Bernie Madoff's Lesson About a Free Lunch
For anyone taking stock of 2008, Barack Obama is the inevitable choice as Person of the Year. But he's not the only American whose story suggests that this thrilling, dramatic, unforgettable year will be seen as a demarcation of grand historical eras, a bright line between yesterday and tomorrow. My choice for runner-up is Bernard Madoff.
In a sense, we're all Bernie Madoff. We've been running our economy in accordance with his accounting principles for a generation -- and now we face a most unpleasant reckoning.
As everyone knows by now, Madoff -- once one of the most respected financiers on Wall Street -- stands accused of being perhaps the biggest swindler in history. Before his arrest this month, he reportedly told his sons that he had defrauded investors of up to $50 billion. He allegedly followed the playbook written more than eight decades ago by the elegant grifter Charles Ponzi, who used money from new investors to pay juicy returns to old investors. That works fine for a while, but every Ponzi scheme eventually collapses in ruin.
Wall Street veterans recall how investors once begged to be allowed to invest their money with Madoff. Unlike Ponzi, he didn't promise to deliver flashy double-digit returns overnight. He "earned" his investors 1 percent or 2 percent a month, bull market or bear, rain or shine. Because he didn't overpromise, and because he limited his clientele, he was able to keep the scheme going for decades.
Such steady gains, unsullied by the occasional bad year or disastrous quarter, are patently impossible. Some potential investors took one look at Madoff's operation and took a pass. Some of the millionaires, billionaires and professional money managers who unwisely gave their money to Madoff were guilty of allowing greed to overwhelm their powers of observation and reason.
But not all of Madoff's investors could have been in the dark. Some must have realized how unlikely it was that he had found some sort of magical strategy or technique that would always make money, no matter what the financial markets were doing. Some investors, I would wager, must have calculated that they could get in, get their return and get out before the whole thing fell apart.
Which makes me wonder how many of us had our eyes open when housing prices were soaring in Ponzi-like leaps -- by 10 percent or more a year, in some parts of the country -- while middle-class incomes were largely stagnant. How many of us stopped to ask just who was supposed to be able to pay $1 million for a standard suburban split-level, even if it had an upgraded kitchen with a Sub-Zero fridge?
The whole subprime mortgage industry was based on the idea that housing prices would always rise. Given that assumption, it was perfectly rational for first-time homebuyers to sign up for adjustable-rate mortgages that they couldn't really afford. From the moment they signed the loan papers, they would be building equity -- through appreciation -- that soon would make it easy, and lucrative, to refinance or sell.
In other words: Get in, get their return and get out before the whole thing fell apart.
I'm not saying that average Americans were as culpable as Wall Street in creating this financial and economic crisis; our sins were venial, whereas theirs were mortal. Madoff's alleged fraud was at least straightforward. Much worse was the creation of exotic "derivative" investment products -- whose true value turned out to be impossible to ascertain -- that were bought and sold with enormous leverage. As long as real estate values kept rising, it didn't matter what these chimerical investments were worth. What mattered to Wall Street was the ability to collect enormous fees from real people, in real dollars, for trading unicorns and dragons.
After the bursting of the Internet and housing bubbles, I think we're done with bubbles for a while. Obama's first challenge -- and it may take much of his first term -- is to get the economy back into a pattern of tangible, sustainable growth. He will be able to thank Madoff for giving us the simplest possible explanation of what we knew all along but chose to ignore: that there's still no such thing as a free lunch.