What The Fraudster Knows

It is a new season and there are new accusations of fraud: car dealers in Alabama, a Vietnamese banking tycoon, Scottie Pippen's financial adviser (convicted). Every fraud is a warning and a lesson in greed, but do they have more to teach us other than caveat emptor?

Consider the fraudster - that man or woman of confidence and performance who adopts a fake name or title, who forges assets or fudges numbers, who doctors accounts or relationships. It is not hard to think of examples. Jeff Skilling and Ken Lay of Enron were revelations in 2001, but it turned out they were merely the opening act. The past decade and the recent financial crisis outed no small number of confidence men, among them Bernie Madoff, Christian Gerhartstreier (a.k.a. Clark Rockefeller), and Bernard Ebbers. As these confidence men and their frauds now recede into the recent past, they will join a long list of notorious rogues.

For example: John Law, a Scotsman born near the end of the seventeenth century. On the assets side of the ledger, Law appeared to have a great head of hair, was the son of a successful goldsmith and went on to become a close adviser to Louis XIV in France. He developed groundbreaking thinking on the functioning of credit systems and central banks, and was an early proponent and adopter of paper money.

The liabilities, however, are the chief reason Law is remembered. In 1716, he established the Banquee Generale Privee, which brokered shares in, among other things, the Mississippi Company. The Company attracted investors intrigued by New World possibilities and promise, while allowing Law to consolidate French national debt.

There was, however, nothing behind the Company, and as prices soared, Law found himself in a confidence game, propping up paper prices through all means available, including banning trade in large amounts of gold and silver. When Law's charade collapsed, and the Company with it, so too went French confidence in the type of financial assets that would prove crucial to stability and power over the next two centuries.

Law's fellow Scotsman, Sir Gregor MacGregor arrived on the scene a century later. In 1821, posing as having freshly returned from the Latin American wars of independence, MacGregor made the social rounds in London claiming to be the Liberator of the Floridas, the Cazique of Poyais, the Prince of the Mosquito Shore. Anybody want to buy beachfront property in an invented country on the Bay of Honduras?

Outlandish, perhaps, but MacGregor was selling shares and property in a London market of strutting dandies and global goods, a market smitten by opportunity in Latin America. The Latin American bubble would burst in 1825, but not before those who sailed to Poyais came to the brutal and deadly realization that there was no such place.

As assets diversified, companies expanded and new geographic locations for investment emerged over the remainder of the nineteenth century, the opportunities for fraud increased. "Everything," noted one turn of the century publication, "was swagger." Men of the market had swagger yachts, swagger palaces, swagger entertainments, it added. And in such an environment, the line between legitimate business and fraud grew hazy. Buy a company, stack its board with famous names, over-capitalize it, pay out the directors, and close up shop. This was the route of Ernest Terah Hooley, the so-called "Napoleon of Finance."

And, of course, such was the gall and bravado of Charles Ponzi that, nearly one-hundred years after his investment scheme first fell apart in 1920, his last name is still commonplace. Italian born, Ponzi was a well-turned out showroom who globetrotted through the early twentieth-century economy, carrying out spurious schemes in Europe, Massachusetts, Florida, and Brazil.
So outlandish are these schemes that the temptation is to see them as exceptional -- the victims as fools, the perpetrators as hunters of the naïve and vulnerable. But consider, for a second, what fraudsters know.

First, they know what the market wants. Law tapped into French appetite for New World investment, while MacGregor fed off what many financial historians felt to be the first modern investment bubble, Latin American sovereign debt in the first half of the 1820s. Most importantly, they know the market wants returns, which Law offered at nearly forty percent, and which Madoff nearly four centuries later would all but guarantee.

Second, they know how the market works. Law knew the financial structure of early 18th century France better than anybody else alive - he all but set it up. Beaumont Smith, a British financial official, committed roughly £350,000 worth of fraud through the sale of fraudulent bills in the mid-nineteenth century. He knew that the market moved at such a brisk trading pace that nobody held bills long enough to discover they were forged. MacGregor and Hooley understood and exploited the intricacies of Georgian and Victorian financial and commercial structures. The fraudsters of Enron understood a modern day fraud requires a little help from a third-party accounting friend.

They know that in a speculative environment, a fraud is only a fraud if the bottom falls out; or as Trollope put it in The Way We Live Now, "Nobody really loved Melmotte and everybody did believe. It was probable that such a man should have done something horrible! It was only hoped that the fraud might be great and horrible enough."

Third, and most alarming of all, they know how trust works. They know the psychology, ambitions, and social arenas behind the markets. Law, close to the Crown, appealed to the Royal desire to consolidate the debt. MacGregor, the Cazique, understood the desire in 1820s London to rub shoulders with soldiers returned from Latin America, while also making a shilling. And our more recent fraudsters have shown a remarkable ability to build trust not only through social circles (Madoff) and assimilation (Rockefeller, née Gerhartstreier), but through exploiting the very processes of verification designed to prevent fraud.

We ogle these historical fraudsters, placing them at the fringes of capitalism and history. But if history is any guide, there will be soon be another and another. And those at work now know not only the market, but also you, better than you think.