Aren't We All Unwitting Participants in Ponzi-Like Schemes?

Bernard Madoff, former chairman of the Nasdaq, has apparently been running a Ponzi scheme. According to some, he stole $50 billion--$1 billion for each of his 50 respected years on Wall Street.

The news coverage of this latest Wall Street scandal amuses me. It's shocking, commentators say, that something like this could have happened. The only shocking thing is that more individuals and firms on Wall Street haven't been accused of/caught running Ponzi schemes. After all, what types of individuals work in the financial sphere? Isn't greed one of the primary qualifications? Finding a fraudulent investment business on Wall Street is about as surprising as finding a liquor cabinet empty after entrusting it to an alcoholic.

Another amusing aspect of the Madoff scandal is who the victims are. Henry Blodget, the ever entertaining host of Yahoo! Finance's Tech Ticker (not a stranger to scandal himself), reported that some of Madoff's investors knew something fishy was going on. That's why they invested. No one could produce such high, steady returns year after year with such a safe investing strategy. While they were being cheated, they thought Madoff was cheating others through insider trading. Serves them right. It won't be at all surprising if all these thieves in their own right get compensated for their losses by their government friends. (It would be nice if innocent victims were compensated, though.)

A Ponzi scheme is a simple thing. The thief sets up a fake investment enterprise, and persuades his friends, coworkers, etc, to invest in it. He then sends them statements or even cash dividends, showing that the investment is going well. This attracts more money from the original investors and new ones. Should any investors wish to withdraw their money (in normal circumstances most won't, because their statements show that their investment is doing well), the money from newer investors is used to pay them. Early investors who decide to withdraw their money are paid by the funds new investors deposit. On it goes, until the thief's greed is satisfied and he makes off with the money or there aren't enough new investors to fund the redemptions of earlier investors.

The latter is what happened to Madoff. Losing money everywhere else, too large a number of his investors were forced to redeem their deposits. If the markets hadn't crashed, it's quite possible Madoff's scheme would have gone on much longer, and some of his investors could have made money (if their orderly withdrawals coincided with equal or larger new deposits).

This brings me to some of the Ponzi-like schemes almost all of us participate in.

Stocks: We buy paper with the hope that some sucker in the future will buy that paper from us for more than we paid. (Perhaps not quite as true with dividend paying stocks).

Social Security: The money deducted from our paychecks isn't put away for our future use. Rather, it is used to fund currently retired workers. When we retire, those who work then will fund our SS payments. If this isn't a Ponzi scheme, I don't know what is: early investors are paid by the contributions of new investors. The entire thing is based on the premise that there will be more and more workers in the future. It's far from certain that this premise is true.

Our Economy Before the Credit Crisis: People took out loans on their houses and bought junk. When their houses rose in value, they took out larger loans, repaid the old loans (early investors paid off with the deposits of later investors), and bought more junk. Repeat this a few times. Then some of the loans reset at higher interest rates and couldn't be paid back (more redemptions than can be funded by new investors). This triggered more loan defaults, and the buying of less junk, which resulted in more defaults.

Government (and Corporate) Bonds: You buy a government bond. The interest the government pays you comes from the money it borrows from others, that is, other bond buyers (and to a lesser and lesser extent tax revenues). When your bond matures, the government pays you with more borrowed money (and to a lesser and lesser extent from tax revenues).

Insurance (car, medical, loan default, unemployment, stock broker, etc): This is just like Social Security. We pay a premium to the insurer in exchange for compensation when an event insured against occurs. When the event insured against happens (doctor's visit, stolen or damaged property, etc), the insurer funds our compensation from others' premiums. That is, it's like having new investors pay for the redemptions of earlier investors. If the insurer has too many claims, it won't be able to pay all its clients. Some state unemployment funds are facing this problem. As unemployment rises, they have to pay out more benefits while the premiums they collect get smaller. The last workers, while paying everyone's benefits, will get nothing when they lose their jobs.

Bank Deposits: Not quite a Ponzi scheme, but close. We put our money in the bank, and the bank is supposed to invest it. Put another way, the bank borrows money from us and lends it to others. At some banks we get interest for our trouble. Withdrawls are funded mostly by new depositors, or with other borrowed money. Should a large enough percentage of depositors want their money back at once, the bank will fail. Assuming there's no insurance, not all the money will be returned, as some of the bank's investments will not be good ones.

There are many more Ponzi schemes, I'm sure.

As long as there is confidence, a Ponzi scheme can work for a long period of time. Nevertheless, its design is such that it cannot work indefinitely. Either confidence is lost or it grows too big to be sustainable, and the whole thing collapses. Ponzi scheme collapse isn't just possible - it's inevitable.

So what do we do? Press our policy makers for reforms. Build systems that aren't pyramid schemes. And if you're forced (or choose) to participate in Ponzi schemes, try to get paid in cash or real assets that you can use even if no one wants to buy them from you. For example, if investing in stocks, prefer dividends. Convert some of that cash into stuff you can use just in case cash becomes worthless, etc.

Comments

[investor88:]

Good perspective on proliferation of Ponzi schemes, not just Madoff doing it.

2008 Dec 14 06:52 AM

[WMBANZAI7:]

MADOFF THE FAKE WALL STREET TRADER
(Rudolph the Red Nosed Reindeer)
WilliamBanzai7

You know Vesco and Boesky, and Keating and Milken,
Leeson and Mozer, and Ponzi and Wiggen,
But do you recall, the most famous securities fraudster of all?

Madoff the FAKE WALL STREET TRADER
Had a GIANT PONZI SCHEME,
And if you ever saw it,
You could say it was Wall Street's own worst dream .

All of the other Wall Street fraudsters
Used to laugh and call him names;
They never believed poor Madoff
Made a legitimate Alpha trade,

Then one shaddy Wall Street trading eve,
Madoff spilt his own beans to the SEC
"Madoff oh your scheme's so bright,
It will create a fright on CNBC tonight?"

Then how the Wall Street fraudsters loved him
As they shouted out with glee,
"Madoff the FAKE WALL STREET TRADER,
You’ll go down in securities fraud history."

2008 Dec 14 08:59 AM

[carey_jim:]

I don't think most investors are unaware that they have been and still are participating in markets that are Ponzi schemes, as you put it.

Investors are always looking for ways to make money from market opportunities and they don't care what name is given to an investment opportunity.

Some people call these "investment opportunities" "financial musical chairs."

Musical chairs is a children's game where children circle around a line of chairs accompanied by music. When the music stops, the children fight for a free chair. The game starts with exactly one chair missing so that all but one child will be able to find a seat. When all but one child are seated, one more chair is taken away and the music starts again.

The child who gets the last seat is the winner.

Maybe this is a uniquely American game to help American children prepare for their future.

Don't forget what your name sake taught us about human nature: Bellum omnium contra omnes

2008 Dec 14 11:59 AM

[notsosmart:]

ponzi & tontine.been saying it for years.we are "witting".since humans are involvedcant be fixed.

2008 Dec 14 12:11 PM

[CLH:]

The social security tax is the biggest ponzi scheme of all times.

2008 Dec 14 01:46 PM

[Leser:]

Hats off to this author, Devin Hobbes, and to the five subsequent commentators. You are all correct. (Superb seasonal Wallstreet doggerel, wmbanza17. Thanks.)
If we are to do anything to correct this flaw, it has to start with ourselves and avoid involvement in investments that are exploiting others as well as investments in which we ourselves will be exploited.
Which ones are they?

2008 Dec 14 02:12 PM

[Thomas Smic...:]

The recent LandAmerica 1031 Ponzi is a work in process. Hundreds of innocent real estate transfers secured in "escrow" have been defrauded by Fidelity Title with their willing accomplices at LandAmerica, selling thy title business to Fidelity and Chapter 11-ing the 1031 exchange facet of their business for a ninty profit of almost $300m. Again, the little guys get screwed and the law firms receive the proceeds from the Chapter 11 legal fees. Maybe Lenin was right - shoot the bastards first and dare the rest to misbehave.

What do I call 500 attorneys drowning in an ocean surrounded by sharks? A good start.

2008 Dec 14 04:55 PM

[Did U Think...:]

WHAT A GREAT POST!!! I totally agree that modern economics is nothing more than a myriad of Ponzi schemes all working together in the hopes of getting more out than you put in - a sort of economic perpetual motion machine.

Where does all this start?
- Fiat currency
- Fractional reserve banking
- Keynesian economic policies

Abolish all of the above and you will never see another economic bust again because it will all revert to a work for what you get system that enforces paygo. Prices will come down because they will not be getting propped up by credit. Even medicial treatment prices will fall because they will not be propped up by deep pocketed insurance companies.

I store all of my long term wealth in physical gold because I know for sure that the Ponzi scheme called the USD is getting long in the tooth.

2008 Dec 14 10:26 PM

[donzelion:]

Calling stocks a ponzi scheme seems a bit excessive. The thing about a ponzi scheme is that everyone always assumes the fix is in, they can't lose, great returns with no risks. Most stock buyers are a bit less gullible than that.

Yet WMBANZAI7 has inspired a different tact:

Dashing through the slow
In a one-horse choked humvee
Over the slumps we go
Laughing at AIG – ha ha ha!

Jingles sell, What the hell, No one really cares
Oh what fun to cut and run
And feed sheep to the bears.

2008 Dec 15 11:12 AM