Bernard Madoff: a Financial Terrorist?
This week we learned that former Nasdaq chairman Madoff likely swindled investors out of $50 billion – arguably the largest financial fraud ever. And thinking about the gravity of the scam, it occurred to me that Madoff’s scam could be compared in terms of its effects to terrorism. Here’s how:
Consider that there was a time when terrorism wasn’t the big deal that it is now. This was before advances in technology, when terrorists only had recourse to low-level weaponry like stones and knives – which, while harmful on an individual level, are not quite weapons of mass destruction. In time, though, “better” technology came along, leading in turn to “better” terrorist tactics: suicide bombing and the like. Still peanuts, though, compared to what came later: 9/11 planes, bio terror – this is when things really got serious; now even one crazy person can cause a world of damage.
Now, I think Madoff’s case is equivalent in a financial sense. Whereas in the past one person’s monetary misdeeds could affect a handful of people at most, now there’s more at stake: a single person – like Madoff – can cause a whole lot of fiscal damage. And the reason lies in interconnections: when companies began investing with other companies, any fraud can spread and cause damage across many companies.
There’s one other similarity here. What makes terrorism so powerful are its randomness and intentionality: it can strike any time, and you never know when you’ll be a victim and it is done on purpose. Things that we can’t predict, control or at least think we can control make us more afraid. And that’s exactly the case with Madof’s scheme: the investers probably assumed that they were in control and all of a sudeen we all learned that we are much less in control, and that someone can do this to any of us.
If we view the stock market through this terrorism perspective, and we understand that just a few individuals can cause so much damage, it becomes clear that more regulation is needed – we do so much to check people at airports — shouldn’t we use the same level of security for hedge funds?
The Honest Truth About Dishonesty: How We Lie to Everyone - Especially Ourselves
But in the stock market, it is always the case that the bigger the gain, the bigger the potential risk. It’s just that every manager competes for the biggest gains, to gain the most clients. TIAA/CREF, the professors’ retirement fund, chooses much safer investments, albeit with lower returns. One could, for instance, only buy tax-exempt munis backed by the state as well as the local county, or inflation-indexed treasury bonds. Foreign exposure always means unquantifiable risks—just ask those investors who bought Ecuadorean bonds.
I think “The Black Swan” is perfectly germane to the Madoff debacle
Although terrorism is random, as children we all learned to conquer the fear of the random attack. When I was a schoolchild, we all practiced “duck and cover”. Once a week we had to, at a signal from the teacher, duck under our school desk. This was to protect us from a Russian H-bomb attached to a rocket aimed at New York City. Fairly soon, we all realized that we were alive in the AM when we awoke, because the Russians hadn’t launched the previous night. We never took the threat seriously, because it was totally out of our control, so worrying was totally non-productive.
Why aren’t the Japanese as afraid of A-bombs as we are of a repeat of 9/11? After all, they were bombed twice, not once, and now there are many more A-bombs available to many more nations, including China.
Irrationality strikes again.
P.S. For “Russia”, of course I mean “Stalin”, a certifiable paranoid world leader.
Isn’t one of the lessons we should learn from terrorism is that we have a tendency to overreact to rare-but-spectacular events? We’ve spent well over a trillion dollars and at least 4,000 American lives reacting to the 9/11 attacks; more than the attacks themselves cost.
I bet it would be pretty easy to come up with financial regulations that had hidden costs of more than the $50 billion that Madoff swindled.
So, you ask: “Shouldn’t we have as much security for hedge funds as for airports?” And it seems to me the rational answer is No. First, nobody dies if a hedge fund goes belly-up. And second, we spend too much money on irrational airport security (see Bruce Schneier’s blog for details).
people do die when a hedge fund goes belly up. people whose fate depends of the continued existence of those funds. people who rely on the trusts that went belly up. people who lose their jobs and their homes due to financial turmoil. people who can’t afford proper health care as a result of losing their retirement.
this is one of the completely irrational things that we do as a society: we take someone whose crime was getting caught three times with crack and we put them in jail for life. and we take someone who caused vast financial turmoil leading to death and degradation of life quality for literally hundreds of thousands of people, and we put them in a country club for a few years and then let them back out into the financial world to wreak havoc all over again.
we simple have no sense of scale when we look at crimes, and if there is blood involved we throw the book at ‘em, and if it’s financial we say “it’s only money”. well, follow the money and you will see devastation far beyond what one violent person acting on their own could even begin to equal.
It is NOT clear more regulation is needed in the financial markets. Financial regulation created the corrupt rating agencies, it created the incompetent Federal Reserve. Regulation has almost always come with privilege for the status quo. Regulation has helped create a herd mentality among financial institutions and investors and diminished respect for proper due diligence. If you really want to see the seeds of our financial ruin, look at fractional reserve banking (which could only be created by government “regulators”).
This is a very interesting discussion. However, I respectfully disagree with the analogy between regulating the financial markets and airport security. Yes, airport security is an irrational overblown response, which has negatively affected all of our lives without a corresponding benefit. The more relevant analogy is with Federal Aviation Regulations (and the international system that applies to airlines throughout the world). This complex system and has been a key factor in globalization and a better standard of life. In the early years of aviation, the general public was frightened by air travel and airplanes were mainly used for mail delivery. Following passage of the Air Commerce Act in 1926 (which created the Federal Aviation Agency) air travel has become progressively safer (despite occasional terrorist attacks on airplanes) due to regulation of all aspects of aviation and travel by ordinary citizens is now commonplace. Regulation of financial market was instituted with the creation of the Securities and Exchange Commission in 1934. It is not an exaggeration to say that there has been little innovation in market regulation since 1940 (with the exception of the Sarbanes-Oxley Act of 2002 which addresses corporate reporting and accounting and not markets). This is despite the internationalization of financial markets and the introduction of a myriad of new financial instruments. Virtually none of the new financial innovations of recent years are regulated, on the mistaken belief that financial markets are self-regulating and that financial actors will behave ethically and in the interests of the common good. This includes instruments, such as derivatives, that Warren Buffet has called financial weapons of mass destruction. Remarkably, there is no uniform international system of regulation. Clearly, we need our national system of regulations to encompass the new products and an international system, like that administered by the International Civil Aviation Organization, to regulate the global financial system.
I completely agree with Kevin Moore. Regulation creates more problems than it solves.
It’s important for investors to be wary of someone guaranteeing them 10-15% returns. Those who blindly trusted him and invested with this notion in mind shouldn’t be surprised. They and others will learn from this and the market will force hedge funds, etc. to become more transparent and responsive if they want our money. No matter what your business is, it comes down to trust. If you don’t trust Wall St. don’t invest. They will get their act together if they want the privilege of our trust and our money- if the market is allowed to do it’s thing.
BK is right. It’s always a matter of trust (and guarantees)and due diligence. I imagine that Morgan, Rothschild, Lazard etc. were very careful as to whom they lent or invested money, so I doubt any of them had a crash or lost 90% of their investment.
Dan:
I got your book from the library, and could not put it down. Lent the library book to a friend, and then ordered two books from Amazon: one to gift and one to re-read and lend to others. Great job. Can’t wait to follow more of your observations on your site.
I think your analogy is strained. In particular, successful large-scale fraud is an inside job. The swindler is indistinguishable from colleagues of genuine probity — just the sort of person who is likely to get tapped for an important post. Head of NASDAQ, say, or governor of Illinois. Regulation is a farce when the crooks are in charge.
The predictably irrational behavior of trusting crooks would be an interesting area of study.
Also, the predictably irrational behavior of assuming that passing new regulations will improve the situation, when we know that our enforcement efforts are hampered by crooks at every level. For example, we all know that a significant number of congressmen are crooks, but we expect workable anti-crook legislation from them anyway.
I would suggest that all of you read “The Black Swan”, which discusses how mega-events of low probability can and do affect our lives.
How long did it take the authorities to realize that Billy Sol Estes had no vegetable oil in his storage tanks, or that (was it Prudential?) listed millions of dollars worth of phantom life insurance policies?
Madoff is but one example of large scale financial irrationalities. What about the bonus compensation system that drives executives and bankers to ignore potentially (now actual) catastrophic risk of financial engineering so that they can reach bonus hurdle rates? Had anyone of substance in the value chain of derivatives, stood back and appropriately measured the risk of exponential growth of that market and then had the courage to stand might theresults have been different and the current chaos been avoided?
The $50B figure emerged early in the news on this matter – and soon the myth will turn to legend and become fact. Nobody knows what the losses are and it will take months of forensic accounting to uncover the losses and maybe years of litigation to reconcile the accounts. So – let’s call it an alleged $50B theft/ponzi scheme/embezzlement, etc.
With respect to UCD Neuroscientist, there is no uniform international system of regulation because of the myriad of different cultures, languages, existing competition law, a differing philosophies of economics and law. Indeed, one can apply game theory to international regulation if one wants to but it would be to establish the lowest common demoniator of regulation.
The newest forms of financial products will not be purchased again by market participants. Does this not suggest that to some extent the market is self-regulating?
The Madoff issue shows that assumptions about individuals character carry for a lot in business and trust can be easiy misplaced.
But Dan, isn’t the phenomenon of the “stock market” generally about irrationality? Just think of the various Wall Street summaries: “X took a dive because of under-par earnings.” Or even more irrational, when something bad happens to people and the stock responds positively: “Y company axed 1,000 workers, making the stock go up N points.”
Your book is all about trying to find ways to quantify known examples. I wish that you would opening ponder more of those that you can (yet) quantify but that are still examples of irrational behavior — For example, why is gambling one of the number one industries in the US, even though the odds are obvious you won’t win? Same with lotteries – a NY state lottery ticket actually tells you the odds are something like 17,000,000 to 1, and yet millions of people play the lottery – why?
Perhaps there is something attractive in irrationality? In the long run, people generally do wind up with more from the stock market – but it has to be done with a long range view and with knowledge.
So if you don’t yet want to deal with irrationality, perhaps you can deal with risk. I know age has something to do with it (if one drafted 26 year olds, one can be sure there would be more people unwilling to go to war).
Why do people invest in something which they know entails a certain (and sometimes great) amount of risk?
I think the size of Madoff’s crime needs to be put in to context. The U.S. stock markets are down about $8 trillion over the last year. House values are down $3-4 trillion. Over the last 10 years or so there have been billions in fees charged (all perfectly legal) by investment advisors, mortgage brokers, appraisers and so on. Effectively much of this was theft. And in my view the potential damage is much great when the effective theft is perpetrated by people who don’t even realize what they are doing is wrong. And perhaps aren’t even capable of realizing that this is so. Our irrational natures and poor educational systems are a big part of the problem. Books like Mr. Ariely’s will hopefully help in correcting the problem.
I believe that any punishment Madoff receives should be levied on the perpetrators of our current market speculation crisis, as well. The architects of the mortgage buildup and the once thriving investment firms have all been proven guilty of fiscal corruption. In actuality, the entire scheme of speculation is a crime against humanity.
When will the American people treat corporations as people (which, legally, they are)? When will we finally agree that a corporation can be punished? If the investment banks can apply for a bailout, I see no reason why Bernie Madoff & co. cannot.
Meanwhile, their collective fall has finally driven the government to want to pursue social services and infrastructure development. Maybe we should be anointing these thieves as saints instead.
It reflects the ideological prism through which one views these events to suggest that Madoff falls in the same category as other participants in the financial markets. So discussing Madoff as somehow emblematic of what is necessary is quite silly unless you think grasping at that straw somehow advances an argument to which you were already adhered.
Madoff was allegedly engaged in fraud — essentially the implicit inverse of the caution that “previous returns don’t guarantee future results” — purportedly concealing the fallacy of this reputation by pyramid tactics, rather than actually investing the moneys with which he was entrusted.
The idea that Madoff is evidence that more regulation is needed is the most laughable of suggestions — albeit appropriate since it is predictably irrational.
His is just the kind of operation that the government has no business offering a stamp of approval.
His investors were wealthy institutions and individuals who should have known better and were responsible for their own due diligence.
But the concept applies equally to hedge funds that actually invest at higher risks for higher returns.
Instead of treating the entire economy as some kind of put option written by the government we should accept that regulation will be just as predictably irrational as it’s absence and work on limiting it to the narrowest possible contexts.
I’m not a believer in deposit insurance but these existing government institutions and explicit interventions serve as more rational guideposts. If they want to tell insured institutions they can’t invest in certain ways, fine. But that is highly preferable to implicitly or explicitly insuring more institutions.
The high irony of the current circumstance is that it is equally fear of government risk as market risk that is keeping money on the sidelines. When Frank and company are talking about essentially abrogating loan contracts at their whim, is it any wonder that the private market isn’t lending any money?
It reflects the ideological prism through which one views these events to suggest that Madoff falls in the same category as other participants in the financial markets. So discussing Madoff as somehow emblematic of what is necessary is quite silly unless you think grasping at that straw somehow advances an argument to which you were already adhered.
Madoff was allegedly engaged in fraud — essentially the implicit inverse of the caution that “previous returns don’t guarantee future results” — purportedly concealing the fallacy of this reputation by pyramid tactics, rather than actually investing the moneys with which he was entrusted.
The idea that Madoff is evidence that more regulation is needed is the most laughable of suggestions — albeit appropriate since it is predictably irrational.
His is just the kind of operation that the government has no business offering a stamp of approval.
His investors were wealthy institutions and individuals who should have known better and were responsible for their own due diligence.
But the concept applies equally to hedge funds that actually invest at higher risks for higher returns.
Instead of treating the entire economy as some kind of put option written by the government we should accept that regulation will be just as predictably irrational as it’s absence and work on limiting it to the narrowest possible contexts.
I’m not a believer in deposit insurance but these existing government institutions and explicit interventions serve as more rational guideposts. If they want to tell insured institutions they can’t invest in certain ways, fine. But that is highly preferable to implicitly or explicitly insuring more institutions.
The high irony of the current circumstance is that it is equally fear of government risk as market risk that is keeping money on the sidelines. When Frank and company are talking about essentially abrogating loan contracts at their whim, is it any wonder that the private market isn’t lending any money?
I would suggest that all of you read “The Black Swan”, which discusses how mega-events of low probability can and do affect our lives.
Yes, more regulation is needed but to protect consumer confidence. Hedge fund clients are defined as “sophisticated investors” so the argument that regulation was not needed. But it is needed mostly to combat greed and cheating with very little liklihood of being cahght (in Madoff’s case due to his stature among the investment community). Greed motivates the clients to invest without doing due diligence. Consumer confidence suffers, as well as those who invested, when fraud is uncovered. Why? Because some investors are pension funds which typically are funded by the “little guy” with no power over how or where the funds are invested. But crush the confidence of the little guy consumers that were what was keeping the economy going, and you create a recession. Compound this with value destruction suffered by high risk, highly leveraged (a.k.a. extremely greedy) investment banks and hedge funds and you end up with a depression. I don’t think “terrorist” is the right noun in this financial instance.
We need to return to a more regulated environment. The comments above that regulation causes more problems than it cures forget the massive deregulation we have undertaken over the past thirty years. And we have the results in front of us to show what deregulation achieves.
But more than regulation we need enforcement. Madoff’s alleged crimes went undetected because the agency that should have caught him was understaffed both in terms of numbers and talent, and was controlled by people who ideologically are opposed to enforcement. They believe that markets are best left untouched by government. Somehow, in their view, the market system will reveal Madoff’s better than properly trained auditors will.
Further: the notion that regulation created the ‘corrupt’ rating agencies is just nonsense. They are corrupt because the market created incentives for them to look the other way that were never balanced by strong regulation to ensure their objectivity.
The whole financial system has become infested with ‘free market’ groupthink that cannot tolerate the notion that there is a role for objectivity and independence. As a result the public trust is gone.
Frankly no one who makes a living in the financial market[s] has credibility left. Their shallow pursuit of excessive market returns has driven all of us to the brink of an awful collapse. The failure of their thinking is exposed as self-evident by the shambles on their balance sheets and income statements. They should shed their hubris and get on with learning how to lend and borrow safely.
Untrammeled capitalism has been shown to be a disaster. As we pick up the pieces we need to remember that all extremes are to be avoided. Extreme deregulation and extreme regulation are both equally foolish. The World Bank just estimated that the current disaster, rooted as it is in the various ponzi schemes foisted on us by the banks and Wall Street generally [and not just Madoff] has cost $20 trillion so far. That’s an expensive way to learn deregulation is not so good after all.
There were quite a few red flags around Madoff’s firm. One of the biggest was that he custodied his own assets. Those who did due diligence and enforced high standards didn’t invest with him. Here’s one article that talks about the red flags http://online.wsj.com/article/SB123188437723478727.html.
Doesn’t really look like new regulations are needed, rather better enforcement (and care by investors.) The existing regulations probably would have been sufficient to control Madoff, but they weren’t enforced. http://online.wsj.com/article/SB123118320006554629.html
If people find something they believe in (e.g., Madoff’s honesty and high returns), they will always find a way to get around regulations they think are just getting in their way.
‘free market’ groupthink that cannot tolerate the notion that there is a role for objectivity and independence.
I would suggest that all of you read “The Black Swan”, which discusses how mega-events of low probability can and do affect our lives.
hm. hope to see same more info
Talent, you will tell nothing..
many thanks for the article, I love it
I do not think he will use the money against humanity, I think it is rather for his own pocket
50 billion dollars, real money! Oh man, I’d like one tenth of it))
I think that’s theft from the given sum will count as terrorism. Who makes his own country and its people by 50 billion and it still can not sleep well is somehow a terrorist.