some guy in lebanon

So Bernard Madoff has admitted that the Financial Services and Management division of his company is essentially an enormous Ponzi Scheme. $50 Billion U.S. is at stake, as are the subsequent investments of hundreds of millions of dollars hedged on money, debt, and guarantees from Madoff’s organization. In the end, charities are being closed, and confidence in Wall Street is once again being tested. This time, however, nobody can blame lower-middle class Americans for accepting bad loans (a horrible thesis but a common one). This is a classic case of the rich trying to get richer and a charasmatic individual, Bernard Madoff, taking them all for an enormous ride. It is too bad though that many charities find themselves 100% exposed to the collapse of Madoff’s organization.

FoxNews reports that,

Many charities have been devastated by Madoff’s unparalleled investment failure, which paid off false returns to investors and went unnoticed by many observers for more than a decade. Billionaire Mort Zuckerman, CEO of Boston Properties and owner of the New York Daily News, told FOX News that his charitable trust lost $30 million because of Madoff’s mishandling.

In the context of reality, however, I’m curious how this particular scheme of Madoff’s differs in any real way from the Wall Street of the last 15 years.

Wikipedia gives a pretty good example of a Ponzi Scheme:

Suppose an advertisement is placed promising extraordinary returns on an investment—for example 20% for a 30 day contract. The golden key is to bamboozle ordinary people who have no in-depth knowledge of finance or financial terms. High flown terms that sound impressive but are essentially meaningless will be used to dazzle investors. Terms such as “global currency arbitrage”, “hedge futures trading”, “high-yield investment programs”, “offshore investment”. Taking advantage of the lack of investor financial sophistication, the promoter will then proceed to sell them a stake in his pot of gold.

With no proven track record for the investors, only a few investors are tempted, usually for smaller sums. Sure enough, 30 days later the investor receives the original capital plus the 20% return. At this point, the investor will have more incentive to put in additional money and, as word begins to spread, other investors grab the “opportunity” to participate. More and more people invest, and see their investments return the promised large returns.

The reality of the scheme is that the “return” to the initial investors is being paid out of the new, incoming investment money, not out of profits. No “global currency arbitrage”, “hedge futures trading” or “high yield investment program” is actually taking place. Instead, when investor D puts in money, that money becomes available to pay out “profits” to investors A, B, and C. When investors X, Y, and Z put in money, that money is available to pay “profits” to investors A through W.

One reason that the scheme initially works so well is that early investors—those who actually got paid the large returns—quite commonly reinvest their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus those running the scheme do not actually have to pay out very much (net)—they simply have to send statements to investors that show how much the investors have earned by keeping the money in what looks like a great place to get a high return. They also try to minimize withdrawals by offering new plans to investors, often where money is frozen for a longer period of time, for example 50% return per month for one year. They then get new cash flows as investors are told they could not transfer money from the first plan to the second.

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. problems paying out the promised returns. When the promoters start having problems, the word spreads and more people start asking for their money, similar to a bank run; The scheme will collapse under its own weight, as investment slows and the promoters start having
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.

Bernard Madoff, indicted by the SEC for securities fraud, bragging to Congress about profits

Pretty nifty right? Well the question in my mind is, when the vast majority of Wall Streets profits are hedged essentially on the belief that land and property values will continue to increase forever, the belief itself hedged largely on suspension of disbelief and on charismatic individuals, what is the real difference between this and a Ponzi scheme?

Consider Wikipedia’s definition of a “Bubble”:

A bubble relies on suspension of disbelief and an expectation of large profits, but it is not the same as a Ponzi scheme. A bubble involves ever-rising (and unsustainable) prices in an open market (be that shares of a stock, housing prices, the price of tulip bulbs, or anything else). As long as buyers are willing to pay ever-increasing prices, sellers can get out with a profit. And there doesn’t need to be a schemer behind a bubble. (In fact, a bubble can arise without any fraud at all – for example, housing prices in a local market that rise sharply but eventually drop sharply because of overbuilding.) Bubbles are often said to be based on “greater fool” theory. Although, according to the Austrian Business Cycle Theory, bubbles are caused by expanding the money supply beyond what genuine capital investment supports, and in this case would qualify as a Ponzi scheme, with expanded credit taking the place of an expanded pool of investors.

If this is true, when the modern financial market and its relationships to speculative real estate lending, both at prime and sub-prime rates, is taken into account, one has to wonder about the true complicity in this most recent scandal on Madoff’s part, and the entire sub-prime lending crises itself. Because in my mind, whoever wrote the Wikipedia entry about a bubble is incorrect about whether the financial markets in the past 15 years have become anything but a vast Ponzi Scheme – one far bigger than Madoff’s triffel $50 Billion, but instead involving trillions of dollars that have woven their way around the entirety of the American capitalist model, and we have all been taken for a ride.

Bernard Madoff might be the “bad guy” and everyone else he did business with “poor stooges,” but in age of far-too-cheap credit, a Federal Bank with a policy that has stealthily increased the money supply by leaps and bounds for far too long, and the essential Americanization of global financial markets that have led to exposure throughout the world, I seriously wonder: Just who is the Ponzi, who is the stooge, and what in the world are we going to do next?

Thanks for destroying capitalism jerks.

The Dao that can be experienced is not true;
The world that can be constructed is not true.
The Dao manifests all that happens and may happen;
The world represents all that exists and may exist.
-Dao De Jing