Ponzi Nation

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Wall Street trader Bernard Madoff allegedly defrauds the rich and famous out of tens of billions of dollars. Minnesota businessman Tom Petters allegedly fleeces hedge funds out of $3.5 billion. And socialite New York lawyer Marc Dreier may have duped some hedge funds into giving him hundreds of millions of dollars for an apparently bogus real estate scheme.

All of these scams are big and all appear to be some kind of Ponzi scheme, designed to take in money from new investors to pay-off earlier investors. A Ponzi scheme is one of the oldest financial frauds around. And many are referring to the Madoff caper as the biggest Wall Street fraud ever.

But derivatives consultant Janet Tavakoli may be onto something. In a note to her clients, she says the biggest Ponzi scheme of all may be the one that brought the world financial markets to its knees. And that’s the scheme that united Wall Street bankers with mortgage lenders in a bid to funnel more and more money into the market for supbrime homes loans. She says the packaging of iffy home loans into securitized bonds that could be sold to insitutional investors—many of them relying on borrowed money—was a system born to fail.

“The largest Ponzi scheme in the history of the capital markets is the relationship between failed mortgage lenders and investment banks that securitized the risky overpriced loans and sold these packages to other investors—a Ponzi scheme by every definition applied to Madoff,” says Tavakoli. “These and other related deeds led to the largest global credit meltdown in the history of the world.”

About a year ago, BusinessWeek made a similar point in an article about the two Bear Stearns hedge funds that collapsed in June 2007 and helped spark the credit crisis. The story focused on a novel type of collateralized debt obligation that the managers of the Bear funds used to tap funding from money-market funds. The CDOs which were widely copied on Wall Street helped fuel the market for these esoteric securities, along with the underlying housing boom.

In that article, BusinessWeek likened the new market that the Bear funds helped inspire a pyramid scheme. Or, as Tavakoli says, a Ponzi scheme.

One of the hallmarks of a Ponzi scheme is an investment vehicle that generates consistent, steady returns. That’s what discourages investors from pulling too much money out of the fund—the event that ulimately causes a Ponzi scheme to collapse. One reason so many wealthy people showered money on Madoff is that his fund generated predictable returns—rain or shine.

The Bear funds similiarly generated steady and stable returns before the bottom fell out of the subprime mortgage market. In the final months before the Bear funds collapses, Ralph Cioffi and Matthew Tannin scrambled to find new investor money and other sources of funding. This past summer, federal prosecutors charged Cioffi and Tannin with deceiving investors about the health of the funds and actively discouraging investors from pulling their money out.

Cioffi and Tannin were the first Wall Street executives charged in the financial meltdown. Now you can add Madoff’s name to that list and more are sure to follow. One thing the credit crunch is unearthing are lots of long running scams. Just as money has dried up for legitimate businesses, there’s no money to keep the Ponzi machine going.

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