Bozo Sapiens

Exploring how our cognitive, logical, and romantic failures are a fair price for our extraordinary success as a species.

Trust Me: Why Ponzi Schemes Work

Why we will never learn to avoid investment fraud.

His website said: "The owner's name is on the door. Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm's hallmark."

Can it have been only a year ago? The story still sounds as unlikely as every other part of the operation: Madoff called in his two sons to explain why he wanted to pay out staff bonuses early, despite having problems meeting a $7 billion call for investor withdrawals. The explanation turned out to be simple: "it is all just one big lie." Despite their (and their families') many years of close involvement with their father's company, the sons were, they say, shocked and horrified - and, on this date, reported him to the authorities. It soon became clear that years of chicanery, assisted by regulatory incompetence, had allowed Madoff to convince his clients he was running a fund of over fifty billion dollars, when in fact he had made no investments on their behalf at all: it was, he said, "a giant Ponzi scheme."

A Ponzi fraud is the most basic form of mutual fund, its simplicity untarnished by having to buy any actual assets: early investors get paid with the deposits of later ones, while later ones see their paper gains add up, just as long as they don't attempt to cash out. Our susceptibility to a good story (officially dubbed the availability heuristic) demands that the promoter claim some brand of novel financial wizardry; the original Charles Ponzi said he was exploiting a price difference in international postal reply coupons. Our belief that extraordinary things are more likely to happen to us than in general (an aspect of attribute substitution) feeds on the shared buzz of mutual investment: "all our friends are talking about it."

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Madoff, though an experienced trader and thrice chairman of NASDAQ, had no magical money generator to propose - but he was operating in a time of generally rising markets. So he did two very clever things: he offered, not spectacular returns, but reliable, credibly modest gains; and he was brusque and aloof, often refusing to accept investors' money. When others were trumpeting 50% profits on edgy, speculative investments, Madoff could point to a solid annual 10% from companies you'd heard of. When the markets dropped, Madoff still reported a gain of around 5% - just about what you might have gotten if you had sold out at the peak and popped your portfolio into some safe haven. Nothing that he did seemed like black magic - as he pointed out, he was only matching the gains of the S&P 500 - it's just that it was eye-stretchingly improbable for the real world of investment.

Take matching the gains of the S&P: an index, by definition, is the value of an ever-changing notional portfolio composed of the best-capitalized companies in a market. To replicate it, you need to buy and sell, which has its own costs. Anyone whose strategy is simply to match the index, therefore, is going to fall short of it. Madoff claimed to use hedging instruments and good stock-picking to increase his ability to catch rises and avoid falls, but these still couldn't explain the relentlessly positive results he posted, month after month. Some of the professionals who put money his way assumed he was "front running:" illegally using the power of his huge fund to influence prices to its own advantage - but that was the odd thing. He didn't influence the market; there were never any "Madoff buys" moments. People couldn't see the gorilla in the room... because it wasn't there.


This was where aloofness came in useful. As with nightclubs and fashion houses, exclusivity in investment is inherently desirable. We want what is denied to others; we become more respectful and credulous to get it. Madoff kept people out and, with further cunning, let those who got in discover what they had in common: usually, Jewishness. The sense of affiliation, and the trust that comes with it, set Madoff above question. Private individuals and charities (that is, those with no legal requirement to audit their investments) made the bulk of his client list. As their paper profits continued to accrue, they put more and more of their capital in. In one example among many, the Holocaust survivor Elie Wiesel, his wife, and his Foundation for Humanity all lost everything. "Feeder" funds would steer further investors Madoff's way, taking a 4% fee simply for forwarding people's checks; when the end came, quite a few discovered they had lost their savings with Madoff without ever having heard of him before.


And now it's all gone - eighteen billion dollars of real money. But where? The stated assets of the Madoff family (the penthouse, the yacht, the house in Palm Beach, the place in France) are not, in these obscene times, beyond the means of many hedge-fund managers. The sale of his personal effects revealed, with its hundreds of similar watches and personalized Mets jacket, a life depressingly dowdy for such a titan of crime. Madoff, now Inmate Number 61727-054, has said almost nothing about his motivation and methods, except to admit guilt. The money may still be hidden - to benefit whom, when? - or it all may simply have gone in fees and costs, just to keep up a pointless charade. The overwhelming impression of Madoff is pure arrogance: a chilly emptiness, in which winning is all, and fulfillment is represented by numbers - even fake ones - on a piece of paper.

 

If you enjoy such stories of human fallibility, you can find a new one every day at http://bozosapiens.blogspot.com.  See you there.

Michael Kaplan writes about chance, fate, probability and error. He is the author of Bozo Sapiens: Why to Err is Human.

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