Photo credit: David Hammons, “Too Obvious” (1996), Studio Museum of Harlem / Google Art Project
By Jason Zweig
11:18 am ET May 28, 2013
In this interview, the renowned short-seller Jim Chanos points out that the average investor is right not to trust the integrity of the financial markets. (Someone showed a nice touch by posting it on April Fool’s Day.)
In the interview, Chanos makes three important points.
First, in recent years financial fraud has rarely been detected and exposed by the people the public might reasonably expect to do so: accountants, regulators and law-enforcement authorities, whom Chanos calls “the normal guardians of the marketplace.” Instead, frauds more often have been rooted out by whistleblowers, short-sellers and journalists.
Second, prosecutions of financial crimes are essential in the minds of investors, but are discretionary in the eyes of government officials. The Bush administration cracked down on accounting fraud at Enron, Tyco and WorldCom, sending senior executives of all three companies to prison. Chanos says the Obama administration has taken the view that some banks, even those that might have been culpable in the financial crisis, can be so large that prosecuting them could destabilize the financial system – the so-called too big to jail rationale.
Third, individual investors will never trust the market until these issues are addressed.
The 2008-09 financial crisis, like the crash of 1929, could have been a perfect pretext to transform the way business was done on Wall Street. Unfortunately, despite the famous words of former White House chief of staff Rahm Emanuel — “You never want a serious crisis to go to waste“ — the opportunity has been squandered, at least in my view.
You can summarize the outcome of the financial crisis in one sentence: Good things happened to bad people, and bad things happened to good people. Some people who contributed to the crisis kept hundreds of millions of dollars apiece in compensation and will spend the rest of their lives in luxury. The victims of the crisis — borrowers, taxpayers and investors — have spent the ensuing years trying to regain some of what they lost.
As I wrote in early 2010, this kind of outcome violates a basic psychological need. Humans can’t live normal lives without believing in what psychologists have christened “positive illusions.” Among them are overconfidence, the belief that we know more than we do; the illusion of control, the sense that we have more power over what happens around us than we do; and unrealistic optimism, the tendency to think positive things are more likely to happen to us than to other people.
If we honestly accepted how little we know, how little we can control and how little advantage we have over other people, we wouldn’t be able to get out of bed in the morning. As the Nobel Prize-winning psychologist Daniel Kahneman has said, “The combination of optimism and overconfidence is one of the main forces that keep capitalism alive.”
Another positive illusion is known as “belief in a just world.” Although we all know full well that it isn’t true, humans need to believe that we generally get what we deserve, with good things happening to good people and bad things happening to bad ones. The fact that it’s an illusion is beside the point. As psychologists Melvin Lerner and Dale Miller wrote in 1978, if we all believed that the world is as unjust as it actually is, society would grind to a halt or devolve into Hobbesian chaos:
Without such a belief [in a just world] it would be difficult for the individual to commit himself to the pursuit of long-range goals or even to the socially regulated behavior of day-to-day life. Since the belief that the world is just serves such an important adaptive function for the individual, people are very reluctant to give up this belief, and they can be greatly troubled if they encounter evidence that suggests that the world is not really just or orderly after all.
A study published in 2009 concluded that when people don’t believe the world is just, they become significantly less willing to wait for a financial gain. After all, if you can’t be sure that you usually will get what you deserve, why would you ever trust a counterparty to honor its contracts or promises?
Think for a moment, in this light, about the contrast between the last two great booms and busts.
In 1999, many investors turned into speculators, day-trading absurdly overpriced Internet stocks against the advice of traditional investing experts. Many of those speculators knew they were violating the rules of common sense but gambled that they could get out before the bubble burst. When it did, they had no reason to blame “the system.” They had gotten exactly what they deserved, and they knew it; bad investing habits had produced terrible investing outcomes. They had no one to blame but themselves.
Now fast forward to 2007. Many investors had learned to diversify, to buy and hold, to minimize their gambling and think long-term. And they still went on to lose half their money — even though they had done exactly what the wisest investing pundits had long recommended.
This time, good investors got terrible investing results. Meanwhile, many traders and managers at the pinnacle of Wall Street kept much of their gains, even as billions of taxpayers’ dollars went to bail out their firms. Of course, many Wall Street executives lost billions of dollars in stock-related gains, and thousands of them lost their jobs.
If ever there was an ideal example of an “unjust world” in the eyes of some people, Wall Street of the past few years is it.
What, then, would it take to restore trust and to revive belief in a just world? Chanos didn’t say, but I think there are three possibilities.
* The first, and least likely at this point, is a ritual humbling.
In the wake of the 1929 crash, Ferdinand Pecora, who led the investigative Pecora Commission in the U.S. Senate, humiliated one banking titan after another with revelations of self-dealing and other shady behavior. Richard Whitney, president of the New York Stock Exchange, ended up being thrown into the slammer at Sing Sing for embezzlement. The outrage and revulsion that followed the post-Crash investigations led to the series of reforms that overhauled Wall Street’s practices in the 1930s.
More than a half-century later, federal prosecutor Rudolph Giuliani went after insider trading with similar zeal, even having some alleged perpetrators hauled off the trading floor in handcuffs. Some of the cases fell apart, but the public’s sense of a level playing field was restored.
However, as Michael Perino, author of a riveting biography of Pecora, The Hellhound of Wall Street, told me in a conversation last year, “It’s only when things get really bad that [the U.S. can] overcome the normal political forces that are at play and we can achieve significant reforms. At this point, it might take another crisis to do something.”
* Second, Wall Street could apologize. According to the psychologist Dale Miller, a good apology must:
take responsibility and blame for what happened,
show remorse and an acknowledgement that the rules of normal behavior are in place for good reason and shouldn’t have been broken,
include a pledge not to violate people’s trust again,
express unhappiness about what went wrong and a willingness to do something to try to make it right.
Anyone with a husband, a wife or a significant other knows all that, of course. So far, many financial titans have sounded largely unabashed and oblivious to the public perception that their firms weren’t paragons of virtue.
As the Epicurean Dealmaker has often pointed out, investment bankers are intensely competitive people who care about their fees. But as spouses know, the effort to make a sincere apology, even when you don’t entirely mean it, can help you understand the anger someone else is feeling.
This long after the crisis, however, there’s little chance of getting good apologies out of Wall Street’s kingpins.
* Finally comes the only possibility that seems even remotely feasible at this point: forgetfulness.
Time is the novocaine of markets: After a long enough period passes without further severe losses, memories blur pain fades. As I wrote earlier this month, investors have collective “memory banks,” in which shared experiences shape their perceptions. Those between the ages of 18 and 25 are especially sensitive to recent returns, since that’s all they hold in their memory banks.
An investor who retired in 2007 — and one who turned 18 that year — will have a very different view than a younger investor who first got into the market in mid-2009 and has seen U.S. stocks rise more than 150% in four years. As time passes and the financial crisis shrinks in the rear-view mirror, the stock market will seem “safer” and people will trust Wall Street again.
That brings us to the last point. Investors need to be able to trust that they will be treated fairly. But they never should trust too much. Once investors start believing that Wall Street is a friendly place where everybody knows your name and no one is out to get you, we’ll have another 1929 or 1999 on our hands.