We are all Madoff investors

By J Saft
January 2, 2009

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

It was perhaps inevitable that we ended 2008, the year we learned we were up the creek, with a great financial scandal: the Madoff Ponzi case.

What is even more remarkable is the way in which the alleged fleecing of many billions of dollars from wealthy people and charities — investors who should have known better or employed people who did — serves as a mirror for the broader culture, showing how we went wrong and where we are left now that we realize our errors.

The main difference really is that Madoff’s purported victims, or enablers or co-fantasists, say they found out their wealth was illusory all of a sudden whereas for most people in the English-speaking world, this is happening little by little.

Bernard Madoff, for those of you just waking after a long winter’s nap, is accused of defrauding as much as $50 billion from investors in funds he promised would deliver a steady — suspiciously steady — 12 percent or so a year in good times or bad. But rather than a miraculous hedging strategy, authorities say Madoff has confessed to running a pretty simple Ponzi operation: paying out “earnings” to those who demanded them from new commitments of cash from those who wanted in. And of course, given that the man could “make” heady sums with no risk in all markets, the cash flowed in and the redemption calls were, for a long time, manageable.

Madoff has not appeared in court to formally answer the charges. But that there was one man, or a man with confederates perhaps, who was willing to engage in a harebrained fraud that was mathematically doomed to failure would not be that surprising, sadly. That an army of either rich sophisticated investors or their highly paid advisors played along and, seemingly, genuinely believed that they were growing rich is far more interesting.

One point, highlighted by Tim Lee of consultancy piEconomics in Stamford, Connecticut, is that the $50 billion headline figure is about as inflated as California real estate prices were a year ago. That $50 billion is likely to turn out to be not the amount lost but the amount people wrongly thought they had. It’s likely that the actual strategy followed by Madoff could return little more than Treasury notes minus fees; in other words he could make for you what you could get for yourself with no help but then pay himself handsomely for the gymnastics.

That implies that a lot — for long-time investors the vast majority — of their “money” invested and now “lost” with Madoff was about as notional as a credit default swap contract with a man you met outside the bus station downtown. Much of the money never existed, other than on the attractive and no-doubt glossy statements sent by Madoff. It was simply what people would have had if he’d been a genie.

EXTRAORDINARY POPULAR DELUSIONS

And it’s in this way that we are all Ponzi limited partners: we too thought our retirement funds and houses were growing miraculously, though ours was an illusion fueled by debt rather than fraud, and we too made plans based on those asset values that now stand in ruins.

“The financial system as a whole has had the characteristics of a Ponzi scheme if we look at it fundamentally,” said Lee, who was very early in warning about deflation.

“By this I mean that we should think about the true value of assets as being derived from the future flow of goods and services that the assets can lay claim to or produce. If market prices of financial and real estate assets rise a lot but there is no increase in the ability of the economy to provide goods and services in the future, then the apparent increase in wealth is illusory.”

That means that savings must rise and expectations about the kind of growth and income that capital can safely command must fall. The process of everyone figuring that out over the next year or so will be a continued hole in the side of the stock market and, despite the risks inherent in Treasuries due to quantitative easing and fiscal stimulus, a boon to holders of government debt.

There are a lot of individuals, pension funds and non-profits out there who have penciled in benchmarks for returns on assets that are probably too high for the coming cycle, irrespective of the losses of this year, and I am talking about people thinking of a modest 8 percent.

Those people and institutions will be forced to take steps to right that, and this time it won’t be by searching for risk or yield, it will be by saving more and cutting back on expenditure.

This will cascade through the economy and until the savings are replenished and productively deployed, higher government spending will be a balm on a burn at best.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on here. –

49 comments

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Bravo! I’ve been called everything from unpatriotic to socialist to everything but mister for over 7 ten years for voicing the obvious: starting with the dot com debacle the Dutch reminded us had all the markings of the tulip fiasco in their country centuries earlier, moving on to allwing even people o welfare to borrow for both mortgages and credit cards knowing it couldn’t be repaid, to the common American who just refuses to see there’s no difference between a person running out the door of a shop with a new tv or pretending to pay with credit he can’t repay.

we’ve all been not only wanting, but demanding the right to live like nobility based on income we don’t have, borrowing money we can’t repay, and deluding ourselves from the fact that a share of stock is only worth what you eventually sell it for.

Now, like spoiled children who’ve been told our tummy aches are our own fault, we want to scream at anything sounding like an adult voice, even when the adult voice is saying, “the boat’s sinking, shut up and help bail!”

Banks have traded bad credit card back and forth to pretend profitability for decades hoping the house of cards would never collapse, and we have an economy running wild and driven by college kids who see no harm in driving up the cost of many things under the weight of consumer demand, knowing they have no money…just plastic.

We’ve had years of the “bigger idiot theory”, with everybody hoping a bigger idiot would buy what we bought as a stupid price for a idiotic one.

Corporations got too caught up in making sure to report profit at any price to their future, politicians have juiced statistics and manipulated reality, while American workers can’t compete with somebody making $5 a day.

And American workers who blame everybody but themselves gladly spent the 60s, 70s and 80s refusing to pay for American made products with no regard to lost jobs (until the domino finally fell on their own head).

We have a consumer economy with no consumers, and until we recreate working wages, coupled with corporate AND personal fiscal responsibility, deflation, monitization and public works projects may save the country and government, but we will avoid becoming a second rate nation state by sliding directly into the gutter.

China can’t keep loaning us money to buy their unsafe, cheaply made products forever. Even they will eventually demand cash. And not American Dollars, cash that has value and the ink is dry when it hits their hands.

Posted by Brian Foulkrod | Report as abusive

The simple word for this is “exponents.”

You know, that nasty mathematical concept called “The Power Function”?

The most important mathematical concept in the universe – bar none.

To put this in perspective, 12% a year return means that in 30 years (a reasonable investment horizon) you would have THIRTY TIMES your original investment.

It is this sort of utter nonsense that led to the Internet bubble, the Housing bubble, and now we’re going to do the Treasury bubble!

I wrote about this in my blog (the web site above) this morning and in fact posted several articles on it over the weekend.

THERE IS NO UNICORN THAT EJECTS SKITTLES FROM THE “BUSINESS END.”

If you want to know how bad the exponential function gets, simply figure out how many people you end up with if you start with 1 million in a city and a 4% growth rate over 100 years.

Answer: FIFTY MILLION. Will they fit?

The author is correct in that “we’re all Madoff”, but then again, so is our government and so are our markets.

The ONLY way to clear the market is to force the insoluble debt into the open and DEFAULT IT. Everyone is trying to find a way to avoid this, but mathematics say that it CAN’T be avoided.

We tried in 2000-03 and all we did was make the inevitable crash three times as bad. Now we’re facing it again and EVERYONE wants to put it off AGAIN.

Folks, either we do it this time or, if we keep this up, we will risk destroying not just a lot of jobs and having a depression, but destroying our political system as well.

Let’s not go there, ok? I like my nation and will suffer an INEVITABLE Depression (even if three times as bad as it would have been if we had accepted it in 2000) to avoid political and economic collapse.

At least regular people can take some comfort in the fact that after 8 years of Bush grabbing all he could to make many of the already wealthy filthy rich, that at least some wealthy folks now have an idea of what it feels like to suffer due to lack of money. Too bad for them, but now they know how many of the lower and middle classes feel for much of their lives. And, none of it is right and should never happen in a right society.

“How does it feel?” (Thank you, Bob Dylan.)

Posted by richard | Report as abusive

I agree with Bob. I make 45K annually and I am debt free. Never had any. Why?… because I always live within my limits and I live quite well thank you very much. Bought some gold and silver stocks though. I also have a small emergency fund in euros deposited overseas… just in case. I feel uneasy about the state of the dollar. Who knows what’ll happen at this point.

Posted by Hans | Report as abusive

How do you make a living smirking at what everyone does, critical of mistakes after the fact and not taking a position on how to fix problems? Where is the value added?

Posted by Steve Sherman | Report as abusive

AustrianSchool:

The desperate nature of your tone makes my day. Thanks.

Let let me clarify. The point of my post is not what economic system fail, but will lessons be learned. I pointed out other countries have learned their lessons and have benefited. The US is nowhere near learning anything yet. But we shall see in 2009.

Oh yes I am a capitalist! But of course there are many forms of capitalism – each nation adjust things to fit their needs. The US adjusted things to fit its needs too – which is now universally recognized as laissez fair casino racketeering for the elites and screw the rest. To correct the USA’s profoundly and systematically corrupted ‘capitalism’ (which suddenly turned into neo-stateism to save the skins of the elites in power) is impossible without a generational national upheaval. It is like: How do you fix a guy like Madoff and turn him into a Warran Buffett, multiplied by a 100 million times? Isn’t that the essence James Saft column?

Posted by TomK | Report as abusive

To any sober and sane investor it has been obvious for well over 10 years that something was very wrong about our US economic system and our economy. McMansions sprouting up everywhere. Real Estate values inflating in some years well into double digits. To me it all seemed absoultely crazy and unsustainable. The #1 red flag was home values becoming so high that only Rich foreigners, Doctors, Dentists and Lawyers and of course wall streeters could ever afford to buy those homes. I said to myself, how on earth can a young family just starting out ever think about achieving the American Dream. I calculated that in a typical household the Husband and Wife would be forced to work at least 1 full time job each and of course do some part time work to supplement their incomes in order to afford the Mortgage and all the other bills that come in the mail. I asked myself “how long can such a family endure all of this work”? without divorcing, burning out etc. It is painfully clear today, we are a nation of people who live way beyond our means, just in order to “Keep Up With The Joneses”. I am originally from New York City, which gentrifieid beyond imagination and has become one of the most unaffordable, places on earth to live. I figured out as I reached retirement age that I must get out. I did and moved to the mid-west where I bought a gret Levittown type home for $114,000. I pay $2,000 a year in taxes. The same house on Long Island is $500,000+ at the very least plus $8,000 a year in taxes. We have done this to ourselves, and if we are not careful we most certainly will be doomed to re-live it over and over.
May God Have Mercy on all of us, everywhere.

Posted by Ron Wagner | Report as abusive

Despite the fact that there are plenty of individual exceptions, I don’t think we should be too hard on James for employing the journalistic “we are all to blame” line to illustrate a more fundamental point (as made by Tim Lee) about the mis-pricing of assets.

Near where I live (Norwich, Norfolk, UK) there is a pleasant village with a pretty decent collection of new homes (the site has been developed over the last 7 years). About 4 years ago, while in the process of selling my London terraced house for a silly sum and moving to the country, I got details on the houses being developed. One in particular caught my eye – it was pastiche vernacular (which, for my sins, I love) and was way out of my league at £480,000. I liked it so much I kept the details (for day-dreaming).

That same house is now on the market for £320,000 (before the buyer starts negotiating) a fall of some 35% (which might indicate how far behind the curve the official figures really are). However , and here’s the kicker,using an online calculator I have tentatively worked out that if you bought it as a buy-to-let investor you would still be losing money because the going rent on similar properties would not cover the mortgage with a 10% deposit (even if house prices were rising by 3% a year).

Which might indicate that prices have even further to fall. In fact, a friend who has been a successful buy-to-let investor told me that she could only make it break even at about £240,000.

Thanks for another great insight, I hope there isn’t too much more fodder in the system for more… but alas, I expect to read more such articles for the next year, or two, or three…
What I can’t figure out is why are the politicians (I am in the UK, having recently returned from Australia) spending so much effort defending and supporting such an obviously rotten system? Why spend all those public taxes on private companies? The only companies I would support been taken over (and run) by the governments (or newly commissioned tax payer [private + corporate] funded organisation) are the Ratings Agencies who have surely been at the front of the canoe that has lead us all up a smelly creek… and then dropped the paddle.

Posted by Peter H | Report as abusive