(For previous posts in this series, see here.)

Many of the people who were swindled by Madoff were those who suffer from what William Deresiewicz, a professor of English at Yale, calls ‘entitled mediocrity’. These are people who see themselves as smart merely because of their background and formal education and not out of any actual achievement. In a recent article in The American Scholar titled The Disadvantages of an Elite Education, Deresiewicz reflects on his own rising self-awareness of the limits his privileged education has created.

I never learned that there are smart people who don’t go to elite colleges, often precisely for reasons of class. I never learned that there are smart people who don’t go to college at all.

I also never learned that there are smart people who aren’t “smart.”
…
The second disadvantage, implicit in what I’ve been saying, is that an elite education inculcates a false sense of self-worth.
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There is nothing wrong with taking pride in one’s intellect or knowledge. There is something wrong with the smugness and self-congratulation that elite schools connive at from the moment the fat envelopes come in the mail. From orientation to graduation, the message is implicit in every tone of voice and tilt of the head, every old-school tradition, every article in the student paper, every speech from the dean. The message is: You have arrived. Welcome to the club. And the corollary is equally clear: You deserve everything your presence here is going to enable you to get. When people say that students at elite schools have a strong sense of entitlement, they mean that those students think they deserve more than other people because their sat scores are higher.

It’s no coincidence that our current president [George W. Bush at the time of writing], the apotheosis of entitled mediocrity, went to Yale. Entitled mediocrity is indeed the operating principle of his administration, but as Enron and WorldCom and the other scandals of the dot-com meltdown demonstrated, it’s also the operating principle of corporate America.

It is this smug self-assurance of one’s own smartness that leads these people to fall prey to those who know exactly how to play on their weaknesses. Recently a hedge fund manager Andrew Lahde decided to retire after he had made enough money to live comfortably for the rest of his life, and he had some harsh parting words about the kinds of people that made it so easy for him to be so successful at making money. He said that the so-called ‘smart people’, who had a high opinion of themselves that was not based on any real achievements, were the easiest ones to take advantage of.

I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades.

Lahde was making money at these people’s expense legally but the people at the losing end were the same kinds of people who were swindled by Madoff.

America prides itself on being a meritocracy, that people get to the top by virtue of their ability and hard work. It is not clear if that was ever really true but there are definitely reasons to doubt it now. It is true that there are no legacies of a feudal system like a formal aristocracy and inherited titles. But we do now have in place a system that seems to perpetuate a ruling class. Wealthy people have created a system whereby they can send their children to elite primary and secondary schools and colleges (often starting with elite pre-schools!) where they move around largely with people like them and develop the contacts that, coupled with their parents’ network of business and social relationships, enable them to get onto the fast track of business and government. So we end up with a self-perpetuating elite.

What we have now is a one-party pro-war/pro-business form of government controlled by a wealthy elite that sees its role as preserving the privileges of the already privileged.

America has become an oligarchy, and that is not a good thing because it is usually a sign of impending collapse.

Next: The dangers of being ruled by an oligarchy.

POST SCRIPT: Telling the truth about religion

British comedian Marcus Brigstocke riffs funnily, but accurately, on the violence and hate and demands for special treatment that permeates the three so-called Abrahamic religions (Judaism, Christianity, and Islam) and the so-called ‘moderate’ religious people who are its enablers, something that I have said before.

(For previous posts in this series, see here.)

While Bernie Madoff has pleaded guilty to various charges of fraud, what he actually did has not yet been unraveled and who else was involved not revealed, though all the signs are that it was a pyramid, or ‘Ponzi’, scheme in the classic tradition, pretending to have a business that made money while merely taking money from newer investors to pay off the obligations to the older ones.

As with Charles Ponzi and Allen Stanford, there had been clues long before that Madoff was running some kind of fraudulent scheme, but those who suspected it were not sure exactly what. As long ago as November 2005, Harry Markopolos, an investment hedge fund manager and derivatives expert, sent a confidential report to the Securities and Exchange Commission, the supposed watchdog agency, saying that based on his analysis Madoff could not be providing his returns legitimately. In his report, Markopolos listed 29 red flags about Madoff’s operation.

As Eamonn Fingleton, a former editor for Forbes magazine and the Financial Times, explains in the CounterPunch newsletter of Feb 1-15, 2009:

Markopolos’ interest had been first piqued as far back as the 1990s, when colleagues told him of this amazing fund manager who was ostensibly using a conservative options-based hedging strategy to generate consistently superlative returns. As an options expert, Markopolos quickly determined that what Madoff was claiming was impossible (in this conclusion, he was joined by many Wall Street authorities, not least analysts at Goldman Sachs). Either Madoff was faking or he was pursuing a quite different investment strategy, in all probability a shady one, known as “front-running” (more about this in a second). At a minimum, Madoff was a liar.

What is front running?

Front-running refers to the practice by brokers of exploiting privileged knowledge about future buying and selling by large financial institutions to make private profits. A typical instance might start when a broker receives a big order from an institutional investor to buy shares in, say, IBM. This is more or less guaranteed to send the price shooting up, and if the broker can nip in seconds ahead with an order for his personal account, he or she is guaranteed an almost certain, risk-free, and instantaneous profit. Front-running is pandemic on Wall Street and, as Madoff’s more sophisticated investors realized, almost no one was better placed to profit from it than Madoff.

So this is the scheme that Madoff led his investors to suspect that he was carrying out. While it is technically illegal (since it involves using insider knowledge), it is not uncommon because it is hard to prove and prosecute. What aroused Markopolos’s suspicions is that, as in the case of the Ponzi and the Afinsa/Escala business models, while it was superficially plausible, the returns being provided implied a scale of operations that simply was not possible. But only people who understand the business model being used and do the calculations realize this. As Fingleton writes:

[A]fter years of piecing together information from a wide variety of mainly private sources, however, Markopolos became convinced that front-running was not the explanation. That left only one possibility: Madoff was running the biggest Ponzi scheme in history.

But others had also had their suspicions aroused, though they did not make them public.

For years, [Madoff] had been pegged as an outright Ponzi artist by Goldman Sachs and Credit Suisse, for instance, and he was blacklisted also at Deutsche Bank, Merrill Lynch, and UBS. Indeed, as far back as 1991, CounterPunch contributor Pam Martens, in her capacity as a Wall Street broker had told him she was on to his game and had so advised a client.

The business media and the regulatory agencies also dropped the ball. Markopolos’ now famous dossier was also given to the investigative reporter John R. Wilke of the Wall Street Journal. As Fingleton says:

It is hardly an exaggeration to say that, on the strength of an afternoon’s research, a good reporter could have worked up any one of Markopolos’ points into a cracker of a front-page story. Taken as a whole, the dossier represented the biggest “career development opportunity” any journalist has been handed since Deep Throat delivered the goods on Richard Nixon to Woodward and Bernstein a generation ago.

And yet, nothing happened. Neither the SEC nor the Wall Street Journal picked up on Markopolos’s investigation. Even the New York Times, which had to have been aware of all the worried whisperings about Madoff that were circulating in the elite social circles that their own editors inhabited, did not investigate or reveal these misgivings until after the scandal broke. Why?

Infected by the “greed is good” virus that has ravaged political discourse for nearly three decades, American financial regulation has now become so corrupt and incompetent that it would embarrass a Third World kleptocracy. What is news – at least to those who lack independent sources of information – is that top American editors and reporters now seem no more willing to tackle wealthy and well-connected crooks than their avowedly venal and cowed peers in, say, Jakarta or Harare.

This is what Jon Stewart excoriated Jim Cramer for in the now famous interview. But Cramer was merely a pathetic minor representative, a circus clown, of the financial reporting industry. The sickness runs deep. Consider the recent decision by Andrew Rosenthal, editorial page editor of the New York Times, to publish an an op-ed piece by one Daphne Merkin saying that there were no “victims” in the Madoff case since “no one was holding a gun to anyone’s head, saying sign up with Mr. Madoff or else.”. It is certainly true that some of the investors who gave Madoff money were driven by greed. But who is Daphne Merkin? In her piece she coyly says parenthetically that “I did not know Mr. Madoff nor did I invest with his firm, but have a sibling who did business with him.”

But as that excellent blog Talking Points Memo pointed out, there is far more to this connection.

That sibling is Ezra Merkin, the financier and former chairman of GMAC, who was the second-largest institutional investor in Madoff’s funds, losing billions of other people’s money. In a civil suit filed this week by New York Attorney General Andrew Cuomo, Ezra Merkin, who collected over $40 million from Madoff’s funds, was charged with “betraying hundreds of investors” by lying to them about how much of their money he had invested with Madoff, and by failing to disclose conflicts of interest.

So there were many people who were swindled by Madoff because other money managers like Merkin gave him their money, sometimes despite explicit instructions not to. When TPM contacted Rosenthal to question why the full extent of Daphne Merkin’s connections with Madoff was not made explicit and why she was given this platform to mitigate Madoff’s crime, he refused to answer, which suggests how complicit the media has become in the face of massive government and financial corruption.

Next: The problem of ‘entitled mediocrity’

POST SCRIPT: Biblical torture

The story of Job is one of the weirdest in the Bible, which is quite an achievement when you consider that it is a book full of truly weird stories. God essentially allows the devil to torture an innocent man for no reason other than to prove a point. This animation gives you a quick and accurate synopsis of the story.

(For previous posts in this series, see here.)

Bernard Madoff has reportedly swindled investors out of $50 billion of their money. You might have noticed that news stories repeatedly emphasize their surprise that the people who were defrauded were ‘smart’ people. If you look at the stories more closely, you will find that they do not really specify what they mean by smart. What they point to is that they had a lot of money, lived well, moved in exclusive circles, and attended elite schools. These are the measures that most people use to determine whether someone is ‘smart’ or not. It seems to be a basic assumption that rich people who have had extensive formal education at elite institutions cannot, by definition, be fools. Hence they must be ‘smart’.

But there is a difference between being merely conventionally ‘smart’ as determined by these measures and being genuinely smart. The biggest suckers are those who have convinced themselves that they are smart but really are not.

I once watched the magician James Randi give a demonstration of his tricks to a group of physicists and he completely bamboozled them. He said that it is really easy to fool people, and the more well educated people are, the more confident such people are of their own cleverness, the easier it is for magicians and other tricksters to take advantage of them.

Madoff seemed to have taken advantage of four psychological weaknesses that such conventionally smart people tend to have. The first is that he provided attractive and steady returns on their investments, but nothing spectacular. ‘Smart’ people are suspicious of get-rich-quick, something-for-nothing schemes, rightly suspecting that those must be frauds. But here was someone who was providing a slightly above average rate of return of about 10% on investments when the stock market was going up, and still managing to provide good returns when the market was going down. So he was definitely outperforming the market but not by amounts that might make people too suspicious. It seemed plausible that he had some kind of system, although he never said exactly what he was doing that enabled him to be so steady, claiming that doing so would reveal his business secrets.

The second was that he was well-connected, a friend of the elite, a former chair of the NASDAQ stock exchange, a public benefactor. He was a member of the exclusive Palm Beach Country Club where he played golf with many of the people who eagerly sought him out to invest their money. They felt he was one of them, their friend. People tend to trust members of their own class, their own social circle.

Third, he played hard to get so that people were made to feel that he was doing them a favor by taking them on as clients. People sought him out, tried to get their friends to recommend them to him as clients, and sought to curry his favor. And he would turn money and people away, thus increasing his appeal. When people have irrationally set their hearts on achieving a goal, they do not pay attention to the normal warning signs that govern their other actions. (Woody Allen riffs on Madoff’s technique and his victims.)

Fourth, and perhaps most significant, was that he gave people a wink and a nudge that the system he was using was perhaps not quite legitimate, that he was skating close to the edge and using insider knowledge that may have come with being former chair of NASDAQ, and that other people, those ignorant poor saps, were being exploited in order to give them their returns. So those who invested with Madoff felt that they were also financial players, that they were on the same side as him, making money at the expense of suckers like you and me.

These very rich people have no problem with people who take money from those less well off, since they often do so themselves, both legally and illegally. That comes naturally to them. What they found shocking was when it was revealed that Madoff’s targets were themselves. Madoff was playing a classic con game, taking advantage of rich and greedy people’s willingness to take unfair advantage of people poorer than themselves.

It is the same psychology that was used by the small-time conman to lure the big-time gangster into the con in the classic film The Sting. If you have never seen this Paul Newman-Robert Redford film, you have missed a treat. Here is the classic poker scene from it.

Next: How Madoff ran his scam.

POST SCRIPT: What we need is more sports!

The Onion News Network reports on plans to expand the NCAA playoffs to 4096 teams.

(For previous posts in this series, see here.)

Following up on yesterday’s post, Charles Ponzi’s scheme used the fact that a person could legally buy postal coupons in one country using the currency of that country, but in the denomination of the currency of another country. If you mailed the coupons to the other country, the recipient could then exchange the coupons in their post office for stamps.

In 1920, after World War I, the British and German currencies lost value compared to the US dollar. But since postal coupons were based on fixed exchange rates set in 1907 by the International Postal Union and were thus based on a higher value for those currencies, Charles Ponzi saw the chance for a scheme that would work by sending money overseas to buy coupons for American stamps that had greater value than the amount he had sent, and having the coupons shipped back to him. As economist Michael Hudson says, “An American penny could buy foreign stamp orders that could be converted into six cents in U.S. stamps, for a 500 per cent profit.”

But there was a catch.

The problem was that it would take a truckload of such postal orders to make serious money. A million-dollar investment would involve a hundred million penny coupons – which then would have to be converted into stamps and sold in competition with the U.S. Post Office, presumably at a discount, mainly in immigrant neighborhoods.

This shipping of such huge numbers of coupons from one country to another, and then trying to sell the stamps on the street to get back cash, would have involved hard work and been tedious. So what Ponzi did was simply tell investors that this was his business model for making money, but not actually carry it out.

Focusing on the principle of arbitrage rather than such laborious implementation, Ponzi explained that he could make a 400 per cent gain after expenses. He promised that investors could double their money in 90 days, pretending to take due account of the costs and shipping time from Europe to America.

Ponzi, like every other perpetrator of such schemes since, took advantage of that aspect of human psychology, especially common among greedy investors, that as long as they are getting the interest rate on their money that they were promised, they would not inquire too closely into the details of the business, being satisfied with vague generalities that gave them something plausible to believe in.

Ponzi had noticed this trait much earlier when he had worked at as a teller at a bank that attracted investors by paying higher interest rates than their competitors and used that money to invest in real estate, expecting those prices to rise. When the real estate market took a downturn and their investments went bad, the bank went bankrupt. But while they were making money, the bank’s depositors were quite happy, a scenario that should sound depressingly familiar to people today.

Ponzi promised to double his investors’ money every three months and he delivered, at least at the start. What he did was to pay on schedule to the early investors, who spread the word that this was a good investment. More investors gave money, which Ponzi used to pay the promised interest to the earlier investors. As long as increasing numbers of new investors (or to use a technical term, “suckers”) were coming in with new money, he could pay off the earlier ones, thus creating a pyramid of investors, the ever-growing large base supporting payoffs to the smaller group closer to the top.

When his Securities Exchange Company paid early investors the high returns he had described, they spread the word to others. Ponzi’s inflow of funds rose from $5,000 in February 1920 to $30,000 in March, and $420,000 by May. By July an estimated $250,000 a day was flowing into his firm, mainly from small investors who let their book credits build up rather than taking out their money. Some people put their life savings into the plan, and even borrowed against their homes.

Like other frauds, Ponzi spent money lavishly on himself, living well, buying a mansion, and even bringing his mother over from Italy. And Hudson points out that like the Ponzi schemes of today, there were enough clues that he was running a racket if only financial reporters and investigators took the trouble to look for them. In each case, there were a few people who had stumbled upon the fact that the sheer volume of transactions that would have to be involved to generate such returns did not, and could not, match the reality, and that hence there must be some racket going on.

The financial reporter Clarence Barron (publisher of Barron’s) noted that if he really had invested the money as he told his investors he had done, Ponzi would have had to purchase 160 million postal reply coupons. Yet the post office reported that few were being bought at home or abroad, and only 27,000 were circulating in the United States.

There were similar clues that shady dealings were going on in the Escala/Afinsa stamp fraud of 2006, if only people were willing to look into the actual workings of the business.

The denouement came shortly after Lloyd’s of London withdrew from a 1.2 billion euros policy to insure Afinsa’s stamps. One of its experts noticed that if $6 billion really had been invested, it would have bought up all the investment-grade stamps in the world many times over. The fact that stamp prices did not reflect any such extraordinary buying implied that few bona fide stamp transactions occurred at all, and there had been a massive over-billing.

The same is true for the fraud perpetrated by Allen Stanford, which began to unravel when a Venezualan financial analyst looked into Stanford International Bank (SIB) as a favor to a friend who was thinking of investing in it. “No matter how hard he tried, he could see no way in which SIB’s business model could produce the returns that it claimed to or fund the dividends that it was continuing to pay its investors.”

Bernard Madoff’s scheme was similar, as we will see tomorrow.

POST SCRIPT: Quote

“There are two novels that can change a bookish fourteen-year old’s life: The Lord of the Rings and Atlas Shrugged. One is a childish fantasy that often engenders a lifelong obsession with its unbelievable heroes, leading to an emotionally stunted, socially crippled adulthood, unable to deal with the real world. The other, of course, involves orcs.” (From Kung Fu Monkey.)

Recently there have been two major fraud scandals in the US, one perpetrated by Bernard Madoff and the other by Allen Stanford, both based on so-called ‘Ponzi’ schemes. These exploded on the financial world as big surprises. But there was a similar huge scandal that took place in 2006 but since its impact was felt mostly in Spain, the media here did not give it much publicity, though doing so might have alerted people earlier as to what Madoff and Stanford were up to. Economist Michael Hudson gives the background on the Spanish fraud.

The Spanish scheme involved the trading of rare stamps by a Spanish holding company called Afinsa that bought up a New Jersey stamp auction firm and combined it with a Spanish auction firm to create Escala, the third largest auction firm in the world, after the much better known Sotheby’s and Christie’s. Their business model was to buy and sell rare stamps for dealers and collectors, making money on safeguarding and curating the stamps while also making profits on the transactions. Since the prices of rare stamps seemed to be always going up, they were able to promise and deliver to investors steady rates of return of 6% to 10%, higher than government bonds and much of the rest of the market, and thus convince investors to put money into the company.

But in May 2006, Spanish police raided the firm and on examining the books, found that the stamps they purportedly had either did not exist or were of much lower value than claimed. The firm was accused of running a pyramid or ‘Ponzi’ scheme.

So exactly what is a Ponzi scheme? Hudson recapitulates the original scheme by Charles Ponzi that has inspired a particular kind of fraud that will be forever associated with his name.

Charles Ponzi was a poor Italian immigrant who arrived in the US in 1903. His stated business model was based on what is called ‘arbitrage’. This is where a person takes advantage of a difference in the price of something in two different markets separated by either space or time, so that if one buys in one market and sells quickly in another market for the higher price, then one makes a profit, often without the nuisance of even having to take possession of the item being bought and sold. (True arbitrage, where the buying and selling is done simultaneously in two different places, is only possible in modern times and with deals that can be transacted electronically, such as securities and currencies and other similar financial products.)

People do this with foreign currency trading if they can predict which way the value of a currency will go. Suppose that at some time a US dollar and a British pound are at parity, meaning that they have equal value. You could buy a dollar with one pound and if the pound later depreciates so that it now trades at two pounds to one dollar, then the dollar that your original pound bought can now be used to buy back two pounds, giving you a 100% profit.

The financier George Soros is supposed to have hugely increased his fortune by betting that the value of the British pound would go down. He sold so many pounds for other currencies that the market was actually influenced by his actions, with other traders thinking that he was betting on something that would actually happen and they also started selling their pounds, causing a run on the currency and driving down its price, and creating a self-fulfilling prophecy.

The catch with this kind of trading is that the differences in trading values in the two markets are usually very small, especially over short time periods and, because of fees and other costs, ordinary people cannot make money from it. One has to be a trader oneself and thus avoid the commissions or have a lot of money to invest in order to make money. But a hundred years ago in Ponzi’s time, there existed something called postal coupons that enabled an investor to make money on what seemed like a sure thing.

Postal coupons are no more (I think) but they were common when I was a student and were essential back in the days when buying and selling foreign currencies was not easy or if you lived, like me, in a country that did not allow you to convert your local currency into foreign ones.

The problem the coupons solved was this. Suppose that you needed someone in another country to mail something to you but you had to pay the cost of postage. One way was to send money to the recipient to cover the cost of stamps. But this meant that either you or the recipient had to convert your local currency into the foreign one, which could be a nuisance or even, as it was in my case in Sri Lanka, impossible except in the black market.

Postal coupons were created to solve this problem. You could legally buy such coupons in your own country in your own currency but in the denomination of the foreign currency to cover the cost of stamps in the other country, and then mail the coupons. The recipient could exchange the coupons in their post office for stamps and mail your package to you.

What Ponzi did was take advantage of the fact that the exchange rate at which postal coupons were valued badly lagged behind the exchange rates of currencies, enabling him to take advantage of the difference.

Next: How Ponzi’s original scheme worked.

POST SCRIPT: Why not calculate the budget on an abacus?

Why is it that members of Congress, during their debates, still prepare large posterboard charts that are then mounted on hard backing and placed on easels? Do they think they are still in middle school? Haven’t they heard that there are things called computers? Projection systems? PowerPoint? Is there some arcane rule that says that Congressional aides must waste their time producing huge charts that might have just one word or one number? The members of Congress using this seem to think that this produces some kind of dramatic effect when all that it indicates is the sense that the speaker is out of touch.

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