On December 10, 2008, Bernie Madoff’s two sons told authorities their father was running a $65B Ponzi scheme for decades. Supposedly the sons and mother had no idea. Bernie’s scheme began to unravel after the financial crisis in 2008 catalyzed a series of fund redemptions, which ultimately forced Bernie to come clean to his family because he ran out of money. If you watched ABC’s “Madoff,” it does seem like only Bernie, his CFO, a dozen junior employees, and his compliance officer brother had an inkling of what was going on. On June 29, 2009, Bernie was sentenced to 150 years in prison for his crimes.
If the stock market kept going up in 2008, it’s highly unlikely Bernie would have ever gotten caught. He’d probably continue attracting new investment money to pay off old clients. As long as his investors were making money, nobody bothered to dig too deeply. Now that the stock market is violently unstable, up 2% one day and down 2% another, the fear of another massive Ponzi scheme has returned.
PONZI SCHEMES EVERYWHERE
Since the Bernie Madoff scandal, the SEC has supposedly shut down 600+ other Ponzi schemes. It makes you wonder how many terrorist attacks the FBI or CIA have shut down without us knowing either.
What’s alarming is that Harry Markopolos, the financial analyst who informed the SEC of the Bernie Madoff Ponzi scheme, believes he has uncovered three new large Ponzi schemes, one even larger than the $65 billion one Bernie ran.
Markopolos isn’t naming names yet, as he wants to give the SEC enough time and data to “fix and contain” the problem. But if there is indeed a Ponzi scheme greater than $65 billion, I can promise you that once investors find out, there will be a worldwide financial meltdown due to systemic risk.
Here’s what will happen:
1) Every single institutional and retail investor who finds out what the fraudulent fund owns will likely sell the fraudulent fund’s underlying positions because they believe everybody else holding these positions will also sell.
2) When selling gets too fierce, asset prices collapse. When such asset prices collapse, they bring down the valuation of all related companies/assets with it.
3) Funds that are highly leveraged will go out of business, not only because of losses in the portfolio, but also because of massive redemptions by limited partners. This in turn will cause more selling.
4) The front page of every media outlet will highlight the Ponzi scheme(s), the massive financial losses worldwide, and profile people who were directly affected by the Ponzi schemes. Fear will become pervasive. Everybody will freak out, sell equities, and go into cash or bonds until the dust settles.
5) Once the stock market collapses, real estate will also begin to follow. The correction will start with nonprime areas and secondary homes. Eventually prime areas will begin to also soften, making everybody along the wealth spectrum feel blue.
6) With banks at risk of going under because of a wave of nonperforming loans, banks start hoarding cash. To attract even more cash, they raise savings deposit interest rates further limiting the consumers desire to invest in the stock market when they’d rather get a guaranteed return.
7) Banks also raise borrowing costs and tighten up their lending standards. As a result, fewer people can get loans for housing, consumption, and business expenditures. The oil that runs our economic engine dries out and the GDP growth rate declines.
8) With the stock and real estate markets crashing, companies go into survival mode and drastically cut costs. This means there will be mass layoffs. Crime will increase, and so will public dissatisfaction with government.
9) The government will be forced to bailout homeowners and laid off workers with new housing and unemployment assistance programs. Taxes will go up for everyone, not just the very wealthy.
10) With confidence shot, family formations decrease, the population percentage of the aged increases, and a much larger financial challenge for younger generations comes to the forefront.
Let’s hope the SEC contains these new Ponzi schemes reported by Markopolos and nobody ever finds out. Black Swan events are very rare. Yet the dotcom bubble and housing market bubble happened within 10 years of each other. Perhaps we’ll witness another Black Swan event within the next three years.
What can we do to protect ourselves?
1) Deleverage out of equities. During a financial meltdown, leverage is what destroys people’s livelihoods because investors might often owe more than their initial principal investment. If you are unleveraged, the worst you can lose is 100%. You can end up owning money if you lose too much on leverage. The most important deleveraging action is to get out of all long margin stock market positions. Brokerages will force you to liquidate your positions or come up with new cash if a margined position falls below a certain threshold.
2) Do not pay down your mortgage. Unlike brokerage accounts, banks won’t force you to come up with more cash or sell your house if you continue to pay your mortgage on time. Although paying down your mortgage is technically deleveraging, you are increasing your insolvency risk by transferring liquid cash to an illiquid investment.
3) Save cash like a maniac. Cash is definitely king during a financial crisis. Not only will cash provide you a cushion to live, cash may also enable you to buy assets at fire sale prices. Without a strong cash buffer of at least six months worth of living expenses, you may be forced to sell your stocks and real estate at depressed prices.
4) Increase cash flow through multiple income streams. The more income streams you have, the more you will be able to weather the storm. Figure out a way to develop defensive income streams like CD interest income and product income from a book on severance package negotiations to help counteract the potential decline in job, dividend, and rental income. Rental income should be sticky on the way down, but it is still subject to decline if the local economy hollows out due to mass layoffs.
5) Cut expenses well ahead of the crisis. Learning to happily live on less is wonderful because it provides you the option to live off more if desired. Just remember back to the time when you had less money, or no money as a student. How awesome life still was! If you are making $100,000 a year but can comfortably live off $50,000 a year, you can withstand a 50% hit to your income and still maintain the same lifestyle.
6) Hedge with short positions or physical assets. There are a whole bunch of short ETFs that increase in value when the stock market declines. Some names include: DOG, SH, MYY, SBB, DXD, SDS, TWM, and MZZ. You can also buy physical assets such as gold that often increase in value during difficult times. Just remember that long term, the stock market goes up and to the right, therefore, short equity positions should be temporary hedges. If you are an accredited investor, you could invest money in a hedge fund whose main focus is to provide absolute returns in a good and bad market.
7) Review your asset allocation. For those who have at least 10 more years before retirement, having a 50/50 equities/fixed income asset allocation during difficult times will help you lose less as fixed income rises less than equities fall. If things feel like they are going to get really bad, you can continue to push the asset allocation more towards high grade fixed income if you wish. The key is protecting capital, not so much making a positive return.
8) Take advantage of cheaper costs During a recession, if you have the capital and cash flow, this is the best time to take a vacation and see the world. The opportunity cost of missing work / business is less, while travel and accommodation costs are much lower. You might even use this opportunity to take extra classes to increase your knowledge and improve your skills.
9) Start a business. Some of the most famous businesses today, like Uber and Tesla were started during the previous financial meltdown. Financial Samurai was also started in 2009. Perhaps by the time the economy starts to recover, your business will be able to ride the new upswing. At the very least, start your own website. Startup costs are practically nothing nowadays.
THE DUST WILL EVENTUALLY SETTLE
A crisis of confidence leads to a financial crisis. Nothing really works if we don’t trust the government or institutions with our hard earned money. Just make sure you have the cash and cash flow to make it through the storm. Almost everybody I know is much wealthier than they were since the 2008-2009 financial crisis. Probably everybody will be much wealthier 10 years from now as well.
I hope to goodness Markopolos is wrong or the SEC does a splendid job in unwinding the fraudulent fund’s positions quietly. If the stock market can regain its footing and move higher, a lot of these Ponzi schemes will survive. But just in case, I suggest everybody hunker down and prepare for the worst.
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Updated for 2020 and above. The downturn is coming!