Tuesday, April 7, 2009

Ponzi Pyramids

Ponzi Pyramids

Bernie Madoff hit the headlines earlier this year as possibly the biggest stock market scam artist of all time. A few weeks later, Canada allegedly discovered her own mini-version of a Ponzi scheme.

What possesses a person to indulge in a Ponzi Pyramid? I wonder what kind of mind enters the Ponzi Pyramid business.

Exactly what is a Ponzi scheme? How does it work? Why do they do it? Don’t they know they’ll be caught? Are there Ponzi Pyramids where the scammers don’t get caught? Are they crooked from the beginning or do they start honest, and turn crooked?

Recipe for a Ponzi Scam
Let’s pretend we are con artists. We want to steal millions and don’t care who we take it from. We are willing to scam whoever is sucker enough to be scammed. How would we do it?

Step 1: The Victims: who will we steal from?
The easiest people to con have two outstanding characteristic: greed and naïveté. They want to get rich and can be lead to believe that someone other than themselves can make them rich.

Step 2: The Initial Con: it’s always some variation of the theme: “Trust me.”
The scheme should offer participants an abnormally high return and assurances that their money is safe.

Step 3: The On-going Con: once the victims give their money to the con artist, they have to receive constant assurance that they have, indeed made a lot of money. Each month they should be given the sales pitch all over again. “This is a great investment, you have made a lot of money, and if you keep your money invested, you will make even more.” It is VERY important that the investors/victims be constantly encouraged to keep their money in. After all, it’s the con artist who is supposed to make the money, not the investors.

Step 4: The Sting: the con artist has to actually take money out of the pyramid scheme. Perhaps his payoff will be in the form of a management fee or bonus. Usually it is a performance fee based on the stellar returns the con artist shows people in Step 3. The principle is that the con artist takes the money out and the investor/victims are told to keep their money in.

Step 5: The Pyramid: obviously no con artist is slick enough to convince all the investor/victims to keep all their money in. This means the scheme will have negative cash flow: it has to pay out both the con artists and those few investors lucky enough to sell out of the scheme before it ends. To offset this negative cash flow, the con artists will have to generate positive cash flow. They do this in two different ways: [a] selling the scheme/scam to new investor/victims and [b] actually investing the money and getting a positive return on it.

Step 6: The Get-away: one morning the investor/victims wake up to discover they have lost it all. And the con artist is no where to be seen. The Get-away is the part that the they usually mess up. For some reason, con artists don’t know when to quit. They always seem to want more. They stay with the scam too long – eventually the pyramid scheme has too much negative cash flow and not enough positive. The investor/victims wake up to the fact that there is no money in the scheme, but the con artist has not made his get-away. The jig is up.

The authorities recognize the Ponzi scam by the cash flow: those investor/victims who cash out get the money from the new investor/victims putting new money in. When the exit doors and more crowded than the entrance doors, those who want out can’t get out. They blow the whistle to the authorities and the jig is up.

There’s something missing in this scenario, isn’t there? When Mr. Ponzi master-minded his schemes in the USA about 100 years ago, he knew he was conning people and he actually planned his get-away. As soon as the out flow of money was greater than the in-flow, he shut the pyramid down and vanished with the remaining money. But that’s not what happens in the modern scams. Today’s con artists seem oblivious to the fact that they are con artists. They don’t seem to plan their get-aways. Maybe they actually do think they can make abnormally high investment returns with very little risk. Maybe they actually do make some abnormally huge annual return for a short time. After all, how many ordinary Canadians made 30% or 40% when Canadian oil stocks and gold stocks were red hot? We all know ordinary Canadian investors who did it; maybe these Ponzi operators did it too. Maybe they think they can keep on doing it. And maybe they think they can do it for everyone. They can help everyone make abnormally high returns and, of course, be very well paid for it. Everyone would win! Maybe that’s how it all got started.

Do today’s Ponzi look alikes sincerely think he could earn 30% or 40% annual return on their trading account year after year? Did they set up their business plans thinking they really can make super high returns? If they did, there would be no need for a get-away. The gravy train would go on for ever.

Isn’t it amazing? Is it possible that the Ponzi operators AND the investors share two characteristics: greed and naïveté?

“You ain’t seen nothin’ yet!”
Small time operators that adventure into the dizzy realms of financial mania pale beside the exploits of the American establishment. No, we are not referring to the ill-fated Bernie Madoff. We are referring to the biggest financial fiasco ever to hit America; the sub prime mortgages.

Greed and naiveté? People who could never hope to buy a home could now get 100% financing: now they too could participate in America’s housing boom! Mortgage brokers and realtors who once had to beg the banks to lend more money on a given house now were paid fat commissions and finder’s fees for 100% loans! Syndications were assembling billion dollar deals and selling them to banks all over the world. And with all that new money pouring into real estate, prices were rising steadily. Everyone was winning.

Abnormally high rates of return? Low risk? No problem! 30-year mortgages pay way higher interest than short term paper. This mortgage-backed paper pays out short term interest rates and receives long term mortgage rates. This difference in interest rates is known as “the spread,” and this is where the abnormally high rates of return came from. America’s biggest brokers put deals together for the world’s banking community. And everything was backed by people’s homes, the safest investments in America. Everyone wins.

How did it end? Someone noticed that house prices had stopped rising. Then they noticed that there were increasing numbers of mortgages in arrears. Then they started to doubt that the increasingly dangerous long term mortgages could continue to support the short term paper. Soon no-one wanted the short term paper: the buyers stopped buying and the holders wanted to sell. The jig was up.

Is it a Ponzi scheme that’s bringing the world’s economies to their knees?

Up close and personal.
Is your RRSP a Ponzi scheme? Were you naïve enough to believe that the stock market consistently goes up at about 10% per year? Did you believe that you could make money like Warren Buffet and become rich by the time you retire? All you had to do is buy a portfolio of equity mutual funds and hold them for the long term. Do you trust that your financial planner knows best? …and that your mutual funds are being well-managed? Have you checked the fine print of your mutual funds prospectus to see who gets paid how much for what service? They call it the service fee: is it really ‘the sting?’ Are they trying desperately to keep you invested? …making sure they keep on taking their money out, but you keep your money in?

Even closer
Is your pension plan a Ponzi scheme? Was your pension fund manager naïve enough to think he could achieve a long term rate of return of 8%? Now that the stock portion of your pension plan has a negative 10-year rate of return, are new contributors/investors being asked to increase their contributions so the plan will have enough money to pay you when you retire?

Spooky, isn’t it?

The investment world is more Ponzi-like than we’d like to believe. Wherever we find greedy, naïveté investors and slick profit-driven promoters we have the potential for an inadvertent Neo-ponzi scheme. The original Ponzi was a con artist from the beginning. His intention was to steal people’s money. But today’s Neo-ponzis don’t work that way: there is no malicious intent. They start off operating legitimate investment programs. But greed and naïveté on the part of both investors and operators somehow mysteriously shifts the facts and figures of financial reality into the financial fantasies of a Ponzi pyramid.

In my book, Beyond The Bull*, I point out how important it is for investors to understand how other investors earn their money. The more we know about the action of other participants in the market, the more successful we will be in our own investing. Both outright Ponzi con jobs and today’s Neo-ponzi investments warn us of the same thing: it is important to sell your riskier investments when danger appears in the financial world. Don’t cooperate with those who would have you not sell, but rather hang in through thick and thin.


Ken Norquay, CMT,
Chief Market Strategist
CastleMoore Inc

“Buy, Hold, and Know When to Sell.”

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