Those were the days... Scams define end of an era

The sub-prime fiasco was a pyramid scheme of its own, argues Thomas Friedman
Ronald Reagan is dead and Margaret Thatcher is a remote and, through advanced illness, a figure far removed from the world stage.
The revolution they jointly led in the ’80s of ever-advancing markets based on light regulation, easy credit, distrust of the state and unleashing of the “animal spirits” of capitalist accumulation have been discredited as the world faces the worst economic crisis since the Great Depression.
Perhaps it is no coincidence that the cardiac arrest suffered by world markets, including our own, since the collapse of Lehman Brothers on Wall Street last September has brought to light a series of mega-sized Ponzi schemes in the US and, more recently, in South Africa. The lure of easy, outsize pickings and staggeringly high rates of return explains the existence of pyramid schemes, such as those operated by Bernard Madoff, Allen Stanford and our own alleged Ponzi king, Barry Tannenbaum, now conveniently resident in Australia.
Ponzi schemes — named after the eponymous Italian immigrant to the US in the early 20th century who arbitraged the value of postage stamps — essentially pay back early investors with either the proceeds acquired from later investors or even with their own money. The scheme collapses and the fraud is finally revealed when people stop investing and there is no more loot to pay out the creditors. As author Michael Lewis explains, “something for nothing — it never loses its charm”.
Madoff, who apparently embezzled a staggering 50-billion from the rich and even banks and top charitable institutions, kept his operation going for over 30 years by offering consistently above-market rates of return, but not by such a wide margin as to attract either undue suspicion or to be unsustainable — until the unprecedented credit crunch last year caused a mass of withdrawals, which Madoff could not meet, since he had never invested most of the deposits originally received.
Tannenbaum, in contrast, is alleged to have lured hundreds of South African and overseas investors with the promise of a rate of return of between 90% and 200% per annum. Instead of postage stamps, his investors were invited to help buy active pharmaceutical ingredients (APIs), allegedly on behalf of South African drug-makers, and then shared in the proceeds of the profits when the APIs were sold to the drug companies.
The neatness of the scheme is that it fell outside the watch of the Financial Services Board. But when one creditor sought to recoup his investment, plus interest, well, the bird had flown the coop — and the personal cheques which Tannenbaum had issued were dishonoured.
These schemes usually involve high-level fraud, including cooking the books, and financial techniques to make actual losses look like bumper profits, or simply invent non-existent investments or sales. But the detail is less significant than the result. Not only are investors — the greedy, the gullible and innocent third parties — ruined, but the system itself gets discredited.
Last December, when the Madoff scandal broke, I was living temporarily in Washington DC. Two of the city’s most thoughtful commentators saw a much wider implication for the future of free enterprise.
Anne Applebaum described how difficult it was for her to acquire an apartment in Warsaw in the early ’90s — endless form-filling, visits to notaries and the seller requiring to be paid in hard currency and in cash. She described a culture of “low trust”, in which the market and its mechanisms are treated with suspicion.
In contrast, when she bought a car in Washington, she could drive it out of the showroom simply by providing a personal cheque, without any identification. It was this “high trust” culture, which both fuelled American capitalism and allowed its dark underside, in the form of Madoff and the like, to operate. As she put it, “Madoff’s pyramid scheme may have been made possible by our tradition of trust and lawfulness. And now he will bring that tradition down.”
Thomas Friedman was more damning. He saw in Madoff a scheme only slightly more outrageous than the “legal” one Wall Street was running, fuelled by easy credit, low standards and high greed. For him, the sub-prime fiasco was a pyramid scheme of its own: “What do you call giving a worker who makes 14000 a year, a nothing-down and nothing-to-pay-for-two-years mortgage to buy a 750000 home and then bundling that mortgage with hundreds of others into bonds that Moody’s or Standard & Poor’s rate AAA — and then selling them to banks and pension funds the world over. This is what the financial industry was doing. If that isn’t a pyramid scheme, what is?”
Friedman’s fury found an answer last week, when President Barack Obama produced plans for regulatory reform, including an expanded role for government. Clearly, the era of Reagan-Thatcher has ended. The age of exuberance has yielded to an era of control. Let’s just hope that the new medicine doesn’t amount to a treatment that kills the patient.


*Published Sunday Times 28 June 2009

The Looming Recession

Last weekend, exiting President George W Bush, hosted the leaders of the G20 nations at a summit here to discuss a coordinated response to the global economic crisis.

While the world leaders, including our own, rushed into the Capitol, we drove out of it in search of America’s equivalent of the Rosetta Stone to help illustrate the meaning of this sprawling economic mess.

Washington DC is not the place to find it. It is virtually recession-proof, given the high numbers around here who work for Government or are involved in lobbying it. I witnessed this a few weekends ago when we had dinner at the uber-expensive Palm steakhouse (where the rudeness of the waiters is matched only by the number of Washingtonians who clamour for a table here). The bill for a meal for four, without dessert, amounted to around R4000. Fortunately my visiting, and wealthier brother picked up the tab.

But Greenwich, Connecticut seemed to be a better place to take the weakening pulse of the wealth creators (and laterally destroyers) of the American and world financial markets. One of the wealthiest enclaves in the United States, it headquarters the major hedge fund companies and financial service corporations, and is home to some of America’s richest people.

Last Saturday, we approached this gleaming citadel of American capitalism via the neighbouring town of Stamford. My friend, Laurence Kaplan, pointed out two of the imposing and shiny structures which house UBS’s American trading operations – which boasts the largest trading floor in the world - and the Royal Bank of Scotland. Both stand today as monuments to the subprime crisis which has caused them to write down, and write off, tens of billions of dollars of dodgy mortgages and credit default swaps. RBS has landed up as a state-owned asset of Gordon Brown, and UBS’s fate is even worse: last week a US Federal Grand Jury indicted its head of global wealth management on a slew of charges relating to tax evasion and other breaches of American regulatory law.

Our walk along the main street of Greenwich was even more instructive of what Paul Krugman, winner of this year’s Nobel Prize for Economics, recently termed “the long feared capitulation of American consumers”. Indeed, on this crisp autumnal morning, there were hardly any shoppers around. In the chic boutiques and splendid luxury store fronts of this immaculately maintained town (where appropriately, perhaps, the “Stepford Wives” was filmed here four years ago). We were the only visitors at a tony luggage store. The shop assistant advised us, that the dearth of customers was “soul-destroying”. Greenwich might be the high-end of the American retail. But the desertion of its shops and stores is now reflected across the board. Real consumer spending is plummeting and fell at an annual rate of 3.1% in the third quarter while spending on durable goods (cars and TVs, etc.) fell at an annual rate of 14%. As Krugman points out this is a real change in consumer behaviour which could not have come at a worse time. Because while excess household debt got a lot of Americans into their current problems, and trimming debt and boosting savings is always a virtue, a freeze on spending by consumers right now will slide America, and much of the world, into a recession. (The so-called “paradox of thrift”).

Laurence Summers, the once and possibly future US Treasury Secretary, tartly summed up the central cause of the financial markets’ crisis as a case of “too much greed, not enough fear”. But the fear which now keeps shoppers out of the stores presents its own set of headaches. It is further driven by the new fear of banks and lending institutions proving as unwilling as ever – despite the $700 billion rescue package – to lend to consumers and to each other. General Motors, now titters on bankruptcy just two months after celebrating its 100 birthday, it says it may not survive to see another year unless it is rescued by a Federal bailout. Starbucks, the corner-store icon of globalisation, posted a net income drop of 97%.

The current desertion of main street Greenwich is also explained by looming job losses in the financial industry as banks attempt to slash costs, to cushion the blow of further market turbulence anticipated for 2009. The Financial Times reported last week that up to 70 000 jobs could be lost in US banks and financial institutions over the next few months. Across all sectors of the American labour market some 1.2 million jobs have already been lost in 2008 and 3.8 million homes are under foreclosure. Clearly, a fiscal stimulus of some sort is required. But will it work in unfreezing the credit markets? In any event, the new administration is hedged in by the thicket of the national debt, which currently stands at around $10 trillion, and rising.

All this bad news has led to a schadenefreude by the pundits all-round. The most prescient of the lot is Michael Lewis who lifted the veil on the excesses of Wall Street in “Liars’ Poker” way back in 1985. He retuned to splendid form in a recent article posted on Tina Brown’s marvellous new blog “The Daily Beast”. In it he profiles Steve Eisman, a hedge fund manager who was among the first to detect the weakness of the subprime mortgage market, and who made a fortune from shorting it and everyone with a hand in it: first, the lenders; then the rating agencies; finally, the big banks. As he explains, the subprime market was actually too small to feed investors greed and so they created a market of side bets. This is where derivatives and other esoteric, and ultimately toxic, assets created a market which at its height was worth trillions of dollars worldwide.

Lewis also quotes the analyst who apparently first saw the basic lack of real value underlying these assets. Meredith Whitney of Oppenheimers, back in last October, was the first to blow the whistle on this financial house of cards. As she put it “if you want to know what those Wall Street firms are really worth, take a hard look at the crappy assets they bought with huge sums of borrowed money, and imagine what they’d fetch in a fire sale.” Lewis’s own interpretation is priceless: “this woman wasn’t saying Wall Street bankers were corrupt (if mere scandal could have destroyed big Wall Street investment banks, they would have vanished long time ago), this woman was saying, they were stupid.” And this was much more seditious and calamitous.

The marvel of the American economy is that 60% of its citizens own shares today, literally from Warren Buffet to the legendary Joe Six-Pack. But it is now demonstrating the defects of this quality: like its wealth the misery is now spread about, but by no means equally.


*Written for the Weekender, to be published 21 Nov.