12/13/08

The Amusing Madoff Scandal and Other Ponzi Schemes

Bernard Madoff, former chairman of the Nasdaq, has apparently been running a Ponzi scheme. According to some, he stole $50 billion--$1 billion for each of his 50 respected years on Wall Street.

The news coverage of this latest Wall Street scandal amuses me. It's shocking, commentators say, that something like this could have happened. The only shocking thing is that more individuals and firms on Wall Street haven't been accused of/caught running Ponzi schemes. After all, what types of individuals work in the financial sphere? Isn't greed one of the primary qualifications? Finding a fraudulent investment business on Wall Street is about as surprising as finding a liquor cabinet empty after entrusting it to an alcoholic.

Another amusing aspect of the Madoff scandal is who the victims are. Henry Blodget, the ever entertaining host of Yahoo! Finance's Tech Ticker (not a stranger to scandal himself), reported that some of Madoff's investors knew something fishy was going on. That's why they invested. No one could produce such high, steady returns year after year with such a safe investing strategy. While they were being cheated, they thought Madoff was cheating others through insider trading. Serves them right. It won't be at all surprising if all these thieves in their own right get compensated for their losses by their government friends. (It would be nice if innocent victims were compensated, though.)

A Ponzi scheme is a simple thing. The thief sets up a fake investment enterprise, and persuades his friends, coworkers, etc, to invest in it. He then sends them statements or even cash dividends, showing that the investment is going well. This attracts more money from the original investors and new ones. Should any investors wish to withdraw their money (in normal circumstances most won't, because their statements show that their investment is doing well), the money from newer investors is used to pay them. Early investors who decide to withdraw their money are paid by the funds new investors deposit. On it goes, until the thief's greed is satisfied and he makes off with the money or there aren't enough new investors to fund the redemptions of earlier investors.

The latter is what happened to Madoff. Losing money everywhere else, too large a number of his investors were forced to redeem their deposits. If the markets hadn't crashed, it's quite possible Madoff's scheme would go on much longer, and some of his investors could have made money (if their orderly withdrawals coincided with equal or larger new deposits).

This brings me to some of the Ponzi-like schemes almost all of us participate in.

Stocks: We buy paper with the hope that some sucker in the future will buy that paper from us for more than we paid. (Perhaps not quite as true with dividend paying stocks.)

Social Security: The money deducted from our paychecks isn't put away for our future use. Rather, it is used to fund currently retired workers. When we retire, those who work then will fund our SS payments. If this isn't a Ponzi scheme, I don't know what is: early investors are paid by the contributions of new investors. The entire thing is based on the premise that there will be more and more workers in the future. It's far from certain that this premise is true.

Our Economy Before the Credit Crisis: People took out loans on their houses and bought junk. When their houses rose in value, they took out larger loans, repaid the old loans (early investors paid off with the deposits of later investors), and bought more junk. Repeat this a few times. Then some of the loans reset at higher interest rates and couldn't be paid back (more redemptions than can be funded by new investors). This triggered more loan defaults, and the buying of less junk, which resulted in more defaults.

Government (and Corporate) Bonds: You buy a government bond. The interest the government pays you comes from the money it borrows from others, that is, other bond buyers (and to a lesser and lesser extent tax revenues). When your bond matures, the government pays you with more borrowed money (and to a lesser and lesser extent from tax revenues).

Insurance (car, medical, loan default, unemployment, stock broker, etc): This is just like Social Security. We pay a premium to the insurer in exchange for compensation when an event insured against occurs. When the event insured against happens (doctor's visit, stolen or damaged property, etc), the insurer funds our compensation from others' premiums. That is, it's like having new investors pay for the redemptions of earlier investors. If the insurer has too many claims, it won't be able to pay all its clients. Some state unemployment funds are facing this problem. As unemployment rises, they have to pay out more benefits while the premiums they collect get smaller. The last workers, while paying everyone's benefits, will get nothing when they lose their jobs.

Bank Deposits: Not quite a Ponzi scheme, but close. We put our money in the bank, and the bank is supposed to invest it. Put another way, the bank borrows money from us and lends it to others. At some banks we get interest for our trouble. Withdrawls are funded mostly by new depositors, or with other borrowed money. Should a large enough percentage of depositors want their money back at once, the bank will fail. Assuming there's no insurance, not all the money will be returned, as some of the bank's investments will not be good ones.

There are many more Ponzi schemes, I'm sure.

As long as there is confidence, a Ponzi scheme can work for a long period of time. Nevertheless, its design is such that it cannot work indefinitely. Either confidence is lost or it grows too big to be sustainable, and the whole thing collapses. Ponzi scheme collapse isn't just possible. It's inevitable.

So what do we do? Press our policy makers for reforms. Build systems that aren't pyramid schemes. And if you're forced (or choose) to participate in Ponzi schemes, try to get paid in cash or real assets that you can use even if no one wants to buy them from you. For example, if investing in stocks, prefer dividends. Convert some of that cash into stuff you can use just in case cash becomes worthless, etc.



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