Good times create the frauds that bad times expose

The investor Howard Marks was puzzling over why frauds seem to arrive in bunches. He went back to talks with Charlie Munger, with whom he used to discuss markets, about the bezel, economist John Kenneth Galbraith's word for the false wealth that fraud appears to create, which makes everyone feel richer until it is caught.

Marks put the mood of those periods bluntly. In heady times, Marks said, "rather than say, 'That's too good to be true,' people are more likely to ask, 'How can I get in on that?'"

What he meant was that prosperity itself relaxes the checks. Marks quoted economist Michael Pettis describing Galbraith's cycle: Galbraith wrote that "In good times, people are relaxed, trusting, and money is plentiful." Galbraith added, "But even though money is plentiful, there are always many people who need more."

When trust is high, Marks argued, more cheating starts and less of it is noticed, so the hidden overstatement keeps building. When business turns down, scrutiny returns. Galbraith wrote that "Money is watched with a narrow, suspicious eye," that "The man who handles it is assumed to be dishonest until he proves himself otherwise," and that "Audits are penetrating and meticulous." Galbraith added, "Commercial morality is enormously improved."

Marks argued that the same carelessness that leads to bad loans also creates inviting openings for cheating. He stressed that this does not mean finance itself is dishonest. His point is that large pools of eager cash draw dishonest actors, and they have the easiest time when few bother to check the details.

That is why the frauds cluster, Marks said. In his telling, bad loans and frauds pile up together because people who lend and invest tend to judge poorly when times feel safe.