Confidence and Madoff
by Michael S. Rozeff
by Michael S. Rozeff
I was once defrauded of $5. I'm glad. It was a very cheap lesson. It happened in the Soviet Union when my greed got the better of me. I thought I was buying roubles at a good rate on the black market. Instead, I was handed worthless Yugoslav notes that looked like roubles. My wife had told me not to buy them.
Thinking back, I had no reason to be confident in the trader who offered the notes to me at half the going rate. I wanted to buy some items from a booth nearby, and his offer was convenient and conveniently low. I was inexperienced. This was my first purchase. These are excuses. I was taken. He was well-dressed, glib, and persistent. I should have taken all that as a negative signal! Afterwards, he ran to a car. Few Russians had cars at the time.
People who lost to Bernard Madoff lost for many different reasons not hard to imagine. In one way or another, he gained their confidence. In an old video of Madoff, he smiles and steeples his fingers, which is a body language sign of confidence in oneself. It looks to me as if he enjoyed secretly playing his con(fidence) game and putting one over on people.
Confidence comes from two Latin words. The prefix "con" means with. The root "fid" suggests faith. Fides means faith. The mutual fund family "Fidelity" chose its name to suggest that the buyers may have confidence in the company. Fidelity is faithfulness to one's duties. High-fidelity is sound that is faithful to the original. Madoff broke faith with his customers.
Not everyone can be trusted. We especially cannot trust the federal government, which breaks its word continuously. Most of us, as individuals, cannot and do not control government. It has the power over us, so that we have virtually no incentive even to understand its words much less verify them. Hence, when government claims to regulate people like Madoff in order that we may deal with them in confidence and safety, we have no good reason to believe government. The fact that many of us believe what the government says means that government is successful at its confidence games.
People bought securities from Madoff. He misrepresented the risk and return of those claims by using cash inflows (new money) to create steady streams of cash outflows for earlier buyers (old money.) This is what a Ponzi scheme does. The verification process broke down or was overlooked by nearly everyone except Mr. Markopolos, whose persistence finally paid off.
Madoff issued bad credits and got away with it for a long time. Credit depends on confidence. Madoff won the confidence of investors. But credit does not depend on blind confidence. It is confidence born of concrete signs and signals. Investors with Madoff thought they had those signs and signals. They were deceived. Reagan is famous for saying "trust but verify." That is a wise and true saying, and in fact that is how we typically behave. When we stop verifying, we get into trouble.
There is no way to prevent more Madoffs from occurring because credit is inescapable in an exchange economy. The cost of preventing all frauds exceeds the benefits. The cost of the auditing and policing would be prohibitive.
We can make things better, however, by getting government out of the business of inspection, certification, and auditing. In that way, the cost of auditing and revealing frauds will drop dramatically. There will then be fewer frauds perpetrated. With government in the business of checking up on financial institutions, we are worse off.
In a free market, financial firms compete for investment dollars. They compete to provide transparency, that is, honest reporting of returns and risks. Fakes, phonies, and shysters are eliminated when they are found out. In a free market, the competing businesses have an incentive to police the competition and point out potential frauds. They may even hire detectives to check up on suspected shady enterprises. The amount of policing rises.
In a free market, there may arise private associations of firms that enforce strict inspections on the members to assure their reliability. They publish results and the members gain the confidence of the public. In that way, they get more business. Such associations already exist. But the state tends to pre-empt and weaken such possibilities. The state tends to replace private monitoring with its monitoring.
State inspection systems undermine the free market incentives to lower fraudulent behavior. It becomes in the interest of every financial firm merely to meet the minimum standard, not exceed it. The state's inspectors do not have strong incentives to search for and root out fraud. Else, why did the SEC take 8 years to come to grips with Madoff, after the warnings of Mr. Markopolos?
When the public comes to believe that a firm is acceptable because it has passed the government procedures, which members of the public do not verify as to their efficacy, then more frauds are possible. In a free market, the financial firms would actually compete to produce higher standards than their competitors, not minimum standards and the customers would have a higher incentive to monitor these firms. In the regulated market, firms and customers are lulled into passivity. Why? Any business effort to persuade people that it is clean and honest is penalized because the firm has to persuade the public that it is better than what they believe has been passed by the state as acceptable. If the people think that state monitoring is acceptable, then the business efforts to raise themselves above their rivals are less cost-effective.
The larger subject here is credit. There is always a chance that a credit risk will default. Such risks cannot be reduced to zero without incurring prohibitive costs.
Credit arises when one person accepts the issuance of a liability by another person. A liability is an obligation or claim on oneself that a person issues. It promises delivery of some good or asset in the future. Debt is a liability. A promise to pay is regarded by its recipient or the holder of the claim as an asset. That person has advanced credit. If Carl hands his car over to Bill, and Bill promises to make payments in the future to Carl, then Bill issues a liability and Carl holds that liability. Bill is the borrower and Carl is the lender. Bill's liability is Carl's asset.
But Carl cannot be sure that Bill will pay off the debt. No one can ever with complete certainty guarantee a cash flow (or a resource) will be available in the future. Even storing an asset or cash provides no certainty. All sorts of contingencies may intervene that prevent the promise from being fulfilled.
Madoff could not issue a security without the buyers expecting to gain something from their purchases. This follows directly from the action axiom of von Mises. A buyer expects to gain utility from a purchase. At the instant of purchase, utility should rise. This does not mean that the buyer is sure of the future payments. If he buys an uncertain stream of payments, he is sure that his valuation of them exceeds their cost. He could be mistaken. Madoff's buyers were mistaken.
What the buyer expects to gain is not specified in this statement. It is possible that a buyer gains utility from the act of purchase itself. For example, a buyer can gain utility from the act of purchase by feeling he is helping a worthy cause (buying war bonds) or from dealing with Madoff himself. Utility might come from receipt of the paper certificate itself.
When utility from these sources are not present, and usually they are not, then money return is the plausible source of utility or gain. It is the case in most instances, but the return can arrive in other forms, such as other securities, services, goods, coupons, tickets, etc.
A security buyer (who desires return) will not buy the security unless he knows something favorable about the ability and intent of the issuer to make the promised payments. In other words, the buyer who expects a return can only expect it if he expects that the seller will have the ability and intent to make the payments. And in the possible conditions of default, he has some expectations about enforcement and partial recovery.
The security buyer cannot form an expectation of gain without knowledge leading to belief and thus confidence that the gain will occur. In the case of debts, returns are impossible if the issuer has no current or future means to pay. Therefore, the buyer has to satisfy himself that this ability is present and will be maintained in the future or else he can form no expectation of gain. In the recent case of mortgage lenders who made non-fraudulent loans to non-fraudulent persons with sub-standard records of credit and income, the main assurance seemed to be the collateral (the house or dwelling) and the expectation that it would continue rising in price. In addition, other cases in which fraud was involved among buyers and sellers appeared.
The following are methods of learning to expect that a seller or issuer of a debt will make the promised payments. It is not intended to be an exhaustive list. It helps show that lenders do not build up confidence based on blind trust.
A buyer of a debt (a lender) may trust the seller (the borrower) to repay because he has a general knowledge of the seller's reputation and believes that the seller does not want to harm his reputation.
A lender might have personal knowledge of the borrower's behavior in the past. He may know that the borrower has repaid his debts in the past. A lender might gain information about the borrower's character, work habits, plans, capacities, etc.
A lender may expect a borrower to repay because the borrower has obtained the endorsement of a third party whom the lender trusts. The borrower may obtain a co-signer.
A borrower can transmit information about ability and intent to pay by depositing collateral with the lender. This provides knowledge of the ability and intent to repay since the collateral can be sold. If loss of the collateral is damaging to the borrower's business, then, even if the collateral is not sold, the potential harm to the borrower informs the lender that the borrower will try to honor the debt. The collateral may transmit the information that the borrower has in the past been able to accumulate a given level of resources. Collateral is a type of pre-paid conversion or redemption of the debt into cash.
A lender may directly investigate the income of the borrower or other characteristics associated with ability and intent to repay. A lender's knowledge of the borrower's ability to pay is aided by knowledge of a number of things. These include knowledge of the competing debts that the borrower has outstanding, because the security of one's claim depends on the timing and overall volume of all other claims. It helps to know about the business operations and income of the borrower, since these generate the cash flows to service the claims.
A borrower can transmit information so as to obtain funds by securing the security with assets. No collateral needs to be deposited, but the lender can have a call option on the assets in case of default. Otherwise the situation is similar to the case of collateral.
The ability to pay off debt can be measured by the borrower's wealth. When a firm that has a stock outstanding borrows, the market value of the equity measures the wealth that can be applied to paying off debt. Specifically, market value of equity per dollar of borrowing may be a useful number in assessing ability to repay debts.
The fact that a borrower has issued other debt claims transmits information, because some lenders are already endorsing the borrower's ability to pay the claims. The more important and highly regarded is the lender of the claim, the more impact that this may have on the perceptions of others. On the other hand, the prior issuance of debts is a double-edged sword, because the higher the issue volume, the more tenuous become the junior claims, other things equal.
Lenders attach strings to debtors, called debt covenants. Monthly payments are such a string. In the case of business firms, there are many, many covenants that limit the operations of the managers. The lender may preclude the issuance of further debts, or preclude new debts unless they are junior to his own debts.
The borrower can forcibly obtain revenues, as by taxing. This applies to governments. An effective taxing power supports the government's ability to borrow.
Lenders audit the borrowers periodically to make sure that their ability and intent to repay have not been impaired.
How did Madoff gain the confidence of his investors? Which of the above methods did he fake? What kinds of information did investors rely on? What kinds of information should they not have relied on? What kinds of information did he fail to provide? What were the signals that he was being dishonest?
We will find out more and more as time passes. For one thing, Madoff used some intermediary financial firms. They attracted funds from investors, and then they invested with Madoff. This is legal, but, in my view, it is a questionable way for anyone to invest. The reason is that it involves two layers of fees and two layers of agency. Each new fee is hard enough to overcome as compared with buying an index. But also each new agent presents a problem of controlling the behavior of that agent. The bank agent that invested with Madoff had a lower incentive to provide an appropriate level of care than the original investor, and Madoff had an even lower level.
Madoff chose an obscure auditor that he may have controlled. At a minimum, he controlled the paper flow to that auditor. There is no choice in investing but to evaluate the auditor, little as we are able to do so. The intermediaries who invested with Madoff were not properly suspicious.
Madoff used relationship investing, including country club, religious, and such ties. Word of mouth is often an excellent supplement to other means of assessment. It should not be the sole means.
Madoff's primary method of gaining confidence was that the returns on investing with him were thought to be above-average and very steady, given the risk. They were manipulated to look that way. He offered what seemed to be a free lunch. In this case, what is too good to be true is not true. Mortgage loans offered at no or low interest are also too good to be true. Free Medicare benefits for everyone at a cost that is less than the amounts paid in payroll tax are too good to be true. Twelve percent stock returns indefinitely are too good to be true when an economy is growing at six percent. The only remedy for these hopes and promises is to find out what kinds of returns have actually been delivered in the past and understanding how they have been delivered. High past stock performance arises when the price/earnings ratio is low at the start of the period and high at the end of the period. Medicare works as long as the pool of people paying in exceeds those drawing out, as in any Ponzi scheme. Low interest loans work until the interest resets higher or the property stops rising in price.
Madoff traded on his reputation earlier in life at NASDAQ. He betrayed his trust. The man is a scoundrel. There is little or no protection against such a person except the kinds of checking up that are mentioned above.
If you want to know how to invest, I suggest, as a beginning, reading The Battle for Investment Survival. In this book, Gerald Loeb recommends handling your own investments. He suggests dealing only in New York Stock Exchange listed securities and then only in an opportunistic way. That is, there will be many instances when one should be in cash or in some other asset class than stocks altogether. Leave exotic securities and methods to others. There is plenty of risk even in the best of liquid and listed securities.
There is a very great deal wrong with the way in which government has induced Americans, through laws and taxes, to invest through agents and pension plans whom they cannot control. The system discourages people from learning how to handle their own investments, and that is one level of protection against turning over large amounts of money to others, in the course of which one occasionally encounters the Madoffs of this world.
Our system of government automatically discourages us from handling our own governance. Despite the charades of voting and parties, our system precludes our handling our own governance. We are stuck with a great big Bernard Madoff called the U.S. government. He calls himself Uncle Sam and tries to establish a friendly relationship with us. Confidence in him is unwarranted. Beware.
December 23, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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