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I have been asked a few things about Bernie Madoff’s ponzi scheme so I thought I would put together a general piece on ponzis. My first job out of university was to work on the investigation of one for seven years, so I have some experience here.

In general, setting up a ponzi scheme is an easy thing to talk about, but it has to be done carefully. There have been lots of them throughout history and there will be more in the future. They are simple to explain and if you want to get rich quick (and then poor even quicker), simple to operate. They can be kept going for as long as more people want to put more money in that take it out.

Briefly, you start and investment scheme where the only actual income is from depositors. If people want “their” money back, you pay them with investor’s money, not from the investments you made, as you have not normally made any.

Creating a Scheme

To explain them is also simple. If you want to create one that will last at least a while, do this:

  1. Open a scheme that has a quasi-plausible business model (Ponzi himself used one involving the trading of US stamps in a form of regulatory arbitrage and, in Albania, it was arms smuggling and laundering money). Make sure it sounds good and that you understand the correct language to use to explain it. If you cannot sell this you will collapse early – or not even get going.
  2. At the start, ensure you have enough surplus money lying around that early withdrawals can be met – this is a necessary cost as these things can take time to get going. Having a good business reputation can help here, but if you have good a good sales patter this is not as necessary.
  3. Keep away from actually investing the money in the actual strategy you said you would. You need to keep the money lying around so that it can be repaid. Taking any risks with it means you could actually lose some. This is the main difference from banking in that actually worrying about the investment strategy takes time away from sales. For this to be a true Ponzi scheme you need to ensure that you are never actually going to make enough money out of any investments you actually make to repay the depositors.  If you wanted to operate a bank you would have to do the hard work of actually investing and that is not the idea here. Keep it in cash and/or on a normal deposit at a real bank.
  4. Offer high, but not stupidly high, returns from that scheme.  Ponzi overdid his, offering a doubling every 90 days. Albania was much the same. Madoff’s steady 10% p.a. was much more sustainable.
  5. Make sure your auditors notice the fees you pay them, not your books. Where possible, take the regulators out for long lunches or to the sorts of entertainment facilities that they could not admit to going to. Most regulators are underpaid, so are happy to be made to feel important.
  6. If you do have staff (they are probably needed as you do not want to do all the work yourself and you need to look successful) try to make sure none of the staff have a full picture of the scheme. If they do, make sure they are good at taking stress and are happy to receive good money. Generally, avoid doing this, though. If they ask questions give them the standard snow job and then move them out. Quickly. If possible, only hire staff you can sack for cause at a moment’s notice.
  7. Keep it exclusive so that people do not ask too many questions in fear that they may be excluded. Again, Ponzi overdid this by taking in money from all and sundry. You need people who are not going to want their “investment” back any time soon. Madoff had this down to a “T”. Politicians are ideal investors as they can then influence any regulators not persuaded by the lunches. If the politicians were business geniuses they would not be politicians.
  8. Once your bona fides are established and you keep paying out, cashflow from investors (AKA suckers) will be higher than the amount you need to pay out under most circumstances.
  9. Keep the people’s confidence (i.e. greed) going by sending out regular statements, always showing a healthy, growing balance.
  10. Hope that the suckers never want it back, or that you die before they do ask for it. Most ponzis fail at this step. The higher the return you offer, the faster you get here.

And that is it. Bernie was particularly good as he offered high, but not stupidly high, returns and he played the exclusivity thing well. As usual, though, he forgot about step 10 – but he did keep it going for a long time.

One thing to note is that, at step one, you may actually intend to make money from the scheme – i.e. you may not start out with the intent of committing the crime of fraud (in the case of Albania other crimes were contemplated, but fraud was not one of them). This is fine, most start out that way. It is easier to salve your conscience if you can claim that you did not mean this to happen when you start.

Before you start lying on the statements to investors, though, you have a choice – start down the road marked “fraud” or give up. That is when you make the choice.

Avoiding Losing Money

Generally, if you are a smart investor you can spot these schemes with a few simple rules.

  1. The fund is offering a high, steady return. This is the major pointer. Steady returns are normally low and high returns are normally not steady. Sometimes you will find one that is – and it doing it genuinely. This is very rare. If you find one let me know. Please.
  2. The auditors are questionable or absent.
  3. The sales patter is very, very good – heavy on personal recommendations but light on detail. If you ask too many questions they back away. “Hey, it’s our scheme. Do you want in or not?”

If you get all three of these (or only two) my advice would be to walk away.

Regulators and Auditors

If you are a regulator or auditor, most people are going to be pretty upset if you close one of these down early – if you are concerned about your career my advice would be to take the lunch and then write an ambiguous memo recommending further oversight or more aggressive audit practices. That way you are not going to be the one that spoils the party (and risks your career to do so) but you can later claim you were a whistleblower and therefore cannot get sacked for lax oversight. In any case you get to have good lunches along the way.

Most regulators or auditors that shut these down early get the politicians that were investing in the scheme upset and this can be a serious CLM. Much better to wait until it collapses and then hit the guilty party with a heavy sentence.

Making Some Money

Read this section only if you are happy doing morally questionable things.

Of course a very smart (but not risk adverse) investor may want to get in on the first floor and ride this one to at least close to the top – if you get out before the burst you can make good returns. You may also be able to sue someone if you get caught and get out too late. Not for your risk adverse investor and don’t be too greedy. Make a good return and get out if the economy starts looking even a little shaky. Ponzis normally take at least a few months of economic downturn to collapse.

This strategy will also allow you to look good at dinner parties – “Phew – I got out a few months before it collapsed“. Of course, a person who is listening who knows what this means will know that you are either one of the suckers or possibly complicit – but not many will. Most will think you were just lucky.

Stay Away

My strong advice, though, is to stay away from this whole thing. Remember, things that look too good to be true probably are. If you want to make money, do the work yourself. Do all those things your parents taught you (and Bernie probably told his kids as well).

If you want to make lots of money you need to work hard and take risks. Deal with it.

Comments Warning

If you want to use comments on this thread to talk about how normal banks are actually ponzis I will summarily delete them and any comments that refer to them I will edit to remove that content. There are other threads here that deal with that issue, which, as I have said, is not correct.

I don’t often post jokes, but some of these were banking relevant and appealed to my sense of humour (yes, I do have one):

The Top Twelve Indicators that the economy is bad (US version):

12. CEOs are now playing miniature golf.

11. I got a pre-declined credit card in the mail.

10. I went to buy a toaster oven and they gave me a bank.

9. Hotwheels and Matchbox car companies are now trading higher than GM in the stock market.

8. President Obama met with small businesses – GE, Pfizer, Chrysler, Citigroup and GM, to discuss the Stimulus Package.

7. McDonalds is selling the 1/4 ouncer.

6. People in Beverly Hills fired their nannies and are learning their children’s names.

5. The most highly-paid job is now jury duty.

4. Mothers in Ethiopia are telling their kids, “finish your plate; do you know how many kids are starving in America?”

3. Motel Six won’t leave the lights on.

2. The Mafia is laying off judges.

And my most favorite indicator of all…

1. If the bank returns your check marked as “insufficient funds,” you have to call them and ask if they meant you or them.

If you have any others feel free to leave them in comments.

It’s good to know that I am not the only one looking at this proposal and not knowing whether to laugh or cry. The post titled “A Mighty Wind” over at The Dealmaker’s blog is well worth a read. Just watch it though – the language is not entirely worksafe.

There are some great quotes in there:

Forget the no doubt significant fact that substantial portions of the Administration’s regulatory proposals were authored by products of a government-to-industry-to-government merry go round like Hank Paulson, Larry Summers, and Tim Geithner. Forget the fact that the Administration is said to have consulted heavily with industry participants and lobbyists for input on proposed regulations. No, what really matters at the end of the day is that the Commodity Futures Trading Commission is overseen by the House and Senate Agriculture Committees.

But investment bankers adapt. Change is the water we swim in, the air we breathe. We will adapt to whatever stupid new regulations and incompetent, undertrained, overmatched new regulators you throw at us. And we will come out on top, as always.

It’s just too bad we’re gonna have to charge you extra for the added headache.

Classic. The important points though, are entirely valid – even that last one that comes across as a smirk. Every regulation costs money to comply with and that has to come from somewhere. I can guarantee you that they are not going to be paying the people less as they need more to comply with the regulations – and more smart people to work out the best way to do so. The shareholders need to be compensated more for the increased risk of investing. The buildings will not cost less.
The people who pay for all this are the depositors and borrowers – i.e. you. Oh – and the taxpayers. Oops – you again.

I will be adding this one to the blogroll.

[UPDATE]
If you want to have a look at a near final draft of the proposed changes, it is here. I understand this is the one most people are working off.
Another opinion is here. As this one is a Reuters blog, it is much cleaner. There are, for example, no uses of the “f” word.

This so-called “new” regulatory “system” for the US – at least on the first draft – looks like it is simply going to add a few more regulators into an already over-governed financial system. Adding in more regulators to a system in which, even at the lowest count, there are more than 54 I cannot see as an improvement. From prior experience all I can see it doing is increasing the amount of buck-passing, adding yet another reporting layer and making it even less clear than it already is as to who it is a given financial institution has to listen to.

If you are going to have a regulated system at least make it bloody clear who is responsible and then give them the powers to deal with most, if not all, problems. Then trust them to do their jobs – i.e. get out of the way.

The Australian example is a good one – the government delegated regulatory powers to APRA. There is little doubt over who regulates what – in Australia APRA deals with systemic and individual financial institutional risk – banks, insurers, the lot. The ASX deals with listed companies where it has anything to do with information to shareholders. ASIC deals with companies and any non-APRA regulated small financial entities. The individual States have some responsibilities with respect to consumer protection. AUSTRAC deals with money laundering and some elements of criminal behaviour. The Federal Police deal with other alleged criminal activity.

Even that takes a while to say – and does leave some overlaps, but it is nothing compared to the situation in the USA. At least I can get most ofthe Australian system into one paragraph.

I have always thought the correct way to deal with a mess was to tidy it up. The suggested system seems to amount to clean up a mess by throwing more rubbish on it. It is an innovative solution to the problems – but I cannot see it as brave, useful or intelligent. The US has only just sorted out how to go to Basel II – it has not yet been implemented.

If I can put in my suggestion – other than a free banking system (unlikely to be politically possible) the best solution would be fairly simple. Make the Fed responsible as the sole regulator of all non-State chartered financial institutions, insurance and banking alike. Close the FDIC and allow private sector insurers into the market. Close the OCC and all of the other parts of the alphabet soup that are currently failing to do their jobs.

Close down Fannie, Freddie, Sallie, Maggie (or whatever the rest are called) and the rest – if they need a federal guarantee (implicit or explicit) to do their jobs then they probably should not be doing it. Sell off all of their assets and then the US government makes good on all outstanding liabilities – and the shareholders lose their holdings unless by some miracle they are actually worth something.

Replace US accounting standards with proper ones – IFRS will do. The Fed then implements Basel II the way they wanted to do it (which is also the should be done) – not the half-arsed way they have had to do to get it past the FDIC.

Get all that done and you would have a “New Regulatory System” – and one you could be proud of. As it is you are just going to make a bad situation worse.

Not too much fun in the current situation – but this is worth it. Get in quick, though – the first two in the series have been removed, presumably due to copyright issues.

Hat tip – The Finanser.

Slightly wonky topic today, but one that is very important. Most of you out there doing financial modelling should already know this (but could do with some reminding) and those looking into this sort of modelling (and bank management who get fed these reports) should know.

For most situations the normal distribution is not the one you should be using for financial modelling.

I’ll say it again in a different way – if you are going to use the normal distribution first prove that it is the correct one to use.

I know that the Basel II Accord mandates its use (even helpfully giving the Excel function “NORMSDIST” in the footnotes) as do many other regulations but there is a mountain of analysis in the academic sphere showing that the normal distribution is not the most correct – understating the probability of the “long tail” or “black swan” events.

Lévy distributions are much more correct – there are particular examples that give much more weight to the long tail than a typical normal distribution does. Work done by Mandelbrot and Taylor (yes, Mandelbrot of the pretty fractal pictures) in the 1960s first showed this and there has been considerable work since then. Just have a wander through Google Scholar for some fascinating reading.

Why then do we keep using the normal distribution? I think that it is just a habit and that we get it drummed into us at university. There has been an enormous amount of work done on the normal distributions, so we also look to leverage off this.

My message to management, then, is this – if a risk assessment comes to you having used the normal distribution the first question you should ask is “Why have you used the normal distribution?” If the answer is something along the lines of “We always use it.” then you should ask them to go back and justify its use. If the answer is “We have been told to do so by the regulators.” then you should tell them “Fine – use it for regulatory numbers. Just give me the real numbers as well.” If the answer is “We have modelled the market and the normal distribution is the best fit after considering the other possible distributions.” then your answer should be “Fine – thanks for that.”

Time for a quick poll. The ABS figures today claims that Australia had positive growth over the previous quarter – but revised downwards estimates for growth in the two quarters before that.

This vote, then is simple – do you think that next quarter the ABS will revise downwards its estimate for growth this quarter and, if so, will that be enough of a downward revision to mean that we had a technical recession?

Will the ABS revise growth downwards? (Poll Closed)
 
 
 
 
 
 

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