THE BIZOP NEWS

For several years, I have written about the compliance techniques that fraud criminals use when working their "magic" on various investment schemes. My own view is that we can learn much about the ordinary functioning of markets by seeing how fraud is enabled. I appear to somewhat alone in this view - most commentators see fraud as an abnormal activity - I see it as the natural product of bounded rationality in a big hurry.

For example, in this this sub-prime mortgage credit crunch, I saw various techniques used by Charles Ponzi that were not noticed by various commentators. It would be useful to review these tricks.

The relationship between fraud and negligent credit expansion has a long and colorful history in the United States.

Stephen Mihm wrote a lovely piece in the New York Times entitled "Counterfeit Nation", in which he wrote:

"The recent rumbles and ruptures in the financial markets are finally making people reassess the dubious systems of credit that have arisen in the past few years. In retrospect, it seems clear that honest, tried-and-true ways of borrowing money were recklessly abandoned and replaced by financial legerdemain: black-box transactions, synthetic collateralized debt obligations, mezzanine tranches and credit-default swaps — to cite just a few of the exotically named financial instruments now facing scrutiny. America’s once-solid economy became a house of cards, a web of debt masquerading as wealth, a system crying out for correction. As one Wall Street banker quoted by The Financial Times concluded, the recent credit crunch suggests that things are finally “returning to a more ‘normal’ level after ‘abnormally’ loose conditions over the past few years.”

But what if the last few years of playing fast and loose with credit were not a deviation from the norm but a return to America’s economic roots? Though it is hardly the sort of thing you read about in heroic histories of America’s rise to economic greatness, the credit system in the United States has often been, in effect, a confidence game writ large, relying heavily on shaky paper promises, shell games and other trickery. The standard account would have you believe that the road to individual and national wealth was paved by hard-working, honest entrepreneurs who steered clear of get-rich-quick schemes, counterfeiters’ printing presses and suckers’ swindles. But for better and for worse, such shady institutions lie at the heart of the country’s moneymaking past and, if recent events are any indication, its present."

So what are some of the tried and true Ponzi techniques?

First, you must establish that your enterprise is beyond reproach. A solid name like Securities Exchange or Sentinel is a good start.

But how do you convince the "investors" of the success of your fledgling enterprise? You have to show them the money, which you don't have. Ponzi started by making up promissory notes, in the range of $100 to $10,000 from his Securities Exchange to his investors. He happened to accidently drop them at a crowded bar. Naturally, it looked as if he was engaged in serious high finance.

The brilliant trick here was how he reacted to the crowd. One young person asked what the notes represented, Ponzi sloughed off the question, saying that "no doubt, one of his elders could explain the mechanics of the postal exchange" to him, but he had no time.

Now, there was nothing to explain - the postal exchange program was a fraud. But Ponzi had already cleverly set up a naive group as conferring authority on his scheme. No doubt it could be explained by someone in this "wise group".

Today, we have hedge funds for the sophisticated investor - investors apparently both in need of purchasing very clever trading skills, but without any corresponding need to have high quality information which would confirm the trader's reputation. Lawrence Melton has a number of excellent articles about the contractions behind the very concept of "the sophisticated investor".

There is no better way to a mark's heart than to shower the mark with praise about his sophistication, intelligence and general worldliness. Now we have institutions that will do that for us. Excellent progress.

Next, not only does the Ponzi schemer have to target people who think that they know more than they do, the sophisticated investor, it helps to have some natural monopoly or charm you can exploit. Ponzi was a classic - he urged the local Italian community to rise above its usual economic depression and become rich with him.

While there are crass appeals like this, we have done better by institutionalizing the fraud with credit rankings. As explained by Professor Frank Partnoy,

"On one hand, rating agencies have great market influence and even greater market capitalization. On the other hand, numerous studies suggest credit ratings are of limited informational value. This paradox - continuing prosperity of credit rating agencies in the face of declining informational value of ratings - has generated extensive debate among commentators."

"that regulatory dependence on credit ratings explains the paradox. Numerous legal rules and regulations depend substantively on credit ratings, and particularly on the credit ratings of a small number of Nationally Recognized Statistical Ratings Organizations (NRSROs). Moreover, the barriers to entering the NRSRO market are prohibitive. The result is that credit ratings issued by NRSROs are valuable to financial market participants even if their informational content is no greater than that of public information already reflected in the market."

So if Moody's says that some bank's brand new wonderful Structured Investment Vehicle is AAA rated because the defaults on the bonds are not correlated or independent, do we think that their historical data is to be relied upon? What does it matter, since it is AAA branded, many institutions can now legally purchase, what might turn out to be crap?

Isn't Rick Bookstaber correct when he argues the historical correlation should not be relied upon?

"Rating agencies do not consider this new dynamic, so the ratings underestimate risk. If a set of A-rated bonds are put in a portfolio, the principle of diversification leads that portfolio to be less risky than the individual bonds. And the lower the correlation between the bonds, the lower the risk. Historically, bonds are not very correlated when it comes to default, so a rating agency that relies on historical data might come to the conclusion that the portfolio of bonds has low enough risk to merit an AAA rating. But if there is a credit derivative-based crisis, those bonds will become more correlated for no reason other than that they are bound into the same derivative instruments."

Finally, you need to have a plan for the inevitable bank run - bail or run?. When Ponzi was being audited by the State Bank Inspector, and in the middle of a bank run on the Securities Exchange, he conceived of an audacious scheme. He knew he was short some $7 million -utterly insolvent. However, he was a major shareholder at one of the local banks, Hanover Trust. He planned a simple repo with the Hanover: he would take $7 million in cash, show it to the auditor, obtain a clean bill of health, and then replace the money the next day.

Today, we have a far more sophisticated scheme, but at essence the same. As explained byStephen Cecchetti, when faced with a bank run, the Federal Bank of the United States injects liquidity into the markets in the following manner.

"In all of these cases, the funds were put into the banking system using what are called “repurchase agreements” or “repos” for short. Here’s a dictionary-style description: A repurchase agreement is a short-term collateralised loan in which a security is exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date at an agreed-upon price, as soon as the next day. For example, a bank that has a U.S. Treasury bill might need cash, while a pension fund might have cash that it doesn’t need overnight. Through a repurchase agreement, the bank would give the T-bill to the pension fund in exchange for cash, agreeing to buy it back at the original price – repurchase it – with interest the next day. In short, the bank gets an overnight loan and the pension fund gets some extra interest."

The mechanics should not obscure the basic fact that if some of the participants in this scheme are frauds, then we have the classic Ponzi move of stealing shareholder money to use as collateral for an insolvent fraud. Greg Newton pointed out that this Ponzi move was exactly what Sentinel is accused of by the SEC.

"Sentinel placed at least $460 million of clients’ securities...in Sentinel’s house account...and, significantly, was available to be pledged as collateral. When SEC examiners asked Sentinel representatives which securities in the ‘house’ account were owned by clients...Sentinel representatives responded that it could not identify who owned those securities."

For this bit of Ponzi schemeing, Greg Newton awarded Sentinel Management the Wizard Prang,

"

So, congratulations then, Phil and Eric Bloom, and their material contribution to last week’s global credit market crisis which, on Friday, caused the Federal Reserve Board to not only crack the discount window at the New York Fed, but also invite, even solicit, applications.

For what, it transpires, was not the potentially systemic financial meltdown. But rather a good old-fashioned Ponzi scheme, built on nothing more complicated than the use of client assets as collateral for your own, as yet uncertain, ends."

Stephen Mihm will have the last word, and buy his book when it comes out in September, 2007

"With the proliferation of no-doc mortgages, interest-only loans and a dizzying array of new financial instruments, there is ample proof that America remains in the broadest sense what Hezekiah Niles once described as “a nation of counterfeiters.” Genuine counterfeiters no longer lurk in every corner of the financial system, but a new crop of miscreants has fueled the boom: fraudulent real-estate appraisers, for example, and companies offering “credit repair” services that erase bad credit by “borrowing” someone else’s more reputable history of paying his bills on time. Some of these practices are illegal; others are within the bounds of the law. The murky business of devising collateralized mortgage obligations, whereby subprime mortgages can be born again as new, lower-risk securities, is legal. Whether it is a good idea is another thing altogether.

Perhaps the current wave of debt machinations will end badly. Then again, in the long run, it may not. Consider the impressions of another novelist, the British writer Frederick Marryat, who visited the United States in the wake of the panic of 1837. As he surveyed the wreckage of broken banks and worthless paper, he came to a surprising conclusion. “If all the profits of the years of healthy credit were added up,” he wrote, “and the balance sheet struck between that and the loss at the explosion, the advantage gained by the credit system would still be found to be great. The advancement of America depends wholly upon it. It is by credit alone that she has made such rapid strides, and it is by credit alone that she can continue to flourish.”