Archive for the ‘Madoff’ Tag
Continuing my ramblings about commission, I refer you, gentle reader, to my earlier posts about Bernard Madoff.
Madoff operated a classic Ponzi scheme, and in my earlier post I postulated that the market as a whole had done the same to its participants, largely as a result of commission.
A classic, or simple, Ponzi scheme, is an investment product producing above-average returns to early adopters by siphoning-off the deposits made by new investors. So long as the scheme continues to attract new depositors, investors get a good return; but it is as fraudulent as a chain letter. It is, of course, exactly the same thing, but less honest. At least with a chain letter you are told how it works, but the inexorable arithmetic is the same in both cases. Madoff made his scheme last for so long by providing only slightly above-average returns, which both made it seem more credible and extended the time-scale of the inexorable arithmetic.
I think that in addition to the simple Ponzi scheme used by Ponzi, Madoff and many others, it is possible to conceive of complex Ponzi schemes. A simple scheme is implemented in a self-contained financial instrument, whereas a complex scheme does the same thing using multiple instruments where the value flows between them; but from the outside, the effect is the same. A complex scheme could then be either contrived or emergent. In a contrived complex Ponzi scheme, the operators of the various instruments deliberately set out to achieve the Ponzi effect and design them to do so. I think that some of the housing/buy-to-let/mortgage frauds may be contrived complex Ponzi schemes; estate agents, solicitors and mortgage brokers are typically implicated in a conspiracy to defraud.
Much more disturbing, however, is the case of the emergent complex Ponzi scheme. In this case, it is the interaction of various financial instruments, each of which is itself entirely legitimate, which leads to a Ponzi effect. One such instrument might be broker’s commission. Indeed, I suspect it is the main villain in my very strong hunch that most of the financial services sector has been operating for much of the last quarter-century as a very large emergent complex Ponzi scheme. Not a deliberate, criminal enterprise, but one nevertheless where the operators have benefitted enormously as punters have lost. I suspect that it is a property of commission-based sales in savings products that a complex emergent Ponzi scheme is inevitable.
Perhaps there is evidence for this, but I think that first I need an adequate algebra to make the case and then to derive relations which can be tested against available metrics.
Madoff’s scam, his fraudulent investment vehicle, was a classic pyramid scheme, an illegal chain letter on a massive scale. Chain letters at least are transparent: if you are dumb enough to send money to the person at the top of the list, you know it’s going straight into his pocket.
So, as commorancy says in the comment to my earlier post, how many more frauds are out there? How many more frauds have the regulators missed? I doubt that there are many that are quite so blatant as Madoff’s. His was conspicuously lacking in transparency; he didn’t use external brokers, and his auditors were a two-bit firm from out of town. What’s scandalous about Madoff is that so many well-paid investment managers put their clients’ money into it when all the signs were there that it was a bad one. Nicola Horlick has lost £10m of her clients’ money, and she’s blaming the SEC. It’s true that the SEC seem to have been particularly lax here, but regulators don’t have unlimited resources. Ms Horlick is supposed to be smart: it’s her job to check, and she shouldn’t have to rely on the regulator to do her job for her. She and dozens of other similarly over-paid parasites working for Santander (which has lost £3 bn), HSBC (£1bn) and others were woefully negligent ; and if I were one of her clients, I would be consulting m’learned friends.
But that doesn’t mean to say that there isn’t a bigger problem, to which I have alluded in my earlier post. Lots of people managing other people’s money – ultimately, most of it is our pensions and savings, don’t forget – have been paid a lot of money, because they have led us to believe that they are smart. They believed it themselves, and lots of them are indeed smart. They want to believe that they were smart enough to make above-average returns for us all by making smart decisions in the market, and for a long time they have done so. Here’s how.
Now, Madoff’s above-average returns were made by paying out new investors’ deposits as dividends to existing investors. This is an old, and pervasive trick in the market; and while Madoff’s scheme was fraudulent and illegal, a lot goes on that’s legal. Go into a bank branch; you’ll queue for hours to cash a cheque, but in the lobby will be a couple of people with no queue. They can’t do anything useful for you, but they can sell you an investment product. The bank gets a fat commission from selling the savings plan or pension product. That commission comes out of the first year’s deposits you make towards your pension. It goes to the bank’s bottom line – it’s much more profitable selling investment products than cashing cheques. So profitable, in fact, that the bank can afford to cash cheques free. Now, the fund manager whom you are paying to look after the money in your pension fund looks at the banks’ financial statements and sees that they are profitable. So she decides to put your money into bank stocks. You get some of the returns, which are earned from the commission paid by new depositors.
Spot the basic difference between Madoff’s illegal scam and the legal one which has been the financial services sector since 1986?
No, me neither.
We should stop being so surprised. They have already revealed themselves to be monumentally stupid, but the weekend’s announcements from many major banks that they are heavily exposed to the Madoff investment fund still leaves me open-jawed with astonishment.
How much money were these guys paid? To invest their clients’ money? In something which was so obviously a fraud? What value exactly have they been adding all these years?
In physics, there are many different fundamental laws. If an experiment, or a theory, appears to break any of these laws, it is subjected to intense scrutiny, and so far all such cases have been shown to be wrong. Two of those fundamental laws are the first and second laws of thermodynamics, often expressed respectively as “you can’t get something for nothing”, and “you get damn all for sixpence”. Now these laws also apply in finance. I believe, though I do not think I have the maths to prove, that the same laws apply identically in finance. But never mind the maths: there is another well-known financial law, which is probably another expression of the second law of thermodynamics, and it goes like this -
“If it looks too good to be true, it probably is”.
Guess what. The Madoff fund looked too good to be true, and lots of people for many years have been saying so. Quite a lot of smart people steered clear of it, and told others to steer clear of it, for almost exactly that reason. (The other reason given was that it was conspicuously lacking in transparency. If it had been transparent, its fraudulent nature would have been revealed much earlier).
What Madoff did, cleverly, was to produce returns which were on the almost-believable side of unbelievable. He didn’t promise his clients 50 or 100% returns on Treasury Bills, just 10-12%. On a lucky day, an average trader might make those returns for real – but no real traders get lucky and stay lucky that long. The financial sector likes to believe that there’s less luck and more skill in investment, because if it’s skill, and not luck, it justifies how much they all get paid. They wanted to believe that Madoff really was that smart, because they wanted to believe that they were all smart.
We’ve come to see over the last few weeks and months that mostly, they weren’t that smart, and the Madoff fund just shows how dumb many of them can have been. Britain’s got a pin-up poster girl of finance, a lovely-sounding lady called Nicola Horlick, aka “superwoman” because she has brought up five children while earning millions as a fund manager. She was on the radio yesterday morning confessing that she’d put some of her clients’ money into the Madoff fund and was exposed to the tune of a few million here or there, and – get this – because she thought the returns were believable.
What’s that quote from Lincoln again? About fooling people? He said it in relation to democracy, but it’s just as applicable to finance.