Livinglies's Weblog

In the Berkshire Hathaway 2002 Annual Report, Warren Buffett called derivatives “financial weapons of mass destruction carrying dangers that, while now latent, are potentially lethal.”

Virtually all Ponzi schemes are fake securitization schemes. Ponzi’s victims thought they were buying shares of an exclusive arbitrage system based upon fake ownership of postal receipt, Madoff’s victims thought they were buying into an exclusive fake options trading scheme in a faraway market operated in Europe, and Wall Street’s victims were split into two classes (1) investors thought they were buying, indirectly, shares of ownership of fake loan portfolios that existed in name only and (2) homeowners who thought they were buying a loan product that did not exist on the other end of the transaction.

The reason why Ponzi schemes are still so attractive to sociopaths is that they work. People seem to be born with an inclination to believe something that they want to be true — regardless of how preposterous the claims. Ponzi schemes are all about selling something you don’t own. But the “successful” Ponzi schemes seem to start with a real business plan. On paper, there was nothing wrong with the theoretical business plan of Ponzi, Madoff or the investment banks. In practice, they never intended to do the business plan. They intended to fake it and they did, with varying degrees of success. All Ponzi schemes succeed and then fail.

Charles Ponzi, for whom the scheme was named, started off in arbitrage of postal service receipts. But he “expanded” the scope of the business by reporting exchanges that never occurred. The trading business essentially vanished but he kept selling shares. Madoff sold shares in a nonexistent hedge fund. With investment banks, they created the illusion of a trading vehicle — a REMIC Trust — and then never put anything in it. Securities were issued on the premise of the REMIC trust owning loans but not on the premise of sharing or selling shares of transactions with homeowners.

In all PONZI cases the upside for the founders of the scheme was that as long as there were investors who could be conned into buying, the scheme would continue to put money into the pockets of the founders and those who acted as commission agents for the founders.

By enlarging the promise of ever-higher returns and downplaying any risk in the “investment” more and more people gave him money under the belief that they were investing their money safely. Like all such schemes, it dried up when people stopped buying into the scheme because there were no returns on the investment other than those faked by Ponzi when he remitted part of incoming investments to prior investors.

If you look at the Madoff Ponzi scheme and the “securitization” Ponzi scheme from Wall Street you can see that the sophistication of the schemes has increased but the bottom line is always the same. The scheme is largely or totally dependent upon new sales to new suckers. Like the Madoff scheme, the Wall Street scheme is taking decades to play out, which is great, because the founders get the benefit of the state of limitations to legally bar claims for damages from their illicit activities.

Since I have spent a great deal of time analyzing both the Madoff and Wall Street “securitization” forms of Ponzi schemes I thought it might be a good idea to share the attributes of “successful” Ponzi schemes. By “successful” I obviously mean those in which victims poured large sums of money, often their entire life savings, into this scheme.

• The scheme always promises something that no ordinary financial service can promise because it is simply impossible. There is no such thing as an investment that might produce rates of return that are higher than the market levels without a concurrent increase in risk. So the founder of such schemes plays up the increase in the rate of return and downplays the risks.
  • So in a market where the average rate of return on investment is 3% per year, the scheme might offer 12% which is pretty much what Madoff did.
  • Investment banks relied upon a hybrid that enabled them to launder the illicit revenue.
  • They were promising the highest quality investment grade providing a rate of return that was higher than anything available on the open markets, but they were entering into transactions with homeowners in which the nominal interest rate was far higher. (Look up arbitrage).
  • This enabled them to pay homeowners far less than they received from investors and treat the balance as trading profits that were reported on an as-needed basis. The balance was and remains parked in offshore accounts. I have referred to this as the second-tier yield spread premium. That might be a misnomer since there is no “yield spread premium” on an investment or loan that does not exist.
• Investors will be lulled into complacency by the receipt of payments as scheduled in their investment contract. This is simply a marketing ploy to get people talking about the great investment they just made and how proud they are of having the business acumen to have discovered this pearl.
• Statements are issued each month. This is a key ingredient of the scheme. Putting it in writing is the best way of confirming the bias of the victims that they made a sound investment. Madoff issued monthly statements that conformed to the usual form and content of such statements. Investment banks issued statements to investors and statements to homeowners that also conformed to the facially valid statements in the industries that they were supposedly operating within. The problem, of course, is that there was no options trading by Madoff, no lending by investment banks, and no “securitization” of mortgage loans. But statements often allow the scheme to run undetected for years or even decades.
• The scheme is based on a “Secret” formula. With Madoff, it was an options trading strategy that nobody else has thought of and which only he can execute or even understand. It is proprietary trade secrets. With investment banks, it was a “bond” trading strategy that nobody else has thought of and which only they can execute or even understand. Only “Quants” could possibly understand the algorithms that created the ranches and derivative security offerings derived therefrom. The problem of course is that the quants were massaging data about transactions with homeowners and investors and not creating a pro-rata share of ownership of anything.
• It is always about “proprietary trade secrets”. The secret is that nothing they’re telling you is true. Both Madoff and investment bankers said they required supercomputers that required stratospheric computations taking many days to complete and then produced transactions that could be executed in milliseconds. This is the “secret sauce” that many investors find so alluring. They’re getting in on the ground floor of something really exciting (and stupid).
• The big Ponzi schemes all have “feeders.” And the more feeders they have, the more they enhance the illusion that what they are saying is true.
  • Madoff started with an accounting firm that advertised itself as the only path to be accepted into Madoff’s brilliant hedge fund. Eventually, he had all sorts of “feeders” that included institutional investors and “qualified” investors.
  • Investment bankers developed feeders by either duping or corruptly influencing credit reporting agencies, securities rating services, and insurance companies to make it appear as though the crap they were issuing were real securities that were worth something.
  • The feeders all get commissions and kickbacks because no investing is really happening. There is plenty of money to overpay all sorts of people because there is no investment activity other than getting more money or value from victims. It is a Ponzi scheme which means that the business of this scheme is to get more investors.
• The big Ponzi schemes must appear to be institutional. Despite the historical fact that most crashes occurred as the result of bad behavior by institutions, they continued to be viewed as credible. Madoff made himself into an institution. That was a high-risk gambit that exploded in his face when the scheme crashed. Investment banks, while institutional, recognized the risk of being “the one.” So they retained other institutions to serve as the face of the scheme without sacrificing control.
• All Ponzi schemes carry a mystique of exclusivity. Victims of Madoff literally had to wait for approval from Madoff himself in order to have Madoff take their money. Fund managers and homeowners considered themselves lucky to get a piece of a new derivative offering or “loan” offering. The investment banks took advantage of the IPO mentality of investors who want to get into the ground floor of an offering. But the securities were unreal and unregulated.
• The base of all Ponzi schemes is the absence of any real investment activity.
  • Madoff’s scheme relied upon his superhuman ability to make a market in options trading. No options existed and Madoff was not operating or making any market in any options.
  • Investment bank schemes relied upon their superhuman ability to make a market in derivatives trading PLUS the illusion of loan accounts receivable owned mysteriously by either the investment bank or a REMIC trust that was understood to be the investment bank.
    • Of course, the investment bank and the designated “institution” kept their distance from the real action. The intermediaries between the homeowners and the investment bank was a company calling itself a lender, servicer, trustee or originator even though they were not permitted to touch any money and therefore could not account for it, but who nonetheless produced witnesses who testify that the opposite is true for the case involving foreclosure.
    • The intermediary between the institutional investors (without whom no money could have been paid to homeowners to induce them to sign notes and mortgages) and investment banks was the selling agent.
    • The interesting thing about the “Securitization” Ponzi scheme is that there were two classes of investors — fund managers whose business was investing and homeowners who had no notice or access to any information that they were investors in the Ponzi scheme. In both cases, the scheme could only “succeed” by selling more “derivatives” or “loans.”
• All Ponzis schemes rely upon false documentation. The big ones spend a lot of money creating a consensus of opinion that the documentation is authentic and valid.
  • Madoff was audited more than once and passed with flying colors.
  • Securitization schemes were audited multiple times by multiple rating agencies, insurance carriers, and even regulators.
  • Despite clear warnings to agencies and investors, Madoff’s scheme was not revealed until his sons reported him. Madoff operating a fraudulent scheme was simply unthinkable and impossible.
  • So far, the investment banks are still operating securitization Ponzi schemes with impunity.
  • And yet, in any court action where a court ordered compliance with requests to show ownership through payment for loan accounts, no such evidence was forthcoming, the entire position of the foreclosure mills and the investment banks rests solely on a consensus of opinion that they would not lie.

The reasons why the securitization Ponzi scheme has not been outed are as follows:

1. The Class 1 investors who purchased the worthless securities are fund managers who (a) don’t want to admit error and (b) don’t want to reduce benefits to retirees who are too remote from the investment to (i) know that it exists and (ii) know anything about it.
2. The Class 2 investors who thought they were purchasing loan products have never been informed that they were investors in the scheme. So they don’t know that they have been cheated out of “profits” and they don’t know the amount of set-off that should offset their promise to pay the disguised “loan.” They still don’t know because most of them have never thought to make inquiries or do any research, and they don’t have access to the data or court decisions that might have alerted them.
3. All the insiders who know the truth got rich off of the scheme and were part of it. They have no reason to go public because they’re still making money far beyond their normal earnings potential.
4. The media outlets including those sporting investigative journalism simply switched off reporting about the mess created in the mortgage meltdown. The reporters who were digging were told to stop, and they did. The reasons for this are various. What is clear is that publications like The New York Times and Rolling Stone were getting deep into the mess when suddenly they were switched off like a lamp. (E.g. see Matt Taibbi and Gretchen Morgenson).

THE UPSHOT: It was actually the investment banks that caused the Madoff scheme to fail when it did. They caused the mortgage meltdown and that caused the “freezing” of the “bond” markets. Add the foreclosure crisis that created a panic amongst investors generally. Investors did what they usually do in such situations — take their money out of the market and wait for things to settle down. The bond market was negatively affected because most of the activity was in derivatives. People were all Sellers and few of them were buyers. They wanted their money out of the market.

When people stopped buying derivatives because they could see the “defaults” in “mortgage loans” the bond markets froze because there was no market making without buyers. That panic started the panic in the stock markets. And so there was a run on any kind of fund including hedge funds, of which Madoff was supposedly one. Only Madoff did not have the investment or the money. But for the mortgage meltdown, Madoff might have continued for more decades. So far the investment banks are continuing their own run with impunity but that might change when regulators realize that the transactions have not been reported honestly to the SEC, FTC, CFPB, etc. But we might be a long way from that day.

Of course there is a certain irony in all of that. Defaults in home mortgages, even if they occurred and even if they occurred in a significant amount of transactions with homeowners, could not really impact the position of investors unless the investment bank wanted that impact to occur. Sure enough, they did want it because they had created, issued and sold or purchased insurance, credit default swaps that would pay windfall profits to them if the securities they issued were to be subjected to an “event” which was in the sole discretion of the investment banks to declare.

They got two benefits — a reduction in what the investors could reasonably expect from the discretionary payments of the investment banks (under cover of homeowners “defaults” that were erroneously presumed to have caused losses to investment banks) and payment on large swathes of securities that were index referenced on homeowner transactions that (a) did not exist or (b) were not even in default even by common definitions of default. See AIG payout of $40 billion to Goldman Sachs.

I just finished listening to a seminar for lawyers. Among the things that were said is that the outcome of an audit for a troubled bank depends heavily on the relationship that was previously built with the regulators. With no depositor or borrower sitting at the table, regulation of the investment banks and commercial banks is a one-sided deal with only the regulator and the bank in the room. The government is supposed to be sitting in that room making sure that the interests of the little guy are taken into consideration before an outcome is announced for a failed bank or failed scheme or, more importantly, the beginning of any new scheme.

The SEC is charged with evaluating the disclosure of risk in new securities offerings. They say that they never got the chance to do that because the “certificates” were excluded from regulation in 1998-1999. But that would only be true if the securities they issued were mortgage-backed bonds and not just IOUs, which is what everyone now knows them to be. So regulation is possible but simply not done. Those certificates were securities subject to regulation pure and simple and they had nothing to do with the ownership of any obligation from any homeowner. Analysis easily reveals that they were junk bonds or debentures having no intrinsic value save the hope that the investment bank, in its sole discretion would make payments on some scheduled basis. Like all derivatives, they are bets, not any investment in any asset.

The result was entirely predictable and was in fact predicted by many people before I ever entered the picture. If you exclude a particular form of securities sale from regulation, the investment banks are going to flock to it because they have permission to say, or not say, anything they want. But they were not permitted to lie or withhold vital and material information from fund investors or homeowners who did not even know they were investing in a securities scheme.

The possibility for both regulation and recovery of taxes that should have been paid still exists. In all vents, allowing the investment banks to continue foreclosing on loan accounts that do not exist (except for purposes of foreclosure) is continuing to undermine the economy of the U.S. and other economies around the world. Based upon heuristic computations, it is entirely possible that the U.S. government is entitled to receive more than $5 trillion in back taxes on income that was not reported, or reported as a return of capital.

Note also that with respect to securitization Ponzi schemes the premise is that there was a lack of sufficient business activity to justify the offer of investment. In securitization schemes, this means that the primary advertised activity was not happening at all or was not happening in sufficient quantity to justify the intake of investor money and value.

This was hidden in transactions with homeowners. While they were paying money to and on behalf of most homeowners in those transactions, they were not purchasing a loan account receivable. The money was paid only because it was the only way to get homeowners to execute a note and mortgage which was the only way that investment banks could claim they were securitization transactions. But the reality is that no loan account receivable was created nor any reserve for bad debts — because there was no debt. By their execution of the note and mortgage, homeowners thought they re getting a loan when inf act they were investing in the fake scheme perpetrated by Wall Street.

Specifically, the entire scheme was completely dependent upon the existence of an enforceable loan account receivable created in transactions with homeowners. But, contrary to the illusion promoted by the investment banks, no loan account receivable was ever created or maintained. The reference to data about the transaction was the basis for asserting the existence of a loan — rather than actual ownership or even claims to own the nonexistent loan account receivable.

And the enforceability of the promise elicited from homeowners was entirely dependent upon the ability of the investment banks, operating through sham conduits, to convince a court that the paperwork should be enforced regardless of who owned the underlying obligation, even if there was nobody who owned the obligation. this was contrary to all existing laws in all U.S. jurisdictions. See Article 9 §203 UCC adopted verbatim.

Hence, investors thought they were indirectly buying large pools of loans when they were just getting a discretionary IOU from the investment bank. And homeowners thought they were getting a lender, a loan account, compliance with lending statutes, and a counterparty who had some risk of loss if the “loan” went south. Both were taking risks that they knew nothing about.

 

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