The Subtlety of Evil in a Complex World

Edward J. Steffes
Unitarian Universalist Fellowship at Salisbury
April 27, 2008

Some forms of evil are very old and very obvious.  We humans have always been pretty good at finding things to fight about and ways to hurt each other, although the conditions under which we live affect the frequency and nature of our conflicts.  Anthropologists have found high levels of social cooperation and sharing in small-scale hunting-and-gathering societies, but even they were not without their interpersonal quarrels and individual acts of violence.  One of the saddest facts about human history is that the same advances that enabled people to produce more wealth and support larger populations, such as farming and animal domestication, also gave them more to fight over, as tribes and eventually states competed to control resources such as land, animals, and human laborers. Democratic nation states have had some success in combating certain evils, such as slavery, but their size, diversity and continual self-transformation create many points of tension and conflict.

Some of the crudest forms of evil still threaten us today.  We can be murdered, raped, robbed, assaulted, or burglarized, just to mention five of the seven crimes the FBI counts in its crime index.  War is still very much with us too, and has the potential to be more lethal than ever.  But in addition to these old and obvious threats, we are vulnerable to distinctly modern ones, such as having our identity stolen or having our computer files destroyed by a virus.  The scale and complexity of modern society makes people interact in complicated ways, and the harm that can be done is often much more subtle and sophisticated than a direct personal attack.  As a result, we have to be more sophisticated in how we understand evil and how we go about combating it.  There’s no use in railing against sin if we are naïve about the nature of the threats that confront us today.  We can preach “Thou shalt not steal,” but we better also be prepared to address the subtle forms of stealing that exist in a complex economy.

Recently I read two books that talk about robbery: The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, by William Black [1] and The Battle for the Soul of Capitalism: How the financial system undermined social ideals, damaged trust in the markets, robbed investors of trillions—and what to do about it, by John Bogle [2].

These books are admittedly using the word “robbery” a little loosely.  The FBI’s Uniform Crime Reporting Handbook defines robbery as “the taking or attempting to take anything of value from the care, custody, or control of a person or persons by force or threat of force or violence and/or by putting the victim in fear.”[3] By that definition, the activities described in these books are not robberies; they are more subtle than that.  We can more accurately describe them as financial fraud or mismanagement.  In many ways they are more insidious than robbery, because they can victimize people on a large scale without many of the victims even knowing they’ve been harmed.

Fraud in the savings & loans

The S&L crisis of the 1980s may seem like old news now, but it has a lot in common with the more recent subprime lending crisis.  The looting of the S&Ls by dishonest businessmen falls into the category of “fraud.”  The FBI defines fraud as “the intentional perversion of the truth for the purpose of inducing another person or other entity in reliance upon it to part with something of value or to surrender a legal right. Fraudulent conversion and obtaining of money or property by false pretenses.”[4]  More specifically, the looting of a financial institution is called a “control fraud,” in which the perpetrators use a company they control both to carry out the fraud and to cover it up.

In the 1980s, such a fraud was not a rare or isolated occurrence in the S&L industry.  There was a pattern of dishonest behavior that illustrates how our complex economic and political system can encourage subtle forms of evil.  Three factors that contributed to these frauds were a spike in interest rates, excessive deregulation, and the role of money in politics.

Some of you will remember that around 1979, the Federal Reserve Board under Paul Volcker raised interest rates in an effort to slow down the economy and reduce inflation.  This created a problem for the S&Ls.  They needed to pay higher interest to depositors, or else the depositors could take their money where they could get a better return.  But it wasn’t easy for them to charge their borrowers more interest because their loans were typically 30-year fixed-rate mortgages. 

Deregulation came to the rescue.  The Reagan administration believed that businesses could operate more effectively if they were freed from the burden of too much regulation.  The S&Ls were deregulated in a number of ways, especially through the Garn-St. Germain Act of 1982.

  • They could pay higher interest rates to depositors
  • They could make other kinds of loans besides home mortgage loans
  • They could be owned by one individual
  • They could lend up to their entire net worth to one borrower
  • Their accounting rules changed in numerous ways, making it easier for them to show a profit even when they were in trouble
  • And regulators would examine their books less often.

The Reagan administration was determined to avoid closing troubled S&Ls.  Their deposits were federally insured, and a federal bailout would add to the deficit at a time when Reagan was claiming to be able to cut taxes, spend more on defense, and still balance the budget.  The more permissive accounting rules made it possible for S&Ls to remain open and appear more profitable than they were.  Some deregulation was necessary, but it went so far that it created a golden opportunity for con artists. 

Here’s a rough idea of how I might defraud an S&L, if I were an unscrupulous businessman:

What’s really scary about this is how easily almost everybody was fooled by such schemes: the accounting firms that audited the books, the Congress, leading economists, the media, and of course the general public.  The most competent and honest regulators at the Federal Home Loan Bank Board, which regulated the S&Ls, did catch on eventually, when they saw mile upon mile of empty office buildings in cities like Houston and high rates of default on loans.  But when they tried to rein in the con artists, they ran up against the third factor I mentioned, the role of money in politics.

Many of the con artists were major political contributors and had many friends in high places.  Some of the worst S&Ls in Texas had close ties to House Speaker Jim Wright.  The best known of the businessmen under investigation, Charles Keating, had the support of the Senators who came to be known as the “Keating Five”: Alan Cranston, Dennis DeConcini, John Glenn, Donald Riegle and John McCain.[5]  The con artists were able to get Congress to pass legislation that weakened the Bank Board, and they got President Reagan to replace the head of the Bank Board with someone who would go easy on them.  The new head than tried to block his own field offices from investigating the failing S&Ls.  By dragging their feet on the investigation, the administration managed to keep the scandal from breaking until after the 1988 election.  Vice President George Bush, Sr., who had been the administration’s point man on S&L deregulation, was elected President, largely on the strength of his “read my lips, no new taxes” pledge.  Meanwhile the S&L frauds were costing the taxpayers at least $150 billion, which averages out to about $1,600 for every household in the country at that time.  (And this was twenty years ago, when the dollar was still worth something!) 

Although I’ve mentioned a few of the key players in the scandal, the subtlety of the evil makes it hard to blame the scandal on a small number of individuals.  It developed out of policies that weren’t evil in themselves and were very popular at the time: raising interest rates to fight inflation, reducing government regulation, and funding election campaigns with private contributions.  Often all it takes to create a fiasco is to take a reasonable idea and carry it to an extreme.

Poor stewardship of mutual funds

John Bogle’s book describes a kind of rip-off that is even more subtle than fraud.  Unlike the savings and loan scandal, which was mostly a phenomenon of the 1980s, it is a continuing problem that has hardly begun to be addressed.  I would call it a problem of poor stewardship, the failure of mutual fund managers to operate their funds in the best interests of investors.  Stewardship is an ethical concept, but it does have some basis in law.  The Investment Company Act of 1940 says that mutual fund managers must run their funds in the interests of the investors, not just in their own interest.  

We have heard a lot in the last eight years about the so-called “ownership society,” in which more people own their own homes and own stock in corporations.  We now know that the high rate of home ownership was achieved partly by making shaky mortgage loans that are now going into default.  And although more workers do own stock through retirement plans, most of those accounts are small, and a lot of that new wealth has been offset by the dramatic decline in traditional pensions.  The number of owners may have increased, but the shares of ownership have become more unequal, with the richest tenth of the population owning more of the national wealth that at any time since the 1920s.  Bogle argues that we have been moving toward a system of “managerial capitalism,” in which managers have been allowed to become more and more self-serving.  This is the context in which he discusses the poor stewardship of investment funds by mutual fund managers.

Now I have to ask your indulgence, because I think the Bible says you’re not supposed to do math problems on the Sabbath.  But I need to remind you of something you probably learned in school, and hopefully also have learned from experience.  When you compound percentages over many years, a small difference in percentages can produce a large difference in results.  If you borrow $100,000 in a fixed-rate mortgage for 30 years at 6%, you will pay about $116,000 in interest over the course of the loan.  But if you have to borrow the money at 7%, you will pay $140,000 in interest.  That extra 1% costs you about $24,000 in additional interest. 

When you invest your money, each percentage point you earn on your investment is equally important.  Suppose you are saving for retirement through a tax-sheltered retirement plan.  You invest $4,000 a year for 25 years, for a total investment of $100,000.  To simplify the discussion we’ll assume that this money is invested in stock mutual funds, although you would also want to invest some of your retirement money in something more conservative.  Let’s say you earn a return of 10% a year, which is close to the long-term historical average for the US stock market.  At the end of the 25 years, your $100,000 investment has grown to $393,000, and you have a nice nest egg to supplement your Social Security in retirement.  But if you earn only 1% less, your $100,000 grows to only $339,000, a difference of $54,000.  If you earn several percent less, the difference is enormous, as we’ll see in a moment.  Bogle’s concern is that the typical mutual fund investor is getting far below a market return because of the way most mutual funds are organized and operated. 

One reason for that is a big change over the last half century in how mutual funds are organized:

In the industry’s early years, funds were run by small, privately held professional firms that could make a tidy profit by managing money but could not capitalize that profit by selling shares of the company to outside investors.  The SEC maintained that the sale of a management company was the sale of a fiduciary office, and that the profits reaped by the manager from the sale represented an illegal appropriation of fund assets…
But a California management company challenged the SEC’s position.  In the ensuing court battle, the SEC lost.  As 1958 ended, the regulatory wall that had prevented public ownership of management companies since the industry began thirty-four years earlier came tumbling down.[6]

The public ownership of mutual fund companies meant that the fund managers were now responsible to two groups of people with somewhat conflicting interests: the investors in the funds, who wanted the best possible return on their investment, and the shareholders of the management company, who wanted the company to take a large part of the returns as profit. And increasingly, mutual fund companies have come to be owned by giant conglomerates that focus more on sales and profits than stewardship. Mutual fund companies could have increased their profits just by increasing their assets under management, since investments in mutual funds increased from a mere $2 billion in 1950 to $8 trillion in 2005.  In fact, because of economies of scale, they could easily have cut the rates they charge investors and still made a fine profit.  But instead they did the opposite: They increased the annual percentage taken by management.  The “expense ratio” of the typical stock fund increased from 0.77% of assets to 1.56% of assets.

That’s the first bite to come out of investors’ gains, but we’re just getting started.  A second problem is that there are additional hidden costs that you won’t read about in the prospectus, especially trading costs.  Mutual funds used to be largely buy-and-hold operations.  They assembled a diversified collection of stocks and held them for a long time, typically turning over only about 8% of their portfolio a year.  Now they turn over about 40% a year, indicating that the funds are trying to make more money by timing the market.  One fund sells a stock, thinking it is about to go down, while another buys it, thinking it is about to go up.  They can’t both be right, but both have to pay the transaction costs, which are quietly passed along to the investors.  Research suggests that hidden costs reduce the returns of the average investor by another 1 to 1.5%. 

And we’re not done yet.  We also have solid research showing that the typical mutual fund investor does even worse than the very funds which he or she holds, even after fund expenses are taken into account.  This paradoxical finding results from a combination of the way investors behave and the way funds are marketed.  Bogle describes it this way:

While the conflict of interest between fund managers and fund owners explains the large cost-driven gap in long-term performance between the average fund and the stock market itself, there is another major conflict that has cost fund investors even more.  Fund managers have moved away from being prudent guardians of their shareholders’ resources and toward being imprudent promoters of their own wares.  They have learned to pander to the public taste by capitalizing on each new market fad, promoting existing funds and forming new funds, and then magnifying the problem by heavily advertising the returns earned by their “hottest” funds, usually highly speculative funds that have delivered eye-catching past returns.  This focus on marketing has had a profoundly negative impact on fund investors, who have paid a huge penalty both in the timing of their fund purchases and in the selection of funds they purchased.  As a result, mutual fund shareowners have fared far worse than have the funds themselves.[7]

Let me explain this further.  A mutual fund company might be running fifty different funds, but it calls attention to the ones that have been doing well recently.  So we get a lot of ads for “5-star” funds, and a lot of media hype about them.  Money then flows into those funds, but a lot of it comes in after a hot streak, which is often not sustained as market conditions change.  Statisticians talk about “regression toward the mean,” which in this context means that the hotter the streak, the more difficult it is to sustain.  For most investors, performance-chasing is a losing strategy, because it puts them behind the curve, buying things after they’ve gone up and selling them after they’ve gone down.  As a result the biggest gains go to the few, while the biggest losses go to the many.  Research at the University of Michigan concluded that this cost the average investor 1.3% a year for stocks listed on the New York Stock Exchange, and even more for investments in the Nasdaq or foreign exchanges.[8]

And one final problem is that most employees invest through company-sponsored retirement plans that charge perhaps another quarter-percent or half-percent for administrative costs.

Putting it all together, the average investor in stock mutual funds is probably lagging the market by about 4 percentage points.  Going back to our investment of $4,000 a year for 25 years, a 10% return gave us a total of $393,000, but a 6% return gives us a total of only $219,000, a shrinkage of $174,000, far more than the $100,000 you invested in the first place.  Since financial planners usually recommend that retirees withdraw no more than 5% a year from their nest eggs, that would reduce your annual withdrawal from close to $20,000 a year to only $11,000 a year.  What is remarkable is that this enormous drag on performance is almost completely unnecessary.  Some mutual funds go out of their way to avoid the things that erode returns: the high fees, the overactive trading, and the encouragement of performance-chasing by hyping recent returns.  These good stewards deliver over 90% of the market’s gains to their investors.

In 2003, the Senate subcommittee on Financial Management, the Budget, and International Security held hearings on the mutual fund industry.  Senator Peter Fitzgerald, the Republican chairman of the subcommittee, stated:

It’s time for a wholesale reexamination of how mutual funds are organized and managed.  The governance structure of a typical mutual fund is a study in institutionalized conflicts of interest.  Until we eliminate the conflicts, lots of mutual funds will continue to engage in behavior that benefits fund managers at the expense of fund shareholders….The mutual fund industry is now the world’s largest skimming operation—a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings.[9]

Again I want to emphasize that this is happening at a time when fewer workers are guaranteed a pension, and so their retirement depends on their mutual fund returns.  Corporate managers have been shifting the risks of retirement investing to their employees, and then retirement fund managers have been putting the investors at even more risk by failing to live up to their fiduciary responsibilities.  And it’s all being done so quietly that hardly anyone is making an issue of it. 

Perceiving subtle evils

Subtle evils are by definition difficult to perceive.  They don’t stand out clearly enough from the everyday policies and practices of our society.  Last week John Wright talked about the importance of how we frame issues.  Many Americans—and especially many economists—put economic behavior in a very rosy frame, describing it with value-laden words like rational, natural, and free.  If you see economic behavior as the decisions of rational people acting according to the natural economic laws of the free market, then what’s to criticize?

One of William Black’s complaints is that economists have practically theorized fraud out of existence by relegating it to the realm of the irrational.  In a free market, you see, very little fraud should occur, because if you’re caught at it it’s very bad for business.  It would be irrational for customers to tolerate it, and therefore irrational for businesses to commit it.  One judge was so enamored of this theory that he dismissed a fraud case without hearing the evidence, on the grounds that the accounting firm in question couldn’t have engaged in the alleged behavior because it had too much to lose by doing so.  I think this is a promising line of defense in other criminal cases.  (“Your honor, I couldn’t possibly have killed my wife; it would have been so foolish of me!”  Case dismissed!) 

All theories make assumptions.  The idealized model of a free market made up of rational decision makers assumes a high level of transparency.  Each actor can see and understand what the others are doing.  But the whole point of a con game is to hide what you’re really up to, thus getting the victims to act against their rational self-interest.  This is especially easy when ordinary people are confused by the financial transactions in which they participate, whether it’s a tax-sheltered annuity or an adjustable-rate mortgage.  As Daniel Yankelovich said recently, “The whole notion of capitalism is supposed to be enlightened self-interest; what we have now is unenlightened self-interest.”[10]  Dan Reingold, who was one of the leading stock analysts of the 1990s, ended his book about Wall Street by saying:

Of all the lessons I’ve learned in my time on the Street, the most difficult one to swallow is that I no longer believe in the transparency of the American financial system.  When I came to the Street, I saw it as a place where there were plenty of sharks, but also as a place where American capitalism reigned supreme, a place where everyone had a chance to do well if they were smart, hardworking, and a little bit lucky….
But I…came to realize that for people who don’t have access to [the] inner sanctum, Wall Street is not a game at all.  It’s deadly serious, and it’s rigged against most of its participants—everyone but the few with a seat at Wall Street’s special tables.[11]

A rational economic system is not an accomplished fact, but an ideal for which we struggle.  A large part of the battle for better behavior must be a battle for disclosure, a battle for honest accounting and straightforward financial statements.  The Department of Labor just released in December a set of proposed rules for fee disclosure in 401(k) plans, so employees can find out what it’s really costing them to have a particular company manage their plan.  I would also like to see performance data for mutual funds presented in a manner that is more relevant to the individual investor: not just the fund’s rate of return over x number of years, but the rate of return for the dollars you actually invested in the fund, with a comparison showing what those dollars would have earned in an appropriate market index such as the S & P 500.  Then you could actually see the shrinkage Bogle describes.

Those of us who would like to see economic reform have to contend with another belief that frames discussion: that the economy runs according to natural economic laws, and it works best when it’s left alone.  Ronald Reagan endorsed this laissez-faire view of the economy when he said that government isn’t the solution; government is the problem.  I’ve never understood why we should regard the capitalist economy as any more “natural” than any other human institution.  The pursuit of self-interest and profit may come naturally to humans, but so does the quest for community.  Competition may be natural, but so is cooperation.  Participating in economic exchanges may be natural, but so is making rules to govern those exchanges. The rules of the marketplace are not just natural laws, but rules that people make, often through a political process.  Corporate managers may disparage government and politics, but that’s a little hypocritical, because they are often actively engaged in shaping the rules through their lobbying, campaign contributions and lawsuits.  In 1978, the Supreme Court gave bankers a great victory by ruling that banks chartered in one state are not subject to the usury laws of any other state in which they do business.  The result was a boom in predatory lending, as financial institutions rushed to offer high-interest loans to financially shaky borrowers they previously would have avoided.  Recently those lenders got Congress to tighten the bankruptcy laws to make it harder for the borrowers to escape their debts.  If it’s okay for policymakers to protect the interests of the powerful, why is it any less legitimate for them to protect the interests of the less powerful?  Laissez-faire economists seem to confuse democracy with weak government, the kind of government that looks the other way while powerful financial interests rig the system for their own gain.

And finally, I have no objection to using the idea of freedom to frame our discussions of behavior, as long as we include more than one conception of freedom.  When conservatives use the term, they are often talking about economic freedom or free-enterprise capitalism, especially the freedom of managers to run their businesses as they see fit.  But if free competition results in enormous disparities of wealth and power, some people may be free to get away with too much, while others are deprived of meaningful choices.  And as Abraham Lincoln said, “Those who deny freedom to others deserve it not for themselves, and cannot long sustain it.”  In that situation, a more liberal conception of freedom becomes important: the freedom of the weaker players in the market—consumers, workers, small investors—to organize themselves, especially through government, to liberate themselves from the oppression of the economic predators.  And so when liberals talk about freedom, they are more likely to be talking about political democracy as a remedy for the excesses of free-enterprise capitalism.  Conservatives may feel that government regulation is bad because it threatens our economic liberties, while liberals may feel that unregulated capitalism is bad because it threatens our democracy.  I would also suggest that public opinion tends to vacillate between these two positions.  When Ronald Reagan was elected, the prevailing sentiment was that Big Government was undermining capitalism.  Now public opinion seems to be shifting more toward the position that runaway capitalism is undermining democracy.  This is the view, for example, of Robert Reich’s recent book Supercapitalism.[12] 

The freedom we experience in modern society then, is both part of the problem and part of the solution.  Our complex world offers us more freedom than ever to devise complicated schemes to fool people and separate them from their money.  But it also offers us the freedom to wise up, to inform ourselves, to organize and take collective action for our own protection.  Only then can we be delivered from the evils that beset us, and only then can we be truly free. 

References

[1] William K. Black, The Best Way to Rob a Bank Is to Own One. Austin: University of Texas Press, 2005.

[2] John C. Bogle, The Battle for the Soul of Capitalism. New Haven: Yale University Press, 2005.

[3] http://www.fbi.gov/ucr/handbook/ucrhandbook04.pdf , p. 21.

[4] Ibid, p. 140.

[5] John McCain probably did less than the others to support Keating, but he did accept large campaign contributions from him; he also accepted vacation trips from Keating that he failed to report; his wife invested in one of Keating's real estate projects; and he did attend two unusual meetings in which the senators met with federal regulators specifically to complain about the Keating investigation.

[6] Bogle, p. 177.

[7] Bogle, p. 164.

[8] Ilia D. Dichev, "What are stock investors' actual historical returns?" American Economic Review: March 2007, 386-401.

[9] Bogle, p. 194.

[10] Shelley A. Lee, "Daniel Yankelovich on the Pulse and Voice of the American Public." Journal of Financial Planning: December 2007, p. 26

[11]Dan Reingold, Confessions of a Wall Street Analyst: A True Story of Inside Information and Corruption in the Stock Market.  New York: HarperCollins, 2006, pp. 314-15.

[12]Robert Reich, Supercapitalism.  New York: Alfred A. Knopf, 2007.