On Financial Frauds and Their Causes Investor Overconfidence

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American Journal of Economics and Sociology, Inc. On Financial Frauds and Their Causes: Investor Overconfidence Author(s): Steven Pressman Reviewed work(s): Source: American Journal of Economics and Sociology, Vol. 57, No. 4 (Oct., 1998), pp. 405-421 Published by: American Journal of Economics and Sociology, Inc. Stable URL: http://www.jstor.org/stable/3487115 . Accessed: 09/03/2013 11:48 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . ht
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  American Journal of Economics and Sociology, Inc. On Financial Frauds and Their Causes: Investor OverconfidenceAuthor(s): Steven PressmanReviewed work(s):Source: American Journal of Economics and Sociology, Vol. 57, No. 4 (Oct., 1998), pp. 405-421Published by: American Journal of Economics and Sociology, Inc. Stable URL: http://www.jstor.org/stable/3487115. Accessed: 09/03/2013 11:48 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org. .  American Journal of Economics and Sociology, Inc. is collaborating with JSTOR to digitize, preserve andextend access to  American Journal of Economics and Sociology. http://www.jstor.org This content downloaded on Sat, 9 Mar 2013 11:48:22 AMAll use subject toJSTOR Terms and Conditions  OnFinancialFraudsand TheirCauses: InvestorOverconfidence BySTEVEN RESSMAN*ABSTRACT. hispaperexaminestwopossibleexplanationsforwhyinves- tors are so oftenand soeasilytakenbythelikes ofRobertBennett and hisNew Era fraudorNick Leeson'ssinkingof the esteemedBaringsBank.Irule out thetraditionalexplanationsofferedbyneoclassical economicssuch asasymmetricnformationna worldofcalculablerisk. Iarguethatthe literatureonempirical psychology,whichemphasizeshowpeoplemakechoicesin a worldcharacterizedby uncertaintyprovidesa moreplausibleexplanationforwhyfinancialfraud issoprevelant.Thepaperemphasizestheinterdisciplinary spectsoffinancial raudsand concludeswith somepolicy prescriptionsorpreventingfinancialfraud. IntroductionEVERY EWMONTHSnother caseoffinancialfraud seemstomake it to thefrontpagesofthedaily newspapers.On a somewhatsmallscale,companyheads suchasBarryMinkow(Akst,1990;Domanick,1989)and CrazyEddie Antar,the New York electronicskingwho ran commercials thatconcludedwiththe memorable line Ourpricesare insaaaaaaaaaaaane (Queenan,1988),receivejailsentences afterembezzling largesums ofmoneyfrom the firmstheystarted.In search of muchlargersumsofmoney,MichaelMilkendeceivedinvestors abouttherisksinvolved wheninvestinginjunkbonds(Stewart, 1991;Sobel,1993),while BankersTrustdeceivesitsclientsabout thedangersoffinancial derivatives(Holland,Himmelstein,andSchiller, 1995;Loomis1995).And in one ofthegreatestfrauds of this*[StevenPressman,Departmentf EconomicsandFinance,MonmouthUniversity,WestLongBranch,NJ07764.E-mailpressman@mondec.monmouth.edu).]rofessorPressman'snterestsncludemacroeconomicolicy,povertynd ncomedistribution,ndthehistoryf economichought.HispublicationsncludeEconomicsndItsDiscontents(editedwith RichardHolt,Elgar,1998)andQuesnay'sTableauEconomique: CritiqueandReconstructionKelley,1994) AmericanJournalof Economics andSociology,Vol.57,No.4(October,1998).?1998AmericanJournalofEconomicsandSociology,Inc. This content downloaded on Sat, 9 Mar 2013 11:48:22 AMAll use subject to JSTOR Terms and Conditions  406AmericanJournalofEconomics andSociologycenturyoranyothercentury,Nick Leeson(Leeson, 1996;Pressman,1997)bringsdownBaringsBank,one of the oldest and most conservative inan-cial institutions n theworld,throughhis illicitandriskytradingnforeignexchangeoptions.Baringshad financedtheAmericanpurchaseofthe Lou-isiana Territories rom Francen1803,andbytheearlynineteenthcenturyhadbecomebanker to the Britishroyalfamily.Instancesof financialfraud have not been limited to theprivatesector.FrancesCox,the Treasurer f FairfaxCounty,Virginiausedherpositiontoembezzlemorethan half a million dollarsduringthe1960sandthe1970s(Coughlan,1983).AndOrangeCounty,encouragedbyMerrillLynch,wentbankruptafterwildlyspeculatingin financialderivativesJorion,1995).Whydo such financialfraudscontinuallyrecur?What are the causes ofthese fiascos?Whatcan traditional conomictheorytellusaboutthecausesof financial frauds and theirpossiblecures?These are thequestionsthatwill beaddressedin the remainderof thispaper.The next section looks atoneparticularase of financial fraud-NewEraPhilanthropy.This casestudyis useful for two reasons.First,it containsmanycharacteristicsfother financial frauds.Thus,it is agoodcase touseif we want to drawsome lessons or morals.Second,becausemany collegesand universitiesweredupedbyNewEra,New Era slikelyto beofgreaternterestto theacademic readersof thisjournalhan thecollapseof alargefinancial nsti-tution or someegregiouscase of embezzlement. IINewEraPhilanthropy-ACaseStudy ITISHARDTO BELIEVE HATA CHARITYWOULDRUN A PONZISCHEME; utthisisexactlywhat theFoundationfor NewEraPhilanthropydid,makingitpartof thebiggestfinancialscandalin thehistoryofphilanthropy.JohnG.Bennett,Jr.,wasthefounder anddrivingforceofNewEraPhi-lanthropy.He was born in1938andgrew upin aworking-classPhiladel-phia neighborhood.In1963,BennettgraduatedfromTempleUniversityandbeganwork as an administratoror adrugand alcohol abuseprogram.Then in1982hebeganacompanycalledthe Center orNewEraPhilan-thropy. This firm advisedcorporationsaboutwhichnonprofit organiza-tions should receivetheirmoney(Stecklow,1995).In1989,BennettbegantheFoundationforNew EraPhilanthropy.At This content downloaded on Sat, 9 Mar 2013 11:48:22 AMAll use subject to JSTOR Terms and Conditions  On FinancialFrauds407 first,New Eraprovidedfree investment adviceandassistance tononprofitorganizations.Nonprofitswereinstructedwhere and howto best investtheirendowments. These services earned Bennettconsiderablerecognitionandrespectinthenonprofitcommunity.Theyalsoearned Bennettapo-sition on the BoardsofDirectorsofnumerousPhiladelphianonprofitor-ganizations, ncludingthePhiladelphiaOrchestra.New EraPhilanthropyhenwent intothe businessofhelpingnonprofitsraisemoney.Butitattemptedto do so in a manner that wasuniqueandunorthodox. Bennettpromisedthat insix months timehewould doublethe investment ofany nonprofit organizationhatgavehimmoney.Suchreturns,Bennettclaimed,were madepossiblebywealthyphilanthropistswhowanted tomakeanonymousdonations tocharityhroughNew Era.Whileit is unusualorcharitablerganizationso have toturnovermoneyto receive additionalontributions,New Erahad areadyanswer foranyonewhoquestionedthispractice.BennettclaimedthatNew Eraneeded thein-tereston thismoneyto cover theiroperatingcosts(Knecht&Taylor,1995).Despitetheirunconventionalequesthatnonprofitorganizationsurnmoneyover tothem,New Erahrivedandprosperedntheearly1990s.Numerous factorscontributed o the successof NewEraPhilanthropy.First,Bennetthad close ties to established and well-knownChristianhil-anthropicgroups.Thisgavehim andNewEraan auraofrespectabilityndtrustworthiness.Second,Bennetthad aninfectiousoptimismthat madepeopletrusthim.Third,Bennettpaidsubstantial finder's ees toanyin-termediariesdirectingcharitabledonationsto New Era.Fourth,over thecourseof severalyears,New Eradidpayenormousreturnsonthemoneythatphilanthropistsandcharitiesdepositedintospecialaccounts.Forthemanynonprofitorganizationshat werehard hitbycutsinFederalspend-ing duringthe1980sandearly1990s,thelure of anannual rate of returnof300percentwasjusttoo hard topassup.Finally,andperhapsmostimportant,charitableorganizationselt thatthemoneytheygaveto NewErawas secure.Bennett told donors thattheirmoneywould beputinto escrowor custodial accountsatPrudentialSe-curities.These accounts wouldmake it easierforeachdonor tokeeptrackof itsmoneyand thereturns t wasmaking.The accounts also reducedtherisk thatsomething mightgo wrongand thecharityorphilanthropicor-ganizationwould losethemoneyitgavetoNew Era.In theearly1990s,hundredsofnonprofitsgavelargesums ofmoneyto This content downloaded on Sat, 9 Mar 2013 11:48:22 AMAll use subject to JSTOR Terms and Conditions
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