In his controversial book, A Higher Loyalty: Truth, Lies, and Leadership, the former FBI director James Comey – in a much-quoted opening “Author’s Note” – says, “We are experiencing a dangerous time…” a time in which “basic facts are disputed, fundamental truth is questioned, lying is normalized, and unethical behaviour is ignored, excused, or rewarded… It is a troubling trend that has touched institutions across America and around the world – boardrooms of major companies, newsrooms, university campuses, the entertainment industry, and professional and Olympic sports.” This diagnosis would elicit broad agreement across the political spectrum. What has precipitated this disastrous ethical decline?
I will argue that as much as anything, it is Wall Street.
Wall Street (by that term, meaning the financial industry not only in Wall Street but in the City of London and other financial centers) routinely lives numerous lies. Increasingly over recent decades, it has become well known in the finance field that the search for verifiably effective investment management in pursuit of the goal of outperforming the market average is highly likely to be futile. Nevertheless, pension and endowment fund consultants and money managers cynically pretend that it is a very important pursuit requiring expensive expert services, such as their own. Accordingly, they construct arbitrary and ineffectual but technical-sounding methods for doing it, without fully informing their clients, the public, or investors who are in their care of the likely futility and expense of the whole exercise.
Before lying became normalized in politics, it became normalized in finance. It is well known that in an infamous transaction known as the ABACUS deal, Goldman Sachs contrived to sell a collateralized debt obligation (CDO) to one set of clients in order to enable another major client, John Paulson, to select securities to include in the CDO, the better to short it. This most surely required that Goldman salespeople, representing the CDO to the buyers, not tell them the truth. When questioned in 2010 by Senate subcommittee chairman Carl Levin whether this was unethical and a conflict of interest, Goldman CEO Lloyd Blankfein said, “In the context of market making that is not a conflict.”
Can such a response be justified? Up to a point it can. The economic philosopher Israel Kirzner wrote several books arguing cogently that entrepreneurs need to keep certain information away from their clients, in order to be able to reap a profit from their entrepreneurship. Is there a point at which keeping information away from clients crosses the border into lying? There surely is. And there is another reason why Kirzner’s argument does not apply well to the financial industry, which I will take up later.
This lying is winked at, and even admired by the finance profession. In an article covering a talk by Seth Klarman, founder of the Boston-based Baupost Group, at a CFA Institute annual conference shortly after the Goldman revelations, Advisor Perspectives CEO Robert Huebscher wrote that “Klarman was more forgiving than most of Goldman Sachs.” As justification for that forgiveness, Klarman said, “I know Wall Street will always try to rip our eyeballs out.” This is representative of the normalization of – and even begrudging admiration of – Wall Street’s lying.
Motivated misunderstanding and misinterpretation of mathematics
Much of the mathematics used in finance is a lie. It is used for sales or marketing purposes, not to actually obtain results or even to be correct.
Of course, very few people who use a marketing pitch perceive themselves as lying. If the marketing pitch employs or is based on mathematics that they don’t fully understand – even if they have written it themselves – then they will still not perceive themselves as lying. They will convince themselves that it is the absolute truth. Let us instead call it motivated misunderstanding and misinterpretation of mathematics.
This motivated misunderstanding and misinterpretation of mathematics is not only endemic in Wall Street, especially in the investment advice and management field, it is its stock in trade. For example, the mean-variance optimization model is heavily used in marketing of investment advice, even though it is widely acknowledged that it does not work at all for practical purposes.
Too much motivated misunderstanding of mathematics – sometimes going to absurd extremes – is vetted by academia. Two articles were written using mathematics to “prove” that any non-cap-weighted portfolio has a higher expected return than the cap-weighted market. This is a logically impossible result. A total stock market cap-weighted portfolio can be decomposed arbitrarily into two non-cap-weighted portfolios, only one of which can beat the market portfolio.
In any other field, the authors would notice that they had proved a logical impossibility. They would go back to figure out where their math went wrong. But instead of doing that, they submitted their articles to a finance journal and incredibly, the peer-reviewed journal published them. In the finance field, the level of motivated credulousness is so high that the authors had a good chance of acceptance by the fraternal community of motivated misunderstanders and misinterpreters, including academia. This is what Comey calls “the silent circle of assent” – invoking his prior experience in the United States Attorney’s office in Manhattan prosecuting the tightly-linked and internally loyal Cosa Nostra families.
Comey’s higher loyalty
Comey chose his book’s title carefully. Although the media coverage of the book has, inevitably, focused on personalities, and their clashes and disagreements, that is not what the book is about. It is about Comey’s interesting and instructive experiences in the offices he has held, and most importantly, about his belief that “Ethical leaders choose a higher loyalty to … core values over their own personal gain.”
These core values, Comey says, are “truth, integrity, and respect for others.” He adds, “Those values are more important than the impulses of the bosses above them and the passions of the employees below them. They are more important than the organization’s profitability and bottom line.”
Although a survey would probably elicit 90 percent agreement with this sentiment, even – perhaps especially – in the business world and in the financial world, it has been largely lost in the financial world in practice. Organizations’ profitability and bottom lines have taken precedence. This is evident in the story of the LIBOR fixing scandal, among many other incidents.
Comey, by contrast, scrupulously places the truth – a truth in which he tenaciously believes – above all other goals. This can lead to personality flaws, real and perceived, including – as Comey acknowledges – “that I can be stubborn, prideful, overconfident, and driven by ego.”
Two incidents in which he steadfastly pursues the truth provide examples. In one, he decided to prosecute the much-celebrated and admired tastemaker Martha Stewart, on charges that she benefited from trading on inside information provided to her by a friend and then lied to FBI investigators about it. It was the lie that induced Comey to prosecute. He admits, however, that he was hesitating to prosecute her because it would bring criticism. But then he thought, “I was actually considering letting her go because she was rich and famous. What a miscarriage of justice.”
He asked a staffer, Dave Kelley,
…to find out how many people had been indicted in the United States for lying to federal investigators. How many “regular people” lied and then paid dearly for it? The answer was two thousand. Kelley told me I needed to stop wringing my hands; this was the right thing to do and I should get on with it. He was right. I told my staff to indict Martha Stewart…
Stewart was convicted and sentenced to five months in Federal prison for lying. Comey got “a lot of hate and heat for a decision that had been carefully and thoughtfully made. People just could not, for the life of them, understand how I could make a mountain out of a molehill in an effort to ruin Martha Stewart.”
The Hillary Clinton email story is yet more interesting. Assuming Comey’s account is accurate, he had little alternative but to do what he did – though it might have been the result of his inadvertently limited flexibility to deal with the situation. However, the decision to release the information that a trove of new Clinton emails had been found on Clinton’s assistant Huma Abedin’s laptop just prior to the presidential election hinged crucially on a pivotal detail.
Comey may have inadvertently compromised his flexibility when he had previously, on July 5, 2016, chosen transparency by making a full disclosure of the investigation into Clinton’s emails, announcing that the case was closed and no incriminating evidence had been found. In particular, Clinton hadn’t lied about her personal email server, or her handling of the classified messages that were found on it. But while exonerating Clinton, Comey described her conduct as “extremely careless.” Comey was criticized for this on all sides, but then said he “felt great relief because the FBI and I were finished with Hillary Clinton and her emails.” But then he adds … “If only.”
Just a few months later, on October 27, 12 days before the presidential election, Comey was informed that a far larger trove of Clinton emails had been found on the laptop of Anthony Weiner, the disgraced estranged husband of Clinton’s assistant Huma Abedin. Comey found himself in a bind. Having been completely transparent about the investigation when he thought it was over in July, he felt it was necessary to be completely transparent now, and announced that the case had been reopened because new information had been found.
He was concerned particularly because it was such an enormous amount of email that he thought they could not finish investigating it until after the election. If he and his team kept it secret and announced the result only after the election, they could be accused of having kept incriminating evidence against Clinton from the public, thus swaying the election in her favor. And so, Comey made the fateful announcement the next day that the case had been reopened, possibly influencing the election in the other direction.
Then an odd thing happened, Comey reports. “In a huge breakthrough, one I had been assured was not possible, the wizards at the FBI’s Operational Technology Division figured out a way to do some of the de-duplicating electronically so agents and analysts didn’t need to read hundreds of thousands of emails.”
And so, the investigation of the new trove of emails was completed before the election after all. It was announced that the result of the investigation had not changed. If it had been known beforehand that the emails could be combed through so quickly, Comey might not have felt the need to publicly disclose that the investigation had been reopened.
When is it OK to lie or withhold truth?
As I mentioned earlier, Israel Kirzner wrote extensively about entrepreneurship, among other things making the case that an entrepreneur was under no obligation to disclose the full truth to her clients. Suppose the entrepreneur, through her diligence, found a source for a product at a much lower cost than was generally available. The entrepreneur would then buy the product from that source and resell it to her customers, charging a little less than the going market price.
If her customers asked her where she was getting the product, Kirzner argued that she is under no obligation to tell them. If she did, she would undermine her ability to profit from the work she had expended to find it. Thus, both she and her customers would benefit from her diligence. In this manner does an entrepreneur add value.
Could Goldman’s ABACUS deal be similarly justified? It is hard to see it. First of all, Goldman did not sell a product that was cheaper than another but substantially similar. It was not similar, it was much worse. Second, Goldman did not only withhold the information about how the product was created, it would have had to lie to sell it. Third, instead of both Goldman and its clients benefiting from Goldman’s entrepreneurial diligence, only Goldman did (and its collaborator, John Paulson, a very large client). In short, Goldman lied and sold a bad product that benefited not the clients it was sold to but itself. This is not the kind of entrepreneurship Kirzner had in mind.
Unfortunately, this characterizes all too many of the transactions that Wall Street initiates. The acceptance of this fact illustrates the atmosphere in which “lying is normalized, and unethical behaviour is ignored, excused, or rewarded” that Comey excoriates. And it has been happening for a long time, a time during which Wall Street and its employees have become more and more admired, celebrated, and envied for their wealth. They have led the charge downhill. And we are all suffering for it.
I am gratified to know that Comey will be addressing the annual conference of BNY Mellon Pershing, a company I may have played a very small role in creating in its current form, as a co-founder of Lockwood Advisors, which was merged into Pershing after its acquisition by BNY. Perhaps the choice of Comey to deliver the keynote address is intended to send a message that the financial advisory world means to commit itself to the truth. This will be a good way to start.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, chief investment strategist of Compendium Finance, adviser to mobile financial planning software company Plynty, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
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