Friday, December 19, 2008

Of Madoff and Ponzi schemes

So, Madoff apparently ran a Ponzi scheme quite successfully for about 48 years. It is widely reported that he offered a 10% return regardless of the market conditions. In other words, assuming he ran this from the beginning, he would have managed to increase capital by about 100x.

I have a feeling that he might have designed the return rate so the scheme would blow up after he was dead, but that this latest crisis was too much for the cushion he had. He has been quoted as having trouble coming up with $7 billion to take care of redemptions a few days before he allegedly confessed. If he had not been forced by redemption requests, he'd be still going at it.

But what if he had offered a less attractive rate instead of 10%? Then the theoretical pile of capital would have grown slower, and so he might have had more of a chance to weather the storm. How much of a rate would that be? Particularly, what is the rate that would allow a modern Madoff to run a Ponzi scheme until after the creator's death, thus managing to walk off with a clean Louis XIV move?

Well let's see. 48 years at 10% gives us a factor of 97x or so. So now let's say we want to spread that factor over 60 years instead of 48. That gives us our Ponzi scheme return rate: 7.9%. In other words, if we start when we're say 35 years old, then running a Ponzi scheme Madoff style at 7.9% basically guarantees that the thing will explode after we die.

Now, Ponzi schemes are usually spotted by a ridiculous return. But what if they just don't do that? How could you tell the difference between a Ponzi scheme and a legitimate investment operation if you do not know the internals of how the money is invested first hand? And how many of you actually go through the due diligence? If anything, even professionals such as Banco Santander clearly did not and their customers (meaning us) lost upwards of $2 billion.

This means that any investment that offers us essentially 7.9% annualized return could, in theory, be a Ponzi scheme too --- simply because in practice we will not be able to tell the difference by looking at the return rate alone.

So let's be even more conservative and run our imaginary Ponzi scheme for 70 years. Our calculations show we should offer 6.75%. So basically, we conclude that the most conservative of Louis XIV Ponzi schemes could go ahead and attract investors with a return of 6.75%.

Of course, this is assuming the Ponzi scheme behaves too well and pretends to have gains all the time to prevent redemptions. But how could you tell the difference if the Ponzi scheme claimed losses that are not worse than everybody else's losses? In other words, how do you know for a fact that things like your retirement funds are not in a Ponzi scheme that is designed so that you do not take your money out? For example, such a scheme could a) claim to lose money when others do, b) put stiff penalties for redemptions (like the usual 10% on a 401k), c) make you wait until you're 59.5 years old...

... oh...

All of a sudden such things do not look good at all, do they? And it only gets worse. How much is the stock market usually said to return over time? 11%, right? Well, this means that, using Madoff's scheme as a ruler, we should borderline expect a full blown stock market crash at least once every 43 years, if not more frequently.

And this is where we're told to put our retirement in? You have to be kidding. This means that basically everybody's retirement will be affected by at least one major stock market crash.

Then you realize: banks also lend out more than what they have because we have a fractional reserve system. The idea is that this Ponzi scheme will not blow up because not everybody will withdraw their money at once. So why is this Ponzi scheme legal now? Says who?

But regardless. How many years could we expect the banks' Ponzi scheme to stay alive? If we assume the answer is 80 years (great depression to now), then the annualized rate of growth we get is about 5.9%. How does that compare to other investments?

Now we know that our setup is doomed to fail periodically. Guess who will bailout the banks when we cannot repay the loans back: that's right, us again. And if we cannot print money to pay for the mess because nobody cares for that, guess what: we pay in titles of interest such as real estate, or companies, etc.

The only winners in this game are those very few that set it up in the first place. Are we clever or what...

4 comments:

Alex said...

Great post!
I'm sharing it with friends.
Thanks!

Steve Wart said...

Andres, very interesting.

More research at this article if you're interested

http://ftalphaville.ft.com/blog/2008/12/18/50596/ponzi-the-usa-edition/

mlm prelaunch said...

This illegal scheme makes it hard for legit MLM's to rise from slowly drowning. The responsible persons who fooled the unsuspecting victims should be put to justice.

Andres said...

As far as I know, no MLM is legit... ???...