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 Clus­ter­stock: Bernie 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!