[Previous] [Main Index] [Next]

Sunday, December 14, 2008

BERNARD MADROFF, PONZI-SCHEMES, AND FINANCIAL INNOVATIONS: ANYBODY FOR REGULATION?

Today's Second Buggy Topic

It was left earlier today in a thread at the Marginal Revolution, a good economic web-site run by Professor Tyler Cowen . . . himself an uncommonly flexible libertarian, willing to admit markets do fail now and then --- yes, even in a system-wide sense as in the current financial meltdown. 

The thread was started with Cowen's commentary on Bernard Madoff, the former chairman of the NASDAQ stock market, who then --- as the world now knows --- created his own hedge fund and ran it for decades.  In the process, Madoff became known as a financial wizard . . . yes, even greater than the two Nobel Prize-winning economists who created and ran Long Term Capital Management in the late 1990s.  Alas, just as LTCM turned out to blow apart in 1998 --- it had leveraged its dubious assets 30-fold compared to its $4 billion capital investments (and had, moreover, off-balance assets and other make-believe stuff worth $1 trillion) --- so the longer staying power of Bernard Madoff, who provided 10-15% return to his (earlier) investors, year-in, year-out, turned out to be built on flimsy plaster-of-Paris and to melt down just a couple of days ago when the FBI arrested him and he confessed that his brainstorming hedges in shorts-and-longs and derivatives and others were about as in touch with reality as a Loony-Tunes cartoon. 

The Cunning Con-Game Clarified

More concretely, the whole Madoff hedge-fund --- or maybe private-equity fund (neither has been regulated and the border between them, fuzzy to begin with, became fuzzier still, distinguished originally by the private-equity investing mainly in illiquid funds and the hedgers gambling in liquid ones) --- turned out to be a gigantic, long-living Ponzi-scheme, the biggest fraud in financial history . . . at any rate, since the Dutch bought all of Manhattan from the local Indian guys for about $24 in 17th century terms. 

Sidebar Comment: On hedge-funds, what they are and what their future is likely to resemble in a new, highly regulated environment, click here for an illuminating and humorous account.  For a biting, even more mirthful account of the entire make-believe foundations of how American and other financial wizards and firms believed they could outwit everyone making money on money the last few years --- the upshot of which is our global crisis in financial markets and real economies everywhere --- click here for Michael Lewis's account.  And if you want the most thorough, and simultaneously the easiest-of-all accounts of how the world got itself into this mess, go to NPR's remarkable account found at This American Life

In his scheme, believe it or not, Madoff did no investing in earth-bound funds at all --- whether liquid, illiquid, or ethereal.  He would simply take on new, rolling-in-dough investors --- rich private families, half-demented hedge-funds run by other speculators, banks, Central Banks, and governments all around the world, Kings, Sheiks, and daft draft-dodgers loaded with dough --- all of whom were eager to pay huge, huge fees to BMIS LLC (Bernard Madoff Investment Securities) for the privilege of letting him invest their money each day and use it, unknowingly to them, to pay big dividends to the older investors the next day. 

There's More Too

Of course, once the older investors got a nifty return, they would then invest more money, and so Madoff could use it to pay off the newer investors.  They, in turn --- delighted how quickly their investments were paying off --- would then pour in more money . . . all, you understand, for those skyhooting fees; and on and on the game went until KABOOM!  Bernard in custody.  Headlines blasting world-wide.  Investors left with dropped jaws and, in some instances no doubt, unable to pay their mortgages on $20 million mansions or costly call-girls on-the-keep.

Well, as it happened, the investors have now lost collectively $50 billion . . . the big losers, of course, the newer ones.  Yep, just $50 billion --- Madoff pulling in money for decades, you understand, by reeling in his gargantuan monthly fees --- based on a total capital investment by others of $700 million. 

At the web-site of BMIS LLC --- or just plain B**S for those in the know now --- the following claim is found on the home-page:

Mr. Madoff has "a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm's hallmark."

Others Too 

And the same kind of fancified claim, no doubt, was made by mortgage-brokers, commercial banks in the mortgage business, investment banks buying the financial derivatives based on these mortgages --- one such mortgage, not that unusual, worth $750,000 given to an illiterate, out-of-work Mexican immigrant in California --- and then passed along a chain of get-rid-of-the-risk and get-big-fees-lickety split that extended world-wide, involving AIG and credit-swaps with Ponzi-like intermediaries (many with no brick-and-mortar location) around the globe.  With what consequences we are now familiar.

The Buggy Comments on All This 

Found here.  Note: be sure to click on the "Next" button at the bottom of the initial page of comments at the Marginal Revolution. 

Is There a Moral Here?

Sure is . . . and nobody ever put it better than the great, great George Gershwin in one of his most famous songs, Nice Work If You Can Get It:

The man who only live for making money
Lives a life that isn't necessarily sunny;
Likewise the man who works for fame --
There's no guarantee that time won't erase his name
The fact is
The only work that really brings enjoyment
Is the kind that is for girl and boy meant.
Fall in love -- you won't regret it.
That's the best work of all -- if you can get it.
Holding hands at midnight
'Neath a starry sky...

Oh that is nice work if you can get it.
And you can get it -- if you try.
Strolling with the one girl
Sighing sigh after sigh...
Oh nice work if you can get it.
And you can get it -- if you try.