December 16, 2008

Ancient History and New Victims

Story Time!

A long time ago, there was a young man who was a new immigrant to America. He had been told, and he believed, that America was the land of opportunity for anyone willing to work hard and learn a trade. He tried various approaches to earning money, including work as a dishwasher (and eventual waiter) of the restaurant on whose floor he slept and a bank teller.

His fortune was finally made when, while selling advertising to businesses, he hit upon the idea of arbitrage - buying goods from one market where it is cheap and selling it in another where it is more valuable. The distances are irrelevant: so long as there is a seller and purchaser who have different ideas of the value for an item, money can be made between them.

Within days, he was making thousands of dollars. He showed potential investors the money he had made, and offered to let them in on what was a stunning return (fifty percent!) for what was an easily explained - and clearly demonstrated - idea.

They invested, he produced; within weeks word was getting around about the immigrant with a golden touch. New investment started flowing in from more and more people getting the astounding return exactly as promised. People saw cash in their hands and promptly threw it back into the new company that was making them rich.

Soon enough, investment capital had gone from a few thousand to millions. As there always is when millions of dollars is involved, a lawsuit raised questions; and as often happens when millions is involves, the Financial Wizard paid everyone who asked questions, and the questions stopped.

But questions soon followed from people he couldn't simply hand money to go away. He was exposed as a fraud, arrested, and eventually deported. Investigators couldn't find where the investor's money went, and finally concluded he had simply spent millions of dollars of other people's money. Some went to his exuberant living expenses (He's rich, and thus good with money! Invest with him!) and more went to the investors themselves. Well, some of it did, any way.

Later investors provided the cash for him to pay older investors when their dividends came due. The older investors saw their cash, plus a generous profit, and handed it back (plus more, having gotten a mortgage for this fantastic deal). That money was later returned, plus yet another huge bonus, with the sure knowledge that they would reinvest. Who needed to make money when people would simply hand it to you?

The man's name was Carlo ("Charles") Ponzi, and he has a financial scam variant named after him. He had, and pissed away, millions of dollars in a matter of months, scamming some 17,000 hopeful victims. In 1920 dollars, that would be the equivalent of $10,000,000 using the Consumer Price Index.

Not bad for four months, eh? If he had been set loose for 40 years, perhaps he'd have been close to Bernard L. Madoff's $50 billion of ghost money.

The scam has been around for decades, and it's always the same bait and the same hook.

The Bait

Cash. It's that simple. Ponzi offered a staggering 50% return on investment: that's more than enough to make any reasonably intelligent person highly suspicious. (Note: having money does not make one intelligent; not even reasonably so.) Madoff handed out 11% or better on investor's returns for fifteen straight years - including through two market crashes.

The Hook

When questions arise, there's an extra layer of protection scam runners have: trust. Ponzi had the newly arrived Italians; Madoff had the members of his country club. Both of them started out talking to people they knew, people like them. Those first victims would be talking to someone who they knew they could trust. He's our people, and he wouldn't betray our people, would he?

And then those folks, getting huge returns on their investment, would tell others they knew: you know, people like them. Hey, there's this great kid made good, he's looking for investors, and you could do worse, yes? Look what he did for me! And my gosh, have you seen his house?

Madoff, unlike Ponzi, likely had no intention of stealing money from his investors. Most likely he got caught in one of the many pitfalls of the markets he played in, and simply couldn't stand to tell the people who trusted him, many of whom were philanthropic institutions, that they wouldn't be meeting projected marks. It was just a little cover-up: they would make up for it next year...

Sound familiar?

You want to trust people, especially ones who remind you of yourself. It's difficult to question someone who you already believe knows more than you do; but to doubt one that has brought you a reward for trusting him is nearly impossible for many.

Many investment scams still rely on exactly this tribalism to find new victims: Hispanics in the southern United States have seen Spanish-only banks appear, last for a year or two, then vanish. How can that happen? The people investing are strangers in a strange land, exactly as the first of Ponzi's victims were - they need someone they can trust, who also knows the world they are trying to exist in. Who better than someone who speaks their language? There are even smaller groups catered to, sometimes opening in rented mall space.

There are other variants circulating about that use the Us-verses-Them mindset to ensure trust, and to encourage the idea that to question is to betray that trust. "Women's Investment Circles" are a classic example, meeting at each other's homes (with help from a facilitator), getting women to recruit their friends and expand the Circle - whose members then go looking for others to recruit... There are people who prey on religious congregations; who pose as new-age gurus starting "healing colonies"; who have free-energy machines that "they" don't want you to know about.

Every group has been ripped off at one point or another: religious congregations, political activists, home makers, sports fans. I'm sure if I lived in Italy, I'd be writing about how the Moroccans coming to the country are too naive; or about the Koreans if I lived in Japan.

When Ponzi was arrested, people were furious... with the officers. Even in prison, he was getting inquiries from potential and past investors who simply didn't believe he was misleading them, combined with the fervent hope that the magic ride wasn't over... plus one other thing.

A funny thing about poker hands: many people find it harder to fold a hand they've put $500 into than one they've only invested $5 into. There comes a tipping point, different for everyone, where the gambler decides they "can't afford to walk away" from their investment. So they pay more, dream bigger, and ignore any signs that they're headed for disaster. Even more interesting is that people who are bluffing, who know their hand is worthless, are more likely to fold their hand, cut their losses and look for the next opportunity. But people who have bad hands, ones that they are playing despite fifty-to-one odds against, they're the ones who stick around. They pray, deeply and devoutly, that a miracle happens to pull them back to their original level of savings. The hope is what keeps them, misplaced though it may be.

This simile falls apart when you realize while there are few miracles in poker, there are none in the financial world.

The big question is this: how can you trust any of your investing when some of the wealthiest people in the world fall victim to a well known scheme more than seventy-five years old?

All that can help is the same thing that help in every other circumstance where people are looking to take advantage of you:

1) Multiple sources of information;
2) Increase your personal knowledge of what's claimed;
3) Keep your emotions in check, especially if you hear an Us-verses-Them message.

Money: yet another reason why keeping skeptical is a healthy idea, physically and financially.


Since I have the chance, I'm going to point you to a certain Mr. Madoff pontificating on the economy (hat tip to Crawl Across the Ocean, or CAtO, over on the right, there). As he puts it:
Red Tory links to an old video of Madoff pontificating on life on Wall Street, and how he goes down to the SEC and complains that Wall Street is over-regulated, and how now that they can't make money from commissions any more, the big money is made by taking risks, and how the public doesn't understand that "in today's regulatory environment is is impossible for a violation of the rules to go undetected, particularly over a long period of time". Great stuff!

Go, look, and laugh.


posted by Thursday at 10:25 pm


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