From the Archives
A 19th century account of financial fraud that reads as relevant today as it did back then. Consider the first page of Chapter 1:
“Without any great violence, all the incentives to commercial crime may be brought under the one common rubric — the desire to make money easily and in a hurry.
The apprentice-boy, who robs the till of a few shillings in order that he may enjoy himself on a particular evening; the gigantic forger or swindler, who absorbs thousands that he may outshine the people who live and breathe around him, are so far in the same predicament that they cannot endure any delay to the gratification of this common passion.
Apart from these, but still actuated by the same desire, is the reckless speculator, who would risk everything in the hope of a sudden gain, rather than toil safely and laboriously for a distant reward. The speculator may, of course, be a perfectly honourable man, who would instinctively shrink from any deed that would invoke the interference of the criminal law; but if for time is adverse, he is on the high road to wrong-doing, and, moreover, there are many crimes not enumerated in the statute-book that are still heavy sins against the dictates of morality.”
Today’s Sunday Reads will dive into a debate that stemmed from Twitter last week, which was so eloquently answered by my good friend Wall Street Cynic.
So, to reiterate, the question we are aiming to answer in today’s post:
“What with bitcoin, dogecoin, NFTs, and GameStop-type memes, has there ever been a period in which so many obvious frauds have taken over mainstream investment trading?”
Now, before we get into the historical examples already referenced in @WallStCynic’s tweet, I think this excerpt from Matt Levine’s newsletter does an excellent job summarizing some of the mania currently rampant in markets. In particular this excerpt was in reference to the soaring price of Dogecoin in advance of Elon Musk’s hosting of Saturday Night Live, which some investors thought might boost Dogecoin’s price:
“Just imagine traveling 10 years back in time and trying to explain this to someone; just imagine what an idiot you’d feel like. “There’s going to be this online currency that people think is a form of digital gold, and then there’s going to be a different online currency that is a parody of the first one based on a meme about a talking Shiba Inu, and that one will have a market capitalization bigger than 80% of the companies in the S&P 500, and its value will fluctuate based on things like who is hosting ‘Saturday Night Live’ and whether people tweet a hashtag about it on the pot-joke holiday, and Bloomberg will write articles and banks will write research notes about those sorts of catalysts, and it will remain a perfectly ridiculous content-free parody even as people properly take it completely seriously because there are billions of dollars at stake.”
I think we can all agree that we’re living in strange times. However, I would like to apply this same logic to one of my favorite speculative years in financial history to address today’s debate: 1825.
A Speculative Year: 1825
As is often the case, 1825 was a year of bubbles and manias due to low interest rates and cheap credit. Investors that had relied upon government consol bonds for their primary source of income were forced to reach for yield and returns by investing in riskier assets. Most of the speculative fervor in this period manifested itself in high-yielding Latin American debt, mining stocks, and domestic joint-stock companies (I discussed this bubble with Jim Grant on Real Vision, which you can watch here).
Winton summarized the boom in questionable domestic companies:
‘From this time ‘bubble schemes came out in shoals like herring from the Polar Seas’, illustrated by the fact that the number of bills coming before Parliament for forming new companies shot up from 30 in March to 250 in April.
All manner of companies were ﬂoated. Many were related to Assurance; there were also some novel ventures such as the Metropolitan Bath Company which aimed to pump seawater to London so that poor Londoners could experience seawater bathing, and the London Umbrella Company which intended to set up umbrella stations all over the capital.
Many ventures, however, were arrant swindles designed to test investor credulity. Such examples include the Resurrection Metal Company, which intended to salvage underwater cannonballs that had been used at Trafalgar and other naval battles, and a company (possibly a parody) which was set up ‘to drain the Red Sea, in search of the gold and jewels left by the Egyptians, in their passage after the Israelites’.”
Yet, these companies were not the worst of it. The most outrageous example of speculation and fraud from 1825 is found in the story of Poyais (pointed out in the illustration below). I wish that Matt Levine was alive in 1825 so that he could have written a Money Stuff on how Gregor MacGregor managed to create a fictitious country named Poyais, and successfully float its bonds on the London Exchange.
The Island of Poyais
Gregor MacGregor not only had the most Scottish name imaginable, but was also deemed the ‘King of Con-Men’ by The Economist for pulling off the ‘greatest confidence trick of all time’. How does one earn this royalty status among con-men and scam artists, you may ask? In MacGregor’s case it was by finding an uninhabited piece of land on the coast of Honduras, creating a fictitious country called Poyais, and selling over a billion dollars worth of ‘Poyais bonds’ in London by misleading investors into thinking the uninhabited jungle he had found in Honduras was actually a legitimate country boasting beautiful architecture, an opera house, parliamentary building, cathedral, and more.
As he sailed back to London, MacGregor began plotting how he would lure investors into his new scheme. As it turned out, however, the British public did not need much convincing for investing in the sovereign debt of another Latin American ‘country’ like Poyais, given the the rampant speculation in Latin American debt that already existed. MacGregor was able to easily capitalize on this mania.
When the Grand Cacique of Poyais (MacGregor’s self-appointed title) arrived in London he wasted no time spreading the word about investment opportunities in his newly discovered kingdom. MacGregor even published a book detailing the tropical paradise of Poyais, and how attractive the country was for both investors and settlers alike. An excerpt from the book below even claims that MacGregor had avoided making exaggerated claims about Poyais (ha!):
“He [MacGregor] has endeavored, as much as possible, to avoid making any statement which might appear doubtful or exaggerated…and he has therefore confined himself, as much as possible, to such plain and positive facts, as are established beyond the shadow of doubt.” — Sketch of the Mosquito Shore (1822)
The hype surrounding MacGregor and Poyais steadily evolved into a full-fledged mania as thousands of engravings were sold around London and Edinburgh portraying the magnificent buildings and infrastructure of Poyais. Just to reiterate again, the reality was that Poyais was a largely uninhabited jungle with no infrastructure of the sort. But, no matter! Nonetheless, offices were opened in London and Edinburgh for selling Poyais land grants to excited applicants at 4 shillings an acre.
After drumming up a frenzy from the British public, MacGregor focused his attention on courting investors. In 1822, the Scotsman issued $200,000 in bonds offering a 6% yield. Measured in today’s money, the value of these bonds eventually reached $3.6 billion.
Incredibly, the bonds were backed by the export-tax revenue that Poyais would allegedly generate, despite the fact that there was no infrastructure, people, or businesses in the region. At one point, the Grand Cacique even secured bonds against the revenues of a non-existent mining company in Poyais. These boring details, however, did not prevent investors from purchasing MacGregor’s fraudulent bonds.
Perhaps this was due to the fact that MacGregor’s pitch came at a time when government bonds (consols) only yielded 2–3%. Consequently, when MacGregor offered investors a 6% yield on the Poyais bonds, or double the government consol’s yield, they leapt at the opportunity. Chasing returns would cost many investors their lives.
Investors in the Poyais Kingdom were jolted back into reality when the settlers arrived at their new home in Honduras. The first ship, Honduras Packet, set sail on September 10, 1822 with 50 settlers on board. Many of them came from poor background, and had left their homeland for the utopia that MacGregor had promised. Few would live to take the return journey back to Britain.
As the ship finally pulled into the port of Poyais, nothing could have prepared the passengers for what they encountered. Far from being a tropical paradise with beautiful infrastructure, the land was uninhabited and undeveloped, apart from a couple mud-huts on the beach.
Unfortunately for the new arrivals, this discovery was only the beginning of their troubles in paradise. Shortly after they came on land, a hurricane tore through the region, sweeping away their ships. In an instant, the Poyais investors and settlers found themselves stranded. Then, when the situation couldn’t seem to get any worse, the settlers were stricken by either yellow fever, or malaria.
“Not one, was able to assist another out of such a number, and many of those who had newly come from Scotland were well advanced in years, and had come here to end their days in peace and comfort.” — Poyais Survivor
Eventually, seven ships in total came to Poyais with passengers looking to settle in MacGregor’s fairy tale paradise. Of the 240 settlers that arrived, only 60 survived.
So, to address the debate laid out at the onset of this post, there has certainly “been a period in which so many obvious frauds have taken over mainstream investment trading”. Today’s post will dive further into some interesting examples of fraud, how fraud persists, and other periods of speculative excess. Enjoy!
Why This is Relevant:
Perhaps no “Golden Age of Fraud” is better known than the year 1720, when both the South Sea and Mississippi Company bubbles imploded. This paper looks at one of the most famous anecdotes from the South Sea Company debacle, which provides an excellent insight on the levels of speculation rampant in London at the time.
While the the author of this article, Dr. Andrew Odlyzko, points out that the story is probably apocryphal, one of the most repeated stories of the South Sea Bubble was the promotion of a company that “lured investors into putting money into “an undertaking of great advantage, but nobody to know what it is’.” As Odlyzko notes, however, even if that specific anecdote is apocryphal there were equally ludicrous examples of investors blindly investing their money while chasing returns. For example, while the South Sea Company gets all of the focus for it’s dramatic rise, William Goetzmann and his co-authors demonstrate just how parabolic the returns in another exciting new industry were at the same time: Insurance firms.
As expected, the South Sea Bubble of 1720 offered a perfect example of how investors will herd into newly formed companies following the outsized success of a particular stock in the hopes that they will “hit the lottery” and experience a similar rally.
“The ebullient atmosphere of 1719 offered new opportunities to promoters, and they began soliciting money from investors. Figure 1 [below] shows, in the scatter plot, the number of new projects announced each month, but multiplied by 10, so that the 88 projects of June 1720 correspond to 880 in the figure. These numbers are taken from William Scott’s The Constitution and Finance of English, Scottish and Irish Joint-stock Companies to 1720. As can be seen, out of the almost 200 projects that Scott tabulated, only 13 were started in 1719. But they were noticed by many observers. Also noticed was what seemed to many skeptics to be the inordinate credulity of the public that was eager to get involved. This led to the first of the events that likely inspired the ‘undertaking of great advantage, but nobody to know what it is’ fable.”
“Starting on Friday, December 18, 1719, the Daily Post carried for several days an ad for an ‘extraordinary scheme for a new insurance company to be proposed, (whereof publick notice will speedily be given in this paper),’ with ‘permits to subscribe’ offered for £0.05 each. No names of projectors, nor details of the scheme were cited.
The sale of the ‘permits’ took place on Thursday, December 24. Two days later, this same paper had an ad which offered refunds for the ‘several hundred’ of those permits that had been sold and explained that the whole thing was a hoax designed to show how easy it was to ‘impose upon a credulous multitude’.”
In 2019 I went on Bloomberg’s Odd Lots podcast to discuss one of my favorite bubbles and manias in history: The 1690s Tech Bubble. Listen in the link above and let me know what you think!
Why This is Relevant:
Another particularly speculative and fraudulent year is found in 1825.
“The panic of 1825 was the culmination of several years of euphoric investment in sovereign debt and precious metals that included one of the most remarkable swindles of all time: bonds sold in the name of a made-up country, called Poyais.”
“Armed with cheap banknotes and a romantic disposition, British speculators ventured deep into the jungle of Latin American investments during the early 1820s in the quest for the continent’s legendary treasure mines. Yet all they found were profit-sucking leeches and accursed pyramid schemes .”
Why This is Relevant:
This article makes the case for why we should be using the term ‘Howe Scheme’ instead of ‘Ponzi Scheme’ to describe scams representing a ‘pyramid-esque’ structure.
In the 19th century a female fortune-teller turned financier opened a bank offering guaranteed interest rates of 8%, and even offered to pay the first three months interest in advance for new depositors. Sweet deal! Suffice it to say that the accounting practices of this institution were, well, questionable…
What makes this anecdote particularly interesting, however, is that Howe’s business advertised a “mission-driven” purpose of being a “bank run by women, for women.” This seemingly do-good business approach potentially lessened the warranted scrutiny on Howe’s business, and allowed her scheme to persist. There are surely some parallels to “greenwashing” and ESG today…
“Sarah Howe’s early life is mostly a mystery… but by 1877 she was single and working as a fortune-teller in Boston. It was a time of boom and invention in the United States. The country was rebuilding after the Civil War, industrial development was starting to take off, and immigration and urbanization were both increasing steadily. Money was flowing freely (to white people anyway), and men and women alike were putting that money into the nation’s burgeoning banks. In 1876, Alexander Graham Bell invented the telephone, and in 1879 Thomas Edison created the lightbulb. In between those innovations, Sarah Howe opened the Ladies’ Deposit Company, a bank run by women, for women.
The company’s mission was simple: help white women gain access to the booming world of banking. The bank only accepted deposits from so-called “unprotected females,” women who did not have a husband or guardian handling their money. These women were largely overlooked by banks who saw them — and their smaller pots of money — as a waste of time. In return for their investment, Howe promised incredible results: an 8 percent interest rate. Deposit $100 now, and she promised an additional $96 back by the end of the year. And to sweeten the deal, new depositors got their first three months interest in advance. When skeptics expressed doubts that Howe could really guarantee such high returns, she offered an explanation: The Ladies’ Deposit Company was no ordinary bank, but instead was a charity for women, bankrolled by Quaker philanthropists.
Word of the bank spread quickly among single women — housekeepers, schoolteachers, widows. Howe, often dressed in the finest clothes, enticed ladies to join, and encouraged them to spread the news among their friends and family. This word-of-mouth marketing strategy worked, Howe’s bank gathered investments from across the country in a time before easy long-distance communication. Money came in from Buffalo, Chicago, Baltimore, Pittsburgh, and Washington, all without Howe taking out a single newspaper advertisement. She opened a branch of the bank in New Bedford, Massachusetts, and had plans to add offices in Philadelphia and New York to keep up with the demand. Many of the women who deposited with the Ladies’ Deposit Company reinvested their profits back in the bank, putting their faith, and entire life savings, in Howe’s enterprise. All told, the Ladies Deposit would gather at least $250,000 from 800 women — although historians think far more women were involved. Some estimate that Howe collected more like $500,000, the equivalent of about $13 million today.”
“This is all untrue, as Howe’s own statements to the press before her downfall suggest that, in fact, she had a sharp wit. In response to one newspaper’s critique of the Ladies’ Deposit Bank, Howe wrote: ‘The fact is, my dear man, you really know nothing of the basis, means or methods on which our affairs are conducted, and when shut up in the meshes of your savings-bank notions, you attempt an exposition of the impossibility of our existence, you boggle and flounder about like a bat in a fly trap’.”
Why This is Relevant:
It seems at odds with the times that in an age of such mass information and transparency, there could still be such widespread examples of fraud and wrongdoing in markets. However, as previous editions of this newsletter have covered, increased information certainly does not mean increased knowledge or efficiency. This paper looks at how the increasingly distant relationship between an investment bank’s reputational risk and underwriting duties led to more instances of default. When the credit rating agencies began to form, investment bank’s could simply rely on their ratings and no longer worry about the reputational risk of underwriting a bond offering that defaulted. If that were to occur, it would be the rating agency’s fault, not the bank’s. As the authors note, this led to a “market for lemons”.
The role of underwriters today is vastly different than it was in the past. This thought provoking article explores the evolving duties of underwriters and rating agencies over time. Perhaps the best overview is found on page 3 of this article:
“In the past era (by which we mean the long-run period that began in the early 19th century and ended with the interwar crisis), underwriters provided valuable certification services. They tried to secure prestige by convincing investors that their name was associated with safer products. They did this not for the sake of honesty, altruism, or self-esteem but rather because doing so entailed benefits.
Today is different: underwriters have shed their role as certifiers and have outsourced it to rating agencies. The resulting reduction in liability risk also means that more competitive banks are prepared to issue riskier securities. We suggest that this new situation has given birth to a market for lemons, a market that did not exist in the past. We conclude that the next sovereign debt tsunami will crash on a foreign debt market that is by design more accident prone than its predecessors.”
This stark contrast in the roles of underwriters in each time period has led to what the authors call “the default puzzle”. This puzzle stems from the fact that underwriters used to have a vested interest in how the bonds they underwrote performed, as it could hurt or benefit their corporate brand. This meant that banks acting as underwriters were responsible for carrying out the roles of modern credit rating agencies. If a bank underwrote bonds that ended up defaulting, this would tarnish the bank’s reputation. Investors would ask “How could they fail to see the default risk before deciding to underwrite?”.
The result was a bond market in which very few ‘junk bonds’ were issued, as underwriters were wary of putting their reputations at stake. The defaults that occurred were generally clustered around the few financial intermediaries that were willing to underwrite the ‘junkier’ bonds, and take on the reputation risk.
BUT! As we all know, credit ratings changed everything.
“The investment banks that became involved in the new market probably welcomed the transformation (they included reincarnations of interwar New York leaders such as JP Morgan or National City Bank). Fees were now smaller, of course, but liability risk was also reduced. Rating agencies would be the new lightning rod for accusations of financial malpractice. The banks, although undoubtedly informed, would now be able to show to unhappy customers the grades given by (possibly less informed) rating agencies.”
In essence, there’s no longer a need to worry about reputation risk attached to underwriting, because if anything goes wrong, it is the rating agency that is blamed. Consequently, there is now a booming “market for lemons.”
“A further implication is that government debt today is by construction more risky and volatile than it was in the past. Moreover, this debt is certified by agents who do not have direct access to the flow of soft information normally obtained through the underwriting and banking relationship. Instead, these agents must rely on published information only. Should trouble come, rating agencies have no means to help and no privileged information. Underwriters have no reason to provide support, because they have escaped liability by transferring certification duties to the rating agencies. By contrast, in the past, a bank as both issuer and certifier saw the wisdom of not jeopardizing its reputation and was often willing to serve as a lender of last resort.”
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