If it’s too good to be true, it’s too good to be true.

Yesterday i wrote about recognizing lies.  It is also fundamental to anyone who deals with contracts that they recognize that the higher a price one gets, the higher a risk one is taking.  So, if you buy “junk” bonds, you are getting a high interest rate, but along with the high interest rate comes a high risk you’ll get paid nothing at all.  That’s why they are called “junk” bonds — they’re the bonds of high-risk borrowers.  If you want to lend to those borrowers, you might get a lot back, but you might get nothing.  You can assume, therefore, that if you are told you can’t lose — that you’ll always make money, — that the risk you are taking is infinite.

These are the fundamental points Ben Stein made in this last Sunday’s New York Times when he connected the Bernie Madoff fraud, the sub-prime mortgage crisis, and the 80′s rise and fall of Drexel Burnham Lambert, the investment bank that specialized in the junk bond market:

ABOUT two years ago, a little delegation from a major investment bank arrived at my home in Beverly Hills. These nice young people were from the bank’s “wealth management division.” I told them straight away that I didn’t have anywhere near enough wealth to make their trip worth their time, but they smilingly insisted that we could help each other.

They told me that if I invested a certain sum with them, they would make sure that a large chunk of it was managed by a money manager of stupendous acumen. This genius, so they said, never lost money. He did better in up markets than in down markets, but even in down markets he did well. They said he used a strategy of buying stocks and hedging with options.

I protested that a perfect hedge would not allow making any money, because money made on the one side would be lost on the other. They assured me that this genius had found a way to spot market inefficiencies and, indeed, to make money off a perfect hedge.

I thanked them for their time and promptly looked up Bernard Madoff online. Nothing I saw was even a bit convincing that he had made a breakthrough in financial theory. . . .

My point is not that I was so smart. I am not and I was not. Mistakes are a big part of my life. My point is that, as humans, we seem unable to learn from our mistakes very well.

I have never heard of an entity that could make money in all kinds of markets consistently, year in and year out. Yet we continue to believe that there will be one.. . .

The same goes on a much larger scale for the debacle of subprime mortgages. In essence, it is a much larger version of the Drexel Burnham Lambert junk-bond debacle of the 1980s. Back then, investors were charmed by the idea that the lower-ranked the bond, the more money it would make. It seemed like a great idea: there’s this little corner of the market that the big boys turn up their noses at. But in this little corner, huge money is made. It’s almost like the myth that you get great bargains in poor parts of town.

In fact, the Drexel episode should have taught us to be wary, indeed, of poorly rated debt. But it didn’t. The new version of the myth was so alluring that it drew in not just billions of dollars from lenders and mortgage bond buyers, but much more in derivatives linked to the myth.

Knowing liars

Lawyers should be good at spotting fraud, but they often aren’t.  Same thing with historians. But this time the historians got it right:

About that fabricated (and now canceled) Holocaust memoir, by Herman Rosenblat, which David Mehegan writes about at Off the Shelf … Lesson: sometimes professors know what they are talking about.

Deborah Lipstadt called it a year ago. Here’s Lipstadt, a professor of Modern Jewish and Holocaust Studies at Emory, writing on December 7, 2007: “There is a Holocaust story making the rounds on the Internet which is clearly not true.” At this point, she seems to think it’s just a bit of Internet flotsam: “If you get this email do NOT send it on to other people. Delete it.”

Proceedings of the Old Bailey, 1674-1913

I just discovered The Proceedings of the Old Bailey, 1674-1913, a fully searchable edition of the documents from the 197,745 criminal trials held in London’s central criminal court during that period.

According to John Langbein, the Proceedings are “probably the best accounts we shall ever have of what transpired in ordinary English criminal courts before the later eighteenth century”. Although initially aimed at a popular rather than a legal audience, the material reported was neither invented nor significantly distorted. The Old Bailey Courthouse was a public place, with numerous spectators, and the reputation of the Proceedings would have quickly suffered if the accounts had been unreliable. Their authenticity was one of their strongest selling points, and a comparison of the text of the Proceedings with other manuscript and published accounts of the same trials confirms that what they did report was for the most part reported accurately.

The database is a treasure trove for historians and the curious.  A random search for a topic of some interest to me, stock fraud, undearthed the case of “Richard Slocombe the younger, who was indicted for feloniously and deceitfully impersonating” his father, thereby securing for himself £50 of the £450 worth of “South Sea Annuities” owned by his father.  The records include transcripts and summaries of some of the trial testimony.  Here is the report of Mr. Slocombe’s testimony in his defense and the testimony on his behalf by his uncle.

Prisoner’s defence:

From what I had conceived and collected from discourse between my father and mother, this was mine upon my coming to age; my father is at these years reduced to a degree of insanity, he cannot recollect one half hour what he spoke the last; I am fully persuaded if my mother and sister were here, they would coincide perfectly in what I advance in every respect; as to the transfer, I signed nothing but my own name; if I had been conscious I was doing wrong, I should have made but one transfer, and took all the money at once; I did not act with any view of defrauding, therefore I most humbly hope you will take it in the most favourable consideration and construction; I am not particularly desirous of calling my father.

To his [Slocombe's] character:

John Pierce . I am the prisoner’s uncle; I never knew but that he always bore a good character, he was always very dutiful.

Richard Slocombe the younger was found guilty and was executed.