By Kaufmann | December 18, 2008 5 Comments »
Very recently we witnessed political and social unrest in Colombia due to the implosion of the DMG pyramid scheme (named after the scammer, David Murcia Guzman). And now we got Madoff in Wall Street. These cases today show how difficult it is sometimes to learn from the past. Especially when past events are far way in space and time…
I have received articles from experts in Colombia who found parallels in their current case with the analysis I made long time ago on the Mavrodi’s MMM pyramid scheme collapse, which inflicted major pain on so many Russian citizens in 1994. The focus of my old article was on the MMM Russian case. But there were other such financial collapses caused by pyramid schemes at that time, including in Romania, and then the tragic case of Albania, in which 2,000 citizens died during the civil war that ensued.
Pyramid schemes in the financial sector are known as ‘Ponzi schemes’ – after Charles Ponzi who scammed many Bostonians almost a century ago. A Ponzi scheme fraud occurs when the money of fresh investors, attracted by the promise of ‘fantastic’ dividends, is used to pay the previous investors. The first group of investors get high dividends. The word spreads about the high payoff to those early investors. Fresh investors are attracted, each layer growing in size, until everything falls apart because the much larger group of latecomers cannot be compensated by those coming after them, due to the eventual cap in the number of new investors attracted into the scheme.
A Ponzi scheme is therefore literally a house of cards, with no actual investments, but based on an unrealistic expectation of ever growing cadres of new ‘investor’ cohorts to pay the previous cohort. When such perennial growth fails to materialize, it becomes impossible to pay returns to the previous investors.
So the DMG debacle in Colombia is nothing new. The similarities with past events are obvious. Even in the present, Colombia does not stand alone, as we now face in the US what is arguable: the largest ‘pure’ Ponzi scheme caused by an individual. This is the case of Bernard Madoff, former chairman of Nasdaq stock market. Madoff himself seemed to have acknowledged (even bragged?) that his fraud was a Ponzi scheme (a big lie…), estimated at about US $50 billion!
That is the blatantly obvious part.
But at the same time, and much less obvious, and with little media coverage, is the issue of the link between the financial and mortgage markets disaster (that started months ago in the US), on the one side, and pyramid schemes, on the other.
Even if less obvious, some of the characteristics of the actions and schemes promoted by some of the main participants in the real estate, mortgage and financial markets contain Ponzi scheme elements. Figure what consumers were told (including on their prospective house value appreciation) and promised by mortgage lenders when the massive rush to acquire a house with zero (or less…) down-payments. Then figure the role of mortgage bankers in selling such mortgages in the secondary market, then the role of other financial intermediaries, and of the risk rating agencies, in selling ‘securitized’ (hmmm) paper, and how they were supposedly ‘guaranteed’ through insurance schemes. And how stock market agents attracted so many millions of small and large investors with expectations of abnormally large returns on equity that were to continue for ever. And so on.
Eventually the intertwined real estate and financial house of cards collapses, once credit-unworthy house dwellers start defaulting, while their collateral proves fictitrious since house prices did not appreciate. This starts to expose the the toxicity of all the rest of the intertwined schemes, including the obscure derivative products. The party could only have lasted until the very broad and extraordinary appreciation in housing prices ceased being so broad and so extraordinary…
This has to be studied in more depth, and concrete proposals need to be formulated to mitigate risks of a financial crisis recurrence. Ways of identifying, early on, subtle or not subtle Ponzi scheme elements need to be better identified, overseen, and deterred.
Of course, in the case of the financial crisis, pyramids were not of the ‘pure’ Ponzi scheme type, as opposed to the classic cases of Ponzi himself, Murcia (DMG), Madoff (ex-Nasdaq) or Mavrodi (MMM), which were.
But precisely because the real estate, mortgage and financial crisis in the US had some pyramid features which were more systemic, complex and subtle that the ‘pure’ and individualized Ponzi schemes, and because of the stratospheric costs caused by the financial crisis, it is imperative to acknowledge the ‘quasi-scam’ pyramid elements in this (however subtle), and study them, with a view to come up with concrete measures.
Again, as mentioned in the past, let us recognize that the current ‘macro’ financial crisis was not only caused by a technical regulatory ‘glitch’, or by mere ignorance and foolishness. There was a huge failure of governance, corruption and state capture, as well as lack of transparency and consumer deception in the mortgage and real estate and financial markets.
*** Para leer esta entrada en Español, haga click aquí.