Ponzi schemes and other scams are all too common. Be on your guard, and stay away from deals that are too good to be true

We have not heard the last of this (Madoff) tragedy, but the lesson — beware tales of the fabulous — needs to be told, even shouted.

The investing world is mesmerized by the story of Bernard Madoff, the New York financial whiz who, as his name suggests, made off with what is reported to be US$50 billion of other people’s money. He kept fake books, refused to tell people how he generated exceptional profits, would only take clients who asked few questions, threw out other clients who asked too many questions, and kept up the cash flow by paying existing investors with money coming in from new investors.

That is the classic Ponzi scheme, a scam made famous in the 1920s by Mr. Charles Ponzi. He told his investors they could get a 50 per cent return on their money in 45 days through his knack for buying U. S. postal coupons for a price less than that at which they would be redeemed. That was the model, but he just recirculated money from new to old investors and did some time in jail for his trouble.

What the Madoff debacle, which has reportedly wrecked university trust funds, charities, and the trust funds of the rich and famous, had in common with the original Ponzi scheme and later scams run by junk bond impresario Michael Milken, Bre-X Minerals Corp., and a famous swindle involving non-existent salad oil in the early 1960s, was that people were eager to believe that fabulous wealth could be theirs. Keeping faith, which is the antithesis of the skepticism a wise investor has to bring to the task of money management, allowed the swindles to flourish.

The faithful did not do their research. Worse, the frauds were not well audited. Yet many were so simple in retrospect that sophisticated analysts did not suspect them. Some simple pencil work would have unraveled each.

In the Madoff case, a portfolio advisory firm called Aksia based in New York, checked out the story on behalf of a client. Aksia drilled into Madoff’s partial explanation that he was making a bundle trading options on the S&P 500 Composite Index and concluded that the entire market for these puts and calls, even if it had been monopolized by Madoff, could not account for his gains. Aksia got a gold star for telling clients to stay away.

But others went for Madoff’s ruse, attracted by his celebrity. He had been chairman of the NASDAQ exchange, kept a yacht in New York, had mansions here and there, and traveled with the best and the brightest. To be in his circle was to share his charm.

The rich and the famous liked to be in Madoff’s circle. Hollywood mogul Steven Spielberg, actor Kevin Bacon and at least one French aristocrat were his clients. Even Henry Kaufman, one of the most connected guys on Wall Street and a famous bear known as “Dr. Doom” for his pessimism in the 1980s, was sucked into the Madoff schemes. Now that the truth is out, there has been at least one suicide, there are reports that Palm Beach jewelry stores are being inundated with brooches destined for the estate sale market by Madoff clients who now have neither the income flow he paid nor the cash he held. We have not heard the last of this tragedy, but the lesson — beware tales of the fabulous — needs to be told, even shouted.

THE BRE-X SCAM

Bre-X Minerals was a Calgarybased junior mining corporation that bought into drilling rights in Borneo. The official story is that a geologist on its payroll, Michael de Guzman, figured that he could make the site pay handsomely by adding some gold dust to drill cores ground up for analysis. The cores, suitably salted, turned out to promise fabulous riches. The price of Bre-X stock rose from pennies to $280 per share. Then the story began to unravel. A potential sale of the mine to American copper and gold giant Freeport McMoRan led to independent analysis of the site, which turned out to be virtually barren of gold.

Even as the story was unraveling, some investors continued to buy the story, reasoning that something so big just could not be a fraud. Among the losers were the Ontario Municipal Employees Retirement Board, which lost $45 million, and a few analysts who insisted to the bitter end that there was gold in them thar hills. Geologist de Guzman supposedly jumped out of a military helicopter over the Borneo jungle. His body was found days later badly decomposed and eaten by local fauna. A report in 2006 said that one of his wives had received money from him. The financial community figures that anybody smart enough to work the biggest gold swindle in history could fake his own death.

Bre-X turned out to be the King Solomon’s mine of the 1990s. It was supposedly the biggest gold mine in the world and everybody wanted to believe it was true. But close reading of analysts’ reports would have revealed that Bre-X never let outsiders do their own tests on cores. Bre-X cores were ground and salted with gold and then presented to analysts. The skeptical did not get the press that the believers got.

MILKEN’S BOND SCAM

Junk bond king Michael Milken promoted the idea that low bond ratings should be no barrier to investment. If a bond portfolio had a default rate of eight per cent and the bonds in it paid 20 per cent more than treasury bonds, you could take a hit and still win. Trouble was that the eight per cent was the rate at which defaults occurred each year. But a junk bond’s odds of default over its lifetime until promised redemption was in a range of 20 per cent to 50 per cent or more. That wiped out the gains. Milken pleaded guilty to a variety of securities violations in 1990. A know-it-all attitude and a lot of bad karma got him a record fine of $200 million. He paid another $400 million to investors he hurt and served 22 months before being sprung by ace appeals lawyer Alan Dershowitz.

In the wake of the scandal, Milken’s employer, Wall St. banking giant Drexel Burnham Lambert, went out of business. Investors wised up to the fact that junk bonds tend to have volatile and, in the end, inadequate returns to compensate for risk. The field of subinvestment grade bond selection is best left to experts in the field who buy this kind of financial crud when it is cheap — as it is now (but don’t rush out yet for it is due to get even cheaper) — and sell when business is booming and interest is being paid. Statistical analysis of junk bond returns would have shown the boom-bust nature of this market and discouraged long-term investment in it.

WHEN VEGETABLE OIL GOES RANCID

The last of these big swindles is really the simplest. In the mid-1950s, Anthony de Angelis, a commodities trader in New Jersey, formed Allied Crude Vegetable Oil Refining Corp. The company acted to fulfill the plan of the U. S. Food for Peace Program, which aimed to provide basic foods to poor people in Europe still suffering from the effects of World War II.

De Angelis, who had already a record for selling substandard meat, bought a run down tank farm in Bayonne, New Jersey and began buying salad oil. He borrowed money from 51 banks that included Bank of America, and from major stock brokers of the day including Ira Haupt & Co., and from big commodities traders such as Bunge Ltd. De Angelis paid interest, using fresh loans to service the old ones. Shrewd analysts found that he was claiming to have more salad oil that was thought to exist in the United States.

When De Angelis was asked to show auditors around, he would send them up to the top of his tanks and let them dip their probes into the oil. And oil there was, being pumped through a maze of underground pipes to the top of each tank as the inspectors headed to it. What the auditors did not know was that they were finding only the “cream” in each tank, for below the oil was — wait for it — water. De Angelis had used the basic physics that fat molecules are lighter than water molecules to take several hundred million dollars from the smartest guys on Wall Street. My mother, a client of one of the brokerages that lost huge sums in the money of the day, went away a little poorer.

News of the big swindle broke just after President John F. Kennedy was assassinated. As a result, De Angelis did not get the press coverage he and his crime deserved. American Express, one of De Angelis’s lenders, suffered a major drop in its stock price. The legendary investor, Warren Buffett, picked up five per cent of Amex for US$20 million, and De Angelis, after doing time in jail, went out and started another fraud involving cattle sales.

The lesson: if a trader claims to be doing more business than is known to exist in a market — recall Madoff on this point — then go put your money somewhere else.

We’ll end this sermon with an observation: If you see that an asset is popular, that bigshots are in it, that it is having a terrific run and that the sky seems the limit, these should be signs to stay away or at least to be very skeptical. The old story that the great financier Bernard Baruch told, that when his shoe shine boy urged him to buy into stocks in the summer of 1920, it was time to leave the market, is possibly apocryphal, but true enough.

The time to buy is when a thing is cheap. When it is having a run that exceeds statistical probability or the known long-term returns of its asset class, then stay away. Or go to Vegas where, in exchange for the probability that you will leave town poorer than you came, you at least get a floorshow.

Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life After Work, was published at the beginning of January by Viking Canada.

About the author

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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