The Ponzi plot: a perennial plague

Ponzi: adj. referring to Charles Ponzi, an Italian immigrant who bilked thousands out of their money in the early 20th century using the investment scam that is now named after him – a “Ponzi Scheme.”

Plot: n. a secret plan for accomplishing a usually evil or unlawful end

Perennial: adj. persistent, enduring, present at all seasons of the year

Plague: n. : a disastrous evil or affliction

Staying on yesterday’s theme of “If it sounds too good to be true, it probably is,” we turn our attention to the Ponzi scheme, which has returned again to the headlines.

In a Ponzi scheme, potential investors are wooed with promises of unusually large returns, usually attributed to the investment manager’s savvy, skill or some other secret sauce.

The returns are repaid, at least for a time, out of new investors’ principal, not from profits. This can continue as long as new investors line up with cash, and old investors don’t try to withdraw too much of their money at once.

Ponzi schemes are also known as pyramid schemes, from the shape of any chart that reflects their basic premise — that ever-growing layers of new recruits are needed to provide gains to the smaller, earlier cohorts.

And from Wikipedia:

The catch is that at some point one of three things will happen:

  1. the promoters will vanish, taking all the investment money (less payouts) with them;
  2. the scheme will collapse under its own weight, as investment slows and the promoters start having problems paying out the promised returns (and when they start having problems, the word spreads and more people start asking for their money, similar to a bank run);
  3. the scheme is exposed, because when legal authorities begin examining accounting records of the so-called enterprise they find that many of the “assets” that should exist do not.

This time, in keeping with the American way of doing things Bigger, More Brilliantly and More Audaciously than has ever been done before, we have Bernie Madoff – who has managed to bilk his wealthy investors out of 50 BILLION dollars. Charles Ponzi must be salivating in his grave!

It was in many ways (almost) a perfect crime. Madoff had stellar bonafides: he had been the head of the NASDAQ, for God’s sake! If the head of an enormous stock exchange didn’t know investing, who did??  He preyed on only the wealthiest, who fought to get in his good enough graces so they could have the PRIVILEGE of giving him their money.

Despite many tips to the SEC over the past few years, Madoff managed to carry on until we had an economic meltdown; too many investors wanted to get their money out and it all came unglued.

I keep thinking that Madoff is just the easiest target to vilify, when really, wasn’t Enron a Ponzi scheme? What about the mortgage industry, the banking industry, the insurance industry?

Jonathan Weil writes at Bloomberg.com:

It’s unclear why the SEC failed to stop Madoff, whether because of corruption, a lack of smarts, a dearth of interest, or some combination. We can say with confidence, though, that many other huge frauds are still operating freely today — and that the government might not be inclined to intervene, even when it knows all about them.

After all, Madoff’s scheme — at least in spirit, if not in its nefarious intent — wasn’t much different than the business models at some of the nation’s largest failed financial institutions.

Back in May, four months before it collapsed, American International Group Inc. increased its dividend at the same time it unveiled plans to raise $12.5 billion in capital. Later, when its cash ran out, AIG got a government bailout, the size of which has expanded to about $150 billion.

Whether you call that a Ponzi scheme or something less sinister, AIG was paying old investors with money raised from new investors. The same could be said of many banks that blew through billions of dollars in freshly raised capital the past couple of years, continuing to pay large dividends even as their balance sheets quietly imploded.

Kind of makes me want to go back to the days of bartering, when you dealt face to face with the maker/grower of the goods you were trading: a cow for pile of blankets. What you see is what you get.

Update 12/19Paul Krugman asks:

How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole? ….

… while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics, in a nicely bipartisan way. And while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics, in a nicely bipartisan way. From Bush administration officials like Christopher Cox, chairman of the Securities and Exchange Commission, who looked the other way as evidence of financial fraud mounted, to Democrats who still haven’t closed the outrageous tax loophole that benefits executives at hedge funds and private equity firms (hello, Senator Schumer), politicians have walked when money talked.

Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else? [emphasis mine]

Read the whole column. Krugman hit a nerve – hundreds of readers responded – and the top dozen or so add further depth.




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