Sunday, December 21, 2008

Madoff Ponzi Scam and Boom-Bust cycles

“At any given time there exists an inventory of undiscovered embezzlement in — or more precisely not in — the country’s business and banks. This inventory — it should perhaps be called the bezzle — amounts at any moment to many millions of dollars. It also varies in size with the business cycle.”- John Kenneth Galbraith, “The Great Crash of 1929”

``Commercial and financial crisis are intimately bound up with transactions that overstep the confines of law and morality shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft embezzlement or fraud” wrote Charles Kindleberger in Manias, Panics and Crashes.

When people generally feel safe, they take in more risk than is necessary even to the point of dispensing with the necessary appraisal or due diligence.

The recent boom bust cycle underscores this; for instance, institutions that bought into financial assets backed by questionable collateral did so because they put their trust on credit rating agencies, they reached for additional yields, they believed that they can “time” (or exit) the markets, they believed that the boom cycle was in a perpetual motion and most importantly, because everyone else have been doing it (herd mentality). And when the tide did go out, most of them got caught swimming naked, to paraphrase Warren Buffett.

Thus, it is no different when Bernard Madoff bamboozled $50 billion off from the who’s who list which includes top rated financial institutions among them banks, (e.g. BNP Paribas, Banco Santander, Fortis Bank Netherlands, HSBC Holdings, Nomura Holdings, Royal Bank of Scotland and etc.) insurers (CNP Assurances, Clal Insurance, Harel Insurance) and Hedge funds (Tremont Group Holdings, Fairfield Greenwich).

To consider, these institutions account for as supposedly smart money outfits since they are backed by an army of “elite professionals”, e.g. economists, accountants, risk managers, quants etc…). Yet at the end of the day, smart money seemed like everybody else; they got what they deserved because they substituted prudence with fad.

When something turnouts too good to be true they always end up as being a fleeting anomaly or a scam.

Yet markets can’t be blamed for these, in fact, there had been some efforts to expose the Madoff PONZI scheme (a fraudulent scheme which involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real from the private sector as Aksia, a firm that does due diligence on investment advisers or by trader Harry Markopolos, who in 1999 wrote that "Madoff Securities is the world's largest Ponzi Scheme," in a letter to the SEC (WSJ).

Figure 2 Wall Street Journal: US SEC budget

Unfortunately, the Security and Exchange Commission, as the oversight body with about 3,371 employees (as of 2007) and with a ballooning (almost tripling) of budget (see figure 2) has failed to detect the fraud until the recent bust conditions heightened risk aversion which ultimately forced the unraveling of the grandest fraud.

This only goes to show how bureaucracy almost always lags the social or market dynamics because to quote Ludwig von Mises in Bureaucracy, ``The bureaucrat is not free to aim at improvement. He is bound to obey rules and regulations established by a superior body. He has no right to embark upon innovations if his superiors do not approve of them. His duty and his virtue is to be obedient.”

Another, again it’s that feeling of safety but this time from the comfort of regulations that exposes people to more risk taking. As James Grant recently argued “the commission is worse than useless because not only is it always behind the curve, its very existence gives many investors a false sense of comfort that a big agency is looking after their interests.”

Regardless of boom or bust conditions it is our duty to conduct the necessary due diligence and depend less on government or its bureaucracy to their work for us, otherwise suffer from similar consequences of fools parting with their money as above. We should never keep our guards down because there will always be a prowling Charles Ponzi or Bernard Madoff in different forms.

As the Wall Street Editorial goes, ``There's a lesson here for investors and Congress. Instead of shoveling more money and power to the regulators who already had plenty of both, let's take care not to overregulate the people who actually warned about Mr. Madoff's miracle returns. Law enforcement is useful in punishing wrongdoers after the fact, which will deter some crooks. But expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff.”

Finally today’s environment brings other possible scams to the surface that have not been widely reported as in Colombia’s Ponzi DMG card and Canadian hedge fund run by Otto Spork dealing with glacier investments.

Yet the Madoff Ponzi scandal also reflects on today’s crisis which stemmed from the debacle of the previous credit bubble borne out of Ponzi financing “securitization-derivatives-shadow banking” structures.

As an aside, possible future crisis emanating from similar Ponzi type of operations, but are clothed with legitimacy as the Social Security entitlement program (AEIR, James Quinn) and the Fractional Reserve Standard (JS Kim, Dr. Ellen Brown) should be closely monitored.

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