The Great Pyramid Of Madoff

December 15, 2008

We do seem to live in extraordinary times. An extraordinary economy – once thought by some to herald an endless boom-time, is coming to an extraordinary end. Once upon a time, Britain’s Chancellor of the Exchequer, Gordon Brown, told us that he had discovered a magical means of ending the cycle of “boom” and “bust” that characterises modern economies.

Not any more.  The global economy is nose-diving deep into bust territory, with all the signs indicating that this will be far from a minor recession. One British cabinet member is quoted by the Telegraph as saying that “as it turns out, [we are] facing a recession deeper than any that we have known, almost certainly.”

The Irish government is predicting the worst recession on recordScotland, dittoGermany is set to experience the worst recession in its history, according to “The Rhineland-Westphalia Institute for Economic Research” and Deutsche Welle magazine.  The World Bank is predicting a contraction in world trade for the first time since 1982. Russia has already downsized growth figures for the year, and an economics minister has now said that these downsized figures are too high.  The Chief Executive of Barclays, commenting on the UK, says that “I think the last 10 years will be seen as an anomaly rather than a normalcy” as house prices shrivel. The OECD has predicted the “worst recession since the 1980s.”

Essentially though, nobody knows how bad this economic crisis will be, yet no-one wants to predict that the “recession” will become a “depression.”

It is very difficult for commentators, investors and politicians to admit that we may be on the cusp of a long-lasting and pervasive contraction of the global economy, with the concomitant threat of labour unrest, the likely expansion of government powers as private capital evaporates and the definite end to the party of the late 90s and 2000s boom. A reporter at Bloomberg, for example, writes that while “The damage is so immense and widespread, the most central banks and governments can hope for next year may be to stop the deterioration and set the stage for recovery in 2010, Failure may heighten the danger of deflation and near-depression.”

“Near-depression,” not actual depression. Complacency is still the order of the day, even in a fairly honest discussion of the disasters that have befallen investors this year:

“While there’s no technical definition of what makes a depression, New York University economic historian Richard Sylla says it would take a U.S. unemployment rate of 10 percent or more for longer than a year. The rate now is at 6.7 percent, well below the Great Depression peak of almost 25 percent.”

“We won’t get the contraction for a great depression,” says Simon Johnson, former chief economist for the International Monetary Fund who’s now at the Peterson Institute for International Economics in Washington. “We know enough to avoid that, but we don’t know nearly enough about getting growth back.”

The logic here is symbolic of the intellectual crisis that is accompanying the economic crisis. While there is, as Bloomberg correctly notes, “no technical definition of what makes a depression” the agency then quotes a presumably authoratative commentator, who states with profound hubris, that “we won’t get the contraction for a great depression.”

How on earth does he know, as we don’t even know what a depression is?

To use an image suggested by investment banker Mohammed el-Erian in the Bloomberg article, “The world economy has “suffered a cardiac arrest.” We don’t know how serious the heart attack has been. We don’t think that initial CPR has done any good, and we’re not sure if moving the patient has made their condition worse. We’ve got one shot with the defibrillators, but beyond that, we’re waiting on divine intervention for the resurrection of the global economy. To put it another way, we’re up shit creek without a paddle.

The old order is  rapidly fading, pace Dylan. People are becoming enraged by job cuts and the obvious corruption of what were once thought to be the world’s pre-eminent financial centres. Not any more.

No case has revealed the sordid inner workings of those centres better than that of Bernie Madoff. Madoff, an investment banker with impeccable connections amongst Florida’s Jewish elite, but also within corporations and investment circles spanning the “faiths” of the world, has spirited away billions of dollars in his clients’ money. $50 billion is the latest figure being circulated, an eye-watering amount, which points towards the “world’s biggest ever financial fraud” as the Guardian reports today.

Madoff’s crime, as far as we know, was to have run what he called a “hedge fund” like a Ponzi scheme. The revenues of earlier investors were covered by monies coming in from new investors, a classic “pyramid model.” For years, Madoff essentially wagered huge returns in the present (his funds did very well, on the whole, for those who were invited to join them) on the ability of himself and his associates to attract future business.

As long as high net worth individuals could be located across the world, his position was a safe one. All the while, it looks like temporary shortfalls could be covered up by salting away money from Madoff’s other firm, Madoff Securities. His Securities firm operated as a “market maker,” using huge flows of capital at the behest of banks and corporations to place bets on whether stocks would rise or fall. In fact, as Baron’s reported in 2001, his firm generally went both long and short on invidual stocks – betting both on their price rising and falling over a given timescale.

Baron’s noted that “The strategy, in effect, creates a boundary on a stock, limiting its upside while at the same time protecting against a sharp decline in the share price” – an extremely valuable service for corporations which might suffer serious turbulence in a truly unfettered market. As the magazine continued, Madoff was rewarded handsomely for his services, judging that “When done correctly, this so-called market-neutral strategy produces positive returns no matter which way the market goes.”

The Securities firm generated what Baron’s described as a “huge river of orders,” a position “which mean[t] that its traders ha[d] advance knowledge, if only by a few seconds, of what big customers are buying and selling.” Capitalizing on this privilege, “By hopping on the bandwagon, the market maker could effectively lock in profits. In such a case, throwing a little cash back to the hedge funds would be no big deal.”

So Madoff’s role as a “market maker” was inherently linked to his role as a hedge fund super-fraudster. Nobody knew how he generated his returns, and nobody really asked. As one trader who chose to stay out of the operation told Baron’s “What Madoff told us was, ‘If you invest with me, you must never tell anyone that you’re invested with me. It’s no one’s business what goes on here.”

His modus operandi was to get as rich as possible, as secretly as possible, regardless of the consequences. He had a certain loyalty, but not to wider society. As the Times reports, “To cap it all, Mr Madoff told his sons he was going to give himself up, but only after giving out the $200 – $300 million money he had left to “employees, family and friends.”

So far, it looks like his malfeasance will affect mainly a clutch of “private investors” – which will generate few tears and no mass protests. Banco Santander, with stakes in Abbey National and the hapless Bradford and Bingley, will suffer, having stashed £1.9 billion in one Madoff operated fund. But bank-exposure is not enormous. This is one for the schadenfreude junkies, I’m afraid, although shares have been dipping but this may, of course, be more closely associated with the failed auto-sector bail out, than Madoff’s implosion.

Madoff’s unbridled greed was made possible by a system which rewarded him and even lionized him for generating money regularly, if opaquely, no matter how he did so. He operated like a magician does with his hat, and his audience – the denizens of Wall Street, assorted Florida country clubs, hopeless European fund managers, all sat slack-jawed and gasping as he pulled out one rabbit after another. No-one questioned the inner workings of his magical machinery. He was allowed to play with amounts of money that could solve global health problems, with minimal supervision.

It’s a monstrous tale, but we would be totally wrong to see Madoff as a singular monster. His is not the major fraud being perpetrated on the people of the world by financial institutions and governments. The ongoing sub-prime meltdown, which sparked this crisis, still has to be investigated to ascertain how conscious the banks and ratings agencies were of the shoddy nature of their goods.

The likelihood is that they deliberately sold on bad debts at high prices, creating a level of fraud that makes Madof’s Ponzi scheme look like a re-silvered scratch card.

Then there are the raft of “bail outs” heading the bankers’ way, money that will allow them to walk away with billions of dollars and pounds of money, money that was generated fraudulently and irresponsibly.

The trillions of dollars that governments are sending to the bankers’ vaults is quite possibly part of a global, hyper-scale Ponzi scheme, in which the losses of the bankers are being hidden by the injection of taxpayers money.

The con artist in the diagram above, continues to enrich himself. The public are being beggared. Workers are being laid off.  Factories are closing. Public services are under threat. Benefits and pensions are at risk, or are evaporating.

The Madoff scandal, while shocking, may tend to obscure that immensely more shocking, and dangerous development.

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