The age of pyramids and the power of illusion

The Securities and Exchange Commission, in a civil complaint, has accused Bernard L. Madoff, a former chairman of the NASDAQ and a well known figure on Wall Street, of running an "ongoing $50 billion Ponzi scheme" according to the Wall Street Journal.

In a separate criminal complaint, Federal Bureau of Investigations agent Theodore Cacioppi said Mr. Madoff's investment advisory business had "deceived investors by operating a securities business in which he traded and lost investor money, and then paid certain investors purported returns on investment with the principal received from other, different investors, which resulted in losses of approximately billions of dollars."

Dan Horwitz, a lawyer for Mr. Madoff, declined to elaborate on the allegations. "Bernard Madoff is a longstanding leader in the financial services industry with an unblemished record," Mr. Horwitz said in an interview. "He is a person of integrity. He intends to fight to get through this unfortunate event."

Madoff was released on bail. Reports said that Madoff had told a group of employees he called to his apartment that "he was 'finished', and that he had 'absolutely nothing' and 'it's all just one big lie'. He told the senior employees that he planned to surrender to authorities in about one week, but wanted to use the $US200-300 million he had left in his possession to make payments to certain selected employees, family and friends, according to court documents." The Australian share market fell 2% on the news of Madoff's arrest.

The historical Ponzi -- Charles Ponzi -- "was an Italian immigrant to the United States who became one of the greatest swindlers in American history." By all accounts, Ponzi was a charismatic and charming man with a vague background -- parts of his biography remain sketchy to this day -- who hit upon a get-rich-scheme which still bears his name.

he worked at a number of businesses, before hitting upon an idea to sell advertising in a large business listing to be sent to various businesses, an idea which others would later, independently, invent as the Yellow Pages. Ponzi, unfortunately, was unable to sell this idea to businesses, and his company failed soon after.

A few weeks later Ponzi received a letter in the mail from a company in Spain asking about the catalog. Inside the envelope was an international postal reply coupon (IRC), something which he had never seen before. He asked about it and found a weakness in the system which would in principle allow him to make money.

The purpose of the postal reply coupon was to allow someone in one country to send it to a correspondent in another country, who could use it to pay the postage of a reply. For use within the same country, postage stamps would be sent; but stamps issued by one country cannot be used in another. IRCs were priced at the cost of postage in the country of purchase, but could be exchanged for stamps to cover the cost of postage in the country where redeemed; if these values were different, there was a potential profit. Inflation after the First World War had much decreased the cost of postage in Italy expressed in U.S. dollars, so that an IRC could be bought cheaply in Italy and exchanged for U.S. stamps to a higher value. The process was: send money abroad; have IRCs purchased by agents; send the IRCs to the U.S.A.; redeem the IRCs for stamps to a higher value; sell the stamps. Ponzi claimed that the net profit on these transactions, after expenses and exchange rates, was in excess of 400%. This was a form of arbitrage, or buying low and selling high, which is not illegal.

Ponzi canvassed friends and associates to back his scheme, offering a 50% return on investment in 45 days. The great returns available from postal reply coupons, he explained to them, made such incredible profits easy. He started his own company, the Securities Exchange Company, to promote the scheme. ...

By July 1920 he had made millions. People were mortgaging their homes and investing their life savings. Most did not take their profits, but reinvested.

Ponzi was bringing in cash at a fantastic rate, but the simplest financial analysis would have shown that the operation was running at a large loss. As long as money kept flowing in, existing investors could be paid with the new money, but colossal liabilities were accumulating.

Ponzi lived luxuriously: he bought a mansion with air conditioning and a heated swimming pool, and brought his mother from Italy in a first-class stateroom on an ocean liner. He was a hero among the Italian community, and was cheered wherever he went.

And then the bottom fell out and Ponzi went from being hero to zero in an instant. But to the end Ponzi saw himself as God's gift to mankind.

Ponzi granted one last interview to an American reporter, and commented about the wild ride he had given Bostonians: "Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over."

The website Changing Minds argues that the "two main levers of confidence tricksters are gullibility and greed. They will exploit the incautious and naive and offer something for nothing as an appeal to our natural desires." One would have thought that the professionals in the financial industry would have learned to spot every sort of con. The recent financial collapse and Mr. Madoff's troubles suggest that maybe we are not as smart as we think.  Former SEC Chairman Harvey Pitt said, "it's unfathomable how this could have gone on for so long without anyone having any clue about it". He expects "the likelihood anyone will get any of their money back is slim to none."

Doug Kass at the Trading Diary says this is a major story:

The story of Bernard Madoff, if the charges of fraud are true, is the single biggest financial story of the year. It is bigger than WorldCom, bigger than Boesky and bigger than Tyco. It attacks at the core of investor confidence -- because, if true, and this could happen ... Investors might think that almost anything imaginable could happen to the money they have entrusted to their fiduciaries.

I'm not sure about the "single biggest financial story of the year". That belongs to the financial meltdown. But then 2008 isn't over yet. And just because someone will ask for it, here's Bernard L. Madoff's political contribution file and his Muckety connections profile, but I don't think it's relevant.