He's a pinball wizard there's got to be a twist, a pinball wizard he's got such a supple wrist. How do you think he does it? (I don't know), what makes him so good? ....he ain't got no distractions, can't hear those buzzers and bells, don't see lights a flashing, plays by sense of smell, always gets a replay, never tilts at all, that deaf, dumb and blind kid sure plays a mean pinball Pinball Wizard - The Who
"Why do you come to me? Why do I deserve such.... generosity?" The Godfather - Don Vito talks Sollozzo
CHARLES PONZI, "OLD SCHOOL" SCAM ARTIST
Original pinball wizard, Carlo Ponzi, aka Charles Ponzi, immigrated to the United States from Italy in 1903. He is, of course, the person who gave his name to a type of swindle that has existed for all time and will continue to exist for the rest of time. What exactly is a Ponzi scheme? Simply put, it is the act of paying out returns to investors exclusively from the capital supplied by future investors. Investors in a pure Ponzi scheme do not actually have their money invested. They unwittingly rely on the promoter to be able to raise even more money to pay them back "with interest". Since the investors must receive a rate of return, the Ponzi artist must always raise more money from the "next" investor than he did from the "prior" investor. The higher the promised return, the greater the amount which needs to be raised. Another term for a Ponzi scheme is its more descriptive title, "Pyramid scheme". One can learn everything one would ever want to know about Charles Ponzi at the Charles K. Ponzi Website
In 1920, Charles Ponzi noticed there was a riskless profit to be had in purchasing US postal stamps in foreign countries at one price and selling them to the US Post Office (or any one purchasing a stamp in the US) for a higher price. In the early 20th century, postal authorities in each country agreed that international mail would be facilitated if each sender of a letter across national boundaries could send a "coupon" to the recipient of the letter. This coupon could be used by the recipient of the letter to purchase a stamp in their home country at their local post office. The recipient would still have to pay for postage, but the coupon combined with their local stamp created paid postage in the original sender's country.
The purchase price was fixed in the local currency by international treaty. Because exchange rates fluctuated, Ponzi noticed he could effectively buy US stamps with these coupons in, for example, France at one price and then sell them in the US at a higher price. This was the premise of his new financial enterprise established in Boston called "The Securities Exchange Company". Ponzi seems eerily prescient as this foreshadowed the 1933 establishment of the also ironically named "Securities and Exchange Commission" by 13 years.
This is the second feature of almost all Ponzi schemes. The "investment thesis" on the surface has some plausibility to it. Of course, Charles Ponzi never actually bought and sold stamp coupons. He just told his investors he did. In Ponzi's scheme, he promised investors that for every $100 they invested, he would pay them $150 in 90 days. This seemed plausible to investors who lined up outside his offices in Boston because one could buy a US postal stamp coupon for 1 cent in Europe, and sell it for 6 cents in the US. He fed a rush to invest with him as "investors" knew authorities would eventually close this loophole. He collected about $10 million by the end. In today's terms this would be the equivalent of $1-2 billion. Not Bernie Madoff or Henry Paulson territory, but at the time it was pretty spectacular.
One of the failures in the "due diligence" process by investors who willingly believed this investment scheme is they did not carefully think through the logistics of Ponzi's "investment process". In order to pay 50% on $10 million, you have to buy one heck of a lot of stamps. Since he was splitting the "profit" "50-50", a legitimate investment process would have required Ponzi to buy about 200 million stamps every 3 months. This was many times over the volume of the flow of international mail by coupon. Plus, what services did he use to get these stamps? Who did he employ to process these in each country? How many trucks did he own? A few simple questions by "investors" would have laid bare the scheme pretty quickly. To keep his scheme going even for 1 more year at his promised return, Ponzi would have had to have raised $70 million just to stay even and keep paying his investors. One can see why it collapsed so quickly after he started. He had not really thought through his own pyramid scheme logistics which lead to his quick arrest.
THE SUBTLE BRILLIANCE OF THE MADOFF ADAPTATION
Bernie Madoff obviously had done his homework. He realized "pure" Ponzi schemes had short shelf lives. He also realized excessive returns would require too much money to be raised too quickly, so his promises were more modest; 1% a month versus 17% for Ponzi. While we do not know yet the full story of Madoff, this author has a guess has to how this scheme was likely conducted. This is speculation but it helps explain its long "shelf life".
Like all Ponzi schemes, there needs to be a plausible investment thesis. When Madoff actually began his program is not entirely clear. It probably began in earnest sometime between 1988-1992. During this period, legitimate investment strategies run by "Quantitative Managers" called Equity Market Neutral "statistical arbitrage" had begun gathering assets due to their above average consistent profits. A "stat arb" manager would be both long stocks and short stocks. Their net exposure to the market was "neutral". They made money by observing that many stocks appeared to have predictable price movements in the short run. "Stat Arb" traders bought "oversold" stocks and sold stocks that were "overbought". The turnover was frequent and required reasonably complex computer algorithms. Madoff said he too had a market neutral "stat arb" program. In the beginning, it is likely investors believed his story.
Madoff's supposed model had a twist. He would own, according to the documents his funds provided to investors, about 35 of the largest stocks in the "S&P" 100 stock index. He would then create "neutral exposure" by shorting an equivalent amount of the market through an option strategy called "split strike options". He would sell call options and buy put options at different strike prices. The details do not matter. It was a method to neutralize his long market exposure to the market just like the "stat arb" managers. He claimed to have a "complex computer algorithm" that did with the 35 stocks and the split strike options what such programs did for more traditional stat arb managers; create consistent monthly returns. Over the years, however, investors began to doubt the plausibility of this stated strategy. This did not prevent investors from seeking out Madoff. In fact, this skepticism increased their desire to invest with him.
The ironic, sardonic, knowing, relativist, amoral, post modern world we live in created a more subtle "investment thesis" that Madoff implicitly understood investors believed. He did this without ever having to utter a word. In fact, he explicitly denied it in many interviews in a cheerful, bemused manner as this 2001 article in Barron's demonstrates Don't Ask, Don't Tell: 2001 Barron's Madoff Article.
Madoff now effectively had 2 offsetting "investment theses". One that he proposed in print, and one that people believed was actually occurring. Few institutional investors believed the split strike concept. It was too blunt. What investors really believed is that Madoff was able to see the short term trends in the stock market because of his substantial equity "market making" business in his broker dealer, "Madoff Securities". He would then adjust his positions, or so his investors believed, in his "hedge fund" in anticipation of large buying and selling in any particular stock in his portfolio. This is called "front running" and is illegal. While it is unlikely investors thought Madoff was engaging in illegal activities, they probably believed he had discovered some technicality which permitted him to do this (or he would have been arrested, right?)
But just as Charles Ponzi did not actually buy and sell stamps, Madoff did not either buy and sell options or front run securities for his hedge fund. The genius of it all, whether intended or not, is that no one did real due diligence on Madoff because there was no point. No one believed the split strike option strategy to begin with so why do due diligence on that? As many articles have shown, there were not enough options in existence for him to even trade the strategy. But investors also could not do "due diligence" on the "front running" strategy because Madoff never said it was part of the strategy. Plus pursuing this line of questioning would simply unmask the unethical or illegal enterprise they were investing in. Given how good the returns were, investors chose to pretend to believe in the "split strike strategy" instead. Brilliant. Madoff trapped his "too clever by half" and "too amoral by half" investors like a black widow spider.
What did Madoff likely do? He probably just went long the market and cooked his books to make his earnings seem steady. Recall the markets went straight up between 1988 and 2000. He also had so many different investors, no one knew what he had under management. As long as the market went up and investors did not demand too many withdrawals he could keep this up. When the market crashed in 2000-2002 is when the scheme likely began to unravel. How he kept it going so long is a testimony to his cleverness and investors willingness to believe and share in questionable profits. The SEC got lulled because when they investigated him, he never was found guilty of front running for his hedge fund. Since the hedge fund was not under their jurisdiction, they never looked at that either and therefore never found either the Ponzi scheme or cooked books. Madoff had complete and utter free reign, a true pinball wizard.
So what is the due diligence lesson learned here? With Ponzi it was a physical logistics question. How could he "move" so many stamps? Here it is a "moral logistics" question. It is pretty clear isn't it? If you think someone is lying about what they are doing, how in the world can you believe they are lying to help you?
HENRY PAULSON REPRISES VIRGIL SOLLOZZO
I know what you are thinking. I am going to stretch credulity and seek to compare the legitimate activities of a Government enterprise, with those of transparently sleazy crooks. Yes, that is true. Except the similarities are too ripe and too easy to make to simply ignore. Being on record in all my earlier writings on this makes me at least consistent. Economist Arnold Kling has made a similar observation, so I do not stand alone. Even my ideological opposite, Paul Krugman, has made similar observations, Madoff as Metaphor.
On September 25th, 2008 Henry Paulson, US Secretary of Treasury, asked his President to address the nation about the upcoming financial meltdown that was about to begin. Mr. Bush was sent to present Pauslon's investment thesis to America President Bush Speaks On The Economy. As with Ponzi and Madoff, Paulson's investment thesis was plausible. Markets were declining. The reason financial markets were declining was that investors had lost faith in the value of mortgage securities. These values were in free fall. However, the reason they were in freefall is that the free markets had "ceased to function properly". In fact, most of these mortgage securities were likely to pay off.
By buying them now, other investors would see the confidence the Government and the American people had in them and would no longer fear to hold them or buy them. So the investment thesis was basically, "hey, these mortgages are pretty cheap". But in addition to the "carrot", Paulson did not want to take any chances. So, even though the mortgages were "cheap", the market did not believe they were cheap "because the market was not functioning properly". So if Americans did not buy these right now, the economy was going to collapse and we all were going to be in pretty big trouble. Oh, and we need to do this in the next 2 days.
Now any person who has studied marketing, or even has an IQ over 40, can see that this is not the most "customer friendly" sales pitch. It was basically, "look, I do not have any time for questions; I am telling you this stuff is cheap and you need to buy it now. And if you don't, you personally are likely to experience severe financial distress". I am not sure Virgil Sollozzo could have said it any more clearly The Godfather - Don Vito talks Sollozzo. But the American people, like old Don Vito himself, could also smell a bad deal when they saw one and rejected it overwhelmingly. Still, Paulson, like Sollozzo, was not going to take no for an answer. Suddenly the American public was forced to just "invest" $700 billion with Hammerin' Hank. Unfortunately, we had no Don Vito on our side to right the situation YouTube - Godfather - Michael and Sollozzo
How is this a Ponzi scheme? It is not an "old school" Ponzi, but it is a Ponzi scheme nonetheless. Lets address the issues. First of all, like all classic Ponzi schemes, the investment thesis was not followed. Paulson never did buy mortgages and, as he later told Congress, never intended to. That is pure Ponzi. Secondly, he also used "other people's money" to pay back original investors who had lost money. The first $350 billion came from people to repay owners of financial institutions who had lost money from other bad investments. So these people got their money back solely from the proceeds of other investors. While this was not a direct repayment, it was an indirect repayment as it helped prop up prices of securities investors still held that would have otherwise declined in value. This too is "old school" Ponzi, but with a "market twist".
Paulson, like Madoff, developed his own adaptations. The "Paulson qua Sollozzo" proposal also "promises" a return on our new investment. But as in the due diligence lesson learned from our Madoff example, what should we think when we catch our investment manager lying? The answer is "How in the world can we believe he is lying for our benefit?" Finally, TARP is worse than a Ponzi scheme, because we are forced to do that which we would not otherwise do. Madoff and Ponzi were "seducers", Paulson is a ......well, you know the word I am looking for.
Many readers may object that this is really being done for our good, as it will help the financial system stay solvent. This "investment thesis" unfortunately will take more time to debunk and will have to be addressed in future essays.This is not being done to "save the financial system". It is being done to "save specific financial firms", a radically different thing.
What is our due diligence lesson from TARP? Moral Hazard is real Moral hazard - Wikipedia, the free encyclopedia. If everyone who ever invests thinks they have access to your pocket every time they lose money, how will that impact future investments? It will simply encourage more of the same irresponsible behavior. We are always told this time is different and we promise, it will never happen again. But lately, it seems, it has been happening quite a bit. The Government is seemingly promising to repay every loss ever experienced by any investor over the last 5 years. Every investment but your investment, that is.
WHAT IS TO BE DONE ABOUT GOVERNMENT SPONSORED PONZI SCHEMES?
The best we can do is speak out and elect public officials who believe in personal accountability, limited Government, self reliance and the obligation of investors to take their lumps when bad investments are made. And not ask others to pay back their losses. Next time one sees a Sarah Palin talking about personal responsibility and self reliance, perhaps we should not be so quick to knowingly chuckle about her "country bumpkinness". And the next time one sees an uber sophisticate "public education advocate" such as Caroline Kennedy (like now) virtually demand her rightful seat on one of the princely thrones, and seem almost perplexed when it is not universally accepted, ask yourself what steps she will likely take to prevent the next Moral Hazard disaster. It is not all that complex, really.