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Bernie Madoff Calls the Whole Government a Ponzi Scheme. He Ought to Know.

February 28, 2011 1 comment

This just in, straight from the horse’s mouth – Bernie Madoff was quoted calling the whole government a Ponzi scheme.  And if there’s anybody who knows a thing or two about Ponzi schemes…

Wall Street swindler Bernard Madoff said in a magazine interview published Sunday that new regulatory reform enacted after the recent national financial crisis is laughable and that the federal government is a Ponzi scheme.

“The whole new regulatory reform is a joke,” Madoff said during a telephone interview with New York magazine in which he discussed his disdain for the financial industry and for its regulators.

The interview was published on the magazine’s website Sunday night.

Madoff did an earlier New York Times interview in which he accused banks and hedge funds of being “complicit” in his Ponzi scheme to fleece people out of billions of dollars. He said they failed to scrutinize the discrepancies between his regulatory filings and other information. 

He said in the New York magazine interview the Securities and Exchange Commission “looks terrible in this thing,” and he said the “whole government is a Ponzi scheme.”

Now, I’m sure there are some people out there who will write this off as the rantings of a common criminal, but I happen to think he makes some interesting points. 

First, his contention that banks and hedge funds were complicit is almost beyond question. 

I would also add that regulators were “complicit” to the extent that they wilfully ignored the warning signs and, in several cases, actual written warnings from concerned parties. 

After all, if you look the other way when your job is to scrutinize, you might as well make your sanction of criminal activity explicit.  And as for the banks and hedge funds, their focus was on short-term gain, secure in the knowledge that bailouts were available to anyone who messed up badly enough.  And even if it cost some individuals their jobs, the pay packages they got in the interim would keep most people comfortable for the rest of their lives.

As for the government being a Ponzi scheme, that’s almost beyond question too.  The definition of a Ponzi scheme is an investment vehicle whereby early investors are paid “returns” from the subsequent capital payments of later investors.  Look at Social Security – that is quite literally the business model.  Medicare – same thing.  Medicaid – same thing, but at a quicker pace.  Together those three programs make up the majority of yearly government spending, and they all involve payments to early “investors” coming straight out of the pockets of later “investors.” 

And look at the other core functions of government, even beyond these obviously flawed entities.  I’ve previously referenced how unions (in their current form) cannot be viable without the full backing of government.  The system involves legislators bestowing favors on a chosen group of people, and in return those people ensure that their benefactors are popularly elected.  How is this any less circular?  And how does the story change when inevitably the music stops and some people are left without chairs?

And what of the new regulatory “reform”?  Well, I have personal knowledge about this, and I can assure you Madoff is absolutely right when he says it’s a joke.  Regulators could have – no should have - looked at the DTC transaction log to ensure that Madoff was not running a multi-billion dollar Ponzi scheme, but nobody bothered.  How is this problem corrected by, in essence, shuffling the pieces of the regulatory regime around? 

So some agencies will be consolidated.  Other agencies will come under the purview of the Fed.  A new agency will be set up to “oversee” all the old agencies.  The fact is, smart people will always be one step ahead of the regulators, and it does not matter even a little bit how the regulatory pieces fit together.  Do you think Madoff would have reconsidered embarking on a Ponzi scheme just because thrifts are now regulated by the OCC instead of the OTS?  Do you think Madoff would have thought twice about stealing people’s money if only the Fed had had an Office of Minority and Women Inclusion before this totally-not-wasteful-at-all reform?

Public choice theory merely gets another underscore.  Of course, beyond all the implications of regulatory capture, etc., we see the pure spoils system at work.  The more regulators fail, the more power regulators get.  And of course, the more people who derive their power from Washington, the more power is concentrated there.  One last question – do you think the legislators mind?

This News is Not News: Social Security is Officially Broke

January 26, 2011 Leave a comment

The President in last night’s State of the Union address explicitly refused to take up his debt commission’s suggestion to raise the Social Security retirement age by 4 years over the next 65 years, which itself was a far-too-modest proposal.  However, in light of this willful turn away from the vagaries of reality, Wednesday’s report from the Congressional Budget Office becomes far more ominous.

I am shocked, shocked, to find out that we are so deeply in debt!

Dig into the CBO report, however, and you’ll find some news that simply isn’t news.  Namely, Social Security is broke.  Of course we already knew this, but according to the rosiest of fictional financial predictions (also known as “normal government accounting”) the jobs growth that we were supposed to see from the stimulus should have put off the revenues-to-outlays deficit by at least another few years.  Now the CBO has owned up to the error.

Unfortunately, Social Security was never structured in a way that would ensure individuals’ responsibility for their own accounts.  It is a pay-as-you-go system wherein current taxpayers see their confiscated money go directly to the pockets of retirees.  There is no recourse except for the promise that current taxpayers will be on the other end of the imbalance someday.  This is perhaps the greatest reason for the current political fact that Social Security is unassailable.

Any surplus that was to be had was, at the time of the law’s passage, based on the assumption of unchanging demographics.  That is, the idea that there would always be enough current workers to support retirees who generally die before taking too much out of the system anyway.  At no point was the law updated to reflect increasing lifespans and falling birthrates.  Although the law was originally written to build up immediate surpluses – and it did so – we cannot tap this “rainy day fund” now.

Of course, we have our politicians to thank for this as well.  Surpluses were to go to a trust fund to be used for occasions such as, well, this one.  Naturally the “trust fund” money was spent with impunity, and all that’s left are IOUs worth roughly the same as the paper they’re printed on.  According to the CBO report, when you factor in the face value of this paper as a cash equivalent, plus interest, Social Security is still technically solvent.  Again, reality tells us otherwise. 

And thinking even more long-term, when the government’s pollyanna projections have us running trillion-dollar deficits from here to the horizon, any shortfall in the net revenues to outlays will be paid by one thing and one thing only: printing more dollars.   The buying power of those dollars will necessarily erode, and this inflationary action will savage savings.  Ironic, isn’t it, that savings will become worth less and less because of a government program designed to supplement … savings?

Again the solution has become the problem.

Crowdsourcing SEC enforcement could better align incentives and allow investors to protect themselves

August 17, 2010 Leave a comment

An interesting proposal from Marcia Kramer and Paul Hinton in the Harvard Business Review involves unleashing the power of the public on the investment industry.  Fraud detection, a function currently vested in the SEC, could be vastly more effective if it were crowdsourced:

Fraud detection is a tedious task that can involve sifting through large amounts of data seeking a signature pattern of discrepancies. This is a task in which crowdsourcing, the chief concept underlying Wikipedia, may be quite useful…

Assessing investment advisor performance claims and reviewing tips are two of the major tasks on Chairman Schapiro’s plate that lend themselves to (crowdsourcing). The investment community possesses crucial skills and information that could supplement the SEC’s efforts. These private sector resources go far beyond what is available to the SEC…

You might be wondering how even a large number of laypersons could produce the type of effective enforcement that the SEC does.  Indeed, the vast majority of consumer-facing investment activity is done aboveboard.  However, it turns out that many of the tasks that SEC takes upon itself to enforce securities regulations are quite simple, and the fact that most investment activity is perfectly lawful almost certainly has less to do with effective SEC enforcement than it does with the fact that, generally, people act within the (admittedly somewhat elastic) standards of our common moral code.  It’s the same reason you and I can walk down the street without being mugged every single day.

But how simple could the analysis really be?  Take Bernie Madoff for example.  Nothing that he did was particularly complicated; indeed the aftermath produced more questions about how it could have passed unnoticed than it did questions about how he pulled it off.  It was a straight Ponzi scheme.  It’s nothing we haven’t seen before.

The Madoff case is not unique in that it could have been detected with sufficient information and very little analysis.  The SEC Report referenced the fact that Madoff’s fraud could have been easily detected if the regulators had bothered to call the clearing company.  DTCC, or the Depository Trust and Clearing Corporation, provides clearing and settlement services for the equities industry, and it keeps a log of trading activity therein.  Madoff reported billions in trading activity that never happened, but the SEC never bothered to look at the DTCC records to see if those purportedly massive trades were actually taking place.  Any lay investor with enough wherewithal to notice that two numbers don’t match up would have and could have caught it, just as the SEC should have caught it.  But the SEC didn’t look.

Kramer and Hinton propose making those records accessible, but they wouldn’t stop there:

Crowdsourcing could also help the short-staffed SEC identify patterns and connect the dots among the hundreds of thousands of tips that it receives annually. This system could extend beyond investment advisors to also cover brokers, public companies, underwriters, municipal issuers, and products.

It’s an intriguing theory, and I recommend reading the article for their counterpoints to what they view as the common objections.  But I think it’s important to highlight a primary reason why, intellectually at least, a crowdsourced platform could be desirable.  In a word, incentives.

Where regulators are tasked with finding and solving problems, they will act in their own best interests, and generally this means establishing a hegemonic power structure that is symbiotic with governmental (read: political) interests.  When brokerage companies are tasked with regulating themselves, they will act in their own best interests, and generally this means maximizing profit – not a bad thing in and of itself – but economic considerations cannot be given primacy over justice.

However, where investors are allowed to effectively protect themselves, investors ultimately get protected.  Giving people a transparent system by which they may look out for their own interests, uncolored by the interests of other parties, would solve the problem of ultimate accountability.  And for the skeptical, it bears noting that accountability has been enforced where this has been tried before:

The concept has already proven itself in Britain where The Guardian newspaper created an online database of 700,000 expense claims by UK members of Parliament for anyone to search; the erroneous and outrageous expenses identified by some 20,000 participants fueled a national scandal.

Perhaps there remains a role for the SEC, but that is a question for another day.  In any case, people should first be given the opportunity to protect themselves before we contemplate intervention in the name of protection.

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