Worst Scams Aren’t Done Alone

As business students, we have a constant mantra that we hold dear to our hearts — one of profit maximization. That, in essence, is our only overarching objective within any activity pertaining to our careers or investment habits. However, how can one predict or construct activities that achieve this purpose? Most rational investors would look up investments that have managed to generate the highest positive returns over decades and commit their trust to these. However, with these methods come assumptions that the financial markets are on an even playing ground, whereas in reality, they may not be.

I have always been obsessed with financial crime and the different, and arguably creative, schemes that criminals use to essentially scam or rob the general public of their money. We can take the example of a Ponzi scheme which relies on the trust of people. A Ponzi scheme is an investment scam that attracts an initial amount of funds from a set of naive investors. This capital base itself then attracts other investors’ funds which would eventually be used to pay off the earlier investors’ commitment and so on. The main idea is that these financial instruments contain no value and trick people into excessively high returns that are still within a reasonable range. The mantra of profit maximization then clicks in, making naive investors forget about the fundamentals since the glamor of high future returns makes them blind about the fact that such an opportunity is probably too good to be true.

Let’s deviate from Ponzi schemes and talk about another financial scam that gained success for similar reasons. We can take the example of arguably the biggest Indian financial scammer to date, Harshad Mehta who robbed the Indian financial markets of over 5000 crore rupees. In today’s USD, that would be around 603 million dollars. His scheme rested on the inefficiencies of the bonds and money market in the 80s and 90s. When banks wanted to make transactions of bonds and other money market instruments, they used external brokers to help them find the best deals in the market. Mehta was one of these brokers that handled the transactions of a lot of government-owned banks, one of the biggest being the State Bank of India. Although its legality was questionable, these banks transferred cash directly to the brokers so that they were able to capture the best deals as soon as they saw them. 

Mehta found a way to exploit this accepted market practice by taking the large funds provided by banks to invest in the stock market within the gap of time in which the banks expected their securities. He was one of the biggest bulls who inflated certain stocks’ prices partially due to pumping excessive sums into stocks or by spreading rumors / insider information about a stock’s future excess growth. Thus, similar to a Ponzi scheme, a lot of his success was due to the trust he had built with people, using promises of high future returns as long as the public closely followed all his steps. What was even more worrying were the kinds of theories he had developed to justify buying into his favorite, already overvalued stocks. For example, one of them was that companies’ stocks should not be valued on their earnings but rather how much it would take to sell the company. Another was the fact that, contrary to traditional investment research and valuation methods, stocks with high P/Es were buys. One of Mehta’s greatest strengths was his charm, as he constantly appeared in magazines, wrote financial columns with these ridiculous theories and spoke regularly in the press. Thus, he was more of a personality that gave hope of glamor in people’s hearts rather than an investor who had well-defined knowledge of fundamentals. Yet, naive investors trusted his every word having seen his rags to riches story. Unaware of its illicit nature, people were blinded and thought that his was the way to go.

This story may not sound scary enough, since we are educated on finance and critical thinking at SSE, however, it may not necessarily be single entities that manipulate investors’ trust. What if it was a whole institution, or worse, a whole system? The causes of the 2008 financial crisis are a reflection of this sentiment. In this period, there was a lot of financial engineering in the form of mortgage-backed securities that covered a lot of subprime debts, disguising them as low risk, AAA investments when they were actually quite the opposite. Furthermore, large investment banks were not carrying these securities since they sold them to external investors and were thus not carrying the risk, however, still being over-leveraged to try and maximize shareholder returns due to immense confidence in the market at the time. These banks also built up the trust in people to invest in the housing market with risky subprime loans before downturns and defaults on these loans inevitably materialized. However, the trust that was built up was not necessarily through banks, but rather through the normalization of a banking system that made people forget about the simple economic cycle where a bubble is always followed by a crash.

I am not suggesting that people could’ve been smarter or should’ve predicted these crashes before they happened. What I am suggesting is that financial scams that flourish, leading huge sums of money into the pockets of a few sly individuals, do not come about on their own, but rather, they come about because of public “contribution.” A lot of trust and confidence goes into such large-scale operations that show a promise of future wealth but never deliver.