The World’s Biggest Ponzi Scheme?

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Two days ago the FBI indicted Bernie Mad­off, prin­ci­pal of Bernard L. Mad­off Invest­ment Secu­ri­ties LLC, on secu­ri­ties fraud. Though the case has yet to run, in the indict­ment the FBI reported that Mad­off con­fessed that his was “basi­cally a giant Ponzi Scheme”  that may have lost some extremely high net worth indi­vid­u­als over US$50 bil­lion.

Madoff’s firm was famous for return­ing con­stant pos­i­tive results, even on a month by month basis, for decades. As Henry Blod­get on Yahoo’s Tech Ticker reports below, many Wall Street pro­fes­sion­als were incred­u­lous of these results, but invested in his firm anyway–because they thought his returns must be com­ing from him exploit­ing his “mar­ket maker” role on the Nas­daq to do insider trad­ing.

This in itself is a deli­cious com­men­tary on the oxy­moron of self-reg­u­lat­ing finan­cial mar­kets. Insider trad­ing is ille­gal, but many big­wigs on the Street were quite will­ing to risk their money with some­one whom they thought could only be mak­ing that much money if he were break­ing the law.

In fact, he was break­ing the law, but not that way: rather than mak­ing prof­its from insider trad­ing and then fun­nelling part of the pro­ceeds to those who gave him the funds with which to do it, he was sim­ply tak­ing in prin­ci­pal from “investors” and pay­ing it back to them as inter­est.

This is what qual­i­fies his (alleged) activ­i­ties as Ponzi Scheme, named after Charles Ponzi,* whose dream of a means to get rich quick by arbi­trage on Inter­na­tional Reply Coupons (IRC) turned into a giant finan­cial fraud.

* Inci­den­tally, while I link to the Wikipedia entry on Ponzi and his scheme, it’s some­what inac­cu­rate on Ponzi’s early his­tory, and also leaves out impor­tant atten­u­at­ing facts about him. By far the best ref­er­ence is the bril­liantly researched and beau­ti­fully writ­ten Ponzi’s Scheme: The True Story of a Finan­cial Leg­end by Mitchell Zuck­off. Read it and you will learn that, in addi­tion to turn­ing into a some­what inad­ver­tent but large scale swindler, Ponzi also lit­er­ally gave the skin off his own back–and on two sep­a­rate occasions–to save the life of a nurse who had suf­fered hor­rific burns. I can’t see many of those accused of run­ning a Ponzi Scheme these days giv­ing any­one the shirt off their backs, let alone their own skin.

Ponzi believed he had stum­bled on a path to riches when he received an IRC in the mail and then found that it was mis­priced around the world. IRCs were designed to facil­i­tate com­mu­ni­ca­tion. Per­son A in coun­try X could write to per­son B in coun­try Y, and enclose an IRC that per­son B could then exchange for a postage stamp for the reply.

Great idea, except that the prices were set before the First World War, and not adjusted after it. For argument’s sake, let’s say the price for an IRC was 1 dol­lar in the USA and 1 lira in Italy, and the exchange rate in 1910 was 1 dol­lar for 1 lira.

Then along comes WWI and cur­ren­cies go haywire–say now that a lira is only worth ten cents. But it still buys one IRC in Italy, which if shipped to the USA will then be exchange­able for a $1 stamp.

Ponzi thought that he could:

  1. Raise dol­lars in the USA
  2. Ship them to Italy
  3. Exchange them for Ital­ian Lira–$1 buy­ing 10 lira (let’s say)
  4. Buy 10 IRCs with the 10 Lira
  5. Ship the IRCs back to Amer­ica
  6. Sell them to peo­ple who were going to buy them at the Post Office for (say) half price
  7. Make a for­tune…

Great idea, except that the great finan­cial jour­nal­ist Clarence Bar­ron cal­cu­lated that, to sup­port the scale of invest­ments in Ponzi’s Scheme towards its end, there would need to be 160 mil­lion IRCs in cir­cu­la­tion; but there were in real­ity only 27 thou­sand to be had.

An aware­ness that this might be the case was prob­a­bly why Ponzi couldn’t con­vince the big end of town to invest–remember the old adage “If it sounds too good to be true, it prob­a­bly is”? (some­thing the “investors” in Madoff’s firm obvi­ously for­got). So he set up a shop front, promis­ing retail investors a 50 per­cent return on their money in 45 days.

Some peo­ple who didn’t know the adage took a punt, and within days Ponzi had his first funds–well before he worked out the mechan­ics of his arbi­trage scheme. When 45 days elapsed and the first “investor” turned up expect­ing his $50 return on a $100 invest­ment, Ponzi gave him money the only way he could–by hand­ing over some of the money ini­tially deposited by those early investors.

Wow! Ponzi makes good on his promise: invest $100, and seven weeks later earn $50. Why if I left that $100 with him–or bet­ter still, left that AND added the $50 he’s just given me (minus say $25 for a good night out in cel­e­bra­tion), then in another seven weeks I’ll have $187.50. And if I re-invest that…”

So went the word, as suc­cess­ful investors in Ponzi’s Scheme bragged to their friends about how much money the nice Mr Ponzi had made them.  Ponzi never got the mechan­ics of the IRC arbi­trage scheme worked out–and he con­tin­ued to dream up schemes that, if they suc­ceeded, would mean his appar­ent div­i­dends were actu­ally legit­i­mately earned–and stuck with the prac­tice of pay­ing out prin­ci­pal deposited by later investors as inter­est to ear­lier ones.

Ulti­mately, he took in some­thing close to US$15 mil­lion from about 40,000 peo­ple. Some of them who got out early walked away a lot wealth­ier, but at the end of the scheme, those still in it could only recoup $5 million–the other $10 mil­lion had gone to the early escapees, and to fund Ponzi’s tem­porar­ily lux­u­ri­ous lifestyle and min­i­mal oper­at­ing costs.

On some scales, Madoff’s is a more mod­est scheme than Ponzi’s–rather than promis­ing 50% every 45 days (which works out at an annual rate of return of 2,680%), Mad­off returned investors roughly 1% a month. As a result, the Big End of Town could per­suade itself that the returns were ini­tially the result of a suc­cess­ful invest­ment strategy–and then later as the sheer vol­ume grew, that they were the result of insider trad­ing.

So Mad­off attracted really wealthy investors: it appears that his firm “man­aged” over US$17 bil­lion for less than 100 investors–though Mad­off him­self allegedly esti­mated his total losses at US$50 bil­lion. And the scheme ran for almost half a century–far longer than Ponzi’s brief time in the finan­cial sun (less than a year).

So is this the World’s Biggest Ponzi Scheme, as some head­lines are trum­pet­ing?

It’s cer­tainly the biggest of what I call Type I Ponzi Schemes: direct, undis­guised schemes in which prin­ci­pal is paid out as inter­est. But the biggest Ponzi Schemes by far are what I call Type II: here, instead of a direct “prin­ci­pal in, inter­est out” pump, we have “bor­row money, buy assets with it, drive up the asset price, sell the assets, pay off the debt plus inter­est, and keep part of the asset price appre­ci­a­tion as profit”.

That, of course, describes mar­gin lend­ing on the stock mar­ket, and above all, lever­aged spec­u­la­tion on house prices. It works a treat while asset prices con­tinue to rise, but a fun­da­men­tal pre­con­di­tion for this is that the level of debt has to rise even faster–since inter­est on the debt com­pounds it, and no real money is being made (by doing bor­ing stuff like pro­duc­ing wid­gets and flog­ging them for a profit–the legit­i­mate equiv­a­lent to Ponzi’s never-prac­tised arbi­trage scheme).

It falls over when the next entrant into the scheme looks at the level of debt required to enter, com­pares it to his/her income, says to self “there’s no way I could ever repay this out of my income” and decides not to play.

In real­ity, the world’s finan­cial sys­tem has become one giant Type II Ponzi Scheme, and we are now reap­ing the whirl­wind of that fiasco. While some made a for­tune by get­ting out early, oth­ers are locked into the down­ward spi­ral as asset prices  plum­met for lack of buy­ers, exces­sive debt, and dis­tressed sell­ing to meet inter­est pay­ments, and mar­gin calls.

Madoff’s (alleged) Ponzi Scheme may be the most dra­matic Ponzi Scheme, but in real­ity we’ve all been for a ride in Ponzi’s Mag­i­cal Mys­tery Machine.

Part of the appeal of it all is the sheer fun of the boom. As Ponzi him­self put it when inter­viewed on his deathbed in a Brazil­ian hos­pi­tal for the des­ti­tute:

Even if they never got any­thing for it, it was cheap at that price. With­out mal­ice afore­thought I had given them the best show that was ever staged in their ter­ri­tory since the land­ing of the Pil­grims! It was eas­ily worth fif­teen mil­lion bucks to watch me put the thing over.”

Below are some early reports on Madoff’s Scheme. I’ll con­tinue adding to them as they come in–though at some stage there will doubt­less be a flood that I can’t keep pace with.

Decem­ber 12: Yahoo Finance Tech Ticker: “I Knew Bernie Mad­off Was Cheat­ing; That’s Why I Invested with Him”. “So why did these smart and skep­ti­cal investors keep invest­ing? They, like many Mad­off investors, assumed Mad­off was some­how ille­gally trad­ing on infor­ma­tion from his mar­ket-mak­ing busi­ness for their ben­e­fit. They didn’t con­sider the pos­si­bil­ity that he was clean on that score but run­ning a good old-fash­ioned Ponzi scheme.”

Decem­ber 12: More on Mad­off and the world’s biggest explicit Ponzi Scheme (in real­ity both the stock mar­ket and hous­ing mar­ket bub­bles were also Ponzi Schemes) The World’s Biggest Ever Heist. “Right now, there are a hand­ful peo­ple whose world has sud­denly been turned upside-down: who have, overnight, sud­denly lost bil­lions of dol­lars of dynas­tic wealth to a Wall Street con man. I’m sure that their names will appear sooner or later. But there really is no prece­dent that I can think of: when has one man ever man­aged to steal $50 bil­lion dol­lars? If the $100 mil­lion Harry Win­ston heist in Paris was the “steal of the cen­tury”, what’s this?.”

Decem­ber 11: Henry Blod­get on Clus­ter­stockBernie Mad­off: The Indict­ment. “The crim­i­nal indict­ment of Bernie Mad­off is embed­ded below. The good stuff starts at the bot­tom of page 2, when the FBI agent begins talk­ing about his inter­view with two of Bernie’s senior employ­ees. Accord­ing to the WSJ, these two employ­ees are Bernie’s sons. Also don’t miss the last para­graph, where the agent inter­views Bernie him­self.”

Decem­ber 11th: Promi­nent Trader Accused of Defraud­ing Clients, NY Times. “On Wall Street, his name is leg­endary. With money he had made as a life­guard on the beaches of Long Island, he built a trad­ing pow­er­house that had pros­pered for more than four decades. At age 70, he had become an influ­en­tial spokesman for the traders who are the hid­den gears of the mar­ket­place. But on Thurs­day morn­ing, this con­sum­mate trader, Bernard L. Mad­off, was arrested at his Man­hat­tan home by fed­eral agents who accused him of run­ning a multi­bil­lion-dol­lar fraud scheme — per­haps the largest in Wall Street’s his­tory…”

Mr. Mad­off invited the two exec­u­tives to his Man­hat­tan apart­ment that evening. When they joined him there, he told them that his money-man­age­ment busi­ness was “all just one big lie” and “basi­cally, a giant Ponzi scheme.”

The senior employ­ees under­stood him to be say­ing that he had for years been pay­ing returns to cer­tain investors out of the cash received from other investors.”

Check the Mad­off Client Data­base to see Madoff’s iden­ti­fied vic­tims, com­plete with a map of there loca­tions. Amaz­ing!

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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  • icon­o­clast


    I refer you to the fol­low­ing arti­cle regard­ing to the Mad­off Ponzi scheme, which exposes the absolute incompetency/corruption of the SEC; they had been informed about this way back in 2000.

    The arti­cle begins with:

    The Wall Street Jour­nal has pub­lished a detailed account of pri­vate fraud inves­ti­ga­tor Harry Markopolos’s efforts over the past 10 years to per­suade the SEC that Bernie Mad­off was run­ning a gigan­tic Ponzi scheme (or, at best, was front-run­ning).

    Markopo­los sub­mit­ted exten­sive analy­sis to the SEC in 2005, which we’ve embed­ded below. The SEC did con­duct an inves­ti­ga­tion there­after, in the course of which Bernie Mad­off “mis­lead” them about the nature of some of his deal­ings with his pri­mary fund-of-funds pro­moter Fair­field Green­wich Group.

    The arti­cle con­tains the actual doc­u­ments that Markopo­los sub­mit­ted to the SEC back then. A very very inter­est­ing read.