjustments, new ideas, new habits of thought, and a new order of values. The psychological climate was changing; the ever-shifting currents of American life were turning into new channels.^[8]

In many ways, financial fraud is also a state of mind for both those peddling it and those on the receiving end of being scammed.

When the Opportunity Presents Itself

There are a number of reasons for fraudulent behavior. Sometimes people are simply lifelong con artists who defraud others because they’ve perfected the game, it gives them a thrill, and it can make them wealthy. Others scam people out of money through an internal justification by rationalizing their actions. These situations usually start out as a legitimate idea but morph into fraud when that idea needs to be taken to the next level to succeed. Then there are the cases where people are motivated to commit fraud because of perverse incentives or some perceived financial need or desire.

But all of these situations require one thing to take place – opportunity. Without an opening, without greedy victims, without an ineffective system, without the requisite lack of controls in place, without an opportunity to take advantage of people, fraud never gets off the ground. And sometimes that opportunity presents itself in crazy ways.

Two brothers from a small town in Spain purchased what they thought was a painting by Francisco Goya, a Spanish painter from the late-eighteenth and early-nineteenth century. But after putting down a deposit for the painting the brothers quickly realized they’d been swindled when the certificate of authenticity never arrived. The case went to trial, where an expert determined the painting was in fact a fake, relieving the brothers of the remaining debt they owed on the deal.

The brothers learned a lesson after this ordeal, but it wasn’t necessarily the one most would assume. Instead of learning from their mistake, they tried to see if they could make others fall for the same scam they fell for. In 2014, the brothers tried to sell their forged painting to an Arab sheik for a down payment of 1.7 million Swiss francs. Not only did they try to sell the same fake painting they had been duped into buying, but they did so at an even higher price than they bought it for! Apparently even the forged art market has pretty decent returns. Alas, there was yet another forgery involved with this scam, but this time it wasn’t a painting. When they tried to cash their deposit for the painting, it was determined the money was forged. And the worst part of it all is that they were charged a commission of 300,000 euros to enter into the deal. Both the sheik and the intermediary who accepted the commission were nowhere to be found once it was discovered the currency was fake.^[9]

Not everyone would have gone down the same path if given the opportunity. But there are people who seem like generally decent humans who end up committing fraud simply because it seems like it’s there for the taking.

When Human Beings Are Involved

Reminiscences of a Stock Operator was originally published in 1923 by Edwin Lefevre. He wrote, “There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.” Substitute ‘fraud’ for ‘stock market’ in that sentence and it still rings true.

J.H. Kelly insisted he could perform medical miracles through a “practical scientific system.” This system involved Kelly helping sick people clear their minds of all problems to concentrate hard enough to “think it away.” As preposterous as this sounds, Kelly became a millionaire many times over. By the year 1900, he was receiving thousands of letters a day from people looking for his healing touch. He charged anywhere from $1,000 to $1,600 in which he would send people a postcard giving them an exact day and time to clear their brain and thus be cured of whatever ailed them.^[10]

Jude Devereux became a best-selling romance novelist who has 30 or so books on the New York Times bestseller list. The sale of her books made her a millionaire many times over which made her a perfect mark for a financial scam. After losing a son to an accident and going through a divorce, a psychic preyed on Devereux at a weak moment in her life. This psychic, who used a fake name, told the author money would attract evil if it remained in her bank account. Deveraux handed over an estimated $17 million. When she testified at the trial for her scam artist psychic, Deveraux admitted, “When I look back on it now, it was outrageous. I was out of my mind.”^[11]

Markets, economies, regulations, and technology are constantly changing and adapting, but human nature remains the one constant throughout history. As long as humans walk the earth, there will be people who take advantage of that human nature and there will always be people who get taken advantage of.

When Innovation Runs Rampant

Times of great technological change provide an ideal atmosphere for financial fraud. It’s during these times of transition where you hear terms like “paradigm shift” that people begin to lose touch with reality when it comes to their finances. Everyone would like to believe fast change will lead to quick profits, which is why scam artists thrive during financial booms, political upheaval, technological innovation, and times of transition. These times bring about great hope but also great uncertainty about the future. Hope is never a good investment strategy, but it makes for a wonderful sales tactic. We all love to dream about becoming healthier and wealthier, and it’s never easier to sell these dreams than when people are filled with optimism about what the future holds.

During times of great change, we perceive conditions as being less risky, hence people are more willing to take risks with their money because they feel it’s actually a safer environment to invest. Technological innovation has improved the world in countless ways, but those periods of transition can make it difficult for people to gauge risk. When antilock brakes were installed on cars people simply drove more aggressively. When commercial ships adopted radar technology it was assumed there would be fewer collisions on the seas. Instead, the captains drove more recklessly.^[12]

In the next chapter, we’ll look at how advances in technology can have simultaneously positive and negative consequences depending on the time horizon.