A puzzling phenomenon.

[agoodwinsmith]

I just read the Stephen Greenspan article about Madoff's Ponzi scheme of having more investors than the schemer has funds to cover if the investors all want their money back at the same time:
http://www.skeptic.com/eskeptic/08-12-23.html#feature
And I wonder - why should the investors have been any more cautious about this scheme than they are about banks?  Don't banks operate on the same process?  That's why they had to be bailed out, right?  So, if an investment scheme runs along the lines of banking, why should the investors be any more cautious of this than a bank - is it because the bank has a chance of being bailed, while the lone-schemer does not?  How on earth is one supposed to be savvy before the fact when the whole financial edifice is a house of cards supported by faith and gullible investment?

The thing is - in every one of the examples sited in the article, people at first made money, and only the laggards got caught holding the empty bag.  Self-castigation and self-congratulation seem beside the point once a scheme turns into a scam.

Comments

[randombler.livejournal.com]

No, banks are not the same as Ponzi schemes. In principle, banks have matching nearly matching sums that they owe (to depositors and other banks they have borrowed from) and that they are owed (to other people to whom they have made loans). They also have a sum of their own money, their capital, which they need to keep to lubricate thew whole thing. If all their debits and credits were paid off at the same time, they would all cancel out and the bank would be sitting there with just its capital and all would be well. By using its capital to secure a much larger, but balancing heap of debits and credits the bank makes money by charging higher interest on the money owed to it than on the money it owes.

A pure Ponzi scheme never has any credits. It just takes the money from the first investors, and almost immediately gives some of it back as apparent profits. Then it takes the rest of the first investors money and pays it as second-round profits to the first investors and to the scond investors. Then the second investors money goes to the third round profits and so on...

I would guess that Madoff never set out to run a Ponzi scheme - his intentions were honest. But what might have happened was that one month, things might have turned out a bit bad, and he should have showed a loss. But his pride was his month-on-month steady returns, and this would have spoiled his clean sheet. So, hypothetically, he paid a bit of profit out of incoming, expecting to be able to pay it back the next month (as they do). And, depending how his funds were organised, this might not have been illegal - but the auditors should have flagged it up in big black letters. And once you have started down a slippery slope, it is very difficult to stop...

The bank problems are different. There are two ways a bank fails - and mixtures of the two. The first is a loss of confidence. Banks borrow short (deposits repayable on demand or at short notice) and lend long (loans and overdrafts with lifetimes of years). If all their depositors want their money back at once, the bank is in trouble. But easily fixable trouble: a bigger bank, or the central bank if none is available, and either buys the troubled bank or lends it the necessary ready money at a punitive rate, wiping out the banks capital but giving depositors their money back.

The second is when the bank loses money. The first money to get lost is the capital, the shareholders funds. As long as it doesn't lose more than the capital, then depositors are OK. If it has lost more then (barring government guarantees)

However, by law the banks must keep a certain ratio of capital to liabilites (loans to others). If it loses money, its capital shrinks, so it must un-lend money, so far as that is possible. At which point it goes to its lending customers and cuts their overdraft limits, or calls in loans, so far as it can. This buggers the customers, who whinge like hell, revealing that the bank is in trouble. This frightens the depositors, and the inter-bank loan market, causing a lack of confidence, which causes the first failure.

The seed of the current problems is that, firstly, very many the banks had stretched their lending to the limit of their capital. Secondly, creative accounting had actually stretched that capital further than, by hindsight, was sensible (too long to explain how, but Basle 2 comes into it). Thirdly, somebody /and it is not certain who/ has lost a huge bucket or money in the sub-prime mortgage fiasco. It is not so much the amount of money lost, it is the uncertainty about how much it is and who has lost it. *Any* bank might be the next to go down - or be pulled down by the next to go down, or be pulled down by that one and so on...

So Madoff has, if reports are correct, simply finally reached the end of the road because of the current crisis. The banks are different.

[agoodwinsmith.livejournal.com]

I can see the detail - but I don't see the difference between Madoff's innocent slip into naughtiness and the banks'. Both start out as above board - and the reason we (the potential investors) know this is because of their reputations. Madoff with years of nonbesmirched savviness and the banks with supposed legal restrictions. It still allows either to ooze into naughty territory for a temporary fix - which if the fates contrive against them becomes not temporary and more easily discovered. How is an investor to know that someone's pride/fear will overcome their principles? Oh gosh - could it be because these are human constructions with human drivers? Both rely on faith to get started and keep rolling and both can be crushed by lack of faith.

Financial history is littered bum-deep in faith-driven bubbles like Enron and dot.com. And the early adopters who know it is all a smoke and mirrors game get in and get out with their gains - and this lends credibility to the investment because some people have made money. Sub-prime has the same stupidity earmarks as dot.com and tulipmania - and there is something, even now, brewing to take its place. Sub-prime is a bank naughty - and early investors made money.

Legal-schmegal - usually laws exist because people are very strongly tempted by the behaviour outlawed. That banks have strong laws restricting them is a caution-light, I think.