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Commentary: Schemes, scams and misplaced concrete

This article first appeared in the St. Louis Beacon, March 26, 2009 - As of this writing, former financial genius Bernard Madoff sits in the clink awaiting sentencing for defrauding investors of about $50 billion-$65 billon. His attorneys have appealed his incarceration, arguing that justice would be better served were he allowed to reside in his penthouse during this transitional period rather than in a facility designed for less accomplished criminals.

Thus far, the judiciary has been unsympathetic.

Note that no one is quite sure just how much cash Madoff made off with. This uncertainty about details seems to be part of a growing trend in this country to be alarmingly casual about calculations involving enormous sums. Add the TARP funds to the Stimulus Package and we've just spent about $1.5 trillion we don't have, give or take $100 billion or so.

The budget deficit -- the money we borrow annually just to pay the bills -- has presently crested at around $1.2 trillion while the Fed recently announced that it intends to introduce an extra trillion dollars into circulation. That's $1,000,000,000,000. To paraphrase the late Everett Dirksen, pretty soon we'll be talking real money ...

Con-men like Madoff exploit the intellect's tendency to play fast and loose with abstractions. To understand how they operate, it's useful to distinguish between pyramid and Ponzi schemes. Both are illegal, but they function differently.

The pyramid fraud involves a geometric growth model for a fake business. Each level of the pyramid is paid by the level beneath it, which in turn must recruit a new generation of members so that it can be paid. The problem here is two-fold: The "business" has no income other than initiation fees paid by new members, and the growth model is mathematically unsustainable.

A pyramid that begins with six "investors" needs to recruit 36 members for its second level. Those 36 then have to solicit 216 people to form level #3, and so on. By the time you get to level 13, the pyramid would require twice the population of the Earth to sustain itself. Needless to say, when the pyramid collapses the few at the top walk away with most of the cash while the many at the bottom get cleaned out.

By contrast, the Ponzi scheme -- the type that Madoff operated -- requires new members to pay money directly to an individual ("Mr. Ponzi") to invest in the lucrative enterprise he's supposedly operating. Ponzi then disperses a portion of the new investments to other members in the form of "investment income" or "earned interest" and pockets the rest.

Like the pyramid, the only income generated by Ponzi's "business" is the money invested by new members. Obviously, when investors seek to liquidate their fictional assets, there's no money in the scheme to pay them and the whole thing collapses like the house of cards it always was.

Interestingly, both scams generate real money so long as the enterprise is growing. It's only when the expansion stops that problems begin. To that extent, they are similar to the situation at AIG: an investment firm that operated neither a Ponzi nor a pyramid scheme, but whose reckless business practices should have been just as illegal.

The American International Group consists of an Insurance Division and a Financial Services Division. The insurance component was federally regulated and it remains well-capitalized. The financial services section, however, took advantage of market deregulation to speculate in exotic financial instruments. This gamble drove the firm to the brink of a collapse that threatened to take down the world banking system.

AIG got into the business of selling "credit default swaps." These were essentially insurance policies for investments. If an individual purchased a security collateralized by packaged sub-prime mortgages, for instance, he could buy a swap from AIG obligating the firm to purchase the security back from him at an agreed upon price, usually set below the original purchase price. This reduced the investor's exposure by limiting the amount of money he could lose on the deal.

So long as the security was trading at levels above the swap price, the money generated by selling swaps was pure profit because nobody cashed them in. When the sub-prime market went south, however, investors sought to redeem their swaps only to discover that the unregulated firm didn't have the money to honor its obligations.

Cutting through all the esoteric economic jargon, AIG was selling empty promises printed on pretty paper. Instead of sending everybody involved to prison, Treasury (the same outfit that's borrowing money to pay its bills) rushed in with $185 billion it didn't have to bail the firm out and thus stabilize the global financial markets. The government now holds an 80 percent stake in the corporation.

Because of federal generosity, AIG was recently able to pay its executives $165 million in retention bonuses. Though a mere drop in the TARP bucket, that's the money our elected representatives are scrambling to retrieve by trying to find a constitutionally permissible way to pass a retroactive tax that only applies to certain people.

Question: If the government owns 80 percent of the firm, why doesn't it just fire everyone involved and install its own management team?

All of this madness serves an object lesson about the dangers of an intellectual error that philosopher A.N. Whitehead termed the "fallacy of misplaced concreteness" -- the tendency to mistake abstraction for concrete reality. When you've secured your retirement by investing in options on derivative futures, you might as well go prospecting for pixie dust.

Speaking of scams and misplaced concrete, has anybody seen Ballpark Village? 

M.W. Guzy is a retired St. Louis cop who currently works for the city Sheriff's Department. His column appears weekly in the Beacon. 

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