In Lying for Money, veteran regulatory economist and market analyst Dan Davies tells the story of fraud through a variety of stories. Boston Ladies’ Deposit Company, Theranos, and more. In this interview, he discusses various types of frauds including the story of Charles Ponzi and what people need to look out for when looking at new investments including bitcoin and NFTs.
Deidre Woollard: [MUSIC] Hi, fools. I'm Deidre Woollard, an editor on Millionacres, and I'm really excited to be here with Dan Davies, the author of Lying For Money. I read the book and I want to interview him because I think this is a book investors should read to understand how frauds happen and what to look out for because it seems like there's a lot to look out for [laughs]. Welcome. Why do you think people are so fascinated by fraud in general? It seems like, aside from murder shows, fraud shows are the most popular.
Dan Davies: Oh, I can't speak about people in general, but I think the thing that appeals to me is that it's a crime that's done by cleverness. These aren't people who are just going to shoot someone on their head and stealing their money, there's a little bit of intelligence involved in all of these frauds. Of course, the other thing I see is you don't really see yourself as being potentially a victim of them. When you hear about murder you think that that could have happened to me, but when you hear that someone's stolen $100 million from a bank with their counterfeit securities, unless you're very rich, you don't put yourself in that position. Then the final thing I think is that we hear about the ones that have been quite successful but ultimately failed, you don't ever hear about really successful frauds, so there's just this magic trick aspect to them. As I was researching the book, all of these stories, you look through them, you see the trick, and then you see the explanation of how it was done, so you're always getting that slight feeling of self-satisfaction where you think, "How could someone be so dumb as to fall for that?" But of course, you're reading the story and you know how it ends. You don't actually read the story about the stories where the fraudster got away with it.
Deidre Woollard: That's really true. I think that was very true in the case of Bernie Madoff, in particular. I think a lot of people thought that there was a little bit of schadenfreude about the fact that the people that lost their money were rich, to begin with.
Dan Davies: Yeah, absolutely.
Deidre Woollard: When I was reading this book, there's definitely a certain pattern and I noticed you talked a lot about the snowball effect and how people seem to get away with the first minor fraud, but then it just keeps building and building and that's how you get in those situations like a Madoff or something like that.
Dan Davies: Yeah, absolutely. The trouble is that this is one of the things that really set apart fraud from other crimes, from an economic point of view, and my own background is economic fraud and criminology. I'm really interested by the fact that if someone is a shoplifter, they can just stop stealing from shops, if you are a drug dealer then you can usually just stop dealing drugs. If you are an embezzler, or if you are a Bernie Madoff, then you can't just stop committing the crime that you committed because the interesting thing about fraud from a criminology point of view, is that it's the exact opposite, almost, of murder in terms of detecting it. When someone's been murdered or his face has been blown off, it's pretty obvious what happened and the mystery is to find out who did it. When you've got someone like Madoff then once you know that the crime's happened it's pretty obvious who did it. The fraudster has to conceal the existence of the crime itself. Actually, it has some pretty profound implication particularly in an investment fraud context because it means that the fraud grows at the same compound rates of interest that's the basis for all of your investments. As soon as you commit a crime as dishonesty, you're effectively putting a wedge between the true economic books and the public books, and that wedge is going to grow at a compound rate. If you've got a fund with $100 million, and you steal $20 million of this, then if your declaring 20 percent compound growth, like your super Bernie Madoff character, then in a few years time, the public books will have doubled and it will be a $200 million fund. But even if you never stole anymore, the original actual invested capital will only be 160 million, so your gap that you've got to cover up grows at [inaudible 00:04:14] compound effect as the rest of the business and that means it snowballs and then you get situations [inaudible 00:04:22] in probably [inaudible 00:04:26] no more than 50,000 US, but the time it finished, it's in the hundreds of millions of US, it blew up the whole bank and that guy was weeping tears of joy when he was finally arrested because it meant that he no longer had to carry on this horrible second job he'd got as a crooked bookkeeper.
Deidre Woollard: Well, I think that's interesting. I think the bookkeeping aspect of it, it seems like you always have to have a crooked accountant on your side to really pull things off.
Dan Davies: Oh, yeah. I thought I had a little bit of a freeze there, I'm going to stop my video and see if that helps.
Deidre Woollard: Okay. All right. In addition to that snowball effect, there's also this factor that you talked about, which is that anybody who perpetrates the fraud, it seems that they do it once and then they keep doing it over and over again.
Dan Davies: Yeah, absolutely, and we let them. I mean, there's two things that go on here as far as I can tell. Firstly, people keep giving them second chances, and no one puts them in actual prison, but more weirdly than that, there seems to be a psychological thing that's going on there [inaudible 00:05:54] it's gone and they will always keep on coming back to the well, and that's, from my mind, as a short-seller certainly, the biggest asset that any short-selling hedge fund has is the list of people who've been involved in previous frauds because they will keep showing up. When you see the name of a crooked broker or a crooked accountant or a crooked director, you can usually short-sell that stock with reasonable confidence that at some point it's going to zero.
Deidre Woollard: Interesting, you talked about Charles Ponzi in the book. One of the things I really liked about this book was that you go through all of the original frauds that happened over time, and I think we all think that these things can't happen again and yet they keep doing it, but tell me a little bit about Charles Ponzi because I think that Charles Ponzi himself is a lot more interesting than what we think of now as a Ponzi scheme.
Dan Davies: Oh, yeah. He was this crazy kind of character that you only got going in the first half of the 20th century. The weird thing actually is that I'm starting a minor campaign, I actually wanted it on International Women's Day, to get the renamed Howe scheme, because there was a lady called Sarah Howe, who actually invented what later became known as the Ponzi scheme. Ponzi wasn't only not the first Ponzi schemer, he wasn't the first Ponzi schemer in the town of Boston. It was the early 20th century, it was the roaring 20s and there were women of these investments schemes going on, so it wasn't as unusual as you might see today to see someone producing huge investment results, but Ponzi himself had been involved in a number of forging schemes before, he was involved in a medical expenses fraud in, I think, Louisiana which caused him to have to leave the state of Louisiana in a hurry, but he showed up in Boston and he told everyone he developed this arbitrage system because there was something called the International Postal Reply Coupons [inaudible 00:08:00] him, whereby you could pay for return postage if you were sending a letter to someone in another country. The prices of stamps set for those international reply coupons effectively defined the system of fixed exchange rates, and since the market exchange rates have moved quite a way, in principle, you could carry out resources, coupons scheme by buying them in countries where they were cheap and then selling the stamps in countries where they were expensive. In fact, it would never have worked, the system had rules against people exploiting it that way, but with just enough of a sense of reality to be. The people began to accept that Ponzi could start promising effectively 50 percent returns on your money over 90 days, so something like 240 percent compound annual. The money just flew in. He had some very talented salespeople. In the end, he started trying to buy banks, and that's when you ran into trouble because the Boston authorities at the time were content to see him running this strange investment scheme, it was largely within the Italian immigrant community who at that time the establishment in Boston didn't really care all that much about protecting them, but then he started taking over a regulated bank and people started saying, "Well, actually maybe, we'd better take something of a look at this guy" and then it all fell apart within a few months.
Deidre Woollard: Let's give us a little time to Sarah Howe because I think you mentioned in the book that men are definitely more likely to commit these kinds of frauds, but Sarah Howe did do that. It also brought up something really interesting that you mentioned in the book which is the idea that women who had money on their own needed a way to make more money. You had something in the book I thought was interesting about never touching the capital and needing to make money outside of that. Explain a little bit about Sarah Howe and what she did.
Dan Davies: As you say really, it is exactly the same thing that websites talk about these days with financial independence. If you were an unmarried middle-class woman with a sum of capital, you needed that capital to provide you for an income essentially for your whole life because you didn't want to be in the situation where you reach the age of 60 and you are out of money and you had to become a seamstress. So there were lots and lots of fraudsters who preyed on unmarried women, spinsters and widows with a bit of investment capital, and point that they could provide them with the sort of 80 or 90 percent return that was probably needed in order to keep a middle-class lifestyle with the amount of investment capital that most will be. They called them unprotected females in those days which is the kind of term you don't hear much anymore. Sarah Howe claimed to be representing the charitable arm of the Quaker religion, no one ever really asked why they might have chosen her since her previous profession was which she was a sideshow fortune seller, but she ran what purely and simply a Ponzi scheme and it was called the Ladies' Deposit Bank, only ladies were allowed to deposit there. You had to be of good character. You couldn't touch the principal which is, probably for anyone who's running an investment fraud, but you got a huge interest payout, which was like a classic pyramid scheme, all made up of the deposits being put in by new investors. It collapsed and she went to jail and she came out of jail and started up an exactly similar scheme, and she went to jail again, then she moved to Chicago and started up. It took about three or four spells in the prison before she realized that her true gift was fortune-telling.
Deidre Woollard: [laughs].Yes, she is a pretty fascinating story.
Daniel Davies: Running through is some weird characters and the strange thing is that all very structurally similar schemes. So you get coming up year-after-year, separated by sometimes hundreds of years. The things going line bioscience today, which I would say are completely recognizable as the same kind of taking place in the mining industry during the gold rush. When you got something like that, you know there's truly deep economic structures here which is showing us any different historical context time and time again.
Deidre Woollard: That's a really interesting point because that brings me to my next question is, in the book you compared the Theranos scandal with gold mining scams. I thought that was really interesting and in an instructive way for investors to think about biotech in general. Can you explain a little bit about how that works?
Daniel Davies: Yeah, I mean it's true. If we start to scan one level of obstruction. How will a gold fatal mining fraud work. The way that gold mining fraud works is you've taken loan to the investors money upfront to dig the gold, and then pass it to, the past known minerals and you keep the investors going and putting more money in by so missing fraudulent geological reports. If anyone wants to know how to do this by the way, these days geological test is those facility, just take Farsi wondering when you are going to get enough gold dust to consolidate by an example.
Deidre Woollard: Wow.
Daniel Davies: Yeah. Now, you think about how biotech would works and it's exactly the same structure. You get investors money on the bases of a technology which is never going to work or where there's no technology there, you keep sending back fraudulent report of drug assessing. In both cases, everyone's accepted that it's a high risk issue. Everyone is accepted it's a small trying to make chances successful, potentially huge payoff. Either literal gold mining or a such new vaccine therapy, etc. You keep from along but did you exploit the fact that people are basically investing in something that they don't know anything about. The other thing I said and this is more of a provocative point, is that you only get fake mining frauds, in real gold race. Similarly you get biotech frauds, usually in very hot areas where there are some genuine medical reports about to happen. Always don't wait to say. Say also the absolute way for saying it. Don't wait to fully understand it yourself. It's out of money, to kind of give people advice for sales and things [inaudible 00:14:53] Because the lawful times with fraud is you have to ask yourself the question, do I want to avoid every single fraud or do I want to get rich? It's in one of those risks. It's something you need to keep your eyes open to. Both try to completely eliminate the risk of dealing with a fraudster. Maybe in speaking, don't ask, we want to totally eliminate it. The optimal level of fraud risk is not zero, the same as of any other trend of investments risk.
Deidre Woollard: That's really interesting because obviously there's so much money going into, biotech right now. There is that biotech Gold Rush happening. That does mean that there may be someone else out there who is doing something similar to Theranos that we may not even know about right now. It may look promising. We may be looking at things that aren't real. That's a real concern.
Daniel Davies: Absolutely, certainly. The way you protect yourself against risk is by diversification, by not letting sums of money on any biotech investments that you couldn't be prevent to lose. I think the rules for protecting yourself in biotech and mining fraud are in many ways, they just some sensible rules for success in any kind of investments.
Deidre Woollard: Well, I think a lot of us assume that once a company's publicly traded that maybe then it's safer. It has to file with the SCC here in the States. Clearly that's not the case, we've heard stories like Enron. What does someone need to keep in mind, even if it's a publicly traded company and even if it's been out there for a little while?
Daniel Davies: I think the thing to keep in mind is that audit is complete processable thing. Not any accounting firm is ever going to do. I mean, the sense of nature, when talking to number of [inaudible 00:16:45]. [laughs] Companies and investors paying for all this once a share holds some service and it prepares of paying more gold money. It shouldn't be surprising that auditors just don't try in things. If you look at Investors in high fraud areas like mining and biotech is really good people in those sectors. In my experience have the thing in common but they never take it on this for granted. They've always carry on channel checks. They always keep ties and make phone calls because they know that if you really want to find a crooked accountant then you can print money and in any of those frauds. I don't want and to means speak kind of paranoid about this, some hated just going around destroying culture of trusting American capitalism. Audit does not protect you because of the amounts of work that's a genuinely a line of audit will take is something that nobody wants to pay for given that, the vast majority of companies are on.
Deidre Woollard: True. I study real estate, that sort of five feet. You talked about in the book about the foreclosure crisis that happened here in the U.S. countrywide loans and the Robo signing, which was just massive. Do you think that that could happen again and we were in a different type of real estate market now, but could that happen again? Would there be a situation in which you start seeing a lot of those really risky loans?
Daniel Davies: That's a really interesting and I have to think about it actually. Because I always think of vast has being three or four scandals that happened at the same time. If we got to think really actually did they dive for the one-year economy. It was a real estate problem. Because that happened again absolutely certainly being maybe with the generation that lived through the last real estate, Robo [inaudible 00:18:52] be. But you'd have to say looking about through this real estate but we probably aren't. Those particular irresponsible learning products, those will take generations towards the comeback, you start looking for financial terminals scandals literally as you start seeing the people responsible for the last scandal [inaudible 00:19:15] die. Because that's where the institutional memory goes and that's why someone comes up with a bright idea saying, "I know how we can make loans more affordable." will just put some option and structures back in there. There's no one left around say, while you're recreating your option on will keep saying those things back. That what's happen books, maybe not for a few more years. This specific issue of Robo signing. Hopefully last one place where we could have made that some progress [inaudible 00:19:48] was related to particular operational for loans. Where you have so many people just effectively packaging loans openings to securities without ever making the investments and the capacity to keep track to let them do the paper work. I think the investor use sense of billions of US dollars was so fine [inaudible 00:20:07]. The bank have become to be educated, that if you compose particular commoners. It's a falsie company, then you can end up spending a lot more on solving the problem than fraction of the sense you saved from every mortgage that you put into the system there. They'll still be trusting of the commoners. Things like Robo signing will happen in all the sectors, but the specific disaster area with the consequences of residential mortgage back securities [inaudible 00:20:38] hopefully even more than a single generation for people's forget how badly they go causing that scam.
Deidre Woollard: I think that's really interesting to that idea that we tend to forget history, we tend to forget what happens. We let ourselves be taken over and over again, partly because like you said, once one generation goes and the next-generation, is like, "Oh, this is new, this seems interesting.".
Daniel Davies: Yeah, It's spherical.Not for me, it feels like it happens only last a week, ancient history for you. Then 10 years down the time there will be someone fully values as far in the past as the 90's, 70's where past on me. They genuinely thinking about it at all.
Deidre Woollard: That brings me to the last thing I want to talk about to, which is the current booms that are happening. There's two that I'm really fascinated by. One of them is Bitcoin. Everything that's happening there as it moves to legitimacy. The other thing that's come up really recently is the NFT. Those have suddenly out of nowhere seem to really pop up. Both of those things seem like they're really just life for scandal. What do you think about those?
Daniel Davies: NFTs, absolutely bizzare. They've come up during the time when I was editing and publishing the book, because in the book I talk about ICOs and coin refuse. Those were the big thing a year or so ago. At that time I was making the joke that, given how poorly regulated ICOs were, and given how much money people were investing in them, anyone who was carrying out securities fraud was a damn fool because you could do the same thing, for the same money, with much less risk in ICOs. In fairness, the SCC got their act together with respect to ICO regulation, and it's a lot harder to go around effectively carrying out unregulated fraudulence securities interest and issuance through the ICOs. But now we've got NFTs and it's hard to even call an NFT a fraud because someone will sell you one. What does this give me ownership of? They said nothing and if they promised you nothing then you can hardly come back in 10 years time, when you've lost all your money, and say this thing was worth nothing, because that was pretty much in the prospects. It's very weird to me and to be honest, without wanting to cast aspersions on any particular person or transaction, this, to me, looks like a solution to the biggest problem the criminal industries had over the last 18 months. Which is that money laundering became suddenly impossible with the pandemic because it's no longer possible to have a neighborhood pizza restaurant that's claiming $50,000 of cash takings every week. I was just looking it up this morning for one of my consulting clients. I'm in London and the UK FCA has a list on its website of 24 companies it knows about that are unlicensed, unregistered for any financial services at all, running Bitcoin ATMs in bars and convenience stores around South London. To me, what's going on with Bitcoin at the moment? All sorts of interesting things but also it's a solution to someone's problem of how to get a hold of a load of spare money that they need to launder. So when you see NFTs going back and forth, evaluation is just in that range of a few multiples of the suspicious transactions reporting thresholds and that makes me raise eyebrows. That makes me think that there's some kind of criminality going on here and that usually means that someone's going to come in and step on it from the regulatory side, and in my view probably better sooner than later.
Deidre Woollard: Interesting, because I feel like right now there's so much hype around NFTs and I feel like a lot of people who may have not bought in at Bitcoin when it first came out and now see the valuations for it, think, "Oh, well, NFTs might be where I can get in now and I'm going to have the same trajectory as Bitcoin." But it seems like it's hard to know because there's so many NFT offerings. There's the digital art aspect of it that a lot of people are investing, that seems to me like it's going to be the Beanie Babies of the 2020s, I'm not really sure. What do you think about that, the art perspective?
Daniel Davies: I was just going to mention Beanie Babies too, which comes to show that there's nothing new under the sun. When you have low interest rates, when you have low trust in some parts of the financial markets, you get strange investment crazes, and one of the things that actually interests me is that there is a considerable historical connection between epidemic disease and investment crazes. The original "to Romania" in the Netherlands took place during an outbreak of the bubonic plague. It was a very similar phenomenon to some of the things we're seeing here which was that you had a load of bored merchants in the town of Hull, and they couldn't really carry out their trade so they hang around in bars making increasingly crazy trades into their futures. Because they were shut down for a pandemic and everyone's in this state at the mind where I think, where there's a slight sense of unreality to the economy. You've got quite a lot of people who've been economically hardly hit by the pandemic. We've also got quite a lot of people whose incomes haven't been affected but their consumption's gone through the floor. So they've got a whole load of excess savings that don't really necessarily feel all that real to them. A bit of a turn turn theory but I think that a lot of that is feeding into some of these odd manias and panics that we've been seeing over the last 18 months.
Deidre Woollard: Wow that is fascinating to me because it makes me think of what we've been having here in the US with stocks that are getting pushed on Reddit, like GameStop and those other things and people investing. There's been so much money going into Robinhood for people starting to play with the stock market in that way and so that's really interesting. Was there a connection with the 1918 epidemic and any other? Was that when the stock market run started to begin or, what do you think came out of that particular pandemic? Is there any connection?
Daniel Davies: It's hard to tell, there's arguments over that. It's hard to tell because there was the first world war going on at the same time as what was then called Spanish flu. Certainly, it was a great time to be in the market in the USA but a lot of that was probably flying capitalist from Europe at the same time. The other example that someone suggested to me was that there was a flu pandemic in the 1950s in some parts of Europe, that seemed to be connected with, not so much investments, but a huge surge in gambling. There was a whole load of racetrack and casino gambling. As you say, with the Reddit and wallstreetbets, they've got it right there in the name. To a large extent these things are substituting not so much from pre-investment as for the same kind of thrill that people get out of casino or sports gambling.
Deidre Woollard: That makes so much sense. Well, thank you so much for your time today and just to wrap up. Any one sentence that you could give people to keep in mind as they're evaluating things?
Daniel Davies: What I would say is, I'll give away one of the secrets from the book, which is that, if something is growing very fast it needs to be checked out and it needs to be checked out in a way that it hasn't been checked out before. These frauds are put together like stage scenery, they only look good from one angle. If you look at it from a different angle then often you will see that a fraudster can only make something look good in certain ways. [MUSIC] They can't create everything that gets checked. Check it out in a way that it's not being checked out before would be my advice.
Deidre Woollard: Well, thank you so much, this was fantastic.
Daniel Davies: Great. Oh thanks so much Deidre, have a great day.
Deidre Woollard: All right, you too. Bye.