An Exploration of Madoff’s $50 Billion Ponzi Scheme Will Unveil the Root Causes of this Global Monetary Crisis

December 16th, 2008

December, 16, 2008

For those of you that have been shocked by the fraud committed by former US NASDAQ Stock Exchange Chairman Bernard Madoff in running a Ponzi-scheme disguised as hedge fund that will create an estimated USD $50 billion of losses for investors, you shouldn’t be. Why? Because we all accept and enable a much bigger global Ponzi scheme that dwarfs the fraud committed by Mr. Madoff. For those of you unfamiliar with Ponzi schemes, a Ponzi scheme basically is any business proposition that fulfills returns to investors not through gains achieved by tangible, real investments but through the simple use of subsequent investors’ money. In other words if you invest USD $1,000 in a Ponzi scheme and are promised 15% returns after one year, the Ponzi scheme operator will merely take USD $150 of another investor’s money to provide you with your 15% returns after one year.

Though such a scheme is a scam, it can work en perpetuity as long as the majority of investors in the scam do not demand their money back at the same time. If they do, this is what will cause the scam to crumble. The Madoff hedge fund is a perfect example of how a Ponzi scheme can successfully operate for decades as long as no investors recognize the scam. Fellow hedge fund manager Harry Markopolos recognized the scam almost a decade ago. After Mr. Markopolos studied the remarkably steady returns of Madoff’s hedge fund and the stock-options strategy reportedly being utilized by Madoff to obtain his stated returns, Markopolos concluded that the results were impossible to achieve with the investment strategies Madoff claimed to be utilizing. In fact, Markopolos explicitly wrote about his concerns almost a decade ago in a letter he sent to the US regulatory body, the Securities Exchange Commission (SEC), in which he stated, “Madoff Securities is the world’s largest Ponzi Scheme.” One can not be more explicit than this accusation.

In fact, Markopolos’s suspicions of Madoff’s Ponzi scheme was not a one-off event, but he repeatedly informed both the New York and Boston bureaus of the SEC of Madoff’s fraud over a nine year period, according to a according to a Wall Street Journal investigation. Yet, the SEC did nothing to shut down Madoff’s Ponzi scheme. Why? Although, Markopolos spotted the Ponzi scheme, and other firms paid to vet hedge funds as honest also spotted the Ponzi scheme, investors in Madoff’s hedge fund did not. Thus, as long as the victims remained unaware, the fraud incredibly lasted more than nine years after it was first identified.

I can only speculate as to the reasons the SEC would look the other way when faced with overwhelming circumstantial evidence of fraud. Still, the SEC’s response to Markopolos’s accusations of fraud and inaction almost exactly mirror the US Commodities Futures Trading Commission’s (CFTC) sluggish response and inaction to heavy, compelling circumstantial evidence of possible fraud that is currently happening in the COMEX gold and silver futures markets (follow this link to read some of this compelling circumstantial evidence).

Besides the obvious reasons why regulators would acquiesce to powerful investment banks and commercial banks and enable them to operate in manners that oppose the interest of the public, what other reasons would regulators have to ignore compelling evidence of fraud? And this is the answer that we must unearth if we desire sustainable solutions to this current economic crisis. If we do not unearth this answer, I guarantee you that within another one or two decades after this current global economic crisis passes, the same crisis will happen again.

As the saying goes, once you tell one lie, one is forced to then cover up that lie with numerous other lies and the chain of lies never ends. The same applies to fraud. Nicola Horlick, the manager of Bramdean Alternatives in the UK, which may lose 9 percent of her funds invested in Madoff’s hedge funds, told the BBC, “This is the biggest financial scandal, probably, in the history of the markets.” This statement is untrue. In fact, Madoff’s fraud is an insignificant speck in the galaxy of financial fraud. The biggest fraud of all, one that absolutely dwarfs the $50 billion fraud committed by Madoff, is the fraud of our current fractional reserve monetary system.

What happened to Madoff’s hedge fund would happen to any large US commercial bank under similar circumstances, and I dare anyone to prove this otherwise. Madoff’s hedge fund’s fraudulent scheme was exposed after more than a decade when investors cumulatively asked for $7 billion of their money back. If investors had asked for such a large cumulative amount in redemptions in 2000, Madoff’s hedge fund would have likely collapsed eight years ago instead of today. According to a January, 2008 SEC filing, Madoff’s hedge fund had approximately $17 billion under management; thus $7 billion represented about 41% of the fund’s deposits.

Now consider if the same thing happened at a US Commercial Bank. If all depositors of any major US commercial bank asked for 41% of their deposits back within a several day span, would any of you have doubt that such an action would bankrupt that bank? Bank runs are always incorrectly described as a loss of confidence in a bank that results in a bankruptcy. The fact of the matter is that if the bank had your money and all the money of all other depositors in their vaults, a bank run could not happen. A bank run leads to a bank bankruptcy because of a simple fact. Just as was the case with Madoff’s hedge fund, they do not have your money.

Thus, if two basically equivalent actions would bankrupt two businesses, why do we consider the leader of one business despicable for his fraudulent activity while we simultaneously accept the actions of the leader of the other business as “legitimate”? And this is the fraud of our current monetary system and fractional reserve banking system that is the root cause of all global economic upheaval today. Sure I know that academics will respond to my criticism of the global monetary system with replies of “this is how banking has always been and besides, what else is one going to do, keep their money underneath the mattress?” But the fact is this is not how banking has always been. There have been historical periods of a sound currency and sound monetary systems with centuries of price stability both in the UK and the United States (but this is a much more complex topic for another day).

Today, most Americans believe that the Reserve Ratio Requirement (RRR) of US commercial banks is 10% because that is the “stated figure” given by the US Federal Reserve. Recently, I asked a few US bankers that have been in the industry for 10 years and Private Bankers that have been working at US banks for more than two decades what the RRR is for US commercial banks, and they all answered 10%. Ten percent is the textbook answer, but it is an Alice in Wonderland fantasy figure and does not reflect reality in the slightest. So yes, even the viral internet movie “Zeitgeist” was erroneous in their explanation of the fractional reserve banking system when they quoted the US reserve requirement for commercial banks at 10%. According to Robert H. Rasche, a senior vice president and director of the Research Division at the Federal Reserve Bank of St. Louis, “Under the legal reserve requirement ratios that were established in December 1990 and April 1992, and the home-brewed ratios allowed via the implementation of retail deposit sweep programs since 1994, reserve requirement regulations no longer are binding constraints on the portfolios of most depository institutions.”

In case you didn’t understand that statement, in plain English, Mr. Rasche of the US Federal Reserve stated that most US commercial banks no longer abide by any reserve ratio requirement at all. In fact, for many types of bank deposits in the US, the stated reserve requirement is amazingly zero percent! In 1991, the US Federal Reserve reduced the reserve requirement for all Eurodollars (all foreign currency deposited in US banks) to 0%. In December, 1990 and January, 1991, for all nonpersonal time deposits (term savings accounts owned by corporations, deposits representing the proceeds of a promissory note or banker’s acceptance, deposits owned by Edge Act Corporations and Agreement Corporations, and deposits owned by foreign banks), the Federal Reserve reduced the reserve requirements to 0%.

If you are a US bank customer, and you wondered why US banks have always shuttled anyone with significant savings into a Money Market Deposit Account (MMDA) for the past decade, you need look no further than the reserve requirement regulations. Though banks will never tell you why they want you to sign up for a sweep account, the reason is simple. The reserve requirements for MMDAs, as governed by the Federal Reserve’s Regulation D, is 0% as well. Thus if you have your money in a type of account that has any type of reserve requirement, it is the banks goal to sweep your money into accounts that have zero reserve requirements.

And if you think the situation is better in other developed and leading economies, you would be sorely mistaken. The Bank of Canada has also since abolished reserve requirements while the system of European Central Banks, in the early 2000’s, only established a pathetic 2% reserve requirement on almost all liabilities (Source: Research Division at the Federal Reserve Bank of St. Louis). Though the majority of people don’t understand this, multiple people possess the same claim on every dollar you deposit in a US bank, and all currency has counterparty risk in today’s global monetary system. In fact, if most people read a prospectus explaining exactly how a large commercial bank uses your investment (“deposit”) without knowing what kind of company the prospectus referred to, most people would refrain from investing in that company due to the risky nature of business operations. The modern day banking system only works today because people have a false confidence in it that is derived from a lack of understanding.

The two charts above, courtesy of the Board of Governors of the US Federal Reserve, visually illustrate the degradation of the safety of the US commercial banking sector. Since the reserve requirements for US Money Market Deposit Accounts was reduced to 0%, one can observe the banking industry’s push to shuttle their clients’ money into MMDAs. Concurrently, you can also notice the precipitous decline in US commercial banks that are now bound in their activity by reserve requirement regulations. As of 2000, according to the US Federal Reserve Board of Governor’s own statistics, more than 70% of all US commercial banks were not constrained in any way by reserve requirement ratios (this figure may even be higher today but I couldn’t find any more up-to-date statistics regarding this). Due to the complicit nature of US regulators that have allowed the majority of US commercial banks to virtually lend out every single dollar that they receive in deposits, and an institutional fractional reserve banking system that allows the creation of money out of thin air, any money deposited in the US commercial banking system is virtually guaranteed to be returned to you with less purchasing power. In other words, every dollar that you put into the US banking system, by the time you withdraw it, will be able to buy less than the dollar you gave them. And that is the biggest Ponzi scheme today.

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