Complete Blog 7 - All aboard the Ponzi train

This week I will be reflecting on my learning of the Madoff Hustle documentary, which provides details of the world’s largest Ponzi scheme, totalling $65B, perpetrated by Bernard Madoff which was uncovered during the financial crisis.

What is a Ponzi Scheme?

It was in second year of University when I first heard of Ponzi schemes. Mark Lochanan’s regulation and financial crime seminars were very interesting and they provided a detailed insight into some of the suspicious behaviours which characterise these financial scams. For those of you who did not have the pleasure of being a part of Mark’s seminars, I will provide my interpretation of a Ponzi scheme. They start with an individual or group who claim to have a new or exclusive investment strategy which guarantees high returns. The first set of investors will be chosen for their high net-worth and lack of investment knowledge. This lack of investment knowledge is coupled with a ‘club’ or exclusive feeling, meaning people are often not thorough in their due diligence as they feel special to have been chosen. Once the first set of investors have parted with their money, the schemer relies on personal meetings to build rapport and deceive additional investors out of their savings. Instead of investing in securities, as investors would have been told, the money from the second group of people is used to provide returns to the first group. This cycle creates an initial buzz about the scheme stimulating demand. Charles Kindleberger, a historian of bubbles, described, perfectly in my eyes, how Ponzi schemes expand, “There is nothing so disturbing to one's wellbeing and judgment as to see a friend get rich”. It is this, rather greedy, nature in people which Ponzi schemes look to exploit. However they rely on an infinite number of investors to dupe, and in an illiquid market, new investors do not wish to tie their money up and so the Ponzi scheme’s source of finance dries up. Once existing investors start wanting their money returned in times of market panic or illiquidity, the scheme begins to reveal itself.

Upon reflection of the programme, I experienced a sense of cognitive dissonance. I wanted to, of course, blame Madoff, but I also wanted to blame the investors. Surely I can't blame them both?

The perpetrator is to blame

My initial thought when watching the documentary was Madoff is solely to blame. He was meant to be a man of principle as a practicing Jew, yet these principles did not translate into action. He was out to benefit himself at the detriment of other people. The hardest part I find is how he was able to meet with existing investors and new potential ones, and blatantly lie to dupe them out of money. I feel physically sick when I lie about how many biscuits I've eaten (perhaps because of the number of biscuits I've eaten!), so how naturally Madoff lied, shows sociopathic traits.

Financial markets only allocate capital efficiently when there is trust. When Ponzi schemes and various other forms of market manipulation are uncovered, household investors understandably become skeptical of the financial markets, creating a mismatch between those with surplus capital and those market participants seeking to borrow. Without trust in the markets and the flow of capital, the Global economy will become dangerously unproductive, which brings with it severe social consequences. As the financial markets touch on everyone's lives, I see it as arguably one of the most important responsibilities for financially informed market participants to create an environment where this trust is not undermined.

One comment showed the true nature of Madoff and many others in the finance industry, “It was only when he was earning money that he came to life”. In my eyes, this encapsulates all that is wrong with finance. Life is about more than earning money. Mankind is bigger than one person. There is a bigger picture here, if people were motivated not by money but to make the world a better place, if they were selfless instead of out to earn as much money as possible for their short existence, society would function better. The idea of corporate growth and personal wealth improvement creates a global culture where it is acceptable to benefit from the misfortune of others. This is where financial ethics comes into play. It is essential for leaders in financial services to have virtuous characteristics because they set the tone for the rest of the organisation. Regardless of the narrative outlined in corporate literature such as codes of ethics, the example leaders provide for assessing the rights and wrongs is unrivaled.

It is clear that Madoff is the key culprit in this scam and the question I was left wondering at the end was, having boasted influential and financially rewarding jobs, what made Madoff launch a fraudulent scheme to dupe billions from investors?

My guess would be greed and power, but the truth to that question will never be found out.

The fault of naïve investors

However, I feel the investors should also take some of the responsibility as their naivety perpetuated the scam.

When watching some of the investors' interviews during the documentary, I couldn't help but draw links to mergers and acquisitions (M&A). M&A are arguably one of the biggest decisions for a corporation, it could mean they create or destroy vast amounts of shareholder value. Unless you are Fred Goodwin purchasing part of ABN Amro (as we have seen in blog 2), executives will mull over a decision for a significant period of time and conduct thorough due diligence. Sometimes that due diligence uncovers problems which impacts the price paid or leads to the deal being scrapped altogether. Regardless of what the due diligence uncovers, it is unquestionably a worthwhile exercise because the corporation fully understands what they are getting involved with.

On an individual level, conducting due diligence on the company or fund where you are looking to invest your life savings seems like a logical thing to do. Perhaps my logic stems from the fact I may be more financially aware than a large number of investors because of the learning I have received from this degree (although £9000 per year to become a cynical individual seems like a scam in itself). However, there are a few basic principles in life and ‘if something seems too good to be true, it probably is’ is one of them. I admire Madoff in one sense – he was very intelligent. He didn’t abide by the typical Ponzi scheme trait of offering high returns, but instead offered steady returns of 1% per month regardless of the market performance – as he knew investors would be suspicious about high returns. So, while I am slightly sympathetic because it didn’t scream ‘FRAUD’, there were nuances which, if explored, would have raised suspicions enough to deter one from investing.

People didn’t question how returns were generated or the investment strategy Madoff had. I believe this is because people don’t like to feel out of touch or uninformed about a particular subject and therefore when strategy questions were asked, Madoff’s “split / strike” response was technical enough to deter people from asking further questions and meant people went along with it.

My upbringing has taught me that there is no such thing as a stupid question, if I do not know the answer. Therefore I believe people should feel comfortable asking any question. Though, I understand it is arguably a societal and cultural problem that this attitude of not feeling comfortable asking questions has come about. In school, which should be a safe environment for questions, when a ‘stupid’ question is asked or an incorrect answer is given, sniggers are often heard. This perpetuates and normalises the notion that questions shouldn’t be asked.

I found myself cringing at the lack of financial sophistication shown by some of those in the documentary. One of the first things I would be asking as a high net worth individual is why has Madoff chosen me? As I’ve eluded to previously, I don’t trust people and therefore my suspicions would have been raised immediately. Even the most basic of investors should understand that returns fluctuate massively depending on the business cycle, despite having a diversified portfolio. Conduct some research; look at auditors – this would have uncovered a tiny company. Is this right for a multibillion $ investment fund? The two don’t align. Alarm bells would be ringing. 

I was actually rather annoyed by an elderly couple who asked for their money back but were convinced by Madoff to retain it in the fund. Grow a backbone. It is your money, you had your views prior to the phone call that you wanted your money back. Do not listen to other people. Madoff nor anyone else would convince an investor’s to keep money in a ‘fund’ managed by them, unless it benefited them.

My key takeaway from this documentary is that I've discovered people are all too trusting and become more self-aware of my cyncicism. There were clear warning signs for investors prior to signing up and the financial nativity meant due diligence was not conducted. Once they had parted with their money I understand that it would have been very difficult to decipher this as a Ponzi scheme because of the lengths Madoff went to in order to create an legitimate impression e.g trading certificates with accurate financial information. However, this only serves to highlight the importance of due diligence prior to investing. Despite this being ethically wrong, the effort Madoff put in is commendable - if only he’d translated this energy into activities which were beneficial for society.

Of course, the regulators are there to protect unsuspecting investors and they are also to blame. However, investors need to think of their lives as one big M&A deal and be skeptical, perhaps even cynical, and conduct due diligence. It is not as though Ponzi schemes are a new phenomenon. So people who read the news should be aware of them, despite having little to no investment knowledge. It is this which makes me have little sympathy.

Bitcoin – a Ponzi Scheme?

While I don't believe it is, a further thought I had when watching the documentary was that Bitcoin has some similar traits to a Ponzi scheme.

Bitcoin's value is not like gold i.e an investment, but instead its value derives from its status as a currency. Market sentiment is that Bitcoin prices will skyrocket once it become integrated into payment norms and they are used regularly by people. However, it is because people believe they will rise in price that they are not currently using them but instead hoarding them. Therefore with nobody using them (aside from the much publicised criminal community), their value as a currency is limited and the price will not increase. Subsequently, the crypto-currency community have been attempting to attract investors to bitcoin to stimulate demand and inflate the prices, in order to realise a profit in the short term, fully aware that if no one uses them - their price is near worthless.

It will be interesting to see how this one plays out in the coming few years.

Summary

So my learning from watching this documentary can be summarised in two ways. The Global economy needs financial ethics to solidify trust in markets and ensure capital is allocated efficiently. People have a completely different outlook on life to me, and instead of trying to improve their own financial position, financial leaders need to set the ethical tone to try to improve the world. I've also learned of the naive trusting nature of many investors who must conduct due diligence to protect themselves. It's a chicken and egg situation. If there scammers didn't exist, the financial uninformed wouldn't need to worry. Yet if there weren't any financially uninformed investors, there would be (very) few scammers.

Students of FN0363: Let's make a collective effort to become more informed and once we are in positions of financial leadership, put measures in place to limit the societal damage caused by financial frauds.