My thoughts on Ponzi schemes

The past year has taught me a few things about finances and about people. Probably the biggest lesson is that just because someone is rich doesn’t make them smart. Bernard Madoff swindled some of the richest people in the world with history’s largest Ponzi scheme. He got people to invest because he promised and seemingly delivered consistent returns year after year regardless of market conditions. He used the cachet of exclusivity to get more money. You could only get in if you had more than $20,000,000, you needed to be introduced and you had to take at face value his “secret” method of investing.

Of course, now that he has been exposed, the hindsighters are coming out of the woodwork. There are several individuals who actually did write the SEC questioning his results and other advisers who told clients not to invest with him. Mr. Madoff’s supposed investing results could not be verified by other investment managers, Mr. Madoff’s firm was audited by a small CPA firm, he cleared the trades through his own firm, prepared his own statements and was very secretive about his methods.

And yet despite all of this and probably in some cases against their better judgment, people invested with him. Why? In many cases, it was because their friends spoke highly of him and shared the same religious background. They belonged to the same country club in Palm Beach. In some cases, it was because the folks that they trusted originally with their money recommended him and claimed that they did background checks and conducted ongoing monitoring of the money. In some cases, people didn’t even know they were invested with him. There are even unattributed reports that some investors “knew” that he was doing something wrong but figured that they were benefiting from it so a “don’t ask, don’t tell” policy was best.

Those of us who are not rich may be tempted to sit back and gloat about the foolishness of the rich. Don’t. The poor and the not-so-rich have their own foolishness as well. The lottery is a case in point. I was listening to a report on NPR the other day about lotteries. The reporter was interviewing lottery officials from around the country and the person who was in charge of the Powerball lottery noted that volumes did not pickup until the jackpot hit $200 million. There seems to be a general opinion that anything less isn’t worth it. The fact of the matter is that the odds of winning are the same no matter how many people play, but normally rational people will take the chance if the number gets big enough, perhaps thinking “what the heck I just might win.”

Those of us who are not rich also fall victim to Ponzi schemes. Ponzi was a promoter who sold stamps and promised a return on the stamps. It was just as crazy as Bernard Madoff but thousands of people bought into the scheme and lost money. The allure of the scheme is the ability to get your money back and also to get a huge return. I remember some year’s back being at dinner with a professional I worked with. Her husband started talking about an investment that he had been offered. If he put in $2,000 he would get his money back in a month plus a 50% return. Being the smug professionals that we were, we knew that it was a Ponzi scheme, that the money he would get back would be from his friends or someone else’s friends who had been drawn into the scheme, but later. We both commented on how terrible it would be to betray our friends by drawing them into a scheme that might lose them all of their money.

And yet, these kinds of schemes flourish. The entire country of Albania was destabilized by a huge Ponzi scheme that was perpetrated shortly after the fall of communism. Recently, in Colombia, riots broke out when the government of the country shut down another such scheme. The riots were not against the promoter but against the government for stopping him. The promoter was viewed as a folk hero because he was bringing prosperity to ordinary people who had been let down by the government.

Are the folks in Palm Beach any different than Latin American peasants? Not in this case. They all lost their savings and in some cases are forced to sell their possessions in order to pay the bills. A pawnbroker in Palm Beach has seen increased business from folks who directly attribute their problems to losses from Madoff. He has had folks bring in prized jewelry and in one case a yacht. Lives have been destroyed by this man and others like him who have stolen the dreams of folks who trusted them.

Before you breathe a sigh of relief that you were not caught up in the Bernard Madoff scandal, you almost certainly have been affected by another feat of financial wizardry gone wrong. I suspect that if you are like me, you have a 401(k) or IRA that is invested in the stock market, usually via mutual funds. I suspect that you may also like me dread the quarterly release of your performance results. The world financial markets have taken a huge hit from the crisis in the US housing market.  In response the US govt and Congress have thrown billions perhaps trillions of dollars at the problem in the hope that something will stick and stop the downward plummet of the financial markets. No one knows what to do because the problem is so big and so unprecedented that they are all guessing. Perhaps the only person who has a notion of what might work is the chairman of the Federal Reserve, Ben Bernanke. Reportedly he is a history buff and one who is particularly interested in that bleakest financial period in US history, the Great Depression.

The current troubles could have been prevented if the basic principle that in order to borrow money, you had to have the ability to pay it back was followed. Instead, in some cases the ability to breathe was the only real criteria applied to granting of loans. How was this made possible? Through another bit of financial sleight of hand. Through logic that only Wall Street could come up with, it was determined that taking a bunch of loans which had no real possibility of being repaid and packaging them together suddenly made them okay and worthy of an investment grade rating. Then, in a further feat of magic, slicing them into component parts and selling these to mutual fund managers and hedge funds, they became part of every American’s financial portfolio whether they knew it or not. To further compound the problem, these wizards bought insurance on the loans from companies who had no business selling insurance since they had nothing to back up the claims when they were made.

So when the inevitable loan defaults started, the investors that had bought the insurance started making claims, the companies that had sold the insurance and had paid out huge bonuses to their principals rather than keep capital just in case started defaulting on their obligations and filing for bankruptcy. Everyone who had bought similar insurance started checking out the financial viability of the companies that had sold them the insurance and realized that they were insolvent as well. So, AIG, the insurance company that had sold the most of these kinds of policies turned to the federal government after every other possible suitor had turned it down. Deemed “too big to fail” the feds lobbed some money at the problem, a lot of money. It started at $85 billion and has been added to since then.

Bear Stearns, Merrill Lynch, Lehman Brothers, Wachovia, WaMu, IndyMac have all gone bankrupt or been sold in a shotgun wedding. And still the money keeps flowing from the federal government and still my 401(k) keeps going down.

What can you and I do about this? The fact of the matter is very little. Your 401(k) advisor, if he’s like mine, is advising you not to stop investing, after all we are buying more shares cheaply. He’s probably right, but it sure seems like throwing good money after bad, doesn’t it?

Hopefully, the government will start to do the job it’s supposed to do which is watch over those things that are too big for smaller governmental units or individuals to handle on their own. Like air traffic control and interstate highways and protecting ordinary folks from financial wizards who create products that make absolutely no sense.

I know that all of this will result in a lot of Congressional hearings, some of them have happened already. New regulations will be enacted which will prevent the same kinds of things from happening again, but there are now thousands of Wall Street wizards out on the street looking for something to do. Since they don’t have practical skills like plumbing and carpentry, they will continue to try to come up with the “next best thing” that will make them rich. Eventually someone will. Markets will soar, the little guys will jump in because they don’t want to miss out, after all, the rich folks are getting richer by the minute. In the end, it will all fall apart again and we will take a step or two backwards. Just hope you are not on a fixed income when the backwards step happens.

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