Beware of false profits

19/06/2009

Villainy in the world of finance extends far beyond Madoff - but have lessons been learned?

by Adam Forrest
"Don’t worry, I know what I’m doing." It’s a phrase that echoes across all the testimonies of Bernard Madoff’s victims, his poisoned assurance that investors should leave their money and the hidden mechanisms of hedge funds to the expert.

In story after story, members of the Jewish-American aristocracy and nouveau riche recount asking the man they knew as “Bernie”, perpetrator of the largest Ponzi scheme in history, just how he was able to guarantee consistently high returns. “Talk to my other clients,” he would suggest with a smile, keen to create the allure of an investment in-crowd.

Some were granted hints about his unique “split-strike conversion strategy”. Such was his reputation, people moved country clubs just to get a chance to talk to Madoff, and were sometimes rejected from participating in his “fund of funds” if they were too suspicious, or their wealth was deemed insufficiently huge.

As Madoff first confessed to his sons on December 10 last year, it was “all just one big lie”. He had not been investing at all. There was no secret to the hedge fund game, which only he knew. Madoff had merely collected all the money in Chase Manhattan Bank and paid established clients requesting withdrawals with other people’s deposits, which he presented to them as if it were profit. The duped lost a collective phantom fortune of $65bn.

It may only be a brief hop from the high-profile Ponzi schemes operated by Madoff and Texan cricket guru Sir Allen Stanford (now charged with running the world’s second-biggest ever fraud) to the widespread malpractice on Wall Street that’s caused financial chaos over the past 18 months.

The Madoff investors learned the hard way that some growth is too good to be true. Since the collapse of the US and UK’s biggest banks and investment firms, bloated on so much bad debt, the rest of us have also been forced to learn at least a little of the language of subprime mortgages, collateralised debt obligations and hedge fund management.

Alan Greenspan and other gurus of high finance may have claimed the seizure of the banking system to be one-in-a-100-year tsunami, but only now is the real story of the credit crunch emerging – involving more greed, recklessness and irresponsibility than most would have believed possible after the exposure of excess on Wall Street and the City of London in the 1980s.

William D Cohan, a former JP Morgan managing director and author of House of Cards, has helped uncovered the short-term, self-serving and ultimately destructive decisions made at Bear Stearns before the US investment house went belly-up in March 2008. He agrees the recent financial villainy extends far beyond Madoff.

“Madoff is considered a criminal because he broke the rules, but what Wall Street did to us is not that different from Madoff,” he tells The Big Issue. “The difference is Wall Street got the rules written for their benefit.” The rules Bear Stearns stretched to breaking point were those revolving around their own hedge funds, which were stuffed full of dodgy subprime mortgage-backed securities. As the housing bubble burst and thousands began defaulting, these bonds rapidly lost value.

But the company bigwigs began financing the hedge funds with billions of dollars each night from the lending market, desperate for the large returns on subprime securities to continue. Bear Stearns became so wildly over-leveraged with loans [for every one dollar in assets, they borrowed up to $35] that their assets and stock price began to plummet, before finally everything collapsed.

Worse still, the hedge fund managers, Matthew Tannin and Ralph Cioffi, had lied to clients about their securities’ prospects, according to the indictment at their arrest in June last year. “The managers had been telling their investors they have been investing in relatively safe securities, but it appears they had not informed them about risky subprime mortgages,” Cohan explains.

“It’s incredible the company put themselves in such a precarious position, to risk their survival this way. It was a death spiral.”


Gillian Tett, the Financial Times journalist attributed with predicting much of the credit market’s calamities, has a slightly different story to tell. Her book – Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe – examines the ingenious beginnings of the process by which people’s debts were turned into profit.

The book focuses a small tribe of whizzkids at JP Morgan who invented something called a credit default swap (CDS) in the late ’90s. The idea was to make money on moving risk elsewhere. It was essentially a type of insurance by which one party could protect themselves against the default on a debt, and so allowed investment companies to believe themselves unhampered by liability.

This meant huge increases in the loans-to-assets leverage ratio and the taking on of even more credit-based securities, as consumers and homeowners were encouraged to live the dream of unending easy loans.

According to Tett, the “Morgan mafia” were actually a conservative bunch, and were appalled when they began to realise how their competitors were loading up on the CDS products and applying them to new areas – including mortgages.

Like mad scientists unleashing a hazardous new compound, they had allowed the development of the collateral debt obligation (CDO) – the packages of mostly bad debt (those subprime nightmares again), which could be “cleaned up” and sold on by being grouped together with less risky debt.

“There was a powerful dominant ideology that said innovation was a very good thing, that slicing and dicing credit risk had made the system safer and more rational,” says Tett.

Everyone from AIG to the Royal Bank of Scotland had become blind to the bigger picture, failing to see how dependent they had become on everyone keeping clear of defaults. “It’s like shopkeepers who are dealing with a gazillion orders and don’t have time to find out what other shopkeepers are doing,” says Tett. “They can’t break into others’ store rooms or look in their cash tills.

John R Talbott, a former investment banker at Goldman Sachs who has also turned to writing (author of The 86 Biggest Lies on Wall Street) , goes further. “The credit default swap market needs to be shut down,” he fumes. “It’s a huge interconnected network of everybody guaranteeing everybody else against defaulting, so you can’t have anybody defaulting without everybody becoming insolvent. It’s a violation of capitalism. They’re nodes in a huge spider web.”

Many companies have collapsed, or come close to it, during the recession. There is money to be made on predicting failure. The Securities and Exchange Commission (SEC), the US equivalent of the Financial Services Authority (FSA), is investigating the possibility some were betting on the collapse of Lehman Brothers and Bear Stearns last year, by short selling of shares on the stock market.

According to Patrick Byrne – CEO of overstock.com, an Amazon-type online department store – an illegal “naked” form of short selling is more widespread than the regulators ever believed possible. Naked short selling involves the sale of shares without even owning them (made possible by the bizarre system of “borrowing” shares on goodwill before you pay for them), which can be used by insiders to manipulate prices and drive down the worth of a company.

Byrne, who believes his own firm has been targeted by the financial hit men, says: “It’s like taking out life insurance on someone and then arranging a death sentence. All the regulatory institutions and financial press have failed to stop this happening.

“It’s ridiculous it’s taken so long to get their attention. I think these are really bad guys, but it’s not them I’m mad at. It’s the institutions that were supposed to protect us. The crooks found ways to corrupt them.”

In a spectacular twist, it turns out none other than Bernie Madoff generously volunteered his time at the SEC to help rewrite the rules on short selling. “I don’t think too many people have very much confidence in the SEC,” says one of Madoff’s biographers, Gerald Strober (author of Catastrophe: The Story of Bernard L. Madoff, the Man who Swindled the World).

“It’s still being run by the same bureaucracy. The little person is left outside this system. To a large degree, it’s business as usual. Nothing is really changing. Wall Street is waiting for the economy to come back; they’re not interested in reform.

“There could very well be other Madoffs out there. Someone could start a Ponzi scheme this afternoon and fly under the radar for years.”


Many observers agree the opportunity for tighter regulation – for widespread reform of the Anglo-American model of finance – is slipping away. President Obama has now proposed some changes (a Financial Services Oversight Council, mortgage companies forced to keep a percentage of loans on their books, and greater risk assesment at the big firms), but critics believe they don't add up to much.

As well as demanding the end of the CDS market, Talbott believes a worldwide agreement on limiting the amount of leverage would protect financiers from themselves.

“Look, these guys are greedy,” he states. “They’ve got fairly boring jobs where they sit in front of TV screens all day, looking for tiny, tiny differences in the value of securities. They’re not interested in reform. They live for the money.”

Tett believes the FSA has been every bit as lax as the SEC, and welcomes the idea of prudence being brought back into the British system. “There are lessons from the pharmaceutical industry, which produces complex innovations that can be valuable but also dangerous… you need credible oversight, regulators who understand what is going on to ensure banks don’t pump out illicit medicines,” she says.

Sadly, the labyrinthine complexity of finance guarantees only a small audience for such important developments, leaving most of us the dark about so much of our recent history.

“The story is always on these computers," says Talbott. "Why haven’t we seen the FBI going into these offices and dragging the computers out? I think of it as a huge cover-up. Nobody seems to want to see full disclosure, but without it, you’re doomed to repeat the whole thing.”