Human Nature at Work

Hopefully there will be many lessons learned from the Bernard Madoff scandal once there is a better understanding of exactly what happened. I am sure there will be a number of in-depth books written on the subject. There will be chapters on asset allocation, due diligence, risk management, the SEC, internal operations of investment companies, compliance officers, investment advisors, fund of funds, hedge funds, auditors, peer review, whistleblowers, independent custodians, lawsuits, transparency, and regulatory change. All of the above are very interesting, but the chapter that I am most interested in is the one on human nature.

In an article entitled “Madoff Mess Is Nothing New” on the Forbes Magazine Web site (http://www.forbes.com/business/energy/forbes/2009/0112/035.html), William Barrett speaks about some of the aspects of human nature that probably came into play. They include that (1) investors counted on reputation, rather than on a diligent inspection; (2) respected members of an affinity community vouched for Madoff; and (3) investors and their advisors welcomed and didn’t question consistent substantial annual returns in both good markets and bad.

These three aspects only scratch the surface, but they do also represent a parallel to the sub-prime mortgage mess, especially in that investors counted on the reputation of those pushing the securities supported by these sub-prime mortgages rather that conducting a diligent inspection. In fact, to a great degree, the sub-prime mortgage industry prospered from a deep understanding of human nature and played upon it successfully for quite some time. In many ways it was a business model designed to capitalize on and encourage certain aspects of human nature to ensure a steady churning supply of mortgages for investments. The fact that substantial bonuses were awarded to many that generated these mortgages and those that sold resulting investments also illustrates how extensively human nature came into play and permitted that house of cards to go on as long as it did.

In many ways, the human nature aspect of the alleged Madoff fraud and the sub-prime mortgage mess reminds me of the Enron and WorldCom debacles. It is that undesirable aspect of human nature, greed, that seems to permeate all three. And as with Enron and WorldCom, there will be substantial regulatory responses to both the alleged Madoff fraud and the sub-prime mess. And human nature being what it is, I also expect a lot of lawsuits trying to establish blame. As with the aftermath of Enron and WorldCom, I don’t believe accountants will escape untouched.