History of Greed

Financial Fraud from Tulip Mania to Bernie Madoff

David E. Y. Sarna, David E. Y. Sarna

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470601808
• eBook ISBN: 9780470877708
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

The "greater fool" theory of economics states that it's possible to make money by buying paper (securities), whether overvalued or not, and later, selling it at a profit because there will always be an even greater fool willing to pay the higher price. Many described in this book profited by peddling such worthless junk to foolish investors. But for some people—Bernie Madoff, Norman Hsu, Sholam Weiss, and "Crazie Eddie" Antar, aka the "Darth Vader of Capitalism"—overvalued securities were not enough. Outright fraud was their way of life. History of Greed is the compelling inside story of the names you know—Charles Ponzi, Baron Rothschild, Lou Pearlman—and the names you don't—Isaac Le Maire, the world's first "naked" short-seller. It's also our story—why we ignore the lessons of the past and fall prey, most every time, to the promise of easy money.

For thousands of years, alchemists unsuccessfully tried to turn worthless base metals into gold. Where science failed at turning nothing into something, business succeeded. Sometimes we praise the creators of derivatives, collateral debt obligations, subprime mortgages, credit default swaps, or auction rate securities as Wall Street's new financial wizards, the creators of "magic paper." Other times, we vilify and prosecute them as scam artists. Sometimes, it's hard to tell who is who. History of Greed reveals the inside secrets of how the markets really work, and how scam artists abuse them to gain an unfair edge or to outright steal. It describes how luftgescheft ("air business"), wizardry, dishonesty, and fraud are used to swindle people. Along with a comprehensive bibliography, History of Greed also details:

• 400 years of financial fraud—from everyday fraud to the odd and unusual
• Accounting fraud (phantom sales), stock option fraud (backdating), auction rate securities, hedge fund fraud, Ponzi schemes, promotion fraud (pump-and-dump scams), and money laundering
• How to detect fraudulent schemes
• How government regulation only fixes yesterday's problems

If it's too good to be true, it probably is. If they say you can't lose, you probably will. History of Greed shows that there really is no such thing as a free lunch, while also detailing how not to become the "greater fool."

Chapter 1

Selling Air

WHY NOW?

 

 

 

 

 

 

Unless you have been living in a cave and have been completely cut off from outside society, you know that in the space of a few months, at least $11,000,000,000,000 ($11 trillion) was lost from the U.S. economy in 2008, and that the world was turned upside down and plunged into a deep recession, if not depression.¹

What happened?

Fraud and greed had a lot to do with it.

In general, pundits, seeking simple answers, blamed it all on subprime mortgages, or on credit default swaps, or on auction-rate securities, or whatever, but these answers are unsatisfying. They are at once both too complex and far too simplistic. For the real explanation of what happened, however, we need to look to the experts, to history, to literature, and even to my Grandma Rachel.

My Grandma Rachel

Grandma Rachel Leah Horowitz, born on Christmas Day in 1893 at the end of the nineteenth century, was a very wise lady who lived to the age of 92. Her husband, Reb Alte Elisha Horowitz, a merchant who was also a noted Talmudic scholar, had died young of esophageal cancer in London, where they then lived, when she was only 39. He left her with nine children and a run-down liquor store in London’s East End. Overcoming many obstacles, she raised these nine children well, and built up the store into a very successful enterprise where she bought and sold wine, whiskey, liquors, and schnapps. She liked the business, she said, because the bottles were real. You could hold them, smell them, drink from them, and enjoy them.

There were other businesses in London that didn’t make anything or sell anything but just traded paper, which turned into more paper. “This is not a real business!” she used to say. “It is luftgescheft,” which in German and in Yiddish means “air business” or “ethereal business.” Someone who engaged in luftgescheften she called a luftmensch (an air person or schemer), and she would have nothing to do with such luftmenschen. My beloved Grandma Rachel Leah lived through the Great Depression, and survived her home being bombed by the Nazis during the Blitz.

Little did she know back then how amazingly prophetic her words would prove to be for the twenty-first century. What happened in the United States of America was essentially the result of all the luftgescheften run by financial wizard luftmenschen who turned money into paper and then supposedly back into even more money, siphoning off outrageous profits in the process. When the music stopped, the entire house of cards suddenly collapsed, and all that was left, of course, was luft (air) and worthless paper.

Tevye the Dairyman

In her dislike of luftgescheften, my grandmother, who was steeped in Yiddish literature, was (at least subconsciously) influenced by the Yiddish literary giant Sholem Aleichem (the literary pen name of Sholem Rabinovitsh, 1859-1916). He, unforgettably, wrote about luftmenschen in his novel Tevye der Milkhiker (Tevye the Dairyman).² First published in 1894, Tevye der Milkhiker is known throughout the world partly because of its adaptation into a play by Arnold Perl called Tevye and His Daughters, which became the famous Broadway musical and film Fiddler on the Roof.

Menachem-Mendl, a distant relative of Tevye, the (impoverished) dairyman, is a luftmensch sans pareil. He begins talking to Tevye, who made a little bit of money helping out a wealthy lady, about stocks and options in a way that Tevye, a simple man, can’t possibly understand. Then he gets to his point. Menachem-Mendl promises Tevye that he can turn 100 rubles into 1,000, and Tevye would be a fool to forfeit the opportunity. Tevye agrees to give Menachem-Mendl his last hundred rubles in order to enter into a shutfus, or partnership, with him—“I put in the money, and Menachem-Mendl put in the brains”—with the two of them splitting the profits (and thereby neatly sidestepping the age-old Jewish prohibition against lending with interest).

You know what happens. It was all lost. Sholem Aleichem also describes in detail Menachem-Mendl’s ultimate failure at various other ethereal (luft) moneymaking schemes—such as his attempt at selling “Londons,” an apparent reference to a currency speculation, which Menachem-Mendl describes to his wife as “a very refined substance” in that “you can’t see it” (classic luft).

So, as it says in Kohelet, “There is nothing new under the sun.” Luftmenschen have been around for ages, if not for millennia.³

Luftgescheften Then and Now

One of the early documented examples of luftgescheften, which presages many other episodes, was recounted by Joseph de la Vega, a Portuguese-Jewish trader who emigrated to Amsterdam to avoid persecution from the Spanish Inquisition. He famously wrote in 1688: “This year too was a year of confusion for many unlucky speculators declared in one voice that the present crisis was a labyrinth of labyrinths, the terror of terrors, the confusion of confusions.”⁴ He could just as well have been speaking about the state of the national and global economy in 2008.

Trillions of value were erased from the nation’s housing stock in 2008 as foreclosures flooded the market, an oversupply of homes built on speculation remained unsold, and real estate prices everywhere plummeted. Martin Feldstein, the noted economist, estimated that overall $11 trillion to $12 trillion of value disappeared.

The value of global financial assets, including stocks, bonds, and currencies, probably fell by more than $50 trillion in 2008, equivalent to a year of world gross domestic product (GDP), according to an Asian Development Bank (ADB) report written by Claudio Loser, a former International Monetary Fund (IMF) director.⁵ “This crisis is the first truly universal one in the history of humanity,” former IMF Managing Director Michel Camdessus said at an ADB forum in Manila.⁶ “No country escapes from it. It has not yet bottomed out.”

Stephen Schwarzman, CEO of the private equity company Blackstone Group, said to an audience at the Japan Society, “Between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half.” He added, “This is absolutely unprecedented in our lifetime.”

Savvy investor George Soros said in mid-February 2009 that the world financial system has effectively disintegrated, and that there is as yet no prospect of a near-term resolution to the crisis. Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union. He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system. ⁷

“We witnessed the collapse of the financial system,” Soros said at a Columbia University dinner.⁸ “It was placed on life support, and it’s still on life support. There’s no sign that we are anywhere near a bottom.”

Who knows what other unthinkable turbulence is yet to come?

As we can see, the economy collapsed from greed-driven luft in the form of frauds, derivatives, strips, collateral debt obligations, credit default swaps, auction-rate securities, and all manner of exotic financial instruments that dominated the financial markets beginning in the 1980s in a feeding frenzy that reached its apex during the two terms of the hands-off administration of George W. Bush, the 43rd president of the United States. What happened was yet another chapter in the sad but recurrent story of greed gone wild. Greedy financial promoters, investment bankers, and their cohorts and all-too-willing accomplices were all allowed to run unchecked by a complacent government.

In April 2010, the Securities and Exchange Commission (SEC) charged Goldman Sachs and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product (ABACUS) tied to subprime mortgages. The SEC alleged that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). The SEC alleged that Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact the hedge fund had taken a short position against the CDO.

“Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market,” the SEC said in its press release.⁹

“The product was new and complex but the deception and conflicts are old and simple,” said Robert Khuzami, Director of the Division of Enforcement. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.” The SEC alleged “that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio. Investors in the liabilities of ABACUS are alleged to have lost more than $1 billion.”

Society apparently forgot the famous words of Hank Rearden, the hero in Atlas Shrugged, the great novel by Ayn Rand (1957), “I work for nothing but my own profit—which I make by selling a product they need to men who are willing and able to buy it.”¹⁰ Instead of making and selling products people need, we in the United States mostly imported other people’s products and we sold luft. Now, we all must pay the price.

Selling luft honestly is bad enough. Selling it dishonestly just makes things worse. As the anonymous blogger who calls himself 1boringoldman wrote, “Piracy made lots of money. Slave trading made plenty of money. The robber barons made money. The problem is that it’s somebody else’s money—taken, not made.”¹¹

The Bezzle Is Shrinking

As the Financial Times remembered, the famous economist John Kenneth Galbraith once proposed a measure of the economic cycle called the “bezzle.” It is a measure of the inventory that has been purloined from investors.¹² In fat years, the bezzle grows as auditors relax. In the lean years, it shrinks as investors become cautious. The allegations against Bernard Madoff, and now Sir Allen Stanford, suggest the bezzle is large—but shrinking.¹³

This is the story of how luft, wizardry, dishonesty, and fraud were used to take other people’s money, ignoring the lessons of history. My Grandma Rachel would have seen it all coming; may her soul rest in peace.

Chapter 2

Crash Postmortem

HOW GREED, HUBRIS, AND LACK OF SUPERVISION DID INVESTORS IN

In Chapter 1, I blamed greed, hubris, and lack of supervision for the crash of 2008. In this chapter, we’ll try to put the events in historical perspective.

The year 2008 is destined to go down in history as a disastrous year for the world’s economy, and a near miss for plunging the world into deep depression. It disrupted the lives of many millions of people, and caused enormous pain and suffering to many.

In this chapter, we look at the major factors that that gave rise to this sad state of affairs, and tackle the obvious questions: Why was the disaster not foreseen? Why was nothing done to prevent it?

Is It Something That Started in the 1980s?

T...

Table of contents

• Praise
• Title Page
• Copyright Page
• Dedication
• Foreword
• Acknowledgments
• Introduction
• Chapter 1 - Selling Air
• Chapter 2 - Crash Postmortem
• Chapter 3 - Why We Do It
• Chapter 4 - Securities Fraud
• Chapter 5 - The Perils of Greed
• Chapter 6 - The Elements of Financial Fraud
• Chapter 7 - “Other People’s Money”
• Chapter 8 - Smaller-Company Fraud
• Chapter 9 - Selling Long and Short
• Chapter 10 - Market Manipulation
• Chapter 11 - PIPEs
• Chapter 12 - Promotion Fraud
• Chapter 13 - Leaks, Front-Running, and Insider Trading
• Chapter 14 - Fictitious Volume
• Chapter 15 - Parachute into Prison
• Chapter 16 - Affinity Group Fraud
• Chapter 17 - Twentieth-Century Ponzi Schemes
• Chapter 18 - Hit Charade
• Chapter 19 - Hedge Fund Ponzi Fraud
• Chapter 20 - Madoff and the World’s Largest Ponzi Scheme
• Chapter 21 - How Madoff Got Away with It
• Chapter 22 - Madoff Plea and Its Aftermath
• Chapter 23 - Mopping up after Madoff
• Chapter 24 - Other Recent Ponzi Schemes
• Chapter 25 - Stanford Group
• Chapter 26 - Ultimate Chutzpah
• Chapter 27 - Detecting Fraudulent Financial Schemes
• Chapter 28 - Fraudulent Offerings
• Chapter 29 - Auction-Rate Securities
• Chapter 30 - $132 Million Tax-Free Exchange Fraud
• Chapter 31 - Not Smart
• Chapter 32 - Boiler Rooms
• Chapter 33 - Accounting Frauds
• Chapter 34 - Stock Option Frauds
• Chapter 35 - Odd and Unusual Financial Frauds
• Afterword
• Notes
• About the Author
• Further Reading
• Index