Published December 16, 2008

The biggest Ponzi scam of all?

By R SIVANITHY
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YOU'D have to wonder - has Wall Street fully digested the enormity of Bernard Madoff's alleged US$50 billion hedge fund fraud?

In days to come, the term 'Ponzi scheme' is surely destined to become a familiar one among stock market circles, as will the name Bernard Madoff.

We can do no better than reproduce online dictionary Wikipedia here: 'A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns ('profits') to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. A Ponzi scheme has similarities with a pyramid scheme though the two types of fraud are different.

'It usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises (and pays) requires an ever-increasing flow of money from investors in order to keep the scheme going.'

The scam was originated by an Italian named Charles Ponzi and involved postage stamps, but any asset would do just as well. All that's needed is a con artist and a gullible pool of investors who want to believe.

In Madoff's case, he allegedly added to his customer base with an impressive track record and promises of high ethical standards, all aided by an aura of mystique and secrecy that had been carefully cultivated over the years.

Of course, greed played a big part as well - with a stellar track record, reports are that he had to turn away dozens of rich investors who were queuing up to give him their millions.

If a reputed fund manager was running such an alleged major scam, what then of others? And will the Madoff news lead to even more fund redemptions that haven't yet hit a complacent Wall Street that is currently pinning its hopes on yet more bailouts by the federal government?

Perhaps more interestingly, as one reader noted yesterday, is the US government running the greatest Ponzi scheme of all, by printing billions of dollars to keep a sinking boat afloat?

To be frank, by bailing out bankrupt banks, insurance giants, mortgage lenders and now possibly carmakers, the US government, the Treasury and Federal Reserve have now entered the business of picking winners and losers.

As one commentator pointed out, it's a buddy-buddy selection system which interferes with free market forces and makes it impossible for ordinary investors to make rational investment decisions.

Buy a stock today in any industry and there's the very real danger that if the company runs into problems and its management hasn't got enough clout on Capitol Hill, it may not enjoy the same 'rescue' deals that others have had and so could be allowed to sink into oblivion.

By one estimate, the US government has either paid or pledged US$2 trillion so far to try and prop up the economy with no discernible positive impact yet. A recent forecast is that at least US$1 trillion more will be needed over the next couple of years but even then, there's no visibility as to when this might have any effect.

Should small, unsophisticated investors, already reeling in the past three months from Ponzi-like scams involving various structured products, actually be invested in this kind of market?

Probably not. Wikipedia's Ponzi definition concludes thus: 'The system is destined to collapse because there are little or no underlying earnings from the money received by the promoter.'

A system which requires the entry of greater fools all the time but one that could crash because there are no fundamentals to speak of? Sounds very much like today's stock market, doesn't it?