The hidden pyramid…

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.


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