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Wednesday, 17 February 2010

Financial Lessons in Mass Deception

Deceit, Incorporated

One of the things you may have noticed as we’ve parlayed our way around the world of finance is how much of what goes on seems to be hidden beneath the surface. It’s almost as though most of the people involved were out to deceive us in an attempt to part us from the limited savings we’ve managed to keep out of the clutches of the taxman.

In fact, at one level, that’s probably exactly what’s going on. Market participants are engaging in an escalating war of deception to persuade people to give them their money. Taken to extremes this even goes so far as to encourage the citizen in the street to lie in order to boost the coffers of the securites industry. All of which is what you get when you replace the natural processes of social trust with actuarial projections.

Communication Equals Deception

There’s a not unreasonable theory that our giant brains have evolved to enable us to lie convincingly. The idea that there are certain tricks we can use to detect people engaging in deception are wrong – the studies that have been carried out in this area show, convincingly, that mostly we don’t have a clue when someone’s pulling our chain. Well, unless the researchers are lying of course. The most famous research in this area has been carried out by Paul Ekman – see (for example) Who Can Catch A Liar? in which Ekman and O’Sullivan show that most experts can’t detect liars. We're not exactly surprised.

As social animals we developed the capacity to interact and work together in order to protect ourselves in a hostile environment. Pretty much as soon as we’d started to do this some people started to freeload. There are some neat experiments, such as this one by Richard Byrne and Nadia Corp which suggest that deception in primates is related to brain size and the complexity of their social groups.

The Social Evolution of Deception

Once some apeman equivalent of a modern day snake oil merchant started engaging in deceit then an arms race developed to try to prevent this. As humans are primarily social creatures freeloaders are to be discouraged. Given that we’re pretty useless at detecting this from verbal or visual clues the most likely approach is to punish transgressors when they’re discovered. For this to have any power it needs to be a group effect and, indeed, if people lose trust in an individual within a small social network then that person can find themselves excluded. In the modern world that may not matter so much, unless you’ve just been kicked off the school football team, but in prehistoric times it would have been a death sentence.

Using social exclusion as a form of punishment for deceit would have been a powerful disincentive to freeloading. However, the underlying mechanisms which allow us to successfully and convincingly dissemble didn’t go away. We are natural liars and we do it surprisingly often. Try and keep a diary for a single day and record every fib you tell: you’ll be startled by the amount of not entirely truthful statements we make. Which brings us to the final nail: we deceive even ourselves about our lying natures. See this paper by Mario Heilmann for a discussion around the social evolution of deception.

The Collapse of Trust Mechanisms

In our much more diversely connected modern world it’s not hard to see how these basic mechanisms for managing trust can break down. Social networks are so distributed and fragile that our ability to detect fraud and then to figure out how to punish people by exclusion are diminished almost to the point of being completely ineffective. Unless you’re a celebrity, of course, and then your transgressions will get splattered all over the media and you’ll be rewarded with a whole new stream of sponsorship deals. Strange inverted world we live in.

Given that the traits of casual deception, both of ourselves and others, seems to be built-in to our natures and that the main defence against this is through social networks then it should be obvious that the financial industry will aim to develop close, tight-knit communities with strong links between financial advisors and clients and two-way systems of social feedback – it’s not sufficient to merely punish bad customers in the event of deceit, bad advisors need also to suffer the consequences.

When The Moral Compass Goes Missing ...

Of course, this is the exact opposite of what happens in modern business networks. The relentless approach to cost cutting means that the social networks which have traditionally connected customers and advisors have been eliminated and ruthlessly replaced with actuarial models that use historical data to show how much fraud will be committed. These models don’t seek to prevent deceit but actually include it, estimating the number of freeloaders who will game the system and developing business models that include these factors.

Unfortunately, as financial institutions have found to their cost, when you take the human being out of its stabilising social network then you remove the guy-ropes that prevent our deceiving brains from coming loose and causing havoc. The surprise is not that more people than expected decided to game the system but that so few did. Actuarial models based on historical data generated in an entirely different context proved to be utterly hopeless at predicting levels of fraud in the new, socially disconnected world.

Liar Loans, Hopeless History

Liar loans are the most public of the problems and financial institutions have rightly been castigated for the lack of due diligence involved in accepting people’s word for the fact they had the means to repay them. Many were simply hoping to flip the assets they were buying for a quick profit, although others appear not to have understood the basic principles of taking a loan out. Stuff like needing to pay it back.

The securitisation of these loans – chopping them up into little bits and then repackaging them before on-selling them to other institutions – was the actuarial way of protecting against defaults. In theory, the models told us, the level of default was sufficiently low to justify high credit ratings for these securities. Unfortunately the theory was based on a history generated under different circumstances, where the loan provider and their customer weren’t totally divorced and where lying would have consequences for the former, if not the latter. Now, cut loose from the need for honesty, the historical numbers were meaningless.

Trust Psychologists, Not Economists

Of course none of this means that the lying loanees don’t bear their share of responsibility but given that trust is determined socially because we’re individually prepared to scheme and freeload if left to ourselves then the consequences of such business practices were all too predictable to anyone with even elementary knowledge of human psychology. Unfortunately it seems that the institutions involved never considered that people might behave differently under changed circumstances and left their actuaries alone to prove that historical numbers tell us about the past, not the future. Again.

That we’re born liars and our honesty is determined by how likely we are to get away without being caught and punished isn’t exactly a morally compelling message. However, being brutally realistic about ourselves is a better basis for making investment decisions than deluding ourselves with a bunch of numbers. Take a human being out of their social network and let them loose without moral constraints and what you have is a recipe for nasty things. But until financial institutions start taking financial lessons in mass deception from psychologists and taking less notice of economists engaged in their own mathematical arms race you’ll likely see this happen again and again. And again.

Related Articles: The Psychology of Scams, Gaming the System, The Rise of the Machines


  1. Hi Tim, I loved your article and posted it on Phil's Favorites, with this intro, which might make me sound clueless - what's guy-ropes?

    Insightful, excellent article about our not-so-excellent human nature. I just don't know what guy-ropes are (probably not my first mental image). - Ilene

  2. Hi Ilene

    I didn't realise "guy-ropes" was British English. They're the ropes you use to hold a tent in place, although I'm sure they've been used for other things :)

  3. Yes, evolutionary biology is a fascinating topic. Matt Ridley's work on that area was always interesting (pity he wasted so much time with Northern Rock, however).

    May I venture a suggestion? The 'liar loans' phenomenon is interesting but it may need a little more thought. You see, in many securitisation transactions, the so-called 'originator' of the loans retains an interest through subordinated debt provided to the securitisation trust, so that the 'originator' bears the so-called 'first loss' piece.

    Let me try to translate that gobbledy-gook: It simply means that the people who made the loan in the first place continue to bear some of the risk that the loan may default. To put some simple numbers to it, let's say that GBP 100,000,000 of loan are securitised and let's say that the 'originator' provides subordinated funding of GBP 30,000,000. That means that for defaults of up to GBP 30,000,000, the person who made the loan suffers the entire risk of loss. As you can imagine, that tends to have a settling effect in terms of ensuring that the borrowers are in fact credit-worthy.

  4. thanks, i'll post your definition up too, the other things are no doubt closer to what I was thinking, would never have guessed tent holders in a million years

  5. We are natural liars and we do it surprisingly often.

    This is so. And it is important to point this out.

    It is not the only thing that is so of us humans, however.

    We are also natural truth tellers. We devote enormous amounts of energy to writing songs and books and manuals that tell the truth about stuff.

    We're a mixed-up bunch. We destroy entire economies with Get Rich Quick investing approaches. Then we wade into the rubble and begin the long process of rebuilding them stronger than they ever were before.

    We've been liars and truth-tellers since the beginning. I don't think this is going to change. We just get more creative re our efforts pursuing both tasks.

    We're a funny sort of animal, that much is fair to say.


  6. Great article! But next to the fact that we are at the same time natural liars and natural truth tellers, we are also freeloaders and altruistic.

    So I don't disagree, but the take away from this article shouldn't be that people are only born liars.

    Read the work by Frans de Waal for example to get the more nuanced picture:

  7. May I venture a suggestion? The 'liar loans' phenomenon is interesting but it may need a little more thought. You see, in many securitisation transactions, the so-called 'originator' of the loans retains an interest through subordinated debt provided to the securitisation trust, so that the 'originator' bears the so-called 'first loss' piece.

    ‘Tis true but never as simple as it seems. There’s some interesting research around the Originate to Distribute model which effectively shows that those institutions which were more lax in their lending standards suffered disproportionately when everything went south, probably because they were left with a lot of very low standard mortgages which they couldn’t flip. See Originate-to-Distribute and the Sub-Prime Mortgage Crisis.

    Hi Arjan

    Great article! But next to the fact that we are at the same time natural liars and natural truth tellers, we are also freeloaders and altruistic.

    I agree: I’ve touched on altruism here: When a Dollar’s Not Just a Dollar. However altruism it evolved it must have been associated with relatively tight-knit social groups, perhaps for gene preservation. It certainly wasn’t intended to cope with situations where we’re dealing with remote, faceless individuals. Change the social situation and you likely change the response. Of course, being pithy and wide-ranging in 1200 words is always a challenge :)

  8. I have often thought about how the world of finance would be in that film 'The Invention of Lying'.

    In it nobody can lie apart from one guy. Do you think they would have sound banks?